What is a Dividend?
A dividend is a payment of a share of the profits of a corporation to its shareholders. A dividend for a corporation, is the equivalent of owners drawings for a non-incorporated business.
When a business makes a profit, it can either decide to retain those profits, in which case they are added to retained earnings forming part of the shareholders equity in the business, or it can pay part of the profits to the shareholders by way of a dividends. This is explained more fully in our retained earnings statement tutorial.
Assuming there is no preferred stock issued, a business does not have to pay a dividend, the decision is up to the board of directors, who will decide based on the requirements of the business.
A business in the process of growing may need the cash to fund expansion, and might be better served by retaining the profits and using the internally generated cash rather than borrowing. The investors in the business understand that they might not receive dividends for a long period of time, but will have invested in the hope that the value of their shares will rise in the future.
In contrast, an established business might not need to retain profits and will distribute them as a dividend each year. The investors in such businesses are looking for a steady growth in the dividends.
On the date that the board of directors decides to pay a dividend, it will determine the amount to pay and the date on which payment will be made. At this point the dividend is said to have been declared.
As the business does not have to pay a dividend, there is no liability until there is a dividend declared. As soon as the dividend has been declared, the liability needs to be recorded in the books of account as a dividend payable.
Declared Dividends Example
Suppose a business had declared a dividend on the dividend declaration date of 0.60 per share on 150,000 shares. The total dividend liability is now 90,000, and the journal to record the declaration of dividend and the dividend payable would be as follows.
The debit to the dividends account is not an expense, it is not included in the income statement, and does not affect the net income of the business. The amount is a charge against the retained earnings of the business, it is a distribution of retained earnings to the shareholders not an expense.
The credit entry to dividends payable represents a balance sheet liability. At the date of declaration, the business now has a liability to the shareholders to be settled at a later date.
At the same time as the dividend is declared, the business will have decided on the date the dividend will be paid, the dividend payment date.
On the payment date, the following journal will be entered to record the payment to shareholders.
On the dividend payment date, the cash is paid out to shareholders to settle the liability to them, and the the dividends payable account balance returns to zero.
The important points to remember when accounting for dividends are that the liability of the business to the shareholders is established as soon as the dividend is declared, and that dividends are a distribution of the profits of a business to the shareholders and are not an expense.