Definition: Dividends in arrears are accumulated past unpaid dividends owed to cumulative preferred stockholders. You can think of this as an account that keeps track of the amount of distributions that the corporation owes its cumulative preferred shareholders because it didn’t make its minimum dividend payments in prior periods.
What Does Dividends in Arrears?
Cumulative preferred stock is unique in that it has the right to claim a minimum distribution each year. However, it does not have the right to receive a payment each year. The board of directors annually makes the decision to declare and pay dividends to shareholders. If nothing is declared or paid, the cumulative shareholders don’t get a payment for the year.
Instead, they account for the payment they should have received in the dividend in arrears account. Each year nothing is paid, the minimum amount is added to this account.
When future dividends are paid to shareholders, the cumulative stockholders have the right to be paid before any other shareholder to the extent of the arrears account. This means that they are paid before non-cumulative preferred and common stockholders. If the distribution is smaller than the full arrears account, the entire payment will go to cumulative shareholders.
Let’s look at an example.
Big Bad Corp. issued 100 $10 cumulative preferred shares at the beginning of year one. No dividends were declared or paid in the first year, so $1,000 went in arrears. Year two was the same as year one. Nothing was declared or paid, so another $1,000 was put into arrears.
At the end of the third year, the board of directors declares and pays a $1,500 dividend. Since there is a $3,000 balance in the arrears account (including year three’s balance), cumulative preferred shareholders are paid first. The entire $2,500 payment goes to cumulative shareholders and reduces the arrears account to $500. No common or regular preferred stockholders are paid this year.