Dividend reinvestment plans (DRIP)
Many large corporations and most mutual funds allow their stockholders to have their cash dividends actually reinvested in new shares of stock. As an encouragement and in recognition of the fact that the arrangement allows the corporation to avoid broker fees and other issue costs, the shares are sold to the stockholders at a slight discount below fair value.
Assume that the Sample Company has such a plan and declares a cash dividend of $10,000,000; this entry would be recorded on the date of declaration:
Assume that the holders of 10 percent of the stock elect to have their dividends reinvested in shares that have a par value of $12 and a market value (reduced by a discount) of $20. Thus, at the date of payment, only 90 percent of the dividend will be paid in cash and 50,000 new shares will be issued ($1,000,000 / $20). This entry would record the event:
While the end result of a reinvestment plan is virtually identical to that achieved by a small stock dividend, the actual chain of events is decidedly different and there is no ambiguity as to how it should be accounted for. In the event that the plan also allows stockholders to supplement their cash dividends with additional sums, the issuance of shares in return for these payments are accounted for in the same manner as other newly issued stock.