Preferred shares are considered a “hybrid” security. This means that as far as the company that issued them is concerned, they fall somewhere between a bond (debt) and a common share (equity).

A company sells preferred shares to people in exchange for cash, just like bonds and common shares. Preferred shares are similar to bonds in some respects, and similar to common shares in other respects. The following table provides a brief comparison.

This table contains some huge generalizations, but it is accurate enough to give you an idea of the fundamental accounting problem facing companies that issue hybrid securities, namely, should preferred shares be shown on the balance sheet as a liability or as equity?

As you can see, depending the various guarantees and options that a preferred share has, it might end up seeming more like a bond or more like a common share. That is what determines whether they should be listed in the liability section or the equity section of the balance sheet.

I'll come back to this explanation later and pretty it up. In the meantime, my students need it for an exam!