Ch 15.3 (Dividend Policy) Flashcards
Dividend Payouts
A dividend check provides proof that at least some portion of a company’s profits is genuine.
Determining the proper amount of dividends to pay is a difficult financial management decision.
Why do very few companies pay dividends in amounts equal to their legally available retained earnings?
- To maintain agreements (bond covenants) with specific creditors, to retain all or a portion of the earnings, in the form of assets, to build up additional protection against possible loss.
- To meet state corporation requirements, that earnings equivalent to the cost of treasury shares purchased be restricted against dividend declarations.
- To retain assets that would otherwise be paid out as dividends, to finance growth or expansion. This is sometimes called internal financing, reinvesting earnings, or “plowing” the profits back into the business.
- To smooth out dividend payments from year to year by accumulating earnings in good years and using such accumulated earnings as a basis for dividends in bad years.
- To build up a cushion or buffer against possible losses or errors in the calculation of profits.
Financial Condition and Dividend Distribution
Management must pay attention to legality and economic conditions (liquidity) of dividend distributions. A company should not pay a dividend unless both the present and future financial position warrant the distribution.
In short, management needs to consider availability of funds to pay the dividend.
SEC and Dividends
SEC encourages companies to disclose their dividend policy in their annual report, especially those that (1) have earnings but fail to pay dividends, or (2) do not expect to pay dividends in the foreseeable future. In addition, the SEC encourages companies that consistently pay dividends to indicate whether they intend to continue this practice in the future.
Types of Dividends
- Cash dividends.
- Property dividends (dividends in kind).
- Liquidating dividends.
They can be accumulated profits (that is, retained earnings), on some other capital item such as additional paid-in capital, stocks, or some other asset.
All dividends, except for stock dividends, reduce the total stockholders’ equity in the corporation.
Liquidating Dividend
A dividend not based on retained earnings.
Should be disclosed to the stockholders so that they will not misunderstand its source.
Cash Dividends
Board of directors vote on its declaration.
A declared cash dividend is a liability. Because payment is generally required very soon, it is usually a current liability.
Companies do not declare or pay cash dividends on treasury stock.
Many companies focus more on increasing share price, stock repurchase programs, and corporate earnings than on dividend payout.
Debit to Retained Earnings (or Cash Dividends Declared) and a credit to Dividends Payable
Property Dividends (Dividends in Kind)
Dividends payable in assets of the corporation other than cash.
When declaring a property dividend, the corporation should restate at fair value the property it will distribute, recognizing any gain or loss as the difference between the property’s fair value and carrying value at date of declaration.
Debit to Retained Earnings (or Property Dividends Declared) and a credit to Property Dividends Payable.
Liquidating Dividends
Dividends based on other than retained earnings.
Some corporations use paid-in capital as a basis for dividends.
Such dividends are a return of the stockholder’s investment rather than of profits.
Any dividend not based on earnings reduces corporate paid-in capital
Stock Dividends
The company distributes no assets.
Each stockholder maintains exactly the same proportionate interest in the corporation and the same total book value after the company issues the stock dividend. Of course, the book value per share is lower because each stockholder holds more shares.
Issuance by a corporation of its own stock to its stockholders on a pro rata basis, without receiving any consideration.
From retained earnings to capital stock (and additional paid-in capital if applicable)
Note that the stock dividend does not affect any asset or liability. The entry merely reflects a reclassification of stockholders’ equity.
Small(Ordinary) Stock Dividends
When the stock dividend is less than 20–25 percent of the common shares outstanding at the time of the dividend declaration, the company is therefore required to transfer the fair value of the stock issued from retained earnings.
Stock Split
To reduce the market price of shares.
Accounting records no entry for a stock split. However, it enters a memorandum note to indicate the changed par value of the shares and the increased number of shares.
Reverse Stock Splits
Some companies are considering reverse stock splits in which, say, five shares are consolidated into one.
The downside to this strategy is that analysts might view reverse splits as additional bad news about the direction of the stock price.
Stock Split v Stock Dividend
A stock split increases the number of shares outstanding and decreases the par or stated value per share.
A stock dividend, although it increases the number of shares outstanding, does not decrease the par value; thus, it increases the total par value of outstanding shares.
If the stock dividend is large, it has the same effect on market price as a stock split. This effect usually results only if the number of shares issued is more than 20–25 percent of the number of shares previously outstanding.
Large Stock Dividend
A stock dividend of more than 20–25 percent of the number of shares previously outstanding.
Basically, a stock split.
Companies transfer from retained earnings to capital stock the par value of the stock issued, as opposed to a transfer of the market price of the shares issued as in the case of a small stock dividend.
