Unformatted text preview: Debt/Equity = ($250,000 + $100,000) ÷ $330,000
= 1.06 c. If management classifies the stock as stockholders' equity, then the company will not be in violation of its
debt agreement. However, if management classifies the stock as debt, then the company will be in
violation of its debt agreement. Since violating debt agreements can be quite costly to both the company
and managers, managers have incentives to classify the stock as stockholders' equity.
The terms of the preferred stock make it appear to be more similar to debt than to equity. For example,
the stock has a specified rate, does not participate in the benefits of ownership (i.e., does not vote and
does not participate in profits), and has a fixed life. Based upon these factors, it appears that the stock is
in substance actually debt and should be classified as such.
Auditors will typically be guided by generally accepted accounting principles (GAAP) in deciding how to
report an item. However, in most cases, GAAP does not provide clearcut gu...
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