Dividends, Reserves and Retained Earnings WACE Accounting and Finance Unit 3
“Record interim and final dividends, declared dividends and transfers to and from reserves, and reconcile the opening and closing balances of retained earnings for a company”
Profit belongs to shareholders, but the company decides how much to pay out and how much to keep. An interim dividend is paid during the year; a final dividend is declared after year end. A declared but unpaid dividend is a current liability. Transfers to a reserve set aside retained earnings for a purpose without leaving the company. Closing retained earnings equals opening retained earnings plus profit, less dividends and less net transfers to reserves.
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What this dot point is asking
SCSA wants you to record dividends and reserve transfers correctly and reconcile retained earnings from its opening to its closing balance.
Interim versus final dividends
An interim dividend is declared and usually paid partway through the financial year by the directors, out of profit earned so far. A final dividend is proposed by directors at year end and confirmed at the annual general meeting. Once a dividend is declared, the company has a present obligation to pay it, so it is recorded as a current liability until paid.
The entry to declare a dividend reduces retained earnings and creates a liability: debit Dividends (or Retained Earnings), credit Dividends Payable. When paid, debit Dividends Payable, credit Cash.
Be careful to separate the two events of a final dividend. Declaration is what reduces equity and creates the obligation; payment merely settles the liability and reduces cash. If a question asks only for the year-end position, you record the declaration and show Dividends Payable as a current liability, with no cash entry yet. An interim dividend collapses these two steps into one, because it is declared and paid together during the year, so it goes straight from Retained Earnings to Cash with no payable.
A dividend can only be paid out of profits, and directors must judge that the company will remain solvent after paying it. This is why retained earnings, not share capital, is the source of dividends: share capital is contributed by owners and is preserved, while retained earnings is the accumulated profit that belongs to shareholders and may be distributed.
Reserves
A reserve is an appropriation of retained earnings, earmarking profit for a purpose such as future expansion or asset replacement. Transferring to a reserve does not move any cash; it simply reclassifies equity.
A transfer to a general reserve moves an amount out of retained earnings into the reserve account, both of which sit within equity. Total equity is unchanged. The transfer signals that those profits are not intended for immediate distribution. A later transfer back from the reserve to retained earnings reverses this and makes the amount available again for dividends.
The entry is: debit Retained Earnings, credit General Reserve. A transfer back reverses it.
Reconciling retained earnings
Retained earnings accumulates profit not yet distributed. Its movement each year is:
This reconciliation is the heart of the retained earnings column in the Statement of Changes in Equity.
Hale Ltd opens the year with retained earnings of $120 000. Profit for the year after tax is $90 000. During the year it paid an interim dividend of $15 000 and at year end declared a final dividend of $25 000. Directors also transferred $20 000 to a general reserve.
Start with opening retained earnings of $120 000 and add the $90 000 profit, giving $210 000. Subtract the interim dividend of $15 000 and the declared final dividend of $25 000, leaving $170 000. Then subtract the $20 000 transfer to the general reserve:
Closing retained earnings is $150 000. The $25 000 final dividend, being declared but unpaid, also appears as a current liability (Dividends Payable) on the Balance Sheet, while the $20 000 now sits in the General Reserve within equity.
A dividend is a distribution of profit to owners, not an expense of earning profit. It must never reduce the profit figure in the Income Statement. Instead it reduces retained earnings in the appropriation of profit, and a declared but unpaid dividend is shown as a current liability. Putting dividends in the Income Statement understates profit and double counts the reduction in equity.
Exam-style questions
Questions in the style of SCSA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
WACE 2022-style7 marksTindale Ltd opens the year with Retained Earnings of $95 000. Profit after tax for the year is $72 000. The company pays an interim dividend of $18 000, declares a final dividend of $28 000, and transfers $15 000 to a General Reserve. Reconcile opening to closing Retained Earnings, and state which item also appears as a current liability and why.Show worked answer →
A 7 mark response needs the reconciliation, the closing balance, and the liability point.
Reconciliation. Closing Retained Earnings .
Working. ; less interim ; less declared final ; less transfer to reserve . Closing Retained Earnings is .
Liability. The 15,000 transfer stays inside equity (now in the General Reserve) and does not change total equity. Markers reward the correct order of items, accurate arithmetic, and identifying only the declared dividend as the liability.
WACE 2023-style5 marksExplain the effect of a transfer from Retained Earnings to a General Reserve on total equity and on cash, and explain why a company might make such a transfer.Show worked answer →
A 5 mark response needs the equity effect, the cash effect, and the purpose.
Effect on equity. The transfer debits Retained Earnings and credits General Reserve. Both accounts sit within equity, so total equity is unchanged; the transfer only reclassifies one part of equity as another.
Effect on cash. None. No cash moves; a reserve is an internal earmarking of accumulated profit, not a separate fund of money.
Purpose. Directors transfer to a reserve to signal that part of retained profit is being set aside for a future need such as expansion or asset replacement, and is not intended for immediate distribution as dividends. This restrains the amount shown as freely distributable. Markers reward the no-change-to-total-equity point, the no-cash point, and a sensible purpose.