This course is the fourth course in a five-course Financial Reporting Specialization. This course focuses on the recognition, measurement and subsequent accounting for equity, pensions, share-based compensation and cash flows utilizing the FASB Accounting Standards Codification and other resources.
Equity: Preferred Stock
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From the course by University of Illinois at Urbana-Champaign
Accounting Analysis II: Accounting for Liabilities and Equity
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University of Illinois at Urbana-Champaign
8 ratings
Course 4 of 5 in the Specialization Financial Reporting
From the lesson
Module 3 Equity
In this module, the conversation changes from liabilities to equity. You will learn how to account for the issuance of common stock and basic transactions such as cash dividends, stock dividends, stock splits, and the purchase and reissuance of treasury stock. The module also includes a discussion of preferred stock and accumulated other comprehensive income.
Meet the Instructors
John HeppClinical Assistant Professor of Accountancy
Department of Accountancy
Hi, welcome back. In this session,
we're going to talk about preferred stock.
Now preferred stock's been around for a long, long time,
unlike recent innovations like derivatives and
all that fancy stock options, and things of that nature.
Preferred stock goes - It's been around just about as long
as there's been corporations. So what is it?
Well, at the time when corporations were first being set up,
a lot of common shares really had a fixed dividend and expectation.
This is what pár value was all about back in those days.
And the main difference between preferred and
common stock really was preferred shares were paid first.
They got their dividends first.
Of course over time both have evolved significantly.
Common stock par values today are either in nominal or nonexistent.
Preferred stock is not used as often,
especially by public companies.
But you still will see it,
and it still figures in the calculation of earnings per share.
So it is an odd type of equity.
It was a financial instrument that has characteristics of both debt and equity.
Today if this was being invented we'd probably want to classify it as debt,
because it's not part of the residual interest of the firm,
but there's a long history,
a legal history of classifying as equity.
It's based mainly on the legal structure of it.
So a debt like feature of preferred stock is that it does have a stated rate of return.
It's like interest.
And equity like feature is that the shareholders are at risk for
the investment and it's subordinate to any bondholders or anything.
They are only a senior to the common stock itself typically.
So here's some fast vocabulary.
It's a security that has preferential rights compared to common stock.
And participation rights are sometimes fun.
And sometimes common stock will be able to participate.
This means that in addition to getting their dividend on a stated interest rate first,
they may also be able to participate in any additional dividends that are paid later.
FASB defines these participation rights as contractual rights of
security holders to receive dividends or returns from the securities issuers profits,
cash flows, or returns on investment.
Like I say, this is usually the ability to participate in
addition to the stated return that a preferred stock will have.
Now the accounting for this is really a form of true GAAP.
What do I mean by true GAAP?
It's truly generally accepted accounting principles.
It's based upon the way it's just always been done.
Again this is because it's such an old type of financial instrument.
We don't have really an accounting standard.
There's no provisions in the ASC that describe the accounting for preferred shares.
It's based upon the way it's always been done,
generally accepted accounting principles.
There are however some disclosure provisions in GAAP.
Dividends.
So the preference for dividends usually means that the dividends on the preferred stock
have to be paid first before any dividends are paid and the common stock.
That's the preference.
Preferred stock dividends,
they're not a liability until declared.
That's the same as dividends on common stock.
So in both cases,
there's no liability like there would be with
accrued interest to pay an amount to the debt holder,
in this case a preferred stock holder.
There's no liability until the dividends are declared.
Of course once it's declared,
dividends then do become a liability of the entity.
And again, these dividends are usually expressed as a percentage of par.
For example, if you have preferred stock with a six million dollar par value,
it pays eight percent,
you would pay a dividend of eight percent every year of six million or 48000 dollars.
There can be a premium or a discount on preferred stock which will go into a pick.
It doesn't amortize the way a discount or premium would on debt.
Now the dividends can be either cumulative or non cumulative. What do we mean by that?
Non cumulative dividends mean that
if there are no dividend is declared in a particular year,
say the company didn't have a very good year and
there's no money available for dividends.
If they're not declared in the current year, they're gone.
They're forfeited. The shareholder will never make that up.
If the amount of dividends, though, is cumulative,
that means if I don't pay dividends this year,
well, I have to pay them next year.
And again I'm going to have to pay them and make any arrears,
clear any arrears on this preferred dividend stock
before I can make any dividend payments on my common stock.
That's the preference again.
So if it's cumulative,
I have to clear up everything that hasn't been paid in prior years as well as
anything that's due in the current year before I can make any payments on common stock.
And there can be other restrictions that apply to.
I mean, certainly today common stock is different.
150 years ago, virtually all common stocks paid dividends,
and fairly large dividends,
in fact if you look at perspective prospectuses from those days
the planned interest was an important part
of the prospectus and shareholders expected to get their claim to a dividend on it.
But today, of course, a lot of shareholders aren't looking for dividends,
they're looking for either capital or returns or when they
sale and acquirement in a public market.
Or there can be other ways that the company can get cash out too.
So this is a restriction that comes from Goldman Sachs,
which has some preferred stock that it issued after the troubles in the mid 2000s.
It says that they're not only it's their ability to declare paid dividends,
is it dependent on their ability to pay preferred structures,
but also they may not be able to redeem stock,
buyback, or otherwise acquire the stock as say a treasury stock purchase.
So the restriction goes beyond just paying dividends.
So let's look at an example of cumulative rights.
So Tech Motivators issues 1,000,000 and six
percent cumulative preferred stock for 1,100,000 on July 1st.
So remember that extra 100,000 would be accounted for as APIC.
It's preferred stock, and it wouldn't be a premium that would amortize over the future.
It just means that the preferred shareholders paid more
for this stock than the stated par value.
The stated par value, though,
is the only amount that would get redeemed potentially in the future.
And the only amount in which dividends would be paid.
So let's say Tech does not pay dividends in year one or year two.
Now notice it's being issued halfway through the year.
In year three, TMI's board decides that it can pay 200,000 dollars in dividends.
So how would it allocate the amount of those dividends?
Well, how much would be available to the common shareholders.
They have to clear the arrears,
and remember the stock was issued halfway through the year in the first year.
So they'd have to clear 1,000,000 times six percent times half a year or 30,000 dollars.
There's the year two dividend,
which was declared and not paid.
There's a year three dividend which was declared and not paid.
The common shareholders could receive 50,000 dollars if the board declares a dividend of
200,000 because they would need to clear that 150,000 dollars of arrearages first.
Now that amount could be reduced further if the preferred shares are participating.
So if the preferred shares were also able to participate say on
an equal basis with the common shareholders in a participation,
then that 50,000 dollars would be split
25-25 between the preferred shareholders and the common shareholders.
Not a real common provision,
but you could see this.
Now the exact amounts are always determined by the terms of the preferred stock.
This is a contractual matter,
a legal matter, that goes into the terms.
You have to look at the terms of the stock to see what would be available.
And of course this is also going to be a factor in measuring earnings per share,
as we'll see in the next lesson.
Disclosure. The FASB does require disclosure that you have a preference
either in involuntary liquidation or a stated
value the shares should disclose the liquidation preference on the stock.
This is so common shareholders know how much would be going in front of them.
But remember, preferred stockholders are going to be behind any debt holders.
They will take precedence in law.
You also have to disclose any call features or
cumulative dividends and the aggregate amount of arrearages.
This is going to be important because a common share
a stockholder would need to know how much was in arrears.
How much would have to be paid out before they could hope to see a dividend.
So today, preferred stock is mainly a private thing.
You don't see it very often in public companies.
It's usually not considered to be a very good deal for stockholders,
because the benefits of owning their preferred stock are usually offset by risky.
You're essentially an equity holder at law.
So you don't have any preference in getting
your money back and in fact there have been some court cases
that have really eroded the rights of preferred stock holders over the years.
But they are more common with private firms.
Now, say private equity firms,
they often use preferred stock usually with prefer conversion stock, conversion rates.
This risk for them though may be lower,
because they usually have greater influence over the issuer.
It is still available as a means
to give certain parties perhaps a guaranteed return in front of common shareholders.
But its use is not as widespread as it was say,
even 50 or 60 years ago. You do see it.
I think you'll see it more with your private clients than with public clients.
But you should be aware of how it works.
And that wraps up our lesson. Thank you.
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