(Hybrid securities, LO 2) In August, 2006 Ethelbert Ltd. (Ethelbert) issued 10,000 shares of cumulative, redeemable preferred stock to investors for $500,000. The preferred shares pay an annual dividend of $4 per share and are redeemable begin- ning in 2011. Ethelbert must redeem the preferred shares before September 1, 2020.

Ethelbert’s summarized balance sheet just before the preferred shares were sold was:

Required:

a. Do you think that the preferred shares are really debt or equity? Explain.
(Consider the characteristics of debt and equity in your response.)

b. Prepare the journal entry to record the issuance of the preferred shares and calculate the resulting debt-to-equity ratio, assuming that the shares are classified as debt.

c. Prepare the journal entry to record the issuance of the preferred shares and calculate the resulting debt-to-equity ratio, assuming that the shares are classified as equity.

d. How do you think Ethelbert’s management would want to classify the preferred shares for accounting purposes? Explain.

e. How do you think Ethelbert’s management would want to classify the preferred shares for tax purposes? Explain.

f. How do you think Ethelbert’s management would account for the preferred shares if the classification for tax purposes had to be the same as the classification for accounting purposes?
g. Does it matter how the preferred shares are classified? Explain.

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Ethelbert Ltd. Summarized Balance Sheet (Just before the sale of preferred shares) Assets $4,400,000 Liabilities Total assets $4,400,000 Shareholders' equity Total liabilities and shareholders' equity $2,000,000 2,400,000 $4,400,000