Dividends are distributions of earnings by a corporation to its stockholders. Usually the corporation pays dividends in cash, but it may distribute additional shares of the corporation’s own capital stock as dividends. Occasionally, a company pays dividends in merchandise or other assets. Since dividends are the means whereby the owners of a corporation share in its earnings, accountants charge them against retained earnings. Dividends are always based on shares outstanding!
Before dividends can be paid, the board of directors must declare them so they can be recorded in the corporation’s minutes book. Three dividend dates are significant:
- Date of declaration. The date of declaration indicates when the board of directors approved a motion declaring that dividends should be paid. The board action creates the liability for dividends payable (or stock dividends distributable for stock dividends).
- Date of record. The board of directors establishes the date of record; it determines which stockholders receive dividends. The corporation’s records (the stockholders’ ledger) determine its stockholders as of the date of record.
- Date of payment. The date of payment indicates when the corporation will pay dividends to the stockholders.
To illustrate how these three dates relate to an actual situation, assume the board of directors of the Allen Corporation declared a cash dividend on May 5, (date of declaration). The cash dividend declared is $1.25 per share to stockholders of record on July 1, (date of record), payable on July 10, (date of payment). Because financial transactions occur on both the date of declaration (a liability is incurred) and on the date of payment (cash is paid), journal entries record the transactions on both of these dates. No journal entry is required on the date of record. The Dividends Payable account appears as a current liability on the balance sheet.
Cash dividends are cash distributions of accumulated earnings by a corporation to its stockholders. To illustrate the entries for cash dividends, consider the following example. On January 21, a corporation’s board of directors declared a 2% cash dividend on $100,000 of outstanding common stock. The dividend will be paid on March 1, to stockholders of record on February 5. An entry is not needed on the date of record; however, the entries at the declaration and payment dates are as follows:
|Jan 21||Retained earnings ($100,000 x 2% dividend)||2,000|
|Declared 2% cash dividend to payable Mar 1 to shareholders of record Feb 5.|
|Mar 1||Dividends payable||2,000|
|Paid the dividend declared on January 21.|
Often a cash dividend is stated as so many dollars per share. For instance, the dividend could have been stated as $2 per share. When they declare a cash dividend, some companies debit a Dividends account instead of Retained Earnings. (Both methods are acceptable.) The Dividends account is then closed to Retained Earnings at the end of the fiscal year.
A company that lacks sufficient cash for a cash dividend may declare a stock dividend to satisfy its shareholders. Note that in the long run it may be more beneficial to the company and the shareholders to reinvest the capital in the business rather than paying a cash dividend. If so, the company would be more profitable and the shareholders would be rewarded with a higher stock price in the future.
Preferred Stock Dividends
Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to preferred stockholders as a return for the use of their money. For no-par preferred stock, the dividend is a specific dollar amount per share per year, such as $4.40 per share. For par value preferred stock, the dividend is usually stated as a percentage of the par value, such as 8% of par value; occasionally, it is a specific dollar amount per share. Most preferred stock has a par value. The formula for calculating ANNUAL preferred dividends is:
Preferred shares outstanding x preferred par value x dividend rate
Usually, stockholders receive dividends on preferred stock quarterly. Such dividends—in full or in part—must be declared by the board of directors before paid. In some states, corporations can declare preferred stock dividends only if they have retained earnings (income that has been retained in the business) at least equal to the dividend declared.
Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.
Cumulative preferred stock is preferred stock for which the right to receive a basic dividend accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock.
For example, assume a company has 10,00 shares of cumulative $10 par value, 10% preferred stock outstanding, common stock outstanding of $200,000, and retained earnings of $30,000. The company did not pay dividends last year. The company would pay the preferred stockholders dividends of $20,000 (10,000 shares preferred stock x $10 par value x 10% dividend rate = $10,000 per year x 2 years) before paying any dividends to the common stockholders. If the board declares dividends of $25,000, $20,000 would be paid to preferred and the remaining $5,000 ($25,0000 dividends – $20,000 paid to preferred) would be shared by common stockholders. Common stockholders are not guaranteed dividends and will receie only the amount left over after paying preferred stock holders. Keep in mind, you can never pay out more in dividends than you have declared!
Dividends in arrears are cumulative unpaid dividends, including the dividends not declared for the current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability until declared by the board of directors. However, since the amount of dividends in arrears may influence the decisions of users of a corporation’s financial statements, firms disclose such dividends in a footnote. An appropriate footnote might read: “Dividends in the amount of $20,000, representing two years’ dividends on the company’s 10%, cumulative preferred stock, were in arrears as of December 31″.
The board of directors of a corporation possesses sole power to declare dividends. The legality of a dividend generally depends on the amount of retained earnings available for dividends—not on the net income of any one period. Firms can pay dividends in periods in which they incurred losses, provided retained earnings and the cash position justify the dividend. And in some states, companies can declare dividends from current earnings despite an accumulated deficit. The financial advisability of declaring a dividend depends on the cash position of the corporation.