Liquidating Dividend
Summary
TLDRThis session explores the concept of liquidating dividends, distinguishing them from regular dividends by explaining that they are a return of capital, not a distribution of profits. Retained earnings, which only increase through net income, are the source of regular dividends. However, when a company pays out more than its retained earnings, it's considered a liquidating dividend, which is not taxable. The video uses the example of a company with $800,000 in retained earnings declaring a $1 million dividend, resulting in a $200,000 return of capital. This scenario is common in companies extracting natural resources, which eventually close down. The presenter also encourages accounting students and CPA candidates to visit their website for additional study resources.
Takeaways
- 💡 Dividends typically come from a company's retained earnings, which are profits that have been reinvested into the business.
- 📉 Retained earnings can decrease not only when dividends are paid but also when the company incurs a loss or experiences other transactions that reduce its balance.
- 🚫 A liquidating dividend occurs when a company pays out more in dividends than it has in retained earnings, effectively returning part of the investor's original capital.
- 💼 Liquidating dividends are not considered taxable income because they represent a return of capital, not profits earned by the company.
- 🛑 Companies that are nearing the end of their operational life, such as those in the natural resource extraction industry, may distribute a liquidating dividend as they wind down operations.
- 🔢 If a company has a retained earnings balance of $800,000 and declares a dividend of $1 million, it will have to return $200,000 of capital to shareholders as a liquidating dividend.
- 💼 The return of capital (ROC) is recorded in the company's financial statements, often as a debit to 'Paid-in Capital' or 'Common Stock', depending on the company's structure.
- 📋 Investors are informed about the liquidating dividend through the company's annual report and tax documents, which clearly distinguish it from taxable dividends.
- 📚 Understanding the concept of liquidating dividends is crucial for accounting students and CPA candidates, as it is covered in intermediate accounting and the CPA exam.
- 🌐 For further study and to improve understanding of such topics, the speaker recommends visiting their website, which can supplement CPA review courses and accounting studies.
Q & A
What is a liquidating dividend?
-A liquidating dividend occurs when a company distributes more money to its shareholders than it has in retained earnings, effectively returning part of the investors' original capital.
Where does a dividend typically come from?
-Dividends typically come from a company's retained earnings, which are the accumulated profits that have not been distributed as dividends.
What is retained earnings and why is it important?
-Retained earnings are the portion of a company's net income that is retained by the company for future use. It is important because it represents the company's reinvested profits and is used to finance growth, pay off debt, or pay dividends.
How does a company's net income affect retained earnings?
-A company's net income increases retained earnings when it is positive. Conversely, a net loss decreases retained earnings.
What happens if a company pays a dividend that exceeds its retained earnings?
-If a company pays a dividend exceeding its retained earnings, the excess is considered a return of capital (ROC) or liquidating dividend, which is not taxable to the shareholders.
Why is it necessary to inform investors when a liquidating dividend is paid?
-It is necessary to inform investors about a liquidating dividend because it is not a distribution of profits and therefore not taxable. Investors need to know this to avoid misunderstanding it as taxable income.
Can you give an example of a company that might experience a liquidating dividend?
-Companies that extract natural resources, like an oil company, might experience a liquidating dividend when they have extracted most of their resources and start to close down operations, returning excess capital to shareholders.
What is the difference between a liquidating dividend and a regular dividend?
-A regular dividend is a distribution of a company's profits to shareholders, while a liquidating dividend is a return of part of the investors' original capital when the company distributes more than its retained earnings.
How is the return of capital (ROC) accounted for in a company's financial statements?
-The return of capital is accounted for by debiting the paid-in capital or common stock account, depending on the company's structure, to reflect the return of the investors' original capital.
What is the significance of retained earnings being reduced to zero in the context of a liquidating dividend?
-When retained earnings are reduced to zero, it signifies that all the company's accumulated profits have been distributed, and any additional distribution is a return of capital to the shareholders.
How can understanding liquidating dividends benefit accounting students or CPA candidates?
-Understanding liquidating dividends can benefit accounting students or CPA candidates by providing a deeper insight into dividend distributions, retained earnings, and tax implications, which are topics covered in intermediate accounting and the CPA exam.
Outlines
💹 Understanding Liquidating Dividends
This paragraph introduces the concept of liquidating dividends, which occurs when a company distributes more in dividends than it has in retained earnings. Dividends typically come from a company's retained earnings, which are built up over time from net income. If a company pays out more in dividends than it has in retained earnings, it is not distributing profits but rather returning capital to investors. This is known as a return of capital (ROC) and is not taxable. The speaker uses the example of a company with $800,000 in retained earnings that declares a $1 million dividend, resulting in a $200,000 ROC. The paragraph also mentions that companies in natural resource extraction often face liquidating dividends as they approach the end of their operational lifecycle.
Mindmap
Keywords
💡Liquidating Dividend
💡Retained Earnings
💡Dividend
💡Return of Capital (ROC)
💡Net Income
💡Taxable
💡Capital
💡Common Stock
💡Paid-In Capital
💡CPA Exam
Highlights
Liquidating dividend is a concept where a company distributes more than its retained earnings to shareholders.
Dividends typically come from a company's retained earnings, which are profits not distributed as dividends.
Retained earnings increase with net income and decrease with losses or dividend payments.
Liquidating dividends occur when a company pays out more in dividends than it has in retained earnings.
When a company pays a liquidating dividend, it is essentially returning capital to investors.
Liquidating dividends are not taxable as they represent a return of capital, not a distribution of profits.
Companies that extract natural resources, like oil, may experience liquidating dividends as their resources deplete.
An example is given where a company with $800,000 in retained earnings declares a $1 million dividend.
The excess of the dividend over retained earnings is treated as a return of capital.
The concept is important for tax accounting and is covered in intermediate accounting courses.
Understanding liquidating dividends is crucial for accounting students and CPA candidates.
The speaker suggests using their website as a supplementary resource for accounting and CPA exam preparation.
Investing in oneself by studying for the CPA exam can lead to lifelong professional dividends.
The speaker emphasizes the importance of passing the CPA exam for an accounting career.
Studying hard for the CPA exam is encouraged as it is a significant investment in one's future.
Transcripts
hello and welcome to the session in
which we would look at the concept of
liquidating dividend what is the big
idea for liquidating dividend well let's
talk about dividend first
where does dividend comes out of from
well dividend comes out of retained
earnings what is this account retained
earnings so it's very important that we
understand this account retained
earnings in order to understand what is
different in order to understand what is
liquidating different
over the years companies generate net
income so as they generate their income
every year the retained earnings will
increase on the credit side
if they for any year they incur the loss
the loss would reduce the retained
earnings
also when the company pays dividend they
pay dividend out of retained earning it
reduces retained earning and many other
transaction reduces retained earnings
the only thing that technically increase
retained earning is net income
now what happens sometime is this what
happened if the company pays dividend in
excess of accumulated earnings simply
put over the years we have this account
that's called retained earnings and we
have
ten dollars in here in total what
happened if we decided to pay
12 dollars in dividend because remember
dividend is on it reduces retained
earnings well what happened under those
circumstances circumstances technically
this is not a dividend
why not well remember dividend comes out
of earnings
dividend is a distribution of the profit
so if you don't have the profit what are
you distributing well simply what you
are distributing is the capital the
money that the investors invested in the
company in the company initially this is
called return of capital or roc
is it allowed sure it's allowed why not
if that's what you want to do that's
fine but you have to tell the investors
that what you are giving them now is
their money why because if they get it
without knowing it's their money they
may think it's a profit it's part of the
profit therefore it's taxable if you
tell them this is a liquidating dividend
then it's not taxable return of capital
is not taxable so what companies do
experience this liquidating dividend
companies extract the natural resources
for example an oil company that is
extracting oil from the ground and what
happened is this the company is created
for for the sole purpose of extracting
the oil selling it making a profit
distributing the profit to the
shareholders now what happens is this at
some point after they have extracted the
majority of the oil they'll start to
close down the company
so what they do they have no intent of
buying another well to extract the oil
so they will start to give all the money
back to the shareholders some of that
money may not be profit well if it's not
profit it's part of
the capital the original capital of the
owners so let's assume adam company had
a retained earning balance of 800 000 so
simply put they have a balance of
800 000 in the retained earning over the
years
the board declared a dividend of one
dollar on the one million shares they
have they have one million shares and
they're going to pay each shareholder a
dollar well guess what they're paying a
million
well they only have 800 000 and retained
earnings what does that mean it means
you're gonna reduce retained earnings by
eight hundred thousand bring retained
earnings down to zero and you're gonna
pay out cash of a million dollar well we
are missing a debit of two hundred
thousand well guess what this two
hundred thousand is return of capital so
what we do is we debit paid in capital
nexus of power now if the company does
not have paid in capital they only have
common stock then we debit obviously
common stock basically the company is
closing therefore we are returning the
money to the capital we have to let the
investors know that of this one million
dollar and usually it's stated
in the annual and in the annual tax
sheet 200 000
as roc return of capital in other words
or they indicated as liquidating
dividend in other words we tell the
investors don't pay taxes this is not
part of the profit the only the only
part that's taxable coming out of the
profit is the eight hundred thousand and
you would learn more about this topic in
your tax accounting course this topic is
covered in advanced accounting i'm sorry
in
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