I am a little bit confused with the accounting treatment of bond with warrant. The proceeds from issuing a bond with warrant will be separated into fair value of the bond and fair value of the warrant, and separately recorded into liability and equity. Here are my questions: 1. If the bond was issued at fair value, then all proceeds from the issuance will go to liability and there would leave no money for the warrant part. Alternatively, if the bond was not issued according to fair value of the bond based solely on discounted future cash flow, then how will the price be decided on the bond + warrant combination and what’s the basis of the valuation? Auction? And in any case, which market interest value will be used to discount the cash flow - the prevailing market interest rate of similar bond, or some discount to the prevailing interest rate for conventional bond? And again, if there is discount, who and how will the discount be decided? 2. In subsequent financial statements, bond value will be calculated at the discounted future cash flow at report date using prevailing market interest rate for similar conventional bonds, is it correct? If there are difference in book value and market value, will the accounting standard require a mark-to-market? If it is required to mark to market, how will the difference be accounted for? As Gain/loss in income statement, or directly goes into equity? Level I book only discussed the secirities that the company holds, not the issuer side. 3. Whatever goes into equity, be it the initial proceeds allocated as equity value of the warrant, or subsequent accounting gain/loss from market value vs. book value (if it is accounted for), in which account will they get into? Additional paid in capital? Or OCI - unrealized gain/loss? Thanks if anyone can give me clear answer to these questions, best if you could also point me to some examples (e.g. example financial statement with clearly stated foot notes, etc. ) so that I could do further study. Of, if anyone tell me all those questions are not level I, then I will have a much sweeter sleep tonight Thanks a lot!
Big question with no time for a big answer, but I’ll start. The price of a security is determined by the underwriters who take on the risk (if you drive around NYC you can see the downside of all that risk in these huge glass towers built on pretty easy work). I think lots of your questions can be answered by a Google search on underwriting. Once the bond is issued, disregarding optionality, the accounting for the bond is pretty well fixed. You absolutely can’t issue bonds and then mark your short position to market by showing a gain when your credit rating goes to heck. The accounting I’ll leave for someone else or do it later.
OK got a minute maybe - I don’t know how much of this is LI material. For detachable warrants, the warrants and the bonds are accounted for separately. The only big issue is allocating the sale proceeds to the warrant and the bond. There are two methods for doing this, incremental and proportional. I suspect that if its part of the LI curriculum you would know about it by now. The proceeds from the warrant is paid-in capital, as you say. As for who gets to make these decisions, it’s just like any other accounting decision - someone gets the authority to make the call about whether or not the market value of the bonds and/or warrants is determinable and then it becomes a corporate decision. You need to be able to make a defensible decision, disclose it (hopefully), and investors can decide if it’s correct or not. One of the goals of the CFA process is that you should be able to look at some of those decisions that were made with goals consistent with pleasing shareholders and evaluate whether that gives a fair picture of the value of the company. If the company sold 100M worth of bonds+warrants but then recorded the value of the combined total as $120M, you should probably question that.
This is an earlier post (from Prior to the December exam) on Bonds with Warrants – which details the accounting treatment: A convertible bond with warrants is equivalent to a Bond issued at a discount. So if we consider an example with a 1000$ par bond, 10% bond with 10 warrants @ 3$ each … @ issuance this is equal to a 97 discount bond and the T-Accounts would look like DR Cash 1000 DR Bond Discount 30 CR Bond Payable 1000 CR Common Stock warrants 30 If the warrants can be converted to 1 common share each of 5$ Par value at 20$ At exercise —> DR Common Stock warrants 30 DR Cash 200 (20 * 10) CR Common Stock 50 ( 5*10) CR Additional paid-in Cap, 180 (Plug) Hope this helps DR = Debit, CR = Credit. Thanks and regards CP
Thanks a lot for the explanation. cp, I will search for the post you mentioned. Joey, you are right that I will need many back ground information. Actually I have no background in neither accounting nor finance.