Dividend accounts are a special type of expense account, but like all expense accounts, they must be closed at the end of the year or the statement date so that the balance sheet remains balanced. Depending on whether a dividend is declared or has been distributed, not closing dividend accounts will affect the balance sheet differently. As a type of expense, however, dividends have no effect on income statement. But dividends are reported in the statement of shareholders’ equity and statement of cash flows when declared and paid.
Companies don’t declare and pay dividends at the same time. Thus, accounting recording of dividends involves more than one set of journal entries. At the date of dividend declaration, the company holds itself liable for making the promised future dividend payments and sets up a liability account called dividend payable. Meanwhile, the company recognizes the dividend payable as a dividend expense. The related journal entries would debit dividend expense and credit dividend payable. At the date of dividend distribution, another set of journal entries would debit dividend payable and credit cash, reflecting the use of cash for dividend payments and the elimination of dividend payable liability.
The dividend expense account remains present unless it is closed into retained earnings. The close of a dividend account is not dependent on dividend distributions, which may or may not occur by the financial statement date. To close the dividend expense account, a set of journal entries would credit the dividend expense and debit retained earnings, reducing retained earnings as a result of recognizing the dividend expense. Suppose that the company has not distributed its dividends and paid off its dividend payable liability as of the statement date, without closing the dividend account by reducing retained earnings, an earlier increase in the liability account of dividend payable would make the balance sheet unbalanced.
If dividend distributions occur before the statement date, failure to close the dividend account would also result in an unbalanced balance sheet from reduced assets rather than increased liabilities. The procedure to close the dividend expense account remains the same. Once the dividend expense account is initially debited, it stays in its original entry regardless of actual dividend distributions. To clear the dividend expense entry is to close the dividend expense account. With a dividend distribution, the cash account has been first credited, a reduction of the total assets. So if the company doesn’t close its dividend account by reducing retained earnings, its balance sheet would be unbalanced with less assets on side and more equity on the other side.
Other Financial Statements
The closing of dividend accounts reduces retained earnings but the existence of dividend expenses has no direct impact on a company’s calculated net income. Companies pay dividends out of net income after tax because dividend expenses are not tax deductible. Besides, net income by definition is the earnings available to common shareholders and thus, dividends should not be deducted to arrive at net income. As a result, dividend expenses don’t show up on the income statement. However, dividends can be found on the statement of shareholders’ equity after declared and closed. Dividends can also be found in the statement of cash flow as a cash outflow in the financing activities section if they have been distributed and paid in cash.