How are dividends related to net income and retained earnings?

Dividends are distributions of a corporation's earnings to its shareholders, which is why they are directly related to net income and retained earnings. When a company earns a profit, it can choose to reinvest those earnings back into the business or distribute a portion of them to shareholders as dividends.

The correct answer highlights that when dividends are declared and paid out, they are deducted from net income on the company's financial statements. This deduction decreases the amount available for reinvestment and reduces the amount of retained earnings. Retained earnings represent the cumulative amount of net income that has not been distributed as dividends over time. Therefore, paying dividends results in a reduction of retained earnings.

This relationship is critical for understanding how a company's profitability affects shareholders' equity. As dividends are paid, the retained earnings section of the balance sheet decreases, reflecting the funds that have been distributed rather than retained within the company. This connection emphasizes the impact of dividend decisions on the overall financial health and equity structure of a corporation.