EITF 00-19: Equity vs. Liability for Stock-Indexed Contracts

The Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) issued guidance, EITF 00-19, to address complexities in accounting for financial instruments indexed to a company’s own stock. This guidance established a framework for determining whether these instruments should be classified as equity or as assets or liabilities on the balance sheet. The primary objective was to create a consistent method for analyzing contracts whose value is tied to the company’s shares. The framework has since been integrated into the FASB Accounting Standards Codification (ASC), which now governs these accounting practices.

Scope of Applicability

The guidance established in EITF 00-19 applies to a range of freestanding financial instruments whose value is linked to a company’s own equity. A characteristic of these instruments is that they are legally separate and exercisable apart from other financial instruments or transactions. Common examples include warrants, which give the holder the right to purchase a company’s stock at a specified price, and written call options, which obligate the company to sell its stock at a predetermined price if the option is exercised.

Other instruments within this scope include purchased put options, which give the holder the right to sell stock back to the company, and convertible instruments, such as bonds or preferred stock that can be converted into common stock. The guidance focuses on how to classify these contracts at inception. The central question is whether the contract will be settled by an exchange of shares, qualifying it for equity treatment, or if it could require a cash payment, which would typically result in it being treated as a liability.

The “Indexed to Own Stock” Criterion

A foundational test for determining the accounting treatment of a financial instrument is whether it is “indexed to a company’s own stock.” This means that the settlement amount of the contract is determined by referencing the company’s stock price or value. To meet this condition, the variables that affect the settlement amount must be inputs into the pricing model for a fixed-for-fixed forward or option on equity shares. A standard warrant with a fixed exercise price and a fixed number of shares is an example of a contract that passes this test.

Conversely, if a contract’s settlement value is influenced by factors unrelated to the company’s own stock, it fails this test. A warrant whose exercise price adjusts based on changes in an external benchmark, such as the S&P 500 index, would not be considered indexed to the company’s own stock. The goal is to ensure that only instruments whose economic characteristics are genuinely tied to the performance of the company’s equity are eligible for potential equity classification.

The “Equity Classification” Criterion

Even if a financial instrument is indexed to a company’s own stock, it must meet a second criterion to be classified as equity. This test centers on the method of settlement and whether the company has the unconditional ability to settle the contract in its own shares. If a contract could, under any circumstances, require the company to make a net-cash payment, it generally must be classified as a liability.

A contract fails to meet the equity classification criterion if the counterparty has the right to demand cash settlement. For example, if a warrant holder can choose to receive cash equal to the warrant’s intrinsic value instead of shares, the company does not have the unilateral power to settle in equity. This forces liability classification.

One such condition that historically led to liability classification was a requirement to deliver registered shares if the company could not guarantee its ability to maintain a current registration. The logic was that potential legal or administrative hurdles in the registration process were not entirely within the company’s control, and a failure to deliver registered shares could trigger a cash settlement. This demonstrates the strict interpretation of control required for equity classification.

Accounting Consequences of Classification

The classification of a stock-indexed instrument as either equity or a liability has distinct accounting consequences. When an instrument meets both the “indexed to own stock” and “equity classification” criteria, it is recorded in the equity section of the balance sheet, typically as additional paid-in capital. A feature of this treatment is that the instrument is not subsequently remeasured at its fair value in future reporting periods. The initial value recorded in equity remains unchanged over the life of the instrument until it is settled.

In contrast, if an instrument fails either of the two primary criteria, it is classified as an asset or a liability. This classification requires the instrument to be accounted for under mark-to-market accounting. At each balance sheet date, the instrument must be remeasured to its current fair value. The resulting gains or losses from these fair value adjustments are recognized directly in the company’s income statement for the period.

This difference in accounting can have a substantial impact on a company’s reported earnings. Liability classification can introduce significant volatility to the income statement, as changes in the company’s stock price can lead to large, non-cash gains or losses on the instrument. For example, if a company’s stock price increases, the value of a warrant liability would also increase, resulting in a loss being reported in the earnings for that period.

Codification and Subsequent Developments

The principles originally established in EITF 00-19 were formally incorporated into the FASB’s Accounting Standards Codification, primarily under ASC 815-40, “Derivatives and Hedging—Contracts in Entity’s Own Equity.” This codification integrated the guidance into the authoritative GAAP, making it the central reference for accounting for contracts in a company’s own equity. The core tenets of the original EITF issue, including the two-step analysis of indexing and settlement, remained intact.

Over time, the FASB has continued to refine the accounting for these instruments. A significant development was the issuance of Accounting Standards Update (ASU) 2020-06. This update was intended to simplify the accounting for certain financial instruments, particularly convertible instruments, by reducing the number of conditions that could force liability classification.

ASU 2020-06 eliminated some of the more complex separation models that were previously required for convertible instruments. For example, it removed certain settlement conditions that were deemed to be remote from the analysis that would have previously required a contract to be classified as a liability. The update aimed to provide investors with more transparent and comparable information by making the accounting treatment more consistent with the economic substance of the instrument.