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What is the difference between dividends and interest expense?

Dividends are a distribution of a corporation's earnings to its stockholders. Dividends are not an expense of the corporation and, therefore, dividends do not reduce the corporation's net income or its taxable income. When a dividend of $100,000 is declared and paid, the corporation's cash is reduced by $100,000 and its retained earnings (part of stockholders' equity) is reduced by $100,000.

Interest on bonds and other debt is an expense of the corporation. The interest expense will reduce the corporation's net income and its taxable income. When interest expense occurs and is paid, the corporation's cash is reduced by the interest payment, but some cash will be saved by the reduction in income taxes. The corporation's retained earnings will also be reduced by less than the amount of interest expense. For example, if a corporation has an incremental tax rate of 40%, interest expense of $100,000 will result in $40,000 less in income tax expense and income tax payments. This means that an interest payment of $100,000 will reduce the corporation's cash and retained earnings by the net amount of $60,000 ($100,000 of interest minus $40,000 of tax savings).

Since interest is formally promised to the lenders, accountants must accrue interest expense and the related liability Interest Payable. If the payment for interest is not made, the corporation will face legal consequences.

Dividends on common stock are not legally required. Therefore, if the corporation does not declare a dividend there is no liability for the omitted dividends.