 Hello and welcome to the session. This is Professor Farhat and the session we would look at preferred stock, which is covered in introductory accounting course, intermediate accounting, as well as the CPA exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so, YouTube is where you would need to subscribe. I have 1600 plus accounting, auditing, finance and tax lecture. This is a list of all my courses. If you like my lectures, please like them, share them, put them in playlist, subscribe. If they benefit you, it means they might benefit other people, share the wealth, connect with me on Instagram. On my website, farhatlectures.com, you'll find additional resources such as multiple choice through false, thousands of CPA questions and additional resources. If you are looking to study for your CPA exam and pass the exam, I strongly suggest you check out my website. Why do companies issue preferred stock? Now, we already talked about common stock. So we have common stock and now we're going to be looking at preferred. So if you don't know what common stock is, please look in this playlist. Okay, and I'm going to put the description and make sure you understand what comments. So why do we issue preferred stock? Well, one reason is to raise money, is to get money without sacrificing control. Simply put, get the money and we don't share the money with anywhere else in terms of control. Two, to boost the return earned by common stockholder through financial leverage. You will see that preferred stock is not really a true stock. It works a little bit like that, and that is leverage. And leverage means you are using other people's money to make money of them. This is what leverage is. So preferred stock, you will see it works like a liability. Although it's considered an equity, but you're going to see it works like a liability in one way or another. And also to appeal to investors who may believe the common stock is too risky. What does it mean? Well, in terms of liquidation, in case something happened to the company and the company is going to go out of control. Here's what's going to happen. There's a lane. There's a lane that people will stand in to get their money. Common stockholders, common stockholders are the last people in the lane, the last people. So they get their money last. And right before this group, we have the preferred stockholders. So if the preferred stockholders thinks the company is risky, they will have a priority position in case of liquidation. So if they think the company is too risky, they prefer to buy their preferred stock. And the expected return on the common stock is too low. And if you bought common stock, they're not going to pay dividend while preferred, usually or generally speaking, will pay dividend. Therefore, the return is higher. So those are some of the reasons. So just simply put, it's a separate class of stock. That's all what it is. And typically have a priority. Notice it's called preferred. It means we have, it has a certain preferences. What are those certain preferences? It has preference in terms of dividend. That's the most important preference. And in case of a liquidation, a distribution, in case of liquidation, they come before the common shareholders. Simply put, those are the main reasons. You get your dividend first, which will give you a higher return. And in case of liquidation, you have less risk. That's, those are the two reasons. Usually, okay, it has no voting power. So generally speaking, they have no voting power. So that's why it's not really a true ownership interest in the company because you cannot vote. And what's unique about preferred, usually it has a stated dividend rate. Now, what does it mean, stated dividend rate? It means they tell you exactly how much money you are going to be getting. The good news about the preferred dividend is from an accounting perspective. When we journalize the entry, it's the same as common stock. So let's take a look at a journal entry and explain this stated dividend rate. T company issued 5,000 shares, $1 power value, 7% cumulative preferred for $102. So the first thing is let's journalize the entry. So the company sold issued 5,000 shares for $102. So they would receive $5,000 times 102, which is 5,000 shares and the selling price is 102. They would receive $510,000. That's the cash that the company would receive. Then we have to credit preferred stock because we issued preferred stock. How much do we credit preferred stock? It's the same thing as common stock. What does that mean? It means we take the number of shares times the par value. How many number of shares are we issuing in this example? Easy. 5,000 shares. What is the par value? $100. So we're going to credit. We're going to credit preferred stock for half a million. And what's left is $10,000. Just like common stock, we have an account called pay in capital and access of par value preferred stock. So just like the only thing difference is in common stock, we call it common stock. Here we call it preferred stock. So it's paid in capital and access paid in capital in access of par value preferred stock. So that's the journal entry. So that's easy. Now what you need to be aware of is this 7% cumulative. Notice here it says 7% cumulative. Don't worry about the cumulative. We're going to explain the cumulative in a moment. What we need to worry about here is remember I said it's usually stated as a dividend rate. You remember the statement? Here's an example of it. So what we do is see the par value is $100. This is the par value. We take the par value and we multiply it by a percentage that's stated. So simply put each shareholder would receive $7 per share. So simply put what is the dividend rate? So this is what you need to understand. What is the dividend rate? It's a percentage times the par value. The percent here is 7%. The par value is 100. The dividend is 7% of 100, which is $7 per share. So you need to understand how to compute the dividend per share. It's the percent times the par value. It's a percent of the par value. Very important. We will revisit this in a moment. Now let's talk about cumulative versus non cumulative preferred stock. What does cumulative mean? Cumulative means if we fail to pay the company. Let's assume we have year one, year two, year three, year four. In year one we made no profit. We paid no dividend. In year two we made no profit. We paid no dividend. In year three we made a lot of profit. If we have preferred stock and the preferred stock is considered cumulative, what we have to do? We have to go back. First, pay year one, pay year two, then pay year three for the preferred. It means the dividend don't go away. It's cumulative. Simply put, we're going to have what's called dividend and a year. So what are the dividend and a year? The dividend and a year are year two and year one. It means we owe the dividend from prior year. So dividend and a year must be paid before dividend. May be paid on common stock. So first we have to pay the dividend and a year, then the current. So year three is the current year. Then we pay the common stock. Now if this preferred was non-cumulative, non-cumulative here, guess what? Since we did not pay year one, that's it. We no longer have to worry about year one. If we did not pay year two, we don't have to worry about year two. All we have to do now in year three when we made profit and we're going to distribute dividend, we don't have to worry about the current year dividend. So undeclared dividend from current and prior year do not have to be paid in future years. So if we did not declare the dividend from the current or prior years, we're not responsible for the dividend. So the best way to illustrate this is to just work an example to see how this all works. So this is how the preferred stock is listed on the balance sheet. So remember we have common stock, par value, how many shares authorized, how many shares issued and outstanding, total of 300,000. Now for the preferred stock, it followed the same concept. It followed the same concept. What does it mean to follow the same concept? Preferred stock, we have the par value listed, 1,000 shares authorized of which only 50 are issued and outstanding. And we're going to assume this is a 9% preferred. It means we pay 9%. It means we pay $9 per share because $100 times 9% will give us $9. And this is how the preferred stock is listed on the balance sheet. So let's take a look at an example. Consider the following stockholder equity section is what we saw above. The board of directors declares 5,000 dividend in 2018. In 2019, the board declared and paid cash of 42. Well, let's go back here and let's assume first it's a cumulative. So in 2018, we declared $5,000 of dividend. And let's assume this preferred is cumulative. What does that mean? It means in 2018, well, guess what? In 2018, we had to pay the preferred shareholders $9,000. Why $9,000? Here's why $9,000. Remember we said this is a 9% preferred. We have to pay $9 per share and we have $1,000, 1,000 shares. 1,000 shares authorized. It means we have to pay the preferred shareholders $9,000. We only paid them, we only paid $5,000. It means everything goes to the preferred and now we are $4,000 short for the preferred. It means we're going to pay them $5,000 this year. So this is for the preferred shareholders and zero obviously to the common shareholders in 2018. In 2019, we paid $42,000. Well, if in 2019, we paid $42,000, $42,000, $4,000 for dividend in a year, $9,000 for the current year. And what's left is $29,000 for common stockholders. In 2019, $13,000 goes to the preferred and $29,000 goes to the common. Now, if this stock was non-cumulative, it means we don't have to worry about this $4,000. So in 2018, all the money goes to the preferred. In 2019, we pay $9,000 to the preferred and everything else goes to the common because it's non-cumulative. Non-cumulative means if we did not pay you, we don't have to pay you. And this is the computation again. If it's non-cumulative versus cumulative. Participating versus non-participating, again, the preferred comes in different flavor. Another flavor is participating versus non-participating. Participating means dividend may exceed stated amount once common stockholder receive a dividend equal to the preferred state. Remember in the example that we said, we said it's a $100 par value, 9% $100 par value. It means you're going to get $9 per share. What happened is this, is if this dividend, if I'm sorry, if this preferred is participating, because again, the preferred stock, they come in different flavors. It means once the common shareholders get $9 per share as well, then you have to go back and share with the preferred. Now, most preferred are non-participating. Non-participating means you get your $9 and that's it. But in advanced courses, you have to learn about participating. You just for this course, you just need to know what's the meaning of participating. Now, in intermediate accounting, I do work examples with non-participating versus participating. But here you just have to know the meanings of it. So non-participating, easy. Dividend are limited to a maximum amount each year. Simply put, you're going to get $100 times 9%. You will get $9 per share. If we have 1000 shares, let's assume we have 1000 shares. The maximum we pay per year is 9,000. This is the max. That's it. Here, under participating, we may get more than 9,000. We may get more than 9,000. So the normal thing is non-participating. Now, the best way to illustrate this is to work an example about dividend preferences, specifically cumulative or non-cube. A company outstanding stocks consist of 80 shares of non-cumulative 5% with a par value of $5 and also have 200 shares with a par value of $1. First, it's a 5% times $5. So we have $5 times 5%. So each shareholder, each preferred shareholder is guaranteed a quarter every time the company pays dividend. It's non-cumulative only if they declare and paid. During the first three years, the corporation declared and paid the following cash dividend. Determine the amount of dividend paid to each of the two classes of stockholders. In 2015, we paid $15. Well, the first thing we have to do, we have 80 shares, 80 shares of preferred. So we're going to take 80 shares times a quarter. So we're going to pay them $20. Actually, for 2015, we paid only, yeah, for year 2015, we only paid $15. The whole thing goes to the preferred shareholders and since it's non-cumulative, we only have to pay them $15 and we don't owe them anything. Now, if it's cumulative, we have to pay them $15 and we say we owe them $5, but we don't have to worry about this now. In 2016, we paid $5. Again, $5, we have to pay them $20. Everything goes to the preferred. The $5 goes to the preferred and we don't owe them anything. We don't owe them anything. If it was cumulative, we owe them another $15. In 2017, we paid $200. Of this $200, $20 goes to the preferred shareholders and the remaining, after we pay 20, what's left is $180. $180 goes to the common. So it looks something like this. So we have to pay $20 annual dividend. So in 2015, we have $15. It all goes to the preferred, nothing to the common. In 2016, we paid $5. It all goes to the preferred, nothing to the common. In 2017, $200, we have to pay the preferred $20 and the remaining goes to the common. So the key in this computation is to remember we have to pay per year $20. If we have $20, they get paid first. If not, we don't have to worry about it because it's non-cumulative. Assuming the same example, now we could switch the example and make it cumulative if you want to. If it's cumulative, here's what's going to happen. If this is cumulative, we're going to pay the first $15. It's going to go to the preferred and we're going to owe them $5. And nothing will go to the common for year one. Year two, we paid $5. The whole thing goes to the preferred. The whole thing goes to the preferred and now we owe them $20. Why $20? $5 from year 2015. $15 from year 2016. We owe them $20 now. In 2017, we made a bunch of profit, $200. Well, $40 goes to the preferred. $20 for the current year and $20 for prior years, which is equal to $40. And what's left, now we clear the rear. We don't owe them anything. And the remaining goes to the common. If you like this recording, please like it, share it, put it in playlist. If it benefits you, it means it might benefit other people. Subscribe to the channel. And if you're interested in getting additional resources to pass your CPA exam and do well in your college education to supplement your college education, visit my website. Study hard and stay safe, especially during those coronavirus days.