Preferred stock is a type of equity which gives stockholders preference over common stockholders to dividends and repayment of their investment in the event of liquidation. Preferred stock is sometimes referred to as preferred equity, preferred shares or preference shares.
Issue of Preferred Stock
Preferred stock has a stated dividend rate and par value, and is often issued at a premium to that par value.
For example, suppose a business issues 1,000 7% preferred equity stock with a par value of 100 at a premium issue price of 105.
The business will receive 1,000 x 105 = 105,000 in cash and issues stock with a par value of 1,000 x 100 = 100,000. The premium of 5,000 will be posted to the additional paid in capital (APIC) account with the following journal entry:
|APIC – Preferred shares||5,000|
Preferred Stock Dividends
The dividend on a preferred equity stock is usually fixed and based on the par value of the stock. Using the example above, the business issued 1,000 7% preferred shares with a par value of 100, so the annual dividend on each preferred share is calculated as follows.
Dividend per share = Dividend rate x Par value of each share Dividend per share = 7% x 100 = 7
The total dividend on 1,000 shares is then calculated as follows.
Dividend = Dividend per share x Number of shares Dividend = 7 x 1,000 = 7,000
The journal to post the declared dividend is as follows:
Although in the above example the dividend was fixed at 7%, floating rate preferred shares are available in which the dividend rate varies relative to market rates.
Types of Preferred Stock
There are various types of preferred shares available each with differing benefits (preferences) including the following:
Cumulative Preferred Stock
Cumulative simply means that the dividends on the stock are cumulative. If a business does not declare a dividend in one year, then the dividend will continue to accumulate on the cumulative stock.
The dividends not declared are said to be passed, and are referred to as dividends in arrears. As the passed dividends have not been declared they are not shown as a balance sheet liability but are referred to in a note to the financial statements.
In the above example, the business issued 1,000 7% preferred equity stock at 100 par value.
If the stock are cumulative, and the business does not declare a dividend for two years, then the cumulative preferred shareholders would retain the right to the receive those dividends before the common stockholders receive a dividend.
The dividend passed is 2 (years) x 1,000 x 7% x 100 = 14,000. The dividend for the current year if declared will be a further 1,000 x 7% x 100 = 7,000, giving a total preferred dividend to pay of 21,000, before the common or preferred shareholders can receive a dividend.
Participating Preferred Stock
Participating preferred shares gives stockholders the right to participate in additional dividends in addition to the preference dividend. This is particularly relevant in the liquidation of a business.
Suppose a business is liquidated, if the preferred shares are non-participating, then they simply receive their original investment (in this case 105,000) and any preferred share dividends outstanding. However, if the stock is participating then in addition to the above, the stockholder would receive a share of the remaining proceeds of the liquidation.
Suppose for example the liquidation proceeds were 500,000 and the participating preferred equity stock represented 5% of the outstanding share capital. The amount the participating preferred shareholders receive is calculated as follows:
Original investment = 1,000 x 105 = 105,000 Current year preferred dividend = 1,000 x 7% x 100 = 7,000 Remaining proceeds = 500,000 - 105,000 - 7,000 = 388,000 Additional dividend = 388,000 x 5% = 19,400
Convertible Preferred Stock
Convertible preferred stock gives the stockholder the right to convert the preferred shares into shares in the common stock of the business at a fixed conversion ratio. The conversion ratio is the number of shares in common stock that the investor receives in return for each share in the convertible preferred stock.
Convertible preference shares give the stockholder the benefit of being able to participate in the growth of the business (by converting) if the common stock is doing well, but to retain their preference dividend (by not converting) if the common stock is not performing.
Suppose for example, an investor owns 7% convertible preference stock with a par value of 100 and a conversion ratio of 6.25. With this conversion ratio, the investor could receive 6.25 shares in common stock in return for each share of convertible preferred equity stock. The investor now has a choice to make depending on the current prices of the preferred and common stocks.
Using the 6.25 ratio our 1,000 preferred equity stock are replaced with 6,250 shares of common stock. If the common stock has say a par value of 10, then the par value of the common stock issued is 6,250 x 10 = 62,500, and the premium (APIC) on issue is 105,000 – 62,500 = 42,500.
The journal entry to post the conversion would be as follows:
|APIC – Preferred shares||5,000|
|APIC – Common stock||42,500|
Callable Preferred Stock
Callable preferred stock gives the business the right to buy back (call) and cancel the preferred equity at some future date. To compensate the stockholder for this provision, the call price paid by the business is normally higher than the price the preferred stock was issued for.
As an example, assume as before the business has issued the 1,000 7% preferred equity stock with a par value of 100 and an issue price of 105, but this time the stock is callable at 108.
The cost in cash to the business of exercising the call is 1,000 x 108 = 108,000. The difference between this price (108) and the issue price (105) is 3 per share and the total of 1,000 x 3 = 3,000 is debited as a cost, to the retained earnings account.
The journal to post the buy back of the preferred shares is as follows:
|APIC – Preferred shares||5,000|
Redeemable Preferred Equity Stock
Redeemable means that the business has to buy back (redeem) the stock at some future date. The redemption might be at the discretion of the stockholder or can sometimes be mandatory. Since the business can be forced to redeem the preferred equity stock it is usually considered to be more a form of debt than equity.
The journal entry to post the redemption of the preferred stock is similar to that shown above for callable preferred stock.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.