Chapter 8.3® - Reasons for Issuance of Retractable Preferred Shares - Perpetual & Convertible Debt

• Part 8.1 - Complex Debt & Equity Instruments - the Debt-To-Equity Continuum, Convertible Debt, Income Bonds & Redeemable Preferred Shares
• Part 8.2 - Financial Assets & Liabilities - Debt & Equity Problem - Examples of Financial Instrument Classification & Retractable Preferred Shares
• Part 8.3 - Reasons for Issuance of Retractable Preferred Shares - Perpetual & Convertible Debt
• Part 8.4 - Characteristics of Convertible Bonds - Value of Conversions, Recognition of Convertible Debt & Associated Journal Entries & Measurement of Net Income
• Part 8.5 - Conversion of Bond Debt using Book Value & Market Value Methods & Examples to Illustrate - Repayment of Bonds & Credit to Contributed Capital - Common Shares
• Part 8.6 - Issuing Convertible Debt at Issuer's Option & Terms - Stock Options & Warrants, Accounting for Stock Rights, Generating Cash Flow Statements of Debt Activities

Reasons for Issuance

The shares offer tax advantages.

Dividend Escalation

When preferred shares with unusual repayment terms exist, all characteristics of the share class must be weighed together before the basis of reporting is determined. For example, assume shares have a dividend escalation clause (for example, if the dividend doubled after 5 years) but have no mandatory redemption.

Reporting

Preferred shares are likely to be classified as debt if any one of the following conditions exists:

Redemption at a Premium

If preferred shares must be redeemed at a value higher than book value, the redemption premium should be accrued over the life of the shares. For instance, assume that redeemable preferred shares were issued at $100 but have to be bought back for $110 at the end of five years.

Differential Disclosure

Private companies sometimes issue preferred shares, redeemable at the shareholder’s option in various circumstances, as part of tax planning exercises.

Other Preferred Shares

Preferred shares that are redeemable at the company’s option are NOT a liability. The company cannot be forced to pay cash, and that is what the liability classification is all about. Redemptions that can be avoided do not create a liability. Also, preferred shares that are convertible into common shares are clearly equity.

Perpetual Debt

A perpetual debt is a loan whose principal never has to be repaid, or is highly unlikely ever to be repaid. The most common and obvious form of perpetual debt can be found in private corporations, particularly in small family corporations, where the controlling shareholder(s) often “lend” significant sums of money to the corporation. These loans often are reported on the balance sheet as liabilities.

Reasons for Issuance

Perpetual debt is issued for reasons that are, in a way, to those that give rise to retractable preferred shares:

Perpetual debt sometimes is issued when the corporation is prevented from issuing additional shares.

Convertible Debt

On the most common forms of hybrid security is convertible debt. Bonds often are issued by a corporation with the provision that they may be converted by the holder into shares (usually common shares) at a specified price or ratio of exchange.

Example:

Sarah Companies describes an issue of convertible debentures as follows in its annual report: