• Liquidating dividends occur when the investee company has distributed more dividends than it has earned since the investor company made its investment in the investee company.

• Liquidating dividends are more of a problem with the cost method than with the equity method.

• When a liquidating dividend occurs, it is considered a return of investment rather than a return on investment.  A liquidating dividend reduces the carrying amount of the investment account.

Assume that on January 1, 19X1, the Panas Corporation (investor) purchases a 10% interest in the Zen Corporation (investee) stock for $50,000.  Zen reports income and pays dividends as follows:
 

1.  Entry to acquire the investment:

3. Entry to record year X2 dividend:

4. Entry to record year X4 dividend:

•  Zen's cumulative income since Panas' acquisition of the investment is $70,000; cumulative dividends are $85,000.  Dividends exceed income be $15,000.  So of the total dividend received in 19X4, $1,500 must be considered a return of investment; the remainder of the dividend is considered income for 19X4.

• Another way to look at this problem is that in year 19X1, income exceeded dividends by $10,000, in 19X2, income exceeded dividends by $5,000; The $10,000 and the $5,000, plus the 19X3 income of $10,000, (a total of $25,000) represent the undistributed income earned since acquisition. Ten percent of that amount, $2,500, can be recognized as dividend income; the remainder must be treated as a reduction in the Investment account.