Understanding Convertible Preferred Shares: A Deep Dive into Accounting
Convertible preferred shares are a unique financial instrument that combines the features of both debt and equity. These shares allow holders the right to convert them into a predetermined number of common shares at a later date, making them a hybrid security. From an accounting perspective, convertible preferred shares present both challenges and opportunities for proper reporting. This tutorial aims to break down the accounting treatment of these complex instruments, providing clear examples, journal entries, and financial statement effects.
What Are Convertible Preferred Shares?
Convertible preferred shares are a class of equity securities that have a conversion feature, which grants the holder the option to convert their preferred shares into a specified number of common shares at certain times and under specific conditions. These shares often have characteristics similar to both debt and equity:
- Preferred Status: Like traditional preferred shares, they typically have priority over common shares for dividend payments and liquidation rights.
- Convertible Feature: The key differentiator is the ability to convert into common stock, potentially diluting existing shareholders but also providing a possible upside if the company’s stock price increases.
Accounting for convertible preferred shares is more complicated than regular preferred stock because of their hybrid nature. We need to address how to account for the issuance, dividends, and the conversion process.
Accounting for Issuance of Convertible Preferred Shares
When a company issues convertible preferred shares, the primary consideration is how to classify the shares on the balance sheet. These shares are often classified as equity unless there is a compelling reason to treat them as a liability, such as if they are mandatorily redeemable or if they have features that require the company to settle them in cash.
Let’s work through an example.
Example 1: Issuance of Convertible Preferred Shares
Company XYZ issues 1,000 convertible preferred shares at $100 per share. The conversion rate allows each preferred share to be converted into 10 common shares.
Journal Entry for the Issuance:
Date: [Issue Date]
---------------------------------------------------------
Dr. Cash 100,000
Cr. Convertible Preferred Shares 100,000
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(To record the issuance of 1,000 convertible preferred shares at $100 each)
Here, the company receives cash for the issuance of preferred stock. The Convertible Preferred Shares account is credited for the full amount, reflecting the equity raised by the company.
Accounting for Dividends on Convertible Preferred Shares
Similar to other preferred shares, convertible preferred shares usually entitle their holders to receive dividends. However, the key difference is that convertible preferred shares may also be converted into common stock at any time, which can impact future dividend payments.
Example 2: Payment of Dividends on Convertible Preferred Shares
Company XYZ declares a dividend of $5 per share on its outstanding convertible preferred shares. The total dividend payment will be $5,000 (1,000 shares x $5 per share).
Journal Entry for Dividends:
Date: [Dividend Declaration Date]
---------------------------------------------------------
Dr. Retained Earnings 5,000
Cr. Dividends Payable 5,000
---------------------------------------------------------
(To record the declaration of dividends on convertible preferred shares)
When the dividend is paid, the journal entry is as follows:
Date: [Dividend Payment Date]
---------------------------------------------------------
Dr. Dividends Payable 5,000
Cr. Cash 5,000
---------------------------------------------------------
(To record the payment of dividends on convertible preferred shares)
Dividends on convertible preferred shares are typically paid in cash unless otherwise stated in the terms of the shares. The payment of dividends reduces retained earnings and the cash balance.
Accounting for the Conversion of Preferred Shares to Common Stock
When a holder of convertible preferred shares exercises their option to convert their shares into common stock, the accounting treatment becomes crucial. The conversion typically does not result in a gain or loss. Instead, the preferred stock is removed from the balance sheet, and common stock is issued in its place.
Let’s go through the journal entry for a conversion.
Example 3: Conversion of Convertible Preferred Shares
Suppose an investor decides to convert 200 of their preferred shares into 2,000 common shares (since each preferred share converts into 10 common shares). The carrying value of the preferred shares is $100 each.
Journal Entry for Conversion:
Date: [Conversion Date]
---------------------------------------------------------
Dr. Convertible Preferred Shares 20,000
Cr. Common Stock 2,000
Cr. Additional Paid-In Capital 18,000
---------------------------------------------------------
(To record the conversion of 200 convertible preferred shares into 2,000 common shares)
In this example, the preferred shares are removed from the balance sheet, and common stock is issued. The Additional Paid-In Capital account reflects the difference between the book value of the preferred shares and the par value of the common stock issued.
Note that the conversion does not create a profit or loss for the company or the shareholder, as it is merely a reclassification of equity.
Impact on Financial Statements
Balance Sheet
The issuance, dividend payment, and conversion of convertible preferred shares all have significant impacts on the balance sheet.
- Issuance increases cash (or another asset) and increases equity in the form of convertible preferred shares.
- Dividend Payments reduce retained earnings and create a liability until paid.
- Conversion reclassifies the convertible preferred shares into common stock and possibly additional paid-in capital.
Income Statement
Typically, convertible preferred shares do not affect the income statement unless there are convertible features that involve interest payments (in the case of certain hybrid instruments). Dividends on preferred stock are treated as a deduction from net income, but there is no impact from the conversion on the income statement.
Statement of Cash Flows
In the operating activities section, cash payments for dividends would be reported. The conversion of preferred shares into common stock would not impact the statement of cash flows, as it is a non-cash transaction.
Advanced Considerations: The Impact of Convertible Preferred Shares on Earnings Per Share (EPS)
Convertible preferred shares can also affect a company’s earnings per share calculation. Since these shares can convert into common stock, they are considered dilutive potential common shares. If the preferred shares are converted, the number of common shares outstanding increases, which can lower the EPS.
When calculating diluted EPS, we need to consider the potential conversion of convertible preferred shares.
Example 4: Diluted EPS Calculation
Let’s assume the following:
- Company XYZ has 10,000 common shares outstanding.
- The company has issued 1,000 convertible preferred shares, each convertible into 10 common shares.
- Net income for the year is $50,000.
- The preferred shares are currently converting into common stock.
To calculate diluted EPS, the formula is:
In this case:
The diluted EPS is lower than the basic EPS because of the additional common shares issued through the conversion of preferred stock.
Practice Questions
- Question 1: Company ABC issues 500 convertible preferred shares at $200 each. Each share is convertible into 20 common shares. What is the journal entry to record the issuance of the shares?
- Question 2: Company XYZ declares a dividend of $10 per preferred share on 1,000 convertible preferred shares. What are the journal entries to record the dividend declaration and payment?
- Question 3: If 300 convertible preferred shares are converted into 3,000 common shares, and the par value of the common stock is $1 per share, how would you record the conversion in the journal?
Answers to Practice Questions
- Answer to Question 1:
Date: [Issue Date]
---------------------------------------------------------
Dr. Cash 100,000
Cr. Convertible Preferred Shares 100,000
---------------------------------------------------------
(To record the issuance of 500 convertible preferred shares at $200 each)
- Answer to Question 2:
Journal Entry for Dividend Declaration:
Date: [Dividend Declaration Date]
---------------------------------------------------------
Dr. Retained Earnings 10,000
Cr. Dividends Payable 10,000
---------------------------------------------------------
(To record the declaration of dividends on 1,000 convertible preferred shares)
Journal Entry for Dividend Payment:
Date: [Dividend Payment Date]
---------------------------------------------------------
Dr. Dividends Payable 10,000
Cr. Cash 10,000
---------------------------------------------------------
(To record the payment of dividends on convertible preferred shares)
- Answer to Question 3:
Date: [Conversion Date]
---------------------------------------------------------
Dr. Convertible Preferred Shares 30,000
Cr. Common Stock 3,000
Cr. Additional Paid-In Capital 27,000
---------------------------------------------------------
(To record the conversion of 300 convertible preferred shares into 3,000 common shares)
Conclusion
Convertible preferred shares are a fascinating yet complex aspect of accounting. By understanding the fundamental accounting treatments, such as issuing, paying dividends, and converting these shares into common stock, accounting students can gain a better grasp of hybrid financial instruments. Through examples and practice questions, you now have a solid foundation for managing the accounting of convertible preferred shares in real-world scenarios.
