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.
- 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; and
- 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.