Preferred Dividends And Income Available To Common Shareholders

Why Preferred Dividends Matter for Basic EPS

Net income is the earnings remaining after the company has recognized its expenses and income tax for the period. But common shareholders do not have a claim on all of that income if preferred shareholders have a dividend claim. For basic earnings per share, the numerator is therefore income available to common shareholders, not simply net income.

The key judgment is which preferred dividends belong to the period. The answer depends on whether the preferred shares are cumulative or noncumulative. Once that amount is determined, subtract it from net income and divide by weighted-average common shares. The method below is aligned with the SOA VEE Accounting and Finance syllabus.

Definition: Income available to common shareholders is net income less preferred dividends attributable to the current reporting period for basic EPS. For cumulative preferred stock, deduct the current-period dividend requirement whether or not it was declared. For noncumulative preferred stock, deduct the dividend declared for the current period. Basic EPS is income available to common shareholders divided by weighted-average common shares outstanding.

Determine the Preferred Dividend Deduction

Preferred dividends are distributions to shareholders, not operating expenses. They are not subtracted in arriving at net income. Instead, the dividend deduction is made after net income when determining the amount attributable to common shareholders.

A stated preferred dividend rate is usually applied to the preferred stock’s par value, not to its market price. For a full year, the stated annual dividend per preferred share is the dividend rate multiplied by par value per share. Multiply that amount by the number of preferred shares to obtain the annual preference, subject to the stock’s terms.

\text{Annual preferred dividend requirement} = \text{preferred shares} \times \text{par value per share} \times \text{annual dividend rate}

For a period shorter than a full year, use the portion of the annual dividend that applies to the period, provided the preferred stock terms prorate the dividend by time. The accounting period and the preferred stock terms must be read carefully; do not assume every dividend rate is a monthly rate or that every dividend is prorated in the same way.

Preferred stock type	Current-period amount deducted for basic EPS	Effect of declaration
Cumulative	The dividend requirement for the current period	Deduct it whether declared or not
Noncumulative	The dividend declared for the current period	If none is declared for the period, there is no deduction for that stock

For cumulative stock, an unpaid current-period dividend still reduces income available to common shareholders because preferred shareholders have a current-period claim under the stock’s terms. By contrast, a noncumulative preferred dividend that is not declared does not accumulate as a claim for a later period.

Cumulative dividends in arrears are unpaid dividends from earlier periods. They are not an additional deduction in the current period’s EPS numerator merely because they are declared or paid now. The current period’s cumulative dividend requirement is deducted for the current period; prior-period arrears relate to prior periods.

From Net Income to Basic EPS

Let $NI$ denote net income for the reporting period, $D_P$ the preferred dividends attributable to that period, and $\overline{N}_{C}$ the weighted-average number of common shares outstanding. The numerator is $NI-D_P$. The denominator is weighted-average common shares, since shares issued or repurchased during the year may have been outstanding for only part of the period.

\text{Income available to common shareholders} = NI-D_P

\text{Basic EPS} = \frac{NI-D_P}{\overline{N}_{C}}

The numerator and denominator must refer to the same reporting period. If the numerator is reported in dollars and the denominator in shares, basic EPS is dollars per common share. The weighted-average share calculation is a separate step: use the period-weighted denominator supplied or determined from the common-share changes.

Why the formula works: Net income is the period’s earnings after expenses and taxes. Of that amount, $D_P$ is attributed to preferred shareholders under the dividend rules above, leaving $NI-D_P$ for common shareholders. Dividing that common-shareholder amount by the weighted-average number of common shares expresses the period’s amount on a per-share basis. This is the basic EPS calculation for ordinary, nonparticipating preferred stock; securities or arrangements that create additional common-share claims require other EPS rules.

Worked Calculations

Worked Example: Cumulative Preferred Stock With No Declaration

A company reports net income of $840,000. It has 8,000 shares of 6% cumulative preferred stock, each with a par value of $50, outstanding throughout the year. No preferred dividend was declared. Weighted-average common shares are 160,000. Calculate income available to common shareholders and basic EPS.

Method. Because the preferred stock is cumulative, deduct the dividend requirement for the current year even though it was not declared.

First calculate the annual dividend per preferred share:

\$50 \times 0.06 = \$3.00

The current-year preferred dividend requirement is:

8{,}000 \times \$3.00 = \$24{,}000

Income available to common shareholders is:

\$840{,}000-\$24{,}000=\$816{,}000

Now divide by weighted-average common shares:

\text{Basic EPS} = \frac{\$816{,}000}{160{,}000} = \$5.10

Check. The preferred claim and the common claim sum to net income: $\$24{,}000+\$816{,}000=\$840{,}000$. Basic EPS is $5.10 per common share.

Common mistake avoided: Deducting zero because no dividend was declared would incorrectly produce EPS of $\$840{,}000/160{,}000=\$5.25$. Cumulative status requires the current-period dividend deduction regardless of declaration.

Worked Example: Noncumulative Preferred Stock With a Partial Declaration

A firm reports net income of $510,000 and weighted-average common shares of 120,000. It has 12,000 shares of 8% noncumulative preferred stock with $25 par value per share, outstanding for the full year. The board declares $18,000 of preferred dividends for the year. Calculate income available to common shareholders and basic EPS.

Method. For noncumulative preferred stock, use the dividend declared for the current period. The stated rate is useful for comparison, but it does not replace the declared amount in this calculation.

The annual dividend at the stated rate would be:

12{,}000 \times \$25 \times 0.08 = \$24{,}000

However, the preferred stock is noncumulative and only $18,000 was declared for the year. Therefore $D_P=\$18{,}000$. Income available to common shareholders is:

\$510{,}000-\$18{,}000=\$492{,}000

Basic EPS is:

\frac{\$492{,}000}{120{,}000} = \$4.10

Check. The $18,000 declared dividend plus $492,000 available to common shareholders equals the $510,000 of net income. Basic EPS is $4.10 per share.

Common mistake avoided: Subtracting the full $24,000 stated-rate amount would give $\$486{,}000/120{,}000=\$4.05$. That is not the correct current-period deduction for this noncumulative stock when only $18,000 was declared.

Worked Example: Mixed Preferred Stock and Prior-Year Arrears

A company reports net income of $730,000 and weighted-average common shares of 140,000. It has 6,000 shares of 4% cumulative preferred stock with $100 par value per share, outstanding all year. It also has 5,000 shares of 5% noncumulative preferred stock with $40 par value per share, outstanding all year. During the year, the company declares and pays $8,000 of cumulative dividends in arrears from an earlier year and declares $9,000 on the noncumulative shares for the current year. Calculate income available to common shareholders and basic EPS.

Method. Calculate each class separately. Deduct the cumulative class’s current-year requirement and the noncumulative class’s current-year declared amount. Do not add the old arrears to the current-year deduction.

The cumulative preferred dividend requirement for the current year is:

6{,}000 \times \$100 \times 0.04 = \$24{,}000

For the noncumulative shares, the amount declared for this year is $9,000. Although the stated annual-rate amount would be $5{,}000\times \$40\times 0.05=\$10{,}000$, use the declared current-year amount for this noncumulative stock.

The $8,000 of arrears relates to an earlier period, so it is not added to the current-period EPS deduction. Thus:

D_P=\$24{,}000+\$9{,}000=\$33{,}000

Income available to common shareholders is:

\$730{,}000-\$33{,}000=\$697{,}000

Basic EPS is:

\frac{\$697{,}000}{140{,}000} = \$4.978571\ldots \approx \$4.98

The EPS is rounded to the nearest cent. Check: the current-period preferred deduction of $33,000 plus $697,000 available to common shareholders equals net income of $730,000. The $8,000 arrears payment is not mistakenly counted as a second current-period requirement.

Common mistake avoided: Subtracting $41,000 by adding the prior-year arrears would produce an incorrect numerator of $689,000 and EPS of about $4.92. The current-year cumulative requirement is $24,000; the arrears do not add to that current-year amount.

A Reliable Calculation Sequence

The central challenge is classifying each preferred dividend correctly before dividing. A short sequence makes the calculation easier to audit and helps prevent an incorrect numerator from being hidden by otherwise correct arithmetic.

Identify each class and its terms.
Record whether the preferred shares are cumulative or noncumulative, along with par value, stated rate, shares outstanding, and the relevant period.

Find the current-period dividend amount.
For cumulative stock, calculate the current-period requirement. For noncumulative stock, use the amount declared for the current period.

Exclude amounts that belong to another period.
Do not add prior-period cumulative arrears merely because they are declared or paid in the current period.

Compute the common numerator and EPS.
Subtract the total applicable preferred dividend deduction from net income, then divide by weighted-average common shares for the same period.

A useful arithmetic check is that net income equals the preferred dividend deduction plus income available to common shareholders. This check confirms the subtraction, although it does not by itself confirm that the preferred dividend amount was classified correctly.

Common Exam Traps

Treating preferred dividends as an expense. Preferred dividends are distributions, not income-statement expenses. Do not subtract them in calculating net income; subtract applicable dividends after net income to find income available to common shareholders.
Ignoring cumulative dividends that were not declared. A current-period cumulative dividend requirement reduces the basic EPS numerator even if no declaration was made.
Using the stated rate automatically for noncumulative shares. The current-period declared dividend is the amount deducted for noncumulative preferred stock. Check what was actually declared.
Subtracting prior-period arrears again. Keep current-period cumulative requirements separate from arrears attributable to earlier periods.
Dividing by the wrong share count. Basic EPS uses weighted-average common shares for the reporting period, not preferred shares or simply the ending common-share balance.

Key takeaway: First determine the preferred dividends attributable to the current period: current-period requirement for cumulative shares, current-period declared amount for noncumulative shares. Subtract that amount from net income, then divide by weighted-average common shares to obtain basic EPS.

Check Your Understanding

For each problem, determine the preferred dividend deduction before calculating basic EPS. Round EPS to the nearest cent when needed.

A company has net income of $640,000, 7,000 shares of 5% cumulative preferred stock with $100 par value outstanding for the full year, and weighted-average common shares of 121,000. No preferred dividend is declared. Find income available to common shareholders and basic EPS. (Answer: $605,000; $5.00 per share)
A company reports net income of $390,000 and weighted-average common shares of 100,000. It has 10,000 shares of 6% noncumulative preferred stock with $40 par value outstanding all year. The company declares $20,000 for the current year. Find the numerator and basic EPS. (Answer: $370,000; $3.70 per share)
A firm reports net income of $450,000 and weighted-average common shares of 86,000. It has 3,000 shares of 8% cumulative preferred stock with $50 par value outstanding all year, with $4,000 of prior-year arrears paid this year. It also declares $5,000 on its noncumulative preferred stock for this year. Find income available to common shareholders and basic EPS. (Answer: $433,000; $5.03 per share)
A company has net income of $1,200,000 and weighted-average common shares of 240,000. Its cumulative preferred stock consists of 9,000 shares with $25 par value and a 5% annual rate, all outstanding for the year. It also declares $12,000 for the year on its noncumulative preferred stock. Find the preferred deduction, numerator, and basic EPS. (Answer: $23,250; $1,176,750; $4.90 per share)
A company’s year runs from January 1 through December 31. It reports net income of $500,000 and weighted-average common shares of 150,000. It issued 4,000 shares of 6% cumulative preferred stock with $100 par value on July 1; assume the stock terms provide a dividend prorated for the six months outstanding. No dividend was declared. Find the current-year preferred dividend deduction, income available to common shareholders, and basic EPS. (Answer: $12,000; $488,000; $3.25 per share)

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