EITF 07-5 AND ANTI-DILUTION PROTECTED WARRANTS

WHAT IS THE PURPOSE OF EITF 07-5?
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 required for a scope exception under FAS 133 which would enable a derivative instrument to be accounted for under the accrual method.

WHAT FINANCIAL INSTRUMENT IS SUBJECT TO EITF 07-5? 
EITF 07-5 applies to any freestanding financial instrument (or embedded feature) that has all of the characteristics of a derivative under FAS 133, for purposes of determining whether that instrument (or embedded feature) qualifies for the scope exception under FAS 133.
 
WHAT IS THE EITF 07-5 APPROACH?
EITF 07-5 requires companies to apply a two-step approach, separately evaluating the instrument's contingent exercise provisions and then the instrument's settlement provisions: 

• 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.
• Step 2.  Evaluate the instrument’s settlement provisions.
  

HOW DOES EITF 07-5 AFFECT ANTI-DILUTION PROTECTED WARRANTS/OPTIONS?
Warrants/options with anti-dilution protection passes the first step, given that there is no exercise contingency, however the settlement amount is affected by the occurrence of certain at-market sales of common stock by the Company, which is not an input to the fair value of a fixed-for-fixed option on equity shares. Therefore these warrants/options do not pass step 2. 
The anti-dilution protected warrant would be classified as a liability, given that the warrant settlement amount cannot be considered to be based on the difference between the fair value of a fixed number of shares and a fixed monetary amount. Therefore the warrants are not considered indexed to the company’s own stock and a valuation is required under FAS 133.

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