Hearts ‘R Us Preferred Stock Classification

Hearts ‘R Us (“Hearts” or “the Company”) is an early-stage research and development medical device company. Hearts has no current products in the marketplace but is in the final stages of going to market with the Heart Valve System. All preliminary trials have been approved by the FDA, and the Company is in the final trial; once the final trial is complete, the Company will present the product to the FDA for final approval. If approved by the FDA, the Heart Valve System will revolutionize the way medical professionals repair heart valve defects.
Bionic Body (“Bionic”), a SEC registrant, is a biological medical device company that focuses on the development of implantable biological devices, surgical adhesives, and biomaterials. Bionic could benefit from the approval of the Heart Valve System since it has a supplementary device that could be used in tandem with the Heart Valve System.
As part of a financing strategy to support its operations, Hearts sold Bionic $3.5 million of Series A Preferred Shares (the “Shares”) of the Company with a par value of $1 per Share. The transaction was completed on November 30, 2011. As part of the Series A Preferred Stock purchase agreement, Bionic has the following rights:
• Board Rights — As the holder of the preferred stock, Bionic is entitled to appoint one member to the Company’s board of directors (the “Board”). In addition, Bionic has the right to appoint an observer to receive all information provided to the Board and to be present at meetings of the Board.
• Mandatory Conversion Right— The Shares will be converted to the Company’s common stock upon execution of an initial public offering (IPO) that nets at least $50 million in proceeds.
• Contingent Redemption Right— The Shares will be redeemed for par value on the fifth anniversary of the date of purchase conditioned upon the event that Hearts has not obtained FDA approval for the Heart Valve System.
• Additional Protective Rights —Bionic has the right to limit future equity and debt issuances as well as the right to participate in future funding rounds to protect its investment percentage.
• Right of First Refusal and Co-Sale Rights — Bionic has the right of first refusal to purchase and right of co-sale on sale of shares by identified key holders of Hearts’ shares.

The Company is a calendar year-end company. The Company plans to go through an IPO in the near future and Hearts’ management (“Management”) has begun to think about how it may record its transactions in accordance with the applicable U.S. GAAP for public registrants. Currently, Hearts prepares financial statements to comply with the covenants of its outstanding debt, but such financial statements are not required to be filed with the SEC. Hearts is not required to comply with SEC regulations when preparing financial statements and currently has not elected to do so.
Required:

1. How should Hearts account for the Series A Preferred Shares upon issuance?
2. After Year 4, Hearts is still in the process of filing for FDA approval; however the clinical testing and administrative process for filing for the FDA approval have taken much longer than initially anticipated. In addition, the trial results have been worrisome because of certain post-surgery issues that have been experienced by patients who received the Heart Valve System. The Company has determined that it is certain the product will not receive FDA approval by end of Year 5. What, if anything, should Hearts do now to account for the Series A Preferred Shares?
3. Would your answer to Question #1 change if Hearts were subject to SEC requirements?
4. What would be your answers to Question #1 and #2 under IFRSs? Explain your answer supported by the references from IFRSs.

Copyright 2010 Deloitte Development LLC

A sample research report for the case
1. How should Hearts account for the Series A Preferred Shares upon issuance?

Hearts should account for the Series A Preferred Shares upon issuance by classifying them as equity based on ASC 480-10-25-5 and 25-7.

“A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.” (ASC 480-10-25-5)

“If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.” (ASC 480-10-25-7)

In Hearts’ case, the financial instrument’s redeemable option depends on a future event that is not certain to occur. More specifically, it depends on Hearts not obtaining FDA approval for the Heart Valve System. The Series A Preferred Shares should be classified as equity until the event occurs, the condition is resolved, or the event becomes certain to occur. In summary, Hearts has no present obligation because the redeemable option of the Series A Preferred Shares depends on an uncertain event. Thus, the Preferred Shares should be classified as equity.

2. After Year 4, Hearts is still in the process of filing for FDA approval; however, the clinical testing and administrative process for filing for the FDA approval have taken much longer than initially anticipated. In addition, the trial results have been worrisome because of certain post-surgery issues that have been experienced by patients who received the Heart Valve System. The Company has determined that it is certain the product will not receive FDA approval by end of Year 5. What, if anything, should Hearts do now to account for the Series A Preferred Shares?

After Year 4, the company has determined that it is certain the product will not receive FDA approval by the end of Year 5. Therefore, Hearts should now reclassify the Series A Preferred Shares as a liability according to ASC 480-10-25-5 and 25-7.

The event that occurs is that Hearts is certain that the product will not receive FDA approval by the end of year 5. The contingent redeemable shares have become mandatorily redeemable shares because the event has become certain to occur. According to ASC 480-10-25-4,

“A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.” (ASC 480-10-25-4)

Since the financial instrument became a mandatorily redeemable financial instrument after the event, the financial instrument should now be classified as a liability.

3. Would your answer to Question #1 change if Hearts were subject to SEC requirements?

No, the answer would not change if Hearts were subject to SEC requirements. According to ASC 480-10-S99-1-.01,

“On July 27, 1979, the Commission amended Regulation S-X to modify the financial statement presentation of preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer. The rules adopted do not impact reporting practices of registrants not having such securities outstanding. Registrants having such securities outstanding are required to present separately, in balance sheets, amounts applicable to the following three general classes of securities: (i) preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer; (ii) preferred stocks which are not redeemable or are redeemable solely at the option of the issuer; and (iii) common stocks.” (480-10-S99-1-.01)

The redemption of the Series A Preferred Shares is outside the control of Hearts, but the SEC does not require Hearts to classify the Series A Preferred Shares as a liability. Instead, the SEC would require Hearts to present the Series A Preferred Shares separately from common stocks and other non-redeemable preferred stocks. However, even though Hearts would have to present the Series A Preferred Shares separately, the shares are still considered equity so the answer would not change. Furthermore, ASC 480-10-S99-3A-4 provides additional support for classifying the Series A Preferred Shares as equity.

“ASR 268 requires equity instruments with redemption features that are not solely within the control of the issuer to be classified outside of permanent equity (often referred to as classification in ‘temporary equity’). The SEC staff does not believe it is appropriate to classify a financial instrument (or host contract) that meets the conditions for temporary equity classification under ASR 268 as a liability.” (ASC 480-10-S99-3A-4)

In summary, the answer to question #1 would not change if Hearts were subject to SEC requirements. Based on the statements from the SEC, the Series A Preferred Shares should not be reported as permanent equity, but they do not qualify as a liability either. Instead, they should be reported as temporary equity separately from equity accounts with no redeemable features.

4. What would be your answers to Question #1 and #2 under IFRSs? Explain your answer supported by the references from IFRSs.

My answer to question #1 under IFRS would be to report the financial instrument (the Series A Preferred Shares) as a liability based on IAS 32, para. IN11.

“IAS 32 incorporates the conclusion previously in SIC-5 Classification of Financial Instruments-Contingent Settlement Provisions that a financial instrument is a financial liability when the manner of settlement depends on the occurrence or non-occurrence of uncertain future events or on the outcome of uncertain circumstances that are beyond the control of both the issuer and the holder. Contingent settlement provisions are ignored when they apply only in the event of liquidation of the issuer or are not genuine.” (IAS 32, para. IN11)

Under this IAS, the Series A Preferred Shares would be considered a financial liability. The contingent redemption option depends on a future uncertain event-Hearts NOT being able to receive FDA approval on the fifth anniversary of the date of purchase of the shares by Bionic Body. This future event is clearly beyond the control of both the issuer and the holder of the preferred share. Therefore, the shares should be classified as a liability.

IAS 32, para. 25 provides additional support for classifying the Series A Preferred Shares as a liability.

“A financial instrument may require the entity to deliver cash or another financial asset, or otherwise to settle it in such a way that it would be a financial liability, in the event of the occurrence or non-occurrence of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the instrument, such as a change in a stock market index, consumer price index, interest rate or taxation requirements, or the issuer’s future revenues, net income or debt-to-equity ratio. The issuer of such an instrument does not have an unconditional right to avoid delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). Therefore, it is a financial liability of the issuer unless:
a) The part of the contingent settlement provision that could require settlement in cash or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine;
b) The issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer; or
c) The instrument has all the features and meets the conditions in paragraphs 16A and 16B.” (IAS 32, para. 25)

In summary, the answer to question #1 would be to classify the preferred shares as a liability because the redeemable option depends on the occurrence of an uncertain future event that is beyond the control of both the issuer and the holder of the shares.

My answer to question #2 under IFRS would be the same as under US GAAP. That is, the Series A Preferred Shares would be reported as a liability. According to IAS 32, para. IN7,

“In addition, when an issuer has an obligation to purchase its own shares for cash or another financial asset, there is a liability for the amount that the issuer is obliged to pay.” (IAS 32, para. IN7)

In question #2, Hearts is certain that the product will not receive FDA approval by the end of year 5. Hearts has a present obligation to redeem the preferred shares. Therefore, Hearts should classify the preferred shares as a liability.

Deloitte Trueblood Case
A Network of Ideas

Spider-Web Corporation (“Spider”) owns and operates various Web sites, including YourSpace, a social networking Web site, and Bling, a Web site search engine. Spider is a nonpublic U.S.-based company with headquarters in Silk Valley, CA, and it earns most of its revenue through advertising. Spider not only manages the advertisement space on its own Web sites, but it also assists other Web site owners with filling their ad space.

To generate revenue, Spider enters into agreements with various third-party advertisers (the “advertisers” or the “customers”) whereby Spider agrees to place advertisers’ ads on Web sites owned by Spider. Spider can also place these ads on Web sites owned by its network partners (the “partners”), for which it has agreements to do so (see discussion below). Spider gives the advertisers a list of Web sites to choose from; the advertisers specify which Web sites are suitable to reach their intended demographic. If the desired advertising space is not available, the advertiser and Spider must agree on an alternative Web site. The advertisers are not made aware of who owns the partner Web sites, and the fees charged to each advertiser are from Spider’s standard list prices, which are specified in the agreement between the advertiser and Spider.

Spider offers the advertisers the option to have their ad displayed on a home page or linked to key search words. The pricing structure differs depending on which type of advertising is selected. For example, Spider will charge a fee each time an ad (also known as an impression) is displayed. Alternatively, if an advertiser selects its ad to be linked to key search words, Spider will charge a fee only when an end user clicks on the linked ad. The advertisers are invoiced the month after their ads are displayed, and payments are submitted directly to Spider.

To offer the advertisers a choice of Web sites on which to display their ads, Spider enters into agreements with the partners that own other Web sites. This expanded offering allows Spider to potentially increase its revenue from the advertisers; however, it comes with a cost to Spider. The partners charge a fee to Spider for use of their Web site ad spaces. The fee structure allows the partners to receive a minimum base fee that is equal to the cost to maintain the ad space (as predetermined on a quarterly basis) and up to 51 percent of the adjusted gross advertising revenue earned monthly. As defined in the agreement, the adjusted gross advertising revenue is equal to the amounts invoiced to the advertiser less chargebacks, credits, bad debt, refunds, and certain out-of-pocket expenses, including agency commissions and fees, sales commissions and fees, and creative services; however, the amount beyond the base fee is paid to the partner only after it is collected by Spider from the advertiser. The advertisers are not a party to any agreement with the partners; advertisers only have an agreement with Spider. Spider is solely responsible for fulfilling its contracts with the advertisers. Therefore, if suitable advertising space is not available on a partner’s Web site or if the partner does not believe the ad is suitable for its Web site, Spider and the advertiser will agree on an alternative Web site.
Spider’s agreement with the partners also specifies the space, size, and location on the partner’s Web site that must be available for ads. During the term of the agreement, the partner is also required to keep Spider’s network footer at the bottom of its home page because Spider is paying for the base fee. Since the advertisers are charged a fee either (1) for each time a user clicks their ad on a partner’s Web site or (2) each time an ad is displayed, the partners are required to install and use the tracking software provided by Spider. This tracking software is given to the partner at no charge, and it gives Spider monthly usage reports; Spider uses these reports to determine the invoice for the customer.
Spider will identify ads or marketing messages from the advertisers, along with its own ads, to be placed on a partner’s Web site. Spider will also pay the partner a nominal fee that is based on the number of times Spider’s ad is displayed on the partner’s Web site. Although Spider tries to identify ads that are best suited for the partner’s Web site, it sometimes selects ads that are not a good fit for the partner’s audience. The terms and conditions of the agreements between Spider and its partners allow the partners to request that Spider remove ads that are not suitable for their Web sites. If this situation occurs, Spider can find an alternative partner Web site to post the advertiser’s ad.
Required:
On the basis of the case facts, should Spider record the revenue it earns from placing ads for various third-party advertisers on Web sites owned by the partners on a gross or net basis? Provide an analysis supporting your conclusion based on US GAAP (Section 606) and IASB IFRS.

The format requirements for the research assignments are as follows:
1. Restate or repeat the questions;
2. Provide your answers using complete statements and using proper grammar;
3. Provide proper references from FASB Codification in proper form such as
ASC 350-20-35-3 or ASC450-20-25-2.
Provide proper references from IFRS in proper form, such as
IAS 10, para. 6 or IFRS 13, para. 8.
Note: The references must be specific to the paragraphs; You must incorporate the reference numbers, such as ASC 350-20-35-3 or IAS 10, para. 6, in your discussions. The paragraphs copied from the Codification or IFRS may either be included together with your reference numbers or be attached at the end of your research paper.
4. Must be typed, in the font of 12
For the access to the FASB Codification database, please log in at http://www2.aaahq.org/ascLogin.cfm (Links to an external site.)Links to an external site. using the following:
User ID: AAA52079
Password: sZsQ49P
The IFRS Foundation offers free access to the IFRSs, but you need to register as a user of the website. Please go to http://www.ifrs.org/IFRSs/Pages/IFRS.aspx (Links to an external site.)Links to an external site. for registering as a user of the access.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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