A stock warrant gives the holder the right to buy a certain number of shares at a predetermined price within a specified period of time. Warrant-holders do not receive dividends or vote at annual general meetings until they convert their warrants to shares. Companies issue warrants to make bonds more attractive for investors or as compensation for employees and management.
Detachable vs. Non-Detachable Warrants
Companies may issue bonds with detachable warrants, which can trade separately, or non-detachable warrants, which are integrated with the bond package. Non-detachable warrants are recorded as a liability on the balance sheet. For detachable warrants, the proceeds are divided between debt and equity using the proportional or incremental methods.
Detachable Warrants: Proportional Method
The proportional method is used when both the bond and warrant components have readily available market values. The allocation for the warrants is to paid-in capital-warrants, which is a shareholders' equity account, and for the debt is to bonds payable and to discount or premium on bonds payable, which are liability accounts. The dollar values assigned to each account are based on the cash proceeds from the bond issue. For example, if a company issues $1 million par-value bonds at par and the market values are $125,000 for the detachable warrants and $900,000 for the bonds, then the total market value is $900,000 + $125,000 = $1.025 million. Therefore, the debt and equity allocations are about $878,000 [($900,000/$1.025 million) x $1 million] and $122,000 [($125,000/$1.025 million) x $1 million], respectively. The accounting entries are to debit cash by $1 million, debit discount on bonds payable by $122,000 ($1 million - $878,000), credit bonds payable by $1 million and credit paid-in capital-warrants by $122,000.
Detachable Warrants: Incremental Method
The incremental method is used if a market value is not available for the bonds or the warrants. In this method, the security with the available market value gets the allocation and the remainder goes to the other security. For example, if a company issues $1 million par-value bonds at par and the market price of the detachable warrants is $100,000, then the accounting entries are to debit cash and credit bonds payable by $1 million each, credit paid-in capital-warrants by $100,000 and debit discount on bonds payable by $100,000 ($1 million - $900,000).
The accounting for the exercise of warrants is to debit and zero out any paid-in capital-warrant balances, record the cash proceeds and adjust the common stock-par and paid-in capital-common stock accounts. For example, if investors redeem 1,000 warrants for $20 each in exchange for a $1 par-value common share, then the paid-in capital amount per share is $19 ($20 - $1). The accounting entries are to debit cash by $20,000 (1,000 x $20) and credit common stock-par by $1,000 (1,000 x $1). If the paid-in capital-warrant balance is $2,000 at the time of the exercise, the remaining accounting entries are to debit paid-in capital-warrant by $2,000 and credit paid-in capital-common stock by $21,000 [$2,000 + (1,000 x $19)].
Tips: Debits and Credits
Debits increase asset and expense accounts, and they decrease revenue, liability and shareholders' equity accounts. Credits decrease asset and expense accounts, and they increase revenue, liability and shareholders' equity accounts.