Accounting for Equities

CFA Level 1 - Financial Statements

Preferred Stock Characteristics
Preferred stock (preferred shares) is a hybrid between common stock and bonds. It provides a specific dividend that is paid before any dividend is paid to common stockholders.

• Dividends
  • Preferred stocks pay to stockholders a predefined dividend that is based on a specific amount, or is a percentage of the preferred stock's par value.
  • Like common stock, preferred stocks represent partial ownership in a company.
  • Preferred stockholders do not usually enjoy any of the voting rights of common stockholders or any additional net income distributions beyond the stated dividend payout, unless they are participating preferred stockholders.
• Superiority in the Event of Liquidation
  • Preferred stockholders have precedence over common stockholders in the event of liquidation.
  • Bondholders always have precedence over preferred stockholders from a dividend and liquidation point of view.
  • Unlike bondholders, preferred stockholders cannot force a company into bankruptcy.
• Classification
  • From an accounting point of view, preferred stock is classified as equity, and the dividend payments are classified in a similar fashion as common stock dividends.
  • Unlike interest paid on bonds, the fixed dividend paid out to preferred stockholders is not deductible from earnings before taxes (EBT) and is not tax deductible.
• Attributes

In general, preferred stock can have several attributes; they can be:

• Cumulative - This is preferred stock on which dividends accrue in the event that the issuer does not make timely dividend payments. Unpaid preferred dividends are called "dividends in arrears". Most preferred stocks are cumulative.
• Non-cumulative - This is preferred stock on which dividends do not accrue in the event that the issuer does not make timely dividend payments.
• Participating - This is preferred stock that, in addition to a regular dividend, pays a dividend when common stock dividends exceed a specified amount.
• Convertible - This is preferred stock that can be converted into a specified amount of common stock at the holder's option.
• Retractable - This is preferred stock that grants the stockholder the right to redeem the stock at specified future date(s) and price(s).
• Perpetual - These are preferred shares that have no maturity date.
• Callable (Non-perpetual) - These are preferred shares that have a predetermined maturity date. At the maturity date, the company will buy back the preferred shares at their par value.

• Voting Rights

Most preferred stock is non-voting. However, most of these securities also include a clause that would give holders a predetermined voting right if dividends are not paid for a certain period of time (in most cases, three years).

Stock Issuance

The issuing company will normally receive cash in exchange for shares (stock). The shares may or many not have a stipulated par value. If they do have a par value, the excess paid to the par value will be recorded in additional paid-in capital (paid-in capital) account. If the stock sold has no par value, the full amount will be recorded in the stock account.

Example: XYZ Company has issued 800,000 common shares at a price of $5 per share. With par value of $3 per share:


Without par value:

Stock Repurchase
A program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This is usually an indication that the company's management thinks the shares are undervalued.

Look Out! Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares. When a company does repurchase shares, it will usually say something along the lines of, "We find no better investment than our own company."

With par value of $3 per share:

Without par value:

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