Arguments in favour of presenting redeemable preferred stock as a liability
According to SFAS 150, a mandatorily redeemable preferred stock should be reported as liabilities in the statement of financial position. This is unlike other types of preferred stock that are reported as equity in the stockholders’ equity section of the balance sheet. There are several arguments for the presentation of preferred stock as equity. Below is a discussion of why redeemable preferred stock should be presented as equity in the balance sheet.
Firstly, the definition of redeemable preferred stock shows that it is more of equity than debt. It is defined as preferred stock that allows the issuer to buy it back at an agreed or determinable price (Schroeder, Clark and Cathey). This implies that the redemption of these preferred stocks is at the option of the issuer. This is uncharacteristic of debt instruments. A debt instrument obligates the issuer to repay the amount borrowed. Once the agreed payment period has lapsed, the issuer must repay the debt and any other alterations must be approved by the creditor. Ione condition that debt must fulfil is that it should create an obligation whose settlement terms the issuer is out of control of. Since the redeemable preferred stock is bought back at the option of the issuer, it indicates that the issuer has control over the redemption and can decide to buy it back or not.
Redeemable preferred stocks do not create an obligation unless they have maturity dates upon which the issuer must redeem them (Schroeder, Clark and Cathey). If there is a maturity date, it becomes a mandatorily redeemable preferred stock and should be treated as debt. However, where there is no maturity date, the redeemable preferred stock should be treated as equity as it does not create any obligation to the issuer. The issuer may redeem the preferred stock when market conditions such as interest rates are favorable. In such cases, the issuer can reduce the cost by buying back the stocks and issuing new stocks with lower dividends.
Besides, the issuer of redeemable preferred stock pays fixed dividends to the holder just like other forms of equity (Schroeder, Clark and Cathey). The issuer does not pay interest as the case of debt securities. Dividends on redeemable preferred stocks are paid only when declared by the company although such dividends are cumulative. This implies that the company can decide not to pay dividends until when the company is profitable. Interest on debt is payable every period irrespective of the profitability of the firm. This indicates that there is a difference between redeemable preferred stock and debt. It exhibits similar features as other types of preferred stock hence, it should be presented as equity. The fact that the dividends are fixed and cumulative is not sufficient to treat it as debt.
One of the arguments advanced by proponents of treating redeemable preferred stock as debt is that it takes priority over common stock in dividends as well as the distribution of proceeds of liquidation of the company (Schroeder, Clark and Cathey). It is worth noting that bonds and other debt instruments have priority over all types of preferred stock. This indicates that redeemable preferred stock is not debt otherwise, debt instruments would not have any priority over it. Even non-redeemable preferred stock has priority over common stock in dividend payments. Therefore, there is no sufficient justification to treat redeemable preferred stock as debt and to present non-redeemable and other forms of preferred stock as equity.
Works cited
Schroeder, Richard G, Myrtle Clark, and Jack M Cathey. Financial Accounting Theory And Analysis: Text And Cases. 11th ed. Hoboken, NJ: John Wiley & Sons, 2013. Print.
