1. What three conditions must exist before a cash dividend is paid?
To pay a cash dividend, a company must have earnings or retained earnings because normal cash dividends are a distribution of earnings.
Second, a company must have adequate cash to fund the payment of dividends. There can be circumstances where a company has earnings but no cash (because plant assets were purchased with the cash).
Third, the dividend must have been declared by the board of directors of the corporation. Dividends are not paid regularly like loan payments, but must be decided and declared by the board of directors each quarter. Once declared, they are a legal obligation of the entity.
2. Contrast the effects of a cash dividend and a stock dividend on a corporation's balance sheet.
The cash dividend actually decreases net assets because there is a reduction of cash used to pay the dividends. A stock dividend, on the other hand is simply a reclassification between accounts in the equity section. There is no net change to the balance sheet.
From the perspective of a shareholder, the number of shares increases while the value of the shares decreases. For example a 10% stock dividend to a shareholder who owns 100 shares purchased at $25 = $2500 will become 110 shares with a total value of $2500 or 110 shares x 22.73 = $2500.
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