When a company decides to terminate (either partially or completely) the business, it liquidates all of its financial and non-financial assets including inventory, buildings, and machines.
The sole purpose is accumulating enough funds to pay back liabilities to all the secured and unsecured creditors.
The remaining amount is then paid to the shareholders as liquidating dividends. A more formal definition defines liquidating dividends as a residual payment to the shareholders after paying all the obligations to lenders and creditors when a business is no longer in a position to survive in the market i.e. does not satisfy the going concern principle.
The company can pay liquidating dividends in one or more installments depending on the financial position. It is also important to mention that liquidating dividends is non-taxable for the shareholders
Liquidating dividends also termed liquidating distribution or terminal distribution, is also seen as a form of return capital because instead of just earnings, the company’s owners’ capital is repaid to them.
In case, the assets are less than liabilities then nothing is paid to the shareholders as there would not be enough funds after paying all the debts. This scenario is most common in bankruptcy liquidations.
On the other hand, if the owners decide to sell a part of their business for cash to support existing operations, a liquidating dividend is necessary.
People normally confuse liquidating dividends with regular dividends paid to the shareholders. However, both are entirely different concepts. The following are the key differences:
|Basis of differentiation||Liquidating dividend||Regular dividend|
|Source||Funds left after paying all the obligations||Paid from either profits or retained earnings|
|Income||Return ca[pital; earnings plus capital invested||Source of income for the shareholders|
|Continuity of operations||Paid after the termination of the business||Paid during the continuous operations of the business|
Let’s consider a simple example to clarify further our concept of liquidating dividends. Assume company X has a paid-up capital of $1,000,000 and retained earnings of $300,000 with 300,000 shares outstanding.
It terminates its operations and declares a dividend of $3 per share. In such a scenario, company X will pay a total dividend of $900,000 i.e. $3*300,000 outstanding shares.
Firstly, it will use $300,000 from its retained earnings and the remaining $600,000 will be paid from the paid-up capital account.
Bear in mind, that $3 will not be wholly considered a liquidating dividend but rather a combination of regular and liquidating one.
As we have discussed earlier in the table liquidating is earning of the shareholder plus his/her capital invested.
So, company X is paying $1 ($300,000 of retained earnings/300,000 outstanding shares) as a regular dividend and the remaining $2 as liquidating dividend.
JOURNAL ENTRY FOR LIQUIDATING DIVIDENDS
- At Declaration Date: When a company declares liquidating dividends to shareholders, the bookkeeper will debit the common stock and retained earnings account while crediting the dividend payable account against them. Also, the common stock account represents the paid-up capital account on the balance sheet. The entry should look like the one below.
- At Payment Date: The entry to be made on the day when the company actually pays the liquidating dividends to the shareholders. The bookkeeper will debit the dividend payable account and credit the cash account.
EXAMPLE # 1: The board of directors of company Z decides to terminate the business on January 1st, 2022. The company has $150,000 worth of retained earnings and paid-in capital is based on common stock only. They declare to pay a dividend of $0.20 per share on 1,000,000 shares outstanding on the 31st of the same month. What entries will the bookkeeper of company Z will record when the company declares a dividend and when the liquidating dividend is actually paid out?
- At Declaration Date: Company Z has to pay a $200,000 ($0.20*1,000,000) liquation dividend to its shareholders. Out of which $150,000 will be paid from the retained earnings account and the remaining $50,000 from the paid-in capital/common stock account. The bookkeeper will record this entry as:
- At Payment Date: When the company pays on 31st January 2022, the dividend payment will be debited and the account balance will become zero. At the same time, cash accounts will be credited against it.
As we discussed earlier, $0.20 is not wholly the liquidating dividend paid by company Z.
Rather, $0.15 is being paid as a regular dividend ($150,000 retained earnings/1,000,000 outstanding shares) while $0.05 is a liquidating dividend on each share.
EXAMPLE # 2: Mr. XYZ owner of ABC limited declared a $4 dividend on 1st March 2022 due to dissolving company operations. At that time, the company retained earnings were $300,000 while the paid-up capital was $2,000,000. The total number of outstanding shares is 200,000. How will the accountant pass the journal entry?
- At Declaration Date: First of all, the accountant will calculate the total amount to be paid as liquidating dividend i.e. $4*200,000 outstanding shares = $800,000. As discussed in the earlier example, to pay the Company ABC will first use money from the retained earnings i.e. 300,000, and the rest will be paid from the paid-up capital account worth $500,000 ($800,000-$300,000 = $500,000). At this point, the journal entry will look like the one below.
- At Payment Date: When the company pays, the dividend payment ($800,000) will be debited and the account balance will become zero. At the same time, cash accounts will be credited against it similar to the previous example.
What are the liquidation and regular dividends paid in this scenario? Let’s calculate! $300,000 retained earnings/200,000 number of shares outstanding = $1.5. Subtracting $1.5- $4 we will get $2.5. Hence, $2.5 is the regular dividend being paid by the company ABC while $$1.5 is the liquidating dividend.
IMPACT OF LIQUIDATING DIVIDENDS (IN CASH) ON THE FINANCIAL STATEMENT OF A COMPANY
When a company pays liquidating dividends in cash to its shareholders, it is not directly recorded as an expense on the profit and loss statement. Keeping in mind, that it does not affect the company’s net profit or net income.
But here a question arises: why is it not recorded as an expense if a company pays? The reason is the money is paid out from a reserve account i.e. retained earnings which works as a saving account where the company accumulates excess cash to use in the hour of need.
Retained earnings can be found in the equity section on the balance sheet. Hence, it is not a direct expense for the company.
However, liquidating dividends directly and significantly impacts the owner’s equity section on the balance sheet. It decreases the overall owner’s equity balance and the rest is adjusted in the paid-in capital account.