Liquidating Dividend

Summary

This 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

00:00

💹 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.

Keywords

💡Liquidating Dividend

A liquidating dividend refers to a payment made by a company to its shareholders that exceeds the company's retained earnings. It is not a distribution of profits but rather a return of part of the investor's original capital. In the context of the video, this concept is crucial as it distinguishes between a regular dividend, which comes from profits, and a liquidating dividend, which is not taxable and represents a return of the investor's money. The example given is a company with $800,000 in retained earnings that declares a $1 million dividend, leading to a $200,000 liquidating dividend.

💡Retained Earnings

Retained earnings represent the cumulative net income of a company that is retained by the company rather than being distributed to shareholders as dividends. It is a key component of a company's equity on the balance sheet. In the video, retained earnings are explained as increasing with net income and decreasing with losses or dividend payments. The concept is central to understanding when a dividend becomes a liquidating dividend, as it is paid out of these retained earnings.

💡Dividend

A dividend is a payment made by a corporation to its shareholders, usually derived from the company's earnings. Dividends can be issued as cash payments, as shares of stock, or other property. In the video, the concept of dividend is foundational to discussing liquidating dividends, as it is explained that dividends typically come from a company's retained earnings, which represent its accumulated profits.

💡Return of Capital (ROC)

Return of capital (ROC) occurs when a company returns a portion of an investor's original investment back to them, rather than distributing profits. This is not taxable as it is not considered income but a return of the investor's own money. In the video, ROC is used to explain the non-taxable nature of the portion of the dividend that exceeds the company's retained earnings, hence it is termed as a liquidating dividend.

💡Net Income

Net income, also known as net profit, is the bottom line after all revenues, costs, and expenses have been accounted for. It is an important indicator of a company's financial health and is the primary source of retained earnings. The video emphasizes that net income is the only thing that technically increases retained earnings, which is a precursor to understanding the conditions under which a liquidating dividend might occur.

💡Taxable

In the context of the video, 'taxable' refers to the portion of dividends that are considered as profits and are subject to taxes. Regular dividends, which are paid out of a company's earnings, are typically taxable. In contrast, liquidating dividends, which are a return of capital, are not taxable. This distinction is crucial for investors to understand how different types of dividends affect their tax liabilities.

💡Capital

Capital, in a financial context, refers to the funds invested in a business or the money used to start or expand a company. In the video, the term is used to explain the concept of return of capital, where investors receive back a portion of their original investment, which is not considered profit and is therefore not taxable.

💡Common Stock

Common stock represents the most basic unit of ownership in a corporation. It typically entitles the owner to voting rights and to a share in the company's profits through dividends. In the video, common stock is mentioned in the context of a company that has no paid-in capital and must debit common stock when distributing a liquidating dividend, indicating a return of the investor's capital.

💡Paid-In Capital

Paid-in capital, also known as capital surplus or additional paid-in capital, is the amount by which the issuance of shares exceeds the par value of the shares. It is part of a company's equity on the balance sheet. In the video, paid-in capital is discussed as an account that may be debited when a company distributes a liquidating dividend, indicating that the company is returning part of the capital that was originally invested.

💡CPA Exam

The CPA (Certified Public Accountant) Exam is a professional certification program for accountants in the United States. It is mentioned in the video as a context where understanding concepts like liquidating dividends is important, as they are covered in the exam. The speaker suggests that the video's content can be a useful supplement for those studying for the CPA exam or intermediate accounting courses.

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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