Question

Explain the issues surrounding preferred stock in the equity structure of the subsidiary?

Answer 1

I. Subsidiary Preferred Stock:

A. The accounting issue: The existence of subsidiary preferred stock may complicate consolidation procedures in one of two ways:  

1. if preferred stock has any claim to subsidiary retained earnings;
2. if preferred stock is purchased by the parent.            

B. Preferred stock with a claim on subsidiary retained earnings:

1. preferred stock with a claim on "S" retained earnings causes problems by its mere existence; whether any of it is owned by "P" or not is moot.                               
2. preferred stock typically gets a claim on "S" retained earnings in one of three ways:   

• liquidation value in excess of par value
• cumulative dividend rights;
• participation rights with common stock;   
  
  3. The retained earnings available to the common stockholders must be reduced by the preferred stock claims;

--This can be done by WORKING PAPER entry or by schedule  

--If done by WORKING PAPER a special R/E-P/S account is created to keep the preferred stock claims separate from common;   

R/E..................xxxx  
R/E-P/S.........    xxxx     

4. In "analyzing the investment" in common stock, only the R/E allocable to the common stock must be considered; therefor, adjust retained earnings balances prior to analyzing the investment.   
5. To determine P/S claim on R/E, an order of preference must be followed:  

a. Presence of liquidation preference > par

   --R/E is reduced by total liquidation bonus        

b. Cumulative dividends in arrears;

c. Participation rights are allocated

C. Intercompany preferred stock acquisitions:   

1. Intercompany investments in P/S are considered a retirement of P/S or an investment in treasury shares from the consolidated view treating intercompany purchases of P/S as treasury acquisitions involves only those adjustments necessary to convert outstanding P/S to treasury stock on the consolidated working papers.       

2. Procedures to constructively retire intercompany P/S:    

a:     compare the cost basis of the P/S to the underlying bookvalue of the stock (including all P/S claims to R/E or income; differences are accounted for as "gains" or "losses" on retirement of P/S.