Financial Accounting Quiz: Retained Earnings
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Retained EarningsQuestion 1 of 20

A company has a large retained earnings balance. However, its ability to pay dividends is restricted by a covenant in a debt agreement. This contractual restriction is most similar in economic effect to which of the following?

An appropriation of retained earnings.
A declaration of a stock dividend.
The establishment of a cash sinking fund.
The recognition of a contingent gain.
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Financial Accounting Quiz

Financial Accounting Quiz: Retained Earnings

Practice Retained Earnings in Financial Accounting with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Retained Earnings, giving you a quick way to practice the rules, question types, and explanations that matter most for Financial Accounting.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

A company has a large retained earnings balance. However, its ability to pay dividends is restricted by a covenant in a debt agreement. This contractual restriction is most similar in economic effect to which of the following?

  1. An appropriation of retained earnings. (correct answer)
  2. A declaration of a stock dividend.
  3. The establishment of a cash sinking fund.
  4. The recognition of a contingent gain.
Explanation: Both a debt covenant restricting dividends and an appropriation of retained earnings have the same economic effect: they limit the ability of the company to distribute assets to shareholders in the form of dividends. The former is a contractual restriction imposed by a creditor, while the latter is a voluntary restriction imposed by the board of directors. Both serve to conserve the company's resources.

Question 2

A financial statement user observes the following in a company's stockholders' equity section: Retained earnings, appropriated for bond retirement: $1,000,000. The user concludes the company has segregated $1,000,000 in cash to pay off its bonds. Why is this conclusion potentially flawed?

  1. An appropriation of retained earnings is a restriction on dividend payments, not a segregation of cash. (correct answer)
  2. The appropriated amount must first be used to pay dividends before it can be used for bond retirement.
  3. Appropriated retained earnings represents a liability and will be used to offset the bond payable.
  4. The company likely has a separate cash sinking fund that would be reported as a liability, not in equity.
Explanation: The most common misconception about retained earnings appropriations is that they represent a fund of cash. An appropriation is an action within the equity section that restricts the amount of retained earnings available for dividends. While a company may also set up a separate cash fund (a sinking fund, reported as an asset), the appropriation itself does not create or segregate cash.

Question 3

A company is a defendant in a lawsuit. Legal counsel advises that a loss is reasonably possible but not probable. According to U.S. GAAP, which of the following actions is the appropriate accounting treatment?

  1. Appropriate retained earnings for the estimated loss and disclose the contingency in the notes.
  2. Accrue a loss and a liability for the estimated amount.
  3. Disclose the contingency in the notes to the financial statements only, without recording any journal entries. (correct answer)
  4. Neither appropriate retained earnings nor disclose the contingency until the loss becomes probable.
Explanation: Under U.S. GAAP, for a loss contingency that is reasonably possible, the required action is disclosure in the notes to the financial statements. Accrual of a loss (recording an expense and liability) is only required when the loss is both probable and can be reasonably estimated. Appropriation of retained earnings is a voluntary action taken by the board and is never required by GAAP for contingencies.

Question 4

Riverstone Corp. has the following restrictions on retained earnings: $400,000 appropriated for treasury stock purchases, $250,000 restricted by debt covenant, and $300,000 appropriated for self-insurance. The company also has a $50,000 deficit in accumulated other comprehensive income. If total retained earnings is $1,800,000, what amount is available for dividend distribution?

  1. $850,000 (correct answer)
  2. $900,000
  3. $800,000
  4. $950,000
Explanation: Available for dividends = Total retained earnings - All restrictions: $1,800,000 - $400,000 - $250,000 - $300,000 = $850,000. The deficit in AOCI doesn't directly restrict retained earnings for dividend purposes. Choice B ignores the debt covenant restriction. Choice C incorrectly subtracts the AOCI deficit. Choice D ignores the self-insurance appropriation.

Question 5

At the end of the year, a company has total retained earnings of $950,000, of which $200,000 is appropriated for contingencies. During the year, the company paid $60,000 in dividends and reported net income of $250,000. There were no changes to the appropriation balance during the year. What was the unappropriated retained earnings balance at the beginning of the year?

  1. $560,000 (correct answer)
  2. $760,000
  3. $960,000
  4. $500,000
Explanation: First, work backward to find the total retained earnings at the beginning of the year: Ending RE (950,000)+Dividends(950,000) + Dividends (60,000) - Net Income ($250,000) = $760,000. Since the appropriation balance was unchanged at $200,000, the beginning appropriated balance must also have been 200,000.Therefore,thebeginningunappropriatedbalancewas:TotalBeginningRE(200,000. Therefore, the beginning unappropriated balance was: Total Beginning RE (760,000) - Beginning Appropriated RE ($200,000) = $560,000.

Question 6

A company's board of directors formally approves an appropriation of $5,000,000 from its retained earnings for the purpose of future plant expansion. Which of the following statements correctly describes the immediate impact of this action on the company's financial statements?

  1. Total stockholders' equity decreases by $5,000,000, and cash decreases by $5,000,000.
  2. Total retained earnings decreases by $5,000,000, and a long-term liability for plant expansion is created.
  3. The amount of retained earnings available for dividend distribution is reduced, but total stockholders' equity remains unchanged. (correct answer)
  4. An expense of $5,000,000 is recognized on the income statement, reducing net income and total retained earnings.
Explanation: An appropriation of retained earnings is a reclassification within stockholders' equity. It transfers a portion of retained earnings to an 'appropriated' account, which signals that this amount is not available for dividends. This action does not change the total amount of retained earnings or total stockholders' equity. It is a disclosure of intent and does not involve setting aside cash or creating a liability.

Question 7

A company begins the year with a total retained earnings balance of $800,000. During the year, the board of directors appropriates $150,000 for a pending lawsuit. The company reports net income of $120,000 and pays cash dividends of $50,000. What is the balance of unappropriated retained earnings at the end of the year?

  1. $870,000
  2. $720,000 (correct answer)
  3. $770,000
  4. $670,000
Explanation: First, calculate the ending balance of total retained earnings: Beginning RE (800,000)+NetIncome(800,000) + Net Income (120,000) - Dividends ($50,000) = 870,000.Then,tofindtheunappropriatedportion,subtracttheappropriatedamountfromthetotalendingbalance:TotalEndingRE(870,000. Then, to find the unappropriated portion, subtract the appropriated amount from the total ending balance: Total Ending RE (870,000) - Appropriated RE ($150,000) = $720,000.

Question 8

Three years ago, a company appropriated $2,000,000 of retained earnings for the construction of a new research facility. The facility has now been completed, funded by a long-term note payable. The company's board of directors votes to reverse the appropriation. What is the direct accounting effect of this reversal?

  1. Total stockholders' equity increases by $2,000,000.
  2. Cash increases by $2,000,000 as restricted funds become available.
  3. The balance of unappropriated retained earnings increases by $2,000,000. (correct answer)
  4. Net income for the current period increases by $2,000,000.
Explanation: Reversing an appropriation moves the balance from the appropriated retained earnings account back to the unappropriated retained earnings account. This increases the amount available for dividends. The action is a reclassification entirely within retained earnings and has no effect on total retained earnings, total stockholders' equity, cash, or net income.

Question 9

A company's balance sheet reports a significant retained earnings balance. An investor claims this balance represents a fund of liquid assets that the company has accumulated from past profits. Which statement best evaluates this claim?

  1. The claim is correct, as retained earnings is the primary source of a company's cash reserves from operations.
  2. The claim is flawed because retained earnings represents a cumulative claim on all assets, not a specific fund of cash. (correct answer)
  3. The claim is flawed because retained earnings can only be converted to cash after all liabilities are settled.
  4. The claim is correct only if the retained earnings have been formally appropriated by the board of directors.
Explanation: Retained earnings is an equity account representing the cumulative amount of net income that has been retained in the business, not distributed as dividends. These earnings have been reinvested in various assets (e.g., inventory, equipment, buildings) or used to reduce liabilities. It is not a fund of cash. The amount of cash on hand is reported separately as an asset on the balance sheet.

Question 10

A corporation had the following balances at the beginning of the year: Total Retained Earnings, $1,200,000; Appropriated for Plant Expansion, $300,000. During the year, the company had net income of $200,000, paid cash dividends of $60,000, and issued a small stock dividend that reduced retained earnings by $90,000. The appropriation for plant expansion was unchanged. What is the year-end balance of unappropriated retained earnings?

  1. $950,000 (correct answer)
  2. $1,040,000
  3. $1,250,000
  4. $1,340,000
Explanation: First, calculate the ending balance of total retained earnings: Beginning RE (1,200,000)+NetIncome(1,200,000) + Net Income (200,000) - Cash Dividends (60,000)−StockDividend(60,000) - Stock Dividend (90,000) = 1,250,000.Next,determinetheendingunappropriatedbalancebysubtractingtheunchangedappropriatedbalancefromtheendingtotal:TotalEndingRE(1,250,000. Next, determine the ending unappropriated balance by subtracting the unchanged appropriated balance from the ending total: Total Ending RE (1,250,000) - Appropriated RE ($300,000) = $950,000.

Question 11

A company's board of directors wants to communicate to shareholders that a portion of the company's earnings is being reinvested for a specific strategic purpose and is therefore not available for dividends. Which of the following actions achieves this objective?

  1. Establishing a segregated cash fund for the specific purpose.
  2. Disclosing the strategic purpose in the Management's Discussion and Analysis section of the annual report.
  3. Recognizing a contingent liability for the future cost of the strategic purpose.
  4. Formally appropriating a portion of retained earnings for the specific purpose. (correct answer)
Explanation: The primary purpose of appropriating retained earnings is to restrict the amount available for dividend declarations and to communicate the board's intention to use those resources for a specific purpose, such as plant expansion or contingencies. While setting aside cash (A) or disclosing plans (B) are related actions, only the appropriation formally restricts retained earnings within the equity section of the balance sheet.

Question 12

A company's board of directors votes to appropriate $750,000 of retained earnings for potential losses from a pending lawsuit. Which of the following journal entries correctly records this transaction?

  1. Debit Loss Contingency Expense for $750,000 and credit Estimated Liability for Lawsuit for $750,000.
  2. Debit Retained Earnings for $750,000 and credit Cash for $750,000.
  3. Debit Retained Earnings for $750,000 and credit Appropriated Retained Earnings for $750,000. (correct answer)
  4. No journal entry is required; the appropriation is disclosed only in the notes to the financial statements.
Explanation: The formal appropriation of retained earnings is recorded with a journal entry that reclassifies a portion of retained earnings. The entry debits the general Retained Earnings account (reducing the unappropriated balance) and credits a specific Appropriated Retained Earnings account. This is not an expense (A), does not use cash (B), and requires a formal journal entry, not just a note disclosure (D).

Question 13

A company's unappropriated retained earnings balance was $400,000 at the beginning of the year and $450,000 at the end of the year. The company reported net income of $120,000 and made a new appropriation of $30,000 for plant expansion during the year. What was the total amount of dividends declared during the year?

  1. $40,000 (correct answer)
  2. $70,000
  3. $100,000
  4. $140,000
Explanation: The change in unappropriated retained earnings can be expressed as: Ending Balance = Beginning Balance + Net Income - Dividends - New Appropriations. We can rearrange this to solve for Dividends: Dividends = Beginning Balance + Net Income - New Appropriations - Ending Balance. Plugging in the values: Dividends = $400,000 + $120,000 - $30,000 - $450,000 = $40,000.

Question 14

At the beginning of the year, a company's unappropriated retained earnings were $800,000 and its appropriated retained earnings were $200,000. During the year, the board reversed the $200,000 appropriation as its purpose was fulfilled. The company also declared $90,000 in dividends. The ending balance of unappropriated retained earnings was $1,050,000. What was the company's net income for the year?

  1. $140,000 (correct answer)
  2. $340,000
  3. $240,000
  4. $40,000
Explanation: We can solve for Net Income (NI) using the formula for the change in unappropriated retained earnings: Ending Balance = Beginning Balance + NI - Dividends + Reversals of Appropriations. Plugging in the values: $1,050,000 = $800,000 + NI - $90,000 + $200,000. Simplifying the right side: $1,050,000 = $910,000 + NI. Solving for NI: NI = $1,050,000 - $910,000 = $140,000.

Question 15

Pryce Corp. had a retained earnings balance of $600,000 on January 1, 20X1. During 20X1, the company discovered a $40,000 (net of tax) understatement of 20X0's sales revenue. In 20X1, Pryce reported net income of $130,000 and paid dividends of $50,000. No appropriations exist. What is the correct balance for retained earnings on December 31, 20X1?

  1. $640,000
  2. $720,000 (correct answer)
  3. $680,000
  4. $760,000
Explanation: The discovery of the error from a prior year requires a prior period adjustment to the beginning retained earnings balance. Since sales were understated, prior income was understated, and the correction increases beginning retained earnings. The adjusted beginning balance is $600,000 + $40,000 = 640,000.Theendingbalanceisthencalculatedas:AdjustedBeginningRE(640,000. The ending balance is then calculated as: Adjusted Beginning RE (640,000) + Net Income (130,000)−Dividends(130,000) - Dividends (50,000) = $720,000.

Question 16

A company has a deficit in retained earnings of ($40,000) at the beginning of the year. During the year, it generates net income of $150,000 and declares and pays cash dividends of $30,000. The board also wishes to appropriate $50,000 for plant expansion. Which of the following statements is true regarding the board's desire to appropriate retained earnings?

  1. The appropriation is not permissible because the company started the year with a deficit in retained earnings.
  2. The appropriation is permissible, and it will result in an unappropriated retained earnings balance of $30,000. (correct answer)
  3. The appropriation is not permissible because dividends cannot be paid in a year when a deficit is eliminated.
  4. The appropriation is permissible, but it will reduce the company's total assets by $50,000.
Explanation: First, calculate the ending retained earnings balance before the appropriation: Beginning Deficit (-40,000)+NetIncome(40,000) + Net Income (150,000) - Dividends ($30,000) = $80,000. Since the company has a positive retained earnings balance of $80,000, it is permissible to appropriate $50,000. After the appropriation, the unappropriated balance will be $80,000 - $50,000 = $30,000.

Question 17

A company has a retained earnings balance of $10 million but has very low cash balances and is facing a liquidity crisis. A shareholder demands a dividend, citing the large retained earnings balance. Which of the following statements provides the strongest explanation for why the company cannot pay a dividend?

  1. The retained earnings must have been appropriated by the board of directors, legally preventing a dividend payment.
  2. A company must have both a positive retained earnings balance and sufficient cash to pay a dividend. (correct answer)
  3. Dividends can only be paid from current year net income, not from the accumulated retained earnings balance.
  4. The retained earnings balance must first be converted into an equal amount of treasury stock before a dividend can be paid.
Explanation: Dividend payments require two conditions: (1) a sufficient balance in retained earnings (or legal equivalent) to absorb the dividend, and (2) sufficient cash to make the payment. A large retained earnings balance indicates a history of profitability, but it does not represent cash on hand. The company's lack of cash (liquidity) is the direct reason it cannot pay the dividend.

Question 18

Phoenix Corp. reported the following for 2024: beginning retained earnings of $1,200,000, net income of $450,000, cash dividends of $200,000, and a 10% stock dividend when the market value was $25 per share and par value was $5 per share. If 80,000 shares were outstanding before the stock dividend, what is the ending balance in retained earnings?

  1. $1,450,000
  2. $1,250,000 (correct answer)
  3. $1,290,000
  4. $1,350,000
Explanation: Stock dividend reduces retained earnings by market value: 8,000 shares × $25 = $200,000. Calculation: $1,200,000 + $450,000 - $200,000 (cash dividends) - $200,000 (stock dividend) = 1,250,000.ChoiceAignoresthestockdividendeffect.ChoiceCincorrectlyusesparvalue(1,250,000. Choice A ignores the stock dividend effect. Choice C incorrectly uses par value (40,000) instead of market value for the stock dividend. Choice D only accounts for cash dividends, ignoring the stock dividend.

Question 19

Redwood Industries began 2024 with retained earnings of $3,200,000, including $500,000 appropriated for contingencies. During 2024, the company had net income of $890,000, paid dividends of $350,000, and appropriated an additional $400,000 for plant expansion. At year-end, the contingency that prompted the original appropriation was resolved without any loss, and the board decided to release that appropriation. What is the balance in unappropriated retained earnings at December 31, 2024?

  1. $3,740,000
  2. $3,840,000
  3. $4,240,000
  4. $3,240,000 (correct answer)
Explanation: When you encounter retained earnings questions involving appropriations, remember that appropriated retained earnings are simply segregated portions of total retained earnings - they don't represent separate cash accounts or affect the total retained earnings calculation. Let's trace through the retained earnings changes systematically. Start with total retained earnings of $3,200,000, then apply the standard retained earnings formula: Beginning Balance + Net Income - Dividends = Ending Balance. $\text{Ending Retained Earnings} = \3,200,000 + $890,000 - $350,000 = $3,740,000 Now determine the appropriated portion at year-end. The original $500,000 contingency appropriation was released (returned to unappropriated status), but $400,000 was newly appropriated for plant expansion. Net appropriated amount: $400,000. Therefore: Unappropriated retained earnings = $3,740,000 - $400,000 = $3,240,000. Choice A (3,740,000)representstotalretainedearningsatyear−end,nottheunappropriatedportion.ChoiceB(3,740,000) represents total retained earnings at year-end, not the unappropriated portion. Choice B (3,840,000) incorrectly adds both the released appropriation and new appropriation to ending retained earnings, double-counting the released funds. Choice C ($4,240,000) appears to add the released appropriation amount directly to total retained earnings, misunderstanding that releasing an appropriation simply reclassifies funds within retained earnings rather than increasing the total. Study tip: Always remember that appropriations are internal classifications within retained earnings, not additions or subtractions to the total. Calculate total retained earnings first, then subtract current appropriations to find the unappropriated balance.

Question 20

Which of the following statements best explains the primary purpose and effect of appropriating retained earnings?

  1. Appropriations create a legal restriction that prevents the company from using those funds for any purpose other than the stated objective
  2. Appropriations set aside actual cash in a separate account to ensure funds are available when needed for the specified purpose
  3. Appropriations inform stakeholders that management intends to retain earnings for specific purposes, but do not create legal restrictions or segregate assets (correct answer)
  4. Appropriations reduce the company's tax liability by treating the appropriated amounts as non-taxable reserves for future expenses
Explanation: Appropriations are primarily a communication tool to inform stakeholders about management's intentions regarding retained earnings use. They don't create legal restrictions (unless required by law or contract), don't segregate actual cash, and have no tax implications. Choice A overstates the legal effect. Choice B confuses appropriations with actual asset segregation. Choice D incorrectly describes tax effects that don't exist.