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IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies

A company issues cumulative preference shares carrying a 9% dividend. No dividend was paid on them in the previous year, and the board now wishes to pay an ordinary dividend this year. Which statement is correct?

Holders of cumulative preference shares keep their right to unpaid dividends. The company must therefore clear the arrears and the current year's preference dividend before it pays anything to ordinary shareholders. Only non-cumulative shares lose the missed dividend.

  1. AThe ordinary dividend may be paid first, since preference arrears are only a contingent liability
  2. BThe ordinary dividend can be paid only after the arrears and the current year's preference dividend have been paidCorrect
  3. COnly the current year's preference dividend must be paid before the ordinary dividend; the arrears lapse
  4. DThe preference shares automatically convert into ordinary shares
  5. The arrears are cancelled if the company reports a profit this year

Explanation

Cumulative preference shares carry forward unpaid dividends. Before any ordinary dividend, the arrears and the current preference dividend must be settled. The option saying the arrears lapse describes non-cumulative shares.

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