Academic journal article Academy of Accounting and Financial Studies Journal

Classification of Financial Instruments with Characteristics of Both Debt and Equity: Evidence concerning Convertible Redeemable Preferred Stock

Academic journal article Academy of Accounting and Financial Studies Journal

Classification of Financial Instruments with Characteristics of Both Debt and Equity: Evidence concerning Convertible Redeemable Preferred Stock

Article excerpt

ABSTRACT

This study examines the market perception of a compound financial instrument, convertible redeemable preferred stock (CRPS). CRPS has the form of preferred stock, but also possesses a redemption feature and a conversion feature. Accounting for such instruments is the subject of a pending exposure draft by the Financial Accounting Standards Board. Current accounting rules for CRPS require that it be excluded from equity, but not classified as debt. A sample of firms reporting CRPS for fiscal years 1991 through 1995 is examined using a levels approach. The findings suggest that the market perceives CRPS as debt in two out of the five years under study. In the other three years the evidence is less convincing, raising the question as to whether current accounting rules classify CRPS according to how it is perceived by investors. The results would appear to support the FASB's decision to consider a new accounting standard for instruments with characteristics of both debt and equity. This study is timely and sheds light on an issue under deliberation by accounting standard setters.

INTRODUCTION

Compound financial instruments are securities that have characteristics of both debt and equity. This study addresses one type of compound financial instrument called convertible redeemable preferred stock (CRPS). Specifically, investor perception of CRPS is examined and based on the findings, implications are discussed in regard to accounting for CRPS.

CRPS is a type of preferred stock that contains a debt-like redemption feature requiring the issuer to pay the holder the par value for the preferred stock at a specified redemption date. The redemption feature is similar to the maturity value and date of a debt instrument. In addition, CRPS possesses a conversion feature that allows the holder the option to convert CRPS into common stock, similar to the conversion feature available on convertible debt instruments. In spite of the substance of CRPS, it has the form of "preferred stock" and is accounted for in the U.S. according to current accounting rules for redeemable stock. Examples of recent issuances of CRPS include a $15 million issuance by Frontline Communications Corporation and Mpower Communications Corporation's $207 million issuance, both in February 2000. In the United States (U.S.), redeemable preferred stock is currently accounted for as 'temporary equity'. According to the Securities and Exchange Commission's (SEC) Accounting Series Release No. 268, "Presentation in Financial Statements of Redeemable Preferred Stocks" (Securities and Exchange Commission 1979), redeemable preferred stock should be reported below debt but above stockholders' equity on the balance sheet. Since redeemable preferred stock is not considered debt, the distributions related to redeemable preferred stock are treated as dividends and are not reported on the income statement.

Research investigating CRPS is both timely and relevant. In the U.S., accounting for compound financial instruments, such as CRPS, is under deliberation by standard setters. A decade ago the Financial Accounting Standards Board (FASB), the U.S. body that issues accounting standards, issued a Discussion Memorandum entitled "Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both." It discussed alternatives from current reporting standards for compound financial instruments (FASB, 1990). In 1997 the FASB formally added redeemable preferred stock and convertible debt instruments to its active agenda (FASB 1997).

More recently, March 2000, the FASB announced its tentative decisions on how to approach accounting for compound instruments (FASB 2000). As it relates to CRPS, the FASB would classify it as a liability because, in the absence of the holder exercising a right to convert the security, the issuer is required to settle the obligation by transferring assets, e. …

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