What is the primary impact of paying dividends on retained earnings?

Paying dividends has a direct relationship with retained earnings. When a company distributes dividends to its shareholders, it is essentially sharing a portion of its profits. This distribution reduces the amount of earnings that are retained for reinvestment in the business, leading to a decrease in retained earnings.

Retained earnings are part of the equity section of the balance sheet and represent the cumulative amount of net income that has not been distributed to shareholders as dividends. Therefore, when dividends are paid, it subtracts from this accumulated sum, resulting in a lower figure for retained earnings.

The other responses do not accurately reflect the nature of dividend payments. For instance, increasing capital reserves refers to retained earnings being allocated to reserves, which is not the case when dividends are paid out. Saying that it has no effect on financial statements disregards the clear impact dividends have on both retained earnings and the overall equity of the company. As for the effect on net income, dividends do not influence net income directly; net income is determined before dividends are declared, and paying them out does not change the accounting for net profits in the period they were earned. Thus, option B correctly captures the essence of how dividends impact retained earnings.