What Are Preferred Dividends on a Balance Sheet?

Preferred dividends represent a portion of a company’s profits distributed to its preferred shareholders. These payments are a return on investment for preferred stock holders. Understanding preferred dividends is important for grasping their role in a company’s financial structure and how they affect financial reporting. Their characteristics and accounting treatment differ significantly from those associated with common stock.

Preferred Stock Fundamentals

Preferred stock is an equity security, often described as a hybrid because it combines features of both stocks and bonds. Holders of preferred stock receive fixed dividend payments, determined as a percentage of the stock’s par value or a set dollar amount per share. Preferred stock has preference over common stock regarding dividend payments and asset distribution in a company’s liquidation. This means preferred shareholders must receive their dividends before any common shareholders can be paid, and they have a higher claim on assets if the company is dissolved.

Preferred dividends differ from common stock dividends as they are fixed and paid regularly, providing a predictable income stream for investors. Common stock dividends, in contrast, are variable and depend on the company’s profitability and board decisions. The payment structure for preferred dividends can be either cumulative or non-cumulative, which has implications for shareholders. Cumulative preferred stock mandates that any missed dividend payments accumulate and must be paid in full before common shareholders can receive any dividends.

Non-cumulative preferred stock does not carry forward missed dividend payments. If the board of directors decides not to declare a dividend for a non-cumulative preferred stock in a given period, that payment is forfeited by the shareholders for that period. This distinction highlights that cumulative preferred stock offers greater protection by ensuring all past and current preferred dividends are settled before any distributions to common stockholders. The terms of a preferred stock offering, including its cumulative or non-cumulative nature, are specified when the stock is issued.

Preferred Stock Presentation on the Balance Sheet

Preferred stock, as an equity instrument, is presented within the shareholders’ equity section of a company’s balance sheet. This section lists the different classes of ownership interests in the company. Preferred stock is shown separately from common stock, reflecting its distinct rights and preferences.

The amount listed for preferred stock on the balance sheet is based on its par value, multiplied by the number of shares issued. For instance, if a company issues preferred stock with a $100 par value, the balance sheet will reflect the total par value of all issued preferred shares. Any amount received above the par value when the stock was initially sold is recorded in a separate account, such as “Paid-in Capital in Excess of Par—Preferred Stock.”

The presentation of preferred stock on the balance sheet highlights its role as a component of the company’s capital structure. It represents the capital contributed by preferred shareholders, who, while owning a share of the company, do not have the same voting rights as common shareholders.

Preferred Dividends and Balance Sheet Impact

Preferred dividends are not a permanent line item on the balance sheet. Their impact on the balance sheet is transactional and disclosure-related. A dividend payment only affects the balance sheet when it is formally declared by the company’s board of directors.

Once preferred dividends are declared, they become a current liability for the company. This liability is recorded on the balance sheet under an account such as “Dividends Payable.” This reflects the company’s legal obligation to pay the declared amount to its preferred shareholders. The “Dividends Payable” account remains on the balance sheet until the cash payment is made, at which point both the liability and the company’s cash balance decrease.

A distinct accounting treatment applies to dividends in arrears for cumulative preferred stock. These are unpaid dividends from prior periods that have not been declared by the board. Dividends in arrears are not recognized as a liability on the balance sheet itself because no legal obligation to pay them exists until they are formally declared. However, these amounts represent a claim against future earnings and must be satisfied before any dividends can be distributed to common shareholders.

Companies are required to disclose the amount of dividends in arrears in the notes to their financial statements. This disclosure helps users of financial statements understand the company’s potential future obligations to its preferred shareholders. The existence of dividends in arrears can signal financial challenges or a strategic decision to conserve cash, impacting investor perceptions of the company’s financial health and its ability to pay future common stock dividends.

The declaration of any dividend, whether preferred or common, impacts the shareholders’ equity section of the balance sheet by reducing retained earnings. Retained earnings represent the cumulative profits of a company that have not been distributed to shareholders. When a dividend is declared, the amount is deducted from retained earnings, reflecting that a portion of the company’s accumulated profits is being distributed. This reduction in retained earnings, alongside the corresponding decrease in cash upon payment, illustrates how dividend activity affects both the equity and asset sides of the balance sheet.