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There is no specific guidance on whether a modification to, or exchange of, preferred stock should be accounted for as a modification or an extinguishment. Many preferred stock modifications do not involve changes in cash flows, but may result in a significant change to the fair value of the security, such as a change in the liquidation preference order/priority, voting rights, or conversion ratio. As such, the accounting for preferred stock modifications depends on the facts and circumstances of each transaction, including the nature of, and reasons for, the modification.

7.8.1 Determining the accounting for a modification

When an issuer changes the terms of its preferred stock or exchanges shares of preferred stock for another, it must assess whether the changes or exchange should be accounted for as either a modification or an extinguishment. This assessment can be done either qualitatively or quantitatively. A qualitative assessment is generally appropriate when the changes to a preferred stock instrument are either so inconsequential or so significant that an issuer can easily determine how a change to or exchange of shares should be accounted for without performing a quantitative test. For example, administrative changes to a preferred stock would likely be accounted for as a modification; a modification of preferred stock to include a substantive conversion option would generally be accounted for as an extinguishment of the original preferred stock and issuance of new preferred stock. When preferred stock is modified in a manner that cannot be reliably assessed qualitatively, an issuer should perform a quantitative test to determine whether the modification or exchange should be accounted for as a modification or an extinguishment.
When preferred stock has well-defined periodic contractual cash flows, an issuer may apply the cash flow model used to assess debt modifications in ASC 470-50, Debt – Modifications and Extinguishments, to determine whether a modification or exchange of preferred stock should be accounted for as a modification or extinguishment. Under that model, an issuer would compare the present value of the contractual cash flows (calculated using the effective interest rate of the original instrument) before and after a modification or exchange. If the present value of the contractual cash flows is 10% or more, the modification or exchange is accounted for as an extinguishment; if the present value of the contractual cash flows differs by less than 10%, the modification or exchange is accounted for as a modification. See FG 3.4 for further information on the cash flow model in ASC 470-50.
If preferred stock has characteristics that cannot be reliably assessed using the cash flow model in ASC 470-50, it should be evaluated using another quantitative model, such as the fair value model. Under the fair value model, an issuer would compare the fair value of the preferred stock immediately before and after the modification or exchange. If the fair value before and after the modification or exchange are substantially different, the modification or exchange should be accounted for as an extinguishment; if the fair value before and after the modification or exchange are not substantially different, it should be accounted for as a modification. In practice, “substantially different” has typically been interpreted to be a 10% or more change in fair value.
Question FG 7-15 discusses whether the redemption of existing preferred stock and issuance of new preferred stock to the same investors should automatically be accounted for as an extinguishment.
Question FG 7-15
If an issuer redeems existing preferred stock and issues new preferred stock to the same investors (e.g., exchanges Series A preferred stock for Series B preferred stock), should it be automatically accounted for as an extinguishment?
PwC response
No. The legal extinguishment of existing preferred stock that is replaced with new preferred stock does not automatically result in extinguishment accounting. An issuer should assess, using one of the methods described in this section, whether the exchange should be accounted for as a modification or an extinguishment.

7.8.2 Accounting for a preferred stock modification

If the assessment results in an extinguishment, then the difference between the consideration paid (i.e., the fair value of the new or modified preferred stock) and the carrying value of the original preferred stock should be recognized as a reduction of, or increase to, retained earnings as a deemed dividend. It should also be recognized as an adjustment to earnings available to common shareholders for purposes of calculating earnings per share. See FG 7.10 for information on the extinguishment of preferred stock.
If an issuer determines that an exchange or modification of preferred stock should be accounted for as a modification, it should then evaluate whether the original preferred shareholders paid or received a dividend through the new (or modified) terms. The issuer should measure any transfer of value between preferred shareholders and common shareholders by analogizing to the guidance for stock-based compensation arrangements classified as equity in ASC 718-20-35-3 as the difference between the fair value of the preferred stock before and after the modification or exchange, measured on the modification or exchange date. Transfers of value should be recorded as a reduction of, or increase to, retained earnings as a deemed dividend. In addition, it should also be recognized as an adjustment to earnings available to common shareholders for purposes of calculating earnings per share. It is important to understand the objective and purpose of the modification when determining the appropriate accounting as other accounting literature may be applicable.
Some modifications of preferred stock may occur in connection with the issuance of new preferred stock. For example, when outstanding preferred stock is modified concurrent with the sale of new preferred stock, the modification may reflect concessions made by existing preferred stockholders regarding their rights in order to attract the new capital. The new preferred stockholders may insist on such concessions as a condition of their investment to avoid immediate dilution of their investment upon closing. An evaluation of fair value of the existing securities before and after the modification may indicate that a transfer of value from the existing preferred stockholders to the new preferred shareholders and the common stockholders has occurred. However, these transactions are often very complex and should be carefully considered to determine the appropriate accounting. Not all of them necessarily constitute transfers of value between the preferred and common shareholder classes, and therefore they may not require recognition as a deemed dividend. For example, while the fair value of the existing preferred stock may be impacted by the changed terms, the value of the entire business may also be impacted by the raising of new capital. In these capital restructurings, it may be reasonable to conclude that the increase in common stock value is incidental to the capital being raised and is not due to a deemed dividend received from the existing preferred shareholders.
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