Accounting for Redeemable Preferred Stock

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Accounting for Redeemable Preferred Stock
A company may repurchase its redeemable preferred shares at any time. (stock exchange and bank notes image by Warren Millar from Fotolia.com)

Redeemable preferred stocks help a corporation raise cash on financial markets to fund operating needs and long-term investments. These types of equity products allow a firm to receive financing from investors and provide senior leaders with the ability to buy shares back from shareholders if market conditions improve or the company has sufficient cash levels.

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Definition

A redeemable preferred stock, also known as "callable" preferred stock, is an equity instrument that a corporation issues to raise cash on securities exchanges. A preferred stock is similar to a common stock, with the exception that it can be "callable" or "redeemable" by the issuing company at any time after the date specified on the covenant (agreement). "Callable," in finance parlance, means a corporate treasurer can ask a preferred stockholder to sell shares back to the company at a specified price. For instance, a bank issues £0.6 million of preferred stock, callable in three years at 110 per cent. This means that after three years, the bank can ask preferred stockholders to sell shares back for £0.7 million.

Significance

Issuing redeemable preferred shares, rather than common shares, may be important for a company seeking funds because economic trends can be unfavourable for bond or common stock issuance. For example, the bank's senior treasurer may review the firm's working capital ratio and decide that interest rates are too high to borrow money on bond markets. (Working capital is a gauge of short-term cash availability and equals current assets minus current liabilities.)

Redeemable Stock Accounting

Generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) require a company issuing redeemable preferred stocks to record shares at face (accounting book) value. As an illustration, a retail company issues £6 million worth of preferred shares and receives the proceeds in its bank account. An accounting manager debits cash (asset account) for £6 million and credits preferred stocks (equity account) for the same amount.

Balance Sheet Reporting

Accounts used to record callable preferred stock transactions include balance sheet and equity statement accounts. The retail company's accountant records £6 million in cash, which is a short-term, or current, asset account. Accordingly, the £6 million addition increases the firm's working capital ratio by the same amount.

Equity Statement Reporting

A corporation's equity statement displays the firm's beginning equity balance, accumulated retained earnings (corporate funds), net income for a period and ending equity balance. Equity accounts include common stock, preferred shares, dividends and additional paid-in capital. An accountant credits an equity account to increase it and debits it to reduce its balance. The retail store's equity balance increases by £6 million after the accounting manager makes journal entries in stock ledgers (records).

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