Question

The conversion of preferred stock into common stock requires that any excess of the par value of the common shares issued over the carrying amount of the preferred being converted should be:

a) reflected currently in income

b) reflected currently in income as a discontinued operations item

c) treated as a prior period adjustment

d) treated as a direct reduction of retained earnings. <------------------- answer

Can someone help me with this question? I know the answer is "d" but I'm confused as to why... If possible can you provide a journal entry example of it? That would really help since I'm a visual learner. Thanks in advance!

Answer 1

The answer is d

The preferred shares are being converted into common shares where the carrying value of preferred stock is less than the par value of common stock

Common stock account needs to be credited with the par value

Hence, the difference is debited to retained earnings

For example, assume carrying value of preferred stock is $80, being converted into common stock with par value $100

The journal entry would be

Preferred Stock Debit $80

Retained earnings debit $20

Common Stock credit $100

Since common stock must be credited with par value, the difference would be treated as a direct reduction of retained earnings