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Chapter 11 - Solution Manual

For example in a court of law the amount due upon

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For example, in a court of law, the amount due upon redemption of preferred stock cannot force a company into bankruptcy. Moreover, this amount due to holders of redeemable preferred stock is not includible in the determination of insolvency. Arguably, the effect of the redemption provision is analogous to cumulative dividends on nonredeemable preferred stock. Cumulative dividends do not become a liability until they become due and payment has effectively been declared.
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252 SFAC No. 6 defines equity as the residual interest in the assets of an entity that remains after deducting liabilities. If redeemable preferred stock does not meet the definition of a liability, it must be equity. Separate balance sheet classification of redeemable preferred stock (i.e., separate from equity) is not required under GAAP. All preferred stockholders are considered “stock” holders by law. They are treated in the same way as owners in liquidation - i.e., they are residual owners, but they have claims senior to all other classes of stock. Debate 11-2 Fair Value Option Team 1 SFAS No. 159 allows users to measure financial assets and liabilities at fair value, providing an opportunity to mitigate reported earnings volatility without having to apply complex hedge accounting. Rather than designating a fair value hedging relationship under Statement 133, entities may elect to apply the fair value option to the hedged item at its inception. Reporting financial instruments at fair value and including unrealized changes in fair value in earnings would reflect the economic events in the periods in which they occur and faithfully represent the underlying economics—a key objective of the conceptual framework. Thus, the effect of a company’s credit worthiness on its capital structure would be reflected in balance sheet measurements of debt and equity. The FASB believes fair values for financial assets and financial liabilities provide more relevant and understandable information than cost or cost-based measures. The Board considers fair value measurements of financial instruments to be more relevant to financial statement users than cost-based measurements because fair value reflects the current cash equivalent of the entity’s financial instruments rather than the price of a past transaction. The FASB also believes that, with the passage of time, historical prices become irrelevant in assessing an entity’s current financial position. Reporting holding gains and losses for debt would reveal the results of management decision to pay or not pay off debt, to replace debt with new debt (that would reflect current market conditions and credit worthiness) and to substitute or not substitute debt for equity, or vice-versa. In other words, the effects of credit-worthiness and changes in interest rates due to current economic conditions on firms are not captured using the historical cost model Team 2 If you believe that current value should be applied to liabilities, then giving an option rather than a mandate to do so is inappropriate and could lead to biased reporting whereby management would pick and choose which liabilities to apply fair value to.
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