A reporting entity may issue multiple freestanding instruments in a bundled transaction. Typically, a debt or preferred equity instrument is issued with a share issuance contract, such as a warrant or variable share delivery agreement. A reporting entity may issue freestanding instruments together to meet its financing objectives, meet its investors’ objectives, or for tax purposes.
If a reporting entity issues a non-detachable equity derivative that is not deemed to be a freestanding instrument (see FG 5.3), such as a warrant, with a debt or preferred stock instrument (e.g., the debt or equity security must be surrendered or repaid in order to exercise the warrant), the combined instrument is substantially equivalent to convertible debt or convertible preferred stock. In that case, the reporting entity should account for the combined instrument using the guidance for convertible debt or convertible preferred stock. See FG 6 for information on accounting for convertible debt after the adoption of ASU 2020-06, FG 6A for information on accounting for convertible debt before the adoption of ASU 2020-06, and FG 7 for information on the accounting for convertible preferred stock.
When multiple investors invest in multiple classes of instruments (e.g., preferred stock, common stock, and warrant) in different quantities, the allocation of proceeds to each instrument should be performed at the investor level, not the class level.
Detachable warrants (or warrants that are deemed to be freestanding instruments (see FG 5.3)) issued in a bundled transaction with debt and equity offerings are accounted for separately. The allocation of the sales proceeds between the base instrument (i.e., the debt or equity instrument) and the warrants depends on the whether the warrants should be accounted for as equity or a liability. See FG 5.2 for information on the analysis of equity-linked instruments.
If the warrants are classified as equity, then the proceeds should be allocated based on the relative fair values of the base instrument and the warrants following the guidance in ASC 470, Debt.
Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) shall be allocated to the two elements based on the relative fair values of the debt instrument without the warrants and of the warrants themselves at time of issuance. The portion of the proceeds so allocated to the warrants shall be accounted for as paid-in capital. The remainder of the proceeds shall be allocated to the debt instrument portion of the transaction. This usually results in a discount (or, occasionally, a reduced premium), which shall be accounted for under Topic 835 [Interest].
Although this guidance is for debt instruments issued with warrants, preferred shares issued with equity-classified warrants should be accounted for in a similar manner.
If the warrants are classified as a liability and recorded at fair value with changes in fair value recorded in the income statement, then the proceeds are allocated first to the warrants based on their fair value (not relative fair value). The residual is allocated to the remaining debt and/or equity instruments. This approach avoids the possibility of recording a day one gain or loss on the warrant, which could arise if the allocation were made on a relative fair value basis.
The allocation of proceeds to the warrant, using either method, will typically create a discount in the associated debt or equity instrument, which should be recognized as interest expense or a dividend in some cases.
When a freestanding warrant is issued in a bundled transaction along with a debt instrument, and an embedded derivative must be bifurcated from the debt instrument, we believe that the allocation of proceeds should first be performed between the freestanding instruments (the warrant and the debt instrument). The proceeds allocated to the debt instrument should then be further allocated between the debt host contract and the bifurcated derivative based on the fair value of that derivative as prescribed by ASC 815-15-30-2.
In rare cases, the fair value of the liability-classified warrants may exceed the proceeds received in the bundled transaction. The guidance described in FG 5.4.5 related to the issuance of a hybrid instrument when the fair value of the embedded derivative liability required to be measured at fair value (e.g., bifurcated derivative) exceeds the net proceeds received should be applied by analogy to the bundled transaction. As a result, if the fair values are appropriate, the transaction was conducted on an arm’s length basis, and there are no rights or privileges that require separate accounting recognition, the difference between the fair value of the liability-classified warrants and the net proceeds received is recognized as a day-one loss in earnings. See FG 5.4.5 for additional considerations related to the application of the guidance.
Example FG 8-4 illustrates the model for allocating proceeds when equity-classified warrants are issued in connection with a debt instrument. Example FG 8-5 illustrates the model for allocating proceeds when liability-classified warrants are issued in connection with a debt instrument.
EXAMPLE FG 8-4FG Corp issues $1,000 of debt and 100 detachable warrants to purchase its common stock, in exchange for $1,000 in cash. FG Corp concludes that the warrants meet the requirements for equity classification.
Since the warrants are classified as equity, FG Corp allocates the proceeds from the issuance of the debt instrument and warrants based on their relative fair values.
The fair values and amounts allocated to the debt instrument and warrants are shown in the following table.