Is Preferred Stock Considered Equity on the Balance Sheet?

Yes, preferred stock is classified as equity on a company’s balance sheet. However, its unique structure gives it characteristics of both equity and debt, making it a hybrid security. This dual nature often creates confusion, but its treatment under established accounting principles is specific.

Core Characteristics of Preferred Stock

Preferred stock signifies an ownership interest in a corporation, but it comes with a set of rights that are distinct from common stock. One of the most significant features is its dividend preference. Companies must pay dividends to preferred shareholders before any dividends can be distributed to common shareholders. These dividends are often set at a fixed rate, providing a predictable income stream for investors.

Another defining characteristic is the liquidation preference. In the event a company is liquidated or files for bankruptcy, preferred stockholders have a higher claim on the company’s assets than common stockholders. This means they are entitled to receive their initial investment back, plus any unpaid dividends, before common stockholders receive any proceeds. This preference is detailed in the company’s certificate of incorporation.

A key trade-off for these preferential rights is the absence of voting power. Unlike common stockholders, who can influence corporate policy and elect the board of directors, preferred stockholders usually have no say in the company’s governance. This structure separates the economic benefits of ownership from the control of the company.

The Debt-Like Features of Preferred Stock

The confusion surrounding preferred stock often stems from its similarities to debt instruments. The most prominent debt-like feature is the fixed dividend payment, which functions much like the fixed interest payments on a bond. This creates a predictable income stream for the investor, a characteristic more associated with debt than common stock.

Some types of preferred stock further blur the lines by including features like a maturity date, at which point the company is obligated to redeem the shares for cash. This is very similar to a bond’s maturity date. Another debt-like feature is callability, which gives the issuing company the right to buy back the preferred shares at a predetermined price after a certain date.

Balance Sheet Classification and Rationale

Despite its debt-like qualities, U.S. Generally Accepted Accounting Principles (GAAP) classify preferred stock as equity. The specific rules are outlined in the Financial Accounting Standards Board’s (FASB) guidance on distinguishing liabilities from equity. The primary reason for its equity classification lies in its position within the capital structure during a liquidation. All debtholders, including bondholders and banks, must be paid in full before preferred stockholders are entitled to receive any money. This subordination to all forms of debt firmly places preferred stock in the ownership category, not the creditor category.

However, in certain situations, preferred stock is classified as temporary or “mezzanine” equity. This occurs when the stock is redeemable at the holder’s option or upon the occurrence of an event outside of the issuer’s control. In these cases, it is presented on the balance sheet in a separate section between liabilities and permanent equity to highlight its conditional redemption features.

A distinction that solidifies its equity classification is the nature of dividend payments. Unlike bond interest, which is a legal obligation that can trigger default if missed, preferred stock dividends are discretionary. A company’s board can suspend or skip a preferred dividend without facing legal recourse for bankruptcy. Because the claims of preferred stockholders are secondary to all creditors and their dividends are not a legal liability, accounting standards view the capital raised as an investment in the company rather than a loan to it.