Preference shares or preferred stock are shares of a company which give the holders of such shares a preferred right to the dividends compared to the ordinary shareholders. Preference dividend is paid first, and then dividend to the ordinary shareholders is paid. Similarly, if a company enters liquidation or winding up proceedings, holders of preference shares have a preferred right of receiving their invested amount compared to the ordinary shareholders. Generally, a fixed preference dividend is offered as per the terms of preference shares, for e.g. 8% preference shares mean that 8% of the face value of preference shares will be paid as annual dividends. This is not the case with dividends to the ordinary shareholders.
We can say that there are characteristics of both equity and financial liability in preference shares. For accounting, preference shares are classified as either equity or financial liability depending upon the economic substance of the arrangement, as required by the substance over form principle. Key factor to be considered is whether there is a contractual obligation on the company or not. If there is an obligation to pay preference dividend or redeem the capital, preference shares will be accounted for as financial liability. If there is no such obligation, preference shares will be accounted for as equity.
Irredeemable preference shares
As the name suggests, there is no contractual obligation to redeem or pay back the capital in irredeemable preference shares. If there is no contractual obligation to pay the preference dividend as well, such irredeemable preference shares will be classified as equity.
Redeemable preference shares
There is a contractual obligation to redeem or pay back the capital raised through redeemable preference shares. Therefore, redeemable preference shares are like a long-term loan and are classified as financial liability. Dividend payments should be considered as payment of finance cost.
Cumulative preference shares
There is a contractual obligation to pay all preference dividends. If a company was not able to pay preference dividend due to adverse financial position or some other reasons, it will not extinguish the company’s obligation. Such missed dividends will be accumulated and will be paid in future.
Cumulative preference shares which are redeemable as well are classified as financial liability. However, irredeemable cumulative preference shares have both equity and liability components and are treated like a compound financial instrument. Total capital raised by issuing irredeemable cumulative preference shares is allocated into equity component and financial liability component. Subsequent accounting is done accordingly for both components as explained in our chapter compound financial instruments.
Let’s see an example of redeemable preference shares.
On 1 January 20X1, ABC Company issued 100,000 redeemable preference shares of $2 each. Preference dividend of 7% per annum will be given to the preference shareholders. Preference share capital will be redeemed by the company after 20 years with a premium of $1 on each share. Effective interest rate is 8.08% per annum.
How will the preference shares be accounted for by ABC Company during the financial year 20×1?
First thing is to decide whether the substance of preference shares represents equity or liability. As the preference shares are redeemable, therefore, they will be classified as financial liability.
On 1 January 20×1, financial liability will be recognized at its fair value. The company has raised a capital of $200,000 by issuing the 100,000 preference shares. Financial liability will initially be recognized at $200,000.
For subsequent accounting, we’ll make the amortized cost table. Following entries will be made to record the transactions related to preference shares.