Recently, we've seen a number of startups and emerging companies use warrants to incentivize customers to enter transactions or agree to more favorable deal terms.
While warrants can offer many opportunities for companies and their customers, they also introduce a layer of complexity in accounting practices under the Generally Accepted Accounting Principles (GAAP).
In this article, we aim to demystify the accounting for warrants to customers, shed light on the common oversight regarding their accounting complexity, and explain some of the considerations needed in order to account for them correctly under GAAP.
Understanding Warrants to Customers
Warrants to customers are essentially financial instruments provided by companies to their customers as an incentive to enter into a revenue contract or included as part of a sales transaction. These warrants grant the customers the right (but not the obligation) to purchase the company's stock at a predetermined price within a specified timeframe.
Warrants are commonly used to "sweeten the deal," incentivizing customers to enter into strategic transactions or to drive increased transaction flow and provide a rebate of sorts to the customer earned as certain identified outcomes materialize. Since warrants do not typically entitle the warrant holder to dividends or voting rights, they're valuable to customers solely for their profit-earning potential from increases in stock price.
Warrants are similar to options, but options are typically issued to internal stakeholders, such as employees and directors. In contrast, warrants can be issued to investors, lenders, customers, and other third parties.
Companies that issue warrants typically issue warrant agreements to set out the essential terms of the warrant, such as:
- The exercise price or "strike price," which may be calculated based on a predetermined formula or on the future valuation of the company
- The number of underlying shares and the type of shares (common or preferred stock) the warrant holder has the right to acquire upon exercise
- Procedures and conditions for exercising the warrant, including the warrant's expiration or termination date
- Anti-dilution provisions intended to protect the warrant holder's right to receive the value negotiated when the warrant was issued
At first glance, they might seem like a straightforward customer perk, but the accounting treatment of these instruments can be anything but simple.
Accounting for Warrants to Customers
Many companies, especially those not deeply versed in the nuanced regulations of GAAP, or those used to issuing warrants to non-customers, might not realize the nuance and complexity involved in accounting for warrants to customers. This oversight can lead to accounting errors that impact financial statements and potentially lead to compliance issues. The crux of the complexity lies in the classification and valuation of these warrants, which requires a thorough understanding of the relevant accounting standards.
The accounting treatment of warrants to customers involves a nuanced application of two key accounting standards: Accounting Standards Codification (ASC) Topic 718, Compensation – Stock Compensation for classification and valuation of the warrants, and ASC Topic 606, Revenue from Contracts with Customers, for recording the transaction.
In accordance with ASC 606, consideration payable to a customer, which includes equity instruments, should generally be accounted for as a reduction of the transaction price (and, therefore, of revenue). However, if the payment to the customer is in exchange for a distinct good or service that the customer transfers to the entity, the entity should "account for the purchase of the good or service in the same way that it accounts for other purchases from suppliers." The guidance below assumes that the warrant is not for a good or service.
Classifying and Valuing under ASC 718
The first step in accounting for warrants to customers is to classify and value them under ASC 718.
A warrant instrument issued to a customer is equity-classified or liability-classified in accordance with ASC 718. A detailed analysis of the underlying shares included in the warrant must be performed in order to determine the proper classification. An equity-classified warrant is measured at grant-date fair value and is not subsequently remeasured at each reporting period. A liability-classified award is measured at its grant-date fair value and then remeasured each reporting period.
Assuming the share-based payment award is not in exchange for distinct goods or services to be provided by the customer to the company, the amount recorded as a reduction in the transaction price, as a payment to a customer, and should be measured at the grant date according to the fair value-based measurement approach in ASC 718.
Warrants issued to customers may contain:
- Vesting conditions—service or performance conditions that must be satisfied for the customer to vest in an award, or
- Conditions that affect factors other than the vesting of the award—market conditions, service or performance conditions that affect factors other than vesting or exercisability, or
- Other conditions that do not meet the definition of a service, performance, or market condition.
When the vesting is based on a service condition or performance condition as defined in ASC 718, the amount that ultimately is recorded as a reduction of revenue depends on the number of shares that actually vest according to those conditions. Both vesting and non-vesting conditions should be evaluated in light of ASC 718, which specifies that vesting conditions, unlike non-vesting conditions, are not directly factored into the fair value-based measure of the warrant. When vesting is based on a market condition, the existence of that condition affects the grant-date fair value of the award and not whether it is recorded.
As a result, the amount recognized as a payment to a customer through issuance of the warrant would:
- Reflect the actual outcome of any vesting condition, and
- Incorporate any non-vesting conditions in its measurement.
The entity must follow its existing accounting policy election to either estimate forfeitures or account for forfeitures when they occur.
Entities that receive distinct goods and services from a customer should account for the warrant similarly to other supplier purchases, i.e., by applying the guidance in ASC 718. Any excess of the fair value-based measure of the warrant over the fair value of the goods or services received should be reflected as a reduction in the transaction price and recognized according to the guidance in ASC 606.
Recording under ASC 606
Once classified and valued under ASC 718, the accounting for these warrants shifts under the purview of ASC 606.
ASC 606 provides guidance for payments made to a customer that are not in exchange for a good or service. These payments are presented as a reduction of the transaction price and, therefore, of revenue. The reduction of revenue should be recognized at the later of when (1) the company recognizes revenue for the transfer of the related goods or services to the customer or (2) the company pays or promises to pay the consideration (even if the payment is conditional on a future event).
Subsequent changes in measurement due to the form of the consideration should not be included in the transaction price (i.e., it should not be presented as an adjustment to revenue). However, ASC 606 does not specify where such changes should be reflected in the income statement. As a result, the company must use judgment to determine the appropriate presentation in such circumstances.
Navigate the Complexity of Accounting for Warrants to Customers with Expertise
The dual-standard approach required for accounting for warrants to customers under GAAP underscores the need for specialized knowledge and expertise in financial accounting standards. While ensuring accurate and compliant accounting, the interplay between ASC 718 and ASC 606 can pose significant challenges for businesses.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
