If a company declares and pays a cash dividend, what is the effect on the accounting equation?

• A. Increases cash and increases retained earnings; liabilities increase.
• B. Decreases cash (asset) and retained earnings (equity); total liabilities unchanged.
• C. Decreases cash and increases accounts payable; equity unchanged.
• D. Increases cash and increases common stock; liabilities decrease.

Answer: (B)

Dividends reduce what the company has earned and are paid out in cash, so they affect both sides of the equation. When a cash dividend is declared, retained earnings (a part of equity) are reduced and a liability for dividends payable is created. When the dividend is paid, the cash (an asset) is reduced and the dividends payable liability is settled. Net effect across both steps is that assets decrease and equity decreases, while liabilities end up unchanged. So the accounting equation shows a drop in cash and a drop in retained earnings, with no change in total liabilities.