Magazine article Business Credit

Redeemable Preferred Stock: Proposed Changes Could Affect Key Ratios

Magazine article Business Credit

Redeemable Preferred Stock: Proposed Changes Could Affect Key Ratios

Article excerpt

Proposed changes in the financial statement classification of redeemable preferred stock could have a large impact on many ratios currently used in evaluating company performance. Credit managers who evaluate financial statement information should be aware of the new proposed changes, as well as the theoretical arguments underlying them.

Redeemable preferred stock is defined as any stock which: (1) the issuer undertakes to redeem at a fixed or determinable price a fixed or determinable date, (2) is redeemable at the option of the holder, or (3) has conditions for redemption which are not solely within the control of the issuer. The Securities and Exchange Commission (SEC) currently requires that the amount for redeemable preferred stock be listed as a separate item on a company's balance sheet; however, this amount should not be included in total shown for stockholder's equity.

Thus, current practice is to list redeemable preferred stock as an item between the liability and equity sections of a balance sheet. The SEC felt, in making this requirement, that redeemable preferred stock has characteristics significantly different from conventional equity securities, and that the related cash flow obligations should be distinguished from permanent capital. The SEC did not, however, go so far as to say that mandatorily redeemable preferred stock should be considered (and classified) as a liability.


The Financial Accounting Standards Board (FASB), in connection with its financial instruments project, is finally addressing the issue, as raised by the SEC, and is currently proposing new financial statement treatment for redeemable preferred stock. The FASB is proposing that redeemable preferred stock be classified as a liability for balance sheet reporting purposes.

Arguments supporting the classification of redeemable preferred stock as a liability include the following. First, the FASB defines a liability as having three essential characteristics: (1) it embodies a present duty that entails settlement by probable future transfer of assets at a specified or determinable date; (2) the duty obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice; and (3) the transaction obligating the entity has already happened.

By definition, "equity" does not carry an unconditional right to receive distributions of company assets--except in liquidation, and then only after all liabilities have been satisfied. Redeemable preferred stock, however, involves an obligation to redeem it at a specified price and time. Thus, there is a non-discretionary obligation to transfer company assets to the holder. This condition meets the second characteristic of a liability; the company has little or no discretion to avoid the future sacrifice of economic benefits. A second argument supporting the treatment of redeemable preferred stock as a liability is as follows. Under federal bankruptcy law, the holder of mandatorily redeemable preferred stock may be a member of the creditors' committee that petitions a court for involuntary bankruptcy or reorganization of a debtor to protect creditors' rights. Holders of redeemable preferred stock are not entitled to participate pro rata with unsecured creditors in a distribution of the remaining assets of a bankrupt corporation. However, they do essentially have the same legal rights as a creditor, as long as the issuer is solvent and qualifies to distribute assets to owners.

To see what type of an impact this might have, consider the balance sheet for ECOLAB, Inc. …

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