What is the effect of declaring a cash dividend on the date of declaration?

Declaring a cash dividend on the date of declaration creates a legal obligation for the company to pay that dividend to shareholders. This legal obligation is recorded as a liability, specifically as "Dividends Payable," which increases total liabilities. At the same time, the company reflects this obligation by reducing retained earnings, since dividends are distributions of earnings to shareholders.

Retained earnings represent the cumulative profits that have been retained in the business rather than distributed as dividends. When a dividend is declared, it reduces the amount of retained earnings because it represents a decision to distribute a portion of these earnings to shareholders. Hence, the correct response indicates that declaring a cash dividend decreases retained earnings, appropriately reflecting the financial implications of such a decision. This helps maintain accurate financial reporting and ensures that stakeholders are well-informed of the company's distribution policies and financial position.