Accounting for Stock Warrants

A stock warrant is a contract between a company and investors, which gives them the right to purchase newly issued shares of a stock at a set price for a set period of time. The company directly issues the new stock instead of using issued stock. However, investors that get a stock warrant do not have a legal right to the ownership of stock, but only a right to purchase it in the future. Similarly, for the company, a stock warrant does not lock in investors to buy the stock. They still have a choice of not exercising the right.

Since the warrant sets the price of the newly issued stock, it can be beneficial to the investors. Especially when the price of the company’s stock rises in the stock market, investors can profit from the lower price of stocks offered to them through warrants. Similarly, the market price of the stock of a company will not affect the price of the warrant, as the company issues the new stocks, and the price is preset.

There are many different types of stock warrants that companies may put into use. The two main types of stock warrants are put and call warrants. A put warrant limits the amount of equity that the investor can sell back to the company at a given price. A call warrant, on the other hand, guarantees the investor’s right to purchase a predetermined number of shares at a predetermined price. There are also other types of warrants such as covered, naked, traditional, and wedded warrants. These are classified based on the degree of risk and value of the warrant.

Accounting for Stock Warrants

When it comes to accounting for stock warrants, the company issuing them must ensure two things. First, the company must recognize the fair value of the equity instrument issued or the fair value of the consideration received, based on whichever is reliably measurable. Second, the company must recognize the asset or expense related to the goods or services at the same time.

If the option to exercise the stock warrant expires, the company cannot reverse the related expense or asset recognized. Furthermore, if a company receives warrants in exchange for products or services, it can recognize revenues normally, as they would under the accounting standard related to revenue.

Once the company determines the fair value of the stock warrant, the company can use the following accounting treatment to account for the transaction.

Dr Expense/Asset

Cr Stock warrants

When the investor exercises the option to avail the stock warrants, the company can use the following accounting treatment to convert the stock warrant balance into equity.

Dr Stock warrants

Cr Share capital

Cr Share premium

The value of the share capital and share premium will depend on the original fair value measurement of the company.

Valuation of Stock Warrants

A warrant can be valued using the binomial tree approach. Dilution needs to be taken into consideration. Basically, the valuation proceeds as follows,

  1. Build a tree for the underlying stock
  2. Calculate the warrant value at each end node of the tree.
  3. Move on to the previous time step and calculate the warrant value at each node on this time slice using the warrant values at the precedent nodes.
  4. After the warrant value is calculated at a node, check whether early exercise is allowed and optimal. The warrant price at this node is then the greater of this value and the payoff of the early exercise.
  5. Continue in this manner until the warrant is valued at all nodes of the tree.
  6. The value at the root node of the tree is the price of the warrant at the valuation date.

Conclusion

A stock warrant gives investors the right to purchase newly issued shares of a company at a set price within a set period of time. The accounting treatment of stock warrants requires the company to determine the fair value of the stock warrant at the date of measurement. When the investor exercises the right to buy shares, the company must convert the stock warrant’s balance to equity.

Post Source Here: Accounting for Stock Warrants

About Harbourfront Technologies

We are a boutique financial service firm specializing in quantitative analysis and risk management. We combine the power of traditional structured finance with modern high performance computing in order to deliver unique solutions to our customers. Our clients range from asset management firms to industrial, non-financial companies. Visit http://tech.harbourfronts.com to learn more about us.
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