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7.10 Preferred stock extinguishment
Publication date: 31 Dec 2022
us Financing guide
When preferred stock is extinguished, the issuer should include the gain or loss on extinguishment in its net income attributable to common shareholders used to calculate earnings per share, as described in ASC 260-10-S99-2.
Excerpt from ASC 260-10-S99-2
If a registrant redeems its preferred stock, the SEC staff believes that the difference between (1) the fair value of the consideration transferred to the holders of the preferred stock and (2) the carrying amount of the preferred stock in the registrant’s balance sheet (net of issuance costs) should be subtracted from (or added to) net income to arrive at income available to common stockholders in the calculation of earnings per share. The SEC staff believes that the difference between the fair value of the consideration transferred to the holders of the preferred stock and the carrying amount of the preferred stock in the registrant’s balance sheet represents a return to (from) the preferred stockholder that should be treated in a manner similar to the treatment of dividends paid on preferred stock.
Although there is no guidance specifically on point, we believe direct costs associated with a preferred stock extinguishment (e.g., attorney fees) should be included when calculating the amount of consideration transferred.
If the fair value of the consideration transferred is greater than the carrying amount of the shares surrendered, (1) retained earnings should be reduced by the difference (or additional paid-in capital in the absence of retained earnings), and (2) earnings available to common shareholders should be reduced by the difference.
If the fair value of the consideration transferred is less than the carrying amount of the shares surrendered, the difference should be credited to retained earnings and added to earnings available to common shareholders.
7.10.1A Redemption of convertible preferred stock with a BCF—before adoption of ASU 2020-06
As discussed in ASC 260-10-S99-2, when a reporting entity redeems convertible preferred stock, it should allocate a portion of the redemption consideration to the reacquisition of the BCF; the remainder of the consideration is allocated to the redemption of the preferred stock. The amount of consideration allocated to reacquisition of the BCF should be equal to the intrinsic value previously recognized (i.e., the original intrinsic value). When the EITF reached this conclusion in its deliberation of EITF Issue 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, it acknowledged that this treatment is inconsistent with the approach applied to the redemption of convertible debt with a BCF. In that circumstance, the redemption consideration is allocated to the BCF based on its extinguishment date intrinsic value.
Example FG 7-5A illustrates how to account for the redemption of preferred stock with a BCF.
EXAMPLE FG 7-6A
Redemption of preferred stock with a BCF
Redemption of preferred stock with a BCF
FG Corp issues $1,000 of convertible perpetual preferred stock and 100 detachable warrants to purchase its common stock in exchange for $1,000 cash. The convertible preferred stock is convertible into 100 shares ($1,000 convertible preferred stock / 100 shares = $10 conversion price) immediately upon issuance. The warrants have a strike price of $10 per share.
FG Corp’s stock price on the date the instrument is issued, which is the commitment date, is $10 per share. The fair value of the warrants on that date is $300.
FG Corp concludes that the warrants should be classified as a liability. Since the warrants are classified as a liability, FG Corp first allocates the proceeds to the warrant based on its fair value ($300); the remaining proceeds ($700) are allocated to the convertible preferred stock. However, a BCF exists at inception as the conversion price ($7 per share) is less than the fair value of the shares the preferred stock is convertible into ($10 per share) and must also be recorded. A BCF is recorded in additional paid in capital for $300 resulting in the preferred stock carry value at issuance being recorded for $400.
One year after issuance, FG Corp redeems the convertible preferred stock for $1,200. The convertible preferred stock’s carrying amount is now $700 since the discount created by the BCF was immediately amortized as the preferred stock was convertible immediately.
How should FG Corp account for the redemption of its convertible preferred stock?
Analysis
The redemption of the convertible preferred stock based on allocated reacquisition proceeds of $900 ($1,200 cash paid - $300 original intrinsic value of the conversion feature) would be recorded with the following entry:
Dr. Convertible preferred stock |
$700 |
|
Dr. Retained earnings (loss) |
$200 |
|
Cr. Cash |
$900 |
FG Corp would then record the redemption of the BCF at its original intrinsic value of $300.
Dr. Additional paid-in capital (BCF) |
$300 |
|
Cr. Cash |
$300 |
The $200 charged to retained earnings upon redemption is in addition to the $300 charged to retained earnings when the BCF was recognized.
7.10.2 Extinguishment of a subsidiary’s preferred stock
The accounting for the redemption of a subsidiary’s preferred stock depends on its balance sheet classification, as discussed in ASC 810-10-40-2 and ASC 810-10-40-2A.
Excerpt from ASC 810-10-40-2
[If] the mandatorily redeemable preferred stock is not accounted for as a liability, then the entity’s acquisition of a subsidiary’s mandatorily redeemable preferred stock shall be accounted for as a capital stock transaction. Accordingly, the consolidated entity would not recognize in its income statement any gain or loss from the acquisition of the subsidiary’s preferred stock.
Excerpt from ASC 810-10-40-2A
If mandatorily redeemable preferred stock is accounted for as a liability, then any amounts paid or to be paid to holders of those contracts in excess of the initial measurement amount are reflected as interest cost and not as noncontrolling interest charge. Topic 860 specifies whether a liability has been extinguished and Subtopic 470-50 requires that the parent recognize a gain or loss upon extinguishment of the subsidiary’s liability for mandatorily redeemable preferred shares for any difference between the carrying amount and the redemption amount.
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