MAT 201 Module 3 Dividends and Retained Earnings Example

Cash, Shares or Neither? Dividends and Retained Earnings at a Growing Creamery

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Business Administration Program, Aspen University

MAT 201: Principles of Accounting II

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Month Day, Year

Cash, Shares or Neither? Dividends and Retained Earnings at a Growing Creamery

Two years after incorporating, Cedar Valley Creamery had its best results yet. The yogurt line ran at capacity by summer, and net income reached $612,000, whose components Module 4 examines. Employee and supplier stockholders began asking whether they would see any return before selling their shares back. The board had to decide whether to pay a dividend, how much and in what form. This paper explains the decisions and records them.

The Board's Choice

The board met in February to weigh three uses for the year's earnings: paying cash to owners, keeping the cash to build a refrigerated warehouse planned for next year and buying back more shares from departing employees. It decided to pay a modest cash dividend of 30 cents a share, about 28% of earnings, and to keep the rest. The warehouse will cost about $1.1 million, and the board wanted to fund at least half of it from retained cash rather than new borrowing, which also keeps the creamery within its loan agreement's limit on debt. Later in the year, it added a 5% stock dividend to recognize the owners without spending cash.

The Cash Dividend and Its Dates

On March 10, the declaration date, the board declares the dividend. The corporation now owes it, so a liability is recorded: debit Retained Earnings $172,200 (574,000 shares at $0.30); credit Dividends Payable $172,200.

March 25 is the record date. Stockholders who own shares on that date receive the dividend. No entry is made.

On April 15, the payment date, the creamery pays: debit Dividends Payable $172,200; credit Cash $172,200.

Treasury shares receive no dividend, which is why the calculation uses the 574,000 outstanding shares rather than the 580,000 issued. Some companies record declared dividends first in a temporary Dividends account and close it to retained earnings at year-end; the effect on the statements is the same.

Does Dividend Policy Matter?

Miller and Modigliani (1961) proved that where markets are frictionless, with no taxes, no trading costs and everyone equally informed, a firm's value depends only on its investment decisions and the earnings they produce, not on how those earnings are divided between dividends and retained earnings. A stockholder who wanted cash could sell shares; one who did not could reinvest dividends. Dividend policy, in that world, is irrelevant.

Real markets are not perfect, and the creamery's are less perfect than most. Cedar Valley's shares cannot easily be sold, so a dividend is one of the few ways employee owners can receive cash without giving up their stake. Taxes and information also matter, which is why actual dividend decisions are made with care.

How Executives Actually Decide

Brav et al. (2005) surveyed and interviewed hundreds of financial executives about payout policy. They found that managers were very reluctant to cut dividends once established and would pass up some investments to avoid doing so, so they raised dividends slowly and only when confident the higher level could be sustained. Repurchases, by contrast, were treated as flexible, adjusted to available cash and investment needs. The link between dividends and earnings had weakened compared with earlier decades.

Cedar Valley's board followed this pattern. It chose a dividend it is confident it can pay again next year, rather than paying out most of a good year's profit.

Disappearing Dividends

Fama and French (2001) documented that the proportion of U.S. publicly traded firms paying cash dividends fell from 66.5% in 1978 to 20.8% in 1999. The trend matters for Cedar Valley because many of its employee owners assume corporations normally pay dividends. Part of the decline came from changing firm characteristics, as more firms were small, had low profitability and strong growth opportunities. But even after accounting for those features, firms had become less likely to pay dividends, a lower propensity to pay.

The Stock Dividend

In October, the board declares a 5% stock dividend, issuing 28,700 new shares to existing owners in proportion to their holdings. A distribution this modest is booked at what the shares are worth, here the appraised $20, rather than at par.

Entry: debit Retained Earnings $574,000; credit Common Stock $28,700, which is the new shares' total par value; credit Additional Paid-in Capital $545,300 for the remainder.

A stock dividend moves amounts within equity. Total equity does not change, no cash leaves and every owner holds the same percentage of the company as before, in more shares.

Large Stock Dividends and Splits

Had the board declared a large stock dividend, above 20% to 25% of shares, it would have been recorded at par rather than fair value, because a large distribution changes the price per share enough that fair value is no longer meaningful. A stock split, such as two shares for every one, changes the number of shares and the par value per share but requires no journal entry at all, since total par value is unchanged. Cedar Valley's board chose a small stock dividend because it wanted owners to see a tangible reward while keeping the share price, as set by appraisal, roughly where it was.

What Dividends Tell Owners

For a company without a market price, a dividend also communicates. The board's letter to stockholders explained that the dividend reflects confidence in the yogurt line and that the board intends to maintain it, while the remaining earnings fund the warehouse. That explanation matters as much as the amount: owners who understand why most earnings are retained are less likely to sell their shares back at the first opportunity.

Statement of Retained Earnings

Conclusion

The board paid a modest, sustainable cash dividend and added a stock dividend that cost no cash. Miller and Modigliani explain why such choices would not matter in a perfect market, and Brav, Graham, Harvey and Michaely and Fama and French show why, in practice, boards treat dividends carefully. The retained earnings statement records the result.

References

Brav, A., Graham, J. R., Harvey, C. R., & Michaely, R. (2005). Payout policy in the 21st century. Journal of Financial Economics, 77(3), 483-527. https://doi.org/10.1016/j.jfineco.2004.07.004

Fama, E. F., & French, K. R. (2001). Disappearing dividends: Changing firm characteristics or lower propensity to pay? Journal of Financial Economics, 60(1), 3-43. https://doi.org/10.1016/S0304-405X(01)00038-1

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433. https://doi.org/10.1086/294442