What is a Dividend?
A dividend is a payment of a share of the profits of a corporation to its shareholders. Dividends for a corporation are 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 dividends account is a temporary equity account in the balance sheet. The balance on the dividends account is transferred to the retained earnings, 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 dividends payable account balance returns to zero.
The important points to remember when accounting for a dividend 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.
Dividend Payout Ratio
The dividend payout ratio is the ratio of dividends to net income, and represents the proportion of net income paid out to equity holders.
The dividend payout ratio formula can be stated as follows:
The calculation can be done on a per share basis by dividing each amount by the number of shares in issue.
Any net income not paid to equity holders is retained for investment in the business.
A high dividend payout ratio is good for short term investors as it implies a high proportion of the profit of the business is paid out to equity holders. However, a high dividend payout ratio leads to low re-investment of profits in the business which could result in low capital growth for both the business and investor. A long term investor might be prepared to accept a lower dividend payout ratio in return for higher re-investment of profits and higher capital growth.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.