"When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck." — James Whitcomb Riley



The above quote is sometimes referred to as the "Duck Test." When the test is applied to accounting for preferred stock, the duck walks, swims and quacks just like debt. Yet preferred stock is listed on the balance sheet as equity rather than a liability.



Suppose I decide to open a bar for bikers and other counter-culture types — let's call the bar "Poor Mac's." I am long on insight but short on cash so I decide to enlist the services of a co-investor. Let's say we decide to split the profits 60/40 in my favor and the two parties incorporate. We divide the stock of the company accordingly. I invest $60,000 and my partner invests $40,000. We list the amount on the equity portion of our balance sheet under paid in capital.



As the months pass, I find out that I am undercapitalized and I lack sufficient liquidity to perform basic maintenance tasks which are required to keep the bar going. I talk to my partner and we decide to get a business loan to conduct the necessary maintenance. Say the business loan is written for $100,000 and it carries a 15% interest rate since it is unsecured. The debt is listed in the liability section of the balance sheet as long term debt.



Business is proceeding well but the annual interest expense of $15,000 is hurting the profits of the business. My partner and I decide we need to come up with an additional plan to eliminate the debt.







We attempt to sell stock to others promising a percentage of the profits in return, but no one is interested. Finally we find a potential investor in my aging Aunt Murty who has a $100,000 CD which is set to roll over at a tiny rate of interest. Murty is interested but she wants income so we cut a deal by issuing 100,000 in preferred stock with a coupon of 7.5% and the right to convert her share into 50% of the common in the event we sell the bar. Both sides are enamored; we quickly use the recently raised capital to pay off the debt and just like that we begin saving $7,500 per year in interest expense.



Business really starts to pick up and a certain biker known as "Buzzard" takes a fancy to the bar. It seems that Buzzard has extremely "deep pockets" since he is always buying drinks. My partner suspects that he may be selling meth in the bar but neither one of us has the mettle to confront this chap. Instead we decide to invent a story about how we are "burned out" running the business and are looking for a buyer.







Buzzard's ears quickly perk up. It seems that he needs a place to launder his cash and Poor Mac's looks like the perfect opportunity. The parties strike a deal and the bar is sold for $500,000 with all inventory included.







The division of the $500,000 occurs as follows due to the terms of our preferred agreement: I get $150,000, my partner gets $100,000 and Aunt Murty bankrolls a cool $250,000. Obviously, Aunt Murty is the really winner in the transaction. The two partners are not pleased with the split but it is much better than running a "meth bar," or getting shot.







Now lets examine the Wikipedia definition of a liability from the International Accounting Standards Board:



In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. A liability is defined by the following characteristics:



1) Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time;



2) A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand;



3) A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement; and,



4) A transaction or event obligating the entity that has already occurred.



Now let's examine the parable in terms of whether the issuance of preferred shares to Aunt Murty fits the definition of a liability. A liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.



1) The issuance of the preferred share represented an obligation to pay Aunt Murty an annual interest payment of 7.5%. That sounds like a liability to me.



2) The settlement of the preferred stock ultimately involved a obligation to pay Aunty Murty half the proceeds from the sale of the bar. That certainly sounds like a liability as well.



Now lets look at the characteristics of a liability:







Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time;







Aunt Murty's $100,000 investment replaced a loan which was used to improve the business — liability.







A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand;







The owners of the bar had an obligation to convert Aunt Murty's preferred shares to common in the event the bar was sold — can you say liability.



A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement;







The owners were obligated to pay Aunt Murty and had no discretion to avoid paying her — strike three.







It certainly appears that in the case of Aunt Murty and Poor Mac's, the preferred shares walked, swam and quacked just like a liability.







Conclusion







The point of this lengthy parable is to emphasize the need for investors to closely examine the long-term ramifications and liabilities which preferred stock can present.



Virtually every bank stock now contains one or more types of preferred stock. The ultimate liability that exists for common shareholders in bank stocks is not easily discernible without conducting extensive research. In the case of Buffett's large purchase of Bank of America (NYSE:BAC) preferred shares, investors need to analyze the underlying liabilities and obligations which directly affect the intrinsic value of the common shares. One would never know that those obligations exist if they merely examined the liabilities listed on the balance sheet.





About the author: