Companies use equity as a method of raising funds. Most people associate equity finance with ordinary or common stock. However, companies may also use preference shares as an alternative to obtaining funds from investors. The accounting treatment of these shares differs from that used for ordinary stock. Before discussing that, it is crucial to understand preference shares.
What is a Preference Share?
A preference share is a special type of equity instrument companies may issue to raise finance. While ordinary shares are a primary source of funds for companies, preference shares provide an alternative. However, these shares include some features that make them unique. A preference share allows the holder to receive the first claim on profits.
While a part of equity finance, preference shares also include debt characteristics. For example, these shares come with guaranteed income for the holder. This feature is more common in debt instruments than equity. However, these shares may not include voting rights, making them significantly different from common stock. Preference shares also come in various forms.
What is the accounting treatment of Preference Shares?
The accounting treatment of preference shares differs based on their type. Companies must identify the characteristics that are crucial to this treatment. While they may come in different types, the two most common forms include redeemable and irredeemable preference shares. The accounting treatment for these may differ as follows.
Redeemable Preference Shares
A redeemable preference share includes an option for the issuer to redeem at a specified rate or price range. Although it is an equity instrument, accounting standards require redeemable preference shares to be treated as a liability. Therefore, any dividends paid to shareholders get treated as interest expense. This accounting treatment differs from that used for irredeemable shares.
Irredeemable preference shares
Companies do not get the same option of redeeming irredeemable preference shares. Therefore, the accounting treatment of these shares is the same as used for equity instruments. Companies must record and recognize irredeemable preference shares under equity. On top of that, any payments made to these shareholders fall under dividends rather than interest expenses.
What are the journal entries for Preference Shares?
Like the accounting treatment, the journal entries for preference shares differ based on the underlying type. Companies must determine whether these shares come with an option to redeem at a later date. Based on that, they can use the relevant journal entries. The journal entries for redeemable preference shares have already been discussed in detail in this article.
For irredeemable preference shares, the journal entries are straightforward. When a company issues irredeemable preference shares, it must record them as equity. The journal entry for this stage is as follows.
| Dr | Cash or bank |
| Cr | Irredeemable preference shares (Equity) |
Companies must also record any payments made to the shareholders of these preference shares. As stated above, this treatment is similar to issuing dividends to common shareholders. Therefore, the accounting entry is as follows.
| Dr | Dividends paid (Retained earnings) |
| Cr | Cash or bank |
Example
A company, Blue Co., issued 10,000 irredeemable preference shares at a value of $10 per share. The company received cash for this transaction. Blue Co. records this transaction as follows.
| Dr | Cash | $100,000 |
| Cr | Irredeemable preference shares | $100,000 |
A year later, Blue Co. paid $1,000 to its irredeemable preference shareholders in cash as a dividend. The company recorded this transaction as follows.
| Dr | Dividends paid | $1,000 |
| Cr | Cash | $1,000 |
Conclusion
Preference shares are an equity instrument companies use to raise finance. They provide an alternative to using ordinary stock to obtain funds. Usually, they come in two types, redeemable and irredeemable preference shares. The accounting treatment for preference shares differs based on which type companies issue.
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