Shareholders enjoy receiving dividends, but many are not quite sure how dividends work. The easiest way to figure out the accounting impact of dividends is to study a corporation’s balance sheet, which reports on the company’s assets, liabilities and stockholder's equity. The equity section is the key to understanding dividends. It lists accounts for retained earnings, which are the accumulated profits of the company, as well as accounts for paid-in stock and additional paid-in stock. Dividends are paid from the retained earnings account. Stock splits do not affect the balance sheet.
All public corporations issue a single form of common stock and have the option of issuing one or more types of preferred stock. Common stock confers partial ownership of the corporation and a share of earnings upon stockholders. Common stock may pay a dividend, but preferred shares always do. Preferred shares are designed to pay high dividends, but they benefit little from company growth. If a company is liquidated, preferred stock shareholders are paid off ahead of common stock shareholders. Both kinds of stock may occasionally pay stock dividends. Stocks may have a par value, which is a nominal minimum price of the shares. Par value per share is frequently 1 cent or less.
Small Stock Dividends
A small stock dividend distributes new shares that number 25 percent or less of existing shares. The total market value of the new shares is subtracted from retained earnings. The par value of the new shares is added to the paid-in stock account and the remaining value is added to additional paid-in stock. The new shares are distributed to existing stockholders on a pro-rated basis. The market value of the existing shares is decreased by the ratio of new shares to existing ones, so that a stockholder’s position value doesn’t change despite having more shares.
Large Stock Dividends
When the number of new shares exceeds 25 percent of the total, the entire transaction uses only par values. The par value of the new shares is subtracted from retained earnings and added to paid-in stock. This is also the procedure used for stock without par value, which is allowed in many states, including California. Proration and stock devaluation proceed as for small stock dividends. Many accountants feel that the whole notion of stock par value is obsolete.
Splits are announced in the form “x-for-y” shares. For instance, if XYZ Corporation announces a 2-for-1 common stock split, the 10 million existing outstanding shares valued at $90 each are replaced by 20 million shares valued at for $45 each. The accountant makes no changes to the company books, but does make note of the split amount and date. The corporation adjusts the earnings per share and cash dividends per share as appropriate, but the price-earnings ratio remains unchanged.
- Stock Split Secret$: Profiting from a Powerful, Predictable, Price-Moving Event; Miles Nelson, Darlene Nelson
- The Neatest Little Guide to Stock Market Investing: 2013 Edition; Jason Kelly
- Financial Accounting; Robert Libby et al.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.