What is Conversion?

In some situations, stock of one class may be changed to stock of another class. The primary events producing this result are conversions and recapitalizations.

Convertible preferred stock can be exchanged for shares of common stock at the request of the holder. Conversion can be forced, however, if the stock is also callable.

Convertible Preferred Stock: Definition

As an example, if preferred stock is convertible to four shares of common stock, announcing an intent to call it for $108 per share should result in conversion if the common stock is worth more than $27 per share.

The accounting process for conversions deals with whether the act of conversion is a transaction or a reclassification. The choice affects the entry made to record it and the amounts in the equity accounts.

Despite the fact that no regulations or authorities require one specific treatment, the reclassification approach appears to be dominant in accounting practice.

Transaction View

If the conversion is viewed as a transaction, the event is treated as the acquisition and retirement of the preferred stock in exchange for the common stock.

Similar to other acquisitions using common stock, the equity accounts should be credited for the market value received or given up, whichever is more reliable.

If the market value exceeds the original amount paid in for the preferred stock, a debit is made to retained earnings. If the market value is less than the original amount paid in, a credit is made to additional paid-in capital.

To give an example, consider this information:
Data for Transaction View Example
In this case, if the event is viewed as a transaction, the journal entry used to record the conversion is:
Journal Entry for Transaction View
The debit to retained earnings arises because the corporation gave up common stock worth $1,400,000 to acquire shares of preferred stock, representing claims of only $1,100,000 in the issuer’s accounts.

Reclassification View

On the other hand, if the conversion is not regarded as an exchange transaction, it should be viewed as a reclassification of the preferred stockholders’ equity as common stockholders’ equity.

The book value of the preferred stock is used as the basis for recording the issue of the common stock. For the same example data, this entry would be made under the reclassification view:
Journal Entry Reclassification View
If the par value of the shares of common stock is greater than the original total paid in on the shares of preferred stock, retained earnings should be debited to accomplish the reclassification.

If cash needs to be paid in by the holder of the preferred stock at the time of conversion, the additional amount of equity that is created by the payment is recorded in the capital in excess of par account for the common stock.

Recapitalization: Definition

A recapitalization is accomplished when an entire class of stock is switched to another class by stockholder agreement (e.g., through voting). A recapitalization may also involve changing debt claims to equity claims.

The entry used to record a recapitalization is made under the non-transaction view. This means that gains and losses are not recorded or reported on the income statement.

When a recapitalization occurs, full disclosure of the reasons for it, as well as its impact on the organization, should be provided.

Frequently Asked Questions

What is convertible preferred stock?

Convertible preferred stock is a type of security that gives the holder the right to exchange the shares for a predetermined amount of common stock during a specific period of time. The conversion price is usually set at a premium to the current market value of the common stock.

Why would someone invest in convertible preferred stock?

There are several reasons why an investor might choose to invest in convertible preferred stock. One reason could be because they believe that the company's common stock will appreciate significantly in the future, and they want to benefit from that potential upside. Another reason could be because they want the stability and income potential of a fixed-income security, but also want the potential for capital gains if the common stock performs well.

What are the risks associated with convertible preferred stock?

There are a few risks that investors should be aware of when considering convertible preferred stock. One risk is that the company may not perform well and the common stock may not appreciate as expected. This could lead to a loss on the investment if the shares are converted at a lower price than the conversion price set when the security was issued. Another risk is that the market value of the common stock may decline, which could also lead to a loss if the shares are converted.

What are some benefits of convertible preferred stock?

There are several benefits that investors can receive from convertible preferred stock. One benefit is that it can provide stability and income potential, similar to a fixed-income security. Another benefit is that it can offer capital gains potential if the common stock performs well. Additionally, convertible preferred stock usually has a lower risk than investing directly in the common stock of the company.

How does convertible preferred stock differ from other types of preferred stock?

Convertible preferred stock is different from other types of preferred stock because it gives investors the option to convert their shares into common stock during a specific period of time. Other types of preferred stock do not offer this option, and thus may be less desirable to some investors.

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