FAR Chapter 18 - Preffered Stock and Common Stock

dividends on preferred stock

% of par value of par value of pref. stock

non-participating

(par value/share)(annual dividend %) is the maximum possible divident

3 dates to be aware of

- declaration date - date of record - payment date

When a corporation purchases shares of its stock that were previously sold by the company the event can be accounted for in 2 possible ways:

-As a share buyback, less typical approach -Treasury Stock, more typical approach

In a treasury stock purchase a corporation buys back the common stock

but does NOT retire the stock immediately

As a result, expected returns are usually HIGHER,

dividends and share price appreciation

Note that share treasury stock transactions

do NOT affect net income

The amount of dividends should take into account the alternatives uses of the funds,

e.g., should the company pay off debt ? Should the corporation reinvest the funds in potential company projects ?

Some states may even further restrict dividend policy,

e.g., to protect creditors when a company is holding treasury stock

That is,

each class of stock has an individual stock contract

"Small" stock dividends

essentially no flexibility

the common stock is usually the LESS STABLE and consequently common stock is usually MORE RISKY than preferred stock

expected returns are usually HIGHER, i.e., dividends and share price appreciation.

Stock splits are

expressed as a ratio of the number of shares after the split relative to the number of shares before the split

Also, the rights that are granted as well as denied may vary considerably across classes of common stock

for different corporations, e.g., Alphabet vis a vis Microsoft

That is, if the preferred stock is noncumulative and a corporation does NOT declare a dividend for a particular year (e.g., fiscal year 2019),

he corporation does NOT need to "make up" (i.e., declare and pay that dividend) in the future (e.g., fiscal year 2020).

The potential upside,

i.e., increase in dividends and increase in share price, is essentially unlimited

Retired shares become unissued shares,

i.e., it is just as if the corporation never sold the shares

Redeemable

-Company is required to buy back shares at a set price per share -Ceteris paribus, the ability to require the company to buy back the preferred shares will make the preferred stock MORE valuable relative to nonredeemable preferred stock and consequently its market value will be HIGHER relative to nonredeemable preferred stock -Ceteris paribus, the ability of the preferred shareholders to require the company to redeem the preferred stock would make the preferred stock MORE LIKE DEBT as opposed to equity

Preferred stock is usually

-Nonparticipating -cumulative -has a senior claim to dividends (senior to common stockholders) -has a senior claim to assets in the event the corporation is liquidated (senior to common stockholders)

Mandatorily redeemable preferred stock

is stock that is required to be repurchased by the company

As such, the common stock is usually the LESS STABLE and consequently common stock

is usually MORE RISKY than preferred stock

As such, the potential upside, i.e., increase in dividends and increase in share price,

is usually limited

Retired shares become unissued shares,

it is just as if the corporation never sold the shares

For that reason, when a corporation increases the dividend per share,

it puts pressure on the corporation to maintain that level of dividends

The method used almost exclusively in practice is the cost method

-We focus exclusively on the cost method -When treasury shares are purchased at different costs, a cost flow assumption must also be made, analogous to inventory -However, for treasury stock in practice first-in-first-out (FIFO) and weighted average are the most popular choices -We focus exclusively on FIFO and weighted average

Common stock is usually

-has a junior claim to dividends (junior to preferred stockholders) -has a junior claim to assets in the event the corporation is liquidated (junior to preferred stockholders)

In a reverse stock split

-increase the par value of shares & reduce the # of shares proportionately

In typical stock split

-reduce the par value of a share & increase the # of shares

callable

-shareholders must sell shares to the company -Ceteris paribus, being callable by the company will make the preferred shares LESS valuable relative to noncallable preferred stock and consequently its market value will be LOWER relative to noncallable preferred stock -Ceteris paribus, the ability of the company to call the preferred shares will make the preferred stock MORE LIKE DEBT as opposed to equity

Under IFRS,

most preferred stock is shown as debt on the balance sheet and the dividends are reported as interest expense on the income statement

Nonconvertible

no option of converting preferred shares to common shares

participating

not limited to the percentage of the par value in a given year

Under generally accepted accounting principles (GAAP),

only mandatorily redeemable preferred stock CANNOT be shown as equity.

Share buyback

A corporation can provide value to its common shareholders by increasing the dividend per share or engaging in a stock buyback, among other things

Note that share buybacks do NOT affect net income

Also, note that share buybacks can cause a decrease in retained earnings but cannot cause an increase in retained earnings.

Although the transaction is accounted for as a purchase of treasury stock, a corporation could subsequently retire those shares,

Although the transaction is accounted for as a purchase of treasury stock, a corporation could subsequently retire those shares. o In that case, the retirement would be accounted for just as if the shares had been retired immediately except for one thing.

A property dividend should be measured at fair value.

As such, a gain or loss would be recognized when the dividend is declared, based on the difference between the book value of the asset and the market value of the asset

There are an infinite number of rights that may be granted or denied to a class of common stockholders

As you might expect, the rights that are granted as well as denied may vary considerably across classes of common stock of a given corporation, e.g., Alphabet (i.e., Google).

Convertible

preferred shareholder has the option of converting preferred shares to common shares

A purchase of treasury stock can be defined as a corporation

purchasing shares of its common stock, and theoretically planning to reissue those shares.

Treasury shares held by the company are not part of the shares that the company has outstanding

Cash dividends are NOT declared or paid on treasury stock.

Callable by the company

Company has the option to repurchase shares at a set price per share

Increasingly corporations are more inclined to engage in stock buybacks as opposed to increasing dividends

Corporations are reluctant to reduce dividends on common stock, as this is viewed very negatively by the stock market, i.e., causes a large decline in the stock price

Cash dividends and purchase of treasury stock

DECREASE total shareholder's equity

change in market value for a stock split

Each "old" share before the stock split was worth $120. After the stock split each share "old" share becomes 3 "new shares, i.e., (3)(1 share).

Stock dividend

Existing Shares ("Old" Shares) REMAIN Outstanding and "New" shares are ADDED

Stock Split

Existing Shares ("Old" Shares) are REPLACED with "New" shares

Basically, that dividend is "lost" to preferred shareholders

For that reason, the market for noncumulative preferred stock is pretty limited Consequently, preferred stock is usually cumulative

corporations are reluctant to reduce dividends on common stock, as this is viewed very negatively by the stock market, i.e., causes a large decline in the stock price.

For that reason, when a corporation increases the dividend per share, it puts pressure on the corporation to maintain that level of dividends

Sale of Common Stock and Net income

INCREASE total shareholders equity

Stock splits

In a stock split "old" shares are REPLACED by "new" shares

Sometimes, a major difference across classes of common stock are the voting rights

In certain cases, the shares available to the public have no voting rights or limited voting rights

The rights of stockholders are specific to that class of stock

that is, the rights of stockholders are specified in the stock contract between the corporation and the stockholders of that class of stock.

Unlike an increase in the dividends per share, engaging in a stock buyback is not viewed by the stock market as an indication

that the firm will continue buying back its common stock

A major difference across classes of common stock are the voting rights

In certain cases, the shares available to the public have no voting rights or limited voting rights. For example, Alphabet has 3 classes of shares -Class A has 1 vote per share, available to public -Class B has 10 votes per share, NOT available to public, held by insiders -Class C has 0 votes per share (i.e., nonvoting stock), available to public

Many corporations use a capital stock, e.g., common stock, with no par value

In that case the Paid-in Capital in Excess of Par associated with that class of stock would not be used

Although the transaction was accounted for as a share buyback, a corporation could reissue those shares in the future

In that case, the reissue would be accounted for like the sale of any other UNISSUED STOCK, as illustrated earlier

Although the transaction is accounted for as a share buyback, a corporation could reissue those shares in the future

In that case, the reissue would be accounted for like the sale of any other unissued stock, as illustrated earlier

Accordingly, the preferred stock price is usually MORE STABLE and consequently preferred stock is

LESS RISKY than common stock. ·As a result, expected returns are usually LOWER, i.e., dividends and share price appreciation.

With "large" stock dividends

Motivation may be to reduce the market value per share to make the stock more marketable

Noncallable by the company

No option for the company to repurchase shares at a set price per share (shareholders cannot be forced to sell shares to the company)

· Reverse Stock Split, e.g., 1 for 3 stock split

REPLACE existing shares with new shares INCREASE the par value per share proportionately REDUCE the number of shares proportionately Motivation may be to increase the market value per share to avoid the stock being delisted by a stock exchange as a result of a low market value per share

Typical Stock Split, e.g., 3 for 1 stock split

REPLACE existing shares with new shares REDUCE the par value per share proportionately INCREASE the number of shares proportionately Motivation may be to reduce the market value per share to make the stock more marketable

"small" stock dividends measure the dividend at the fair value

Reduce Retained Earnings

"large" stock dividends measure the dividend at fair value

Reduce Retained Earnings or Paid-In Capital in Excess of Par

Nonredeemable

Shareholder CANNOT require company buy back shares at a set price per share

Redeemable by shareholders

Shareholder can require the company to buy back shares at a set price per share

Thus, to retire the treasury shares, the journal would be identical except for one thing, as mentioned above

Specifically, to retire the treasury shares, there would NOT be a credit to cash, instead there would be a credit in the journal entry to treasury stock

More shares of stock are distributed to existing shareholders

Stock Dividends are expressed as a Percentage

· Preferred stock generally has a senior claim to dividends relative to common stock (implicit assumption).

That is for any year (e.g., 2019), a company must declare and pay a dividend to preferred shareholders before any dividend can be declared and paid to common shareholders

it is usually primarily common stock owners who own the residual interest in a corporation

That is, preferred stock is more like debt than equity in the typical situation

"small" stock dividends

The total market value of common equity will NOT change either. Thus, the market value per share will change accordingly

These missed dividends are often referred to as dividends in arrears.

This does NOT create a liability for the company

For example, in a 10% stock dividend an additional 10% of the outstanding shares are distributed

Thus, if 200,000 shares are outstanding an additional 20,000 shares would be issued, i.e., 20,000 = (10%)(200,000)

For example, in a 3 for 1 stock split each "old" share is REPLACED by 3 "new" shares

Thus, if 200,000 shares had been outstanding, the 200,000 "old" shares would be REPLACED with 600,000 "new" shares,

The par value has no real economic meaning. Firms set the par value per share very low to avoid the sale of stock below par value, i.e., discount. Corporations often set the par value at a small fraction of a dollar, e.g., the par value per share of Apple is $0.00001.

Unlike common stock, where par value of a share has no real economic significance, with preferred stock the par value of a share has economic value as the par value of a share drives the amount of the dividend per share

Thus, unlike an increase in the dividends per share

a stock buyback does NOT put pressure on the corporation to continue buying back its common stock

As such

a stock buyback provides the corporation more flexibility in regard to their future actions

In a share buyback a corporation buys back the common stock

and IMMEDIATELY retires the stock.

the ability to convert the preferred shares to common shares will make the preferred stock MORE valuable relative to nonconvertible preferred stock

and consequently its market value will be HIGHER relative to nonconvertible preferred stock

Thus, no assets will ever be distributed

and no liability is ever incurred.

A share buyback can be defined

as a corporation buying back shares of its common stock, and theoretically not planning to reissue those shares

It's time consuming and expensive to change the par value of a stock so companies may account for a stock split

as a stock dividend

Increasingly corporations are more inclined to engage in stock buybacks

as opposed to increasing dividends

If the preferred stock is cumulative (implicit assumption) and a corporation does NOT declare (and pay) a dividend for a particular year (e.g., fiscal year 2019)

the corporation must "make up" the dividend (i.e., declare and pay that dividend) in the future before any dividends can be provided to common shareholders, e.g., in 2020

If preferred stock is noncumulative

the only constraint on the company in terms of allocating dividends between preferred stock and common stock is that a full year's dividends for the current year must be declared (and paid) to preferred shareholders before a dividend can be declared (and paid) to common stockholders.

if a company had multiple classes of common stock

the rights of those stockholders would vary across classes

When the company accounts for the transactions as treasury stock transactions,

the shares are NOT retired when repurchased.

When the company accounts for the transaction as a share buyback,

the two (2) transactions emphasized are the ORIGINAL SALE of the shares and the REPURCHASE of the shares.

When the company accounts for the transactions as treasury stock transactions,

the two (2) transactions emphasized are the REPURCHASE of the shares and the SUBSEQUENT RESALE of the shares. Note that this is different from a share buyback.

So, when the financial press discusses huge fluctuations in a firm's stock price,

they are usually talking about the common stock, e.g., Apple

when there are dividends in arrears,

this does affect dividends to common shareholders and therefore should be disclosed in the notes to the financial statements

In stock splits

total par value remains unchanged

Stock dividends does NOT affect

total shareholder's equity

Consequently,

under GAAP non-mandatorily redeemable preferred stock is usually shown as equity

As long as the transaction is completed in the same fiscal period this does not raise any issues for our purposes. On the other hand form example, if a dividend were declared at the end of 2020 but not paid until 2021,

we could NOT ignore the different dates, e.g., we would need to report a liability for Dividends Payable on the 12-31-2020 balance sheet.

As such, it is usually primarily common stock owners

who own the residual interest in a corporation, as noted earlier

Ceteris paribus, the ability to convert the preferred shares to common shares

will make the preferred stock MORE LIKE EQUITY as opposed to debt

Per the Securities and Exchange Commission (SEC):

· Dividends < 25% are considered "small" stock dividends · Dividends > 25% are considered "large" stock dividends

"Large" stock Dividends

· Essentially, lots of flexibility