What Are Dividends?
A dividend is a method of redistributing a company's profits to shareholders as a reward for their investment. Companies are not required to issue dividends on common shares of stock, though many pride themselves on paying consistent or constantly increasing dividends each year. When a company issues a dividend to its shareholders, the dividend can be paid either in cash or by issuing additional shares of stock. The two types of dividends affect a company's balance sheet in different ways.
- Companies issue dividends to reward shareholders for their investment.
- Dividends paid can be in the form of cash or additional shares called stock dividends.
- Cash dividends affect the cash and shareholder equity on the balance sheet; retained earnings and cash are reduced by the total value of the dividend.
- Stock dividends have no impact on the cash position of a company and only impact the shareholders equity section of the balance sheet.
When most people think of dividends, they think of cash dividends. However, companies can also issue stock dividends. When a company issues a stock dividend, it distributes additional quantities of stock to existing shareholders according to the number of shares they already own. Dividends impact the shareholders' equity section of the corporate balance sheet—the retained earnings, in particular.
Retained Earnings on the Balance Sheet
Retained earnings are the amount of money a company has left over after all of its obligations have been paid. Retained earnings are typically used for reinvesting in the company, paying dividends, or paying down debt. While net profit is the amount of income that remains after accounting for the cost of doing business in a given period, retained earnings are the amount of income accrued over the years that has not been reinvested in the business or distributed to shareholders.
Cash Dividends on the Balance Sheet
Cash dividends affect two areas on the balance sheet: the cash and shareholders' equity accounts. Investors will not find a separate balance sheet account for dividends that have been paid. However, after the dividend declaration and before the actual payment, the company records a liability to its shareholders in the dividend payable account.
After the dividends are paid, the dividend payable is reversed and is no longer present on the liability side of the balance sheet. When the dividends are paid, the effect on the balance sheet is a decrease in the company's retained earnings and its cash balance. In other words, retained earnings and cash are reduced by the total value of the dividend.
By the time a company's financial statements have been released, the dividend is already paid, and the decrease in retained earnings and cash are already recorded. In other words, investors will not see the liability account entries in the dividend payable account.
For example, assume a company has $1 million in retained earnings and issues a 50-cent dividend on all 500,000 outstanding shares. The total value of the dividend is $0.50 x 500,000, or $250,000, to be paid to shareholders. As a result, both cash and retained earnings are reduced by $250,000 leaving $750,000 remaining in retained earnings.
The ultimate effect of cash dividends on the company's balance sheet is a reduction in cash for $250,000 on the asset side, and a reduction in retained earnings for $250,000 on the equity side.
Stock Dividends on the Balance Sheet
While cash dividends have a straightforward effect on the balance sheet, the issuance of stock dividends is slightly more complicated. A company's executive management might want to issue stock dividends to its shareholders if the company lacks excess cash on hand or if they want to decrease the value of existing shares, driving down the price-to-earnings ratio (P/E ratio) and other financial metrics. Stock dividends are sometimes referred to as bonus shares or a bonus issue.
Stock dividends have no impact on the cash position of a company and only impact the shareholders' equity section of the balance sheet. If the number of shares outstanding is increased by less than 20% to 25%, the stock dividend is considered to be small. A large dividend is when the stock dividend impacts the share price significantly and is typically an increase in shares outstanding by more than 20% to 25%. A large dividend can often be considered a stock split.
When a stock dividend is declared, the total amount to be debited from retained earnings is calculated by multiplying the current market price per share by the dividend percentage and by the number of shares outstanding. If a company pays stock dividends, the dividends reduce the company's retained earnings and increase the common stock account. Stock dividends do not result in asset changes to the balance sheet but rather affect only the equity side by reallocating part of the retained earnings to the common stock account.
For example, say a company has 100,000 shares outstanding and wants to issue a 10% dividend in the form of stock. If each share is currently worth $20 on the market, the total value of the dividend would equal $200,000. The two entries would include a $200,000 debit to retained earnings and a $200,000 credit to the common stock account. The balance sheet would be balanced following the entries.