Introduction to accounting for preferred stock
February 23, 2014
There are three main forms of financing available to a corporation. In this article, we discuss preferred stock, the middle-of-the-road option that sits between debt and common equity.
A corporation has a high degree of flexibility when figuring out how best to finance operations. Taking on debt is usually inexpensive but restrictive and issuing common stock means giving up a lot of corporate control. A third option is to issue preferred stock, a customizable security which toes the line between debt and equity. Like debt, preferred stock carries a stated percentage rate - unlike debt, however, this percentage is a dividend rate, not an interest rate. Below, we’ll discuss why this difference is so important, but we should first cover four basic characteristics of preferred stock.
First, preferred stock has a par value and a stated dividend rate - for example, a corporation might issue $100, 8% preferred stock. That means every share of the stock yields an annual dividend of $8. Second, preferred stockholders are paid before common stockholders when the company is liquidated. Creditors and bondholders, however, are paid before both types of stockholders. The third characteristic is that preferred stock does not carry voting privileges. Finally, like common stock, preferred stock can be bought and sold on secondary markets.
As mentioned above, preferred stock can be customized to best match the needs of both the investor and the corporation. We will now discuss the different customizable features that can apply to preferred stock.
One of the most important characteristics of preferred stock is whether it is cumulative or noncumulative stock. Corporations are not required to pay the stated preferred dividend rate - this is one of the main reasons preferred stock is so flexible. If the preferred stock is cumulative, however, the corporation faces a special liability called dividends in arrears. Corporations cannot pay dividends to common shareholders until all unpaid preferred dividends are satisfied. Over a long period of time, dividends in arrears can cause major headaches. If the stock is noncumulative, the corporation is not required to pay those prior dividends.
Participating shares can receive disbursements when common dividends are declared (they “participate” in the dividend along with the common shareholders). Nonparticipating shares, on the other hand, do not receive any more than the stated dividend rate associated with the shares.
Convertible preferred stock can be exchanged for a specific number of common shares at the option of the holder. This is a popular provision for investors because they can potentially take advantage of future company growth.
Callable or redeemable preferred stock can be liquidated for a specific price at the option of the corporation. The call premium is the difference between the face value and the call price. A premium is usually demanded because the investor may not like being forced to get rid of his investment. Some redeemable stock is required to be redeemed on a specific date, which makes it more like a bond.
Now that we have thoroughly described the concept of preferred stock, we can go over some related journal entries you might encounter.