University of Central Florida (UCF) ACG2021 Principles of Financial Accounting Final Practice Exam

When a dividend is declared, the retained earnings of a company decrease. This occurs because dividends represent a distribution of profits to shareholders. When the board of directors declares a dividend, an obligation is created for the company to pay that amount to shareholders.

As the company earmarks a portion of its profits to distribute as dividends, those profits are no longer available to be retained within the company, leading to a reduction in retained earnings. The decrease reflects that the portion of profit that is being returned to shareholders is no longer part of the company's retained earnings, which are typically used for reinvestment in the business, paying off debt, or other operational needs. Thus, the accounting equation is maintained, but there is a direct impact on the retained earnings account.

In summary, the declaration of a dividend initiates a direct decrease in retained earnings as it signifies the distribution of previously earned profits to shareholders.