Distributions to Shareholders: Dividends
Net income is accumulated through time in retained earnings, which is reported as part of shareholders’ equity on the balance sheet. Dividend distributions reduce retained earnings. They are simply a transfer to shareholders of a portion of what they already own—the increase over time in the net assets of the firm recognized as net income. The portion of net income retained by the firm represents reinvestments by shareholders. The declaration of dividends is formalized by three important dates because of the administrative complexity of identifying shareholders of record at any given point in time
Net income is accumulated through time in retained earnings, which is reported as part of shareholders’ equity on the balance sheet. Dividend distributions reduce retained earnings. They are simply a transfer to shareholders of a portion of what they already own—the increase over time in the net assets of the firm recognized as net income. The portion of net income retained by the firm represents reinvestments by shareholders. The declaration of dividends is formalized by three important dates because of the administrative complexity of identifying shareholders of record at any given point in time
- On the date on which the board of directors declares a dividend, called the date of declaration, the firm incurs a legal liability to distribute the dividend.
- The recipients of the dividend will be the owners of the stock as of a specific future date, called the date of record.
- On the date of payment, the dividend distribution occurs
Typically, these three dates are several weeks apart.
Corporations generally pay dividends in cash. However, corporations can also pay dividends with
Corporations generally pay dividends in cash. However, corporations can also pay dividends with
- interest-bearing promissory notes (scrip dividends).
- investments in other corporations’ stock (property dividends).
- corporate assets, such as property (dividends in kind).
For cash, scrip, and in-kind dividends, the retained earnings component of shareholders’ equity is reduced by the fair value of the item distributed on the date of declaration and a liability is recorded. Dividends decrease the net assets of a corporation, and this decrease is reported in the statement of shareholders’ equity. The date of record has no impact on the corporation’s accounting. No change in equity occurs on the date of payment because both assets (cash or property) and liabilities (dividends payable) decrease (that is, no change in net assets). If dividends are declared but not paid by year-end, a (nonoperating) liability for dividends payable appears in the current liabilities section of the balance sheet
In many jurisdictions (especially non-U.S. countries), the balance of retained earnings represents the limit for dividend payments. However, payments to shareholders that exceed the balance in retained earnings, called liquidating dividends, can occur. If the dividend is greater than the retained earnings balance, in most jurisdictions, the increment must be used to decrease contributed capital. A liquidating dividend is a return of the original investment by shareholders (that is, their original contribution to the firm when they purchased common shares).
Stock Dividends and Stock Splits
On occasion, corporations distribute additional shares of their own stock to current stockholders in the form of stock dividends. Unlike other forms of dividends, stock dividends do not:
In many jurisdictions (especially non-U.S. countries), the balance of retained earnings represents the limit for dividend payments. However, payments to shareholders that exceed the balance in retained earnings, called liquidating dividends, can occur. If the dividend is greater than the retained earnings balance, in most jurisdictions, the increment must be used to decrease contributed capital. A liquidating dividend is a return of the original investment by shareholders (that is, their original contribution to the firm when they purchased common shares).
Stock Dividends and Stock Splits
On occasion, corporations distribute additional shares of their own stock to current stockholders in the form of stock dividends. Unlike other forms of dividends, stock dividends do not:
- involve a transfer of assets to investors.
- result in a change in total shareholders’ equity.
- change the proportional ownership of shareholders.
- change investor wealth
The effects of stock dividends and splits on retained earnings and contributed capital are determined by accounting rules and jurisdictional legal requirements. In small stock dividends (distributions of less than 20–25% of common shares), the fair value of shares issued is transferred out of retained earnings and into contributed capital. U.S. GAAP is ambiguous with respect to midrange dividends (20–100%), and frequently, laws of the state of incorporation determine the accounting treatment. However, in most cases (and consistent with SEC guidance), midrange stock dividends are treated as a transfer of the par value of shares among shareholders’ equity accounts (that is, from retained earnings to contributed capital or within contributed capital accounts).
Most large distributions that are greater than or equal to 100% are in the form of a stock split. Suppose a company wanted to double the number of shares outstanding and therefore halve the price of its stock. This could be accomplished by issuing a 100% stock dividend or a 2-for-1 stock split. Similar to midrange stock dividends, accounting for a large stock dividend depends on appropriate state law. Most of the time, the par value of the shares is transferred to common stock from either retained earnings or additional paid-in capital. Firms may also wish to reduce the number of shares outstanding using a reverse stock split. For example, in a 1-for-2 reverse stock split, the number of shares outstanding is reduced by 50% and the stock price per share doubles. In the past, firms have engaged in reverse stock splits to meet minimum share price requirements to be listed on organized exchanges and to attract institutional investors that may have policies prohibiting the acquisition of shares traded below a threshold price.
In a stock split, U.S. GAAP does not require an amount to be shifted from retained earnings to contributed capital, but state laws may allow an amount to be shifted from either retained earnings or additional paid-in capital to common stock. Accounting rules require that the par value of individual shares be adjusted so that the total par value after the stock split is the same as the total par value before the split. Therefore, in a 2-for-1 split of 50,000 shares of $10 par value stock, a company issues an additional 50,000 shares and reduces par value to $5 on all 100,000 shares. From an analysis viewpoint, it is important to remember that:
Most large distributions that are greater than or equal to 100% are in the form of a stock split. Suppose a company wanted to double the number of shares outstanding and therefore halve the price of its stock. This could be accomplished by issuing a 100% stock dividend or a 2-for-1 stock split. Similar to midrange stock dividends, accounting for a large stock dividend depends on appropriate state law. Most of the time, the par value of the shares is transferred to common stock from either retained earnings or additional paid-in capital. Firms may also wish to reduce the number of shares outstanding using a reverse stock split. For example, in a 1-for-2 reverse stock split, the number of shares outstanding is reduced by 50% and the stock price per share doubles. In the past, firms have engaged in reverse stock splits to meet minimum share price requirements to be listed on organized exchanges and to attract institutional investors that may have policies prohibiting the acquisition of shares traded below a threshold price.
In a stock split, U.S. GAAP does not require an amount to be shifted from retained earnings to contributed capital, but state laws may allow an amount to be shifted from either retained earnings or additional paid-in capital to common stock. Accounting rules require that the par value of individual shares be adjusted so that the total par value after the stock split is the same as the total par value before the split. Therefore, in a 2-for-1 split of 50,000 shares of $10 par value stock, a company issues an additional 50,000 shares and reduces par value to $5 on all 100,000 shares. From an analysis viewpoint, it is important to remember that:
- the accounting for stock dividends and splits simply reallocates amounts within shareholders’ equity.
- the total amount of shareholders’ equity remains unchanged, because assets have not been disbursed from the corporation (that is, cash has not been paid out).
- increasing the number of shares outstanding does proportionately decrease per-share amounts for earnings, book value, and cash flow.
To illustrate the accounting for stock dividends and splits, assume that Mystic, Inc., reports the following in its 2012 financial statements:
- Common stock, $3 par, 2,263 million shares outstanding
- Average share price during 2012: approximately $20
- Common dividends paid during 2012: $0.20 per share
Exhibit 7.2 shows the financial statement effects of the following events. (Assume
the events are independent.)
- Mystic declares and pays a dividend of $452.6 million (2,263 million shares 3 $0.20 per share). Assume that the dividends are declared and then paid at a later date
- . Mystic distributes a property dividend by giving common shareholders common shares of another company that it carries as a short-term investment in marketable securities. The securities have a fair value of $2.0 million and an original cost of $1.8 million. Mystic uses mark-to-market accounting for these securities and declares the dividend at some time after the securities have been marked to = market.
- Mystic distributes a 10% stock dividend (10% 3 2,263 million shares outstanding ¼ 226.3 million shares; 226.3 million shares 3 $3 ¼ $678.9 million par value; 226.3 million shares 3 $20 market price ¼ $4,526 million fair value).
- Mystic distributes a 100% stock dividend (2,263 million additional shares; 2,263 3 $3 ¼ $6,789 million par value).
- Mystic declares a 2-for-1 stock split
- Mystic declares a 1-for-2 reverse stock split.
Note that dividends distributed in the form of assets (that is, cash and property; Transactions 1 and 2) decrease shareholders’ equity (the sum of the last three columns). Dividends distributed in the form of common stock (Transactions 3 and 4) generate a rearrangement of shareholders’ equity but no change in total shareholders’ equity. Likewise, stock splits (Transactions 5 and 6) have no effect on total shareholders’ equity or the balance of any account in shareholders’ equity. Cash outflow for cash dividends is reported in the financing section of the statement of cash flows
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