Dividends in Arrears Defnition, Link With Preferred Shares

What Are Dividends in Arrears?

Preferred stock shares are issued with a guarantee of a dividend payment, so if a company fails to issue those payments as promised, the total amount owed to the investors is recorded on its balance sheet as dividends in arrears.

If a company has dividends in arrears, it usually means it has failed to generate enough cash to pay the dividends it owes preferred shareholders.

Understanding Dividends in Arrears

Investors in preferred stock buy shares primarily for the dividend. They are essentially a hybrid of stocks and bonds.

That is, they represent an ownership stake in the company, as any stock does. However, they are not typically bought with the expectation that their price will rise in the near future, enabling the owner to sell the shares at a profit.

Rather, they are an investment in income. Preferred shares come with a guaranteed return in dividends. This may be a set percentage or the return may fluctuate with a certain economic indicator.

In any case, as with bonds, the investor expects to receive a monthly or quarterly payment of a certain amount. The shares can be sold on an exchange, like common stock, but the typical owner of preferred shares is in it for the income supplement.

Like bonds, preferred shares appeal to a more conservative investor, or they comprise the conservative portion of an investor's diverse portfolio.

When Dividends Are Suspended

A board of directors can vote to suspend dividend payments to owners of shares, preferred or common.

If the company suspends the payments, they must be recorded on the company's balance sheet as dividends in arrears. The intention is to pay the amount owed when possible.

A vote to suspend dividend payments is a clear signal that a company has failed to earn enough money to pay the dividends it has committed to paying. At the very least, some of its obligations, such as payments to regular suppliers, may be more urgent.

In any case, all dividends that are due to preferred shareholders must be paid prior to the issuance of any dividends to owners of common shares.

Common Shares Vs. Preferred Shares

The vast bulk of stock purchases and sales are of common shares. Holders of common stock have an ownership stake in the issuing company. The company may, if its board of directors chooses, vote to give the owners of common shares a dividend, which represents each owner's share of the profits.

However, the board can't allocate any dividends to owners of common stock until they set aside the amount they owe preferred shareholders. Those dividends are not a bonus. They're a commitment.

Similarly, any dividends in arrears due to the owners of preferred shares must be paid in full before the board considers paying a dividend on common shares.

Voting Rights

There are some other differences between common and preferred shares.

First, preferred shares are usually more expensive and their prices are less volatile over time.

In addition, owners of common shares have voting rights and may participate in major business decisions if they choose. Owners of preferred shares generally do not have voting rights.

However, preferred shareholders have a higher claim on company assets in the event of bankruptcy. This is not especially meaningful since even preferred shareholders are in line for repayment behind secured creditors, unsecured creditors, and tax authorities. Even bondholders are higher in line since their investment represents secured credit.

Example of Dividends in Arrears

Assume that company ABC has five million ordinary shares and one million preferred shares outstanding. The company pays dividends to common shareholders every other year, while preferred shareholders are guaranteed a $3 dividend per share.

At a minimum, ABC must pay out $3 million in dividends each year.

Due to a failing economy and some legal issues with one of its directors, ABC's profits take a huge dive, leaving it with just enough to pay the most urgent bills. The board elects to suspend all dividend payments until revenues pick up.

However, three years later, ABC is still floundering. Now it owes preferred shareholders $9 million in unpaid dividends.

With the launch of a revolutionary new product, ABC finally sees its profits pick up. However, given the size of its pressing financial obligations, it is still unable to pay its preferred dividends.

Five full years after its near-collapse, ABC's recovery is complete and it is more profitable than ever.

ABC is able to pay the $15 million in dividends in arrears owed to its preferred shareholders. Then, it might think about issuing a dividend to its long-suffering common shareholders too.

The Fine Print

In general, preferred shares carry a guaranteed dividend that will accrue over time if left unpaid, as in the example above. However, only cumulative dividends carry this benefit.

Companies have the option of issuing non-cumulative dividends, meaning that shareholders do not have a claim on any dividends left unpaid due to a drop in profits.

Luckily, these types of dividends are far less common.

Callable Shares

Though companies want to reward shareholders for investment, they are not in the business of giving away more money than they have to. Some companies limit their liability by issuing callable shares.

This type of preference share can be repurchased by the company at its discretion for a predetermined price on a given date.

Preferred share dividends, like bond rates, are largely influenced by the interest rates set by the Federal Reserve at the time they are issued. Companies that issue callable shares retain the option to repurchase existing preferred shares and reissue them with a lower dividend rate when interest rates fall.