Retained earnings is not cash

Three dates, two entries

On 15 November Prairie Sky’s board declares a cash dividend of $0.40 per share on its 200,000 outstanding common shares, payable on 20 December to shareholders of record on 1 December. Total: $200{,}000 \times 0.40 = 80{,}000$.

Declaration date (15 November). The moment the board declares, the company owes its shareholders $80,000 — a legal liability. The debit is not an expense: a dividend is a distribution of profit to owners, not a cost of earning it.

Dr Dividends Declared        80,000
    Cr Dividends Payable            80,000

Ex-dividend and record date (1 December). Shares trade constantly, so the company needs a cut-off. Whoever is on the shareholder register at the close of the record date receives the dividend. Because a trade now settles the next business day (Canada moved to T+1 on 27 May 2024), the TSX sets the ex-dividend date on the same day as the record date: a buyer on or after the ex-dividend date settles too late to be on the register. Under the old T+2 regime the ex-date fell one business day before the record date — a textbook printed before 2024 will still say so. The record date is a list-making exercise — no entry is recorded.

Payment date (20 December). The liability is settled: Dr Dividends Payable 80,000 / Cr Cash 80,000.

At year-end, Dividends Declared — a temporary equity account — is closed: Dr Retained Earnings 80,000 / Cr Dividends Declared 80,000. Some textbooks debit Retained Earnings directly on the declaration date; the year-end balance is identical, and this course uses Dividends Declared so the year’s distributions are visible in one account.

Three tests before the board declares

1. The legal test. Under the Canada Business Corporations Act, s. 42, a corporation may not declare or pay a dividend if (a) it is, or would after the payment be, unable to pay its liabilities as they come due, or (b) the realisable value of its assets would be less than its liabilities plus the stated capital of all its shares. Either test alone blocks the dividend. Retained earnings appears nowhere in the section — the test is solvency, not the size of the retained-earnings balance.
2. The cash test. A dividend is paid in cash. Retained earnings is an accounting total of profits kept in the business over its life; that money has long since been spent on inventory, equipment and receivables. A company can have millions of retained earnings and nothing in the bank.
3. The strategic test. Cash paid out is cash not reinvested. A company with high-return projects ahead of it may serve shareholders better by keeping the money; a mature company with no such projects should return it.

Why the confusion persists

Retained earnings sits in the equity section beside Common Shares, and both are large numbers that seem to say “the owners have this much”. But equity is a claim on the assets, not a pile of any particular asset. To find out whether a dividend can be paid, look at the asset side — cash and near-cash — and at the cash forecast, not at retained earnings.