The evaluation of whether an instrument is indexed to the entity’s own stock is applicable to contracts and transactions that are linked to or settled in the company’s equity shares. In order for an equity-linked contract to avoid fair value accounting, it must be both indexed to the company’s stock (the subject of this post) and be eligible for equity classification.
The first test in determining whether an instrument is indexed to the entity’s own stock is to evaluate any exercise contingencies. Any exercise contingency, that is any condition that must be met or a trigger that must tripped in order for the holder exercise, is linked directly to the company’s stock (e.g., stock price, trading volume) or to an index that is directly related to the entity’s operations (e.g., sales revenue, EBITDA, net income) will pass this first test. Conversely, if any exercise contingency is linked to the stock of another company, a stock index (e.g., Fortune 500 index), an interest rate, a regulatory event or really anything else not associated with the company’s stock or its operations, will fail this test.
If the first test is failed, the instrument is automatically deemed not indexed to the entity’s own stock and fair value accounting must be applied. If, however, this first test is passed, the second test must be evaluated.
The second test for determining whether an instrument is indexed to the entity’s own stock looks at the settlement provisions; specifically, the settlement amount must be equal to the difference between the fair value of a fixed number of its shares and either a fixed monetary amount or a fixed amount of debt (ASC 815-40-15-7C and 7I).
In determining whether this criteria is met, the settlement amount must be evaluated based on all of its terms and conditions. If there are terms and/or conditions that are not normal inputs to the pricing of a fixed-for-fixed option or forward contract, then the contract or provision is not considered indexed to the company’s own stock. Thus, if the instrument’s has variables, terms and/or conditions other than those used as inputs to determine the fair value of a fixed-for-fixed option or forward contract or that increases the exposure to those used to determine the fair value of a fixed-for-fixed option or forward contract, then the contract or provision is not considered indexed to the company’s own stock.
This second criteria is covered in detail in our post, Evaluating the Settlement Provisions of a Contract in an Entity’s Own Stock.