A business that operates as a corporation has the option of issuing shares of stock to investors as a means of raising capital for the company. In some cases, shareholders receive periodic dividends from the earnings of the company. However, the company's board of directors can only declare a dividend when the business reports net income for the year or has a sufficient balance in its retained earnings account.
The retained earnings account on a corporation's balance sheet represents the cumulative amount of earnings the company reports as net income in prior fiscal years. Companies report the retained earnings account in the equity section of the balance sheet since it's the shareholders who have a rightful claim to those funds in the event the corporation liquidates. It also includes the account balance on the statement of shareholder's equity, which reports the changes in overall shareholder equity from one accounting period to the next. Whenever a corporation's board of directors declares a dividend, it must reduce the balance in the retained earnings account.
Dividend Declaration Date
The dividend declaration date is the day the board of directors determines the amount and payment date of shareholder dividends. Once the dividend is declared, the corporation has a liability to make that payment. As a result, it's necessary to prepare a journal entry to record the liability and to reduce the available retained earnings balance. Accomplish this with a debit entry to the retained earnings account for the amount of the declared dividend and a credit entry to a dividends payable account.
Dividend Payment Date
When the board of directors declares a dividend, it also establishes the date that the company will make a payment to shareholders. At the time of a dividend payment, a second entry is necessary to reduce the liability and to account for the reduction in cash. This is done with a debit entry to the dividends payable account and a corresponding credit entry to the cash account.
A dividend is not always paid in cash. In some cases, a corporation's board of directors will decide to issue a dividend in the form of additional stock, which also affects the balance of the retained earnings account. To illustrate, suppose a corporation has 100,000 shares of $5 par-value stock outstanding. If it declares a 20-percent dividend, this means that it will provide a total of 20,000 additional shares to all shareholders in proportion to their current stock holdings. If the current market price of each share is worth $50, it requires a debit entry to reduce the retained earnings account for the total $1 million value of the dividend. However, two separate credit entries are necessary to other shareholder equity accounts. One credit entry is equal to the overall par value of the dividend of $100,000, which is the minimum amount that the corporation can legally sell shares for, to the common (or preferred if made to preferred shareholders) stock account. The remaining $900,000 credit is made to the additional paid-in-capital account.
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