I'm Larry Walther, this is principlesofaccounting.com Chapter 14.
And in this module we are going to very simply look at features of common and
preferred stock.
Now companies may issue different types of stock.
For example, a family business may create a class A and a class B stock.
They may retain the class A stock, which has voting rights, and
sell to the public the class B stock, which does not have voting rights.
They're able to share the ownership of the business but
retain control of the business.
Different classes of stock have advantages and
disadvantages that can be modified on a company-by-company basis.
Oftentimes, tax and financing considerations drive this process.
Now, in addition to multiple classes of common stock,
a company may issue preferred stock.
It's called preferred because it is a preference in dividends.
Its dividends are paid before the common shareholders get their distributions.
Dividends are more or less expected each period.
Preferred stock usually has a par value that's significant.
And the dividend right is stated as a percentage of par.
For example, it may be 10% preferred stock.
So 10% of par value would be the dividend.
Some preferred stocks are cumulative.
This means that if a company fails to pay a dividend in a particular period that
that dividend has to be paid at some point in the future before the common can ever
collect those dividends.
Dividends that have been missed on cumulative preferred stock are called
dividends in arrears.
They have to be brought current before other distributions can be made to other
classes or shareholders.
Non-cumulative, if a dividend is missed it's just lost to history.
Preferred stock usually does not vote, not always, but typically it's not voting.
It does maintain its liquidation preference.
It's usually paid off after creditors but before common stock.
Preferred stock may be callable.
That is, the company may reserve the right to repurchase it at a prearranged price
within some particular time window.
For example, callable at 105 means the company could buy back its preferred stock
at 105% of its par value.
Preferred stock may also be convertible.
This is a nice feature because it enables the holder of those shares to exchange
them for common shares.
For example, there may be a three to one exchange ratio,
f40 shares of common might be issued for 1 share of preferred.
This is great from an investor point of view because they get their
preferred dividend.
And if the common stock appreciates significantly in value, they may be able
to enjoy that ride by exchanging those preferred shares for the common.
Some preferred stock may have a fixed maturity date
that allows the company to buy back the stock.
Or may even require the company to buy back the preferred stock at some
future date.
Now, looking at common stock more closely,
typical features, some common sometimes pays dividends, sometimes it doesn't.
Some common sometimes has pre-emptive rights, sometimes it doesn't.
The pre-emptive right, something that'd typically be specified in the articles of
incorporation, says that if you own 10% of a company and
the company wants to issue additional shares, you have a right of first refusal.
You're able to buy or maintain your 10% ownership by buying in the new share
issuance before those shares are offered to other parties.
It's intended to prevent a particular shareholder's interest from being diluted.
Oftentimes that feature is not present however.
Voting, normally the common stock has a voting right.
It enables that group of shareholders to control the company, elect the board of
directors, select the auditor, basic matters of corporate governance.
In event of liquidation of a business, common shareholders come last in line,
that's a bad thing.
But the good thing is that it's their surpluses,
they get all of the residual that doesn't go to creditors and preferred stock.
All the residual interest flows to the common stock.
Common shareholders are entitled to receive reports on financial performance
about a business that they own.
Par value, a par value represents the legal capital of the firm.
There is some historic precedent for this, although it is long since lost in history.
Original purchasers of stock are contingently liable to the company
if they buy stock below par value.
That is, the company can later call for additional capital contributions.
As a result, most companies, when they issue stock,
will issue it at a price far above par value.
That negates any concern about an additional call on shareholders for
additional capital contributions.
It's usually stated as a nominal price.
You might see a $1 or even a $0.01 par value.
As a practical matter then,
par value is not just real important, but it does trigger accounting significance.
We record common stock at its par value.
And any purchase price or issue price in excess of par value is recorded to have
paid in capital in excess of par value account as shown in this journal entry.
Here the company issued 100,000 shares of $1 par value stock or $1 million.
So they issued it at $10 a share.
There's the debit to cash, $1 million.
The credit to common stock is the $100,000.
That's 100,000 shares at $1 par per share.
And the 900,000 difference goes to Paid in Capital in Excess of Par.
Some companies may issue stock without par value,
in which case cash is debited and common stock is credited for the issue price.
There would be no need to maintain a separate Paid in Capital account.
A stock can be issued for other than cash, for land or other assets.
The specific asset account would be debited, instead of cash.
And common stock would be credited for the fair value of the asset or
the fair value of the stock, whichever is more clearly determinable.
Cash dividends, dividends are a matter of board discretion, at least and
certainly insofar as common stock is concerned.
Many companies, however, pride themselves in a long history of regular dividends and
even in increasing dividends on a regular basis.
Other companies prefer to reinvest accumulated earnings in new ventures
of the business.
A dividend declaration is a formal action by the board of directors to indicate that
a divided will be paid.
It establishes a legal liability to the company.
Dividends account is direct reduction of retained earnings.
So let's see what happens.
On the date of declaration, we debit dividends and credit dividends payable.
When the payment occurs, we'll turn around and
debit dividends payable and credit cash.
Notice in this case I've got a two-month lag between the date of declaration and
the date of payment.
So let's think about those dates for a minute.
The date of declaration's the day the board acts to declare a dividend.
The date of payment is the day they disperse the funds.
There's usually about a month after the date of declaration,
up until an ex-dividend date.
The ex-dividend date determines when the right to receive the dividend shifts.
So if you own stock on the date of declaration but
sell it before the ex-dividend date you lose the right to receive that dividend.
If you own the stock on the date of declaration and
continue to hold it beyond the ex-dividend date, then when you sell the stock you
will have retained the right to receive the dividend.
So an ex-dividend date usually precedes the date of record.
Date of record is the formal date when a company would look at its shareholder
records to determine who to distribute dividends to on the date of payment.
The ex-dividend date for a practical matter, for record keeping purposes,
exceeds the stipulated date of record by two or three days, typically.
Finally, let's look at the stockholders' equity section.
It should include detailed descriptions of the type of stock and its basic features.
The number of shares authorized, the number issued, the number outstanding.
Legal capital is a term used to mean total par value.
Total paid in capital is the legal capital plus paid in capital
in excess of par value.
And here's an illustration of a stockholders' equity section,
it's fairly complex.
I've got preferred stock and common stock with very detailed disclosures.
Additional paid in capital on both classes of stock, and
then additional retained earnings to come up with the total stockholders' equity.
To close this module let's consider the presence of preferred stock
just a bit more.
In the illustration we showed that there was $100 par value 8% preferred stock.
This means that it pays $8 in dividends per year for each share.
And furthermore, it was cumulative.
Any dividends that are missed will become dividends in arrears.
Now if the notes to the financial statements indicate that the company has
not paid dividends for
the last two years and $5 million of dividends are paid in total.
The question is how much is paid to the preferred and
how much is paid to the common?
The mathematics here, 4.8 million will go to the preferred.
Then it's $8 a share times 200,000 shares is $1,600,000.
They would need to pay the two years in arrears plus the current year or three
years at $1,600,000 each, so 4,800,000 would go to the preferred shareholders.
Only 200,000 of that dividend declaration would be available
to the common shareholders.
This indicates and emphasizes and underscores the importance of paying very
close attention to the disclosures of the classes of stock.
And reviewing the footnotes to determine, for example, whether the preferred stock
is cumulative or not and whether there are dividends in arrears or not.
Again, the dividends do not appear as a liability until they're actually declared
by the board of directors.