WHY IS IT IMPORTANT?
When a company is successful, its leaders may decide to pay out dividends to shareholders, so it’s important to account for these dividends in official records. Stakeholders may request to examine financial records, or regulatory bodies may require them. Proper accounting for dividends ensures that a company’s books remain complete and balanced.
What is a dividend?
A dividend is a method for a company to share its profits with its stakeholders. A company that consistently pays out valuable dividends is appealing for investors, so many companies prioritize meeting their dividend goals consistently in order to keep company valuations high. The most common types of dividends are:
- Cash: The most basic form of dividend payment, a cash dividend allows a company to pay out a portion of the company’s profits to stakeholders directly.
- Stock: The other common dividend option is a stock dividend, in which shareholders receive additional shares in the company. Just as dividends are an indicator of a healthy company, stock dividends often raise the company’s overall valuation. However, they result in a drop in the per-share cost as they increase the total shares that value is divided into.
- Assets: Although implemented less often, a company may elect to reward shareholders with assets as a dividend during a successful period for the company.
- Dividend reinvestment program (DRIP): When a company offers shareholders a DRIP, the company provides an opportunity to reinvest a cash dividend by purchasing additional shares of stock currently owned by the company
How do dividends work?
When paying out dividends to shareholders, companies usually allocate rewards proportionally relative to the number of shares owned. There are, however, multiple situations where a business gives out dividends that change the exact allocation, including:
- Common: A common dividend is when a company pays out proportional dividends to all shareholders. Companies frequently pay common dividends on a regular schedule, such as quarterly or annually, to increase their appeal to shareholders.
- Preferred: When a company does not wish to allocate dividends to all shareholders or cannot do so, they may opt for a preferred dividend. Only shareholders who own preferred shares in the company receive the benefits of a preferred dividend, resulting in smaller outlay by the company to cover the dividends.
- Special: In addition to regularly scheduled dividend payments, a company may elect to make a one-time dividend allocation known as special dividends as a result of an exceedingly successful event or period that generates significant value for the company.
How do dividends affect the balance sheet?
When recording dividends on a balance sheet, the type of dividend paid out affects how you note it, as cash dividends and stock dividends look different in financial records. Below are the ways cash dividends and stock dividends can affect a balance sheet:
Cash dividends on the balance sheet
When providing cash dividends, a company goes through two phases that each affect the balance sheet in different ways. From the point that a company declares dividends, they record it in the books as a liability on the balance sheet. This liability remains on the books only until they pay the dividend, at which point they reverse the liability record. This means that an investor examining records after payment sees no entry for the payments.
After a company makes payments to clients, a company must record the dividends in both retained earnings and cash balance. Paying dividends both reduces the cash on hand for the company and makes use of retained earnings, so accountants debit both books equal to the total cost of the dividends.
Stock dividends on the balance sheet
A company may prefer a stock dividend when it is low on cash reserves or when seeking to reduce the share cost of the company in order to improve the price to earning (P/E) ratio of the company. A stock dividend that increases total shares by less than 25% is considered a small dividend, while larger dividend percentages are commonly referred to as a stock split.
Accountants multiply the dividend percentage by the cost per share. They subtract the resulting value from the company’s retained earnings records and add it as a credit to the common stock account.
Why is it important to understand accounting for dividends?
It’s critical for a company to maintain accurate and balanced financial records. Accurate records ensure that all value in a company is accounted for so that decision makers within your company can act on updated information.
Outside entities, such as a regulatory body or a company that is considering purchasing your company or entering a partnership agreement, may also request financial information. Keeping accurate records allows all parties to have a full understanding of your company’s finances to avoid unnecessary complications such as a government audit.
How to account for dividends
If your company has paid dividends out to stockholders, it’s important to note them in your books accurately. Here is how to record a cash dividend in your accounting records:
1. Decide on a dividend plan
Whether your company is making a regular dividend payment as part of a scheduled set or offering a special dividend to stockholders, it’s important to choose a dividend amount that can be safely managed within your current finances. Common elements to consider when deciding on the size of a dividend include:
- Profitability: The primary concern before paying any dividends is the profitability of the company. In order to pay out dividends responsibly, a company should be profitable and in possession of on-hand cash to cover the costs of the dividends.
- Expectations: The stockholders for a company may have invested in the company because of a track record of dividends or projections for strong dividend performance. In these situations, a company may opt for larger dividend payments to meet the expectations of stockholders and keep interest in stock high to maintain its value.
- Previous dividends: Many investors view consistently improving dividend payments by a company as a strong indicator of company strength, while decreasing dividend sizes may be seen as a warning sign. In order to project a stronger image, a company may seek to make a round of dividends larger than the prior rounds.
- Future dividends: While previous performance can encourage a company to increase the size of a dividend payment, it is important to consider the next round of dividends as well. A smaller increase that the company can improve on again in the next round is preferable to a large dividend that is not sustainable and leads to a dividend reduction in the future.
- Other uses: Paying out dividends is just one use for a company’s cash on hand. A company may also elect to reinvest the money into the company in areas such as advertising, payroll expansion or acquiring new equipment. This allows the company to increase performance and generate additional profits in the future, and should be balanced against the potential benefits of paying dividends.
2. Receive board approval
In order to pay out dividends, the company’s board has to approve of the payments. Board members assess the finances of the company and the proposed dividends before holding a vote. If the board approves of the dividends, they set both a record date and a payment date. In order to be eligible to receive a dividend payment, a stockholder must be an owner on the record date, which means if an owner sells shares between the record date and payment date, the original owner receives the dividend, not the purchaser.
3. Record the dividend as a liability
As soon as a dividend payment is declared, list it as a liability on the company’s financial records in the dividend payable account. After the board approves a proposed dividend payment and sets a payment date, calculate the total cost of the dividend by multiplying the amount being paid per share by the total shares being paid out.
4. Distribute dividends
Make payments to all shareholders who owned qualifying stock on the payment date ratified by the company board. After making payments, update the dividend payable account by removing the liability from the records to show that you have settled the dividend.
5. Record deductions
With the liability removed from your books, you need to make a permanent record of the dividends. Record the cost of dividend payments equal to the liability calculation in both the company’s cash reserves in your asset records and your retained earnings in equity records.
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