Because a warrant holder can receive issuer shares, the issuer usually classifies warrants as equity instruments and carries their value in the warrants paid-in capital account in the stockholders’ equity section of the balance sheet. Companies large and small can use warrants to raise capital.
Warrants as Equity
If the warrants are classified as liabilities, the issuer reports the deal as a debt issuance. Say the issuer pays a coupon of 10 percent on a three year bond that costs $1,000. Under the contingent liability method, or fair value approach, the issuer would recognize the obligation to pay the 10 percent coupon as a liability with the value of the debt recognized at $1,000.
If the issuer issued warrants instead of a bond, the issuer would also recognize the value of the warrants as $1,000 to the warrant liability account in the liabilities section of the balance sheet.
The more conservative approach is to classify the warrants as equity. An issuer can carry them at cost or at the fair value. For example, Apple initially classified its $250 million of warrants issued in 2007 as a liability when the going rate was around $500. The fair value was probably closer to $1 billion based on the current Apple price of $500. Because it did not expect to exercise these warrants, it did not want to set the fair value at $1 billion, which would have required an additional $1 billion of paid in capital. In addition, the warranty expense would be around $32 million a year, $16 million on the debt and $16 million on the preferred.
Both methods have their advantages and disadvantages, and both are acceptable depending on the facts and the issuer’s reporting style.
Effect on Earnings
If the issuer reports the transaction as a liability, the creditor has already made a pretax profit. The issuer can then use the gain as debt issuance costs or can use the gain to lower the effective cost of borrowing. For example, assume the issuer is selling a bond with a coupon rate of 10 percent.
If the issuer issues warrants, it will recognize the worth of the warrants to the warrant liability account in the liabilities section of the balance sheet. More than likely, the fair value of the warrants will much greater than the face value of the warrants.
This means the issuer collected more than the cost of the bonds. It also means the issuer has a pretax gain on the transaction.
Part of the gain, however, will offset or erase the gain by lowering the effective cost of borrowing. For example, assume the issuer’s cost of borrowing is 8 percent. The issuer will record the 6 percent difference in the amortization of debt discount account on the balance sheet. This reduces the issuer’s tax bill.
Issuing Warrants May Not Stabilize the Price
A prudent investor will look at the difference between the fair value of the bond and the issuer’s cost. For example, Foreign Affairs currently has a 10 percent coupon bond selling for $1,150. The fair value of the bond, though, is $1,000. The issuer is going to have to sell the bond for $1,000. In the meantime, the issuer is not going to get much, if any, interest on the $150 it gets for the bond. To investors, the price of the bond is $1,150.
If the issuer issues the bond as is, investors are going to view the deal as unhealthy. They will prefer to purchase the stock for $1,150, which they view as $1,000 worth of bonds.
The issuer wants to keep the price of the bond at $1,000 so it uses warrants to drive the stock price down between $1,000 and $150. This may or may not work, as it depends on how the market reacts.
Issuers may not always be able to find the price of the bond, especially overseas. They may try to estimate the price of the bond using the information they have available. The other option is to follow the contingent liability method to value the warrants. Say the issuer imitates a 10 percent bond and raises $1 million. For the sake of the example, assume the issuer issues the bond using a cashcarried interest feature, meaning the issuer gets the interest along the way. This avoids taking a fixed interest rate on the future value of $1 million, and allows the issuer to accept the proceeds now. The fair value of this bond is $1 million. The fair value of the warrants, though, may be $2 million.
If the issuer follows the contingent liability method, it records $2 million to the warrant liability account in the liabilities section of the balance sheet. It records $1 million to the debt liability account in the liabilities section of the balance sheet. This $1 million is the remainder of the bond value after deducting the test for the bond’s redemption value. It doesn’t matter if the fair value of the bond is $1 million or $2 million, the $1 million remainder is still the fair value of the bond.
A company can also record the contingent liability for a known bond because it is reasonable to assume a debt issuance. For example, a company borrows $1 million at 10 percent and uses some proceeds to pay a dividend. If the bond is currently trading at $1 million, the issuer would record the contingent liability for the $1 million bond at $1 million. If the proceeds were used to pay a dividend, though, the issuer would use the fact of the dividend to raise the value of the bond. This would make the contingent liability worth less.
Include an Equity Payoff
If a company issues a convertible bond, the company can use warrants attached to other securities attached to the convertible bond. This can all be recorded in one place.
A company can use warrants for equity issuance. For example, a company can issue $1 million of stock using warrants with a value of $1 million. Sometimes the company can issue shares at a very large premium, sometimes up to 50 percent, to compensate the warrant holders. The issuer can also issue warrants that are cash settled based on the future value of the shares. This often creates a synthetic bond.