Final answer:
Dividends in arrears are dividends on preferred stock that have been declared but not yet paid to shareholders. These dividends accumulate over time until paid and must be settled before any dividends can be distributed to common stockholders. The correct answer is option: 1) Dividends that have been declared but not yet paid to shareholders.
Step-by-step explanation:
The correct description of dividends in arrears is (option 1) Dividends that have been declared but not yet paid to shareholders. This situation typically occurs with preferred stock, where dividends are expected to be paid on a regular schedule. If a company does not declare a dividend in any period, the dividend is said to be in arrears. According to the terms of most preferred stock, these unpaid dividends must be paid out before any dividends can be paid to common stockholders.
When a dividend is in arrears, preferred shareholders have a claim on any future earnings and dividends. Companies often report dividends in arrears in the notes to their financial statements. Dividends in arrears accumulate until the company decides to pay them. It is important to note that dividends are not considered a liability until they are formally declared by the board of directors. Once declared, the company is legally obligated to pay the dividend to its shareholders.