What is the effect of a stock dividend on the accounting equation and retained earnings?

• A. Retained earnings decrease; Common Stock or Additional Paid-In Capital increases; total equity remains the same
• B. Retained earnings increase; Common Stock increases; total equity increases
• C. Retained earnings unchanged; Common Stock decreases
• D. Retained earnings decrease; Cash decreases; total equity decreases

Answer: (A)

Stock dividends move value within equity rather than altering the overall balance sheet size. When a stock dividend is issued, the company transfers an amount from Retained Earnings to paid-in capital. The journal entry debits Retained Earnings for the fair market value of the new shares and credits Common Stock for the par value of those shares and Additional Paid-In Capital for the excess. As a result, Retained Earnings decreases, Common Stock (par value) and/or APIC increase, and total equity stays the same. There is no cash impact, which is why options implying a cash outflow or an increase in retained earnings aren’t correct.