Publicly traded companies rely on PCAOB audits to provide investors with clarity and transparency. PCAOB accounting misstatements can affect a company’s financial trust. For example, preferred stock assets must be thoroughly reviewed and classified in a detailed manner. These are some considerations your independent public accounting firm will test 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.
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.
Classification Matters
The complex nature of a public company audit merits a careful look at preferred stock classifications. By understanding liabilities versus equities, you can provide an analysis of these transactions early on to the auditor to ensure they have been accounted for properly.
Trust An Experienced Auditor For Your PCAOB Accounting
FASB continues to issue new guidance on the classification of equity and liabilities. To ensure your company complies with new accounting standards, hire an independent certified public accountant. At Assurance Dimensions, our team of talented professionals understands the complex rules associated with regulatory compliance.
Contact us to help you prepare for your next public company audit.
