EITF 07-5 “Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock” - Accountinghowto.com - 8/23/08

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.