This week, I watched, with amazement, Larry Kudlow’s joust with Congressman Brad Sherman about accounting. Sherman was fresh from his Stalinist show trial of bank CEOs. Having spent the afternoon berating the banks for having the audacity to pay a dividend to their beleaguered shareholders, Sherman went on to lecture Kudlow about the same topic. Larry pointed out that the money for the dividends didn’t come from TARP and so it is really none of congress’s business. Sherman said that, because dividends come from “capital,” that indeed it was taxpayer money.

Kudlow was right, and Sherman needs a little accounting refresher. Dividends are paid out of retained earnings, which is the accumulated net income of the business. They are not paid out of direct investment accounts such as preferred stock. The TARP money was in the form purchase of preferred stock, which is a completely separate account than retained earnings.

It’s actually even a little bit worse for his case: companies pay dividends out of the retained earnings account, which means even companies that don’t have any net earnings can pay dividends without touching TARP money, because retained earnings are the accumulated wealth of prior years of net income. If I lose money this year, but made money last year, and I pay a dividend this year, the money is not coming from preferred stock accounts, or common stock accounts, it’s coming from the net income of prior profitable years. Bank of America, for example, is sitting on over $70 billion in retained earnings, all available to distribute to the shareholders to whom it rightly belongs.

The bookkeeping entry is simply this: you credit the cash account, and you debit the retained earnings account – that’s it. No debit to the preferred stock holder account.

In other words, the dividends are paid with corporate earnings, just as they should be; not with TARP money.

Brad Sherman is not just a member of the House Financial Oversight Committee; he’s considered the resident expert on topics such as finance and accounting for the group. Nevertheless he was flat wrong on the core question in his debate with Kudlow. He confused different capital accounts with one another. Continued...