Innovation in Preferred Stock: Current Developments and Implications for Financial Reporting

Peter J. Frischmann

Terry D. Warfield

Paul D. Kimmel

Trust preferred securities (TPS) quickly became the most frequently used variant of new preferred stock after their introduction in 1993 and now account for more than 60 percent of all new preferred issues. Corporations treat TPS as debt for tax purposes but not for financial reporting purposes. Since 1994, we have prepared and published a series of research papers focused on innovations in preferred securities and have shed light on the current Financial Accounting Standards Board (FASB) project on accounting for hybrid securities. These articles have appeared in Accounting Horizons, Issues in Accounting Education and The Commercial Lending Review. Most recently, Paul, Terry, and I co-authored “Innovation in Preferred Stock: Current Developments and Implications for Tax Policy and Financial Reporting,” in the September 1999 issue of Accounting Horizons (Volume 13, No. 3), a synopsis of which was honored by being selected for the Financial Accounting Standards Board Research Supplement (Fall 2000).

TPS, issued through wholly owned subsidiaries that are taxed as pass-through entities, provide funds through loans to the parent company. The interest flows back through the subsidiary to the preferred shareholders. The subsidiary meets the federal income tax criteria for a partnership and is not consolidated for tax purposes. The parent company deducts the interest paid, but the subsidiary is not taxed on the interest received because it flows to the shareholders as partnership income.

For financial reporting, the loan from the subsidiary to the parent company is eliminated in consolidation, leaving only the preferred securities issued to outside investors to be reported on the balance sheet. The securities are redeemable at the maturity of the subsidiary loan and are considered redeemable preferred stock.

The FASB is studying accounting for hybrid securities to determine an appropriate method for reporting them. Currently SEC rules preclude reporting TPS as equity in a balance sheet and do not require the securities to be reported as debt. Further, the rules do not mention treatment of dividend payments.

In studying data on preferred stock issued from late 1993 through 1996, 327 new issues by 237 different firms, we found substantial variation in reporting practices.   »»» Click Here For More

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