Warrants are often issued in conjunction with debt to help raise capital and are used to incentivize investors seeking potential upside on the value of the equity. A warrant grants the holder the right, but not the obligation, to purchase a company’s shares on or by a specific date at a specified price.

Accounting Models

Warrants are considered written call options that meet the definition of a derivative. The accounting for warrants can either fall under ASC 480, Distinguishing Liabilities from Equity (“ASC 480”) or ASC 815, Derivatives and Hedging (“ASC 815”). The recognition and measurement provisions under each model are different; therefore, it is critical to first determine the appropriate model to use. The following steps should be followed to determine the appropriate model:

1. Is the warrant within the scope of ASC 480?

The first step is to determine if the warrants are within the scope of ASC 480, which applies to freestanding financial instruments with characteristics of both liabilities and equity. To be within the scope of ASC 480, the instrument must embody either:

1. An obligation to buy back the issuer’s shares by transferring assets, or
2. Issue a variable number of shares for which the monetary value is predominantly fixed, varies with something other than the fair value of the issuer’s equity shares or varies inversely in relation to the issuer’s equity shares.

If either criteria is met, the warrant is within the scope of ASC 480, and the Company should record the warrant as a liability at fair value, with changes in fair value recorded in earnings each reporting period. If the warrant does not meet the criteria under ASC 480, the Company should proceed to the next step to determine the balance sheet classification under ASC 815.

2. Is the warrant indexed to the issuer’s own stock?

A warrant can be classified as either equity or liability (asset) under ASC 815. The warrant can only be classified in equity if it is (1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial position.

ASC 815-40 provides the following two criteria for evaluating whether an equity-linked financial instrument is considered indexed to its own stock:

1. Evaluate the instrument’s contingent exercise provisions, if any.
2. Evaluate the instrument’s settlement provisions.

Exercise contingencies would preclude an instrument from being considered indexed to an entity’s own stock if they are based on something other than the market for the issuer’s stock or an observable index other than an index measured by reference to the Company’s own operations.

For an instrument to be considered indexed to an entity’s own stock, the settlement amount needs to equal the difference between the fair value of a fixed number of the entity’s equity shares and a fixed monetary amount or a fixed amount of a debt instrument issued by the entity.

If one of the criteria is not met, an instrument is not considered indexed to the issuer’s stock. Instead, it should be classified as an asset or liability and remeasured at fair value through earnings.

If both criteria are met, the Company should continue to the next step to determine if the warrant meets all the conditions for equity classification.  

3. Does the warrant meet all the conditions for equity classification?

The equity classification guidance in ASC 815 contains detailed criteria for an equity-linked instrument to be classified in equity. Equity classification is heavily dependent on how the instrument settles and whether the settlement is entirely within the control of the Company. Generally, if net cash settlement is required for any event not within the Company’s control, the warrant should be classified as a liability or asset instead of equity. In addition, the Company must have the ability to settle the contract in its shares.

If all the conditions for equity classification are met, it is excluded from the derivative recognition and measurement provisions under ASC 815. The warrant should be classified as additional paid-in capital and measured at inception at either 1) fair value or 2) on a relative-fair value basis if issued with other financial instruments. Subsequently, there would be no remeasurement and the warrants would continue to be classified in equity.

If the conditions for equity classification are not met, the warrant should be accounted for as an asset or a liability. The initial and subsequent measurement should be at fair value, with changes in fair value recorded in earnings each reporting period.

Multiple Financial Instruments

Warrants are often issued in a bundled transaction with debt and equity and are required to be accounted for separately. The allocation of the proceeds between the host instrument (the debt or equity instrument) and the warrants depends on whether the warrants are accounted for as equity or liability.

If the warrants are equity-classified, the proceeds should be allocated based on the relative fair values of the host instrument and the warrants.

If the warrants are liability-classified, the proceeds should first be allocated to the warrants based on their fair value, with the residual allocated to the remaining host instrument (i.e., the debt or equity instrument). This prevents the possibility of recording an immediate gain or loss on the warrant, which could otherwise arise if the allocation were made on a relative fair value basis.

Accounting Upon Settlement

The accounting at settlement depends on whether the warrant is classified as equity or liability.

When an equity-classified warrant is exercised, the amount of cash received is based on the strike price of the warrant. The offset will be recorded in equity reflecting the share issuance.

When a liability-classified warrant is exercised, the warrant should be revalued to fair value through earnings immediately prior to settlement, and the new carrying amount should be transferred to equity.