Allocating the transaction price, or: if it weren’t the warrant…

Here’s the background to another issue recently discussed by Canada’s IFRS Discussion Group:

  • Entities often issue securities that consist of a standalone equity instrument (e.g. share purchase warrant or a share) and a debt instrument (e.g. a note or debenture) that have been contractually linked as a unit solely for the purpose of offering them for sale to investors. The investor subscribes and pays a fixed price for these units. Upon purchase, the two instruments in the unit can be separated and transferred independently.
  • The Group is asked to consider specific examples of the following two units and discuss the initial measurement of these units from the issuer’s perspective: (a) Unit A: one share and one warrant that both meet the IAS 32 Financial Instruments: Presentation criteria to be classified as equity instruments, and (b) Unit B: one debenture and one warrant that meets the IAS 32 criteria to be classified as financial liabilities.

The Group discussed a scenario where Unit A is issued for CU100, but the sum of the individual fair values of the share and the warrant is CU105. It’s clear that only CU100 can be added to equity, but how should that be allocated between the two instruments? You might take the view that the more reliably measured component – presumably the share – should be valued first, with the warrant measured on a residual basis. Maybe it seems preferable to measure the amounts based on their relative standalone fair values. Or maybe it’s a pure matter of choice, including the choice of not separating the two components at all.

The group didn’t like that last idea, but otherwise thought different approaches would be acceptable, as long as they’re applied consistently (I personally prefer the methodology of valuing the share first, for the reasons described below, but when the issue is just one of reallocations within equity it’s not too big a deal). Unit B is perhaps a bit more challenging. The group again discussed a scenario where the individual fair values of the debenture and the derivative financial liability arising from the warrant is CU105, but total proceeds received are only CU100. IFRS 9 requires in such a case that when a financial instrument’s fair value at initial recognition differs from its transaction price, and the fair value isn’t evidenced by a quoted price in an active market, then the difference between the two is deferred, and subsequently recognized as a gain or loss “only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.”

For Unit B then, an approach which doesn’t involve measuring the warrant at its fair value would generate such a deferred amount, perhaps suggesting that the superior approach is to initially recognize the warrant at fair value, and to allocate the remainder to the debenture, to be recognized as part of the amortized cost calculation over time. This might be supported by analogy to the requirements for measuring embedded derivatives. Nevertheless, most group members supported the approach of allocating the transaction price on a reasonable non-residual basis, for example based on the instruments’ relative stand-alone fair value. The meeting report comments as follows:

  • Some Group members noted that it is uncommon in practice to have the sum of individual fair values of the debenture and warrants to exceed the transaction price (resulting in a “day 1” difference). Members encourage a careful review of the assumptions and unobservable inputs used to calculate the fair value of the components to the instrument to understand the cause of the difference.

This, surely, is really the key to the issue – any apparent excess of individual fair values over total transaction price is most likely to indicate a dubious and implausible fair value measurement. Especially when dealing with small companies, one often enters something of a fantasy zone in which a Black-Scholes or other model may insist that (say) a particular warrant has a fair value of CU5, even though the details of the negotiation of the bundled transaction under which it was issued doesn’t support that value, and everyone realistically knows that no one would pay such an amount to acquire such a stand-alone warrant. Many of us have encountered situations where the supposed fair value of the warrant seemed entirely disproportionate to that of the underlying shares.

The other part of the problem though is that, in the example above, the overall transaction value of CU105 may be a product of bargaining and intuition rather than of rigorous valuation techniques. This might be particularly the case where the instruments are being issued in return for non-monetary assets which also lack a clear basis of valuation (for purposes of the current discussion, it appears the group assumed they were issued for cash). In that situation, of course, the recoverability of the carrying value of those assets may become the more pressing issue…

The opinions expressed are solely those of the author

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