Final answer:
Retained earnings decrease when a stock dividend is issued because the value of the stock dividend is transferred from the retained earnings to paid-in capital, thus reducing the total retained earnings balance.
Step-by-step explanation:
When a company issues a stock dividend, it's distributing additional shares to its shareholders instead of cash. This action does not bring in any cash or other assets; instead, it transfers part of the company's retained earnings to common stock.
Retained earnings are typically used to reinvest in the company, pay down debt, or distribute dividends to shareholders. When a stock dividend is declared, the amount of the dividend declared is moved from retained earnings to paid-in capital.
Because the company is using its retained earnings to issue additional shares, even though there is no cash outflow, the total retained earnings balance decreases as this balance represents the accumulated profits re-invested in the business.