Stockholders' Equity: Classes of Capital Stock

The corporation

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.

A dividend is a distribution of assets (usually cash) that represents a withdrawal of earnings by the owners. Dividends are normally paid in cash.

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. 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 percent 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 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. 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 percent 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. An appropriate footnote might read: "Dividends in the amount of USD 20,000, representing two years' dividends on the company's 10 percent, cumulative preferred stock, were in arrears as of 2007 December 31"

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 is preferred stock that is convertible into common stock of the issuing corporation. Many preferred stocks do not carry this special feature; they are 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.

Investors find convertible preferred stock attractive for two reasons: First, there is a greater probability that the dividends on the preferred stock will be paid (as compared to dividends on common shares). Second, the conversion privilege may be the source of substantial price appreciation. To illustrate this latter feature, assume that Olsen Company issued 1,000 shares of 6 percent, USD 100 par value convertible preferred stock at USD 100 per share. The stock is convertible at any time into four shares of Olsen USD 10 par value common stock, which has a current market value of USD 20 per share. In the next several years, the company reported much higher net income and increased the dividend on the common stock from USD 1 to USD 2 per share. Assume that the common stock now sells at USD 40 per share. The preferred stockholders can: (1) convert each share of preferred stock into four shares of common stock and increase the annual dividend they receive from USD 6 to USD 8; (2) sell their preferred stock at a substantial gain, since it sells in the market at approximately USD 160 per share, the market value of the four shares of common stock into which it is convertible; or (3) continue to hold their preferred shares in the expectation of realizing an even larger gain at a later date.

If all 1,000 shares of USD 100 par value Olsen Company preferred stock are converted into 4,000 shares of USD 10 par value common stock, the entry is:

Preferred Stock (-SE) 100,000
Common Stock (+SE) 40,000
Paid-In Capital in Excess of Par Value – Common (+SE) 60,000
To record the conversion of preferred stock into common stock.

An accounting perspective:

Business insight

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Most preferred stocks are callable at the option of the issuing corporation. Callable preferred stock means that the corporation can inform nonconvertible preferred stockholders that they must surrender their stock to the company. Also, convertible preferred stockholders must either surrender their stock or convert it to common shares.

Preferred shares are usually callable at par value plus a small premium of 3 or 4 percent of the par value of the stock. This call premium is the difference between the amount at which a corporation calls its preferred stock for redemption and the par value of the stock.

An issuing corporation may force conversion of convertible preferred stock by calling in the preferred stock for redemption. Stockholders who do not want to surrender their stock have to convert it to common shares. When preferred stockholders surrender their stock, the corporation pays these stockholders par value plus the call premium, any dividends in arrears from past years, and a prorated portion of the current period's dividend. If the market value of common shares into which the preferred stock could be converted is higher than the amount the stockholders would receive in redemption, they should convert their preferred shares to common shares. For instance, assume that a stockholder owns 1,000 shares of convertible preferred stock. Each share is callable at USD 104 per share, convertible to two common shares (currently selling at USD 62 per share), and entitled to USD 10 of unpaid dividends. If the issuing corporation calls in its preferred stock, it would give the stockholder either (1) USD 114,000 [(USD 104 + USD 10) X 1,000] if the shares are surrendered or (2) common shares worth USD 124,000 (USD 62 X 2,000) if the shares are converted. Obviously, the stockholder should convert these preferred shares to common shares.

Why would a corporation call in its preferred stock? Corporations call in preferred stock for many reasons: (1) the outstanding preferred stock may require a 12 percent annual dividend at a time when the company can secure capital to retire the stock by issuing a new 8 percent preferred stock; (2) the issuing company may have been sufficiently profitable to retire the preferred stock out of earnings; or (3) the company may wish to force conversion of its convertible preferred stock because the cash dividend on the equivalent common shares is less than the dividend on the preferred shares.