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Redeemable preferred stock.

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 on 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.

FASB Proposes Now Treatment

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., which Table 1 presents as of December 31,1990. The order of presentation, and all amounts and account titles are exactly as reported by ECOLAB in its 1990 annual report.

[TABULAR DATA 1 OMITTED]

Notice that the Series A Redeemable Preferred Stock, $110,000,000, is listed as a separate item between liabilities and equity. It is not considered part of equity, nor is it grouped and totaled with liabilities. This treatment is in conformity with current SEC regulations.

Based on the amounts reported by ECOLAB, various summary figures were computed under three alternative assumptions: (1) with redeemable preferred stock treated as equity (this was the accepted treatment prior to ASR No. 268); (2) with redeemable preferred stock treated as neither a liability or equity (this is in conformity with current SEC regulations); and (3) with redeemable preferred stock treated as a liability (this is the proposed new treatment by the FASB). For each alternative assumption, summary amounts were computed for current assets, non-current assets, current liabilities, non-current liabilities, and total stockholders' equity. These summary amounts are presented in Table 2.

[TABULAR DATA 2 OMITTED]

When comparing treatment of redeemable preferred stock as equity, as opposed to a liability, total non-current liabilities increase from $239,035,000 to $349,035,000. This represents a 46 percent increase in non-current liabilities, due solely to the reclassification of the redeemable preferred stock. Likewise, total stockholder's equity falls from $452,587,000 to 342,587,000, a 24.3 percent decrease.

The impact on selected financial ratios is even potentially greater. Table 3 presents five commonly used financial ratios, each computed under the treatments of classifying redeemable preferred stock. The ratios computed were: total liabilities to total assets, total liabilities to total equity, long-term debt to current assets, long-term debt to total assets, and long-term debt to total equity.

[TABULAR DATA 3 OMITTED]

The debt/equity ratio (as measured by total liabilities to total equity) increases from 1.0460 to 1.7029, a 63 percent increase. And long-term debt to equity increases from.5281 to 1.0188, a 93 percent gain. Thus, any financial ratio calculated using liabilities or equity could be impacted significantly by the new proposed treatment of redeemable preferred stock. Table 3 gives an example of how this reclassification affects the financial ratios for ECOLAB, Inc.

Effect on Reported Not Income

In addition to having an impact on the balance sheet, reclassification of redeemable preferred stock could also have an effect on a company's reported net income. Although details of the specific treatment are still under consideration by the FASB, the discussion memorandum states that dividends on the redeemable preferred stock should be treated according to the underlying classification model.

Thus, if the preferred stock is considered (and classified) a liability, the dividends on that preferred stock should be considered similar to interest that is paid on other liabilities. This would essentially have dividends on the preferred stock treated as "interest expense" for purposes of computing company earnings. And, not only would earnings be affected, but any financial ratio based on earnings to evaluate company performance would be also.

At a Glance

Proposed rules by the Financial Accounting Standards Board would require classification of redeemable preferred stock as a liability on a company's balance sheet.

This would affect many of the ratios credit managers use every day to evaluate company performance.
COPYRIGHT 1992 National Association of Credit Management
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Wertheim, Paul
Publication:Business Credit
Date:Oct 1, 1992
Words:1108
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