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7.4 Preferred stock recognition and measurement
Publication date: 31 Dec 2022
us Financing guide 7.4
Preferred stock should be recognized on its settlement date (i.e., the date the proceeds are received and the shares are issued) and is generally recorded at fair value. When preferred shares are sold in a bundled transaction with other instruments, such as warrants, the proceeds received should be allocated to the preferred stock and other instruments issued. How the proceeds are allocated depends on the accounting classification of the other instruments issued.
If the warrants are classified as equity, the proceeds should be allocated based on the relative fair values of the preferred stock instrument and the warrants. If the warrants are classified as a liability and recorded at fair value with changes in fair value recorded in the income statement, the proceeds should be allocated first to the warrants based on their fair value. The residual should be allocated to the preferred stock instrument. See FG 8.4.1 for more information on freestanding warrants issued in a bundled transaction with preferred stock.
In rare cases, the fair value of the freestanding liability-classified warrants may exceed the proceeds received in the bundled transaction. The guidance described in FG 5.4.5 related to the issuance of a hybrid instrument when the fair value of the embedded derivative liability required to be measured at fair value exceeds the net proceeds received should be applied by analogy to the bundled transaction. As a result, if the fair values are appropriate, the transaction was conducted on an arm’s length basis, and there are no rights or privileges that require separate accounting recognition as an asset, the difference between the fair value of the liability-classified warrants and the net proceeds received is recognized as a day one loss in earnings. See FG 5.4.5 for additional considerations related to the application of this guidance.
If preferred stock is sold using an escrow arrangement in which cash is deposited in an escrow account for the purchase of the shares, the issuer should determine who owns the escrow account in the event of the investor’s bankruptcy. If the investor’s creditors have access to the escrow cash in the event of its bankruptcy, the cash held in escrow should not be recorded on the issuer’s balance sheet, and if the preferred stock is not legally owned by the investors, the preferred stock should not be recorded until the escrowed cash is legally transferred to the issuer and the shares are delivered to the investor. In these circumstances, the issuer may need to analyze the arrangement as a contract to issue shares.
Preferred shares may be sold for future delivery through a forward sale contract. In a forward sale contract, the investor is obligated to buy (and the issuer is obligated to sell) a specified number of the issuer’s shares at a specified date and price. See FG 8.2.1 for information on forward sales of an issuer’s own equity securities.
7.4.1 Participation rights
One of the main disadvantages of preferred stock compared to common stock is its limited potential to benefit from increases in earnings. A participation right allows a preferred stockholder to receive additional income when dividends are paid to common shareholders.
If a preferred share host is determined to be more akin to equity than debt, a participation right is considered clearly and closely related to the host equity instrument. If the preferred stock host is more akin to debt, the participation right should be analyzed to determine if it should be separated and accounted for as a derivative under the guidance in ASC 815. See FG 5.4 for more information on analyzing an embedded equity linked component.
In addition, the inclusion of a participation right generally requires the issuer to include the instrument in earnings per share using the two-class method. See FSP 7.4.2 for information on participating securities and the two-class method of computing earnings per share.
7.4.2 Stock issuance costs
The accounting for stock issuance costs depends on how the shares are classified on the balance sheet. Figure FG 7-6 summarizes the accounting for stock issuance costs.
Figure FG 7-6
Accounting for stock issuance costs
Accounting for stock issuance costs
Classification |
Accounting for stock issuance costs |
Permanent equity |
Issuance costs are recorded as a reduction of the share balance/additional paid-in capital |
Mezzanine equity |
Issuance costs are recorded as a reduction of the share balance |
Liability |
Issuance costs are treated in the same manner as debt issuance costs. See FG 1.2.2 for a discussion of debt issuance costs |
We believe issuance costs related to shares classified as a liability that must be accounted for at fair value (with changes in fair value recorded in the income statement) should be immediately expensed. The same treatment would apply when the issuer has elected to apply the fair value option under ASC 825.
When state regulations prohibit charging stock issuance costs to the share balance or additional paid-in capital, they may be charged to retained earnings. See FG 1.2.2 for information on qualifying issuance costs.
Question FG 7-13
FG Corp has 120 shares outstanding owned equally by three investors. A new investor, Investor Corp, agrees to acquire 20 FG Corp shares from each of the existing investors. In connection with the transaction FG Corp agrees to reimburse the existing investors for the transaction costs related to the share sale.
How should FG Corp account for the transaction costs it pays on behalf of the existing shareholders?
FG Corp has 120 shares outstanding owned equally by three investors. A new investor, Investor Corp, agrees to acquire 20 FG Corp shares from each of the existing investors. In connection with the transaction FG Corp agrees to reimburse the existing investors for the transaction costs related to the share sale.
How should FG Corp account for the transaction costs it pays on behalf of the existing shareholders?
PwC response
FG Corp should carefully evaluate whether it is the counterparty to these purchase and sale transactions or if they would warrant any additional accounting. Assuming FG Corp is not required to account for the purchase and sale transactions, the sale of shares from the existing shareholders to Investor Corp does not raise capital and therefore it would be appropriate for FG Corp to expense the transaction costs it pays on behalf of the existing shareholders. However, when all shareholders participate in the sale transaction, it may also be appropriate to record the payment as a dividend, depending on the facts and circumstances of the transaction. See FG 7.7 for information on preferred stock dividends.
7.4.3 Subsequent measurement of preferred stock
The carrying amount of preferred stock may be recorded at a discount to its redemption price. The amount the issuer must pay to redeem a preferred share may be greater than the amount at which the preferred stock was initially recorded for the following reasons:
- The preferred stock is issued in a bundled transaction with other instruments (e.g., warrants); the proceeds received by the issuer are allocated to the preferred stock and the other instruments issued
- Stock issuance costs are recorded as a reduction of the preferred stock balance
- The redemption price includes cumulative dividends whether declared or undeclared
The accounting for a preferred stock discount depends on the classification of the preferred stock and the terms of the redemption provision. See the following sections for further information.
If accretion of a preferred stock discount is required, the accretion amount should be recorded as a deemed dividend, which adjusts retained earnings (or in the absence of retained earnings, additional paid-in capital) and earnings available to common shareholders in computing basic and diluted earnings per share. See FSP 7.3 for more information on computing basic and diluted earnings per share.
7.4.3.1 Liability classified preferred stock
ASC 480-10-35-3 provides guidance on the subsequent measurement of mandatorily redeemable instruments classified as liabilities.
Excerpt from ASC 480-10-35-3
…mandatorily redeemable financial instruments shall be measured subsequently in either of the following ways:
a. If both the amount to be paid and the settlement date are fixed, those instruments shall be measured subsequently at the present value of the amount to be paid at settlement, accruing interest cost using the rate implicit at inception.
b. If either the amount to be paid or the settlement date varies based on specified conditions, those instruments shall be measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount from the previous reporting date as interest cost.
See FG 1.2.3 for information on the amortization of debt discount, premium, and issuance costs.
7.4.3.2 Mezzanine classified preferred stock
The SEC has provided guidance on the subsequent measurement of mandatorily redeemable instruments classified as mezzanine equity. The guidance is codified in ASC 480-10-S99-3A
If an equity instrument subject to ASR 268 is currently redeemable (for example, at the option of the holder), it should be adjusted to its maximum redemption amount at the balance sheet date. If the maximum redemption amount is contingent on an index or other similar variable (for example, the fair value of the equity instrument at the redemption date or a measure based on historical EBITDA), the amount presented in temporary equity should be calculated based on the conditions that exist as of the balance sheet date (for example, the current fair value of the equity instrument or the most recent EBITDA measure). The redemption amount at each balance sheet date should also include amounts representing dividends not currently declared or paid but which will be payable under the redemption features or for which ultimate payment is not solely within the control of the registrant (for example, dividends that will be payable out of future earnings).
If an equity instrument subject to ASR 268 is not currently redeemable (for example, a contingency has not been met), subsequent adjustment of the amount presented in temporary equity is unnecessary if it is not probable that the instrument will become redeemable. If it is probable that the equity instrument will become redeemable (for example, when the redemption depends solely on the passage of time), the SEC staff will not object to either of the following measurement methods provided the method is applied consistently:
a. Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
b. Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
As stated in ASC 480-10-S99-3A14, a redemption amount based on a formula (e.g., a multiple of trailing twelve-month EBITDA) should be calculated using the applicable information as of the balance sheet date. In this example, the reporting entity would use the trailing twelve-month EBITDA as of the balance sheet date. A reporting entity should not, for example, project the future value of the relevant metric expected as of the date of the earliest redemption.
An issuer should consider the nature of an instrument’s redemption provisions when choosing the appropriate accretion method. We believe an issuer should use a method that most closely reflects the underlying economics of the instrument. For example, it may be appropriate for a preferred share redeemable at a fixed date for a fixed amount to be accreted using the method described in ASC 480-10-S99-3A15(a); however, a preferred share redeemable for a variable amount may be more appropriately measured using the method described in ASC 480-10-S99-3A15(b).
Question FG 7-14
Is preferred stock that is both redeemable on a specified date and automatically convertible in the event of an IPO considered probable of becoming redeemable?
Is preferred stock that is both redeemable on a specified date and automatically convertible in the event of an IPO considered probable of becoming redeemable?
PwC response
Maybe. We believe that the probability of the IPO occurring should be considered when determining whether the preferred stock is probable of becoming redeemable. Given the subjective nature of this determination, all relevant facts and circumstances should be considered.
If the preferred stock is redeemable at the option of the holder on a specified date and convertible at the option of the holder in the event of the IPO, it is inappropriate to consider the probability of the IPO occurring because the exercise of the option is controlled completely by the holder. In this case, the preferred stock should be considered probable of becoming redeemable.
Question FG 7-15
FG Corp issued preferred stock with a stated value of $1,000 on June 30, 20X1 that is convertible at the investor’s option into a variable number of FG common shares with a fair value equal to its redemption value at any time after June 30, 20X3. The redemption value is equal to stated value plus accrued but unpaid dividends of 5%. FG Corp has classified the preferred stock as mezzanine equity because there are settlement scenarios where FG Corp may not have sufficient authorized but unissued shares to satisfy this conversion, although those scenarios are remote of occurrence. Must FG Corp accrete the preferred stock to its redemption value pursuant to ASC 480-10-S99-3A15?
FG Corp issued preferred stock with a stated value of $1,000 on June 30, 20X1 that is convertible at the investor’s option into a variable number of FG common shares with a fair value equal to its redemption value at any time after June 30, 20X3. The redemption value is equal to stated value plus accrued but unpaid dividends of 5%. FG Corp has classified the preferred stock as mezzanine equity because there are settlement scenarios where FG Corp may not have sufficient authorized but unissued shares to satisfy this conversion, although those scenarios are remote of occurrence. Must FG Corp accrete the preferred stock to its redemption value pursuant to ASC 480-10-S99-3A15?
PwC response
We believe there are two acceptable views.
- View A
Once FG Corp has determined that the preferred stock is redeemable pursuant to ASC 480-10-S99-3A6, there are no contingencies to consider because the investor can force FG Corp to redeem merely through the passage of time. Therefore, FG Corp must accrete the preferred stock in accordance with ASC 480-10-S99-3A15. - View B
Although FG Corp believes there are scenarios where they must assume cash settlement, they believe potential cash settlement is contingent upon their stock price falling to a level that would require FG Corp to obtain shareholder approval to authorize additional shares. Since FG Corp believes that such an event (i.e., the stock price falling to such a level) is not probable, the preferred stock is not probable of becoming redeemable for cash or other assets, and therefore accretion to the redemption amount is not necessary.
Question FG 7-16
FG Corp issued preferred stock with a stated value of $1,000 on June 30, 20X1 that is convertible into FG common shares. Upon issuance, FG Corp determined that the conversion option must be bifurcated and accounted for separately as a derivative instrument pursuant to ASC 815-15-25. The preferred stock is redeemable at the option of the holder any time after June 30, 20x6. The redemption value is equal to stated value plus accrued but unpaid dividends of 5%. FG Corp has classified the preferred stock host as mezzanine equity in accordance with ASC 480-10-S99-3A. In accreting the preferred stock host to its redemption value, should FG Corp consider the liability-classified conversion option when determining the amount of accretion pursuant to ASC 480-10-S99-3A15.?
FG Corp issued preferred stock with a stated value of $1,000 on June 30, 20X1 that is convertible into FG common shares. Upon issuance, FG Corp determined that the conversion option must be bifurcated and accounted for separately as a derivative instrument pursuant to ASC 815-15-25. The preferred stock is redeemable at the option of the holder any time after June 30, 20x6. The redemption value is equal to stated value plus accrued but unpaid dividends of 5%. FG Corp has classified the preferred stock host as mezzanine equity in accordance with ASC 480-10-S99-3A. In accreting the preferred stock host to its redemption value, should FG Corp consider the liability-classified conversion option when determining the amount of accretion pursuant to ASC 480-10-S99-3A15.?
PwC response
Although there is no direct guidance that addresses the question, we believe that the recorded value of the separated conversion option should be considered when determining the amount of accretion pursuant to ASC 480-10-S99-3A15. This is because, in the event of redemption of the preferred stock, both the preferred stock host and the separated conversion option would be redeemed. In determining the appropriate amount of accretion, FG Corp would first measure the fair value of the separated conversion option, recording the changes in that fair value through earnings. Except as noted below, the period-end recorded value of the preferred stock host would then be determined by subtracting the fair value of the separated conversion from the redemption value of the preferred stock. The accretion amount is then determined by computing the period-end recorded value of the preferred stock host to the beginning-of-period recorded value. The preferred stock host would only be decreased to the extent of previous accretion.
Example FG 7-4 illustrates how to measure a mezzanine equity classified preferred stock instrument that is redeemable based on an index
EXAMPLE FG 7-4
Redeemable preferred stock based on an index
FG Corp issued preferred stock on 1/1/20X1 at a stated value of $1,000 that is redeemable at the option of the investor beginning on 1/1/20X6. Since the instrument is redeemable at the option of the investor, FG Corp has classified the preferred stock as mezzanine equity. The preferred stock is redeemable based on a multiple of five times trailing twelve-month EBITDA as of 1/1/20x6. FG Corp has concluded that the preferred stock is not within the scope of ASC 480-10-25-14 and that the redemption option does not need to be bifurcated from the preferred stock host.
At 12/31/20X3, five times trailing twelve-month EBITDA (based upon the trailing twelve-month EBITDA as of 12/31/20X3) yields a value of $1,200. However, based on FG Corp’s forecast of trailing twelve-month EBITDA, as of 1/1/20X6, the redemption value of the preferred stock would be $1,500. FG Corp has made a policy election to subsequently measure the preferred stock using the methodology described in ASC 480-10-S99-3A15b.
At what amount should FG Corp measure the preferred stock instrument at 12/31/20X3?
Analysis
FG Corp would measure the preferred stock instrument at $1,200 at 12/31/20X3 since this would be the redemption value using the conditions that exist as of the balance sheet date. ASC 480-10-S99-3A15b stipulates that, pursuant to this method, FG Corp should view the end of the reporting period as if it were also the redemption date of the instrument. As such, FG Corp would not use forecasted EBITDA to subsequently measure the instrument.
7.4.3.3 Mandatorily redeemable preferred stock of a subsidiary
If a subsidiary’s preferred stock is classified as a liability in the consolidated balance sheet (e.g., pursuant to the guidance in ASC 480), the dividends and any changes in the carrying amount of the liability should be recorded as interest expense in the consolidated income statement.
If a subsidiary’s preferred stock is classified as equity in the consolidated balance sheet, ASC 810-10-40-2 requires the parent to record the dividends as an allocation of net income to the noncontrolling interest. Accordingly, consolidated net income should not be reduced by dividends on the preferred stock, but net income attributable to the parent (which is the starting point for the earnings per share numerator) should be reduced by the amount of the dividend.
Example FG 7-5 illustrates the accounting for mandatorily redeemable preferred stock of a subsidiary.
EXAMPLE FG 7-5
Redeemable preferred stock of a subsidiary when the redemption is controlled by the issuer
Redeemable preferred stock of a subsidiary when the redemption is controlled by the issuer
FG Corp owns 100% of the outstanding common stock of Sub Co. Sub Co has 100,000 shares of noncumulative preferred stock issued and outstanding, which pays a stated annual dividend rate of 5%. The preferred stock is owned by unrelated parties and has a recorded value of $200,000. FG Corp analyzed the terms of Sub Co’s preferred stock and concluded that the shares should be accounted for as equity in FG Corp’s consolidated financial statements.
In the current year, Sub Co pays the stated annual dividend of $10,000 (5% × $200,000). At the end of the year, Sub Co redeemed its preferred stock for $225,000.
FG Corp has consolidated income before tax and noncontrolling interest of $100,000, and income tax expense of $35,000.
How should the Sub Co’s preferred stock dividend and redemption be presented in FG Corp’s consolidated income statement?
Analysis
Since the Sub Co preferred stock is classified as equity in the FG Corp consolidated financial statements, dividends should be recorded as income attributable to the noncontrolling interest. The total dividend amount during the period is $35,000; $10,000 of preferred stock dividends, and a $25,000 deemed dividend upon the redemption of the shares ($225,000 redemption amount less $200,000 carrying amount).
The dividend on Sub Co’s preferred stock would be included in FG Corp’s consolidated income statement as shown below.
Income before tax |
$100,000 |
Income tax expense |
(35,000) |
Consolidated net income |
65,000 |
Net income attributable to the noncontrolling interest |
(35,000) |
Net income attributable to parent |
$30,000 |
7.4.3.4 Contingently redeemable preferred stock
A discount to the redemption amount of contingently redeemable preferred stock should be amortized only once it is probable the stock will become redeemable. If it is not probable that the preferred stock will become redeemable (and as a result, any discount to the preferred stock carrying amount is not amortized), an issuer should disclose the reasons why it is not probable that the instrument will become redeemable at the reporting date.
Once the security is probable of becoming redeemable, the carrying amount of the preferred stock should be accreted to its redemption value. Contingently redeemable preferred stock that is redeemable only at the issuer’s option should not be adjusted (this assumes that the investor does not control the board of the company).
Figure FG 7-7 lists common redemption provisions and whether the preferred stock carrying amount should be adjusted.
Figure FG 7-7
Accounting for a discount to the redemption amount of preferred stock
Accounting for a discount to the redemption amount of preferred stock
Redemption provision |
Accounting for preferred stock discount |
Redeemable (puttable) at the investor’s option |
The issuer has a policy choice to either (1) adjust the carrying amount of the preferred stock to its redemption amount at each balance sheet date, or (2) recognize any discount over the period from issuance to the date the preferred stock can first be redeemed. However, the carrying amount should not be adjusted to an amount that is less than the initial carrying amount. For this reason, a premium to the redemption amount should not be amortized. |
Callable by the issuer |
The carrying amount of the preferred stock should not be adjusted (assuming the preferred stock investor does not control the board of the company). Any premium (or discount) to the redemption amount should be recognized as a dividend upon redemption. |
Redeemable (automatically or at the investor’s option) upon a change in control |
The carrying amount of the preferred stock should not be adjusted until it is probable that the redemption event (a change in control) will occur. Once the occurrence of the redemption event is probable, the issuer has a policy choice to either (1) adjust the carrying amount of the preferred stock to its redemption amount at each balance sheet date, or (2) recognize any discount over the period from the date the redemption event is probable of occurring to the date the preferred stock can first be redeemed (which is likely to be a short period of time). |
Redeemable (automatically or at the investor’s option) upon a delisting of the issuer’s common stock |
The preferred stock carrying amount should not be adjusted until it is probable that the redemption event (delisting) will occur. Once the occurrence of the redemption event is probable, the issuer has a policy choice to either (1) adjust the carrying amount of the preferred stock to its redemption amount at each balance sheet date, or (2) recognize any discount over the period from the date the redemption event is probable of occurring to the date the preferred stock can first be redeemed (which is likely to be a short period of time). |
A reduction in the carrying amount of preferred stock should be recorded only to the extent the issuer previously recorded increases in the carrying amount. The accreted value of preferred stock should not be adjusted below its initial carrying amount.
An issuer should also apply the guidance in Figure FG 7-7 to determine whether unpaid cumulative dividends included in the redemption amount of contingently redeemable preferred stock should be accreted. If cumulative undeclared dividends are included in the redemption price of preferred stock that is not being adjusted, then the dividends should not be recorded until they are declared. An issuer should determine how to reflect preferred stock dividends in earnings per share independent from its accounting for cumulative preferred stock dividends. In most cases, an issuer’s earnings per share computations should reflect undeclared dividends related to cumulative preferred stock. See FSP 7.4 for information on including preferred stock dividends in basic earnings per share.
If the carrying amount of a preferred share of stock is adjusted for amortization of a discount (or for accrued but unpaid dividends), the adjustment should be recorded as a deemed dividend, which reduces retained earnings (or in the absence of retained earnings, additional paid-in capital) and earnings available to common shareholders in computing basic and diluted earnings per share.
7.4.3.5 Perpetual preferred stock (no redemption)
Perpetual preferred stock is carried at the amount recorded at inception. There is no requirement to carry perpetual preferred stock at its liquidation value; therefore, any discount or premium to the redemption amount should not be amortized. Similarly, cumulative undeclared dividends included in the redemption price of perpetual preferred stock should not be recorded until they are declared.
An issuer should determine how to reflect preferred stock dividends in earnings per share independent from its accounting for cumulative preferred stock dividends. In most cases, an issuer’s earnings per share computations should reflect undeclared dividends related to cumulative preferred stock. See FSP 7.4 for information on including preferred stock dividends in basic earnings per share.
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