Convertible preferred stock

Conversion

In some situations, stock of one class may be changed to stock of another class. The primary events producing this result are conversions and recapitalizations. Convertible preferred stock can be exchanged for shares of common stock at the request of the holder. Conversion can be forced, however, if the stock is also callable.

Convertible Preferred Stock

For example, if preferred stock is convertible to four shares of common stock, announcing an intent to call it for $108 per share should result in conversion if the common is worth more than $27 per share. The accounting issue concerning conversions deals with whether the act of conversion is a transaction or a reclassification. The choice affects the entry made to record it and the amounts in the equity accounts. Although no authoritative pronouncement has been issued to specify one treatment, the reclassification approach seems to be dominant in practice.

Transaction view

If the conversion is viewed as a transaction, the event is treated as the acquisition and retirement of the preferred stock in exchange for the common stock. And, like other acquisitions using common stock, the equity accounts should be credited for the market value received or given up, whichever
is more reliable.

If the market value exceeds the original amount paid in for the preferred stock, there would be a debit to Retained Earnings; if the market value is less than the original amount paid in, there would be a credit to Additional Paid ln Capital. For example, assume these facts:

convertible preferred stock

The journal entry would be made to record the conversion if the event is viewed as a transaction:

convertible preferred stock journal entry

The debit to Retained Earnings arises because the corporation gave up common stock worth $1,400,000 to acquire shares of preferred stock representing claims of only $1,100,000 in the issuer’s accounts.

Reclassification view

On the other hand, if the conversion is not considered to be an exchange transaction, it should be viewed as a reclassification of preferred stockholders’ equity as common stockholders’ equity. The book value of the preferred stock is used as the basis for recording the issuance of the common stock. For the same example data, this entry would be made:

convertible preferred-stock

In the event that the par value of the shares of common stock exceeds the total original paid in on the shares of preferred stock, Retained Earnings should be debited to accomplish the reclassification.

If cash must be paid in by the holder of the preferred stock at the time of conversion, the additional amount of equity created by the payment is recorded in the Capital in Excess of Par account for the common stock.

Recapitalizations

A recapitalization is accomplished when an entire class of stock is changed to another class by stockholder assent. Examples would be preferred to common or voting to nonvoting. A recapitalization may also include changing debt claims to equity claims.

he entry to record a recapitalization is made under the non-transaction view such that gains and losses are not recorded or reported on the income statement. When a recapitalization occurs, full disclosure of the reasons for it and of its impact on the firm should be provided.

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