What it means
Preferred stock sits between debt and common equity: it pays a fixed dividend like a bond's coupon, but the dividend is declared at the board's discretion like a common dividend, and the shares rank behind creditors and ahead of common holders on liquidation. The weakness of the preferred holder's position is that the dividend can be skipped.
The cumulative feature repairs it: skipped dividends do not disappear; they accumulate, and the common shareholders cannot be paid until the arrears are cleared. The mechanics are simple.
A company with 1,000,000 cumulative preferred shares of $100 par paying 6% owes $6,000,000 a year of preferred dividends. If it pays nothing for two years, $12,000,000 is in arrears.
In the third year, before it can pay a common dividend, it must pay the $12,000,000 of arrears plus the third year's $6,000,000: $18,000,000. If it cannot or will not, common holders receive nothing, however profitable the year.
Non-cumulative preferred, by contrast, would have lost the two years' dividends permanently, and the company could pay the third year's $6,000,000 and then a common dividend. The accounting treatment reflects the discretionary nature of the dividend.
Dividends in arrears are not recorded as a liability because the company has not declared them and is not legally obliged to; they are disclosed in the notes (the amount in arrears, per share and in total). They are deducted from net income in calculating earnings per share for common shareholders, whether or not declared, because they must be paid before common holders receive anything.
When declared, they become a liability until paid. On liquidation, the arrears are added to the preferred holders' claim, typically par plus accumulated unpaid dividends, ahead of common equity.
Investors in preferred stock value the cumulative feature and pay for it: cumulative preferred carries a lower dividend rate than non-cumulative preferred of the same issuer, other things equal, because the holder's income is more secure. Issuers accept the feature to lower the rate and because, for most companies, the intention is to pay the dividend anyway.
Banks and insurers issue non-cumulative preferred because regulators require that instruments counted as capital can absorb losses by cancelling payments without the payments accumulating as claims. The feature matters to common shareholders because it defines what stands between them and any dividend.
A company with large arrears is one whose common holders face years without dividends even after recovery, since the arrears must be cleared first; and a company that has accumulated arrears often negotiates with preferred holders to settle them in shares or at a discount. Analysts reading a company with cumulative preferred check the arrears note, deduct the preferred dividend (including arrears) from earnings for the common EPS, and treat the preferred as debt-like in the capital structure.
Variants include participating cumulative preferred (which also shares in common dividends above a threshold), convertible cumulative preferred (convertible into common, with arrears often settled on conversion), and preferred with a dividend that steps up if arrears accumulate, which increases the pressure to pay.
In practice
Real-world examples.
Example
A utility with a century-old issue of 5% cumulative preferred stock has never missed a dividend, and the shares trade as a near-bond.
Example
A shipping company suspends its cumulative preferred dividend for three years in a downturn, accumulates $45 million of arrears, and settles them in common shares when it recovers.
Example
A bank issues non-cumulative preferred stock that counts as regulatory capital because the dividend can be cancelled without creating a claim.
Think of it
“Cumulative preferred means missed dividends pile up and must be paid eventually-they don't disappear.
Formula
Calculation
Annual preferred dividend = Number of shares x Par value x Dividend rate
Dividends in arrears = Sum of undeclared preferred dividends from all prior periods
Amount payable before any common dividend = Dividends in arrears + Current year's preferred dividend
Earnings available to common = Net income minus Preferred dividends for the year (declared or not, if cumulative) (arrears of prior years were deducted in those years)
Liquidation preference = Par (or stated liquidation value) + Dividends in arrears
Worked example. A company has 500,000 shares of 7% cumulative preferred stock, $50 par ($25,000,000), and 10,000,000 common shares. Annual preferred dividend = 500,000 x $50 x 7% = $1,750,000.
Year 1: net income $900,000. The board declares no dividends. Preferred dividends in arrears at year end: $1,750,000. EPS for common = ($900,000 minus $1,750,000) / 10,000,000 = minus $0.085 (the preferred dividend is deducted whether or not declared). Note disclosure: "Dividends on the 7% cumulative preferred stock are in arrears in the amount of $1,750,000 ($3.50 per share)."
Year 2: net income $1,200,000. No dividends declared. Arrears: $3,500,000. EPS = ($1,200,000 minus $1,750,000) / 10,000,000 = minus $0.055.
Year 3: net income $6,000,000; the board wishes to resume common dividends. It must first pay the arrears of $3,500,000 and the year-3 preferred dividend of $1,750,000: $5,250,000, leaving $750,000 of the year's earnings and whatever retained earnings exist for a common dividend. It declares the $5,250,000 to preferred holders and $0.05 per common share ($500,000). EPS = ($6,000,000 minus $1,750,000) / 10,000,000 = $0.425 (only the current year's preferred dividend is deducted; the arrears were deducted in years 1 and 2). Cash out: $5,750,000.
Had the preferred been non-cumulative: years 1 and 2 dividends lost; in year 3 the company pays $1,750,000 to preferred and could pay up to about $4,000,000 to common. The cumulative feature transferred $3,500,000 from common to preferred holders in year 3.
Liquidation illustration at the end of year 2 (arrears $3,500,000): net assets available after creditors $30,000,000. Preferred claim = par $25,000,000 + arrears $3,500,000 = $28,500,000. Common holders receive $1,500,000 ($0.15 per share). Had net assets been $20,000,000, preferred holders would receive it all and common nothing.
Negotiated settlement: at the end of year 2, the company offers preferred holders 1,400,000 common shares (valued at $2.50) in settlement of the $3,500,000 arrears. Preferred holders accept, receiving shares rather than waiting; the company avoids the cash outflow and common holders are diluted by 14%. The arrears note is removed; the dilution appears in the share count.
Pricing: the company's cumulative preferred yields 7% at par; its non-cumulative preferred, if it had any, would need to yield perhaps 7.75% to attract investors to the same issuer, the difference being the price of the accumulation feature.Case study
Seen in the real world.
A private equity firm invested in a manufacturing company through $40,000,000 of 10% cumulative convertible preferred stock, with the founders retaining the common. The company's performance disappointed, no preferred dividends were paid for four years, and arrears reached $16,000,000, which the preferred's terms compounded at 10% (an accumulating feature on the arrears themselves) to about $18,600,000. The founders, whose common equity was worth nothing until the preferred's par and arrears were covered, had lost most of their incentive; the preferred holders, whose claim now stood at $58,600,000 against a company worth perhaps $50,000,000, faced a recovery that depended entirely on the founders' continued effort.
The two sides restructured: the preferred holders waived $10,000,000 of arrears in exchange for a larger conversion ratio, the remaining arrears were settled in common shares, the dividend rate was reduced to 6%, and the founders received a new option pool. The company recovered over three years and was sold, with the preferred holders receiving 2.1 times their investment and the founders a meaningful share. The private equity firm's partner observed that the cumulative feature had protected the firm's claim precisely as intended and had, in doing so, removed the founders' reason to protect it, and that the restructuring had recognised that a claim on a company is worth only what the people running it can be induced to make it worth.
Watch out
Common mistakes.
- Recording dividends in arrears as a liability. They are not owed until declared; they are disclosed in the notes and deducted in computing common EPS.
- Computing common EPS without deducting the cumulative preferred dividend for the year when it has not been declared, which overstates the earnings available to common shareholders.
- Valuing common equity in a company with cumulative preferred without deducting the preferred's par and arrears, both of which rank ahead of common.
Questions
People also ask.
What is the difference between cumulative and non-cumulative preferred stock?
If a cumulative preferred dividend is skipped, it accumulates and must be paid before any common dividend; if a non-cumulative one is skipped, it is lost. Cumulative preferred is safer for holders and carries a lower rate.
Are dividends in arrears a liability?
No, not until declared, because the board is not obliged to declare them. They are disclosed, deducted from earnings for common EPS, and added to the preferred claim on liquidation.
Why do banks issue non-cumulative preferred?
Because regulators require that instruments counted as capital can absorb losses by cancelling payments without creating a claim; cumulative preferred, whose skipped dividends accumulate, does not qualify.
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