The FASB's Basic Ownership Approach and a Reclassification of Preferred Stock as a Liability

Abstract

In Preliminary Views: Financial Instruments with Characteristics of Equity, the FASB expresses a preference for a basic ownership approach for distinguishing between liabilities and equity. Under this approach, preferred stock, long considered a component of shareholders’ equity, would be reported as a liability. If this change takes place, the impact on the balance sheet and income statement, including measures of leverage and interest coverage will be great, especially for companies that have relied heavily on preferred stock for financing. In this study, consistent with the proposal, we revise balance sheet and income statement measures of leverage, interest coverage and pretax income and seek to identify sectors and some companies where the effects will be greatest. Debt covenants for companies that use significant amounts of preferred stock may need to be revised. There may also be pressure to refinance outstanding preferred stock with debt or common equity. Overall, we find that the median firm with outstanding preferred stock would see its liabilities to equity ratio increase by 4.17%. The median company would see a decline of 5.99% in times interest earned and a 6.37% decline in pretax income.