The Intricate World of Preference Shares: Accounting Treatment Explained
Mastering the Accounting of Preference Shares: A Comprehensive Guide
For accounting students, the treatment of preference shares is a crucial aspect of understanding corporate finance and financial statement preparation. Preference shares, sometimes referred to as preferred stock, are a unique financial instrument that holds characteristics of both equity and debt. This tutorial will help clarify how preference shares are accounted for, by walking through the key concepts, various scenarios, journal entries, and financial statement impact. By the end of this guide, you’ll be confident in handling preference shares in your accounting coursework and real-world scenarios.
What Are Preference Shares?
Preference shares are a type of equity security that grants shareholders certain preferential rights over ordinary (or common) shareholders. The key features of preference shares include:
- Dividend Preference: Preference shareholders receive dividends before common shareholders. The dividends are often fixed, and they are paid out regularly, though not necessarily every year.
- Liquidation Preference: If a company goes into liquidation, preference shareholders have the right to be paid before common shareholders, but after creditors.
- No Voting Rights: Preference shareholders typically do not have voting rights in the company, unlike common shareholders who can vote on corporate matters.
Types of Preference Shares
There are several different types of preference shares, each with specific characteristics that affect their accounting treatment. The most common types include:
- Cumulative Preference Shares: If the company is unable to pay dividends in one year, the dividends accumulate and must be paid out in future years before any dividends can be paid to common shareholders.
- Non-Cumulative Preference Shares: If the company does not pay dividends in a given year, the dividend is forfeited and does not accumulate.
- Participating Preference Shares: These shares allow shareholders to receive extra dividends beyond the fixed rate if the company performs well.
- Convertible Preference Shares: These shares can be converted into common shares after a certain period or upon certain conditions.
- Redeemable Preference Shares: The company can buy back these shares at a future date at a predetermined price.
Accounting Treatment for Preference Shares
The accounting treatment for preference shares primarily depends on whether the shares are classified as equity or liabilities. The classification is based on the terms and conditions attached to the preference shares. The distinction is crucial because it affects how preference shares are reported in the financial statements.
1. Equity Classification:
Preference shares are classified as equity if:
- They are non-redeemable, meaning the company is not required to repurchase the shares at any point in the future.
- The dividends are discretionary, meaning the company is not obligated to pay them.
2. Liability Classification:
Preference shares are classified as liabilities if:
- They are redeemable, meaning the company is obligated to repurchase the shares at a future date.
- The dividends are mandatory, meaning the company must pay them regardless of profitability.
The classification determines how the preference shares are reported in the Balance Sheet and affects the treatment of dividends in the Income Statement.
Journal Entries for Preference Shares Issued as Equity
When preference shares are classified as equity, they are treated as part of the shareholders’ equity in the company’s balance sheet.
Example 1: Issuance of Non-Redeemable, Non-Cumulative Preference Shares
Let’s assume a company issues 1,000 preference shares with a par value of $100 each for $100 each. The dividend is non-cumulative, and the company does not have to repay the capital. These shares are classified as equity.
Journal Entry for Issuance:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Bank | 100,000 |
Preference Share Capital | | 100,000
--------------------------------------------------------
- Explanation: The company receives $100,000 from the issue of the preference shares. The bank account is debited to reflect the receipt of cash, and the preference share capital is credited to reflect the issuance of equity.
Example 2: Declaration of Dividends on Preference Shares
Assume that at the end of the year, the company declares a dividend of 10% on its preference shares. For 1,000 preference shares, the total dividend to be paid is $10,000.
Journal Entry for Dividend Declaration:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Preference Share Dividend | 10,000 |
Dividends Payable | | 10,000
--------------------------------------------------------
- Explanation: The dividend is declared and a liability (dividends payable) is created. The dividend expense is recorded under preference share dividends, and the liability for the payment is reflected under dividends payable.
Example 3: Payment of Preference Share Dividends
When the company pays the declared dividend, the following journal entry is made.
Journal Entry for Dividend Payment:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Dividends Payable | 10,000 |
Bank | | 10,000
--------------------------------------------------------
- Explanation: When the dividend is paid, the dividends payable liability is reduced, and the bank balance is decreased.
Journal Entries for Preference Shares Issued as Liabilities
If the preference shares are redeemable, they are classified as liabilities. The company is required to redeem these shares at a future date, which creates a financial obligation.
Example 4: Issuance of Redeemable Preference Shares
Suppose a company issues 500 redeemable preference shares with a par value of $100 each for $100 each. The company must redeem these shares in five years.
Journal Entry for Issuance:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Bank | 50,000 |
Redeemable Preference Share Liability | | 50,000
--------------------------------------------------------
- Explanation: The company receives $50,000 in cash, and it recognizes a liability for the redeemable preference shares, as it will need to repay the shareholders in the future.
Example 5: Dividend Payment on Redeemable Preference Shares
Let’s assume the company declares a 5% dividend on the redeemable preference shares. The dividend on 500 shares at $100 each is $2,500.
Journal Entry for Dividend Payment:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Redeemable Preference Share Liability | 2,500 |
Bank | | 2,500
--------------------------------------------------------
- Explanation: The dividend is paid to preference shareholders, and the liability is reduced. The payment decreases the bank balance and the liability for the redeemable preference shares.
Impact on Financial Statements
The issuance and dividend payments of preference shares impact both the Balance Sheet and the Income Statement. Let’s examine the effects:
1. Balance Sheet Impact
- Equity Classification: Preference shares issued as equity are recorded under Shareholders’ Equity in the Balance Sheet. The amount received from issuing preference shares increases the equity section.
- Liability Classification: Preference shares issued as liabilities are recorded under Non-Current Liabilities (if redeemable after more than one year) in the Balance Sheet.
2. Income Statement Impact
- Equity Classification: If preference shares are classified as equity, the dividends are not recognized as an expense in the Income Statement. The dividend payments are a distribution of profit to shareholders, not an expense of the business.
- Liability Classification: If preference shares are classified as liabilities, the dividend payments are treated as an interest expense and appear on the Income Statement.
Practice Questions
Now that we’ve gone through the core concepts and journal entries, let’s test your understanding with some practice questions.
Question 1: A company issues 1,000 non-redeemable preference shares at $100 each with a 7% dividend rate. At the end of the year, it declares and pays the dividend. Record the journal entries for the issuance, declaration, and payment of the dividend.
Answer:
- Issuance of Preference Shares:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Bank | 100,000 |
Preference Share Capital | | 100,000
--------------------------------------------------------
- Dividend Declaration:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Preference Share Dividend | 7,000 |
Dividends Payable | | 7,000
--------------------------------------------------------
- Dividend Payment:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Dividends Payable | 7,000 |
Bank | | 7,000
--------------------------------------------------------
Question 2: A company issues 500 redeemable preference shares at $150 each. The company is required to pay a 6% annual dividend and redeem the shares after five years. What is the journal entry for the issuance and dividend payment?
Answer:
- Issuance of Redeemable Preference Shares:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Bank | 75,000 |
Redeemable Preference Share Liability | | 75,000
--------------------------------------------------------
- Dividend Payment:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Redeemable Preference Share Liability | 3,000 |
Bank | | 3,000
--------------------------------------------------------
Question 3: How would a company account for the issuance of 1,000 preference shares at $50 each, with a 5% cumulative dividend rate? The company declares and pays the dividend after one year.
Answer:
- Issuance of Preference Shares:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Bank | 50,000 |
Preference Share Capital | | 50,000
--------------------------------------------------------
- Dividend Declaration:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Preference Share Dividend | 2,500 |
Dividends Payable | | 2,500
--------------------------------------------------------
- Dividend Payment:
Date: [Date]
--------------------------------------------------------
Account | Debit ($) | Credit ($)
--------------------------------------------------------
Dividends Payable | 2,500 |
Bank | | 2,500
--------------------------------------------------------
Conclusion
Accounting for preference shares requires an understanding of both their equity and liability characteristics. By properly classifying them, understanding their dividend structures, and making the correct journal entries, accounting students can ensure accurate financial reporting. This tutorial has provided you with the key concepts, practical examples, and journal entries necessary to master the accounting treatment for preference shares. Keep practicing to solidify your understanding and improve your accounting skills!
