Audit Memo Example 1 2 
Memo
To: The Files, Client Inc.
Re: December 31, 2009 Audit; Preferred Shares Classification
Background
The Company issued two forms of preferred stock (Series A and Series A-1) in January 2009. The terms of the preferred stock are as follows:
Par value, $0.001 per share
6%, compounded semi-annually dividend rights, payable upon a liquidating event, conversion, or redemption, or earlier if declared by the Board (if upon specific event cash is not available, they shall be paid to the extent that cash is available proportional amongst the shareholders)
Liquidation preference
Voting rights based on number of common shares as would be held had the preferred shares been converted on that date
Ability to elect two Board members
Convertible into common shares at option of preferred share holder at any time, at the original preferred share price, adjusted for dilution or splits of the common stock up through date of conversion
Mandatory conversion upon event of IPO > $75MM in proceeds or upon majority vote by preferred shareholders
Redeemable at option of holder at the earlier of January 30, 2019 or a liquidating event, for a set price plus unpaid but accrued dividends, limited to payout with legally available funds at time of redemption. If legally available funds are not sufficient, shareholder has option to request a note payable in lieu of holding unredeemed shares.
Issue
Are the preferred shares Debt or Equity?
Guidance
ASC 480-10, Distinguishing Liabilities from Equity
Scope of 480-10:
The guidance requires that an issuer classify a financial instrument that is within its scope as a liability because that financial instrument embodies an obligation of the issuer [05-1].
Defining “Obligation”:
All of the following are examples of an obligation [05-2]:
a. a conditional obligation to transfer assets by issuing a put option that would, if exercised, require the entity to repurchase its equity shares by physical settlement. b. a
To: The Files, Client Inc.
Re: December 31, 2009 Audit; Preferred Shares Classification
Background
The Company issued two forms of preferred stock (Series A and Series A-1) in January 2009. The terms of the preferred stock are as follows:
Par value, $0.001 per share
6%, compounded semi-annually dividend rights, payable upon a liquidating event, conversion, or redemption, or earlier if declared by the Board (if upon specific event cash is not available, they shall be paid to the extent that cash is available proportional amongst the shareholders)
Liquidation preference
Voting rights based on number of common shares as would be held had the preferred shares been converted on that date
Ability to elect two Board members
Convertible into common shares at option of preferred share holder at any time, at the original preferred share price, adjusted for dilution or splits of the common stock up through date of conversion
Mandatory conversion upon event of IPO > $75MM in proceeds or upon majority vote by preferred shareholders
Redeemable at option of holder at the earlier of January 30, 2019 or a liquidating event, for a set price plus unpaid but accrued dividends, limited to payout with legally available funds at time of redemption. If legally available funds are not sufficient, shareholder has option to request a note payable in lieu of holding unredeemed shares.
Issue
Are the preferred shares Debt or Equity?
Guidance
ASC 480-10, Distinguishing Liabilities from Equity
Scope of 480-10:
The guidance requires that an issuer classify a financial instrument that is within its scope as a liability because that financial instrument embodies an obligation of the issuer [05-1].
Defining “Obligation”:
All of the following are examples of an obligation [05-2]:
a. a conditional obligation to transfer assets by issuing a put option that would, if exercised, require the entity to repurchase its equity shares by physical settlement. b. a