What it means
When a business issues preferred shares with a cumulative feature, it promises to pay a set percentage of the share value as a regular dividend. If the company hits a rough patch and cannot afford to pay, those missed payments do not simply disappear.
Instead, they become dividends in arrears. This backlog matters immensely because companies cannot pay any dividends to everyday common shareholders until all accumulated arrears are fully paid off to the preferred investors.
This creates a queue where preferred owners have priority, protecting their initial investment returns. In practical terms, this backlog sits off the main balance sheet as a note in the financial statements, but it heavily influences company decision-making.
Potential investors check this figure carefully before buying shares, as a large backlog signals past financial trouble and blocks future payouts to common owners. Managers must treat this backlog as a priority financial obligation.
Ignoring it damages credibility with investors and makes raising new capital nearly impossible. Clearing the arrears is usually the first financial milestone a recovering business aims to achieve.
Imagine a landlord who lets you skip rent for a few months during a hard time. That rent is not forgiven, it simply piles up as arrears, and you must pay it all back before you are allowed to spend money on home renovations.
In practice
Real-world examples
Example 1
TechStart Ltd has cumulative preferred shares worth $200,000 carrying a 5% dividend, which is $10,000 a year. It missed the dividend for two straight years, so $20,000 sits in dividends in arrears. This must be cleared, together with the current year's $10,000, before the founders get any payouts on their ordinary shares.
Example 2
Brighton Bakery skipped preferred shareholder payouts during a tough renovation year, accumulating $15,000 in arrears. The owner must pay this total backlog plus the current year before distributing profits. The arrears are disclosed in the notes to the accounts, so lenders and anyone buying the business can see them.
Example 3
GreenEnergy PLC deferred its cumulative dividends for three years during a supply chain crisis. With $1,000,000 of cumulative preferred shares paying 5%, it owes $50,000 a year, so the arrears reached $150,000. Institutional investors refused new funding until this backlog was fully cleared.
Think of it
Imagine a landlord who lets you skip rent for a few months during a hard time. That rent is not forgiven, it simply piles up as arrears, and you must pay it all back before you are allowed to spend money on home renovations.
Formula
Calculation
Total Arrears = (Annual Dividend Rate x Share Value x Number of Preferred Shares) x Number of Skipped Years
Amount Due Before Any Ordinary Dividend = Total Arrears + Current Year's Preferred Dividend
Worked example: the arrears. A company has 1,000 cumulative preferred shares valued at $100 each, with a 6% annual dividend, and has missed 2 years. The annual dividend is 0.06 x 100 x 1,000 = $6,000, so the arrears are 6,000 x 2 = $12,000.
Worked example: clearing the slate. In the third year the company recovers and has $25,000 of distributable cash. It must first pay the $12,000 of arrears plus the current year's $6,000, a total of $18,000, to the preferred shareholders. Only the remaining 25,000 - 18,000 = $7,000 is available for ordinary shareholders.
Worked example: the non-cumulative contrast. If the same shares were non-cumulative, the two missed years would be lost for good, and the company would owe only the current year's $6,000 before paying ordinary shareholders.Case study
Seen in the real world
This is a fictional, illustrative scenario. Oakwood Retail PLC experienced a severe downturn, forcing management to suspend all dividend payments to preserve cash. Among their share classes were 5,000 cumulative preferred shares, each carrying a $10 par value and a promised 7% annual return, which is $3,500 a year. Because the dividend was cumulative, the missed payment of $3,500 for the first year was recorded as dividends in arrears.
The following year brought another difficult trading period, and the company again could not pay, adding another $3,500 to the backlog. By the end of the second year, Oakwood carried $7,000 in total dividends in arrears. In the third year, the business finally turned a corner and generated a healthy profit. Before management could reward ordinary shareholders or reinvest surplus cash into a new store, they were required to settle the $7,000 backlog, plus the current year preference dividend of $3,500.
Once the total $10,500 was distributed to the preferred stockholders, Oakwood cleared its slate and restored regular financial health. The finance director later pointed out that the outcome would have been very different had the shares been non-cumulative. In that case the first two years of dividends, $7,000 in all, would have been lost to the preferred holders and only the $3,500 for the current year would have been due, which is why investors in preferred shares check the cumulative feature before they buy.
Watch out
Common mistakes
- Treating unpaid dividends on ordinary shares as arrears, when arrears only apply to cumulative preferred shares.
- Failing to disclose the backlog in the financial statement notes, which misleads potential investors.
- Paying dividends to common shareholders while cumulative preferred shareholders are still owed past payments.
Questions
People also ask
Do all preferred shares create dividends in arrears when skipped?
No, only cumulative preferred shares accumulate missed payments. Non-cumulative preferred shares simply lose the missed payment forever if it is skipped.
Are dividends in arrears listed as a liability on the balance sheet?
No, they are typically disclosed in the notes to the financial statements rather than as a formal liability until the board formally declares the dividend.
Can a company buy back its own shares while it has dividends in arrears?
Usually no. Most corporate governance rules and share agreements restrict share buybacks until all preferred dividend arrears are fully settled.