Preferred Stock: Study with Video Lessons, Practice Problems & Examples

Preferred stock is a unique equity class that offers dividends at a fixed percentage, typically higher than common stock. Preferred shareholders forfeit voting rights but gain liquidation and dividend preferences, receiving payments before common shareholders. For example, with 10,000 shares of $100 par value at 8%, preferred shareholders receive $80,000 from a $130,000 dividend, leaving $50,000 for common shareholders. The issuance of preferred stock involves debiting cash and crediting preferred stock and additional paid-in capital (APIC) accounts, similar to common stock transactions.

Issuing Preferred Stock

Now let's discuss a different class of stock ownership in the company; it's called preferred stock. Preferred stock is a special class of stock, and it's more similar to debt because the dividends they pay have a percentage attached to them. I'm going to put this approximately like debt because you're going to see similarities there, but it's not debt. It's not a liability. This is going to be equity in the company, but they are different from the common stockholders. The common stockholders have reins over the retained earnings of the company and everything. The preferred stockholders, well, they're going to have preferences. So let's see what these preferences mean. First of all, they give up their voting rights. The common stockholders are the ones that vote for the board of directors. Preferred stockholders have no voting rights, and generally, this is the case that they have no voting rights in selecting the board of directors, something they give up for these preferences. So what do they get? First, they get liquidation preference. When the company liquidates, if they go bankrupt or whatever it is, they are preferred to be repaid. They are repaid their investment before the common stockholders, right? So if they pay off all the liabilities, whatever money's left, first goes to the preferred stockholders to make sure they get their investment back, and then whatever's left over goes to the common stockholders. So, they have this liquidation preference over the common stockholders, but more importantly, is this idea of the dividends. This is what you're going to deal with more in this class. The dividend preference. The first thing is that they get paid the dividends first before the common stockholders. So what happens if a company pays a dividend and there are preferred stockholders, well that dividend first goes to the preferred stockholders and then whatever's left over goes to the common stockholders, right? So they get this preference in getting their dividend paid first. And they also have this dividend percentage because remember with the common stockholders, they pay a dividend, hey, they get whatever the dividend is, but here they have a specific percentage, and this is why I was equivocating this to debt, even though it's not debt, and I don't want to confuse you there, this is still equity accounts, but there's going to be some sort of percentage dividend that they get, and it's a percentage of their par value. So the difference here with the par value of preferred stock is that it's usually going to be higher. When we are talking about a par value for common stock, the common stock had a par value maybe $0.50, $1 something very low, but a preferred share is going to have a higher par value, something between $10, $100, $500 it's going to be some higher number you're usually going to see. So it generally has a higher par value. So why don't we go ahead and dive into how we do the issuance of preferred stock and you're going to see the issuing of preferred stock is very similar to issuing common stock. We're going to have a very similar entry where we're going to receive cash and then we're going to have our credits to our preferred stock account rather than the common stock account and we're also going to have an Additional Paid-In Capital (APIC). Just like we had with common stock, we have an APIC except it's an APIC of preferred stock, so we want to be diligent in marking it as preferred stock APIC. So let's check it out. The Apartment Depot issued 10,000 shares of a $100 par value, 8% preferred stock for $1,250,000 So notice this 8%, that's their dividend percentage. And this is how you're usually going to see it with preferred stock. It'll have a dividend percentage, or they could just tell you the dollar amount of the dividends. They could have said $8 preferred stock, a 100 par value of $8 preferred stock, well that means the dividend should be $8 for every 100. So what did they do here? Remember, here they're issuing the stock. This has nothing to do with the payment of dividends, so all we need to think about is how much cash did we receive and then we need to increase our equity by that amount. So it tells us here that we received $1,250,000 in cash, so that's going to be our debit to cash and just like we had with common stock, we're going to have a very similar entry where our credit is to the equity accounts. So first, we're going to have a credit to preferred stock and we're going to have a credit to APIC for any excess. Remember, the par value goes to the preferred stock account and the excess over par value is going to go to APIC. And we'll label this APIC and you'll label it something like APIC preferred stock. Just so you know that this APIC is related to the preferred stock, because this belongs to the preferred stockholders. So there we go. We've got our entry set up just like we're used to. We're going to have the debit to cash and the credit to equity. So we just have to think about what are the amounts going to be. We know the cash we received is $1,250,000. That's going to be our debit in this case. What are our credits going to be? Well, the par value has to go to the preferred stock account. So let's go ahead and find out what that par value is. What that yeah. What the par value amount is. So the preferred stock account is going to get the 10,000 shares times the par value of a $100 per share. Well, that comes out to $1,000,000. Right? $1,000,000 is going into the preferred stock account as the par value and any excess goes to APIC. So APIC is going to be the $250,000 extra. Right? Just like we're used to and just like we did with common stock. So not much of a difference here when we do our issuance entry for preferred stock. Our dividends are going to be a little interesting because we have to calculate how much they're going to get in dividends using the dividend percentage. So what did we see happen here? We had our cash increase by the $1,250,000 that we received, and we issued equity. Preferred stock went up by $1,000,000 and the APIC for preferred stock went up by $250,000, right? So those balance out there. Our assets went up by the same amount as our equity. Alright. Let's take a pause here and let's see how the dividends work out with this dividend preference, where the preferred stockholders get paid first and common stockholders get the leftovers. Let's check it out.

Preferred Dividends

Alright, let's try this dividends breakdown. The Apartment Depot currently has outstanding 10,000 shares of a $100 par value 8% preferred stock and 50,000 shares of 50¢ par value common stock. A lot of words there, you gotta kind of decipher what's going on, right? This is all related to our preferred stock right here, and then we're gonna have all this related to our common stock. Okay. So you're gonna want to keep track of these numbers. So the Apartment Depot declares and paid a dividend of $130,000. So we have a $130,000 dividend and remember, the preferred stockholders are going to get their dividend first and whatever's left over goes to the common stockholders. What is the amount received by preferred and common shareholders? So let's go ahead and find out in total what each one receives and then we'll break it down per share.

So if we had 10,000 shares of 8% preferred stock, well, those 10,000 shares, we need to find out what their par value is. Well, the way I like to do it actually is I like to take the $100 par value times the 8%. Remember, this 8% is their dividend percentage. That's the percentage of their par value that they're due to receive as dividends. So $100 times 8%, well, that gives us $8 per share as a dividend. Right? So each share is entitled to an $8 dividend when they pay these dividends and they get an $8 per share dividend times the 10,000 shares, right? There are 10,000 shares of preferred stock, So there's going to be $80,000 of dividends to preferred shareholders. Right? So the preferred shareholders get $80,000 of this and $50,000 dividend and everything else goes to the common stockholders. So the common stockholders get the leftovers, right? They get what's left. So there's the $130,000 dividend minus the $80,000 paid to preferred, right? They got paid first, so $50,000 is what's left over and that's what gets paid to the common common dividends, right? So the common shareholders split this $50,000 leftover. Cool? So that's how we find the total dividend that's paid to each of them, and that was $80,000 for the preferred and we had $50,000 for the common dividend. Oh, let me get out of the way here.

Now that we know the total that each class got, it's easy to find the per share amount. Well, we already found the per share amount for the preferred dividends, just as we saw before. $8 per share, right? And that makes sense because that's what their 8% of the $100 gives them. So it's $8 per preferred share, right? So each preferred shareholder will get an $8 dividend. What about the common dividend? They had $50,000 that was paid in dividends and there were 50,000 shares. So each share $1 per common share. Right? So each common share gets $1. So you want to pay attention to how many shares of each class of stock there are and that's how you divvy it up as the dividend per share. So there was a dollar per share common dividend and an $8 per share preferred dividend.

Alright? So this is how the preferences work. Remember when I told you at the beginning, the preferred stock has a preference when the dividends get paid, they get paid first. Now let's say the dividend had only been instead of being $130,000 if the dividend had only been $60,000 Well that whole $60,000 would have gone to preferred because they are due the first $80,000, right? So if the dividends had been $80,000 $80,001 the first $80,000 would have gone to preferred and then that extra dollar would have been split among those common stockholders, right? So that's how it works. The first $80,000 in this case, we're always going to go to the preferred and whatever extra there is can go to the common. Now what if it was a $1,000,000 dividend? The same thing, right? $80,000 and then the whole $920,000 would go to the common stockholders. Cool? Alright. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is preferred stock and how does it differ from common stock?

Preferred stock is a class of equity that offers fixed dividends, typically at a higher rate than common stock. Unlike common stockholders, preferred shareholders do not have voting rights. However, they have preferences in dividend payments and liquidation. This means they receive dividends before common shareholders and are prioritized in asset distribution if the company liquidates. Preferred stock is similar to debt in that it has a fixed dividend percentage, but it remains an equity instrument. The par value of preferred stock is usually higher than that of common stock.

How are dividends calculated for preferred stock?

Dividends for preferred stock are calculated based on a fixed percentage of the stock's par value. For example, if a company has 10,000 shares of $100 par value preferred stock with an 8% dividend rate, the annual dividend per share is calculated as follows:

$100\times 0.08=8$

This means each share receives $8 annually. If the company declares a total dividend of $130,000, the preferred shareholders would receive $80,000 (10,000 shares × $8 per share), and the remaining $50,000 would go to common shareholders.

What are the advantages and disadvantages of preferred stock for investors?

Advantages of preferred stock include fixed dividend payments, which provide a steady income stream, and priority over common stockholders in dividend payments and liquidation. However, disadvantages include the lack of voting rights, which means preferred shareholders have no say in corporate governance. Additionally, while preferred dividends are fixed, they may be lower than potential dividends from common stock if the company performs exceptionally well. Preferred stock also has less potential for capital appreciation compared to common stock.

How is the issuance of preferred stock recorded in financial statements?

The issuance of preferred stock is recorded similarly to common stock. When a company issues preferred stock, it debits cash and credits the preferred stock account for the par value and the additional paid-in capital (APIC) account for any amount received above the par value. For example, if a company issues 10,000 shares of $100 par value preferred stock at $125 per share, the journal entry would be:

Debit Cash: $1,250,000

Credit Preferred Stock: $1,000,000

Credit APIC - Preferred Stock: $250,000

What happens to preferred stock dividends if a company does not declare dividends in a given year?

If a company does not declare dividends in a given year, the treatment of preferred stock dividends depends on whether the preferred stock is cumulative or non-cumulative. For cumulative preferred stock, unpaid dividends accumulate and must be paid out before any dividends can be paid to common shareholders in future years. For non-cumulative preferred stock, unpaid dividends do not accumulate, and shareholders have no claim to them in the future.