Page 495 - Accounting Principles (A Business Perspective)

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outstanding of USD 100,000, and retained earnings of USD 30,000. It has paid no dividends for two years. The
company would pay the preferred stockholders dividends of USD 20,000 (USD 10,000 per year times two years)
before paying any dividends to the common stockholders.

Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the
current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability
until declared by the board of directors. However, since the amount of dividends in arrears may influence the
decisions of users of a corporation's financial statements, firms disclose such dividends in a footnote. An
appropriate footnote might read: "Dividends in the amount of USD 20,000, representing two years' dividends on
the company's 10 per cent, cumulative preferred stock, were in arrears as of 2007 December 31".
Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred

as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par
value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders.
A corporation's cumulative preferred dividends in arrears at liquidation are payable even if there are not enough
accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock
may be preferred as to assets, dividends, or both.
Convertible preferred stock is preferred stock that is convertible into common stock of the issuing
corporation. Many preferred stocks do not carry this special feature; they are nonconvertible. Holders of
convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common
stock of the same corporation.

Investors find convertible preferred stock attractive for two reasons: First, there is a greater probability that the
dividends on the preferred stock will be paid (as compared to dividends on common shares). Second, the
conversion privilege may be the source of substantial price appreciation. To illustrate this latter feature, assume
that Olsen Company issued 1,000 shares of 6 per cent, USD 100 par value convertible preferred stock at USD 100
per share. The stock is convertible at any time into four shares of Olsen USD 10 par value common stock, which has
a current market value of USD 20 per share. In the next several years, the company reported much higher net
income and increased the dividend on the common stock from USD 1 to USD 2 per share. Assume that the common

stock now sells at USD 40 per share. The preferred stockholders can: (1) convert each share of preferred stock into
four shares of common stock and increase the annual dividend they receive from USD 6 to USD 8; (2) sell their
preferred stock at a substantial gain, since it sells in the market at approximately USD 160 per share, the market
value of the four shares of common stock into which it is convertible; or (3) continue to hold their preferred shares
in the expectation of realizing an even larger gain at a later date.
If all 1,000 shares of USD 100 par value Olsen Company preferred stock are converted into 4,000 shares of USD
10 par value common stock, the entry is:
Preferred Stock (-SE) 100,000
Common Stock (+SE) 40,000
Paid-In Capital in Excess of Par Value—Common (+SE) 60,000
To record the conversion of preferred stock into
common stock.

Accounting Principles: A Business Perspective 496 A Global Text