So your company did well this year—so well that you’ve decided it’s time to give some of it back to your employees and investors in the form of dividends.
That’s great! It’s a positive sign for you and the people who invested time or money into your business that the company is on a lucrative path (and a great way to thank the people who have helped get you there).
Just as dividends probably have a special place in shareholders’ hearts, they have a special place in the world of accounting.
How to Handle Dividends in Accounting
When it comes to putting dividends on the books, many people find themselves a bit unsure about how to represent that money. Are dividends an expense that go on your income statement and affect net profit? After all, it is cash that’s leaving your bank account.
Don’t be fooled, though! Dividends do not count as an expense. That’s because paying out dividends is really a redistribution of profits, rather than a reduction of profit.
Okay, that makes sense, but where else can it live? Looking over your income statement and balance sheet, you probably see no other obvious place to account for these dividend payments.
The Missing Link: Statement of Retained Earnings
The reason you may be confused is because there’s a financial statement we haven’t talked about yet—the statement of retained earnings. This very brief financial statement shows the changes to your retained earnings over time, both giving you a place to detail your dividend payments and also serving as a bridge between the income statement and the balance sheet.
Let’s say Allison launched her creative agency at the very start of 2017. Her retained earnings at the start would naturally be zero since she hadn’t made any money yet. She got some investment from a former employer to help her get started, and hired a small team that really hustled and managed to help her turn a healthy profit in their first year. Their net income, after accounting for all expenses, was $60,000. This was calculated on the income statement.
As a thank you for all their hard work and belief in the company, Allison decides to pay a third of that back to her employees and investors in the form of dividends. That makes the retained earnings for the year $40,000. This number gets plugged into the balance sheet under owner’s equity.
| Statement of Retained Earnings | |
|---|---|
| Retained Earnings, 1/1/17 | $0 |
| Net Income | $60,000 |
| Dividends Paid to Shareholders | ($20,000) |
| Retained Earnings. 12/31/17 | $40,000 |
Now, thanks to the Statement of Retained Earnings, Allison can accurately complete her financial calculations, correctly account for her dividends, and go celebrate the great year with her team!
Abridged by Amy
- Dividend payments do not count as an expense!
- In order to account for dividend payments, you must use a Statement of Retained Earnings.
- The statement of retained earnings is a bridge between the income statement and the balance sheet, subtracting your dividend payments from the net income in order to calculate the retained earnings.
