A company’s shareholders pay dividends from the company’s profits proportionate to the shares they own in the company. Dividend accounting is an integral part of financial management for all companies because every shareholder gets a share from the profits. The accounting treatment of the distribution is crucial as the accuracy of financial reporting depends on it.
Accounting for dividends is an intricate part of accounting, and this guide will help you better understand the entire workflow in this context.
Guide to Dividend Accounting
What is Dividend?
It is the payment a shareholder receives from a company where they own shares. The payment is proportionate to the number of shares. The dividend per share needs to be determined and recorded before it is entered into the company’s profit and loss (P&L) statements. The P&L statement must be updated with the amount declared as dividends paid during the year, dividends claimed, and those claimed but still need to be paid.
Whether the dividend is regular, special, or split, dividends are classified as stock or cash.
Explaining Accounting for Dividends
Dividend accounting is an essential part of cash flow for all businesses. The payment is made to the stockholder’s equity account from the company’s retained earnings account. It is how the company can track what percentage of its profits are dispensed to shareholders.
Significance of Accounting for Dividends
It is of critical significance in ensuring corporate governance. Significance includes –
- Transparency with an accurate reflection of the financial health of a company with the details of profit distribution to shareholders.
- It directly impacts the equity of shareholders and provides stakeholders with a clear view of the company’s profit allocation.
- Proper accounting of dividends is important to maintain investor confidence and is also an essential part of regulatory compliance.
- Dividend accounting helps potential investors in assessing the company’s performance and sustainability.Â
- The accuracy of the process supports strategic decision-making regarding the company’s future dividend policies and capital allocation.
The Process of Accounting for Dividends
Determining Adequate Cash for Dividend Payout
The first step is for the company to decide if it has enough cash flow to distribute dividends as per the payout ratio. The payout ratio is the total money a company needs to pay dividends. If the cash is inadequate, the company may need to sell its assets or borrow money to raise the money.
Declaring Dividends
The next step is for the company’s board of directors to declare dividends. It is a formal announcement highlighting the intention to pay dividends. The announcement also includes the dividend amount, record date, and payment date. Once declared, the company is legally liable to pay the amount to its shareholders, and careful accounting becomes necessary.
Journal Entries for Dividend Declaration
An entry is a must for declared dividends in the accounting records. Thus, the Retained Earnings Account has to be debited, while the Dividends Payable Account is credited after the dividend declaration. Retained earnings are the company’s accumulated net income that has not been distributed to shareholders and is not used for investment in the business.
This journal entry indicates a reduction in the company’s equity and retained earnings and an increase in liability.
Example Entry:
- Debit: Retained Earnings Account
- Credit: Dividends Payable Account
Record Date
It is the date that the company sets to decide which shareholders are eligible to get dividends. No accounting entry is made on this date as it is merely the day when those shareholders who will be paid dividends are identified.
Dividend Payments
This is the date on which the payment is made. It is the date when the company distributes the dividends to its shareholders of record. On this date, the dividend payable account of the company is debited, and the Cash Account is credited. This reflects that the company’s cash assets are reduced, and the liability is paid.
Example Entry:
- Debit: Dividends Payable Account
- Credit: Cash
Different Ways of Calculating in Dividend Accounting
There are three main methods. These are –
- The direct method is where the total amount of dividends is calculated on the basis of what was declared. The amount gets transferred to liability from equity. It is the easiest method.Â
- Retained Earnings is the popular method where companies can keep their earnings intact, and there are no tax implications.
- Retained Net Income is the method where the number of dividends paid is shown in the balance sheet. The retained net income is drawn by subtracting the dividends paid.Â
Standard Methods of Dividend Accounting
- EBITDA – in this case, the dividend payments are subtracted from the company’s earnings. In this method, the focus is on cash flow rather than profits. This method is generally used by analysts and investors where the company’s cash flow is looked at after the income tax, depreciation, and amortisation of assets are subtracted from the earnings.Â
- DDM or the Dividend Discount Model – in this case, only the dividends are looked at; thereby, it does not consider account earnings growth or dividends over time. The method works on the principle that all future dividends will be paid. The future dividends are then discounted to the present.
Accounting for dividends is a crucial process for all businesses and requires careful consideration. It involves accurate record-keeping, too, with specific accounting entries that impact the company’s financial statements. Proper accounting for dividends ensures that the financial statements accurately reflect the company’s financial health and compliance with accounting standards. This guide has been prepared to help you understand the minute details of the process.
Accounting for Dividends by TaxCan Accountants
TaxCan Accountants specialise in navigating the complexities of dividend accounting. They support businesses in managing their profit distributions effectively, ensuring the accurate and compliant recording of dividend declarations, payments, and related tax implications. They help in handling the process from the declaration to the distribution of dividends, such that the integrity of a company’s financial statements is maintained. They work towards preserving the shareholder’s trust and confidence. Their expertise aids in optimising dividend strategies, ensuring that they align with the company’s financial goals and shareholder expectations and comply with regulatory requirements.
More Links!
https://hbr.org/2022/05/the-importance-of-dividends
https://quickbooks.intuit.com/r/taxes/what-are-dividends-and-how-do-they-affect-your-taxes
https://www.accountingtools.com/articles/what-is-accounting-for-dividends.html
