EITF 07-05 and Non-Cash Adjustments

EITF 07-05 is effective for financial statements issued for fiscal years beginning after December 15, 2008.

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) will 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.

Many US-listed Chinese companies have already adopted EITF 07-05 to properly account for the value of their warrants. This resulted in non-cash adjustments to the income statements for all completed quarters of the current fiscal year and will also require such adjustments in future quarters, subject to, among other factors, changes in the Company's share price.

If the share price has appreciated in the quarter a non-cash loss will have to be recorded, if the share price dropped this will usually result in a non-cash gain. This is the main determining factor but not the only one. Now investors tend to react on GAAP bottom-line numbers that are affected by those non-cash adjustments, whether they mean anything for the company's business or not. Share price gains based on such non-cash gains are usually non-sustainable and vice-versa if a stock drops for a non-cash loss which is essentially based on the share price having appreciated in the past quarter then this move will usually be short-lived as long as the company's core business is healthy.

This can create trading opportunities. It might be advised not to hold a stock over an earnings release if a massive non-cash loss is expected to be recorded. Instead it might pay off to speculate on an initial dip after the numbers are out and to buy this dip. On the other side, a company that saw its share price drop over the past quarter might see a lot of buying interest when they record a non-cash gain that boosts GAAP EPS. Such a company is likely to make the bottom-line number stand out in the press release even if this non-cash gain is essentially a non-event for the business and performance of the company. It might be a profitable decision to buy the stock before earnings.

Much of a stock's reaction depends on how the company is communicating the EITF 07-05 related numbers. Most companies with non-cash charges will focus on non-GAAP numbers and report those charges only as a side note, if at all. Others will completely ignore the 'non-cash' effect of the loss (or gain) and communicate the plain numbers. It helps digging out past press releases to determine the company's reporting style.

I've made a basic table of 14 Chinese small caps that are affected by EITF 07-05. This table does not claim to be accurate - it is most likely not - but it should give an idea of what to expect for Q4 earnings which are due to be reported between mid-January and mid-February. The estimated non-cash adjustments in this table are based on share price only (which is not correct) and they do not factor in any other crucial elements as strike price of warrants or any possible developments in the fourth quarter like exercised warrants.