Preferred stock is a class of corporate stock whose holders have preferential rights compared with common stock, typically a stated dividend paid before any common dividend and a stated position ahead of common on liquidation. The capital structure standard defines it in those bare terms, as a security that has preferential rights compared to common stock (FASB Statement No. 129, paragraph 2). Nothing about the label creates those rights. A class is preferred only because the certificate of incorporation or the board resolution issuing it says so, under 8 Del. C. § 151, and that drafting is worked through in common stock.
For a US firm this is a classification question before it is anything else, and what settles it is the redemption terms rather than the name. The FASB Accounting Standards Codification is the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities, and rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants (FASB Statement No. 168, paragraph 6).
Which Balance Sheet Caption the Class Takes
On financial statements filed with the SEC, Regulation S-X splits stock into three captions rather than two (17 CFR 210.1-01). Caption 27 covers preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer, meaning stock redeemable at a fixed or determinable price on a fixed or determinable date, redeemable at the option of the holder, or carrying conditions for redemption not solely within the issuer’s control. Caption 28 covers preferred stocks which are not redeemable or are redeemable solely at the option of the issuer, and caption 29 covers common stocks (17 CFR 210.5-02).
The first of the three is held apart on purpose. Securities reported under it are not to be included under a general heading of stockholders’ equity or combined in a total with the items in captions 29, 30 or 31 (17 CFR 210.5-02). That is the mezzanine, or temporary equity, and a balance held outside equity is one an enterprise value build-up adds back, in enterprise value.
When Preferred Stock Is Not Equity at All
The harder call takes the class off the equity side completely. A mandatorily redeemable financial instrument is classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity, and an instrument issued in the form of shares is mandatorily redeemable if it embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date, or upon an event certain to occur (FASB Statement No. 150, paragraph 9). Such items are presented as liabilities and are not presented between the liabilities section and the equity section (FASB Statement No. 150, paragraph 18), so a share that meets the test cannot be parked in the mezzanine instead, and the reclassification moves the leverage ratios a lender tests, in covenants.
The Codification carries this as Topic 480, Distinguishing Liabilities from Equity, with a scope exception written for nonpublic entities that are not SEC registrants. The classification, measurement and disclosure guidance does not apply to mandatorily redeemable financial instruments that are both issued by nonpublic entities that are not Securities and Exchange Commission registrants and mandatorily redeemable, but not on fixed dates or not for amounts that either are fixed or are determined by reference to an interest rate index, currency index, or another external index (FASB Accounting Standards Update 2017-11, paragraph 480-10-15-7A). At a nonpublic issuer that is not an SEC registrant, a share redeemable at a formula or appraised price can therefore fall outside that guidance even though it has to be redeemed.
Cumulative Dividends and Arrears
Cumulative means an unpaid preference accumulates and has to be cleared before any dividend can be paid on common. Noncumulative means a passed dividend is gone.
Arrears on a cumulative class are not a recorded liability, because the power to declare a dividend is the board’s and is discretionary, set out in stockholder and in owner’s equity. They get disclosed instead. An entity discloses, on the face of the statement of financial position or in the notes to it, the aggregate and per-share amounts of arrearages in cumulative preferred dividends (FASB Statement No. 129, paragraph 7), and that reaches all entities, public and nonpublic, that have issued the securities it addresses (FASB Statement No. 129, paragraph 3).
Where an entity presents earnings per share, the period’s accumulation on a cumulative class reduces it even where no dividend is declared. That presentation is required of entities that have issued common stock or potential common stock trading in a public market, and of an entity that has made a filing or is in the process of filing with a regulatory agency in preparation for the sale of those securities in a public market (FASB Statement No. 128, paragraph 6). Income available to common stockholders is computed by deducting both the dividends declared in the period on preferred stock, whether or not paid, and the dividends accumulated for the period on cumulative preferred stock, whether or not earned (FASB Statement No. 128, paragraph 9).
Where a US Firm Meets the Class
The corporate return gives preferred its own sub-line. Capital stock is line 22 under Liabilities and Shareholders’ Equity, with preferred stock on line 22a directly above common stock on line 22b (IRS, Form 1120, Schedule L). What that caption carries, and why it is not what the shares sold for, is in common stock.
The trap sits one election over. A corporation that has more than one class of stock does not qualify as a small business corporation, and a corporation is treated as having only one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds, with differences in voting rights among shares disregarded (26 CFR 1.1361-1(l)(1)). A dividend or liquidation preference is a difference in exactly those rights, so a client that issues preferred stock puts the corporation outside that definition, while issuing nonvoting common leaves it inside. The election is in c corp vs s corp.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a trial task lets a firm grade a real block of its own equity work before a client’s balance sheet depends on it.
