- Account for cumulative preferred dividends
- Account for the declaration and distribution of stock dividends
If a company’s board of directors wants to pay common stockholders a dividend, they must pay the preferred stockholders first.
Preferred Stock Dividends
Preferred stockholders are paid a designated dollar amount per share before common stockholders receive any cash dividends. However, it is possible that the dividend declared is not enough to pay the entire amount per preferred share that is guaranteed—before common stockholders receive dividends. In that case, the amount declared is divided by the number of preferred shares. Common stockholders would then receive no dividend payment.
Preferred stock may be cumulative or non-cumulative. This determines whether preferred shares will receive dividends in arrears, which is payment for dividends missed in the past due to an inadequate amount of dividends declared in prior periods. If preferred stock is non-cumulative, preferred shares never receive payments for past dividends that were missed. If preferred stock is cumulative, any past dividends that were missed are paid before any payments are applied to the current period.
NON-cumulative preferred stock
25,000 shares of $3 non-cumulative preferred stock and 100,000 shares of common stock. Preferred shares would receive $75,000 in dividends (25,000 × $3) before common shares would receive anything.
| Preferred Stockholders | Common Stockholders | Owed to | ||||
|---|---|---|---|---|---|---|
| Year | Total Dividend | Total | Per Share | Total | Per Share | Preferred |
| 1 | $0 | $0 | $0 | $0 | $0 | $0 |
| 2 | $20,000 | $20,000 | $0.80 | $0 | $0 | $0 |
| 3 | $60,000 | $60,000 | $2.40 | $0 | $0 | $0 |
| 4 | $175,000 | $75,000 | $3.00 | $100,000 | $1.00 | $0 |
| 5 | $200,000 | $75,000 | $3.00 | $125,000 | $1.25 | $0 |
| 6 | $375,000 | $75,000 | $3.00 | $300,000 | $3.00 | $0 |
In this example, no dividends were declared on either class of stock in year one.
In year two, preferred stockholders must receive $75,000 before common shareholders receive anything. Since only $20,000 is declared, preferred stockholders receive it all.
In year three, preferred stockholders must receive $75,000 before common shareholders receive anything. Since only $60,000 is declared, preferred stockholders receive it all.
In year four, preferred stockholders must receive $75,000 before common shareholders receive anything. Of the $175,000 is declared, preferred stockholders receive their $75,000 and the common stockholders get the remaining $100,000.
In year five, preferred stockholders must receive $75,000 before common shareholders receive anything. Since $200,000 is declared, preferred stockholders receive $75,000 of it and common shareholders receive the remaining $125,000.
In year six, preferred stockholders receive $75,000 and common shareholders receive the remaining $300,000.
CUMULATIVE preferred stock
25,000 shares of $3 cumulative preferred stock and 100,000 shares of common stock. Preferred shares would receive $75,000 in dividends (25,000 × $3) before common shares would receive anything.
| Preferred Stockholders | Common Stockholders | Owed to | ||||
|---|---|---|---|---|---|---|
| Year | Total Dividend | Total | Per Share | Total | Per Share | Preferred |
| 1 | $0 | $0 | $0 | $0 | $0 | $75,000 |
| 2 | $20,000 | $20,000 | $0.80 | $0 | $0 | $130,000 |
| 3 | $60,000 | $60,000 | $2.40 | $0 | $0 | $145,000 |
| 4 | $175,000 | $175,000 | $7.00 | $0 | $0 | $45,000 |
| 5 | $200,000 | $120,000 | $4.80 | $80,000 | $0.80 | $0 |
| 6 | $375,000 | $75,000 | $3.00 | $300,000 | $3.00 | $0 |
In this example, no dividends were declared on either class of stock in year one. The preferred stockholders are owed $75,000.
In year two, preferred stockholders must receive $150,000 ($75,000 for year one and $75,000 for year two) before common shareholders receive anything. Since only $20,000 is declared, preferred stockholders receive it all and are still “owed” $130,000 at the end of year two.
In year three, preferred stockholders must receive $205,000 ($130,000 in arrears and $75,000 for year three) before common shareholders receive anything. Since only $60,000 is declared, preferred stockholders receive it all and are still “owed” $145,000 at the end of year three.
In year four, preferred stockholders must receive $220,000 ($145,000 in arrears and $75,000 for year four) before common shareholders receive anything. Since only $175,000 is declared, preferred stockholders receive it all and are still “owed” $45,000 at the end of year four.
In year five, preferred stockholders must receive $120,000 ($45,000 in arrears and $75,000 for year five) before common shareholders receive anything. Since $200,000 is declared, preferred stockholders receive $120,000 of it and common shareholders receive the remaining $80,000.
In year six, preferred stockholders are not owed any dividends in arrears. Of the $375,000 that is declared, they receive the $75,000 due to them in year six. Common shareholders receive the remaining $300,000.
Dividends in arrears are cumulative unpaid dividends, including the dividends not declared for the current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability until declared by the board of directors. However, since the amount of dividends in arrears may influence the decisions of users of a corporation’s financial statements, firms disclose such dividends in a footnote. An appropriate footnote might read: “Dividends in the amount of $20,000, representing two years’ dividends on the company’s 10%, cumulative preferred stock, were in arrears as of December 31.″
In addition to cash dividends, which are the most common way corporations distribute wealth to the owners, it is possible for a company to issue more stock in lieu of cash. But before we discuss stock dividends, let’s review the basics of cash dividends.
Stock Dividends
Stock dividends are corporate earnings distributed to stockholders. They are distributions of retained earnings, which is accumulated profit. With a stock dividend, stockholders receive additional shares of stock instead of cash. Stock dividends transfer value from Retained Earnings to the Common Stock and Paid-in Capital in Excess of Par – Common Stock accounts, which increases total paid-in capital.
Stock Dividends is a contra stockholders’ equity account that temporarily substitutes for a debit to the Retained Earnings account. At the end of the accounting period, the Stock Dividends account is closed to Retained Earnings.
Stock dividends are only declared on shares outstanding, not on treasury stock shares.
Three dates are associated with a stock dividend. The date of declaration is the date the corporation commits to distributing additional shares to stockholders. On that date, the stockholders’ equity account Stock Dividends Distributable is used to record the value of the shares due to the stockholders until the shares are distributed. The date of record is the date on which ownership is determined. Since shares of stock may be traded, the corporation names a specific date, and whoever owns the shares on that date will receive the dividend. There is no journal entry on the date of record. Finally, the date of distribution is the date the shares are actually distributed to stockholders.
When a stock dividend is issued, the total value of equity remains the same from both the investor’s perspective and the company’s perspective. However, all stock dividends require a journal entry for the company issuing the dividend. This entry transfers the value of the issued stock from the retained earnings account to the paid-in capital account.
The amount transferred between the two accounts depends on whether the dividend is a small stock dividend or a large stock dividend.
- A stock dividend is considered small if the shares issued are less than 25% of the total value of shares outstanding before the dividend. A journal entry for a small stock dividend transfers the market value of the issued shares from retained earnings to paid-in capital.
- Large stock dividends are those in which the new shares issued are more than 25% of the value of the total shares outstanding prior to the dividend. In this case, the journal entry transfers the par value of the issued shares from retained earnings to paid-in capital.
For example, assume the Board of Directors of Tanya Corp. met on December 10, 20X1, and declared a 2% stock dividend on 21,000 shares of $10 par common stock outstanding. The fair market value is $15 per share.
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20X1 | ||||
| Dec 10 | Stock Dividends | 6,300.000 | ||
| Dec 10 | Stock Dividends Distributable | 4,200.00 | ||
| Dec 10 | Paid-in Capital in Excess of Par – Common Stock | 2,100.00 | ||
| Dec 10 | To record declaration of stock dividend of 2% (21,000 shares outstanding X $15 X 0.02) | |||
Stock Dividends is calculated by multiplying the number of additional shares to be distributed by the fair market value of each share.
Stock Dividends Distributable is a stockholders’ equity account that substitutes for Common Stock until the stock can be issued. Stock Dividends Distributable can only be in multiples of par, just like Common Stock: the number of shares in the stock dividend times the par value per share.
Paid-in Capital in Excess of Par − Common Stock is used for any amount above par.
On the distribution date, the company will eliminate the liability with this entry:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20X2 | ||||
| Jan 20 | Stock Dividends Distributable | 4,200.00 | ||
| Jan 20 | Common Stock | 4,200.00 | ||
| Jan 20 | To record distribution of 2% stock dividend declared in Dec 20X1 | |||
When a dividend is paid as cash, then the company will have less cash, reducing its value, and therefore, its value per share (theoretically). If the dividend is paid as stock, then there are more shares outstanding, but the value of the company has not increased; therefore, the company’s value per share is reduced.
For example, if a company pays a 10% stock dividend, then it will distribute one share of stock for every 10 shares owned by holders of record, and the total number of outstanding shares will also increase by 10%. A company with a market value of $10,000,000 and 100,000 shares outstanding (trading at $100 each) would still be worth $10,000,000 with 110,000 shares outstanding, and theoretically, the market price per share would be $90.91. If the company had paid that same dividend in cash, it would now have $1,000,000 less in cash and be worth $9,000,000 with 100,000 shares outstanding, so the price should (again, theoretically) go down to $90 per share. The market doesn’t work with that kind of mathematical precision because there are hundreds of other variables, and it operates as an auction.
However, the main advantage of a stock dividend for the company is that the retained earnings can all be reinvested for greater growth. The main advantage of a stock dividend for the stockholder is that no taxes have to be paid on the stock dividend until the shares are sold.
In addition, because stock dividends don’t come out of earnings, they don’t trigger the preferred stock dividend liability.
In the next section, we’ll learn about another more common way for shareholders to acquire additional shares of stock, but first let’s review stock dividends.