Arrears, fair value, and the entry that does not exist

Cumulative preferred shares and arrears

Prairie Sky has 10,000 preferred shares outstanding, each entitled to a $2 cumulative dividend per year — $20,000 a year for the class. Cumulative means that any year’s dividend the board skips does not disappear: it accumulates as dividends in arrears and must be paid, along with the current year’s preferred dividend, before the common shareholders receive anything. Cash-starved by its expansion, Prairie Sky paid no dividends in the last two years, so it enters this year with $40,000 of arrears.

Arrears are disclosed in the notes, not recorded as a liability. No dividend is owed until a board declares it; the arrears are a priority claim on future declarations, not a present obligation. Recording a “Dividends in Arrears Payable” account is the trap.

Worked example — allocating a declaration

This year the board declares $100,000 in total. The preferred shareholders take their arrears first, then their current entitlement; the common shareholders take the rest:

Preferred — arrears (2 years × 20,000)      40,000
Preferred — current year                    20,000
                                            ------
Preferred total                             60,000
Common (100,000 − 60,000)                   40,000

Dr Dividends Declared                 100,000
    Cr Dividends Payable—Preferred            60,000
    Cr Dividends Payable—Common               40,000

Had the preferred shares been non-cumulative, the two skipped years would simply have been lost; the preferred would take only $20,000 and the common $80,000.

A share dividend: fair value, no cash

Instead of cash, a board may distribute new shares. Prairie Sky declares a 5 % share dividend on its 200,000 common shares: 10,000 new shares, issued when the shares trade at $20.00. The dividend is measured at the shares’ fair value — $200,000 — and moves that amount from retained earnings into share capital:

Dr Dividends Declared            200,000
    Cr Common Shares                     200,000

No cash leaves, no asset changes, and total equity is unchanged — it has simply been relabelled from retained earnings to share capital. Each shareholder holds 5 % more shares of an unchanged company, so each share is worth about 5 % less; the holder is no richer. That is why lesson 4.2 refused to count a share dividend as income.

A split: the entry that does not exist

A 2-for-1 share split replaces every share with two. Prairie Sky’s 300,000 outstanding shares become 600,000; the price per share halves; share capital, retained earnings and total equity are all unchanged. Because no amount moves between accounts, there is no journal entry — only a memorandum note updating the share count. A split is done to bring a high share price back into a range small investors will trade. The contrast with a share dividend is the midterm’s favourite: the share dividend moves retained earnings into share capital; the split moves nothing.