Final answer:
The effect of issuing a 5% stock dividend is to transfer part of the retained earnings to paid-in capital, creating additional shares without cash flow and altering the equity section of the balance sheet.
Step-by-step explanation:
The declaration and issuance of a 5% stock dividend generally results in a transfer of part of the retained earnings to the paid-in capital account. When a company issues a stock dividend, it is essentially converting a portion of retained earnings into additional shares of stock and distributing them to existing shareholders proportionately. This does not involve any cash flow but merely shifts the components of the shareholders' equity section in the balance sheet.
For example, if a company has 1,000 shares of common stock outstanding and declares a 5% stock dividend, 50 new shares (5% of 1,000) will be issued. If the par value of the stock is $1, the retained earnings will decrease by $50 (50 shares x $1), and the paid-in capital will increase by the same amount, assuming no other adjustments like additional paid-in capital resulting from stock dividends above par value.