A company balance sheet lays out the accounting equation: assets equal liabilities plus stockholder's equity. The equity portion of the balance sheet has two major subdivisions -- capital and retained earnings. Capital includes paid-in capital -- the par, or nominal, value of stocks and warrants issued by the company -- and additional paid-in capital, which is the fair market value of stock dividends above their par value. Retained earnings are the accumulated profits of the firm. Dividends are distributions from retained earnings to shareholders, and they can take the form of cash or additional stock.
One form of dividend is the distribution of stock to shareholders of record. The dividend shares are awarded on a pro-rated basis and are often fractional portions of a share. For instance, if the board of directors declares a 5 percent stock dividend, shareholders receive 1/20th of a new share for each share they own. The stock dividend dilutes the market price of existing shares by the dividend ratio, in this case by 5 percent. If you had 100 shares trading for $1 each before the dividend, you would end up with 105 shares at $0.9524 each -- more shares but the same total value.
A stock dividend has no effect on assets or liabilities of a firm, because cash is not distributed and new debt is not assumed. The only effect is on the stockholder's equity portion of the balance sheet. The total value of the stock dividend from the corporation’s point of view is the number of dividend shares times the fair, or market, value of each share. If in our example the company had 100 million shares outstanding, each with a 1 cent par value and a $1 fair value, and the dividend amount was 5 million shares (5 percent), $5 million would be removed from retained earnings and distributed to the capital accounts as follows: paid-in capital would increase by $50,000 and additional paid-in capital would increase by $4,950,000.The total outstanding shares would increase to 105 million.
Contrast With Stock Split
In a stock split, the par value of the shares in the paid-in capital account is reduced by the split, and it has no effect on retained earnings. For instance, if our example company issued an 11-for-10 stock split, the 100 million old shares with a par of 1 cent each would be replaced by 110 million shares at a new par value of $0.009091 each. Before and after, the total par value would be $1 million. Shareholders would still experience market price dilution per share, but they would own more shares, so their total position value would not change.
Contrast With Cash Dividend
Cash dividends are almost invariably paid from retained earnings and they never affect paid-in capital. They reduce the balance sheet asset of cash by the same amount as they reduce the amount of retained earnings. Very rarely, the cash to pay a dividend is borrowed rather than taken from retained earnings. In this case, the cash asset is first increased by the amount of the borrowings and then decreased by the amount of the dividend. Liabilities increase by the amount of the borrowings.
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