 Hello and welcome to the session in which we'll discuss stock warrants. What is a stock warrant? Well, it's a certificate given to the holder, given that holder the right, the right to do what? If you have a stock certificate, you have the right to buy the stock. Well, what type of right is this? Because I can buy the stock anyway at a certain price. So they lock you at the price and they give you a specified period of time where at any point you can buy the stock at that price. So that's the privilege of it. It gives you that price. You can lock yourself in. For example, if they give you the price to buy it at 50, and now the stock price is at 80, you can buy it at 50. It's only for a limited period, but never the fact. It's an excellent privilege to have. Very similar to a stock option. If you don't know what a stock option is, don't worry. We're going to have a separate session about stock options. Why are they issued? Why do companies issue those stock warrant? Stock warrant are usually issued with other securities, like if the company wants to sell a bond and what they do to sweeten the deal, they will add to that bond a warrant. And that warrant will give you the option to buy the right, to buy the stock at a certain price. Sometime it's issued to compensate employees and managers. Just basically to compensate that employee will give you that stock right. Sometime it's giving to guarantee that preemptive right to exist in shareholders. So if you are a shareholder and you own 10% of the company, what they would say, they would say, we're going to give you stock rights equal to 10% of any new issuance. So this way, in case we have a new issuance, you have the right to buy those stocks and maintain your 10% ownership. Otherwise, you will lose that ownership if you don't exercise that stock warrant. It also planned the seed to raise money into the future. What's going to happen once you have a stock warrant to exercise them, you have to buy the stock while the company will raise money. Usually the stock warrant are given for five, usually five, but they could be up to 10 years. And simply put, they'll give you 10-year period at any point you can come in and buy the stock price. That's a lot of time. And the stock price could change substantially within 10 years. So the more time you have, the better off is the stock warrant. Well, when a stock warrant is issued with another security, and this is what we're going to be dealing with today. So they sell you a bond, then with that bond comes a warrant. And that warrant is detachable. Very important to understand what detachable is. It means if you bought this bond, a warrant came with it. But you can sell the warrant separately than the bond. So if you decided to, you'd say, I'm going to keep my bond. I want to sell my warrant. Well, that the warrant is detachable. If the warrant is not detachable, then you cannot sell it separately. Therefore, it's part of the bond. Therefore, it's not treated in any special way. It's part of the bond itself. Now, what's going to happen when we have a bond, a security, and a warrant? Then we're going to have to allocate the proceeds between the two securities, the bond and the warrant, using either the proportional method or the incremental method. Remember, if the warrant is non-detachable warrant, we allocate the whole proceeds to the bond. Simply put, we ignore the stock warrant. Now, the best way to illustrate this concept is to take a look at an example. Before we proceed, I would like to invite you to visit farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. So first, let's look at the proportional method. When do we use the proportional method? We use the proportional method when the fair value of both securities are known, the bond as well as the warrant. Let's take a look at an example. Farhatlectures wanted to raise 200,000 by issuing bonds. It means we want to sell bonds and we want to receive 200,000. In order to entice the creditors to invest, Farhatlectures decided to give one detachable warrant for each bond sold for its $1 par value stock. Simply put, the $200,000 bond represents 200 bonds because each bond has a face value of 1,000. We told the creditors that if you invest with us, if you buy one bond, we're going to give you one warrant that's going to allow you to purchase our stock. The value of the bond sold separately is 102. So the bond was sold at a premium and the value of the warrant sold separately is $70. So each warrant is worth $70. And we received in total $215,000. So we did not receive $200,000, we received more. Why? Two reasons. One, the bond was sold at a premium, most likely because we offered a higher rate than the market. Two, we added a warrant to the bond. Now let's see how we're going to allocate the $215,000. First, we said the bond sold separately is worth 102. So we'll take the $200,000 times the price of the bond will give us 204. The warrant sold separately, we have 200 warrants. Again, each bond is a warrant. We have 200 bonds times $70, that's $14,000. In total, the fair market value is 218. Now we find the proportion. The bond represent 204 out of 218. The bond value represent 93.58 of the market value of the deal. The warrants represent 6.42, which is 14,000 divided by 218,000. Simply put, we're going to allocate of the 215,093.58 of the bonds, which is 201,193. And for the warrant, 6.42, which represent 13,807. Let's look at the journal entry, the cash that we received for the bond, 201,193. The premium for the bond, the premium for the bond is 1,193. And the bonds payable always listed at face value, 200,000. Now you might be asking, didn't you tell us at the beginning that it's sold at 102, therefore the premium should be 2%? The reason the premium is 2% is because not because of the interest rate, because also of the warrant. People were willing to pay more to get the warrant. Now we have to account for the warrant separately. For the warrant, we received 13,807, that's debit cash, credit, paid in capital, stock warrant. Now this is an equity account. What we do is we record the stock warrant in the equity account, 13,807. Now obviously together, the 201,193 plus the 13,807 will give us the total amount of 215,000 we received from the proceeds. Now this is the journal entry that we prepared on the previous slide. Now let's assume the creditor exercise, 150 of the 200 warrant by buying the stock at $65. Now they're going to exercise the warrant. Well, 150 out of the 200 warrant is 75% of the warrant. Simply put, 75% of the warrant will need to be removed and turned into stocks. Well, let's see. If they paid $65 per share, we issued 150 shares, the company would receive 9,750. We need to debit, paid in capital, stock warrant. We need to debit this account 75% of its value. And 75% of its value is $10,355.25. Now we need to issue the stock. We're issuing 150 shares and the power value for each stock is $1, giving on the prior slide, that's a power value of $1. And the remainder is a plug which is paid in capital in excess of par and that's going to be the remainder which is $19,955.25. Now let's assume the remaining 50 stock warrant expired and exercised. In other words, we did not issue them. The creditors never bought the shares, never exercised the warrant, they never converted. So what's going to happen is this. We're going to debit the remainder. Remember, we had $13,807. We exercised of a $10,355.25 in here when they bought 150 shares. What remained is $2,897.75 in stock warrant. We are going to debit this account and credit an equity account called paid in capital expired stock warrant. Simply put, they're both equity. When equity went down, the other one went up. Simply put, we got the money and it's part of our equity. Now let's take a look at an example. Same example using the incremental method. Let's assume same thing. Farhad lectures wanted to raise $200,000 by issuing bond. In order to entice the creditor, we decided to give one detachable bond for each, one detachable warrant for each of our bond that has a $1 par value. We received in total $215,000. And all what we know is the warrants are worth $215,000 and all what we know, the warrants are worth $18,000. Well, and under those circumstances, we cannot use the proportional method because we don't know the fair value of the bonds. Well, if we know the fair value of the warrant, that's even easier. We received $215,000 of that amount, $18,000 goes to the warrant while the rest must be going to the bonds. We're going to debit cash, $197,000 for the bonds, credit bonds payable $200,000 and this bond sold at a discount of $3,000. That's for the bond. So now we recorded the bond. What's going to happen? We have to also record the warrant. We're going to debit cash, $18,000, credit paid in capital stock warrant, $18,000. And from here, you know what to do. Once the creditors exercise the warrant, we're going to have to go through the same journal entries that we went through here when they exercise the warrant. The same thing. The only difference is how we distribute this money initially between the bond and the warrant.