Most investors are familiar with cash dividends, which involve a company taking available cash and paying it out to shareholders. But dividends can also be paid in shares of stock, and although the accounting isn't always as straightforward as it is with cash dividends, the adjustments that have to be made on the company's balance sheet are similar. Before, we'll run through the accounting issues involved and go through the calculation of how retained earnings react to a stock dividend.

The general idea
When a company pays a dividend, it's effectively taking the earnings that it retained and distributing it to shareholders. Cash dividends reduce cash on the asset side of the balance sheet, and they reduce the retained earnings in shareholder equity by an equal amount.

With stock dividends, cash isn't involved. Instead, a portion of retained earnings effectively gets transferred to the company's capital accounts, including common stock and paid-in capital in excess of par. That keeps the balance sheet in balance while accurately reflecting the nature of the stock dividend.

Dealing with small stock dividends
Accounting for stock dividends varies depending on the size of the dividend. Small stock dividends are generally defined as payouts of less than 20% to 25% of the current number of the company's outstanding shares.

For small stock dividends, the key distinction is that accounting adjustments are made using the stock's market value at the time of the dividend, rather than just the par value. To calculate the appropriate entries, take the number of shares issued in the stock dividend and multiply it by the stock price. That dollar figure will tell you the net reduction in the retained earnings line.

That entry gets offset in two different ways. First, the common stock account will rise by an amount equal to the number of shares issued in the stock dividend multiplied by the par value of each share. That will typically take care of some but not all of the total reduction in retained earnings.

The difference goes to the account for paid-in capital in excess of par. When you add together the two adjustments, they should give you the total value of the stock distributed in the dividend.

Small stock dividends aren't all that common, and most investors aren't familiar with them. It's still important to understand how to account for them, however, so that you won't be confused when they do occur.

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