Cash dividends are declared by the board of directors and paid to the stockholders or shareholders of the company.
It is the distribution of a part of the company’s retained earnings for the year. The journal entry passed when the cash dividend is declared by the board of directors is as follows:
Retained earnings DR xx
Dividend payable CR xx
When this dividend is paid for, the current liabilities and current assets decrease as well and the following journal entry is passed:
Dividend payable DR xx
Cash CR xx
There are two types of dividends. The dividends paid for the ordinary stock and the dividends paid to the preference shareholders. We will discuss them separately.
All the journal entries passed throughout the year are converted into a trial balance at the yearend which is then transformed into four neat and precise statements also known as the financial statements.
These reports portray the financial information of the business and are made in simplicity for the readers to be able to understand easily. The four financial statements are commonly known as follows:
- Statement of comprehensive income
- Statement of financial position
- Statement of cash flow
- Statement of changes in equity
Impact on the income statement:
A divided expense is reported as an operating expense and reduces the profitability of the business when it is a preference dividend.
A preference dividend is classified as a revenue expenditure whereas the profit after tax is the distribution to shareholders.
It is the leftover profit of the company distributed to the ordinary shareholders only.
Impact on the balance sheet:
A preference dividend is initially booked as an expense against a current liability of dividend payable. It is an expense that will be paid for within the following 12 months hence is a current liability.
A dividend payable is reported as a current liability under the liabilities section of the statement of financial position.
However, when the dividend is paid for, the current assets section is reduced due to an outflow of cash.
Impact on the cash flow statement:
A cash flow statement only exhibits cash transactions. Any non-cash transactions are eliminated.
This is so because the cash flow statements are prepared to understand the liquidity of the company. Being liquid is not equivalent to being profitable.
Liquidity is the ability to spend cash and the cash flow statements present all the cash inflow and outflow amounts. The cash flow statement is prepared in a specific format instructed by IAS 7.
The transactions/activities must be reported under three heads in the following order:
- Operating activities
- Investing activities
- Financing activities
The dividend expense, whether to a preference shareholder or an ordinary shareholder, is deducted from the financing activities section of the cash flow statement.
Impact on the statement of changes in equity:
The statement of changes in equity is an elaborate report providing information about the equity of the company or business.
The equity includes ordinary shares, retained earnings, share premium, revaluation surplus etc.
Retained earnings is a reserve for the accumulation of profit after tax for all the years. Any dividend declared and paid to the shareholders is a reduction of retained earnings reserve.
At the end of the year profit after tax is added to the retained earning whereas dividend is subtracted from the retained earnings.