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Accounting for Common vs. Preferred Stock

Original post by Dennis Hartman of Demand Media

Investors might need to value preferred stock differently than common stock.

Investors who buy stock in a business rely on the company's growth to create value and make their investments grow. This is the case whether an investor buys preferred stock or common stock. Although accounting for each type of stock is similar, some key differences affect how investors value and pay taxes on their stock-related income.

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General Accounting

In terms of general personal accounting, there is very little difference between buying preferred stock and common stock. In each case the stock becomes a personal asset based on its current value. Stock is a marketable security because it is easily convertible to cash, which is important to investors who also run businesses and need access to cash to meet their expenses. With each type of stock, investors can deduct their investment expenses from their taxable income. This includes the cost of tax management or personal accounting software.

Cost Basis

When investors sell common or preferred stock, they must pay taxes on their capital gains, which are profits from the sale. Capital gains on common and preferred stock sales equal the sale price minus the cost basis. Although the sale price is easy to determine (it's the amount the seller receives), determining cost basis is more complex. The same process applies for both common and preferred stock. Investors add the purchase price of stock to any expenses related to acquiring it, such as a broker's fees and consultation charges. An investor who pays a broker's premium for early access to preferred stock when a company goes public has a higher cost basis than a stockholder who buys the same company's common stock for the same price, but with lower fees, later.

Dividends

Accounting for dividends is one of the major differences between owning preferred stock and common stock. Preferred shareholders must receive their dividends before common stockholders do. Not only must preferred shareholders account for dividend income earlier, they might need to account for a larger dividend payment, because preferred shareholders receive stated dividends. Common shareholders sometimes receive less per share, based on the company's finances and any decision by the board of directors to cut dividends.

Par Value

Par value, which applies only to some instances of preferred stock, also affects how shareholders account for their investments. Although the price of common stock can change with the market, preferred stock sometimes has a par value that represents the lowest price the company will issue stock for. Preferred shareholders might have lower cost bases if they buy preferred stock for a low par value and the company later issues common stock for a higher price.


                   

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About the Author

Dennis Hartman is a freelance writer living in California. His work covers a wide variety of topics and has been published nationally in print as well as online. Hartman holds a Bachelor of Fine Arts from Syracuse University and a Master of Arts from the State University of New York at Buffalo.

Photo Credits

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