Cash Dividends on Common Stock

Cash dividends (usually referred to as "dividends") are a distribution of the corporation's net income. Dividends are analogous to draws/withdrawals by the owner of a sole proprietorship. As such, dividends are not expenses and do not appear on the corporation's income statement.

Corporations routinely need cash in order to replace inventory and other assets whose replacement costs have increased or to expand capacity. As a result, corporations rarely distribute all of their net income to stockholders. Young, growing corporations may pay no dividends at all, while more mature corporations may distribute a significant percentage of their profits to stockholders as dividends.

Before dividends can be distributed, the corporation's board of directors must declare a dividend. The date the board declares the dividend is known as the declaration date and it is on this date that the liability for the dividend is created. Legally, corporations must have a credit balance in Retained Earnings in order to declare a dividend. Practically, a corporation must also have a cash balance large enough to pay the dividend and still meet upcoming needs, such as asset growth and payments on existing liabilities.

Let's look at an example: On March 15 a board of directors approves a motion directing the corporation to pay its regular quarterly dividend of $0.40 per share on May 1 to stockholders of record on April 15. The following entry is made on the declaration date of March 15 assuming that 2,000 shares of common stock are outstanding:

Retained Earnings (2,000 X $0.40)	800
Dividends Payable		800

If the corporation wants to keep a general ledger record of the current year dividends, it could use a temporary, contra retained earnings account, Dividends Declared. At the end of the year, the balance in Dividends Declared will be closed to Retained Earnings. If such an account is used, the entry on the declaration date is:

Dividends Declared	800
Dividends Payable		800

It is important to note that there is no entry to record the liability for dividends until the board declares them. Also, there is no entry on the record date (April 15 in this case). The record date merely determines the names of the stockholders that will receive the dividends. Dividends are only paid on outstanding shares of stock; no dividends are paid on the treasury stock.

On May 1, when the dividends are paid, the following journal entry is made.

Dividends Payable	800
Cash		800

21) Preferred Stock

When it comes to dividends and liquidation, the owners of preferred stock have preferential treatment over the owners of common stock. Preferred stockholders receive their dividends before the common stockholders receive theirs. In other words, if the corporation does not declare and pay the dividends to preferred stock, there cannot be a dividend on the common stock. In return for these preferences, the preferred stockholders usually give up the right to share in the corporation's earnings that are in excess of their dividends.

To illustrate how preferred stock works, let's assume a corporation has issued preferred stock with a stated annual dividend of $9 per year. The holders of these preferred shares must receive the $9 per share dividend each year before the common stockholders can receive a penny in dividends. But the preferred shareholders will get no more than the $9 dividend, even if the corporation's net income increases a hundredfold. (Participating preferred stock is an exception and will be discussed later.) In times of inflation, owning preferred stock with a fixed dividend and no maturity or redemption date makes preferred shares less attractive than its name implies.