Cash dividends are declared by the board of directors “BOD” and paid to the stockholders or shareholders of the company. The BOD normally approves to pay the cash dividend at an annual general meeting 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 board of directors declares the cash dividend is as follows:
Dr. Retained earnings XX
Cr. Dividend payable XX
These two accounts are part of the balance sheet. Retained earning is in the equity section. And dividend payable is in the liabilities account of the balance sheet. Dividend distribution does not affect the income statement.
When this dividend is paid for, the current liabilities and current assets, cash specifically, decrease as well, and the following journal entry is passed:
Dr. Dividend payable xx
Cr. Cash xx
There are two types of dividends. The dividends are paid for the ordinary stock, and the dividends are paid to the preferred 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 known as the financial statements.
These reports portray the business’s financial information and are made in simplicity for the readers 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 business’s profitability when it is a preference dividend. A preference dividend is classified as an item of revenue expenditure, whereas the profit after tax is distributed 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 cash outflow.
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 can 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 are 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 earnings whereas dividend is subtracted from the retained earnings.