Dr. M.D.

Chase
Advanced Accounting 710-51CB

Long Beach State University

Special Issues: Intercompany Preferred Stock
Page 1

I. Subsidiary Preferred Stock:

A. The accounting issue: The existence of subsidiary preferred stock may complicate consolidation procedures in one of two ways:
1. if preferred stock has any claim to subsidiary retained earnings;
2. if preferred stock is purchased by the parent.
B. Preferred stock with a claim on subsidiary retained earnings:
1. preferred stock with a claim on "S" retained earnings causes problems by its mere existence; whether any of it is owned by "P" or
not is moot.
2. preferred stock typically gets a claim on "S" retained earnings in one of three ways:
a. liquidation value in excess of par value.
b. cumulative dividend rights;
c. participation rights with common stock;
3. The retained earnings available to the common stockholders must be reduced by the preferred stock claims;
--This can be done by WORKING PAPER entry or by schedule
--If done by WORKING PAPER a special R/E-P/S account is created to keep the preferred stock claims separate from common;
R/E..................xxxx
R/E-P/S......... xxxx
4. In "analyzing the investment" in common stock, only the R/E allocable to the common stock must be considered; therefor, adjust
retained earnings balances prior to analyzing the investment.
5. To determine P/S claim on R/E, an order of preference must be followed:
a. Presence of liquidation preference > par
--R/E is reduced by total liquidation bonus
b. Cumulative dividends in arrears;
c. Participation rights are allocated
EXAMPLE 1: Subsidiary Common Stock
--"P" purchases 70% of "S" on 1/1/x1 for $150,000
--at the time of purchase, "S" SHE was:
"S" preferred stock, $100 par, 6% cumulative, fully participating..
"S" common stock, $10 par...........................................
"S" retained earnings...............................................
Total SHE...................................................

100,000
150,000
50,000
300,000

--The preferred stock has a $5 liquidation preference in excess of par

--the preferred stock is two years in arrears at the date of purchase
Analyze the investment (of the common stock investment):
Cost......................................................................
Purchased BV:
Common stock: (15,000 x $10).........................................
$
Retained earnings 12/31/x0...........................................
less: Liquidation preference ($5 x 1,000)............................
cumulative dividends in arrears................................
right to participate in future dividends (100/250 x (50 - 17)..
Total equity interest attributable to common stock.................
ownership interest ................................................
Excess of cost over book value (to goodwill)......................

$
150,000
50,000
[5,000]
[12,000]
[13,200]

150,000

19,800
169,800
70%
118,860
31,400

Note: The participation feature of the preferred stock is applicable only to that portion of retained earnings remaining after the
cumulative and liquidating preferences have been applied.
C. Intercompany preferred stock acquisitions:
1. Intercompany investments in P/S are considered a retirement of P/S or an investment in treasury shares from the consolidated
view. Treating intercompany purchases of P/S as treasury acquisitions involves only those adjustments necessary to convert
outstanding P/S to treasury stock on the consolidated working papers.

Dr. M.D. Chase

Advanced Accounting 710-51CB

Long Beach State University

Special Issues: Intercompany Preferred Stock
Page 2

2. Procedures to constructively retire intercompany P/S:

a:
compare the cost basis of the P/S to the underlying bookvalue of the stock (including all P/S claims to R/E or income;
differences are accounted for as "gains" or "losses" on retirement of P/S.
NOTE: recall that there are never "gains" or "losses" on a companys own stock transactions; therefore:
--"gains":
(excess of BV over cost) are credited to "P" PIC assuming "P" is investor in P/S;
--"losses":
(excess of cost over BV) are:
1.
offset against "P" PIC from retirement of P/S (to the extent available)
2. offset against "P" retained earnings after "P" PIC from retirement of P/S is exhausted; (this amounts to a "retirement
dividend".
NOTE: this is not PIC in excess
of par, it is a special PIC
created from prior retirements)

EXAMPLE 2: "P" purchases subsidiary preferred stock:

--assume the same facts as example 1 above except that "P" purchases 75% (750 shares) of "S" P/S on 1/1/x3;
--"S" R/E on 1/1/x3, x4 and x5 is $130,000; $138,000 and $145,000 respectively;
--no dividends are paid in years 1 through 5;
--Required:
1.
Situation One:
Calculate the gain or loss on retirement of P/S if "P" paid $128,000 for the P/S;
2. Situation Two:
Calculate the gain or loss on retirement of P/S if "P" paid $148,000 for the P/S
3. Situation Three: Calculate the gain or loss on retirement of P/S if "P" paid $120,000 for the P/S;
3. Compute the value of the investment in "S" P/S account at 12/31/x3; x4 and x5 respectively for situation one and two;
4. Present any necessary elimination/adjustment entries required for requirements 1 and 2 above for years ending 12/31/x3;
12/31/x4 and 12/31/x5.
Show all computations below in good form:
Solutions:

(5k+24k=29k)

Requirements 1 2 and 3:
Cost.......................................
Book value: Par (1,000 x $100)....
Liq. Pref.......................
Div in Arrears (6,000 x 4)......
Participation (100/250 x 130-29)
Total value of P/S:
ownership interest
.75
(gain) or loss on retirement:

$ 100,000
5,000
24,000
40,400
$ 169,400

Date of Purchase 1/1/x3:

Situation
Situation
Situation
One
Two
Three
128,000
$148,000
$120,000

127,050
950

127,050
$ 20,950

127,050
($ 7,050)

Requirement 3: Compute the value of the investment in "S" P/S account at 12/31/x3;x4 and x5 respectively for situations one and two;
Situation One:
Beginning Balance (Cost plus claims on RE).
add: 75% cum div in arrears (for crnt yr)..
75% of 100/250 change in BOY RE.......
Ending balance.............................

12/31/x3
$ 128,000
$
4,500
0*
$ 132,500
$
$5,100

12/31/x4
132,500
4,500
600 **
137,600

12/31/x5
$ 137,600
4,500
300 ***
$ 142,400
$4,800

* No change in RE balance in first year (P/S was purchased at BOY)

** see summary of changes in RE below
*** see summary of changes in RE below
Situation Two:
Beginning Balance ...........
add: 75% cum div in arrears..
75% of 100/250 change in RE.................
Ending balance...............

12/31/x3
$ 148,000
4,500
0*
$ 152,500

12/31/x4
152,500
4,500
600**
$ 157,600
$

12/31/x5
$ 157,600
4,500
300***
$ 162,400

The cumulative feature of P/S is

unique in that it places a claim on
current net income; cumulative
dividends in arrears will be paid
prior to any dividend being
distributed to C/S; they
represent a claim on retained
earnings that will never be
available for distribution to the
common shareholders. The
participation feature does not
affect current income but must
be recognized as a claim against
retained earnings available to the
common stockholders.

Dr. M.D. Chase

Advanced Accounting 710-51CB

Long Beach State University

Special Issues: Intercompany Preferred Stock
Page 3

Requirement 4 (situation one):

a. Retire the P/S
"S" P/S (7,500 x $100)........
"P" PIC-retirement of P/S
Investment in "S" P/S....
b. Adjust BOY R/E allocable to P/S
"S" RE P/S (81,000 .75)....
Investment in "S" P/S........

12/31/x3
75,000
950

52,050

c. Eliminate current yr. income claim of cumulative P/S

Investment in "S" P/S...
--"S" income-P/S (6,000 x .75).

Computations:
Liquidation preference ($5 x 1000 shares)..
Dividends in arrears (4 years x $6,000)....
Participation (100/250)(130; 138; 145).....
Total claim on "S" RE.................
Percentage of "S" P/S owned...........
Intercompany claim on "S" RE..........
Requirement 4 (situation two):
a. Retire the P/S
"S" P/S (7,500 x $100)........
"P" RE........................
Investment in "S" P/S....
b. Adjust BOY R/E allocable to P/S
"S" RE P/S (81,000 .75)....
Investment in "S" P/S........
c. Eliminate current yr. income
claim of cumulative P/S
Investment in "S" P/S...
"S" income-P/S (6,000 x .75).
Summary of Changes in RE:
RE-CS 1/1/x1
RE-CS 1/1/x2
RE-CS 1/1/x3
130
138
145
5
5
5
24
30
36
101
103
104
40.4
41.2
41.6
60.6
61.8
62.4
800
400
x .75
x .75
600**
300***
RE-PS 1/1/x1
RE-PS 1/1/x2
RE-PS 1/1/x3
5
5
5
24
30
36
40.4
41.2
41.6
69.4
76.2
82.6
x .75
x .75
x .75
52,050
57,150
61,950
5,100
4800
9,900

75,950

52,050

---

12/31/x4
75,000
950

57,150

600

75,950

57,150

600

12/31/x5
75,000
950

61,950

300

75,950

61,950

300

12/31/x3
$ 5,000
24,000
40,400
$ 81,000
75%
$ 52,050*

12/31/x4
$ 5,000
30,000
41,200
$ 76,200
75%
$ 57,150**

12/31/x5
$ 5,000
36,000
41,600
$ 82,600
75%
$ 61,950***

12/31/x3

12/31/x4

12/31/x5

75,000
20,950

52,050

---

95,950

52,050

---

75,000
20,950

57,150

600

95,950

57,150

600

75,000
20,950

61,950

300

95,950

61,950

300

128,000 132,500 137,600