Double-entry is one of the fundamentals that the modern field of accounting is based upon. For those who are curious, it is the concept that each transaction impacts two or more accounts. As such, when a business makes a cash sale, it records an entry for cash and an another entry for sales revenue rather than either a single entry for cash or a single entry for sales revenue.
Fortunately, double-entry isn’t a very complicated concept. In fact, it should be mentioned that all business transactions can be recorded using just seven kinds of accounts. First, a business’s assets are considered to be equal to the sum of a business’s liabilities and equities, which is a representation of the idea that a business has gotten its assets through a combination of borrowing and investment. Second, a business records both revenues and expenses in each successive period, which are put together based on causal relationships. Third, a business can experience both gains and losses, which are similar to revenues and expenses but come from something besides the business’s routine operations.
Moving on, an account ledger has a right side and a left side. Entries on the right side are called debits, while entries on the left side are called credits. When a transaction is recorded in an account ledger, the total of the debits must be the same as the total of the credits, meaning that something is very blatantly wrong when this fails to be true. In any case, interested individuals should know that neither debits nor credits are either inherently good or inherently bad. Instead, everything depends on exactly what is being recorded as debits and credits. For an instance, an increase in an asset is considered to be a debit. However, an increase in an expense is considered to be a debit as well. Regardless, it shouldn’t to see why double-entry established itself centuries and centuries ago. First, it is much more informative than what a single entry can manage on its own, which is very useful for anyone who wants to make sense of an account ledger for whatever reason. Second, double-entry offers a convenient way to check the accuracy of the recorded information. Something that can be appealing for both internal and external users of the recorded information.
What Happens When a Corporation Declares a Dividend?
Every transaction can be recorded using double-entry bookkeeping. Naturally, dividends are no exception to this. However, before describing the entries that would be used for dividends, it is useful to say something about what happens with them.
For starters, there are both permanent accounts and temporary accounts in accounting. Permanent accounts are accounts that have balances that will be rolled over into the next period. For instance, all assets and all liabilities are considered to be permanent accounts. Meanwhile, most equities are considered to be permanent accounts, but there are some exceptions to the rule. Speaking of which, temporary accounts are the ones that get reduced to zero at the end of the relevant period so that they can be reused in the next period. Of course, the best examples of these accounts would be revenues and expenses.
In any case, both revenues and expenses are reduced using an account called income summary, which is a debit when revenues exceed expenses and a credit when expenses exceed revenues. Once the income summary has been used in this manner, it is then reduced using another account called retained earnings. This is important because retained earnings can be considered the portion of the business’s equity that comes from the profits that have been reinvested in its operations.
When a business declares a dividend, it is saying that it is going to distribute some of its equity to its shareholders in the form of either cash or some other asset. As such, retained earnings is the equity account that gets impacted in the process. However, the exact way that this happens can see a small amount of variation.
What Does the Declaration of a Dividend Look Like in Double-Entry Bookkeeping?
The first step in accounting for a dividend would be the declaration of the dividend. This consists of a debit to one of two potential accounts. Generally speaking, the debited account is retained earnings. However, it is possible for a business to choose to debit a temporary account called dividends instead, which will be reduced to zero using retained earnings at the end of the relevant period. Meanwhile, the credit would be the creation of a current liability called dividends payable because while the business has declared its intention to pay dividends, it hasn’t handed out the cash or other assets at this point in time.
Eventually, when the business makes the actual payments, there will be a second transaction. This time, there will be a debit to dividends payable to represent the idea that it is being cleared out. As for the credit, the most common would be cash because that is the most common asset used for dividends. Unfortunately, other assets are possible, with stocks being the best-known example.
Accounting for a stock dividend is a more complicated matter. On the debit side, it is still retained earnings that is being deducted. However, the credit side may or may not include paid-in capital in excess of par in addition to common stock dividend distributable depending on whether the stock dividend is considered to be small or large. If the number of new shares is less than 20 to 25 percent of the preexisting shares, the stock dividend is considered to be small. In this case, the par value of the new shares will go into common stock dividend distributable while the rest of the market value of the new shares will go into paid-in capital in excess of par. If the number of new shares is more than 20 to 25 percent of the preexisting shares, the stock dividend is considered to be large. At which point, the par value of the new shares will go into common stock dividend distributable while the market value is a point of no concern from a purely accounting perspective.