6. The Effect of Cash Dividends

I want to talk really quickly about the effect of a cash dividend. I said in another video that you have three important dates when you're issuing a cash dividend. You have the date of declaration, which is essentially the announcement date. You have the date of payment, which is when you pay the dividend, and you have this date of record, which is mostly just administrative. That's when you record who owns the stock. And we said that there are two journal entries. If it's an $80,000 cash dividend, we have a journal entry over here at declaration where we put 80,000 into the dividend, and then we have a dividend payable at 80,000.

And then over here when we pay, we decrease the dividend payable by 80 and we decrease the cash we use to pay it also by 80. So what effect do these journal entries have on the balance sheet? First of all, if we assume that this happens in the same year, so if we assume that declaration and payment both happen in, we'll say, Year 1, then this dividend payable has no effect at all because we open it up and we close it out all within the same year. Now, if the year splits the declaration and the payment, then obviously our liabilities go up in Year 1 and our liabilities go down in Year 2.

But on most of the problems you're gonna see, it's not gonna be split like that. And if it is, dividends payable is clearly a liability, so that shouldn't be too much of an issue for you to figure out. When we declare a dividend, we don't lose cash. When we pay a dividend, that's when we lose cash. So at payment, that's when our cash goes down. Don't get this mixed up when you say you declared a dividend, so your cash went down. Well, you declared a dividend, so at some point in the future, your cash will go down. But don't say we declared a dividend, so our cash went down.

When you declare a dividend, you made a promise, and that's all you did. You made a promise to pay cash in the future. So that checks off this guy over here. Now, what about this dividend account? Now, you gotta think back real far to remember when we did something called the closing process.

So we've got an 80,000 debit in dividends. Now, for the closing process, we had a lot of accounts. We had revenues. We had expenses. We made this income summary account. We had dividends. And finally, we had retained earnings. Hopefully, this is starting to ring a bell. We had revenues at some credit amount, expenses at some debit amount. So to close out revenues, we just put it on the opposite side. So we did a 5,000 debit, and then you put a 5,000 credit to match it up in income summary. To close expenses, you do the same thing, opposite side, a 1,000 credit, a 1,000 debit to close expenses.

You end up with 4,000 credit in the income summary. To close that out, you do the opposite. Now we have a $4,000 debit that's matched by a $4,000 credit to retained earnings. What we just did was we said revenues less expenses equals net income. Net income goes into beginning retained earnings plus net income minus dividends gives us ending retained earnings. So far, we've done this process right here. We closed out revenue, closed out expenses, put them both into income summary. Then from income summary, we close that out to retained earnings. So you'll see what's left is this minus dividends. So if we had a $1,000 dividend here to close out dividends, you'd put it on the opposite side.

So we did a 1,000 credit. You need to do a 1,000 debit, and that gives us ending retained earnings of 3,000. This is the closing process that we did a while back, but it's important now because we're talking about dividends. So when you increase this dividend account, eventually you're going to close this out. You're gonna close that out to 0, and you're gonna move that over into the retained earnings account. So the answer when asked, what effect does the declaration of a dividend have? Well, at closing, when you close out the dividend account, the retained earnings account is going to go down. Any increases in dividends when they're all closed out cause decreases in retained earnings, which is why if you look in some editions of the book, they don't actually put dividend here.

They go ahead and just debit it straight to retained earnings, which I think is crazy because you have to actually go through the closing process to get it over there. But it should be noted that a dividend does not have to be paid to reduce retained earnings. So again, if the year falls right here, the closing process happens at 12/31. So if a dividend is declared in Year 1, it is going to reduce retained earnings in Year 1 because everything gets closed out at 12/31, and you put it in there at Year 1. And so at the end of Year 1, you close it out to retained earnings, which reduces it.