Financial Accounting and Reporting-CPA Practice Exam

To determine the earnings available to common shareholders, it's essential to start with the investee's net income. Net income represents the total profit of the company after all expenses, including operating costs and taxes, have been deducted from total revenue. However, before common shareholders can receive their share of the earnings, preferred shareholders must first be accounted for, as they hold a priority claim on the company's profits.

The preferred dividends are paid out to preferred shareholders before any distributions can be made to common shareholders. Therefore, to find the earnings available to common shareholders, you subtract the preferred dividends from the net income. This provides the residual earnings left for common shareholders after satisfying the commitments to preferred shareholders.

This process illustrates the hierarchy of claims on a company’s earnings and is a crucial aspect of financial reporting in understanding how profits are distributed among equity holders. By following this method, you accurately reflect the financial reality of the company's earnings distribution, specifically for those who own common stock.