Are Dividends a Temporary Account in Accounting?
Explore why dividends are treated as a temporary account, distinct from expenses, and how this classification affects the final balance of retained earnings.
In accounting, accounts are classified as either temporary or permanent. This distinction determines how an account’s balance is handled at the end of an accounting period. The dividends account, which tracks distributions to shareholders, is classified as a temporary account. This affects how it is treated in the accounting cycle and how it ultimately impacts a company’s financial statements.
Understanding Temporary and Permanent Accounts
Temporary accounts, sometimes called nominal accounts, track financial activity over a specific period, like a month or year. These accounts include all revenue and expense accounts, such as Sales Revenue and Rent Expense. At the end of the designated accounting period, the balances in these accounts are reset to zero through a process known as closing. This reset allows for a clear measurement of performance for each distinct period by preventing the transactions of one period from mixing with the next.
Permanent accounts, also referred to as real accounts, are different because their balances are not closed or reset at the end of an accounting period. Instead, their balances are continuous, carrying forward from one period to the next. These accounts are reported on the balance sheet and represent a company’s financial position. The primary categories of permanent accounts are assets, such as Cash and Equipment; liabilities, like Accounts Payable; and equity accounts, including Common Stock and Retained Earnings.
Classifying the Dividends Account
The dividends account is classified as a temporary account. Its purpose is to track the total amount of earnings distributed to shareholders within one accounting period. Because this activity is measured on a period-by-period basis, the account balance must be reset to zero at the end of the cycle. This allows the company to begin the next period ready to accumulate the dividend distributions for that new timeframe.
A distinction must be made between dividends and expenses. While both are temporary accounts and both reduce a company’s equity, they represent different types of transactions. Expenses are costs incurred in the process of generating revenue, such as paying for salaries or utilities. Dividends, on the other hand, are a distribution of a company’s accumulated profits to its owners, not a cost of doing business. This is why dividends do not appear on the income statement, which is designed to show profitability from operations.
The Closing Process for Dividends
At the end of an accounting period, all temporary accounts must be closed, and the dividends account is no exception. This is accomplished by making a specific journal entry, known as a closing entry, which resets the dividends account balance to zero. This step is part of the final phase of the accounting cycle, preparing the books for the start of the new fiscal period.
The closing entry involves a debit to the Retained Earnings account and a credit to the Dividends account for the total amount of dividends paid. For instance, if a company paid $20,000 in dividends, the closing entry would be a $20,000 debit to Retained Earnings and a $20,000 credit to Dividends. This action transfers the total from the temporary dividends account directly into the permanent Retained Earnings account, reducing its final balance.
Impact on Financial Statements
The treatment of the dividends account impacts a company’s financial statements. Because the dividends account is temporary and closed out, it does not appear on the post-closing trial balance or the year-end Balance Sheet. Its effect is instead reflected through the change in the Retained Earnings account.
This impact is most clearly illustrated on the Statement of Retained Earnings. This statement begins with the opening balance of retained earnings, adds the net income for the period, and then subtracts the total dividends paid. The result of this calculation (Beginning Retained Earnings + Net Income – Dividends) is the ending balance of Retained Earnings.
This final, updated Retained Earnings figure is then reported in the stockholders’ equity section of the Balance Sheet. The payment of dividends also reduces the company’s cash. This reduction is reflected in the assets section of the balance sheet and as a financing activity on the statement of cash flows.