As discussed in ASC 480-10-55-33, a warrant on redeemable shares (i.e., puttable or mandatorily redeemable shares) is a liability within the scope of ASC 480 because it creates a conditional obligation for the reporting entity to repurchase its shares for cash (or other assets).

The classification of the underlying shares issued upon exercise should not be considered to determine the classification of the warrants. The fact that the shares are puttable (which allows the holder to compel the reporting entity to redeem the shares) is the key fact in determining the warrant’s classification as a liability.

See FG 5.5 for further information on ASC 480.

A penny warrant is an instrument that requires the holder to pay little or no consideration to receive the shares upon exercise of the warrant. Since the shares underlying the warrant are issuable for little or no consideration (assuming $0.01 is non-substantive in relation to the current share price), they should be considered outstanding in the context of basic earnings per share, as discussed in ASC 260-10-45-13. See FSP 7 for information on including penny warrants in earnings per share.

Penny warrants often do not meet the definition of a derivative under ASC 815 because their fair value at issuance is essentially equal to the fair value of the shares underlying the warrant. As such, they have the characteristics of a prepaid forward sale of equity. A reporting entity should evaluate the penny warrants to determine whether the instrument is considered indexed to the entity’s own stock (see FG 5.6.2 (after adoption of ASU 2020-06) or FG 5.6.2A (before adoption of ASU 2020-06)) and evaluate whether the instrument meets the requirements for equity classification (see FG 5.6.3 (after adoption of ASU 2020-06) or FG 5.6.3A (before adoption of ASU 2020-06)). If the instrument contains a feature that may preclude the instrument from being considered indexed to the entity’s own stock, a reporting entity should also consider whether that feature is substantive in light of the $0.01 exercise price. If the feature results in an adjustment to the $0.01 exercise price, it may be considered nonsubstantive and thus would not preclude the instrument from being indexed to the entity’s own stock. We believe this is the case because if the $0.01 exercise price is nonsubstantive, then a fraction of the $0.01 exercise price must also be nonsubstantive. However, if the feature results in an adjustment to the number of shares underlying the contract, it is a substantive feature which should be analyzed under the guidance and may preclude the instrument from being considered indexed to the entity’s own stock. In addition, if the instrument does not meet the requirements for equity classification in ASC 815-40-25 (e.g., if there are not sufficient authorized but unissued shares to satisfy exercise), we believe that it is generally appropriate to account for the instrument as a liability.

Penny warrants may also be issued on redeemable preferred stock or redeemable common stock, which, similar to a penny warrant on non-redeemable common stock, is economically similar to holding the underlying shares (assuming that the $0.01 exercise price is non-substantive). However, although the penny warrant on redeemable shares is economically similar to owning the underlying shares, the penny warrant is not legally an outstanding share. As such, the penny warrant on redeemable common or redeemable preferred shares may be subject to ASC 480-10-55-33 (see FG 8.2.2.2) and generally should be recorded as a liability.

A reporting entity may issue a warrant that allows the holder to purchase shares of the reporting entity’s next issuance of preferred stock at the same price paid by other investors in that preferred stock. A warrant to participate in a future equity offering is typically issued to a debt or equity investor. The terms of the future issuance of preferred stock are generally unknown and subject to negotiation with potential investors. Absent a future preferred stock issuance, the warrant holder is not entitled to exercise the warrant for any other consideration.

At issuance, these warrants are generally not a liability within the scope of ASC 480 if it is within the reporting entity’s control to decide whether it will sell preferred stock or not. Further, since the terms of any future preferred stock issuance have not been determined, and when determined will generally be based upon market terms, reporting entities generally do not recognize these contracts until the terms of the underlying shares are determined.

See FG 7.6 for information on tranches of preferred stock.

The following guidance related to BCFs in warrants to acquire convertible shares will no longer be applicable upon a reporting entity’s adoption of ASU 2020-06 as the beneficial conversion feature model has been eliminated.

A beneficial conversion feature (BCF) is an embedded conversion option that is in the money at the commitment date. FG 7.3.2.2A provides a detailed discussion on BCFs; this section only discusses the accounting for BCFs in warrants to acquire convertible shares. See FG 7.3.2.2A for further information on the accounting for BCFs.

Whether a BCF in a warrant to acquire convertible shares should be recognized when the warrant is issued or when the warrant is exercised (and the convertible shares are issued), depends on the classification of the warrant itself.

The Emerging Issues Task Force considered whether a warrant to acquire convertible shares may have a BCF during its deliberations of EITF No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. Although this guidance was not finalized, we believe the EITF’s tentative conclusions may be applied in the absence of other guidance. The EITF tentatively concluded that, for warrants classified as a liability, a reporting entity should not assess whether there is a BCF until the warrant is exercised and the convertible shares are issued, provided the warrant can only be physically settled in shares. To determine the intrinsic value upon exercise, the EITF concluded that a reporting entity should compare the fair value of the reporting entity’s common stock (or other shares into which the security is convertible) on the exercise date with the effective conversion price. The effective conversion price should be calculated as the sum of the carrying amount of the warrant liability plus the exercise price of the warrant divided by the number of common shares the warrant holder receives if the conversion feature embedded in the convertible share is exercised.

Example FG 8-1A illustrates the application of this guidance to the recognition of a BCF in warrants classified as liabilities to purchase convertible preferred stock.

EXAMPLE FG 8-1A
Recognition of a BCF in warrants classified as liabilities

FG Corp issues 100 warrants that allow each holder to buy convertible preferred shares. The exercise price is $10 per warrant. Each convertible preferred share is convertible into 5 shares of FG Corp common stock, or 500 shares in total.

FG Corp determines that the warrants should be classified as a liability with a fair value of $1,000.

Two years after the warrants are issued, the warrant holder exercises the warrants and receives 100 shares of FG Corp convertible preferred stock. On that date, the fair value of FG Corp common stock is $25 and the carrying value (fair value) of the warrants is $13,000.

When and how should FG Corp determine whether there is a BCF in the warrants that holders can exercise to buy its convertible preferred stock?

Since the warrants are classified as a liability, FG Corp assesses whether there is a BCF to be recognized when the warrant is exercised, not when the warrant is issued.

Upon exercise of the warrants, FG Corp compares (1) the fair value of the common shares on the exercise date ($25) with (2) the effective conversion price of $28 and determines there is no BCF. The effective conversion price is calculated as follows:

($13,000 carrying amount of the warrant liability plus $1,000 exercise price of the warrant) ÷ 500 shares (the number of common shares received upon conversion of the convertible shares).

The EITF tentatively reached a different conclusion for warrants classified as equity that will be physically settled in shares. For those warrants, the EITF concluded that a reporting entity should assess whether there is a BCF on the date warrants are issued. This conclusion assumes the reporting entity receives fair value for the warrants (or for the warrants and any other instruments issued at the same time) upon issuance. If the reporting entity receives less than the fair value of the warrants, it should assess whether there is a BCF when the warrants are exercised and the convertible shares are received, similar to liability-classified warrants.

To determine the intrinsic value of an equity-classified warrant, the EITF concluded that a reporting entity should compare the fair value of the reporting entity’s common stock (or other shares into which the security is convertible) on the date the warrant is issued with the effective conversion price. The effective conversion price should be calculated as the sum of the proceeds received for (or amount allocated to) the warrant plus the exercise price of the warrant divided by the number of common shares the warrant holder receives if the conversion feature embedded in the convertible share is exercised.

If a reporting entity determines that a BCF should be recognized, it should be recorded as a deemed distribution to the warrant holder. The amount of the BCF cannot exceed the proceeds allocated to the warrant, and should be amortized over the life of the warrants. Upon exercise of the warrants, the unamortized BCF amount should be amortized from the exercise date of the warrant through the stated maturity date of the underlying convertible instrument. If the underlying convertible instrument does not have a stated maturity date, the remaining BCF should be amortized from the exercise date through the date the shares are first convertible.