EITF 07-05 Defining Indexed To A Company's Own Stock
Overview: Effective January 1, 2009, EITF 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to a Company's Own Stock, significantly affected the application of ASC 815 Derivatives and Hedging and ASC 815-40 (pre-Codification EITF 00-19) to both freestanding and embedded derivative financial instruments.
Upon its effectiveness, contracts (warrants, conversion features in debt, etc) that embody or embodied full-ratchet or reset provisions (that is, the strike, exercise or conversion prices adjust to pricing in subsequent sales or issuances) no longer meet the definition of Indexed to a Company's Own Stock and, accordingly, will not meet the exemptions for equity classification provided in ASC 815-15. Those instruments that were previously classified in equity will require reclassification to liabilities and ongoing measurement under ASC 815.
Since its effectiveness, we have identified a number of incorrect applications of ASC 815-40-25. The application of accounting principles is best applied under a systematic and rational architecture that provides for the proper analysis and consideration of all salient standards. We typically apply the AICPA’s Practice Aid Roadmap to Accounting for Embedded Derivatives for purposes of analyzing hybrid financial instruments. However, we’ve found that some companies apply the consensus directly to the financial instrument subject to review (such as a preferred stock) without reevaluating the contract, in its entirety, under the selected architecture. By not reevaluating hybrid contracts in their entirety, different and perhaps incorrect conclusions can result. For example, we note that companies have applied the consensus directly to convertible preferred stock without reconsideration as to whether the hybrid is more akin to a debt or an equity instrument, which is the first step in the process. Different conclusions on that point would likely lead the reviewer down different paths in the application of accounting standards, some with different and perhaps incorrect results.