By Rose Johnson Updated December 07, 2021
A company typically divides its profits between itself and its shareholders. Distributions represent a portion of the profits a company decides to give to its shareholders, while retained earnings represent the portion of profits that a company chooses to keep. Companies choose to share profits in the form of dividends because it encourages shareholders to continue investing in the company. Understanding the transactions pertaining to dividends and retained earnings helps you know the effects of the transactions on a company’s financial statements.
Distribution Payable: Meaning
When a public company earns a profit, it decides whether to distribute excess earnings to shareholders in the form of dividends. In most cases, companies issue cash dividends, but they can also issue stock dividends. According to Investopedia, a cash dividend is a cash payment, and a stock dividend represents additional shares that companies give to their shareholders. Companies typically pay dividends every three months. Companies are not obligated to pay dividends to shareholders, and they sometimes cease dividend payments during unprofitable periods.
Cash Distributions and Equity
When a company declares a distribution payable to shareholders, the declaration directly affects the retained-earnings account under the shareholder-equity section of the balance sheet. The journal entries made with the declaration of dividends include a debit to the retained-earnings account and a credit to the dividend-payable account. A decrease in the shareholders’-equity account and an increase in liabilities on the balance sheet are the result of a declaration of dividends. When the company actually pays the dividends to shareholders, the distribution-payable account is debited and cash is credited. The effects on the cash account are shown on the cash-flow statement under the financing-activities section.
Reasons Companies Retain Earnings
According to the Corporate Finance Institute, in contrast to dividends, retained earnings represent the profits the company chose not to distribute to its shareholders. The retained-earnings account normally contains a credit balance. A company can calculate its retained earnings by subtracting dividends paid to shareholders from net income. The balance in the retained-earnings account is directly related to the net income or net losses within a firm. A company experiencing a net income for several years usually operates with a large retained-earnings account, and the opposite is true when a company incurs net losses for several consecutive years.
Retained Earnings and Equity
The retained-earnings account is one of the line items under the shareholders’-equity section of the balance sheet. The other line item that falls under the section is the paid-in capital category. An increase in retained earnings results in an overall increase in shareholders’ equity. Dividend-paying companies must maintain a balance between their retained-earnings account and dividends paid to shareholders. A company may feel pressure from investors to distribute dividends even when it needs to retain the earnings to improve its financial position.
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Now, let's delve into the key concepts covered in the article:
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Profits Distribution:
- A company divides its profits between itself and shareholders.
- Distributions consist of the portion of profits given to shareholders.
- Retained earnings represent the portion of profits that a company chooses to keep.
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Dividends:
- Dividends are a form of sharing profits with shareholders.
- Companies may issue cash dividends or stock dividends.
- Cash dividends involve a cash payment to shareholders.
- Stock dividends entail issuing additional shares to shareholders.
- Dividends are typically paid every three months.
- Companies are not obligated to pay dividends, and payments may cease during unprofitable periods.
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Distribution Payable:
- When a company declares a distribution payable, it affects the retained-earnings account under the shareholder-equity section.
- Journal entries include a debit to retained earnings and a credit to the dividend-payable account.
- Declaration of dividends results in a decrease in shareholders' equity and an increase in liabilities on the balance sheet.
- Actual payment of dividends involves debiting the distribution-payable account and crediting cash.
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Retained Earnings:
- Retained earnings represent profits not distributed to shareholders.
- Calculated by subtracting dividends paid from net income.
- The balance in the retained-earnings account is directly related to net income or losses.
- A company with net income usually has a large retained-earnings account, and vice versa.
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Equity:
- Retained earnings is a line item under the shareholders'-equity section on the balance sheet.
- Paid-in capital is another line item in this section.
- An increase in retained earnings leads to an overall increase in shareholders' equity.
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Balancing Retained Earnings and Dividends:
- Dividend-paying companies must balance retained earnings and dividends.
- Investors may pressure companies to distribute dividends, even when retaining earnings is essential for financial improvement.
Understanding these concepts is crucial for comprehending a company's financial statements and the impact of transactions on its financial position. It also sheds light on the delicate balance companies must maintain between rewarding shareholders and ensuring financial stability.
