Dividend Preference of Preferred Stock

Preferred stock usually carries a preference for dividends, meaning that preferred stockholders are allocated their dividends before any dividends are allocated to common stockholders. The dividends allocated to preferred stockholders are usually expressed as a dollar amount per share or a percent applied to par value. A preference for dividends does not ensure dividends. If the directors do not declare a dividend, neither the preferred nor the common stockholders receive one.

Cumulative or Noncumulative Dividend
Most preferred stocks carry a cumulative dividend right.  

Cumulative Preferred Stock 
Preferred stock on which undeclared dividends accumulate until paid; common stockholders cannot receive dividends until cumulative dividends are paid. has a right to be paid both the current and all prior periods’ unpaid dividends before any dividend is paid to common stockholders. When preferred stock is cumulative and the directors either do not declare a dividend to preferred stockholders or declare one that does not cover the total amount of cumulative dividend, the unpaid dividend amount is called dividend in arrears Unpaid dividend on cumulative preferred stock; must be paid before any regular dividends on preferred stock and before any dividends on common stock.. Accumulation of dividends in arrears on cumulative preferred stock does not guarantee they will be paid.  

Noncumulative preferred Stock 
Preferred stock on which the right to receive dividends is lost for any period when dividends are not declared. confers no right to prior periods’ unpaid dividends if they were not declared in those prior periods.

Point: Dividend preference does not imply that preferred stockholders receive more dividends than common stockholders, nor does it guarantee a dividend.

To illustrate the difference between cumulative and noncumulative preferred stock, assume that a corporation’s outstanding stock includes (1) 1,000 shares of $100 par, 9% preferred stock—yielding $9,000 per year in potential dividends, and (2) 4,000 shares of $50 par value common stock. During 2010, the first year of operations, the directors declare cash dividends of $5,000. In year 2011, they declare cash dividends of $42,000. See Exhibit 13.11 for the allocation of dividends for these two years. Allocation of year 2011 dividends depends on whether the preferred stock is noncumulative or cumulative. With noncumulative preferred, the preferred stockholders never receive the $4,000 skipped in 2010. If the preferred stock is cumulative, the $4,000 in arrears is paid in 2011 before any other dividends are paid.

EXHIBIT 13.11 Allocation of Dividends (noncumulative vs. cumulative preferred stock)

Example: What dividends do cumulative preferred stockholders receive in 2011 if the corporation paid only $2,000 of dividends in 2010 How does this affect dividends to common stockholders in 2011? Answers: $16,000 ($7,000 dividends in arrears, plus $9,000 current preferred dividends). Dividends to common stockholders decrease to $26,000.

A liability for a dividend does not exist until the directors declare a dividend. If a preferred dividend date passes and the corporation’s board fails to declare the dividend on its cumulative preferred stock, the dividend in arrears is not a liability. The full-disclosure principle requires a corporation to report (usually in a note) the amount of preferred dividends in arrears as of the balance sheet date.

Participating or Nonparticipating Dividend Nonparticipating preferred Stock 
Preferred stock on which dividends are limited to a maximum amount each year. has a feature that limits dividends to a maximum amount each year. This maximum is often stated as a percent of the stock’s par value or as a specific dollar amount per share. Once preferred stockholders receive this amount, the common stockholders receive any and all additional dividends.  

Participating Preferred Stock 
Preferred stock that shares with common stockholders any dividends paid in excess of the percent stated on preferred stock. has a feature allowing preferred stockholders to share with common stockholders in any dividends paid in excess of the percent or dollar amount stated on the preferred stock. This participation feature does not apply until common stockholders receive dividends equal to the preferred stock’s dividend percent. Many corporations are authorized to issue participating preferred stock but rarely do, and most managers never expect to issue it.²