All commercial companies operate primarily to earn profits for their owners. In a company structure, the owners are in the form of shareholders. They can be as little as two in a private company and as many as hundreds and thousands in a public listed company. Each of these shareholders is entitled to his share in the profit generated by the company through its operations. When profit is actually earned, the company may choose to reinvest it back into the business if so required or it may opt to distribute all or part of the profit to its shareholders. If a company decides to distribute profit to its shareholders, it does so in the form of ‘dividend payment’.
Dividend is thus not a charge, but an appropriation from profit which reduces the balance of company’s retained earnings. The nature of dividend in a company is the same as the nature of drawings in a sole proprietorship or partnership business. This article looks at meanings of and differences between two types of dividend distribution – cash dividend and stock dividend.
Definitions and meanings
Cash dividend:
Cash dividend is the distribution of profits of the company to its shareholders in the form of actual cash payment. This cash is usually paid to shareholders through check or electronic bank transfer. The key here is that the shareholders receive an actual and immediate monetary value as dividend.
On obtaining all requisite approvals, the company’s board of directors declares cash dividend by announcing either the dollar amount of dividend or its percentage. The percentage of dividend declared is the percentage of the face value of shares outstanding on the date of declaration. The date on which a company declares dividend is typically termed as “date of declaration” or “declaration date”. The declaration of cash dividends represents company’s obligation to distribute its cash to shareholders. From accounting perspective, cash dividend, once declared, becomes company’s liability.
Companies also set a record date (also named as date of record) prior to actual distribution of dividend. All shareholders who exist in the books as on the record date are entitled to receive the declared dividend. An investor who buys shares after record date is not eligible to receive dividend. In relation to a dividend paying stock, the record date is a much important concept that investors need to understand before buying new shares or selling their already held shares.
On payout date, the declared dividend is paid out either by a check issued in favor of each investor or by a direct electronic credit to his bank account.
Journal entries for cash dividend
(i). On declaration:
The declaration of cash dividend is recorded as a short-term liability by means of the following journal entry:
Retained earnings [Dr]
Cash dividends payable [Cr]
(ii). On payment:
The payment of a cash dividend that has already been declared is recorded by means of the following journal entry:
Cash dividends payable [Dr]
Cash [Cr]
Let’s make the concept more clear with the help of an example:
Example:
On November 28, 2021, Al-Fazal Company’s board of directors declared a $0.60 per share dividend for its common stockholders. On the date of declaration, Al-Fazal had 100,000 shares of common stock issued and had 15,000 shares in its treasury stock. The total cash dividend to be paid was based on the number of shares outstanding, which was the total number of shares issued less shares held as treasury stock. The cash was distributed to shareholders through bank transfer on 10 December 2021.
Al-Fazal Company would make the following journal entries in its books on the date of declaration and payment of dividend:
Amount of cash dividend to be distributed = (100,000 – 15,000) × 0.60
= 85,000 shares × 0.60 per share
= $51,000
(i). Journal entry on November 28, the date of declaration:
Retained earnings…..51,000 [Dr]
Cash dividends payable…..51,000 [Cr]
(ii) Journal entry on December 10, 2021, the date of payment:
Cash dividends payable…..51,000 [Dr]
Cash…..51,000 [Cr]
Stock dividend:
Stock dividend is when the profits of the company are distributed not in the form of cash but by issuing new shares to the existing shareholders.
Stock dividends are generally opted for by companies when they do not have sufficient liquidity to be able to pay cash dividends. These dividends increase the total number of outstanding shares of a company. Theoretically speaking when stock dividend is issued, the share price decreases in the same proportion so as to keep the total market capitalization or market value of the company the same.
Example
Alpha Ltd. decides to issue stock dividend to its shareholders. It declares a stock dividend of 5% (i.e., 5 new shares issued for every 100 shares held). It has 100,000 fully paid-up shares of $10 each outstanding.
The shares issued as stock dividend will be 5,000 shares of face value $10 each (1,00,000 × 5%).
The accounting entries for this in the books of Alpha Ltd are:
(i). On the date of declaration:
Retained earnings a/c…..50,000 [Dr]
Common stock dividend distributable…..50,000 [Cr]
(ii). On the date of distribution:
Common stock dividend distributable…..50,000 [Dr]
Common stock…..50,000 [Cr]
Unlike cash or property dividends, no liability is recorded on the declaration of stock dividend because it does not involve in the distribution of cash or another economic resource. In above example if Alpha prepares a balance sheet before the actual distribution of shares to shareholders, it would report the balance of “common stock dividend distributable account” in stockholder’s equity section under the line item “common stock”.
A company may also choose to record the issuance of stock dividend at the market price of its shares. If market price is used for this purpose, the amount received in excess of face value of shares is credited to “additional paid-in capital account” and the “common stock dividend distributable account” would still be credited with the face value of shares to be distributed. Suppose if Alpha’s share has a market value of $25 and the company records its stock dividend at market price, the relevant journal entries would be made as follows:
(i). On the date of declaration:
Retained earnings a/c…..125,000 [Dr]
Common stock dividend distributable…..50,000 [Cr]
Additional paid-in capital…..75,000 [Cr]
(ii). On the date of distribution:
Common stock dividend distributable…..50,000 [Dr]
Common stock…..50,000 [Cr]
Mostly, the market price is used for recording only small stock dividends; in large scale distributions, companies use par or face value. A stock dividend is considered a small stock dividend when its quantum is 25% or less of the outstanding shares just before the declaration. When the quantum of additional distribution is larger than 25% of the existing number of outstanding shares, the distribution is said to be a large stock dividend.
While a small stock dividend can subsequently have a slight impact on shares’ market price, its core purpose is just the distribution of profit to shareholders. A large scale distribution, however, exerts a significant impact on the shares’ market price. It acts much like a stock split and can bring the share price at a much lower level.
Similar to cash dividend, the stock dividend reduces the balance of retained earnings account on equity side of the balance sheet. However in stock dividend, the cash (or another asset) is not affected rather the amount of outstanding shares increases on the same side (i.e., equity side) of the balance sheet.
Under this type of dividend distribution, the number of outstanding shares of common stock increases and their amount is shifted from retained earnings (i.e., earned capital) account to common stock (i.e., contributed capital) account.
Difference between cash dividend and stock dividend:
Eight key points of difference between cash dividend and stock dividend have been listed below:
1. Meaning
- Cash dividend is a distribution of profits of a company to its shareholders in the form of actual cash payout.
- Stock dividend is a distribution of profits of a company to its shareholders by issuance of new shares.
2. Mode of payment
- Cash dividend is paid out in actual monetary terms. It is generally paid through bank channels i.e., through check, draft or electronic clearing service (ECS).
- Stock dividend is not paid out in pure monetary terms. It is generally paid by crediting shares to the demat account of investors.
3. Expressed as
- Cash dividend can be expressed either as a percentage or absolute amount in relation to face value of shares.
- Stock dividend is generally expressed as a specific number of shares issued for number of shares already held.
4. Impact on cash flow
- Cash dividend causes an outflow of cash and has an immediate impact on the availability of cash with the company.
- Stock dividend does not involve in immediate cash outflow and hence does not disturb the company’s current cash position.
5. Entry on record date
- When declared, the cash dividend is initially recorded as a short-term liability and stays in the books as such until the amount announced is actually paid to shareholders.
- The declaration of stock dividend does not give rise to any liability account. If the company needs to draft a balance sheet between the date of declaration and the date of actual distribution, the declared but unpaid stock dividend can be recorded in equity section of the balance sheet. It stays there until the number of shares announced as dividend are actually distributed and allotted to shareholders on the date of payment.
6. Dilutive impact on entity’s shares
- Cash dividend neither has any impact on the share capital outstanding nor on the share price of the company.
- Stock dividend has a dilutive effect as it increases the total share capital outstanding as well as reduces the share price.
7. Tax impact
- Cash dividend is generally subject to tax as per jurisdictional tax rules. As it is income in the hands of recipient shareholders, it is taxed as such in their hands. There may also be a withholding responsibility on the paying company.
- Stock dividend does not have any immediate tax impact either for the shareholders or on the company. In the hands of the shareholders, they are taxed in the form of capital gains only when the issued stock is subsequently sold or transferred.
8. Opted for when
- Cash dividend is preferred by companies when they have sufficient liquidity and when they do not wish to dilute their capital value.
- Stock dividend is preferred by companies when they do not have adequate liquidity to fund cash dividend.
Conclusion:
Cash dividend and stock dividend are the two methods that companies adopt to pass a portion of their earnings to shareholders. The key point of difference between the two methods is that the former is the distribution of real cash to shareholders and impacts the cash position of the company whereas the latter is the allocation of additional shares to existing shareholders and therefore impacts the number of shares outstanding.
There is no obligation on companies to mandatorily declare and pay a specific amount as dividend because the type of dividend declared as well as its quantum is the prerogative of the company. Several factors such as availability of enough profits and liquidity as well as long term position of the company determine the declaration or nondeclaration of dividends. Both cash and stock dividend are recommended by the board of directors but final decision is subject to approval of the entity’s real owners i.e., shareholders.
