Dividends represent the distribution of resources to shareholders. Usually, these resources include cash or stock that a company pays from its profits. At the end of each accounting period, companies decide how much dividends to pay to their shareholders. Usually, this process occurs annually. In some cases, however, companies may also pay quarterly or ad-hoc dividends.
For investors, dividends represent a type of return they can get from a company’s shares. This return comes from a company’s profits or retained earnings. Most companies prefer to receive dividends through cash payments. Some companies also get share dividends. The accounting for cash dividends also differs from stock. In essence, the accounting process is the same. However, both cash and stock dividends are not similar.
What are Cash Dividends?
A cash dividend is a type of distribution from profits made from a company’s cash reserves. When a company makes profits, it may decide to distribute these profits among shareholders. The primary form of these distributions is cash dividends. For companies to pay these dividends, it is crucial to have a cash reserve to accommodate payments to shareholders.
Cash dividends relate to several factors. Usually, the higher the profits a company makes, the more dividends it will distribute among shareholders. Companies also have a retention ratio that dictates how much profits they will retain before making distributions. In the case of cash dividends, the company’s cash reserves will also play a crucial role in the payments.
Due to the accrual concept in accounting, the profits that companies make do not represent cash inflows. Therefore, the cash dividends that companies will make will not come directly from their profits. Usually, the cash and cash equivalent balances that companies have will impact these payments. Unlike stock dividends, companies cannot distribute these dividends from their equity reserves.
Overall, cash dividends are the distribution of profits from cash reserves. When companies distribute these dividends, they need cash reserves. Any shareholder that holds the company’s shares at the record date will get these dividends. Usually, companies make cash dividends through bank transfers or cash payments to shareholders.
What is the Difference Between Cash Dividends and Stock Dividends?
The primary difference between cash and stock dividends is the resources that companies use to pay them. When a company reports profits, it has the option to pay cash dividends or stock dividends. Usually, companies choose the former due to how common they are. In some cases, companies may also select to go with stock dividends.
Most shareholders prefer to receive cash dividends. Since these dividends come in monetary form, it gets transferred to the shareholder’s account directly. In the case of stocks, the transfer is also direct. However, shareholders do not receive cash. Instead, they obtain stocks. For shareholders who want the former, a sale transaction will be necessary. In other words, stock dividends are less liquid in comparison to cash dividends.
Companies usually choose to pay stock dividends when their cash reserves get depleted. When companies don’t have enough cash reserves, they may decide not to pay dividends at all. However, when they want to distribute dividends regardless, they must go with stock dividends. Usually, companies choose a ratio that dictates how many shares each shareholder will get depending on their existing holding.
In essence, both cash and stock dividends are the same. However, the cash dividends paid to shareholders deplete a company’s cash reserves. With stock, the same does not apply. Instead, it impacts its share reserves. Companies make stock dividends through the issuance of new shares. In some cases, it can also affect share price due to the additional share capital.
Overall, both cash and stock dividends represent a distribution of resources to a company’s shareholders. However, cash reserves are direct payments through its cash reserves. With stock dividends, the share capital and other reserve accounts get impacted. In most cases, cash dividends are a regular distribution of profits, while stock dividends are more ad hoc.
How to Account for Cash Dividends?
The accounting for cash dividends differs from stock dividends. There are several steps involved in this process. However, it is crucial to explain the overall procedure for dividends to understand the accounting treatment of cash dividends. This process begins when a company makes profits. For companies that make dividend payments, shareholders will expect to get paid after a profitable accounting period.
However, companies cannot distribute profits directly to shareholders. Usually, a company’s management team will decide how much dividends to retain and distribute to shareholders. There are several factors that will impact this decision. Usually, the company’s retention ratio will play a role in it. However, other factors such as cash reserves, historical dividends, shareholders’ expectations will also affect it.
Once the management makes a decision, they will present it to the board for approval. Once the board approves the amount, the company will announce the dividend payments. This announcement will also include other information. For example, it will consist of the record date, the dividend per share, the payment date, etc.
With the dividend announcement, the company will create an obligation to pay its shareholders. At this date, the company will recognize a liability for the total amount of the dividends it will pay. The accounting treatment for the announcement of dividends will be as follows.
This journal entry will include the total amount for the dividend payment. Usually, it will be a percentage of the total profits the company makes. This percentage will help calculate the amount which the company will distribute among shareholders. However, this accounting treatment only accounts for the announcement of dividends.
When a company actually pays the cash dividends, it will also create a journal entry. This payment gets made on the payment date announced along with the dividend. The accounting treatment for cash dividends at this point will include reversing the liability created before. Similarly, it will involve reducing the company’s cash reserves for the same amount.
Therefore, the journal entries for cash dividends payments will be as follows.
|Cash or Bank||X,XXX|
A company, ABC Co., generates profits of $100 million during an accounting period. The company’s management decides the shareholders will get 5% of these profits as dividends. ABC Co.’s board of directors approves this percentage for dividend distribution. After the approval, the accompany announces the dividends to the shareholders to be paid a month later. At the announcement date, the accounting treatment will be as follows.
|Retained Earnings ($100 million x 5%)||$5,000,000|
After a month, ABC Co. makes the dividend payments to shareholders. The company uses its bank balances to make this payment. Therefore, the accounting treatment for cash dividends payment will be as follows.
If ABC Co. made the same distribution as stock dividends, the accounting treatment would be different. In that case, ABC Co. would credit the share capital account instead of the bank account. This dividend distribution will also reduce the company’s retained earnings balance. However, it will not impact ABC Co.’s profits reported on the income statement.
Cash dividends are the distribution of a company’s profits through its cash reserves. It is the most common form of dividends that companies pay. Furthermore, it differs from stock dividends in several fundamental regards.
The accounting treatment for cash dividends is straightforward. There are two stages for this treatment. First, companies record a liability at the announcement. Next, it involves accounting for the payments made to shareholders.