Cash dividends

Net income results from management's activities. The long-term effect of net income is an increase in the company's resources and its sources of resources (stockholders' equity, retained earnings). Corporations distribute to owners some of the resources generated by management (net income) in the form of cash dividends. A corporation's board of directors has the responsibility for declaring cash dividends. If it determines the company should distribute cash dividends to owners, the board of directors declares a cash dividend. The board determines the dollar amount of the dividends and the date on which they will be paid. Because it takes time to identify all the owners and distribute checks to them, dividends are paid several days or weeks after they are declared.

Assume a corporation's board of directors declares a $2,000 cash dividend on July 10, with the dividend to be paid on August 12. Show the effects on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

 

 

+ $2,000

dividends payable

 

 

+

- $2,000

dividends

The company's resources (assets) do not change as a result of the July 10 declaration of dividends because the cash will not be paid out until later (August 12). The company's sources of resources increase and decrease by the $2,000 dividends declared. Liabilities increase by $2,000 because the company now owes its owners $2,000 more. Stockholders' equity decreases by $2,000 because the owners now have rights to $2,000 less of the company's resources. In effect, the owners have given up their ownership rights to $2,000 of the company's resources for $2,000 of rights as creditors: the owners have become creditors.  The decrease in stockholders' equity is shown as a decrease in sources of management generated resources because dividends, by definition, come out of those resources generated by management.  Dividends are not returns to owners of some of the resources they invested in the corporation.

Remembering that assets increase with debits and that debits must equal credits, prepare the journal entry to record the $2,000 cash dividend declaration.
 

  Date

Description

Post.
Ref.

Debits

Credits

July 10

Dividends

 

2,000

 

 

    Dividends Payable

 

 

2,000

 

Cash dividends declared

 

 

 

On August 12, the corporation pays the $2,000 cash dividend declared on July 10. Show the effects on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

- $2,000
cash

=

- $2,000

dividends payable

 

 

 

 

The cash dividend payment reduces the company's resources (assets) as the cash flows out to owners. The company's sources of resources (liabilities) decrease by $2,000 because the company no longer owes them the $2,000 once the dividends are paid.

Remembering that assets increase with debits and that debits must equal credits, prepare the journal entry to record the $2,000 cash dividend payment.
 

Date

Description

Post.
Ref.

Debits

Credits

Aug. 12

Dividends Payable

 

2,000

 

 

    Cash

 

 

2,000

 

Cash dividends paid

 

 

 

As a result of declaring and paying cash dividends, the company's resources and sources of resources both decreased by $2,000. While it is important to management to keep owners satisfied by giving them some of the resources generated by the company, cash dividends do decrease the amount of resources managers will be able to use in the future. Corporations must continually evaluate this need to pay owners versus the need to keep resources for management to use in the future.

Distributing cash dividends If a corporation has both preferred stockholders and common stockholders, the distribution of cash dividends depends upon the number of shares of stock owned by the stockholders (called outstanding shares) and the preferences of the preferred stockholders. For example, consider a company with the contributed capital shown below.
 

Contributed Capital

 

  8% Preferred Stock, $10 par, 5,000 shares authorized, 1,000 shares issued

$10,000

  Common Stock, $2 par, 40,000 shares authorized, 10,000 shares issued

$20,000

  Additional Paid-in Capital, Preferred Stock

$2,000

  Additional Paid-in Capital, Common Stock

$30,000

Total Contributed Capital

$62,000

The company has both preferred stockholders and common stockholders. The preferred stockholders own 1,000 shares (shares issued by the company) out of a total of 5,000 shares the company's articles of incorporation allow it to issue (called authorized shares). The preferred stock has a par value of $10 per share and a dividend rate of 8%. Notice the $10,000 in the preferred stock account is the par value of the number of shares issued ($10 par x 1,000 shares issued = $10,000). The 8% dividend rate entitles the preferred stockholders to a dividend of 8% of the preferred stock's par value in the year in which a dividend is declared. Thus, on an annual basis, preferred stockholders could receive cash dividends of $.80 per share (.08 x $10 par = $.80). In total, preferred stockholders could receive cash dividends of $800 (.08 x $10 par x 1,000 shares outstanding = $800). The preferred stockholders would receive the $800 before any cash dividends would be paid to common stockholders.

Based on the company's contributed capital, its $2,000 cash dividends would be distributed as follows.
 

Preferred stock dividends (.08 x $10 par x 1,000 shares)

$800

Common stock dividends ($2,000 - $800)

$1,200

Total dividends

$2,000

Preferred stockholders would receive cash dividends of $.80 per share before dividends would be paid to common stockholders. This is one of the advantages (preferences) of owning preferred stock. Common stockholders would receive cash dividends of $.12 per share ($1,200 dividends / 10,000 common shares outstanding = $.12).
 

** You now have the background to do text exercises 12.7, 12.8, and 12.9.
 

Cumulative preferred stock One popular way companies make preferred stock attractive to investors is to add the cumulative preference. Remember, preferred stock is issued to obtain resources for management to use. The more attractive the preferred stock is to investors, the easier it is to obtain resources. The cumulative preference entitles preferred stockholders to receive dividends before common stockholders, even if the company failed to pay dividends in a prior year. Again, remember that owners receive dividends only after they have been declared by the board of directors. If dividends are not declared, they cannot be received by owners. Thus, without the cumulative feature, preferred stockholders would not receive dividends for any year in which the board of directors did not declare them. With the cumulative feature, however, preferred stockholders are guaranteed to receive their dividends for all years before the company can distribute any dividends to common stockholders.

Consider again the $2,000 cash dividend discussed previously. Assume the board of directors did not declare dividends in the previous year, but instead kept the resources in the company for management to use.

Without the cumulative feature, preferred stockholders would have lost their right to the $800 cash dividends for that prior year. If, however, the preferred stock was cumulative, the $2,000 cash dividend declared this year would be distributed as follows.
 

Preferred stock dividends (last year's dividend)

$800

Preferred stock dividends (this year's dividend)

$800

Common stock dividends ($2,000 - $1,600)

$400

Total dividends

$2,000

Preferred stockholders would receive cash dividends of $1.60 per share ($1,600 dividends / 1,000 shares = $1.60) before dividends would be paid to common stockholders. Thus, the preferred stockholders would receive last year's and this year's dividends. Common stockholders would receive cash dividends of $.04 per share ($400 dividends / 10,000 common shares outstanding = $.04). Dividends protection can be attractive to preferred stockholders, especially if a company has a history of not declaring dividends each year. If preferred stockholders find dividends protection attractive, it should be easier for a company to obtain resources from them.

There are other popular preferences designed to make preferred stock attractive to investors. For example, preferred stock can be participating and/or convertible. Participating preferred stock allows preferred stockholders to receive dividends in excess of the stock's stated dividend percentage. For example, if the above 8% preferred stock were participating, under certain circumstances preferred stockholders could receive dividends greater than 8%. Convertible preferred stock allows owners to change (or convert) their preferred stock into common stock under certain conditions. This conversion to common stock would allow preferred stockholders to take advantage of rapid increases in the value of the company's common stock. Regardless of the preferred stock preferences, it is important to remember that preferred stock is a source of resources to companies. In order to obtain resources, companies make use of various preferences to make preferred stock attractive for investors.
 

Practice Exercise

On January 31, the Christopher Corporation had 20,000 shares of $100 par, 10%, cumulative preferred stock outstanding and 5,000,000 shares of $.02 par common stock outstanding.  On February 15, the Christopher Corporation paid cash dividends of $700,000 on shares outstanding on January 31.  The Christopher Corporation did not pay cash dividends in the previous year.

1.  Calculate the total cash dividends paid on February 15 to preferred stockholders.

On an annual basis, the cash dividends to be paid to preferred stockholders are $200,000 (20,000 preferred shares x $100 par value per share x .10 dividend rate = $200,000).  Since the preferred stock is cumulative, any unpaid dividends from previous years must be paid to preferred stockholders before any of this year's dividends can be paid.  Thus, since the Christopher Corporation had not paid the $200,000 dividends in the previous year, this year the preferred stockholders would receive $400,000, $200,000 for the previous year and $200,000 for this year.

2.  Calculate the cash dividend per share paid to preferred stockholders on February 15.

$400,000 cash dividends / 20,000 preferred shares = $20 dividends per share of preferred stock.

3.  Calculate the total cash dividends paid on February 15 to common stockholders.
 
 

Total cash dividends

$700,000

Less: Dividends to preferred stockholders

$400,000

Dividends to common stockholders

$300,000

4.  Calculate the cash dividend per share paid to common stockholders on February 15.

$300,000 cash dividends / 5,000,000 common shares = $.06 dividends per share of common stock.
 

** You now have the background to do text exercises 12.10, 12.11, and 12.12.

 

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