Discuss the accounting for a firm paying dividends in cash, other assets, or shares of its common stock

Answer 1

ACCOUNTING FOR DIVIDENDS

A firm may pay dividends in cash, other assets, or shares of its common stock.

Once the board of directors declares a dividend, the dividend becomes a legal liability of the corporation. Dividends Payable appears as a current liability on the balance sheet if the firm has not yet paid the dividends by the end of the accounting period.

Property Dividends

Corporations sometimes distribute assets other than cash when paying a dividend; such a dividend is known as a dividend in kind or a property dividend. The accounting for property dividends resembles that for cash dividends, except that when the firm pays the dividend, it credits the asset given up, rather than Cash. The amount debited to Retained Earnings equals the fair value of the assets distributed. When this fair value differs from the carrying value of the assets distributed, the firm recognizes a gain or loss in net income.

Stock Dividends

The retention of earnings may lead to a substantial increase in shareholders' equity, as the firm accumulates net assets that it keeps invested in the business on a relatively permanent basis. The permanency results from the firm's having committed the net assets generated by the earnings process for the long term, for example, by investing in fixed assets. To indicate such a permanent commitment of assets generated by reinvested earnings, the board of directors may declare a stock dividend. The accounting involves a debit to the Retained Earnings account and credits to contributed capital accounts. The stock dividend does not affect total shareholders' equity. It reallocates amounts from Retained Earnings to the contributed capital accounts. When the firm declares a stock dividend, shareholders receive additional shares of stock in proportion to their existing holdings. If, for example, the firm issues a 5% stock dividend, each shareholder receives one additional share for every 20 shares held before the dividend.

The stock dividend relabels a portion of the retained earnings that had been legally available for dividend declarations as a more permanent form of shareholders' equity, because the firm has used some funds represented by past earnings to expand plant facilities or to replace assets at increased prices or to retire bonds. The firm does not have this cash available for cash dividends. The stock dividend does not affect the availability of cash on hand or cash that the firm has already invested; rather, the stock dividend signals to readers of the balance sheet, perhaps more clearly than before, the commitment to investment.

Stock dividends have little economic substance for shareholders. A proportionate increase in the number of shares held by each shareholder does not change that shareholder's ownership interest or proportionate voting power. Although the book value per common share (total common shareholders' equity divided by the number of common shares outstanding) decreases, each shareholder has a proportionately larger number of shares, so the total book value of each shareholder's interest remains unchanged. The market value per share should decline commensurate with the proportional increase in shares, but all else equal, the total market value of an individual's shares should not change. To describe such a distribution of shares as a "dividend"—meaning a distribution of assets generated by earnings—may mislead some readers, but the terminology is generally accepted.