Dividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. They are issued in cash or as additional shares with the board of directors of a company taking such decisions.
Not all stocks offer them as it is an expense for a firm and brings down its retained earnings. ReinvestmentReinvestmentReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio. of retained earnings is crucial for business growth. Investors prefer dividend-bearing stocks as they provide a relatively steady income over and above the earnings that can come off through share trading.
Table of contents
- Dividends are rewards paid to the shareholders of a company typically out financial earnings. Usually, preferred stockholder who have no voting rights hold a greater priority to receive them than the common stockholders who have the voting rights.
- The yield is determined by dividing the annual dividend on each stock by the price per share. Yield helps define profitability of the earnings by shareholders.
- The issue can take many different forms including cash, stocks, property, and scrip among others.
- It is a taxable income for the shareholders, and the tax amount on the same is deducted at source, i.e., by the company at the time of distribution.
Dividends reflect a company’s earning capabilities being a source of income. They are usually paid out of a firm’s profits or accumulated earnings to keep the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. invested in the stock. However, being an expenseExpenseAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital., it reduces retained earnings which not all companies can afford. Also, when in loss, companies cannot issue them.
Since the law doesn’t obligate firms to issue dividends, many prefer to reinvest their earnings to overcome shortfalls or direct the funds towards business growth projects. Large-cap stocks and well-established public companiesPublic CompaniesPublicly Traded Companies, also called Publicly Listed Companies, are the Companies which list their shares on the public stock exchange allowing the trading of shares to the common public. It means that anybody can sell or buy these companies’ shares from the open market. tend to issue them more as they are financially better placed. For instance, AT&T has over 30 years of history of providing dividends, with their 2021 yield being 7.43% at $2.08 per share.
Consequently, such stocks attract investors for offering a relatively steady income over and above the earnings that can come through their sales. Some companies also issue a one-time lumpsum payment to reward their shareholders. The board of directors is responsible for decisions related to profit distribution, which occurs in consent with major stakeholders.
It involves certain decisions based on the type of shareholdersType Of ShareholdersThe common shareholders and preferred stakeholders are the two types of shareholders., the status of company earnings and the type of issue, among others. For example, preferred stockholders hold a stronger claim over these earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments. than the company’s common shareholders.
Chronology of Dividend Issue
The frequency of dividend issues can be monthly, quarterly, annual or semi-yearly, and it involves following a calendar. A company marks certain dates on its calendar to make public announcements and also for charting out distribution details. The Board of directorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. , together with shareholders’ approval, are responsible for these decisions. Let us take you through them.
- Announcement/ Declaration Date: An important element of the calendar, a company’s management announces the upcoming dividend distribution with the declaration date. The payment amount or the type of issue is also decided by the board.
- Ex-Dividend DateEx-Dividend DateAn ex-dividend date is one of the four important dividend dates, usually set one business day before the record date. It is a deadline; shareholders need to buy the stocks before this date to become eligible for the upcoming dividend payout. It is also called the ex-date.: It can be taken as a cut-off date, prescribing the shareholders eligibility to receive them. For example: If a particular stock declares that the cut-off date is July 30, 2021, only the shareholders who possess the stock on July 30, 2021, will be eligible to receive payments. Investors purchasing the stock on July 30th and following dates will not make the cut.
- Date of Record: The company decides on the list of shareholders who will receive the payment and they are reported under the record date. The payment amount or the type of issue is also decided by the board.
- Payment Date: This is the date when the payment is made by the company to the on-record shareholders through direct bank transfer or mails depending on the type of issue.
Below is an excerpt from the chronology of AT&T.
Source – NASDAQ
Dividend Stock Examples
Dividends also come from ETFsETFsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange., mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc and index fundsIndex FundsIndex Funds are passive funds that pool investments into selected securities. if the companies under the fund offer them. When it comes to stocks, oil giant, Royal Dutch Shell (RDS. B and RDS. A), holds an illustrious history of dividend payments.
It is important to note that Covid-19 led the company to cut the payment for the first time since the World War II. However, in July 2021, the company announced a 38% boost of the upcoming payments owing to enormous profits.
In that regard, S&P 500 companies that have consistently raised the payment amount from the last 25 years are called dividend aristocratsDividend AristocratsA company is known to be to dividend aristocrats if it has consistently paid dividends to its stockholders and increased its payout of the dividend year by year for at least 25 consecutive years. These companies have robust financial health.. Given below are some of these famous corporations:
- Abbott Laboratories (ABT)
- The Coca-Cola Co. (KO)
- Colgate-Palmolive (CL)
- Johnson and Johnson (JNJ)
- McDonald’s (MCD)
- Procter & Gamble (PG)
- S&P Global (SPGI)
- Walmart (WMT)
Types of Dividends with their Accounting
1. Cash Type
Here they are paid as cash either through a check or direct bank transfer.
Midterm international Ltd, on January 1, 2019, held the meeting. The cash payment of $1 per share was declared on the company’s outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.. The total outstanding shares of the company are $3,000,000. The initial journal entry that the company will record is –
Now on June 1, 2019, at the time of cash payment, the company will record the transaction as below –
2. Stock Type
Here the company issues common stockCommon StockCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity. to the present common shareholders. The treatment depends on the percentage of an issue concerning the number of the entire previous share issue. If the issue is more than 25%, it will be treated as a stock splitStock SplitStock splits refer to the process whereby a company increases its number of shares, reducing the per-share price of the stocks. .
On January 1, 2019, Midterm international Ltd declared a stock dividend of 20,000 shares. The par value of the sharesPar Value Of The SharesPar value of shares is the minimum share value determined by the company issuing such shares to the public. Companies will not sell such shares to the public for less than the decided value. is $7, and the fair market value is $10.00 on the declaration.
Retained Earnings = 20,000*$10 = $2,00,000
Additional paid-in capitalAdditional Paid-in CapitalAdditional paid-in capital or capital surplus is the company's excess amount received over and above the par value of shares from the investors during an IPO. It is the profit a company gets when it issues the stock for the first time in the open market. = 20,000*($10-$7) = $60,000
Journal entry after the declaration:
3. Property Type
Companies also grant physical assets, real estate, investment securitiesInvestment SecuritiesInvestment securities are purchased by investors, with or without the assistance of a middleman or agent, solely for the purpose of investment and long-term holding. These are recorded in the financial statements as non-current investments and comprise fixed income and variable income bearing securities., etc., to their shareholders. They must record the distribution at the asset’s fair market value. If the fair market value of the assets distributed is different from the book value of assets, then the company has to record the variance in the form of the gain or loss.
New Sports International Ltd plans to declare the issuance of 10,000 bonds. The fair market value of the bonds on the date of declaration of the dividend is $ 60,00,000, which originally the company acquired at $ 40,00,000.
New Sports International Ltd passed the following entries on the declaration date to record the change in assets value while issuing their allotment.
Gain = $ 6,000,000 – $ 40,00,000 = $ 20,00,000
Entry for recording the gain:
Entry to record the transfer:
4. Scrip Type
It is a type of promissory notePromissory NoteA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date. where the company commits to paying the shareholders at a later date. Then, it creates certain notes payableNotes PayableNotes Payable is a promissory note that records the borrower's written promise to the lender for paying up a certain amount, with interest, by a specified date. , which may or may not include interest.
Mid Term International declares a $ 150,000 scrip dividend to its shareholders with an interest rate of 10 per cent. The entries for the same are as follows –
Now suppose the payment date is after one year, so Mid Term International has to pay the notes payable amount and interest accrued during one year from the declaration date.
Interest Accrued = $150,000 * 10% = $15,000
On payment date entry will be:
5. Liquidating Type
It is a payment that allows shareholders to receive their originally contributed capital, primarily at the time of business liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order..
New Sports International Ltd declares liquidating payments of $10,00,000, out of which $2,00,000 is the income, and the remaining amount is the capital reimbursement.
The entry to record the declaration:
The entry to record the payment:
Advantages and Disadvantages
- Dividends often boost an investor’s trust, and confidence since such companies are considered more stable, profitable and reliable. Moreover, with regular payments, shareholders don’t feel the need to sell out their shares for quick returns.
- It is an essential source of income as pension earnings. For example, when Royal Dutch Shell cut back on these payments post Covid-19, it was expected to affect many pensioners who owned the stock either directly or through schemes.
- Apart from being a token of gratitude, they keep shareholders invested in the firm due to regular earnings. People tend to invest in these stocks more, driving up their prices and bringing more capitalization.
- Also, qualified dividends that are deemed so by the SEC, are taxed at lower rates being treated as long term capital gainsCapital GainsCapital gain refers to the profit resulting from selling a capital asset or investment at a price higher than its purchase price.. Certain corporates qualify for dividend received deduction. It is a type of tax deduction which certain firms are allowed when they receive a portion of profit as a shareholder of another corporate.
- However, regular delivering of slices of profits often causes cash crunch for business expansion and capital projects. Thus, it hinders growth in the long run. Also, their computation, tax preparation and distributions increase the overhead costOverhead CostOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc..
- Additionally, since earnings vary for years, sometimes distributions tend to be of meagre amounts, putting off investors.
An example of a dividend is cash paid out to shareholders out of profits. They are usually paid quarterly. For example, AT&T has been making such distributions for several years, with its 2021 third-quarter issue set at $2.08 per share.
When a company makes a profit and has retained earnings, the corporate management proposes to offer a slice of profit to the company’s stockholders (preference, common or other ascertained class of shareholders). The board of directors approves this proposal and determines the payment amount, eligible shareholders, and final distribution.
They account for the taxable income of the shareholders in the same year they are distributed if they are of the unqualified kind. The payments will receive taxation whether they withdraw or reinvest it.
This article has been a guide to what is Dividend & its definition. Here we discuss its types and accounting along with dividend stock examples. You can learn more about firms from the following articles –