What is the cash dividend? – Definition
The cash dividend is the payment made by a company, from its earnings, to its shareholders in the form of Cash. Most investors purchase either common or preferred stock with the expectation of receiving cash dividends.
The amount and regularity of cash dividends are two of the factors that affect the market price of a firm’s stock. Many corporations, therefore, attempt to establish a quarterly dividend pattern that is maintained or slowly increased over a number of years. In profitable years, the corporation may issue a special year-end dividend in addition to the regular dividends. Such stable dividend policies increase the attractiveness of the firm’s stock. The following, taken from a General Electric Company annual report, shows how one corporation implements this policy:
Dividends declared in 1983 were $852 million. This was $1.875 per share, up 12% from 1982, and marked the eighth consecutive year in which dividends were increased. It is General Electric’s policy to maintain a reasonable dividend rate while at the same time retaining enough earnings to enhance productive capacity and to allocate financial resources to earnings growth opportunities.
As this quotation indicates, the management gives considerable thought to the amount and timing of dividends. In addition to the desire of maintaining a stable dividend policy, other factors also affect the amount of cash dividends declared in any one year, for example, the amount of retained earnings or the firm’s cash position and business needs.
From a theoretical and practical point of view, there must be a positive balance in retained earnings in order to issue a dividend. If there is a deficit (negative balance) in retained earnings, any dividend would represent a return of invested capital and is called a liquidating dividend. A corporation can still issue a normal dividend (a dividend other than a liquidating one) even if it incurred a loss in any one particular year, as long as there is a positive balance in retained earnings.
Because there must be a positive balance in retained earnings before a normal dividend can be issued, the phrase “paying dividends out of retained earnings” developed. But this phrase is a misstatement. Dividends are not paid out of retained earnings they are a distribution of assets and are paid in cash or, in some circumstances, in other assets or even stock. Retained earnings are the increase in the firm’s net assets due to profitable operations and represent the owners’ claim against net assets, not just cash.
The maximum amount of dividends that can be issued in any one year is the total amount of retained earnings. However, this is rarely, if ever, done. Again, in order to pay a cash dividend, a firm must have the necessary cash available, and the amount of cash on hand is not directly related to retained earnings. Furthermore, as is evident from the statement in the GE annual report, a firm has other uses for its cash. Most mature and stable firms restrict their cash dividends to about 40% of their net earnings. Returning to the GE example, in 1983 it paid dividends of $852 million, which represented 42% of its net income.
All dividends must be declared by the board of directors before they become a liability of the corporation. There are three dates that are significant to the declaration and payment of dividends. They are the declaration date, the date of record, and the payment date.
The declaration date is the date on which the board of directors declares the dividend. It is at that time that the dividend becomes a liability of the corporation and is recorded on its books. The declaration date is usually several weeks prior to the payment date. A typical dividend announcement may be:
The Board of Directors on December 1 declared a $1.20 per share dividend payable on January 4 to common shareholders of record on December 21.
Only the stockholders as of the date of record are eligible for the dividend. Because of the time involved in compiling the list of stockholders at any one date, the date of record usually is two to three weeks after the declaration date, but before the actual payment date.
The payment date is the date that the dividend is actually paid. It usually occurs about a month after the declaration date.
Journal Entries to Record Cash Dividend
When a cash dividend is declared, the board of directors specifies an amount that is to be paid per share to stockholders as of specified record date on a specified payment date. On the date of declaration of a total dividend of $80,000, this journal entry would be recorded:
Alternatively, some accountants prefer to debit the temporary account known as Dividends Declared which is closed to Retained Earnings at year-end. On the date of payment, the entry would be made:
Many larger firms use a special checking account for disbursing cash dividends.
To demonstrate the journal entries required when a cash dividend is declared and paid, we will return to the above. example in which the board of directors declared on December 1 a $1.20 per-share dividend payable on January 4 to the common shareholders of record on December 21. Because there are 100,000 common shares outstanding, the total cash dividends will be $120,000.
When recording the declaration of a dividend, some firms debit an account titled Dividends Declared, rather than debit Retained Earnings. There is nothing wrong with this procedure, except that a closing entry must be made to close the Dividends Declared account into Retained Earnings. As a result of this entry, the ultimate effect is
to reduce retained earnings by the amount of the dividend.
Occasionally a firm will issue a dividend in which the payment is in an asset other than cash. Noncash dividends, which are called property dividends, are more likely to occur in private corporations than in publicly held ones. Under current accounting pronouncements, the property is revalued to its current market value, and a gain or loss is recognized on the disposition of the asset.
To illustrate, assume that the Ironside Corporation declared a property dividend on December 1 to be distributed on January 4. Marketable securities held by the firm that have a cost of $750,000 and a fair market value (FM V) of $1 million are to be distributed to the shareholders. The journal entries to reflect these transactions are: