Dividends are a type of payment that companies make to investors. Dividend plans vary widely, and most companies have flexible plans that allow them to change dividend amounts or not pay dividends based on their performance throughout the year and how they want to use their income. Dividends are based on the earnings that a company makes throughout the year. From an accounting perspective, the money is transferred from earnings to the investors. This takes several different steps moving through various accounting entries.
Accountants start with the retained earnings account. This account shows all earnings that the business kept from a period after total costs, taxes and various expenses were accounted for. When a company, usually through a decision made by the board of directors, decides on a dividend amount, the dividend is declared. This does not mean that the dividend is actually paid, but it does allow accountants to move the dividend amount decided on from the retained earnings account and into a dividends payable account.
Dividends Payable and Cash
The dividend money sits in the dividends payment account until the date of payment. It is still present in the company during this stage as cash from the company's operations. The money is not necessarily set aside in a special account, it is simply designated for dividends. On the date of payment, the dividends payable account is debited and the cash account is credited. The dividend increases stockholders' equity and lowers the total amount of cash that a business has.
Financial Statement Effects
While dividends may be an addendum in the income statement, they are more properly accounted for in the statement of retained earnings or stockholders' equity, a lesser financial statement that is typically included along with the broader income statement. When dividends are paid, cash leaves the company, so the statement of cash flows that covers the date of payment will also show the reduction that the dividends caused.
In some cases companies will choose to pay investors dividends in the form of additional stock, a common practice when the company needs to pay dividends but wants to keep its cash for future expenses. In this case accountants will debit money from retained earnings, but credit a different "dividend distributable" account for any money that will be given out for the value of the stock. The account will then be debited and common stock will be credited when the stock is actually awarded.