Companies need finance to operate and continue their business. This finance comes from various sources. Usually, companies also offer a return to those who provide funds.
These returns may differ based on several factors. Sometimes, it may be direct, while others are indirect. Either way, companies use these returns to attract more customers and make investments favorable.
The primary income source for most investors includes returns provided by companies directly. Some companies may also offer indirect returns.
Usually, these returns come through capital gains on the underlying security. For example, share prices may appreciate, causing higher returns when the investor sells it.
However, companies also offer direct returns on their underlying securities. While these returns are prevalent, they are not guaranteed.
The primary source of direct returns for companies includes dividends and interest payments. The former comes with equity instruments, while the latter accompanies debt.
Usually, companies provide these to different investors. Interest paid on debt instruments goes on the income statement. However, the same may not apply to dividends. Before discussing that, though, it is crucial to understand dividends.
What Are Dividends?
Dividends represent the distribution of profits or earnings among shareholders. Usually, companies pay these in cash or through stock. Dividends are prevalent for established companies.
As mentioned above, this income source represents the primary earnings investors receive from those companies. However, distributing profits in startups and small companies may not be as common.
For most companies, dividends represent an attraction to gathering new investors. This income provides a stable return to investors.
Usually, investors that want regular and consistent income prefer to invest in companies that pay dividends. While these dividends may differ from time to time, companies keep them constant in most cases. For some companies, these dividends also grow over time. This feature provides further incentives to investors.
Dividends apply to private and public companies. For other business structures, owners can withdraw profits through drawings. The process involves the owner taking resources from the business directly. However, the same does not apply to companies.
Since companies represent separate legal entities, they must follow a specific process to distribute profits. This process is not as straightforward.
The dividend distribution process begins with companies making a profit. Once companies generate income, they must choose whether to distribute it to investors.
Usually, this involves a meeting where companies also decide the percentage of profits for dividends. It occurs through the annual general meeting after presenting the financial statements. Once companies decide on the amounts, they will declare the dividends.
Subsequently, companies will distribute the declared amount among shareholders. This process can take some time and will require approval from the board.
Some companies pay dividends quarterly, while others focus on annual or monthly distributions. On top of that, companies may also pay special dividends, which are irregular. Nonetheless, these represent a crucial income source for most investors.
Do Dividends Go on the Income Statement?
As mentioned, dividends are a profit distribution among shareholders. According to this definition, dividends must reduce a company’s earnings.
Therefore, it must be a part of the income statement as it impacts profits. However, that is not the case. Dividends do not go on the income statement at all. Instead, it affects the other financial statements.
Before understanding why dividends don’t go on the income statement, one must study its elements. The income statement reports three components, revenues, expenses, and profits.
Usually, these generate from a company’s operations over time. Since dividends depend on profits, most people believe they should also be a part of the income statement.
The first element of the income statement is revenues. They represent the income that companies generate from their operations.
In accounting, revenues are inflows of economic benefits during a period. Since dividends do not represent earnings or income, they cannot classify as revenues.
Therefore, they do not meet the requirement to categorize in this class. Consequently, they can’t go on the income statement.
Expenses are the opposite of income or revenues. They represent outflows of economic benefits in an accounting period. Outside accounting, expenses are necessary spending to generate revenues.
While dividends are outflows of economic benefits, they do not help increase sales. On top of that, they do not relate to a company’s operations. Therefore, dividends cannot classify as expenses either.
Lastly, dividends are not profits or losses either. While they represent a distribution of company earnings, they do not go on the income statement.
The primary reason for it is apparent in the above two points. Companies calculate profits on the income statement through revenues and expenses. Since dividends do not constitute any of those, they do not go on the income statement.
Do Dividends Go on the other Financial Statements?
Apart from the income statement, companies also prepare three other financial statements. These include the balance sheet, cash flow statement, and statement of changes in equity. These statements are crucial in accurately presenting a company’s finances. Dividends impact all the other financial statements, although they may not affect the income statement.
As mentioned above, dividends must meet the definition of the items that go on each statement. For the income statement, they are not income or expense. Therefore, it does not go against that statement.
For others, dividends may fall under those definitions. On top of that, they can also indirectly impact one of those financial statements. However, they still depend on the profits that a company makes.
An explanation of how dividends impact the other financial statements is below.
Balance Sheet
Most people think that dividends go on the income statement. However, they don’t. However, dividends don’t become a part of the balance sheet either.
At least they don’t go on the statement directly. Dividends impact retained earnings, which are a part of the balance sheet. However, investors cannot calculate the distribution by using that figure.
Dividends do not meet the definition of assets, liability, or equity. However, they are a contra equity account, which reduces retained earnings.
These earnings increase when companies profit and decrease from losses. On top of that, dividends also adversely impact the retained earnings balance on the balance sheet. However, this impact is indirect. Therefore, the dividend does not go on the balance sheet.
Cash Flow Statement
The cash flow statement includes cash inflows and outflows during an accounting period. This statement focuses on presenting movements in cash and cash equivalent balances.
Dividends impact the statement of cash flows directly. However, this impact only applies when companies pay cash dividends. Stock dividends don’t go on the cash flow statement.
Dividends go on the financing activities section in the cash flow statement. These represent a cash outflow toward a company’s financing needs.
Usually, dividends for one period end up on the cash flow statement for the next. This feature depends on when companies declare dividends and pay them off to investors. Nonetheless, the cash flow statement is a report that dividends impact directly.
Statement of Changes in Equity
Dividends also become a part of the statement of changes in equity. This statement focuses on presenting movements in various equity balances that companies have.
Usually, it includes all items reported in the balance sheet under shareholders’ equity. As a part of these, the statement of changes in equity also shows movements in retained earnings.
The statement of changes in equity includes profits and losses that impact retained earnings. On top of that, it also reports the dividends for the period, which decreases the balance.
In this case, the impact is also direct, like the cash flow statement. The statement of changes in equity also reports on stock dividends as a movement in share capital.
Conclusion
Dividends represent the distribution of profits among shareholders. Companies use these to pay investors for their finances. Usually, companies can use both cash and stock dividends.
While these distributions are outflows of economic benefits, they do not go on the income statement. Dividends impact the other financial statements, sometimes indirectly.
