Any insight into the proper accounting treatment for detachable warrants
The accounting treatment for detachable warrants is a complicated area. Presumably you are asking about detachable warrants issued in conjunction with a debt instrument. The first step is to allocate the proceeds to the debt instrument and the warrants, based on their relative fair values (ASC 470-20-30-2). Next you will need to determine whether the warrants are classified as equity or liabilities. There is a good discussion of this process in the SEC Staff's Current Issues and Rulemaking Projects - copied below:
1. Freestanding Instruments - Warrants
Since warrants are freestanding instruments, the warrants should be analyzed to determine whether they meet the definition of a derivative under SFAS 133 (paragraphs 6 -9 ), and if so, whether they meet the scope exception in paragraph 11 of SFAS 133. If the warrant does not meet the definition of a derivative under SFAS 133, it must be evaluated under EITF 00-19 to determine whether the instrument should be accounted for as a liability or as equity. In order to determine that equity classification of the contract is appropriate, all of the criteria for equity classification in paragraphs 7-32 of EITF 00-19 must be met. These criteria relate to contract terms, not the likelihood of any particular term being triggered. Failure to meet any of these criteria results in classification of the contract as a liability.
While all of the criteria in paragraphs 7-32 should be analyzed, the most common reasons for a conclusion to account for warrants as liabilities are:
1. the warrants could be required to be settled in cash if certain events occurred, such as delisting from the registrant’s primary stock exchange or in the event of a change of control; and
2. the registrant elected an accounting policy for the registration rights agreement that considered the registration rights agreement and the warrant together as a unit and the registration rights agreement could require significant liquidated damages be paid to the holder of the instrument in the event the issuer fails to register the underlying shares under a preset timeframe, or in some cases, where the issuer fails to maintain an effective registration statement with a current prospectus for a preset time period. The liquidated damages usually are expressed as a percentage of the original amount invested by the holder and may or may not be capped at a certain maximum percentage.
In June 2005, the EITF began deliberating the effect of a liquidated damages clause on a freestanding financial instruments, such as warrants. The preliminary deliberations resulted in 4 alternative views (see the deliberations of EITF Issue 05-4 ). In September 2005, the FASB staff postponed further deliberations by the EITF until the FASB could address whether a separate registration rights agreement is a derivative under FASB SFAS 133. On October 20, 2006, the FASB issued a proposed FSP, No. EITF 00-19-b Accounting for Registration Payment Arrangements (see http://www.fasb.org/fasb_staff_positions/prop_fsp_eitf00-19-b.pdf). The proposed FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5, Accounting for Contingencies . The comment period on the proposed FSP ends December 4, 2006. Until the final FSP is issued and adopted, registrants should continue to use their existing accounting policy consistently among all of their contracts, along with clear disclosure regarding the policy selected. Upon the issuance of the anticipated FSP, which for calendar year companies is expected to go into effect beginning with the first quarter of 2007, registrants should apply the transition guidance in the FSP.
As previously mentioned, in analyzing instruments under EITF 00-19, the probability of the event occurring is not a factor. For example, certain warrants can only be settled in cash if the registrant’s stock is delisted from its primary stock exchange. Even if delisting is not considered probable of ever occurring, the warrants would still be classified as a liability under the EITF 00-19 analysis. Similarly, the likelihood that a change in control could occur is not a factor.
I agree that the accounting treatment for detachable warrants is a very complicated area and I would suggest that Jim's answer may not address all of the complexities. I have written numerous white papers for clients related to specific warrant instruments and can say that the terms of the warrant will dictate the accounting and that seldom are warrants attached to different instruments identical.
You say that the warrants are detachable, but the accounting treatment will differ depending on whether they are attached to a debt or equity instrument.
In addition, you will first need to consider if the warrants are mandatorily redeemable. The original pronouncement on this is SFAS 150, which you should cross reference to the ASC.
If the warrants are not within the scope of SFAS 150, you would proceed with the analysis under SFAS 133 as indicated above. At the same time, it may be also be necessary to consider the treatment of the conversion feature, if any, of the host debt or equity instrument.
In addition to the EITF references in Jim's answer, you may also need to consider the ASC cross references from EITFs 07-5 (indexing to an Entity's Own Stock), 98-5 (Convertible Securities with Beneficial Conversion Features), and 00-27 (Application of Issue 98-5 to Certain Convertible Instruments).
If you determine that the warrant is a derivative instrument, you will also need to look at the ASC cross reference to DIG Issue B-6 for valuation allocation.
And, if yours is a public company, you should also look at ASR 268 to see if you can find an exception.
I also agree that the most common problem with accounting for warrants (attached or not) is a cash settlement clause at the option of the holder. I have seen these clauses most frequently buried in the instrument in conjunction with a change of control and generally they are clauses that apply only to the warrant holder and not to the other holders of equity instruments. My best advice to clients when I see these clauses (assuming that the issuance transaction has not been completed) is to get rid of the clause. The removal is seldom a "deal breaker" and will avoid the headache of derivative accounting for the warrant until such time as it is exercised or has expired.
Otherwise, to be clear, I agree with the comments that Jim has presented.
Can anyone give me an example on how to record the detachable warrants as the "investor" on issuance date? For example, DR: Bond Receivable, DR: Discount on Bond, CR: Cash, but do you record anything for the fair value of the warrants?
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