Final answer:
Cumulative preferred stock entitles holders to current dividends and any unpaid past dividends before common shareholders can receive dividends. These dividends in arrears accumulate and must be paid out first, protecting the preferred shareholders' interests.
Step-by-step explanation:
Cumulative preferred stock is a type of preferred stock that provides its holders with the right to receive current dividends plus any accumulated unpaid dividends from past years before any dividends can be paid to common stockholders. This feature is designed to protect the interests of preferred shareholders, ensuring that they receive their fixed dividends before any distributions are made to common shareholders. The accumulation of unpaid dividends is referred to as dividends in arrears, and it must be paid out to cumulative preferred shareholders before any dividends can be declared on common stock.
In other words, if a company cannot pay the dividend on cumulative preferred stock in any year, the unpaid dividends accumulate. These accumulated dividends must be paid out to the preferred shareholders before the common shareholders can receive any dividends in the future. This provision ensures that the rights of preferred shareholders to their promised dividends are honored and prioritizes their payments over those of common shareholders.