One of the characteristic features of a market economy is the competition between mostbusinesses. When summing up the work, the most important financial indicator is profit.Its positive dynamics, along with other economic indicators, indicate the effectiveness ofthe business entity. The further development is influenced by choice of ways of profitdistribution, which remains in the hands of the owners of the enterprise.
Before answering the question of what is retained earnings, it is necessary to take intoaccount those obligations that arise before the company after receiving income. Thefirst such obligation is income tax. This required payment is withdrawn from the amountof gross income almost in the first place, turning the money received into net profit.
After that, the shareholders of the company receive their share from the net profitamount, the so-called dividends. Dividends can turn a profit into a loss, especially if thecompany is in poor condition. And, finally, the remaining part of the capital will bereferred to as retained earnings that will be spent in several possible ways.
Retained earnings of the organization very often act as an indicator of the profitability ofthe company, as well as its attractiveness to investors. They are calculated on anaccrual basis at the end of each specified reporting period. Retained earnings, or rather,its accounting is an essential factor in the preparation of the reports. As a result, thismay affect a category such as dividends and the number of shareholders.
What Impacts Retained Earnings?
Retained earnings are part of the net income that was not paid as dividends but wasretained by the company to reinvest in business development or pay off debt
obligations. In the company's balance sheet, its value is indicated under shareholder’sequity. The formula for calculating retained earnings is as follows:
RE 1 = RE 0 + Net Income – Dividends
where RE 1 – retained earnings at the end of the current period;
RE 0 – retained earnings at the beginning of the current period;
Net Income – net profit;
Dividends – the number of dividends paid.
It should be noted that if the company in the current period did not receive net profit, buthas a net loss, then the formula will look as follows.
RE 1 = RE 0 – Net Loss – Dividends
In most cases, companies save part of their income to invest in areas where growthopportunities can be created, for example, to purchase new equipment or to conductresearch. The retained earnings account is adjusted every time a new entry is added tothe income or expense account.
If the net loss for the current period is more significant than retained earnings at thebeginning of the period, retained earnings may become negative, thereby creating adeficit. It is in this case that the loss becomes uncovered. In other words, the uncoveredloss is the loss that occurred when the enterprise had an actual loss and was unable tocover it with retained earnings, which cause them to become harmful. The leadingcauses of negative retained earnings are considered to be the following:
- Company expenses that are larger than its revenues due to various reasons;
- Fundamental changes in accounting policies, significantly affecting thefinancial position of the company;
- Errors of the past years discovered in the reporting period.
Retained earnings increase when errors are found in the financial statements that haveled to an overstatement of expenses as well as from unclaimed dividends byshareholders if more than six years have passed since their accrual. Accordingly, theerrors that created the overstatement of income will reduce the accumulated earnings.Let's take a look at an example:
Suppose that the revenue from the core business activities of the company amounted to50 thousand dollars, non-operating income – 6 thousand dollars. Costs of production -49 thousand dollars, other expenses – 9 thousand dollars and taxes – 4 thousanddollars. A reserve fund was not created in the company.
After calculating the uncovered loss, the loss amount of 2 thousand dollars will appearin the balance sheet. If at the beginning of the year, a definite amount of retainedearnings was present, then the resulting loss will reduce it. If there were no retainedearnings or retained earnings amount was smaller than the damage, then negativeretained earnings will appear on the report.
Net income is a part of the profit remaining in the company after paying taxes and otherpayments and staying in its full disposal. The company independently determines howto use these funds. In most cases, investors want to get their share in profits in the formof dividends. In turn, if the company pays the bonuses, there will be less or no funds foradding to the retained earnings account.
However, there might be a case when a company had a loss for one or more years, itsaccumulated earnings, the primary source for covering losses and dividend payments,may get depleted and have negative retained earnings balance. A company might havespent its retained earnings on other needs besides covering the losses.
In general, a company would need to have positive retained earnings to pay dividends.In fact, due to incorporation laws, companies are usually unable to pay dividends untilthey can cover the deficit in retained earnings.
Negative shareholders equity
Can shareholder’s equity even ever be negative? Unfortunately, yes. Since retainedearnings are part of shareholder’s equity, continuous significant losses can decreaseretained earnings so much that their negative balance brings the whole shareholder’svalue down.
When stockholder’s equity is negative, it is no longer noted as such on the balancesheet, and instead, the total deficit appears on its balance. To management, owners,and investors, this means that a company will soon go under and might file forbankruptcy.
However, if the company has enough cash to continue running the business, it might beable to do so for as long as it has money. Although shareholders might not getdividends, and their shares will get devalued, they will not owe anything to the company,and creditors cannot demand anything from them.
How Negative Retained Earnings Impact Business
Negative retained earnings hurt the business itself and on its shareholders. Sinceretained earnings are part of the shareholder’s equity, negative retained earnings willdecrease the total number for shareholder’s equity. Besides being unable to paydividends to shareholders, a company that has accumulated deficit that exceeds theamount of contributed capital is at risk of bankruptcy.
If there is a loss, the company needs to carefully analyze the causes, since it can be theresult of a decrease in the competitiveness of products, which will require a change inthe sales strategy or need for changes in production processes, or it may be atemporary occurrence when injecting an impressive but slowly recovering investment inproduction.
Additional funds and a way to earn enough profits to cover the losses would be requiredto bring negative retained earnings back to a positive balance. However, this would taketime that not many owners have to spar. Otherwise, they might lose their investors. Itshould be noted that paying dividends at the expense of borrowed money when acompany is experiencing a loss is unlikely to do any good for any business and mayeven lead to bankruptcy.
Another way to increase retained earnings is to reevaluate the company’s assets. Anaccounting method of reevaluating the holdings to a fair market price will allow addingan adjustments entry to the retained earnings, and it might be enough to bring retainedearnings back to positive values. This will enable a company to be able to start payingdividends sooner.
If a company wants to attract investors, it will have to explain why it has a negativebalance in retained earnings. This might be forgiven for a startup company that has yetto establish itself. Even if a company that has been operating for some time, one badyear might not keep investors from placing their funds into the company.
A completely different scenario will be if a company that has been on the market for along time was not able to accumulate enough retained earnings to cover the low times acompany was/is going through. This might mean that this business is not profitable,and/or management is not able to lead the company to success. It might also happen ifthe company has been paying significant dividends to its shareholders and was not ableto accumulate earnings.