Many large corporations and almost all mutual funds allow their stockholders to reinvest their cash dividends in new shares of stock. These are known as dividend reinvestment plans (DRIP).
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.
Suppose that the Sample Company has such a plan and declares a cash dividend of $10,000,000. The following entry would be recorded on the date of declaration:
Now suppose that the holders of 10% of the stock decide to have their dividends reinvested in shares with a par value of $12 and a market value (reduced by a discount) of $20.
In this case, on the payment date, only 90% of the dividend would be paid in cash, and 50,000 new shares would be issued ($1,000,000 / $20). The following 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 different. Also, there is no ambiguity as to how it should be accounted for.
If the plan also allows stockholders to supplement their cash dividends with additional sums, the issuance of shares in return for these payments is accounted for in the same way as other newly issued stock.