Preference Share

Preference Share Fixed Dividend Equity Ownership Ordinary Shareholders Liquidation Preference Share Capital
A type of equity ownership in a company that entitles holders to a fixed dividend before any dividends are paid to ordinary shareholders.
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Definition

A preference share is a type of equity ownership in a company that provides shareholders with a fixed dividend, typically expressed as a percentage of the nominal value of the share, before any dividends are distributed to ordinary shareholders. It also has a higher claim on assets than ordinary shares in the event of bankruptcy or liquidation, although it ranks below debt obligations such as loan capital.

Examples

  1. Dividend Terms: If a company issues 6% preference shares with a nominal value of $100, the shareholders will receive a fixed annual dividend of $6 per share irrespective of the company’s earnings.
  2. Liquidation Scenario: In the event of liquidation, after all debts and loan capital are settled, the holders of preference shares will be paid on a priority basis before ordinary shareholders but after creditors.
  3. Convertible Preference Shares: A company issues convertible preference shares, which the holders can convert into a specified number of ordinary shares after a certain period.

Frequently Asked Questions (FAQs)

  1. What are preference shares?

    • Preference shares are types of equity shares that provide holders with fixed dividends and priority in asset distribution in case of liquidation over ordinary shares.

  2. How do preference shares differ from ordinary shares?

    • Preference shares entitle holders to fixed dividends before ordinary shareholders and have a higher claim in the event of liquidation, whereas ordinary shares have variable dividends and lower claim priority.

  3. Can preference shares be converted into ordinary shares?

    • Yes, some preference shares are convertible into ordinary shares under terms specified at issuance.

  4. What happens to preference shares in liquidation?

    • Preference shareholders are paid out after debt obligations but before ordinary shareholders.

  5. Are dividends on preference shares guaranteed?

    • Dividends on preference shares are typically fixed and paid out before any dividends to ordinary shareholders, but they depend on the company’s profitability and dividend policy.
  • Dividend: A distribution of a portion of a company’s earnings to shareholders, typically in the form of cash or stock.
  • Liquidation: The process of bringing a business to an end and distributing its assets to claimants.
  • Loan Capital: The borrowed funds used by a company, often in the form of loans or bonds, that must be repaid.
  • Ordinary Share Capital: The portion of a company’s equity ownership that comes with voting rights and variable dividends.
  • Preference Share Capital: The portion of a company’s equity that pertains to preference shareholders and includes the likes of dividend preferences and liquidation preferences.

Online References

Suggested Books for Further Studies

  1. “Accounting for Non-Accountants” by Wayne Label
  2. “Financial Accounting” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
  3. “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield

Accounting Basics: “Preference Share” Fundamentals Quiz

### What is the primary feature of a preference share? - [x] Entitled to a fixed percentage dividend - [ ] Entitled to a variable dividend - [ ] No dividend is provided - [ ] Dividends fluctuate based on company performance > **Explanation:** Preference shares are entitled to a fixed percentage dividend, making them different from ordinary shares, which receive variable dividends based on company performance. ### In the event of liquidation, who gets paid first? - [ ] Ordinary shareholders - [ ] Preference shareholders - [x] Creditors - [ ] Board of Directors > **Explanation:** In the event of liquidation, creditors are paid first, followed by preference shareholders, and then ordinary shareholders. ### What is a typical dividend rate for preference shares? - [ ] 10% - [x] 6% - [ ] Dividend rates vary greatly and can be any amount - [ ] Dividends are not applicable > **Explanation:** While dividend rates for preference shares can vary, a common example provided is a 6% preference share, meaning the shareholder receives a 6% dividend per annum. ### Do preference shareholders have voting rights? - [ ] Yes, always - [x] Typically, no - [ ] Yes, but only in specific situations - [ ] Depends on the company's bylaws > **Explanation:** Typically, preference shareholders do not have voting rights, unlike ordinary shareholders who usually do. ### Which has higher payout priority during company liquidation? - [ ] Ordinary shares - [x] Preference shares - [ ] Undecided shareholders - [ ] Company executives > **Explanation:** Preference shares have a higher payout priority over ordinary shares during company liquidation but rank below debt obligations. ### Are preference shares considered a type of debt? - [ ] Yes - [ ] No, but convertible to debt - [x] No, they are a type of equity - [ ] Sometimes, it depends on the contractual clauses > **Explanation:** Preference shares are a type of equity—not debt—although they have fixed dividend features similar to interest on debt. ### Can preference shares be converted into ordinary shares? - [ ] Never - [ ] Always - [x] Sometimes, under specific terms - [ ] Only if voted on by the board > **Explanation:** Some preference shares are convertible into ordinary shares under terms specified at issuance, offering flexibility for shareholders. ### Why might a company issue preference shares? - [ ] To avoid paying dividends - [ ] To reduce the company’s equity capital - [x] To raise capital while providing fixed dividends to investors - [ ] To replace all existing shares > **Explanation:** Companies issue preference shares to raise capital while providing fixed dividends to investors, making them attractive to certain investors. ### When are preference shares ideally suited for investors? - [ ] When seeking variable dividends - [ ] When aiming for high-risk, high-reward - [x] When seeking fixed and relatively secure dividends - [ ] When wanting complete control over company decisions > **Explanation:** Preference shares are ideally suited for investors seeking fixed and relatively secure dividends as opposed to variable returns. ### What distinguishes preference shares from loan capital? - [ ] Loan capital offers dividends, preference shares do not - [ ] Preference shares are a type of debt - [x] Preference shares are equity, and loan capital is debt - [ ] They are the same > **Explanation:** Preference shares represent equity with fixed dividends, whereas loan capital represents debt that must be repaid with interest.

Thank you for exploring the fundamentals of preference shares and challenging yourself with our structured quizzes. Continue to deepen your financial comprehension and master the intricacies of accounting!

Tuesday, August 6, 2024
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