Question

1. a) What are the principal differences between common stock and preferred stock?
2. b) Preferred stock may be cumulative. Explain this feature.
3. c) How are dividends in arrears presented in the financial statements?

Please provide theory and your own explanation or examples.

Answer 1

a)The principal differences between common stock and preffered stock are as follows:

Preferred Stock	Common Stock
1.Preferred stock does not give shareholders voting rights	1.Common Stock shareholders get voting rights.
2.Preferred Stock guarantee fixed dividends to the shareholders	2.Common Stock has variable dividends which are not guaranteed.
3.When interest rate rises in the market the value of the preferred stocks declines or vice versa.	3.The value of the common stock is regulated by the demand and supply in the market.
4.The preferred stocks holders are givewn priority over the common stock holders.In case of company misses a dividend in bad times it will first pay arrears to the preferred stock holder.	4.The common stock holder are paid after the payment is made to the preferred stock holders.
5.Preferred Stock can be converted into common stock	5.Common stock cannot be converted in to preferred stock.
6.Preferred Stock holders do not have claim on the profits.	6.Common Stock holders have claim on the profits of company
7.In case of insolvency or liquidation the preferred stock holders are paid first.	7.Common stock holders will not receive any money until the preferred shareholders are paid out.

b) Preferred stock may be cumulative.

This means that there are certain preferred stock which are cumulative i.e these stocks are issued with a provision which says that if a company missed its dividend in any year due to financial trouble,the company has to pay those arrears or outstanding dividends to these cumulative preferred stock holders before the other classes of preferred stock holders when the company starts paying dividends again.No dividends will be paid to the non cumulative preferred stock holders until all the cumulative preferred dividends are paid.

For example:A company issued Cumulative preferred stock of par value $10,000 with a dividend rate of 7% annually and issued non cumulative preferred stock of par value $20,000 with a dividend rate of 6%.The economy slows down and the company is able to pay only $ 300 per share.In the next year when the company resumes to pay dividend the company will pay the cumulativre preferred stock holders a current dividend of $700 in addition to the arrears dividend of $300 i.e $1000 .Only after the cumulative preferred stock dividend is paid the dividend will be paid to the non cumulative preferred stock holders and that will be only for the current year dividend i.e $1200.

c) Dividend in arrears are asociated with cumulative preferred stock.In case the company misses to pay dividend on these stocks by the expected date the dividends become arrears .These arrears dividend do not appear on the face of balance sheet as a liability.Instead these must be disclosed in the notes of the financial statements