1. Nature of dividends, dividend types and forms of dividend payments
Dividends represent the amount of money or other assets, normally a portion of the profits, a company distributes to its shareholders.
When a company earns a profit, that money can be used in two ways:
- it can either be reinvested in the business (called retained earnings), or
- it can be paid to the shareholders as dividends.
Each organization's board of directors determines the actual dividend amount that a company will pay out. High-growth companies do not usually offer dividends to its shareholders because all of their profits are reinvested to help sustain high growth. At the same time, more mature companies can pay dividends as their rapid growth has slowed down.
To understand how the dividends are calculated, let us look at the example below:
Example. Assume that a company has 2 million shares outstanding, and it decides to distribute 6 million dollars to its shareholders as dividends. Hence, the dividend to be paid is $3 per share (6 million dollars divided by 2 million shares).
Dividends may have the following forms of payment :
Cash dividends (most common) are paid out in the form of cash.
Stock dividends are paid out in the form of additional stock shares of the issuing company, or other companies (such as its subsidiary). They are usually paid in proportion to shares owned by shareholders (e.g. if a shareholder owns 100 shares, then a 3% dividend will increase his or her stock ownership by 3 shares).
Property dividends are paid out in the form of assets from the issuing company or another company, such as a subsidiary company.
two types of dividends exist:
- Common share dividend (dividends without obligation to be paid).
- Preferred share dividends (fixed dividends that must be paid prior to any common dividends being paid).
Preferred shareholders have a "preference" and rank higher than common shareholders in a corporate liquidation.
Also three dates are applicable when accounting for dividends:
Date of declaration is the date when a board of directors formally authorizes the payment of the cash dividends or issuance of shares of stock.
Date of record is the date when it is established who will receive the dividends.
Date of payment or distribution is the date when the dividends are paid to the stockholders.
2. Presentation of dividends
When a board of directors decides that earnings should be retained, they have to account for them on the balance sheet under shareholders' equity. Effectively, the funds accumulated from net earnings just remain in retained earnings until the time the board decides to pay out dividends.
At the same time if a company decides to pay dividends, the payment is not considered an expense: it is the division of after tax profits among shareholders.
The following should be considered in understanding the impact of dividends on the financial statements of a company:
- Cash or property dividends decrease assets and shareholders' equity of the company.
- Stock dividends only change components of shareholders' equity and do not impact total shareholders' equity balance.
- Dividends do not impact net income / loss of the company on the income statement.
- The cash flow associated with a cash dividend is recorded in the financing activities on the statement of cash flows.