Dividends can be defined as the share of profits that are paid to the investors or the shareholders of the company in return for their investment in the particular company for a period of time. Since shareholders are technically the owners of the company, they are compensated through a profit-sharing, on an annual, semi-annual, or quarterly basis.
This is one of the ways in which shareholders recover their investment in the company, and eventually gain profits as a result of their financial commitment to the company.
Dividends are mostly declared by the board of directors of the company in annual general meetings before they are paid out. In most cases, the declaration date differs from the payout date, and therefore, relevant journal entries need to be made in order to reflect these changes in the financial statements of the company.
In some countries, the dividend payment to the shareholders need to get the approval from the local regulator and in most case, it is only paid from the realize profit.
In this regard, it is also important to understand the timeline, as well as the terminology associated with dividend payouts:
- Dividend Declared: This is the date when the shareholders meet to decide the dividends that need to be paid out to the shareholders. This is when they strategize and communicate the dividend payout for the particular year or quarter.
- Dividend Recorded: This is when the accountants record the declared dividend, as well as the respective amounts in the general ledgers.
- Dividend Paid: Dividend paid is the timeline when the declared dividends are actually paid and subsequently distributed to the public.
Types of Dividends
Dividends are broadly categorized into two types: Cash Dividends and Stock Dividends. As far as cash dividends are concerned, they are the dividends that are paid to the shareholders in the form of cash. On the other hand, Stock Dividends are dividends that are paid to the company in the form of common share equity.
In this regard, it is important to note the fact that in the case of stock dividends, the company does not pay out any cash. All dividend settlement is done in the form of common share equity.
Declared Cash Dividends – Journal Entries
Dividends are declared in the Board Meetings of the company. This is the time where all the board members sit and decide on the way forward for the company, in order to strategize the dividend payout, contingent on the cash resources they have on hand.
This is because dividends can only be paid from the cash reserves of the company. In case the company does not have sufficient cash to pay out dividends, they are unlikely to pay the amount in cash.
At the date of the board meeting, all these factors are considered, depending on which dividends are declared.
Dividend declaration can be assumed as communication of intent by the company pertaining to the dividends that they have to pay. Once the dividend payout is decided and communicated, the following journal entries are made:
Dividends declared are treated as an expense in the company. This is because the amount of dividends is essentially generated from the profits of the company.
Since they are ‘declared’ and not yet paid, dividends declared are treated as a Current Liability in the financial statements of the company. Since it is a short-term obligation, it makes sense for companies to record it as current liabilities in the financial statements of the company.
However, it must be noted that this is a temporary account, which is only created for the time between the dividend is declared and the dividend is issued. This is a contra account to the Retained Earnings account, and the balance in this account is subsequently adjusted in the Retained Earnings account at the end of the period.
It is optional for the company to maintain a Dividends Declared Account, and they can simply make the debit in the Retained Earnings Account, once the dividend is declared.
This is mostly adopted by companies that do not want to maintain separate accounts for Declared Dividends for a particular year. In the case where the company wants to do direct debits in the Retained Earnings Accounts, the following journal entries are made:
Cash Dividends Paid – Journal Entry
As mentioned earlier, dividend declaration date and dividend payout date might exist in different accounting periods. Therefore, once the dividends are actually paid out to the shareholders, the following journal entries are made:
The impact of Cash Dividends on the Financial Statements
Cash Dividends are mostly paid by companies in order to provide a return to the shareholders as a result of their investment. Therefore, cash dividends mostly impact cash, as well as shareholder equity accounts.
Once the declared dividends are paid, they are removed from the Current Liability part of the Balance Sheet, and they are eventually credited from cash – since the payment for these dividends is made from cash. Therefore, when dividends are declared:
- Retained Earnings are debited in the Income Statements. Current Liabilities increase in the Balance Sheet.
Subsequently, when dividends are paid:
- Current Liabilities are debited in the Balance Sheet – since the liability account closes down.
- Bank is credited since it decreases following the payments made to the shareholders.
Therefore, it can be seen that when dividends are paid, the size of the Balance Sheet reduces, because cash, as well as retained earnings, decrease from the Net Assets and the Equity part of the Balance Sheet.
From an investor’s perspective, the total amount of dividends that were paid during the year are viewed in the financing section of the Statement of Cash Flows. This shows how much cash is entering, or leaving the company.
Cash Dividends vs Stock Dividends
In certain cases, companies also prefer paying stock dividends instead of cash dividends. When organizations choose to issue stock dividends, it results in an increase in the number of shares outstanding.
The main rationale behind companies issuing stock dividends is to reserve cash. This is because instead of reducing cash, the number of shares is increased. It must also be noted that stock dividends impact the financial statements in a different manner, as compared to cash dividends.
How do Stock Dividends impact the financial statements?
When stock dividends are declared, the amount is debited equivalent to the amount generated by multiplying the current stock price by the shares outstanding by the dividend percentage.
Once stock dividends are paid for, the amount is subsequently reduced from the Retained Earnings and increased in the Common Stock account. Therefore, stock dividends do not change the asset side of the balance sheet. In fact, they only reallocate retained earnings to common stock.
Journal Entries for Declaration and payment of Stock Dividend
In order to record journal entries for stock dividends, when they are declared, the following journal entries are made:
|Common Stock Distributable||xxx|
In the same manner, once these dividends are paid, the following journal entries are made:
|Common Stock Distributable||xxx|
The main rationale behind the journal entries above is to record the issue of new shares, and the respective changes in equity in the Balance Sheet of the company. Hence, when a company issues stock dividends, the only difference is the transfer from retained earnings, to the common stocks that are newly issued as dividends.
It must also be noted that in the case of stock dividends that are paid, market capitalization or shareholder wealth does not change. It just increases the number of shares issued for the people.