What is the effect of declaring and paying cash dividends on the financial statements?

• A. Declaration increases cash and retained earnings
• B. Declaration creates a current liability Dividends Payable and reduces retained earnings
• C. Payment increases cash and still leaves the liability
• D. Declaration has no effect until payment

Answer: (B)

Declaring cash dividends reduces stockholders' equity and creates a current liability. When the dividend is declared, retained earnings are decreased because the company commits to distributing part of its earnings, and a Dividends Payable liability is recorded to show the obligation to pay that cash. When the dividend is paid, the liability is cleared and cash is reduced. So, declaring and paying cash dividends ultimately lowers both cash and retained earnings, with the declaration step specifically creating the Dividends Payable obligation and reducing retained earnings. The other statements misstate either when cash is affected or whether the liability remains after payment.