Business Finance Homework Help

When accounting standards changed to require debt and equity securities be accounted for according to their substance rather than their legal form, it created a challenge for many SME’s that had undertaken in vivos estate planning.

In such estate freezes, typically the founder of the company transferred the fair value of the equity of the company (at the time of the freeze) to a new class of preferred shares held by her/him. These shares were redeemable at the option of the holder (the founder) for the FMV of the company at the time the estate freeze was implemented. Common shares could then be issued to the founders children for nominal consideration, and post freeze value accretion in the company would accrue to them.

When “substance over form” accounting was implemented, these shares were considered debt. As a result, many SME’s were put offside on debt covenants on their bank financing. Accountants spent much time explaining substance over form accounting to bankers.

As a result, a special exception to substance over form accounting was created by Canadian accounting standard setters to allow hi lo pref shares to be classified according to their legal form, as equity.

Recently, the appropriateness of the exception is being re-examined (see following article): Redeemable preferred shares: Accounting proposal could complicate estate tax plans

In your view:

– are hi-lo pref shares debt or equity? Why do you think so?

– Why are the standard setters re-visiting the accounting for hi-lo pref shares now? Do you think this is appropriate?

– do you think the exception accounting should be allowed to continue? why or why not?