Warrants

What is Warrants?

Corporations occasionally issue a special kind of equity security known as warrants. The holder of a warrant has the right to purchase a specified number of shares of stock at a stated price before an expiration date. Warrants, which are also known as stock rights and stock options, are often marketable and traded on exchanges.

Sources of Warrants

The value of the warrants comes from three sources.

First, the option price for the purchase of shares stated in the warrant may be less than the market value of the shares themselves. Thus, for example, if a warrant allows the holder to buy a share of stock worth $100 for only $70, then the warrant itself should be worth at least $30.

The second reason that the warrant has value is the potentially higher rate of return that can be earned from an increase in the value of the stock. In the above example, both the holder of a share of stock and the holder of a warrant enjoy a one dollar gain for each dollar increase in the value of the share. However, the shareholder has $100 invested while the warrant holder invests only $30.

The third reason that the warrant has value lies in the fact that it acts to limit the holder’s loss if the stock declines in value, That is, the warrant holder can lose no more than the value of the option while the stockholder potentially can lose the full value of the stock.

For these three reasons, the market value of traded options typically exceeds the discount below the stock’s market value represented by the option price. Indeed, when the option price is equal to or greater than the stock price, there is no discount, but the warrant would generally still have a market value because of the potential for earning a higher rate of return and the limit on the holder’s loss,

Reasons for issuing warrants

Three common reasons for issuing warrants are:

  1. To compensate employees—warrants arc given to employees in place of cash consideration.
  2. To provide a return to place of distributing cash or shares, the corporation may issue warrants to its stockholders as a dividend.
  3. To improve the marketability of other securities—warrants may be sold in conjunction with preferred stock or bonds in order to improve their marketability.

Once issued, warrants remain outstanding until they are exercised or lapse. they are outstanding, disclosures should be provided about their terms and other features

Journal entries

A journal entry is appropriate because the issuance of the warrant represents a sacrifice for the firm. Theoretically, the amount used in the entry should be the aggregate market value of the rights. If a reliable measure is not available, a rough estimate of market value can be made by deducting the option price from the stock’s fair value. If there is no market value for the option and the option price exceeds the stock’s market the accountant is led to conclude that no sacrifice has occurred and no entry would be recorded.

The account credited in the entry is a special stockholders’ equity account known as Warrants Outstanding. This item is a component of stockholders’ equity (even though it represents claims held by nonowners) because the claims arise through ownership rights. The account debited depends on the situation. If cash is received, then Cash should be debited. If services are received from employees, then Compensation Expense should be debited.

If services are to be received in the future, then Deferred Compensation Expense should be debited. If the warrants distributed to stockholders like a dividend, then Retained Earnings should be debited. On the day that the warrants are exercised (known as the exercise date), the should record the collection of cash and the closing of the Warrants Outstanding account. The total credit equals the sum of the cash received and the carrying value of the warrants. If the warrants lapse, their account is closed to Additional Paid-In-Capital.

For example, assume that the Sample Company issues warrant to its stockholders for 100,000 shares of its $20 par value common stock. The market value of the stock is $50 and the option price allows holder to buy a share for only $45. The warrants are soon sold separately for $8 each. This journal entry would be made to record the issuance of the warrants:

Warrant journal entry

When the warrants are exercised, this entry would be made (assuming that they are all exercised at the same time):

Warrant-journal-entry-1

The credits to the equity accounts are the same as those that would be made if the shares had been sold for $53 each ($45 cash plus $8 per warrant). If all the warrants lapse, this entry would be made:

Warrant-journal-entry-2

In the event that a stock split or dividend occurs while warrants are outstanding, the number of warrants and the option price per share are adjusted in proportion to the size of the split or dividend.

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