The main source of finance for companies, especially small-size companies and startups, is equity finance. Equity finance consists of finance that companies raise through their shareholders. In exchange for the finance they provide, shareholders receive the shares of the company. The shares of a company give its shareholders the ownership of the company for the proportion of shares they hold. The ownership in a company can give them different rights, one of which includes the right to receive dividends and the right to the assets of the company, if it goes into liquidation.
In this article, we cover accounting for dividends and retained earnings. This includes the definition of dividend, dividend policies, and how to account for dividends and retained earnings.
Table of contents
- What is a Dividend?
- Why Does Company Need to Distribute Dividend?
- What is Dividend Policy, and What Are the Different Types of Dividend Policy?
- How Dividend is Calculated?
- How Dividend is Recorded and Presented in the Financial Statements
What is a Dividend?
Dividends represent the distribution of the company’s profits to a class of its shareholders. Usually, the board of directors approves a company’s dividends that it must pay to its shareholders. However, the shareholders of the company must also approve of the dividends before the company pays them. For the shareholders, dividends represent a type of reward, mostly in cash, that the company pays them for their investment.
Mostly, companies pay dividends to their shareholders annually, after the end of each accounting period. However, some companies also pay their shareholders quarterly, while some other pay dividends semi-annually. In some rare cases, companies may also pay dividends monthly. For shareholders to be eligible for payment at the time the company pays dividends, they must hold the shares of the company before the ex-dividend date.
There are many types of dividends that companies pay. Dividends paid in cash are the most common and also preferred by shareholders. However, some companies may also pay their shareholders in other forms such as stock. These types of dividends are not as common as cash dividends. However, they allow companies more flexibility in how they pay their shareholders.
In accounting terms, people often confuse dividends. Some people ask are dividends assets or liability? Some others ask, is a dividend an expense? However, they are none of the above. For accounting purposes, dividends are a reduction in the retained earnings or profits of a company. Or they can also be a reduction in the equity of a company.
Dividends are not assets as they are not a resource that a company owns or controls. They are neither liabilities as they aren’t an obligation to pay. Finally, dividends are not expenses either, as they are do not represent an outflow of economic benefits during a period and are also not a part of the Statement of Profit or Loss of a company.
Why Does Company Need to Distribute Dividend?
There are many reasons why a company needs to distribute dividends to its shareholders. First of all, shareholders need some form of return for their investment in a company. Without an expected return, there is no reward for shareholders. Therefore, to provide them with the return they expect from their investment, the company must pay a dividend to them. The company may also provide them with returns in the form of capital gains. However, most companies reward their shareholders through dividends.
Dividends are also crucial for potential investors and the market’s perception of a company. The ability of a company to pay dividends to its shareholders regularly helps develop a positive perception for its shares in the market. If a company cannot pay dividends regularly, it sends a negative signal regarding the company to the market. Therefore, dividends play a vital role in communicating the strength and sustainability of a company to its shareholders, potential investors, and the market.
Dividends are also an important source of income for most shareholders. Usually, there are two classes of shareholders. The first class of shareholders is those who look for dividend returns from their investments. The other class of shareholders is those who require capital gain returns from their investments. For dividend shareholders, dividends are vital in deciding where they want to invest. Similarly, for some dividend shareholders, dividends may be the only source of regular and reliable income. Therefore, companies need to distribute dividends to satisfy those shareholders.
What is Dividend Policy, and What Are the Different Types of Dividend Policy?
The dividend policy of a company defines the structure of its dividend payouts to shareholders. The dividend policy of a company is part of its strategy. Although companies are not obliged to pay their shareholders for their investments, they still choose to do so due to various reasons mentioned above. Therefore, companies regard dividend policy as an important part of their relationship with their shareholders. There are three main types of dividend policies that companies may adopt. These include constant, residual, and stable dividend policies, based on different theories.
Constant Dividend Policy
Companies adopt a constant dividend policy when they want to pay a percentage of their profits as dividends for every period. A constant dividend policy can have its advantages and disadvantages. First of all, this dividend policy allows shareholders to benefit from increasing profits of a company, thus, allowing them to earn higher in times of increasing profits. However, they may also be at a disadvantage as it also means they may earn lower or, sometimes, nothing when the profits of the company are declining. A constant dividend policy creates volatile returns for shareholders.
Residual Dividend Policy
Companies that adopt a residual dividend policy pay their shareholders a dividend from their remaining profits after paying for capital expenditures and working capital requirements. As with constant dividend policy, the residual dividend policy can create volatile returns for shareholders depending on the profits, capital expenditure, and working capital requirements of a company. However, investors are more likely to accept a residual dividend policy as it allows companies to use profits for future growth, which results in higher returns in the future for investors.
Stable Dividend Policy
Companies that adopt a stable dividend policy pay a fixed and predictable dividend to their shareholders after each dividend period. It is the most common policy among the types of dividends policies. Investors also prefer a stable policy for dividends as it is not volatile and can help them predict their returns. A stable dividend policy has the advantage of giving shareholders the same return without considering the profits of the company. However, it may end up negatively impacting a company that has had low profits or even losses.
How Dividend is Calculated?
Companies use many different methods to calculate the dividend they want to pay to their shareholders. These calculations depend on several factors such as the dividend policy of a company, its past dividend payouts, its dividend payout ratio, etc. Companies must also consider the requirements of its shareholders when calculating the dividends to pay out to their shareholders.
Shareholders or investors looking to calculate the dividend that a company has paid in the past can use different methods to calculate it. For example, they can calculate the dividends of a company through the changes in its retained earnings. They can also use specific ratios, such as the dividend payout ratio or dividend yield of a company to calculate its dividends.
How Dividend is Recorded and Presented in the Financial Statements
The dividends that a company pays out are recorded and presented in its financial statements in two different steps. The first step is when the board of directors of the company declares dividends and shareholders approve it. In this step, the company does not pay out dividends to its shareholders. However, due to the declaration of dividends, the company creates an obligation for itself to pay its shareholders. Therefore, the company must record this in its books.
To record the accounting for declared dividends and retained earnings, the company must debit its retained earnings. It is because dividends, as mentioned above, are a decrease in the retained earnings of a company. Therefore, a debit in retained earnings balance means it decreases. Similarly, the company must also create a liability for the amount of the declared dividend. This liability is a credit to an account named Dividends Payable. For example, if a company declares dividends of $10,000, the accounting treatment will be as follows.
Dr Retained Earnings $10,000
Cr Dividends Payable $10,000
The second step is when the company pays dividends to its shareholders. Assuming it pays dividends in the form of cash, the company must credit its cash account, while also eliminating the balance in the dividends payable account created before. For instance, when the company in the above example pays its shareholders dividends of $10,000, it must use the following accounting treatment to record the transaction.
Dr Dividends Payable $10,000
Cr Cash $10,000
Dividends are also presented in the financial statements of a company. First of all, the dividends payable balance created due to the declaration of dividends will be a part of the company’s Statement of Financial Position as a current liability. The dividend paid will be presented in the Statement of Retained Earnings as a reduction in retained earnings.
Dividends represent the reward that a company pays to its shareholders in exchange for their investment. Companies need to distribute dividends for various reasons which may include satisfying shareholder needs or maintaining a positive market perception. There are three different types of dividend policies that companies can adopt, including constant, residual, and stable dividend policies. The calculation of dividends also depends on these dividend policies and some other factors. Companies must account for dividends and retained earnings in two steps, once when they declare dividends, and next when they pay shareholders.