Retained earnings is a common accounting concept that many businesses face. Thisterm stands for funds received from the economic activities of the company andavailable at its disposal after payment of tax deductions, dividends, fines, etc. Simplyput, all required payments. An alternative name for retained earnings is earned surplusor accumulated earnings. In some cases, the concept retained capital is used.
The main difference between retained earnings and net income is that it is alwayscalculated not only for a specific period, but also for the total life of the enterprise. Netincome, on the other hand, is determined only for the reporting period. At the end of theyear, both indicators can be the same.
Retained earnings are included in the equity section of the balance sheet. By default, itis believed that it must be distributed among the owners and used to optimize thecompany's business model. Until that point, such a profit can only be called the debt ofthe company in relation to its owners. It refers to long-term sources of financing,therefore the goal of the company's financial strategy should be its mandatoryaccumulation.
There are several basic ways to distribute retained earnings. Among them:
- dividend payments to owners/shareholders;
- compensation for earlier losses;
- accumulation of funds for the reserve fund;
- other goals agreed upon by the owners.
How are Retained Earnings Calculated?
The RE formula is as follows:
RE = RE 0 + Net Income/Loss – DividendsWhere RE = retained earnings and RE 0 = retained earnings for the beginning of theperiod
Retained earnings increase the liability side of the balance sheet, and, consequently,the shareholder’s equity. Let’s review how to calculate retained earnings (RE) based onthe example below:
Home Supplies LLC ended the year of 2017 with a profit of 50 thousand dollars, incometax amounted to $6,000. After paying the taxes, the profit amounted to $44,000. It is thisamount, as retained earnings, that is reflected in the balance sheet for 2017 in theequity section.
If at the beginning of the year the value of retained earnings was already on the balancesheet, then at the end of the year it will be increased by $44,000. Otherwise, it will beequal to $44,000. If dividends were paid, this amount will decrease by the amount ofdividends paid and the payment of the dividend will also be noted on the balance sheet.
What is Balance Sheet?
Each organization should report to the IRS, owners, investors, etc. For this, a number ofmandatory financial statements are compiled. The main document that reflects theactivities of the enterprise for the year is the balance sheet. You can also find retainedearnings on balance sheet.
Balance sheet is a financial statement in which static accounts with their numericalvalues are grouped together. This is done in accordance with the consideration ofaccounts from two points of view – assets and sources of their financing – the balanceconsists of two parts: assets that are shown by type and group and liabilities side, whichshows the shareholder’s equity and liabilities of the organization.
On both sides of the balance sheet, homogeneous accounting objects are groupedaccording to different criteria (for example, by the principle of turnover – current andlong-term). The essence of balance is to maintain a balance on both sides of theequation.
The assets reflect fixed and working capital. Fixed capital – the entire combination ofmeans of production. This part of the capital is characterized by the fact that it takespart in a number of production processes, gradually transferring its value to the finishedproduct.
Working capital means the total of all elements that take part in one production cycle,giving their value completely to the manufactured products. Fixed capital includes sucha part of the asset as buildings, structures, transport; the rest is to working capital.
The legal status of the enterprise is characterized by its liability, which shows all of itsobligations, determines the dependence on those who have placed funds at its disposal.
Thus, the liability side of the balance sheet determines the legal dependence of theenterprise on other organizations and individuals.
The liabilities side of the balance sheet also contains all the capital of this organization(authorized, subscribed, issued). The presence of capital in the balance sheet of theorganization shows the degree of dependence on those who invested in it. Let’s reviewthe liabilities side of the balance sheet closer in the next section because this is whereyou will see retained earnings on balance sheet.
What is Shareholder’s Equity?
In the balance sheet of a company, the share of owners is called shareholders' equity,as shown below.
Please note that the equity section of the business balance sheet consists of two parts:(1) equity (investment capital) and (2) retained earnings. Equity is the initial investmentof shareholders in a corporation. Retained earnings on balance sheet – profits that acompany made from the day it started operating, net of losses, dividends, or transfers toequity.
Thus, shareholder’s equity may come from funds directly invested in the business byinvestors, or from income earned by the company and reinvested in the business, whichis known as retained earnings. In many countries, retained earnings are the basis forcalculating the maximum possible distribution of past profits to shareholders. Retainedearnings are not funds to be distributed among shareholders. Retained earnings areprofits reinvested in a corporation.
The shareholder's equity of the company’s balance sheet also contains essentialinformation on the share capital of the corporation: types of shares, their nominal value,number of shares authorized for issue, number of shares issued and outstandingshares. Balance sheet is truly one of the most informative financial statements.
How to Analyze the Balance Sheet
Retained earnings can affect the balance sheet in two ways. Since they are part of theshareholder’s equity, any increase in retained earnings will increase the shareholder’sequity account and liabilities side of the balance sheet and vice versa.
Since retained earnings are affected by cash flow such as net income, expenses anddividends, any changes in these accounts will also change the amount of retainedearnings. For example, if a company had large shipping expenses, this cash flow willmean that retained earnings will be smaller and shareholder’s equity will be decreased.
Another way that retained earnings will affect the balance sheet is the payment ofdividends. If it was decided that the company will reinvest a larger part of the profitsback into the business, then it will pay less dividend, so and retained earnings willincrease, simultaneously increasing the shareholder’s equity account.
What do changes in retained earnings mean for the owners and investors? An increasein retained earnings will mean that the company will be able to grow and bring moreprofits and bigger dividends to the investors. A decrease in retained earnings can eithermean a loss instead of profit or payment of dividends, which is the reason investorsplace their money into any company.