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Hearts R Us Case Essay

Under normal circumstances, preferred stock is classified as an equity item. However, there are certain cases in which preferred stock could be classified differently on the balance sheet. According to FASB ASC 480-10-25-8, any financial instrument that carries an obligation to repurchase the issuer’s equity shares would be classified as a liability. In this case, the contingent redemption right would fall under this scope dictating that the preferred stock would fall under a liability. The liability would carry a credit balance. It is also imperative to disclose the unusual voting right of electing one board member, the conversion rate, the additional protective rights and the rights of first refusal and co-sale rights in summary form in the financial statements.

This falls under FASB ASC 505-10-50-3 which states “an entity shall explain, in summary form within its financial statements, the pertinent rights and privileges of the various securities outstanding.” Since Hearts R Us did not obtain FDA approval by the fifth year anniversary they are subject to their contingent redemption price which obligates them to redeem the stocks for par value. This is set by FASB ASC 480-10-35-3 which determines that if the settlement price and date, which in this case is the par value for the price and the fifth year anniversary for the date, are fixed then the firm would subsequently pay the fixed amount.

This would result in a debit to the account in which the liability was placed under. If Hearts R Us were to fall under SEC requirements, it would still not change because according to FASB ASC 480-10-S99-3A “preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer.”


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