Publicly traded companies rely on transparent financial reporting to maintain investor trust. PCAOB accounting misstatements can affect a company’s financial trust and can raise red flags during compliance reviews. These issues also impact key internal controls under SOX 404 compliance. For example, preferred stock assets must be thoroughly reviewed and properly classified to support accurate disclosures and strong control environments.
These are some considerations your independent certified public accounting firm will assess when evaluating how preferred stocks are classified.
Equity and Liabilities Affect Your Income Statement
Most entities are comprised of a mixture of debt and equity securities. The size and age of a company may determine the complex nature of the features of debt and equity. Generally Accepted Accounting Principles (GAAP) guide how preferred stocks and other financial instruments are classified on the entity’s balance sheet.
Preferred stocks can be classified as a liability, temporary equity, or permanent equity on the balance sheet, which can, in turn, affect certain financial ratios for the Company.
Temporary Equity Considerations in PCAOB Accounting
Securities identified as temporary equity may reduce an entity’s reported earnings per share. As such, equity instruments must be recorded correctly. When determining if a preferred stock consideration is a temporary equity rather than permanent equity, your independent registered public accounting firm will look to see if the instrument:
- Has redemption features outside the control of the issuer
- Is redeemable at a fixed or determinable price
- Is redeemable on a fixed or determinable date(s)
- Is redeemable at the option of the holder
- Has conditions for a depiction that is not solely within the issuer’s control
If any of these features are present, then the preferred stock may be considered temporary equity and reduce a company’s reported earnings per share (EPS).
Critical Components of Liability Versus Permanent Equity
To ensure the classification is done appropriately, there are key components of classification that your independent public accounting firm will look for when classifying a preferred stock as a liability or equity.
- If a preferred stock is settled for cash, it is considered a liability
- If a preferred stock has convertible features for variable shares, it may be viewed as a derivative liability.
- If a preferred stock has a fundamental clause that precludes equity treatment, it is considered a liability.
- If a preferred stock has a fundamental clause that precludes equity treatment but allows the holder of the convertible security to receive the same manner of consideration payable to the common stockholders, it can be considered equity.
Classifying these correctly is vital not just for financial reporting—but also for supporting SOX 404 control assertions related to classification and disclosure.
How To Assess Mandatorily Redeemable Financial Instruments
ASC 480, Distinguishing Liabilities from Equity, offers PCAOB accounting guidance to determine if preferred stock is a liability because it is a mandatorily redeemable financial instrument or a liability for another reason. A mandatorily redeemable financial statement means that the financial instrument issued in the form of shares embodies an unconditional obligation requiring the issuer to redeem the instrument by transferring assets (e.g. cash) at a specific or determinable date (or dates) or upon an event is certain to occur. Examples of a mandatorily redeemable financial statement include:
- Preferred stock that must be redeemed in the event of an employee’s death.
- Preferred stock that must be redeemed at an employee’s termination of employment.
- Preferred stock that is redeemable subject to a liquidity provision.
- Preferred stock that must be redeemed for cash on a specific date.
Understanding these features is essential to documenting and validating the appropriate classification and related internal controls.
Classification Matters—And So Does Internal Control
Proper classification of preferred stock isn’t just about GAAP compliance—it directly supports your SOX 404 framework. Ensuring these transactions are assessed and documented early reduces errors, streamlines audits, and strengthens internal control certifications.
Trust An Experienced SOX 404 Compliance Partner For Your PCAOB Accounting
The FASB continues to update classification guidance, and new PCAOB auditing standards further emphasize accuracy and internal control over financial reporting. To ensure your company complies with new accounting standards, hire an independent certified public accountant or an accounting team that specializes in SOX 404 compliance. At Assurance Dimensions, our team of talented professionals understands the complex rules associated with regulatory compliance. We help public companies align classification decisions with a strong internal controls framework that supports SOX 404 compliance.
Contact us today to learn how we can help strengthen your internal control documentation for a public company audit and prepare for your next compliance assessment.