What is the difference between dividends and interest expense?

Definition of Dividends

Dividends are a distribution of a corporation's earnings to its stockholders. Dividends are not an expense of the corporation and will not reduce the corporation's net income or its taxable income. (Cash dividends reduce the corporation's cash and its retained earnings, which is reported on the balance sheet as part of stockholders' equity. Cash dividends are not liabilities until they are declared by the corporation's board of directors.

Definition of Interest

Interest on a corporation's bonds and other debt is an expense of the corporation and it reduces the corporation's net income. For profitable corporations, interest expense also reduces its taxable income and the corresponding income tax expense. The income tax savings ultimately reduces the net cost of the interest paid.

Since the corporation entered into a contract to pay interest to its lenders, if the interest is not paid the corporation can face legal consequences. As a result, any accrued interest expense and the related liability must be recorded by the corporation.

Example of Dividends vs. Interest

If a profitable corporation declares and pays cash dividends of $100,000, the corporation's cash and its retained earnings (and therefore its stockholders' equity) are reduced by $100,000. However, the corporation's net income is not reduced as dividends are not a business expense.

Assume that a different profitable corporation pays $100,000 in interest to its lenders. The $100,000 will appear on the corporation's income statement as interest expense and will reduce the line net income before income tax expense and the line income tax expense. If the corporation's incremental combined federal and local income tax rate is 30%, the corporation will reduce its income tax expense and tax payments by $30,000. This means that the corporation's net cost of the borrowed money is $70,000 ($100,000 of interest paid to lenders minus $30,000 of income tax savings).