DEFINITION of Arrearage

An amount on a loan, cumulative preferred stock or any credit instrument that is overdue. Arrearage is also referred to as "arrears".

BREAKING DOWN Arrearage

In the case of a preferred dividend, if the company does not pay the dividend to its shareholders, that dividend income accumulates. This means that in the future, arrearage must be paid to preferred shareholder before any dividends can be paid on common stock.

Dividends in arrears tends to occur when a company fails to turn a significant enough profit with which to pay their preferred shareholders the dividends guaranteed to them. These unpaid dividends are frequently referred to as “omitted preferred dividends”.

To qualify as dividends in arrears when unpaid, the dividends must be for the kind of preferred stock that has the so-called “cumulative” feature. Cumulative preferred stock allows for the accumulation of any undeclared preferred dividends from prior periods and the preferential distribution in later periods, before any new dividends and common dividends.

Take the example of a telecom corporation that has a cumulative preferred stock with an annual dividend amount of $20,000. If this company has omitted the dividends for the past five years, then there is $100,000 of dividends in arrears. Consequently, in order to pay any dividend income out to common stockholders, the corporation must first pay its preferred stockholders $120,000 in arrears, which is calculated by combining the $100,000 in past dividends still owed, plus the current year preferred dividend amount of $20,000.

One point of note: unlike preferred stock, any missed common stock dividends are simply declared to be “lost” and therefore deemed irretrievable. But common shareholders have advantages that preferred shareholders don’t get to enjoy. For example, if common shareholders reach a certain threshold of ownership percentage of a public company, they gain voting rights, and are entitled to participate in major business decisions such as electing board members, influencing mergers and acquisition activity and weighing in on new product rollouts.

On the other hand, while preferred shareholders do not have voting rights—even if they achieve an ownership stake in the issuing company, they enjoy other perks, such as higher claims on company assets then common shareholders, in the event of bankruptcy situations. Furthermore, the dividend payouts to preferred shareholder behave like bonds, in that they are locked in at fixed rates—a characteristic attractive to more risk-averse investors.