EITF 07-5 “Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock”

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Linda Cavanaugh
CPA

By: Linda Cavanaugh, CPA I am catching up on my reading. Here is the next installment!!

EITF 07-5 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. It should be applied to outstanding instruments as of the beginning of the fiscal year in which it is adopted. Any adjustment would be recognized in the opening balance of retained earnings.

The objective of EITF 07-5 is to provide guidance for determining whether an equity-linked financial instrument is indexed to an entity’s own stock. This determination is needed for a scope exception under Paragraph 11(a) of FAS 133 which would enable a derivative instrument to be accounted for under the accrual method. For example a stock warrant is a derivative instrument, but if it is indexed to an entity’s own stock it is scoped out of FAS 133 accounting.

The classification of a non-derivative instrument that falls within the scope of EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” also hinges on whether the instrument is indexed to an entity’s own stock. A non-derivative instrument that is not indexed to an entity’s own stock can not be classified as equity and must be accounted for as a liability. For example a physically settled forward contract to issue an entity’s own stock in exchange for cash would not meet the net settlement criteria under FAS 133. If the price for the shares is linked to the S&P 500 index, the instrument would not be indexed to the entity’s own stock and would have to be accounted for as a liability.

This EITF does not apply to share-based awards under FAS 123R.

It does apply to any freestanding financial instrument, whether or not it is a derivative, which can potentially be settled in an entity’s own stock.

Under EITF 07-5, two steps should be followed to determine if an instrument is indexed to an entity’s own stock. If Step One does not preclude the instrument from being indexed to an entity’s own stock, then Step Two is performed to complete the determination.

Step 1. Evaluate the instrument’s contingent exercise provisions, if any, to see if the provision precludes the instrument from being indexed to the entity’s own stock.

Paragraph 14 of EITF 07-5 defines a contingent exercise provision as “a provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event.” These provisions could include the timing of the ability to exercise the instrument or provisions that extend the length of time the instrument is exercisable. If the strike price or number of shares is to be adjusted upon the occurrence of an exercise contingency, then the instrument is to be evaluated under the guidance of paragraph 13 of EITF 07-5.

The financial instrument being evaluated fails Step One if the exercise contingency is based on an observable market or an observable index (unless it is the market or index for the issuer’s stock). A market index such as the Dow Jones or S&P 500 would preclude the instrument from being indexed to an entity’s own stock. If the contingent exercise provision is based on sales revenue or net income of the issuer, it would not be precluded from being indexed to the entity’s own stock.

Step 2. Evaluate the instrument’s settlement provisions to determine if the instrument would be classified as equity or a liability.

Paragraph 15 of EITF 07-5 states “an instrument (or embedded feature) would be considered indexed to an entity’s own stock if its settlement amount will equal the difference between the fair value of a fixed number of the entity’s shares and a fixed monetary amount or fixed amount of a debt instrument issued by the entity.” In other words, the changes in the settlement amount should mirror the changes in the fair value of the entity’s stock (they should be correlated). The strike price or the number of shares would not have to be fixed to be considered indexed to an entity’s own stock.

An instrument would not be considered indexed to an entity’s own stock if the variables that could affect the settlement amount were not inputs to the fair value of a fixed-for-fixed forward or option on equity shares. These variables could include the entity’s stock price, the strike price, the term, expected dividends, or interest rates. In other words, the changes in the settlement amount and the changes in the fair value of the company’s stock are not the same (i.e. they are not correlated). For example if the amount of cash received upon the exercise of the instrument is denominated in a currency different than the entity’s or the settlement amount depends on a new drug being approved by the FDA, the variables that determine the settlement amount are not inputs to the fair value of a fixed-for-fixed forward or option contract and the instrument would not be considered indexed to the entity’s own stock.

If a previously bifurcated embedded conversion option in a convertible debt instrument, no longer meets the criteria for bifurcation under FAS 133 after the adoption of this EITF, the amount of the liability already recorded should be reclassified to equity. Any debt discount associated with the instrument should continue to be amortized.

The EITF has several examples to help you determine if the instruments are indexed to the entity’s own stock. Good luck and have fun.

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