One of the characteristic features of a market economy is the competition between most businesses. When summing up the work, the most important financial indicator is profit. Its positive dynamics, along with other economic indicators, indicate the effectiveness of the business entity. The further development is influenced by choice of ways of profit distribution, which remains in the hands of the owners of the enterprise.
Before answering the question of what are retained earnings, it is necessary to take into account those obligations that arise before the company after receiving income. The first such obligation is income tax. This required payment is withdrawn from the amount of gross income almost in the first place, turning the money received into net profit.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 profit amount, the so-called dividends. Dividends can turn a profit into a loss, especially if the company is in poor condition. And, finally, the remaining part of the capital will be referred 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 of the company, as well as its attractiveness to investors. They are calculated on an accrual 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, this may 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 was retained 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’s equity. 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, but has 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 growth opportunities can be created, for example, to purchase new equipment or to conduct research. The retained earnings account is adjusted every time a new entry is added to the income or expense account.
If the net loss for the current period is more significant than retained earnings at the beginning of the period, retained earnings on balance sheet may become negative, thereby creating a deficit. It is in this case that the loss becomes uncovered. In other words, the uncovered loss is the loss that occurred when the enterprise had an actual loss and was unable to cover it with retained earnings, which cause them to become harmful. The leading causes 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 the financial 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 have led to an overstatement of expenses as well as from unclaimed dividends by shareholders if more than six years have passed since their accrual. Accordingly, the errors 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 thousand dollars. A reserve fund was not created in the company.
After calculating the uncovered loss, the loss amount of 2 thousand dollars will appear in the balance sheet. If at the beginning of the year, a definite amount of retained earnings was present, then the resulting loss will reduce it. If there were no retained earnings or retained earnings amount was smaller than the damage, then negative retained earnings will appear on the report.
Net income is a part of the profit remaining in the company after paying taxes and other payments and staying in its full disposal. The company independently determines how to use these funds. In most cases, investors want to get their share in profits in the form of dividends. In turn, if the company pays the bonuses, there will be less or no funds for adding to the retained earnings account.
However, there might be a case when a company had a loss for one or more years, its accumulated earnings, the primary source for covering losses and dividend payments, may get depleted and have negative retained earnings balance. A company might have spent 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 until they can cover the deficit in retained earnings.
Negative shareholders equity
Can shareholder’s equity even ever be negative? Unfortunately, yes. Since retained earnings are part of shareholder’s equity, continuous significant losses can decrease retained earnings so much that their negative balance brings the whole shareholders value down.
When stockholder’s equity is negative, it is no longer noted as such on the balance sheet, 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 for bankruptcy.
However, if the company has enough cash to continue running the business, it might be able to do so for as long as it has money. Although shareholders might not get dividends, 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. Since retained earnings are part of the shareholder’s equity, negative retained earnings will decrease the total number for shareholder’s equity. Besides being unable to pay dividends to shareholders, a company that has accumulated deficit that exceeds the amount 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 the result of a decrease in the competitiveness of products, which will require a change in the sales strategy or need for changes in production processes, or it may be a temporary occurrence when injecting an impressive but slowly recovering investment in production.
Additional funds and a way to earn enough profits to cover the losses would be required to bring negative retained earnings back to a positive balance. However, this would take time that not many owners have to spar. Otherwise, they might lose their investors. It should be noted that paying dividends at the expense of borrowed money when a company is experiencing a loss is unlikely to do any good for any business and may even lead to bankruptcy.
Another way to increase retained earnings is to reevaluate the company’s assets. An accounting method of reevaluating the holdings to a fair market price will allow adding an adjustment entry to the retained earnings, and it might be enough to bring retained earnings normal balance back to positive values. This will enable a company to be able to start paying dividends sooner.
If a company wants to attract investors, it will have to explain why it has a negative balance in retained earnings. This might be forgiven for a startup company that has yet to establish itself. Even if a company that has been operating for some time, one bad year 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 a long time was not able to accumulate enough retained earnings to cover the low times a company 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 if the company has been paying significant dividends to its shareholders and was not able to accumulate earnings.