When a company pays its stockholders a dividend, it's converting a portion of the stockholders' stake in the company into cash. On the company's balance sheet, a cash dividend shows up as a decrease in retained earnings and a decrease in stockholders' equity. However, it's important to note that this decline in equity does not mean that the stockholders have lost any value.
The stockholders of a corporation are the owners of the company, and as such they're entitled to share in the company's profits. It's up to the board of directors -- elected by the shareholders -- to decide how much of the profit should be distributed to the stockholders, and when it should be distributed. These distributions generally come as cash dividends. However, the board is not obligated to distribute all the profits. It can choose to have the company hold on to some or all of its profit. Whatever the board decides to do with the profit will be reflected on the company's balance sheet.
The balance sheet essentially has two sides, and the totals on each side must match, which is why it's called a "balance" sheet. On one side are the company's assets -- anything of value held by the company. On the other side are its liabilities -- debts and obligations -- and its stockholders' equity, which is simply the difference between the assets and the liabilities. Stockholders' equity is what the stockholders actually own: the amount they would receive if the company were to sell its assets, pay off all its liabilities and distribute the leftovers. On the balance sheet, stockholders' equity is broken down into two basic categories: paid-in capital and retained earnings. Paid-in capital is the money the company has received from selling shares of its stock to the public. Retained earnings is the sum total of the company's profits and losses over the years.
When the company makes a profit, the profit goes on the asset side of the balance sheet as cash. A matching total has to go on the opposite side of the sheet. It goes under retained earnings, which increases stockholders' equity. When the board of directors approves a cash dividend to stockholders, that dividend is paid out of the cash on the asset side of the balance sheet. To match the outflow of cash, retained earnings -- and thus stockholder equity -- declines by an equal amount.
Conversion of Equity
Say a company has 10 million shares outstanding, and its board decides to pay a dividend of 50 cents a share. The total amount of the dividend comes out to $5 million, so the cash account on the asset side of the balance sheet goes down by $5 million. Meanwhile, that $5 million worth of profit is no longer being "retained" by the company, so it comes out of retained earnings. Stockholders' equity has declined by $5 million. But that money isn't "gone." It's now in the pockets of the company owners, each of whom received 50 cents for each share owned. The stockholders lose $5 million worth of paper value -- money that was tied up in the company's assets -- but they gain $5 million in cash. It's an even trade.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton et al; 2010
- AccountingCoach: How Do Cash Dividends Affect the Financial Statements? Harold Averkamp
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