Dividends aren’t considered an expense for accounting purposes. Instead, companies subtract them from the equity section of their balance sheet.
Investing comes with plenty of benefits, such as the ability to grow wealth and save for your biggest financial goals, including retirement. Another important benefit of investing is the possibility of earning dividends. Dividend payments can serve as an additional source of income and can help you grow your investment portfolio more quickly.
For investors, dividends are a type of income. But how are they classified for companies? Do they appear on a company’s cash flow statement? We’ll discuss that in this article, as well as share an example of how dividends work and some of their pros and cons.
What are dividends?
Before we dive into how companies account for dividends, let’s first explain what dividends are and how they work for investors.
Dividends are payments that publicly traded companies make to their shareholders. They serve as a way for companies to pass along some of their profits to investors. Not all companies pay dividends, and some do only occasionally. But those companies that regularly pay dividends usually do so quarterly (though they can also pay them monthly or semiannually).
How to earn dividend payments
Generally speaking, for an investor to earn dividends, they must own shares in the company as of the ex-dividend date. If someone buys shares after that date, they won’t be paid dividends. Similarly, even if an investor sells their shares before the dividends are paid, they’ll still receive the dividend because they owned the shares on the ex-dividend date.
Whether a company pays dividends and how much they pay depends on several factors. First, larger and more established companies are more likely to pay dividends. These companies aren’t investing in growth at as high a rate as newer companies or those still in their growth phase. As a result, they’re more willing and able to pass those profits along to shareholders.
Companies are also more likely to pay dividends when they do well. When a company is going through a hard season or when the economy as a whole is struggling, companies may cut back on their dividends to ensure their financial security.
Cash dividends vs. stock dividends
Dividends can come in two primary forms: cash or stock. While cash dividends are more common, some companies prefer to offer a stock dividend.
- Cash. A cash dividend is simply a cash payment a company makes to its shareholders. Cash dividends are usually set at a per-share amount. For example, a company might pay dividends of $1 per share. If an investor owns 100 shares, they’ll be paid $100 in dividends.
- Stock. In this case, the company simply issues new shares of stock to its existing shareholders, usually in proportion to each shareholder’s current holdings. For example, a shareholder that owns 1% of the company’s stock would be paid 1% of the company’s stock dividends.
It’s important to keep in mind that offering dividend payments through cash or stock dividends doesn’t affect a company’s net income.
Are dividends an expense for tax purposes?
It may seem like dividends paid to investors should be considered an expense for a company since it’s money leaving the company. But for accounting purposes, dividends aren’t recorded as an expense on a company’s income statement.
When a company pays dividends, it generally does so from its profits or retained earnings accounts. A company’s retained earnings account holds an amount it sets aside, just as an individual would set some of their income aside in a savings account.
A company’s retained earnings are recorded in the equity section of its balance sheet. Rather than dividends being recorded as an expense on a company’s income statement, they are simply subtracted from that retained earnings amount on the balance sheet. In other words, these dividends are reallocated from the company’s equity to additional paid-in capital accounts and common stock.
Why aren’t dividends considered expenses?
Dividends aren’t considered expenses for a few different reasons. First, dividends simply aren’t an operating expense like the others that would be recorded on the income statement. And unlike true expenses, dividends can’t be deducted for tax purposes.
For example, when a company spends $1,000 on equipment, it can write off that expense to help reduce its tax burden. But if a company pays $1,000 in dividends, it can’t write off that amount. If a company could write off dividends, it would serve as a way for companies and their shareholders to avoid taxation on those profits. In that case, far more companies would probably pay dividends to their investors.
Dividend payment example
Suppose a company has 1,000 shareholders and decides to issue dividends in the amount of $1 per share, for a total of $1,000 in dividend payments. The company isn’t paying an expense, nor does it record the $1,000 in dividends on its income statement.
Suppose the company previously had retained earnings of $5,000, which were recorded on its balance sheet as equity. Once the company makes the $1,000 in dividend payments, it would reduce its retained earnings on its balance sheet to $4,000.
Pros and cons of dividends
Dividends come with some serious advantages, but not all companies offer them. Of course, dividends also have some disadvantages. Below we’ll talk about some of the pros and cons of dividends for both investors and companies.
Here is a list of the benefits and drawbacks to consider.
- Additional income. Dividends serve as an additional income stream for investors. When you buy stock, you may be hoping the stock will increase in value over time so you can sell for a profit. And while that’s a great way to build wealth, it doesn’t provide any ongoing income. But dividends are paid on a monthly, quarterly, or semiannual basis. As a result, they can provide a source of passive income that investors can either have deposited into their bank accounts or be reinvested to help their portfolio grow even more.
- Provide income during tough economic times. Dividends are especially beneficial when other investments aren’t performing well. If the economy is struggling or the stock market experiences a bear market, you’ll probably see your portfolio lose some of its value. Income investments like dividend stocks can help boost your returns during those seasons of the business cycle.
- Better tax treatment. Some dividends also have preferential tax treatment. Depending on whether you earn qualified or ordinary dividends, you may be able to enjoy the long-term capital gains tax rates, which are lower than your ordinary income tax rate.
- Companies can attract investors. Dividends also have advantages for companies. They provide a way for companies to pass some of their profits along to shareholders. As a result, they can help companies attract more investors. Some companies have made a name for themselves as excellent dividend stocks, so when investors want to earn a bit of passive income, that’s where they turn.
- Difficult growth. Companies that pay dividends may grow more slowly than other companies. That’s not to say dividend companies aren’t successful — quite the opposite, actually. However, those well-established companies are no longer in the season where they experience extreme growth. On the other hand, a successful start-up that’s currently growing rapidly isn’t likely to pay dividends but may offer a higher rate of return on its stock price.
- Reduces money available. This also puts companies in a difficult situation. Sure, they want to attract more investors, and dividends can help them do that. But paying dividends means less money is available to reinvest in the company.
- Inefficient for taxes. Dividends can also be inefficient for tax purposes. When you own a stock, you can hold it for years and years and not pay capital gains taxes until you sell it. But when you earn dividends, you’ll have to pay taxes on them in the year you earned them. And depending on the type of dividends you earn, some could require that you pay your ordinary income tax rate rather than the lower capital gains tax rate.
- Not guaranteed. A final disadvantage of dividends is that, unlike bond interest payments, they aren’t guaranteed. A company that has historically paid dividends each quarter could suddenly decide to either reduce its dividends or simply stop paying them altogether.
- Dividends are payments that companies make to their shareholders as a way of passing along some of their profits.
- An investor may receive dividends in one of two forms: additional shares of stock dividends or cash dividends at a certain per-share rate.
- Dividends aren’t considered expenses for accounting purposes. Instead, they are subtracted from the equity section of a company’s balance sheet.
- Dividends have plenty of benefits for both companies and investors, but they also have some downsides for both parties.
View Article Sources
- Topic No. 404 Dividends — IRS
- Publication 550: Investment Income and Expenses — IRS
- Are Reinvested Dividends Taxable? — SuperMoney
- How Capital Gains and Losses Affect Your Taxes — SuperMoney
- Tax Deductions and Credits List: Complete Guide for 2022 — SuperMoney
- How to Guarantee You Will Get a Tax Refund Next Year — SuperMoney
- How To Buy Stocks With a Debit Card — SuperMoney
- Beginner’s Guide to Investing — SuperMoney
- Best Brokerages | May 2022 — SuperMoney