Convertible preferred shares are preferred stock that gives shareholders the option of converting their preferred stock into common stock after a specific period. The time period before the preferred stock is eligible for conversion as well as the conversion rate is stated in the shareholder’s preferred share purchase agreement.
When investors purchase preferred shares, they are not purchasing an interest in the company as they would with the purchase of common stock. Instead, preferred shareholders receive regular interest payments as long as they own the preferred shares or until the shares reach their maturity date. If the shares are not convertible, at the maturity date, the company redeems the preferred stock outstanding and pays preferred shareholders their initial investment amount.
Convertible Preferred Shares
When investors own convertible preferred shares, they may convert the shares into common stock any time after the conversion date stated on the preferred share purchase agreement. A company can also include an option in the purchase agreement that gives it the ability to force the conversion of outstanding preferred shares. In a forced conversion, investors must convert their preferred shares into a specific number of common shares, whether they want to convert or not.
Accounting for Preferred Conversion
When investors convert their preferred shares to common shares, the company debits the preferred stock account and credits the common stock account. If the common stock price at the time of conversion is more than the par value of the preferred stock then the company debits retained earnings for the difference between the two prices. If investors paid a premium on the preferred stock at the time of purchase, the company must also make adjusting entries to the additional paid in capital accounts.
Additional Paid in Capital
Additional paid in capital is the amount of money investors paid for the preferred stock at purchase in excess of par value. Additional paid in capital is also referred to as a premium. Mathematically, additional paid in capital is the issue price of the preferred stock minus its par value multiplied by the amount of preferred shares issued. If this excess exists, then the company also debits the additional paid in capital – preferred stock and credits additional paid in capital – common stock at the time of the stock conversion.
Par value is often a nominal value, such as one cent or even less, assigned to each share of a stock, so it's normal for stock to be worth more than its par value regardless of company performance.