Redeemable Preferred Stock Rated 1 or 2

patbaker12

In chapter 8 of the source, it says that these preferred stocks are recorded at the purchase price plus acquisition costs, but in chapter 22 it says that they are recorded at amortized cost. The latter seems like it would be correct...

graham

Yes, the source text gives two different versions of how to value redeemable preferred stocks of NAIC class 1 and 2. That means at least one is incorrect, possibly both. I did some research but didn't find a definitive answer. I'm sure there is a rule written down somewhere that an accountant would know but since I don't have that information, let's try to think through what would make the most sense.

First recall how bonds of different NAIC ratings are valued:

• NAIC 1,2: amortized cost
• NAIC 3,4,5,6: min (amortized cost, fair value)

But valuation of bonds is a simpler problem than valuing stocks. (Valuation of bonds is discussed in the wiki for Odomirok chapters 6-7.) You know the face value, purchase price, coupon rate, and maturity date. The cash flows are laid out in advance and there's generally less risk than for stocks so it's relatively easy to understand what a bond is worth.

Valuation of stocks however is a much more complicated task. The stock market goes up and down all the time. Methods for valuing stock in a particular company is way beyond the syllabus for this exam and it's touched on only lightly in Odomirok. But let's get back to your original question. Note the following:

• Redeemable preferred stock has a maturity date. That means it can be amortized. (If there is no maturity date, there's no period over which to do the amortization.) Redeemable preferred stock also pays dividends, which is kinda-sorta like coupon payments with bonds. So it looks like amortized cost is consistent with the way bonds are treated.
• Note that the market value of a redeemable bond is essentially capped by its redemption price. If a company can buy it back at a preset redemption price then nobody would pay more than that. So using market price to value this type of stock probably wouldn't make sense. (This was not one of the choices, but I'm just trying to think through all the possibilities.)
• The other option given in the text for the value of redeemable preferred stock is purchase price + acquisition costs. Now, you might value it like that initially because that's concrete information, but when the stock ages that seems less reasonable. It just seems to make more sense to apply amortization over the "term" of the asset to be consistent with how bonds are treated.

Conclusion: Based on the above, I think amortized cost is likely the best way to value redeemable preferred stocks of NAIC class 1,2.

Important Post-Script: This material on redeemable preferred stocks is quite detailed and I suspect you could easily go down a rabbit hole trying to sort it all out. My general advice in studying for Exam 6 is to stick quite closely to what's been asked on prior exams. There's a lot of repetition and it's absolutely imperative to know how to do all the questions on the past several exams in your sleep! It's true that sometimes the examiners throw in a new type of question, but it's hard to predict what it will be. Just make sure you have a super-solid foundation. If you then get a new type of question, you will be able to take a good educated guess at how to solve it.