When a company issues preferred stock, it guarantees investors a financial return in the form of dividends. Consequently, an investment in preferred stock is an investment in a guaranteed income stream in the form of dividends.
In all cases, an investor in preferred stock has a valid expectation of a monthly or quarterly payment of a certain amount. If the dividend payment is not made, the dividends are said to be “in arrears.”
Common vs. Preferred Shares
The greatest volume of stock trades consists of the purchase and sale of common stock. But while those who own common stock are eligible to receive dividends, which represent a shareholder’s interest in company profits, only preferred shareholders must receive them.
In fact, unlike dividends paid to owners of common stock, the dividends paid to preferred stockholders represent a legal commitment of the company. And, a company must pay those dividends, before it allots dividends to common stock owners.
If a publicly-traded company ceases operations and goes into liquidation, its stock becomes worthless. Even so, some stockholders may be entitled to a portion of the company's remaining assets.
In the event of bankruptcy, preferred shareholders have a higher claim on company assets than do those who own common stock. But in this case, the claims of secured creditors, unsecured creditors, including bondholders, and tax authorities take precedence over holders of both preferred and common stock.
Another way that preferred shares differ from common shares is that the cost of a preferred share is typically higher than that of common stock. What’s more, the prices of preferred stock are more stable than that of common stock.
Definition of Cumulative Dividends in Arrears
If a company’s operations and investments fail to generate the cash needed to pay the required cumulative dividends to holders of its preferred cumulative stock by a certain date, it’s said the company has dividends in arrears.
Dividends in arrears are not authorized by the company's board of directors because the company lacks the funds to make the needed payments. In this case, a nonpayment (or a series of nonpayments) is disclosed in the footnotes that accompany the company's financial statements.
Read More: Different Types of Dividends
Payment of Cumulative Dividends in Arrears
If and when the cumulative dividends in arrears are paid, the payments go to the current holder of the affected preferred stock. In addition, the dividends appear in the issuing company's balance sheet as a short-term liability.
Dividends in arrears must be paid to preferred shareholders before the board approves dividends to common stock shareholders.
Typically, the preferred share dividend is guaranteed. Consequently, cumulative dividends in arrears will accrue over time. Holders of preferred shares with noncumulative dividends do not receive dividends in arrears at a later date.
Read More: When Does a Dividend Accrue?
Example of Dividend Arrearage
Assume a company’s outstanding shares consist of 5,000 common shares and 500 preferred shares. Historically, the company has paid dividends to its common shareholders every two years. In turn, it pays holders of preferred shares with cumulative dividends at $3 dividend per share each quarter. Consequently, the company pays a minimum of $1,500 in dividends each year.
Due to a failing economy, the company is operating in the red. As a result, the company’s board of directors did not approve the payment of dividends for the most recent quarter. After five quarters of no earnings, the company’s dividends in arrears are equal to $7,500.
In the sixth quarter, however, the company benefited from considerable growth by entering new markets. As a result of the growth, the company pays both the current quarter’s dividends in arrears on preference shares, which equals $1,500, and the $7,500 that is owed to its preferred stockholders for a total of $9,000.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.