OCW041: Additional Detail on Preferred Stock

Dividend Preference

A corporation may issue two basic classes or types of capital stock, common and preferred, both of which can receive dividends.

Learning Objectives

Explain the difference between common stock and preferred stock dividends

Key Takeaways

Key Points

  • A corporation may issue two basic classes or types of capital stock, common and preferred. If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal rights.
  • Common stock is a form of corporate equity ownership. Common stock holders cannot be paid dividends until all preferred stock dividends are paid in full. On the other hand, common shares on average perform better than preferred shares or bonds over time.
  • Preferred stock is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (higher ranking) to common stock, but subordinate to bonds in terms of claim.

Key Terms

  • dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).
  • Preferred Stock: Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.
  • dividend in arrears: an omitted dividend on cumulative preferred stock
  • Common stock: Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.

Dividends

A corporation may issue two basic classes or types of capital stock—common and preferred. If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal rights. Common stock is usually the residual equity in the corporation, meaning that all other claims against the corporation rank ahead of the claims of the common stockholder. Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock. Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with different dividend rates or other features.

Companies issue preferred stock in order to avoid the following:

  • Using bonds with fixed interest charges that must be paid regardless of the amount of net income.
  • Issuing so many additional shares of common stock that earnings per share are less in the current year than in prior years.
  • Diluting the common stockholders’ control of the corporation, since preferred stockholders usually have no voting rights.

Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per share.

1903 stock certificate of the Baltimore and Ohio Railroad: Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.

Details on Common Stock

Common stock is a form of corporate equity ownership, a type of security. The terms “voting share” or “ordinary share” are also used in other parts of the world; common stock is primarily used in the United States. It is called “common” to distinguish it from preferred stock. If both types of stock exist, common stock holders cannot be paid dividends until all preferred stock dividends (including payments in arrears) are paid in full. In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid. As such, such investors often receive nothing after a bankruptcy. On the other hand, common shares on average perform better than preferred shares over time.

Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors. However, a company can have both a “voting” and “non-voting” class of common stock. Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company’s board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering. There is no fixed dividend paid out to common stock holders and so their returns are uncertain, contingent on earnings, company reinvestment, and efficiency of the market to value and sell stock. Additional benefits from common stock include earning dividends and capital appreciation.

Details on Preferred Stocks

Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to stock holders’ share of company assets). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock upon liquidation, and in the payment of dividends. Terms of the preferred stock are stated in a “Certificate of Designation. ”

Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds, and because they are junior to all creditors.

Liquidation Preference

The main purpose of a liquidation where the company is insolvent is to satisfy claims in the manner and order prescribed by law.

Learning Objectives

Summarize how the liquidation preference determines which claims will be paid if a company becomes insolvent

Key Takeaways

Key Points

  • The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law.
  • Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims.
  • Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance.
  • Most preferred stocks are preferred as to assets in the event of liquidation of the corporation.

Key Terms

  • Preferred Stock: Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.
  • creditor: A person to whom a debt is owed.
  • liquidation: The selling of the assets of a business as part of the process of dissolving it.

Liquidation Preference

The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law. The liquidator must determine the company’s title to property in its possession. Property which is in the possession of the company, but which was supplied under a valid retention of title clause will generally have to be returned to the supplier. Property which is held by the company on trust for third parties will not form part of the company’s assets available to pay creditors.

Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims. Security by way of floating charge may be postponed to the preferential creditors.

Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance and compel the liquidator to transfer title to the land to them, upon tender of the purchase price. After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.

Plane Liquidation: Planes are an example of liquidated items when companies “go under. ” They are generally auctioned off to the highest bidder.

Priority of Claims

Generally, the priority of claims on the company’s assets will be determined in the following order:

  • Liquidators costs
  • Creditors with fixed charge over assets
  • Costs incurred by an administrator
  • Amounts owed to employees for wages/superannuation (director limit $2,000)
  • Payments owed in respect of workers’ injuries
  • Amounts owed to employees for leave (director limit $1,500)
  • Retrenchment payments owing to employees
  • Creditors with floating charge over assets
  • Creditors without security over assets
  • Shareholders (Liquidating distribution) – Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders. A corporation’s cumulative preferred dividends in arrears at liquidation are payable even if there are not enough accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock may be preferred as to assets, dividends, or both.
  • Unclaimed assets will usually vest in the state as bona vacantia.

Accounting for Preferred Stock

All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock.

Learning Objectives

Differentiate between preferred to dividends, noncumulative, cumulative and convertible preferred stock

Key Takeaways

Key Points

  • Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to preferred stockholders as a return for the use of their money.
  • Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year.
  • Cumulative preferred stock is preferred stock for which the right to receive a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock.
  • All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock. The par value, authorized shares, issued shares, and outstanding shares is disclosed for each type of stock.

Key Terms

  • dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).
  • Common stock: Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.
  • Preferred Stock: Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.
  • cumulative dividend: a payments by the company to shareholders that accumulate if a previous payment was missed

Preferred Stock

Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock. Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with different dividend rates or other features. Companies issue preferred stock to avoid:

1903 stock certificate of the Baltimore and Ohio Railroad: Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.

  1. using bonds with fixed interest charges that must be paid regardless of the amount of net income;
  2. issuing so many additional shares of common stock that earnings per share are less in the current year than in prior years; and
  3. diluting the common stockholders’ control of the corporation, since preferred stockholders usually have no voting rights.

Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per share.

Types of Preferred Stock

When a corporation issues both preferred and common stock, the preferred stock may be:

  • Preferred as to dividends. It may be noncumulative or cumulative.
  • Preferred as to assets in the event of liquidation.
  • Convertible or nonconvertible.
  • Callable.

Preferred as to Dividends

Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend is the amount paid to preferred stockholders as a return for the use of their money.

For no-par preferred stock, the dividend is a specific dollar amount per share per year, such as USD 4.40. For par value preferred stock, the dividend is usually stated as a percentage of the par value, such as 8% of par value; occasionally, it is a specific dollar amount per share. Most preferred stock has a par value.

Usually, stockholders receive dividends on preferred stock quarterly. Such dividends—in full or in part—must be declared by the board of directors before paid. In some states, corporations can declare preferred stock dividends only if they have retained earnings (income that has been retained in the business) at least equal to the dividend declared.

Noncumulative Preferred Stock

Noncumulative preferred stock is preferred stock in which a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.

Cumulative Preferred Stock

Cumulative preferred stock is preferred stock for which the right to receive a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock. For example, assume a company has cumulative, USD 10 par value, 10% preferred stock outstanding of USD 100,000, common stock outstanding of USD 100,000, and retained earnings of USD 30,000. It has paid no dividends for two years. The company would pay the preferred stockholders dividends of USD 20,000 (USD 10,000 per year times two years) before paying any dividends to the common stockholders.

Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability until declared by the board of directors. However, since the amount of dividends in arrears may influence the decisions of users of a corporation’s financial statements, firms disclose such dividends in a footnote.

Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders. A corporation’s cumulative preferred dividends in arrears at liquidation are payable even if there are not enough accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock may be preferred as to assets, dividends, or both.

Convertible Preferred Stock

Convertible preferred stock is preferred stock that is convertible into common stock of the issuing corporation. Convertible preferred stock is uncommon, most preferred stock is nonconvertible. Holders of convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common stock of the same corporation.

Preferred Stock and the Balance Sheet

All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock. The par value, authorized shares, issued shares, and outstanding shares is disclosed for each type of stock.


Source: Accounting