Question

Matt has been told by his instructor that dividends reduce retained earnings (and therefore stockholders’ equity)....

Matt has been told by his instructor that dividends reduce retained earnings (and therefore stockholders’ equity).
However, since he knows that stockholders are receiving the dividends, Matt doesn’t understand how paying dividends would decrease stockholders’ equity. Explain this to Matt.

Business   Accounting   
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Answer #1

Company is a separate legal entity, it has a separate identity of its own which is separate from its owners (stockholders). Stockholders hold only percentage of ownership in the company by investing in the company.

The company may decide from time to time to pay dividends to its stockholders out of the net income earned over the period, since stockholder's also want some return on their investment.

Net Income is added to retained earnings and when dividends are paid to stockholder's, it is reduced from retained earnings, since it is paid outside the business to the stockholders or investors as their return.

Paying dividends is distribution of profits and hence reduced from retained earnings.

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