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How To Hide Salary Costs by Paying With Dividends

This page is explanatory of the points made at Understand Equity.

Dividends can be used to hide management compensation, because they are recorded below the Net Income line. Shares are issued to management for an IOU. The plan may have a name like "Unit Purchase Loan Plan". Distributions paid on those shares pay down management's debt and should honestly be considered management salary. The issue of shares is just an excuse to label the cash 'dividends' instead of 'wages'. The exact same thing could be accomplished by paying wages and requiring the executive to buy shares with it. It is impossible to determine from the financials what the dollar value of this is.

While this strategy will always raise reported Net Income in total, it will only raise EPS when the dividends are greater than earnings. So you see this strategy in REITs and Income Trusts with high distributions. The following two pairs of examples compare the resulting EPS when extra salary is paid:

  • ( A - B - C ) as salary that is expensed, and
  • ( a - b - c ) as dividends.
under two conditions:
  • when distributions exceed earnings
  • when distributions are less than earnings

What happens for companies whose distributions exceed earnings.

The first comparison below shows what happens to the EPS of a company that pays dividends (distributions) greater than earnings. The starting point for all the subsequent examples is shown in (A). In case you are wondering, the capital structure of the company makes no difference. In (B) you see the effect of earning the base case $100 Net Income and paying additional $6 wages. In (C) $1.50 dividends per share are paid.

The same company could chose to issue 4 more shares to management so that the dividends on those shares would equal the salary paid above. In (a) you see the shares issued at book value, but it makes no difference at what price multiple they are issued. In (b) you see that Net Income has not been reduced by the additional wages. In (c) the dividends ($156) are larger than above ($150) because there are more shares outstanding. You can see that the reported EPS, as well as Net Income is higher than for the company expensing the extra salary.

What happens for companies whose distributions are less than earnings.

The next comparison repeat the process above but this company's dividends are less than earnings. When the company choses to pay salary with dividends, it must issue a lot more (12) shares because their $0.50 /sh distributions are so much small than the $1.50 /sh in the first comparison. The additional shares ends up diluting the reported EPS more than would be the case if salary was expensed.

Net Income is still higher when wages are paid with dividends ($100 vs. $94). But EPS is lower ($0.89 vs. $0.94). Because the markets put such an emphasis on EPS, management probably will not choose this strategy for hiding management compensation in these circumstances.

(A) and (B) are the same as in the first comparison, but (C) reflects the lower ($0.50 /sh) dividends.

Compare that to paying the compensation with dividends.