When a Cash Dividend Becomes a Corporate Liability
A cash dividend happens when a company pays money to its shareholders. The company decides to share some of its profits with the people who own stock in it. The amount each shareholder gets depends on how many shares they have.
Cash dividends are one way companies can return value to shareholders. Companies can also do stock buybacks. With cash dividends, money goes from the company to the shareholders. Dividends are usually paid quarterly (every 3 months). Well-established and profitable companies are more likely to pay dividends.
How dividends are declared and paid
The company’s board of directors must approve and declare the dividend. The board says how much the dividend will be per share, and sets key dates:
- Declaration date: The day the board announces the dividend
- Record date: The date you must be registered as a shareholder to receive the dividend
- Payment date: The day the company mails dividend checks or deposits money into shareholder accounts
An investor must buy the stock before the ex-dividend date to get the next dividend payment. The ex-dividend date is usually 1 business day before the record date.
When does a cash dividend become a liability?
A declared cash dividend becomes a binding legal obligation on the declaration date. This means it becomes a liability for the corporation that day. The company now owes that money to shareholders and must pay it.
Accounting for declared dividends
When the dividend is declared, the company records a journal entry on its books:
Debit: Retained Earnings
Credit: Dividends Payable
Retained earnings go down and dividends payable (a current liability) goes up on the balance sheet by the total dividend amount. Retained earnings are the accumulated profits a company has earned that have not been paid out as dividends.
On the payment date, another entry is recorded:
Debit: Dividends Payable
Credit: Cash
This zeroes out the dividends payable liability and reduces the company’s cash balance, reflecting the dividend payments to shareholders.
What if a company declares a dividend and then can’t pay?
Dividends must be paid from profits or retained earnings. A company cannot legally pay a dividend if it doesn’t have sufficient retained earnings to cover it. That would be considered an illegal “capital distribution”.
The board of directors has a fiduciary duty to ensure dividends are prudent and lawful. Knowingly declaring a dividend that the company cannot afford to pay would violate this duty.
However, in some rare cases, a company’s financial situation could suddenly worsen between declaration and payment dates. If paying the dividend would jeopardize the company’s solvency and liquidity, the board may have to suspend or reduce the payment. Changing or cancelling a declared dividend is a very serious matter that would likely cause the stock price to plummet. Companies try hard to avoid this.
Why companies still declare dividends
Paying a dividend signals that a company is healthy and confident about its future earnings. Many shareholders count on dividends as a source of income. Cutting or suspending a dividend is often taken as very bad news by investors.
Mature, slower-growth companies tend to pay dividends. High-growth companies usually prefer to reinvest profits instead of paying dividends. Investors seeking steady dividend income look for companies with:
- Long history of paying dividends
- Consistent earnings
- Strong cash flows
- Relatively low debt
- Not much need for capital investment
Investors can reinvest dividends in more stock through dividend reinvestment plans (DRIPs). This compounds returns over time similar to interest.