Common and preferred stock

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The common and preferred are two different types of stock (also known as shares) that
corporations issue to raise capital. The basic difference between common stock and
preferred stock lies in the rights and opportunities that stockholders enjoy upon purchasing
common or preferred stock of a corporation.

The common features of both the types of stock are briefly discussed below:

Common stock:

It is the basic type of stock that every corporation issues. The person who purchases the
common stock of a corporation becomes an owner of the corporation and is known as
common stockholder.

The following are the basic rights of a common stockholder (also known as
shareholder):

1. Right to vote for the election of directors and certain other issues. Usually one share
has one vote.
2. Right to participate in the dividends declared by the directors.
3. Right to receive the share of assets upon liquidation of the corporation.
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Preferred stock:

In addition to common stock, many corporations issue preferred stock to raise fund. When a
person buys the preferred stock of a corporation, he is known as preferred stockholder of
that corporation. The rights and opportunities of a preferred stockholder are
essentially different from that of a common stockholder.

The usual rights of a preferred stockholder are given below:

1. The preferred stockholders have a preference over common stockholders as to

dividend. The rate of dividend on preferred stock is usually fixed.
2. If the preferred stock is cumulative, the stockholders have cumulative dividend
rights.
3. The preferred stockholders have a preference over common stockholders as to
assets of the corporation upon liquidation.
4. Sometime, preferred stockholders have the right to convert their preferred stock into
common stock at the option of stockholder. Such preferred stock is known as
convertible preferred stock.
5. Preferred stock is usually callable at the option of the corporation.
From stockholders point of view, the negative aspect of preferred stock is that it does not
have the voting power.

The different features of common stock and preferred stock discussed above appeal to
different classes of investors. Therefore, many corporations issue both the types of stock
to attract as many investors as possible.

Balance sheet presentation:

Both common and preferred stock are reported in the stockholders’ equity section of
the balance sheet. The proper presentation is shown below:

In above example, the company is authorized to issue 100,000 shares of preferred stock
and 2,000,000 shares of common stock. Out of these authorized number of shares, only
50,000 shares of preferred stock and 1,000,000 shares of common stock have been issued.
Notice that the amount of shares that have actually been issued and subscribed has been
written in the amount column.

Reporting mandatorily redeemable preferred stock:

Special characteristics of preferred stock can affect its reporting in the balance sheet. For
example, both International accounting standards (IASs) and US-GAAP now require
companies to report mandatorily redeemable preferred stock as liability rather than equity.
Cumulative and noncumulative
preferred stock
The preferred stock issued by a corporation may be cumulative or noncumulative. This
page briefly explains the difference between cumulative and noncumulative preferred
stock:

Cumulative preferred stock:

In case of cumulative preferred stock, any unpaid dividends on preferred stock are carried
forward to the future years and must be paid before any dividend is paid to common
stockholders. For example, a corporation issues 100,000 shares of $5 cumulative preferred
stock on 1st January 2014 and does not pay any dividend during the year 2014. The $5
dividend per share will be carried forward to the year 2015. If board of directors decides to
pay a dividend of $1,200,000 in 2015, the cumulative preferred stockholders will be paid a
total dividend of $1,000,000 ($5 per share for two years – 2014 and 2015). The remaining
amount of $200,000 will then be distributed among common stockholders.

Disclosure of dividends in arrears on cumulative preferred stock:

Any unpaid dividend on preferred stock for a year is known as ‘dividends in arrears. The
disclosure of dividends in arrears is of great importance for the investors and other users of
financial statements. Such disclosure is made in the form of a balance sheet note. For
example, the disclosure of the above dividend of $500,000 can be made as follows:

Note 4: Dividends in arrears:

As of December 31, 2014, dividends on the $5 cumulative preferred stock were in arrears to
the extent of $5 per share and amounted in total to $500,000.

Non-cumulative preferred stock:

Unlike cumulative preferred stock, unpaid dividends on noncumulative preferred stock are
not carried forward to the subsequent years. If preferred stock is noncumulative and
directors do not declare a dividend because of insufficient profit in a particular year, there is
no question of dividends in arrears. For example, a corporation issues 100,000 shares of $5
noncumulative preferred stock on 1st January 2014 and does not pay any dividend during
the year 2014. The $5 dividend per share will not be carried forward to the year 2015. If
board of directors decides to pay a dividend of $1,200,000 in 2015, the noncumulative
preferred stockholders will be paid a total dividend of $500,000 ($5 per share for one year
only – year 2015) and the remaining amount of $700,000 will then be distributed among
common stockholders.
Example:

The capital structure of Friends, Inc., is given below:

During the current year, management declared a dividend of $70,000. Dividend on

preferred stock are 6% of par value and have been paid each year except for the
immediate past year. The number of shares issued and outstanding of both the types
of stock have not changed for the last two years.

Required:

Calculate the amount of dividend that will be paid to preferred stockholders and common
stockholders if:

1. the preferred stock is noncumulative.

2. the preferred stock is cumulative.
Solution:

Annual dividend on preferred stock:

160,000 × .06 = $9,600

(1). If the preferred stock is noncumulative:

(2). If the preferred stock is cumulative:


Par value stock:
Par value stock is a type of common or preferred stock having a nominal amount (known
as par value) attached to each of its share. Par value is the per share legal capital of the
company that is usually printed on the face of the stock certificate. It is also known
as stated value and face value.

A company is free to choose any amount as the par value for its share but companies
mostly choose a very low amount. For example, the stock of Microsoft has a par value of
$0.00000625 per share and Ford’s stock has a par value of $0.01 per share.

Par value of stock is different from its market value. The market price of the stock of well-
established companies is usually much higher than its par value.

Journal entries for the issuance of par value stock:

The par value stock can be issued in three ways – at par, above par and below par. A
brief explanation and journal entries for all the situations are given below:

(1) At par:
When stock is issued at a price equal to its par value, it is said to be issued at par. The
journal entry is given below:
(i). When common stock is issued at par:

(ii). When preferred stock is issued at par:

(2) Above par:

When stock is issued at a price higher than its par value, it is said to have been issued
above par. When stock is issued above par, the cash account is debited with the total
amount of cash received, capital stock account is credited with the total par value of shares
issued and an account known as additional paid-in capital or capital in excess of par is
credited with the difference between cash received and the par value of shares issued. This
information is summarized in the form of the following journal entry:

(i). When common stock is issued above par:

(ii). When preferred stock is issued above par:

The additional paid-in capital is a part of total paid up capital that increases the
stockholders’ equity.

(3) Below par:

When stock is issued at a price lower than its par value, it is said to have been issued below
par. In such an issue, the cash account is debited with the total amount of cash
received, discount on issue of capital stock account is debited with the difference between
amount received and the par value of shares issued and the common stock account is
credited with the par value of the shares issued. The journal entry for such an issue is given
below:

(i). When common stock is issued above par:

(ii). When preferred stock is issued above par:

The discount on stock reduces stockholders’ equity.

Notice that in all the cases discussed above the stock has been credited with par
value.

The issuance of stock at a discount (below par) is not usual because it is legally prohibited
in many countries and stats. This legal restriction partially explains the reason of choosing a
low par value by most of the companies.
Example:
The Northern company issued 100,000 shares of its $1 par value common stock and
25,000 shares of its $100 par value preferred stock. Make journal entries to record these
transactions in the books of Northern company if the shares are issued:

1. at par.
2. at $10 per share of common stock and $120 per share of preferred stock.
3. at $0.8 per share of common stock and $80 per share of preferred stock.

Solution:

(i). When common and preferred shares are issued at par:

(ii). When common and preferred shares are issued above par:

(iii). When common and preferred shares are issued below par:

No par value stock
No-par value stock, as the name implies, is a type of stock that does not have a par value
attached to each of its share. Unlike par value stock, no-par value stock certificate does not
have a per share value printed on it.

Although prohibited in many countries, the issuance of no-par value stock is allowed in

some states of USA.

Journal entry for issuing no-par value stock:

No-par value stock is issued without discount or premium. The whole amount received as a
result of issuing this type of stock is debited to cash account and credited to common or
preferred stock.

Example:
The US company issues 1,000 shares of its no par value stock at $20 per share, it will
record the following journal entry for this issue:
If the company issues additional 1,000 shares of its common stock at $22 per share, the
journal entry will be recorded as follows:

In above example, we have talked about a true no-par value stock i.e., it is carried in the
accounts at issue price and there is no additional paid-in capital or discount on stock. But in
some states companies are either allowed or legally required to set a minimum per share
value below which the stock cannot be issued. This minimum value is known as stated
value. In such situations, companies have the option to carry the stock in the accounts at
issue price or stated value.  Suppose, for example, the board of directors of the
US company assigns a minimum value of $15 to each share of common stock, the two
journal entries discussed above will be recorded as follows:

(1). If the stock is carried in the accounts at issue price:

(2). If the stock is carried at stated value assigned by the company:

Notice that the journal entries for the issuance of no-par value stock under second option
are similar to that of the issuance of par value stock.

Issuing stock for non-cash assets

Companies need long term fixed assets (land, building and vehicles etc.) to carry out
various business activities. One way to acquire these assets is to purchase them for cash
and another way is to acquire them in exchange of company’s stock. Issuing stock for non-
cash tangible and intangible assets is common among companies but valuation often
becomes a major problem in such transactions. The general rule is to record
these transactions on the basis of fair market value of the non-cash asset acquired or
the fair market value of the stock issued whichever can be more clearly and reliably
determined.

If the fair market value of the asset to be received or the stock to be issued is not readily
determinable, the board of directors or management can determine a value that is fair in
their opinion. They can also seek the assistance of a qualified independent valuer for this
purpose.

Example:
The Northern company purchased a piece of land to build a new factory on it. The company
will issue 20,000 shares of its $10 par value common stock to the vendor of land as
consideration. Make journal entries in each of the following situations:

1. The fair value of the stock is $260,000 and the fair market value of land cannot be
reliably determined.
2. The fair market value of the land is $280,000 and the fair market value of the stock
cannot be reliably determined.
3. The board of directors seeks the help of a professional valuer who values the land at
$270,000.

Solution:

(1). When the fair market value of stock is readily determinable:

(2). When the fair market value of land is readily determinable:

(3). When the land is valued by an independent professional:

Companies may also use their treasury stock to acquire non-cash assets. If treasury stock
is used, the fair value of the treasury stock or the fair value of non-cash asset should be
used for valuation. The cost of treasury stock should not be used for this purpose.

The issuance of stock for a non-cash item is a non-cash financing activity that should be
disclosed at the bottom of the statement of cash flows or in a separate note to the
statement.

Issuing stock for services rendered

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Companies frequently avail services of outside individuals, firms and companies. The cost
of such services may be paid in the form of shares of the company’s stock
As no cash outflow is involved, this method of payment is appealing especially to newly
incorporated and cash poor companies. The major problem involved in such transactions is
the determination of value.

The general rule of recording issuance of stock for services is similar to the rule of issuing
stock for non-cash assets. It is recorded on the basis of fair market value of services
availed or the fair market value of shares issued whichever can be objectively
determined.

For better understanding the procedure of valuation and recording, consider the following
example:

Example:
The Western company hired HK firm for legal services. The HK firm agreed to receive 500
shares of Western company’s stock as consideration of legal services provided. The par
value per share was $5.

Required: Make journal entries to record above transaction in each of the following cases:

1. The fair market value of stock is $5,500 but fair market value of legal services is not
known.
2. The fair market value of legal services is $6,000 but fair market value of shares
issued is not known.

Solution:

(1). When the fair market value of stock issued is known:

(2). When the fair market value of legal services availed is known:
Dividends payable
Definition and explanation of dividends payable

Dividends payable is a liability that comes into existence when a company declares cash
dividends for its stockholders. When the board of directors of a company authorizes and
declares a cash dividend, the dividends payable liability equal to the amount of dividends
declared arises.

A general ledger account titled as “dividends payable account” is used to account for all
declarations and payments of dividends to stockholders. Dividends payable account is a
liability account which is credited when directors declare a cash dividend and is debited
when the cash for a previously declared dividend is paid to stockholders.

Well established companies often pay dividends to their stockholders on regular basis.
However, the students should keep in mind that no dividends payable liability comes into
existence in a period unless and until the board of directors actually authorizes and declares
the dividends in that period.

Presentation of dividends payable on balance sheet

Dividends payable are classified as current liability because they are mostly payable within
one year period of the date of their declaration. If a balance sheet is prepared between the
date of declaration of cash dividends and the date of actual payment of cash to
stockholders, the balance in the dividends payable account must be reported in the current
liabilities section of the balance sheet. For example, Metro Inc. declares a $500,000 cash
dividend on December 15, 2018 and the cash payment against this dividend is to be made
to stockholders on January 15, 2019. Now, if Metro prepares its financial statements on
December 31, 2018, it must report dividends payable amounting to $500,000 as current
liability in its balance sheet.

Dividends payable is a unique liability because the amount of this liability is payable to
company’s own stockholders, not to a third party.
Journal entries related to dividends payable liability

Two journal entries are related to dividends payable liability. One that is made at the time of
declaration of dividends and one that is made at the time of payment of dividends.

1. Journal entry at the time of declaration of dividends:

Dividends are often declared by the company prior to actual cash payment to the
stockholders. When dividends are declared, the retained earnings account is debited and
dividends payable account is credited. The journal entry looks like the following:

Retained earnings [Dr.]

Dividends payable [Cr.]

The above journal entry creates a dividend payable liability equal to the amount of dividends
declared by the board of directors and reduces the balance in retained earnings account by
the same amount.

2. Journal entry at the time of payment of dividends:

When cash for previously declared dividends is paid to stockholders, dividends payable
account is debited and cash account is credited. The journal entry for the payment of cash
dividends looks like the following:

Dividends payable [Dr.]

Cash [Cr.]

As a result of above journal entry, the cash balance is reduced by the amount of dividend
paid to stockholders and the dividend payable liability is extinguished.

Example

During the year 2018, the Manchester Inc. had 500,000 shares of $10 par value common
stock and 50,000 shares of 8%, $100 par value preferred stock outstanding. The board of
directors of corporation declared dividends during the year 2018 as follows:

 Declared a cash dividend of $0.5 per share on $10 par value common stock.
 Declared a cash dividend on 8%, $100 par value preferred stock.

Required: Assuming the dividend declaration is recorded in retained earnings, prepare

journal entries required at the time of declaration and payment of above dividends.

Solution

1. Journal entry required at the time of declaration of cash dividends:

As a result of above journal entry, the Manchester Inc. would debit its retained earnings
account and credit dividends payable account by $650,000

2. Journal entry required at the time of payment of cash dividends:

As a result of above journal entry, the Manchester Inc. would debit its dividends payable
account and credit cash account by $650,000.

*Dividends declared during the year:

Cash dividend on common stock:

= 500,000 shares × $0.5
= $250,000

Cash dividend on preferred stock:

50,000 shares × $100 × 8%
= $400,000

Total cash dividends declared:

= $250,000 + $400,000
= $650,000

Presentation of stock dividends and dividends in arrears on balance

sheet

The declaration of stock dividends is not recognized as liability because it does not require
any future outflow of cash or another asset. Also, the board of directors can revoke stock
dividends any time before they are actually issued to stockholders. The undistributed stock
dividends are generally presented in the stockholders’ equity section rather than current
liabilities section of the balance sheet.

The accumulated but undeclared dividends on cumulative preferred stock are also not
reported as an obligation because they do not give rise to a liability until a formal action of
authorization and distribution of such dividends is taken by the company’s board of
directors. These omitted or undeclared dividends are usually termed as dividends in
arrears on cumulative preferred stock and are normally presented in the foot notes to the
company’s balance sheet. Another acceptable means of disclosure of dividends in arrears
on cumulative preferred stock is to parenthetically report them in capital stock section of
company’s balance sheet.

Treasury stock – cost method

Sometime companies purchase their own shares of stock from stockholders of the
company. Such repurchased shares of stock are known as treasury stock. It includes only
those shares that have not been cancelled or permanently retired by the company after
repurchase. The shares held as treasury stock are not entitled to receive dividends and
share of assets upon dissolution of the company. Also, these shares have no voting rights.

Two methods are used for accounting treatment of treasury stock – the cost method and
the par value method. In this article we have explained the use of cost method, if you want
to understand the use of par value method, read “treasury stock – par value method” article.

Purchase of treasury stock – cost method:

Journal entry:

Under cost method, the treasury stock account is debited and cash account is credited with
the amount paid for acquiring the shares of treasury stock (i.e., the cost of treasury stock).
The par value of shares is ignored for recording the purchase of treasury stock under cost
method. For example, Eastern company repurchases 2,500 shares of its own common
stock from stockholders. The par value per share is $10 and company reacquires it for $80.
The entry for this transaction would be made as follows:

Balance sheet presentation:

Treasury stock is not an asset, it is a contra-equity account that is reported as a deduction

in the stockholders’ equity section of the balance sheet. In above example, treasury stock
purchased by Eastern company should appear in the balance sheet as follows:
Reissuance of treasury stock – cost method:

The shares in treasury stock may be reissued any time. The journal entries for this purpose
are given below:

If treasury stock is reissued at a price above

cost:
If the shares from treasury stock are reissued at a price that is higher than their cost, the
difference is credited to additional paid-in capital. The journal entry is given below:

Suppose, for example, the Eastern company reissues 1,000 shares out of its treasury
stock at $110 per share. The following journal entry would be made for this purpose:
With this entry, the balance in treasury stock is reduced to 120,000 (200,000 – 80,000),
its impact on the balance sheet of Eastern company is illustrated below:

Notice that the additional paid in capital resulting from the reissuance of treasury stock is
reported immediately after additional paid in capital from common stock.

If treasury stock is reissued at a price below

cost:
If the shares from treasury stock are reissued at a price that is lower than their cost, the
difference is debited to additional paid-in capital. The journal entry is given below:
Suppose, the Eastern company reissues 500 more shares from its treasury stock at a price
of $50 per share, the following journal entry would be made to record this transaction:

Notice that this entry reduces the additional paid-in capital from previously issued treasury
stock.

Note for students: If additional paid-in capital from a previously issued treasury stock is not
available then additional paid-in capital-common stock is debited and if additional paid-in
capital-common stock is also not available or is not sufficient, the retained earnings account
is debited.

Book value per share of common

stock
What is book value?

Book value per share of common stock is the amount of net assets that each share of
common stock represents. Some stockholders have keen interest in knowing the book
value of the shares they own. This article is focused on its calculation.
Formula and calculation:

Mostly, the book value is calculated for common stock only. The presence of preferred
stock in the total stockholders equity, however, has a significant impact on the calculation.
The formulas and examples for calculating book value per share with and without preferred
stock are given below:

(1). If company has issued only common stock and no preferred stock:

The calculation of book value is very simple if company has issued only common stock. The
net assets i.e, total assets less total liabilities are divided by the number of shares of
common stock outstanding for the period.

We know that:

Net assets = Assets – Liabilities

Equity = Assets – Liabilities

Net assets = Equity

So, an alternative and equally acceptable approach is to replace the numerator of the
formula by the stockholders’ equity. After such modification we get the following widely used
formula to calculate book value per share:

 Example:

Calculate book value per share from the following stockholders’ equity section of a
company:
Solution:

= $1,776,000/100,000 shares

= $17.76 per share of common stock

(2). If company has issued common as well as preferred stock:

If a company has issued common as well as preferred stock, the amount of preferred
stock and any dividends in arrears thereon are deducted from the total stockholders
equity, the resulting figure is divided by the number of shares of common stock
outstanding for the period. This procedure can be summed up in the form of the following
formula:

Example:

Calculate book value per share from the following stockholders’ equity section of a
company:
The preferred stock shown above in the stockholders’ equity section is cumulative and
dividends amounting to $48,000 are in arrears.

Solution:

= $2,576,000 – ($800,000 + $48,000)/100,000 Shares

= $1,728,000/100,000 Shares

= $17.28 per share of common stock