Accounting: The Language of Business (Part 78)

The future of any corporation is as good as the value system of the leaders and followers in the organization.

N. R. Narayana Murthy

Corporations: Organization, Capital Stock Transactions, and Dividends (Part F)

by

Charles Lamson

Accounting for Dividends

When a board of directors declares a cash dividend, it authorizes the distribution of a portion of the corporation's cash to stockholders. When a board of directors declares a stock dividend, it authorizes the distribution of a portion of its stock. In both cases, the declaration of a dividend reduces the retained earnings of the corporation.

Cash Dividends

A cash distribution of earnings by a corporation to shareholders is called a cash dividend. Although dividends may be paid in the form of other assets, cash dividends are the most common form.

There are usually three conditions that a corporation must meet to pay a cash dividend:

1. Sufficient Retained Earnings

2. Sufficient Cash

3. Formal action by the board of directors

A large amount of retained earnings does not always mean that a corporation is able to pay dividends. The balances of the cash and retained earnings accounts are often unrelated. Thus, a large retained earnings account does not mean that there is cash available to pay dividends.

A corporation's board of directors is not required by law to declare dividends. This is true even if both retained earnings and cash are large enough to justify a dividend. However, many corporations try to maintain a stable dividend record in order to make their stock attractive to investors. Although dividends may be paid once a year or semi-annually, most corporations pay dividends quarterly. In years of high profits, a corporation may declare a special or extra dividend.

You may have seen announcements of dividend declarations in financial newspapers or investor services. An example of such an announcement is shown below.

On June 26, the board of directors of Campbell Soup Co. declared a quarterly cash dividend of $0.225 per common share to stockholders of record as of the close of business on July 8, payable on July 31.

This announcement includes three important dates: the date of declaration; (June 26), the date of record (July 8), and the date of payment (July 31). During the period of time between the record date and the payment date, the stock price is usually quoted as selling ex-dividends. This means that since the date of record has passed, a new investor will not receive the dividend.

To illustrate, assume that on December 1 the board of directors of Hiber Corporation declares the following quarterly cash dividends. The date of record is December 10, and the date of payment is January 2.

Hiber Corporation records the $42,500 liability for the dividends on December 1, the declaration date, as follows:

No entry is required on the date of record, December 10, since this date merely determines which stockholders will receive the dividend. On the date of payment, January 2, the corporation records the $42,500 payment of the dividends as follows:

If Hiber Corporation's fiscal year ends December 31, the balance in Cash Dividends will be transferred to Retained Earnings as a part of the closing process by debiting Retained Earnings and crediting Cash Dividends. Cash Dividends Payable will be listed on the December 31 balance sheet as a current liability.

If a corporation that holds treasury stock declares a cash dividend, the dividends are not paid on the treasury shares. To do so would place the corporation in the position of earning income through dealing with itself. For example, if Hiber Corporation in the preceding illustration had held 5,000 shares of its own common stock, the cash dividends on the common stock would have been $28,500 [(100,000 - 5000) * $0.30] instead of $30,000.

Stock Dividends

The distribution of shares of stock to stockholders is called a stock dividend. Usually, such distributions are in common stock and are issued to holders of common stock. Stock dividends are different from cash dividends in that there is no distribution of cash or other assets to stockholders.

The effect of a stock dividend on the stockholders' equity of the issuing corporation is to transfer retained earnings to paid-in capital. For public corporations, the amount transferred from retained earnings to paid-in capital is normally the fair value (market price) of the shares issued in the stock dividend. To illustrate, assume that the stockholders' equity accounts of Hendrix Corporation as of December 15 are as follows:

On December 15, the board of directors declares a stock dividend of 5% or 100,000 shares (2 million shares * 5 %) to be issued on January 10 to stockholders of record on December 31. The market price of the stock on the declaration date is $31 a share. The entry to record the declaration is as follows:

The $3,100,000 balance in Stock Dividends is closed to Retained Earnings on December 31. The stock dividends distributable account is listed in the Paid-in Capital section of the balance sheet. Thus, the effect of the stock dividend is to transfer $3,100,000 of retained earnings to paid-in capital.

On January 10, the number of shares outstanding is increased by 100,000 by the following entry to record the issue of the stock:

A stock dividend does not change the assets, liabilities, or stockholders equity of the corporation. Likewise, it does not change a stockholder's proportionate interest (equity) in the corporation. For example, if a stockholder owned 1,000 of a corporation's 10,000 shares outstanding, the stockholder owns 10% (1,000 / 10,000) of the corporation. After declaring a 6% stock dividend, the corporation will issue 600 additional shares (10,000 shares x 6%), and the total shares outstanding will be 10,600. The stockholder of 1,000 shares will receive 60 additional shares and will now own 1,060 shares, which is still a 10% equity interest. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 493-495*

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