Accounting for Dividends

CFA Level 1 - Financial Statements

Dividends
Dividends are payments to stockholders that can be made regularly (monthly, quarterly or annually) or occasionally.

• Companies are not required to issue a dividend to their common stockholders.
• Companies may have an obligation to issue a dividend to preferred shareholders (see definition and properties of preferred shareholders).
• A company's board of directors must approve of a dividend before it can be declared and issued.

There are two basic dividend forms:

1. Cash dividends - These are cash payments made to stockholders of record. Retained earnings are reduced when dividends are declared.
2. Stock dividends - These are dividends paid in the form of additional stock of the issuing company to shareholders of record in proportion to their current holdings. A stock dividend does not increase the wealth of the recipient nor does it reduce the net assets of the firm. It is a permanent capitalization of retained earnings to contributed capital.

Dividend Terminology

• Date of Declaration: This is the date the board approved and declared a dividend.
• Date of record: This is thedate set by the issuer that determines who is eligible to receive a declared dividend or capital-gains distribution.
• Ex-dividend date: This is the first day of trading when the selling shareholder is entitled to the recently announced dividend payment. Shares purchased as of the ex-dividend date will not receive the previously declared dividend.
• Date of payment: This is the date on which the company will pay the declared dividend to its stockholders of record as of the date of record.

Accounting for a Cash Dividend
Let's examine the payment process of a cash dividend. We'll use XYZ company again for this example.
XYZ declares a dividend on Jan 1, 2005, for its common shareholders of $400,000 payable to shareholders of record on Feb 1, 2005, and payable on Feb 31, 2005.
Accounting Impact on the Date of Declaration, Jan 1, 2005:

Accounting Impact on the Date of Payment, Feb 31, 2005:

Stock Dividends
Stock dividends involve the issuance of additional shares of stock to existing shareholders on a proportional basis. Stock dividends are issued to stockholders of record as of the record date. The dividends are not paid in cash but are paid as additional shares.Since a company does not pay out any cash when it declares a stock dividend, the company's cash account (current assets) is not affected. The only account that is affected is the company's contributed capital (paid-up capital). When a company issues a stock dividend, the company's retained earnings are reduced by the value of the stock dividend, and the company will increase its common stock and paid-up capital accounts.

Note that the size of the dividend declared is important. If the company declares a 25% or less stock dividend (as a percentage of the company's previous total outstanding shares) then the value of the stock dividend declared is equal to the market value of the shares issued. (Common shares are increased to reflect value of dividend.) If the stock dividend is larger than 25%, the company will transfer 100% of the par or stated value of the common shares to the common-stock account.
Examples:
Stock dividends are best learned by considering an example of a situation where the stock dividend is 25% or less of previously outstanding shares, and where the stock dividend is 25% or more of the previously outstanding shares.

Situation 1: Twenty-five percent or less of previous outstanding shares
XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, one share for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10 and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 20 additional shares for a total of 120. Furthermore, the company will issue 400,000 additional stocks to stockholders. After the dividend is issued, the company will have 20% more shares outstanding.

Accounting impact on date of declaration:



Accounting impact on date of issuance:


Situation 2: More than 25% of previous outstanding shares.
XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, three shares for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10 and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 60 additional shares for a total of 160. Furthermore, the company will issue 1.2 million additional stocks to stockholders. After the dividend is issued, the company will have 60% more shares outstanding.

Accounting impact on date of declaration:


Accounting impact on date of issuance:

Look Out! The most common mistake students make in this section is that they forget to calculate if the stock dividend is less than or higher than 25% of the shares outstanding and the reporting effect it will have.

Stock Split
Stock splits are events that increase the number of shares outstanding and reduce the par or stated value per share of the company's stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. This will double the number of shares outstanding and reduce by half the par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares (i.e. a shareholder owning 2,000 shares out of 100,000 would then own 4,000 shares out of 200,000).

Most importantly, the total par value of shares outstanding is not affected by a stock split (i.e. the number of shares times par value per share does not change). Therefore, no journal entry is needed to account for a stock split. A memorandum notation in the accounting records indicates the decreased par value and increased number of shares.

Stocks that are trading on the exchange will normally be re-priced in accordance to the stock split. For example, if XYZ stock was trading at $90 and the company did a 3-for-1 stock split, the stock would open at $30 a share.Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (regular lot = 100 shares).

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