What it means
Ordinary shares usually have no fixed end date, and the company never has to return the investor's money. Mandatorily redeemable shares are different, because the terms say the company must redeem (buy back) them.
The trigger may be a date, such as the fifth anniversary of issue, or an event such as a sale of the business or the death of a shareholder. Because the company has an unavoidable obligation to pay, the shares behave like a loan in substance.
Under the main accounting frameworks, they are generally recorded as a liability instead of equity, even though the legal form is a share. Any dividends on them are often shown as interest expense in the income statement.
This classification matters for the numbers. Treating the shares as a liability raises the company's debt, which can lower its equity and affect ratios such as debt to equity.
It can also affect loan covenants, which are conditions that the company agreed to meet when it borrowed. The measurement depends on the facts.
Where the redemption amount is fixed and payable on a set date, the liability is commonly measured at the present value of that payment. Interest then accrues each period until the liability reaches the full redemption amount.
Private companies often use these shares in partnerships and family businesses, for instance to fund the buyout of a departing partner. A careful reading of the terms is needed, because a share with an option to redeem, rather than an obligation, may be treated differently.
Disclosure is also important. Companies normally explain the redemption date, the amount, any dividends and the consequences of failing to redeem, so that readers of the accounts understand the commitment sitting behind a security that looks like equity.
In practice
Real-world examples.
Example
A family-owned engineering firm issues shares to a retiring founder that the company must buy back for $1,500,000 in four years. The accountant records the amount as a liability rather than equity, and the company's reported debt rises.
Example
A start-up issues preferred shares to an investor that must be redeemed for $2,000,000 on the sixth anniversary of issue. Because the redemption is required on a set date, the finance team classifies the shares as a liability and discloses the terms. The investor's dividend is shown as a finance cost in the income statement.
Example
A professional services partnership issues shares to new partners that must be redeemed at a formula price when the partner leaves. The firm reports the obligation as a liability and accrues the finance cost over the holding period. Each time a partner leaves, the firm updates its estimate of the amount payable.
Formula
Calculation
Liability at issue = Redemption amount / (1 + Discount rate) ^ Number of years
Suppose a company issues shares that it must redeem for $1,000,000 in three years, and an appropriate discount rate is 10%. The liability on day one is $1,000,000 / (1.10 x 1.10 x 1.10) = $1,000,000 / 1.331 = $751,314.80. After one year, interest of $751,314.80 x 0.10 = $75,131.48 is added, so the liability rises to $826,446.28.Case study
Seen in the real world.
Lakeshore Dental Group is an illustrative, fictional business that issued redeemable shares to a retiring owner in exchange for her stake. The terms required the company to pay her $2,000,000 in five years, regardless of how profitable the business was by then.
When the controller prepared the annual accounts, she recorded the amount as a liability at its present value and showed the yearly increase as a finance cost. The company's debt-to-equity ratio rose, and a lender asked about the impact on its covenant. The bank wanted to understand whether the shares would rank ahead of or behind its own loan if the company ran into trouble.
In this illustrative story, the group discussed the classification with the bank in advance, and the covenant was adjusted. The lesson was that a share in legal form can still be a loan in accounting form.
Watch out
Common mistakes.
- Recording mandatorily redeemable shares as equity because they are called shares, when the obligation to pay makes them a liability.
- Forgetting the finance cost, which should accrue each period as the liability builds towards the redemption amount.
- Ignoring the impact on loan covenants, which may be breached when debt rises.
Questions
People also ask.
What is the difference between mandatorily redeemable and callable shares?
With mandatory redemption the company must buy the shares back, while with callable shares the company only has the option.
Why are they treated as a liability?
The company has an unavoidable obligation to pay cash or other assets, which is the essence of debt.
How are dividends treated?
Dividends on shares classed as liabilities are often shown as finance costs rather than as distributions of profit, which reduces reported earnings accordingly.
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