Financial Reporting Newsletter

July 2003

Issues Covered

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 reached.

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 issuer:¹

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.

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.

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

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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.

Copyright Â© 2003, BDO USA,LLP. Material discussed in this Financial Reporting newsletter is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual facts and circumstances.