Liquidating dividends are dividends paid in excess of a company’s accumulated earnings. They are meant to fully or partially liquidate the company. In accounting, they are not recognized as income by the investor but as a reduction of the investment carrying value.
It is important to distinguish between ‘normal’ dividends and liquidating dividends because they have different accounting treatment. While conventional dividends are recorded by the investor as an income from its investment, liquidating dividends are recorded not as an income but as return of the investment. Each blocks of shares acquired must be treated separately and accumulated earnings since the acquisition should be considered only in determining whether a dividend is an ordinary dividend or a liquidating dividend.
Because liquidating dividends are effectively repayment of investment, they typically do not have the same tax implications as ordinary dividends.
Company A purchased 10% stake in Company B for $120 million.
Because a 10% holding neither shows significant influence nor control, it must be recorded using the cost method (also called fair value method).
The following table shows Company B’s net income, accumulated earnings and dividends declared for the last five years (all amounts in USD in millions):
|Year||Net Income||Total Dividends||Accumulated Earnings||Ordinary Dividends||Liquidating Dividends|
During the first and second year, net income was $14 million and $12 million respectively, and dividends declared amounted to $13 million and $12 million respectively. Because the dividends are totally paid out of relevant year net income, they are all ordinary dividends and must be recognized as income by Company A. The journal entry in the first year would be:
|Dividend income||$13 million|
In the third year and fourth year, dividends declared exceeded the available income. Only dividends paid out of the relevant year net income or any accumulated earnings available since acquisition of the block of stock are recognized as ordinary dividend and the rest are recognized as liquidating dividends. The following journal entry must be made in third year:
|Dividend income||$11 million|
|Investment in Company B||$4 million|