Question

Why do we use the Retained Earnings Account When Converting Preferred Stocks w/ Book Value Method? I understand the Preferred Stock shareholders are receiving an extra return on the conversion and this will reduce the corporation's Retained Earnings as a result. but what is the logic behind this?

for instance:

P/S 5000

APIC - P/S 400

R/E 600

C/S    (6000)

Answer 1

The logic is incremental conversion value has to be absorbed by debit to Retained earnings to balance common stock with preferred stock conversion value because Retained earnings is part of equity. Retained earnings are the sum of accumulated earnings of the firm over a period of time. It is shown under stockholders’ equity and part of the equity that belongs to the shareholders.

When preferred stock is converted into common stock at a given market price it will involve debiting the preferred stock and its additional paid in capital and crediting common stock for the conversion rate agreed. The difference is charged to Retained earnings since Common stock is credited at a particular conversion rate the difference has to be absorbed by equity only. Retained earnings are part of equity and hence it is debited. It implies the conversion for preferred stock is more than preferred stock value and hence more common stock value has been issued. To adjust preferred stock value to common stock value the difference is adjusted in Retained earnings to make it preferred stock conversion equal to Equity issued.