Chartered Financial Analyst Level 2

Explanation

A stock dividend distribution reduces a company's retained earnings but does not reduce total shareholders' equity.

Key Points:

• Stock dividends represent a transfer from retained earnings to contributed capital (common stock and additional paid-in capital)
• The accounting entry for a stock dividend is:
  • Debit: Retained Earnings
  • Credit: Common Stock and Additional Paid-in Capital
• Total shareholders' equity remains unchanged - it's just a reclassification within equity accounts
• Financial leverage ratios are not directly affected by stock dividends since both equity and debt remain unchanged

Why Option A is Correct:

• Retained earnings are reduced by the fair value of the stock dividend distributed
• This represents a permanent reduction in the retained earnings account

Why Other Options are Incorrect:

• Option B: Financial leverage ratios (like debt-to-equity) are unaffected because total equity doesn't change
• Option C: Total shareholders' equity remains the same - it's just reallocated between retained earnings and contributed capital

This is a fundamental accounting concept where stock dividends represent a capitalization of retained earnings rather than a distribution of assets.