Treatment of cumulative dividends on preferred stock
FINANCIAL REPORTING INSIGHTS |
When a company issues preferred stock with cumulative dividend rights, questions often are raised regarding how and when cumulative dividends should be recognized on that preferred stock, given that there is limited authoritative guidance.
Non-redeemable preferred stock
For non-redeemable preferred stock classified as equity, we believe the answer depends on the circumstances under which the entity is legally obligated to pay cumulative dividends. (For purposes of this discussion, non-redeemable preferred stock refers to stock that does not have provisions for redemption that are outside of the issuer’s control).
An entity that is legally obligated to pay cumulative dividends should accrue a liability for dividends as they are earned and become a legal obligation of the entity. Such a situation can occur if the terms of the preferred stock instrument require that the entity pay dividends as they are earned, regardless of whether they are declared. Reference also should be made to Section 3.7 of our Guide, Accounting for debt and equity instruments in financing transactions, for perpetual instruments that are required to pay dividends at rates that increase in subsequent years.
Dividends that have not yet been declared by the board of directors for which there is no legal obligation to pay unless declared should not be recognized until declared by the board of directors. This is consistent with non-authoritative guidance in AICPA Technical Questions and Answers Section 4210.04. It is important to note that while recognition may not be required, consideration should be given to the disclosure requirements of ASC 505-10-50 for arrearages in cumulative preferred dividends, and to ASC 260 for the ramifications of cumulative dividends to earnings per share.
In some cases, the legal obligation to pay dividends is contingent, in which case, it would be appropriate to recognize the dividends upon the occurrence of the contingent event. For example, a cumulative preferred stock instrument may require payment of all accumulated and unpaid dividends if the entity declares a dividend on its common shares, or if the holder exercises an option to convert its preferred shares to common stock. If the entity declares a dividend on its common shares, the entity should accrue a liability for the cumulative unpaid dividends on the preferred stock instrument even if it has not formally declared payment of such dividends. Similarly, for those dividends that become payable upon conversion, a liability should be recognized at conversion (if not paid).
Some entities have a policy of recognizing cumulative dividends as they are earned (regardless of declaration), if the preferred holder has the ability or an unconditional right to trigger payment. Examples include the preceding scenario whereby the holder has a non-contingent conversion option, and if exercised, cumulative dividends are required to be paid in cash. A company following such a policy would recognize the liability for the dividends as they accrue rather than waiting until the conversion option was triggered. The accounting policy selected for the recognition of dividends when the preferred holder has the ability or an unconditional right to trigger payment should be consistently applied.
With the exception of redeemable preferred stock (discussed below) and increasing-rate preferred stock mentioned above, we believe the recognition of unpaid dividends should be through a liability and not through an increase to the carrying amount of the preferred stock.
Redeemable preferred stock
Some preferred stock instruments contain redemption features that are not within the entity’s control and are required to be classified in temporary equity under the SEC staff’s guidance on redeemable securities found in ASC 480-10-S99-3A, with subsequent measurement of the instrument to its redemption amount, including any dividends that would be paid at redemption. Reference should be made to section 3.2.3 of our Guide for further discussion. We believe it is preferable (though not required) that private companies follow this guidance. We also believe a private company that does not follow the subsequent measurement provisions of ASC 480-10-S99-3A for its redeemable stock should account for cumulative dividends consistent with the preceding guidance on non-redeemable preferred stock. In other words, it would not be appropriate for a private company to recognize accrued dividends through an adjustment to the carrying amount of its redeemable preferred stock unless it is also adjusting the carrying amount of the preferred stock to its redemption value in accordance with ASC 480-10-S99-3A.
Mandatorily redeemable preferred stock
ASC 480-10-25-4 requires liability treatment for certain mandatorily redeemable financial instruments. (Refer to section 3.2.1 of our Guide for additional guidance.) Cumulative dividends on mandatorily redeemable stock instruments classified as liabilities that will become payable upon settlement of the instrument (whether or not declared), are reflected in the subsequent measurement of the financial instrument as interest expense, as discussed in that section of the Guide.