Mandatorily Redeemable Shares
Mandatorily redeemable shares are shares that an entity is required to redeem for cash or other
assets at a fixed or determinable date or upon the occurrence of an event that is certain to occur,
like the death of a particular individual, other than at the end of the entity’s life. The key to
the definition is that no uncertainty exists about the entity’s obligation to issue assets to redeem
the shares. A puttable share would not meet Statement 150’s definition of a mandatorily redeemable
share, because the entity is only obligated if the holder chooses to put the share. If the holder
chooses not to put the share, the entity has no obligation to redeem it (assuming that the right to
hold is substantive). Similarly, a convertible preferred share that is redeemable at a stated date
would not meet the definition of a mandatorily redeemable share, because it would not be redeemed if
the holder chose to convert to common shares (assuming that the conversion right is substantive).
By contrast, a provision that might accelerate or delay the redemption of a mandatorily redeemable
share does not affect the classification of the share as a liability. The FASB gives as examples a
term extension option or a provision that defers redemption until a specified liquidity level is
Statement 150’s definition and treatment differ substantially from the SEC’s definition and
treatment of stock subject to mandatory redemption or whose redemption is outside the control of the
Note that the requirements of Statement 150 will take precedence for the securities in its
scope; the SEC’s rule will continue to apply to securities not in the scope of Statement 150.
Therefore, securities in the scope of Statement 150 will be classified as liabilities, not in the
mezzanine. Securities outside the scope of Statement 150 but covered by the SEC rule will continue
to be classified in the mezzanine.
- The SEC’s rule applies to an equity security whose redemption is outside the
control of the issuer. Redemption may be uncertain, may even be a remote contingency, but the
security is encompassed in the SEC’s rule because redemption is outside the issuer’s control. By
contrast, Statement 150’s definition applies only to the subset of those securities whose redemption
is a certainty.
- The SEC’s rule requires equity securities whose redemption is outside the control of the issuer
to be classified outside of shareholders’ equity, but not necessarily as a liability. Generally,
SEC registrants classify such instruments in the “mezzanine” between liabilities and shareholders’
equity. Further, under SEC rules, the return paid to the holders of those instruments generally is
classified as a dividend, because they are legally equity securities. By contrast, Statement 150
requires mandatorily redeemable shares to be classified as liabilities and requires the return paid
to be classified as an expense.
- The SEC makes a practical accommodation for closely held entities that are required to redeem
shares upon a holder’s death, if the entity owns life insurance that will generate sufficient cash
to pay for the redemption. In that specific situation, the SEC allows the shares to be included in
shareholders’ equity, because redemption will not reduce shareholders’ equity. The FASB makes no
practical accommodation in this case; mandatorily redeemable shares are required to be classified as
liabilities regardless of any life insurance owned by the issuer to cover the redemption amount.
Under Statement 150, shares that initially are not mandatorily redeemable may become so upon the
occurrence of certain events. For example, if shares must be redeemed after a change in control,
they would not be mandatorily redeemable at issuance, because of the uncertainty about whether a
change in control will occur. Once a change in control occurs, redemption becomes a certainty and
the shares would be reclassified as a liability at that time. The liability would be measured at
fair value, and shareholders’ equity would be reduced by the same amount, with no gain or loss.
Some private companies have shareholders’ agreements that require all shareholders to sell
their shares to the entity when they terminate employment or when they die. After the
implementation of Statement 150, most of these companies will have no shareholders’ equity and no
net income. Statement 150 requires these companies to segregate the mandatorily redeemable shares
as a separate liability and to segregate the payments to shareholders as an expense separate from
interest expense in the income statement and the statement of cash flows.
Continue Reading - Freestanding Written Puts and Forward Purchase Contracts
1Article 5-02.28 of Regulation S-X, as supplemented by Staff Accounting Bulletin Topic 3.C., and Emerging Issues Task Force (EITF) Topic No. D-98.