12.3 Cash dividends
8 min read•august 20, 2024
are a crucial aspect of corporate finance, representing distributions of profits to shareholders. They play a significant role in a company's financial strategy, impacting its balance sheet, cash flow, and shareholder relations.
Understanding cash dividends is essential for grasping how companies manage their earnings and return value to investors. This topic covers the declaration process, types of dividends, accounting treatments, and their effects on financial statements and shareholder wealth.
Declaration of cash dividends
- Cash dividends are distributions of cash to shareholders as a return on their investment in the company
- The declaration of cash dividends is an important event in the accounting cycle and has implications for financial reporting
Date of declaration
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- The date of declaration is the date on which the board of directors formally approves the payment of a cash dividend
- On this date, the company assumes a legal obligation to pay the dividend, which creates a liability on the balance sheet
- The date of declaration marks the beginning of the accounting process for cash dividends
Approval by board of directors
- Cash dividends must be approved by the company's board of directors before they can be declared and paid
- The board of directors has the authority to determine the amount, timing, and frequency of cash dividend payments
- Factors considered by the board when approving cash dividends include the company's financial performance, liquidity, and future growth prospects
Types of cash dividends
- There are several types of cash dividends that a company may declare and pay to its shareholders
- The type of dividend declared depends on the company's financial situation, dividend policy, and other factors
Regular cash dividends
- are paid on a consistent basis, typically quarterly or annually
- These dividends are usually a fixed amount per share and are considered part of the company's normal dividend policy
- Regular cash dividends provide a stable and predictable return to shareholders (Coca-Cola, Johnson & Johnson)
Special cash dividends
- are one-time or infrequent distributions of cash to shareholders
- These dividends are often declared when a company has excess cash or has realized significant gains from the sale of assets or investments
- Special cash dividends are separate from the company's regular dividend policy (Microsoft's $3 per share special dividend in 2004)
Liquidating dividends
- are distributions of cash that represent a return of the shareholder's investment rather than a distribution of earnings
- These dividends are typically paid when a company is winding down its operations or liquidating its assets
- Liquidating dividends reduce the company's paid-in capital and are not considered part of its normal dividend policy (Enron's liquidating dividends during its bankruptcy proceedings)
Accounting for cash dividends
- The accounting for cash dividends involves several key dates and journal entries
- Understanding these dates and entries is crucial for accurately recording and reporting cash dividends in the financial statements
Dividend dates
- There are three important dates in the accounting for cash dividends: the date of declaration, the date of record, and the date of payment
- These dates determine when the is recognized, who is entitled to receive the dividend, and when the payment is made
Date of record
- The date of record is the date on which a shareholder must be registered in the company's books to be eligible to receive the declared dividend
- Shareholders who own stock on the date of record will receive the dividend, even if they sell their shares before the
- The date of record is typically a few weeks after the date of declaration
Ex-dividend date
- The is usually set one business day before the date of record
- On the ex-dividend date, the stock price is adjusted downward by the amount of the declared dividend
- Investors who purchase shares on or after the ex-dividend date are not entitled to the upcoming dividend payment
Date of payment
- The date of payment is the date on which the company actually pays the declared dividend to eligible shareholders
- On this date, the company's cash balance is reduced, and the dividend liability is eliminated from the balance sheet
- The date of payment is typically a few weeks after the date of record
Journal entries for cash dividends
- The declaration and payment of cash dividends require specific journal entries to accurately record the transactions in the company's financial records
- These entries affect the company's , cash, and dividends payable accounts
At declaration date
- On the date of declaration, the company records a liability for the total amount of the declared dividend
- The journal entry includes a debit to Retained Earnings and a credit to Dividends Payable
- Example: If a company declares a $100,000 cash dividend, the entry would be:
Retained Earnings 100,000 Dividends Payable 100,000
At payment date
- On the date of payment, the company records the actual payment of the dividend to shareholders
- The journal entry includes a debit to Dividends Payable and a credit to Cash
- Using the previous example, the entry on the payment date would be:
Dividends Payable 100,000 Cash 100,000
Effect on financial statements
- The declaration and payment of cash dividends have a direct impact on a company's financial statements
- Understanding these effects is important for analyzing the company's financial position and performance
Retained earnings
- When a cash dividend is declared, the company's retained earnings are reduced by the total amount of the dividend
- This reduction in retained earnings represents a decrease in the company's accumulated profits and equity
- The declaration of cash dividends does not affect the company's net income, as dividends are not considered an expense
Cash
- On the date of payment, the company's cash balance is reduced by the total amount of the dividend paid to shareholders
- This reduction in cash represents an outflow of the company's liquid assets and may impact its liquidity ratios and cash flow statement
Dividends payable
- When a cash dividend is declared, a liability called dividends payable is created on the company's balance sheet
- This liability represents the company's obligation to pay the declared dividend to eligible shareholders on the date of payment
- On the payment date, the dividends payable liability is eliminated, and the cash balance is reduced accordingly
Disclosure requirements
- Companies are required to disclose information about their cash dividends in the financial statements and accompanying notes
- These disclosures provide stakeholders with important information about the company's dividend policy and any restrictions on dividend payments
Notes to financial statements
- In the notes to the financial statements, companies must disclose the amount of cash dividends declared and paid during the reporting period
- They must also disclose the per-share amount of dividends declared and any changes in the company's dividend policy
- Additional information, such as the dates of declaration, record, and payment, may also be disclosed in the notes
Restrictions on cash dividends
- Companies must disclose any restrictions on their ability to declare and pay cash dividends
- These restrictions may be imposed by loan covenants, contractual obligations, or legal requirements
- Examples of common restrictions include maintaining a minimum level of working capital or a maximum debt-to-equity ratio
Dividend policy considerations
- A company's dividend policy is influenced by various factors, including its financial performance, growth prospects, and shareholder expectations
- Understanding these considerations is important for evaluating a company's dividend decisions and their potential impact on shareholder value
Signaling effect
- Changes in a company's dividend policy can have a signaling effect on the market's perception of the company's future prospects
- Increasing dividends may signal management's confidence in the company's ability to generate stable or growing cash flows (Apple's initiation of a dividend in 2012)
- Conversely, cutting or suspending dividends may signal financial distress or a significant change in the company's growth strategy (General Electric's dividend cut in 2009)
Residual dividend policy
- Under a residual dividend policy, a company pays dividends only after it has satisfied its investment needs and working capital requirements
- This policy prioritizes the company's growth opportunities and financial stability over providing a consistent return to shareholders
- Companies with high growth potential or capital-intensive industries often adopt a residual dividend policy (Amazon, Alphabet)
Stability vs growth
- Companies must balance the desire to provide a stable and predictable return to shareholders with the need to retain earnings for growth and investment
- A stable dividend policy may attract income-oriented investors and provide a steady return, but it may limit the company's ability to pursue growth opportunities
- Conversely, a growth-oriented dividend policy may prioritize reinvesting earnings in the business at the expense of providing a consistent return to shareholders
Tax treatment of dividends
- The tax treatment of dividends can have a significant impact on the after-tax return realized by shareholders
- Understanding the differences between ordinary and and their tax implications is important for investors
Ordinary vs qualified dividends
- are taxed at the shareholder's ordinary income tax rate, which can be as high as 37% for high-income earners
- Qualified dividends, which meet certain holding period and other requirements, are taxed at a lower capital gains tax rate, which can be 0%, 15%, or 20%, depending on the shareholder's income level
- To be considered qualified, dividends must be paid by a U.S. corporation or a qualified foreign corporation and meet the holding period requirements (generally 60 days for common stock)
Shareholder tax implications
- The tax implications of dividends can vary depending on the shareholder's individual tax situation and the type of account in which the shares are held
- Dividends received in a taxable brokerage account are subject to taxation in the year they are received, while dividends received in a tax-advantaged account, such as a 401(k) or IRA, may be tax-deferred or tax-free
- Shareholders must consider the after-tax return of dividends when evaluating the total return of their investment and making decisions about their portfolio allocation
Cash dividends vs stock dividends
- In addition to cash dividends, companies may also distribute to their shareholders
- While both types of dividends provide a return to shareholders, there are important differences in their accounting treatment and impact on shareholder value
Differences in accounting treatment
- Cash dividends reduce the company's retained earnings and cash balance, while stock dividends transfer amounts from retained earnings to paid-in capital
- Stock dividends do not affect the company's assets or liabilities, as no cash is distributed
- The accounting for stock dividends involves a journal entry that debits Retained Earnings and credits Common Stock Dividend Distributable (for small stock dividends) or Common Stock and Paid-in Capital in Excess of Par (for large stock dividends)
Impact on shareholder value
- Cash dividends provide shareholders with a tangible return on their investment and can be used to meet immediate cash needs or reinvested in other opportunities
- Stock dividends increase the number of shares outstanding but do not directly provide shareholders with any additional value, as the market price per share is expected to adjust proportionally
- However, stock dividends may signal management's confidence in the company's future prospects and can make shares more affordable and liquid for investors (Apple's 4-for-1 stock split in 2020)
Key Terms to Review (19)
Cash dividends: Cash dividends are payments made by a corporation to its shareholders, typically as a distribution of profits. These dividends represent a return on investment for the shareholders and are usually paid in cash on a per-share basis. The timing and amount of cash dividends are determined by the company’s board of directors, reflecting its financial health and commitment to returning value to its investors.
Declaration date: The declaration date is the specific date on which a company's board of directors announces the intention to pay a dividend to shareholders. This date is crucial as it establishes the formal obligation of the company to distribute dividends, signaling to investors that they will receive payments for their shares. The declaration date sets into motion a series of events, including the determination of the record date and payment date, and influences investor perception and stock prices.
Declaration journal entry: A declaration journal entry is an accounting record made by a company to formally announce the decision to pay a dividend to its shareholders. This entry typically occurs on the date when the board of directors officially declares the dividend, establishing a liability for the company. The declaration journal entry reflects the company's commitment to distribute profits to its shareholders and impacts both the liabilities and retained earnings on the balance sheet.
Dividend coverage ratio: The dividend coverage ratio is a financial metric that measures a company's ability to pay dividends to its shareholders. It is calculated by dividing the company's net income by the total dividends paid out. This ratio helps investors understand whether a company is generating enough earnings to cover its dividend obligations, indicating financial health and sustainability of dividend payments.
Dividend liability: Dividend liability refers to the obligation of a corporation to pay dividends to its shareholders once they have been declared by the board of directors. This liability is recorded on the company's balance sheet as a current liability, reflecting the company's commitment to distribute profits to its shareholders after the declaration date. Understanding dividend liability is crucial because it impacts a company's cash flow and reflects its financial health and commitment to returning value to investors.
Dividend payout ratio: The dividend payout ratio is a financial metric that indicates the percentage of earnings a company pays to its shareholders in the form of dividends. This ratio helps assess how much profit is returned to investors compared to how much is retained in the business for growth and reinvestment. A higher payout ratio suggests that a company is returning more of its earnings to shareholders, while a lower ratio may indicate a focus on reinvesting in the business.
Dividend yield: Dividend yield is a financial ratio that indicates how much a company pays in dividends each year relative to its stock price, expressed as a percentage. It helps investors assess the return on investment from dividends alone, without considering capital gains. A higher dividend yield can attract income-focused investors and may indicate a stable company with consistent cash flows.
Ex-dividend date: The ex-dividend date is the date on which a stock begins trading without the value of its next dividend payment. This means that if you purchase the stock on or after this date, you will not receive the upcoming dividend, as it is only paid to shareholders who owned the stock before the ex-dividend date. Understanding this date is crucial for investors in making decisions related to cash dividends and stock dividends.
Liquidating dividends: Liquidating dividends are distributions of a corporation's assets to its shareholders that occur when the company is in the process of being dissolved or liquidated. Unlike regular cash dividends, which are paid out of retained earnings, liquidating dividends are typically drawn from the company's capital or paid-in surplus, reflecting a return of the shareholders' investment rather than profits.
Ordinary dividends: Ordinary dividends are the most common type of cash distributions paid to shareholders from a company's earnings. These payments typically represent a portion of the company’s profits that is distributed to shareholders as a return on their investment. Ordinary dividends are usually declared on a regular basis, such as quarterly or annually, and are subject to taxation at the individual shareholder's tax rate.
Payment date: The payment date is the specific date on which a company pays its declared cash dividends to shareholders. It is crucial because it marks the moment when shareholders officially receive their dividends, transforming their entitlement into actual cash. The timing of the payment date is important for both the company and the investors, as it affects cash flow management for the company and provides shareholders with a predictable income stream.
Payment journal entry: A payment journal entry is a record made in the accounting system that documents the payment of cash or cash equivalents to settle a liability. This entry typically includes details such as the date of the transaction, the amount paid, and the accounts affected. In the context of cash dividends, this entry is crucial as it reflects the distribution of profits to shareholders and helps track the company's obligations to its investors.
Qualified dividends: Qualified dividends are a specific type of dividend that meets certain criteria set by the IRS, allowing them to be taxed at a lower capital gains tax rate rather than the higher ordinary income tax rate. These dividends typically come from shares of domestic corporations or qualified foreign corporations, and they must be held for a specific period before distribution. This favorable tax treatment makes qualified dividends an attractive income source for investors.
Record date: The record date is a specific date established by a company to determine which shareholders are eligible to receive a dividend payment. This date is crucial because only those who are listed as shareholders on the company's records as of the record date will receive the declared dividends. Understanding this concept is essential for investors, as it affects their entitlement to dividends and their trading strategies leading up to this date.
Regular cash dividends: Regular cash dividends are payments made by a corporation to its shareholders, typically on a quarterly basis, as a way to distribute a portion of its profits. These dividends are a key feature of many companies' financial policies and serve as an indicator of financial health and profitability. Regular cash dividends are often seen as a sign of stability and confidence in the company’s ongoing performance.
Retained Earnings: Retained earnings refer to the accumulated profits that a company has reinvested in the business rather than distributed to shareholders as dividends. This figure plays a critical role in assessing a company's financial health and is an essential part of owners' equity, reflecting the company's ability to generate profit over time and its strategy for growth through reinvestment.
Shareholder Equity: Shareholder equity represents the residual interest in the assets of a corporation after deducting liabilities. It reflects the ownership value that shareholders have in a company and is a key indicator of its financial health. Shareholder equity comprises common stock, preferred stock, additional paid-in capital, retained earnings, and treasury stock. Understanding this term is essential when considering how companies finance their operations and distribute profits to shareholders.
Special cash dividends: Special cash dividends are one-time payments made by a corporation to its shareholders, distributing excess cash that is not expected to be repeated in the future. These dividends often occur when a company has significant profits or has sold an asset and wants to reward shareholders with additional cash. Unlike regular dividends, which are typically paid at consistent intervals, special cash dividends can vary significantly in amount and frequency, making them a unique financial event for investors.
Stock dividends: Stock dividends are payments made by a corporation to its shareholders in the form of additional shares instead of cash. This method allows companies to reward investors without depleting cash reserves, which can be especially important for businesses aiming to reinvest profits for growth while still providing value to shareholders.