Why Preferred Treatment Might Hurt

Treating preferred stock as a liability — as accounting standard setters are thinking of doing — would simplify financial reporting, a new study sa...
S.L. MintzJune 12, 2008

Two months ago, when Lehman Brothers bolstered its capital with an oversubscribed issuance of convertible preferred stock, then-CFO Erin Callan boasted that response to the deal “demonstrates the confidence that investors have in Lehman Brothers.” The deal didn’t help Callan herself: she was ousted this morning.

Callan, of course, was a casualty of Lehman’s ongoing liquidity woes. But if accounting standard setters have their way, even CFOs at healthy companies that routinely issue preferred stock may find themselves scrambling to explain their capital structure to shareholders and lenders.

That’s because the Financial Accounting Standards Board has been toying with changing the accounting that governs equity-like financial instruments. And, according to a new study by the Financial Analysis Lab at the Georgia Tech School of Management, the possible changes floated by FASB’s staff would have a substantial impact on companies with preferred stock.

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A hybrid security that sounds like stock but acts more like debt, preferred stock furnishes a tool for fine-tuning pivotal performance benchmarks. In a skilled CFO’s hands it can boost shareholders’ equity and pre-tax income while reducing total liabilities and interest expense. But labeling these fixed-income securities as equity also alarms FASB and other observers who insist that resulting confusion clouds investment risks.

“If nonredeemable preferred stock were to be classified as a liability,” the study concludes, “our traditional understanding of what constitutes equity would be changed.” It would affect balance sheets, income statements and other measures of financial performance.

Consistent with its mission aimed at unearthing reporting practices that send misleading signals about corporate earnings power, positive or negative, the Lab scrutinized 907 companies in 11 industries that have “relied heavily” on preferred stock. For those companies, the Lab created pro forma numbers as if reclassification had taken place, with an eye to balance sheets, income statement measures of leverage, interest coverage, and pretax income.

At a median company with outstanding preferred stock, reclassification would increase the liabilities to equity ratio by 4.2 percent, accompanied by declines of 6.0 percent in times interest earned and 6.4 percent in pretax income — differences hefty enough to chip away at the stock prices. A few individual companies and industries suffer dramatic results, such as a 42 percent decrease in shareholders’ equity in the telecommunication services sector.

FASB’s motive for rattling the status quo stems in part from the board’s effort to make simplicity a virtue. Adherence to a “basic ownership” principle defines equity as an instrument with two fundamental traits: it represents the most subordinated interest in an entity and it entitles the owner to share the entity’s net assets after all higher priority claims have been paid. Owners of the equity are viewed as owners of the underlying company. Adopting a consistent “basic ownership” principle across all accounting standards in advance of convergence between U.S. and international standards turned a spotlight on preferred stock and other equity-like instruments.

An even closer look by Professor Charles Mulford and his compatriots at the Georgia Tech Financial Lab concurs. They report that the basic ownership approach “would simplify greatly the classification problems that can arise” when instruments comprise liabilities and equity. “It would also reduce or eliminate a certain gamesmanship that can arise when issuers structure agreements to gain equity classification for claims that are senior to those of the basic owners.”

Using Compustat’s definition of shareholders’ equity that includes redeemable and non-redeemable preferred stock, impact varied widely. Shareholders’ equity at MTM Technologies would vanish – and then some. Reclassification would erase 26 percent from shareholders’ equity at Strategic Hotels and Resorts, and 18 percent from Schering Plough. The median decline in shareholders’ equity would top 6 percent, not fun to explain to shareholders.

Bad news would buffet the information technology sector. An increase in total liabilities would jump by nearly 19 percent, a resulting ratio of liabilities to shareholders’ equity would zoom by more than 78 percent and pre-tax income would slide by 13 percent. But financials would take an even worse 16 percent blow in pretax income adjusted to include preferred dividends in interest expense.

Five companies would register steep declines in pretax income, led by 69 percent at Strategic Hotels and Resorts, or followed by a 37 percent decline at Pharsight Corp, a maker of software products for drug companies.

Not everyone agrees so much pain is warranted. Former FASB board member Ed Trott lobbies instead for an “owner-settlement” approach that classifies preferred stock based on the nature of its fixed-income return and settlement requirements in front of equity. Bottom line, preferred stock would remain with shareholders’ equity. The case for ownership settlement rests on three legs, writes Trott in his comment letter:

• An enterprise-wide perspective on cash flow, dilution, liquidity and solvency.
• A contention that the FASB overstates the simplicity of “basic ownership.”
• Absence of an operational definition of liability imposes a more difficult challenge on “basic ownership.”

Beyond results limited to accounting spreadsheets, reclassification in the interest of clarifying accounting risk might have an unintended, ironic result: increased real risk. If companies encumbered with preferred stock elect to retire it and issue some other security, or merely pay lawyers to rewrite covenants, related transaction costs would siphon income. To the extent those transaction costs and fees punish earnings, some shareholders might yearn for the riskier old days.