September 09, 2019

Retained Earnings Formula

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How much does an EA earn?

“What are retained earnings?” you might ask. Retained earnings of the reporting yearare part of the net income that was not distributed by the organization in the reportingyear. These funds are typically used for working capital and fixed asset purchases ordirected towards debt obligations payment. This indicator reflects the final financialresult of the business activities and success (or failure) in the reporting year. Money isthe blood of the economy. Thus they have always to flow and feed it. For this reason,most corporations choose to reinvest a portion of their profit back into their business toallow it to grow and develop.

What are Net Income and Dividends?

Before we dive into the formula for calculation of retained earnings, let’s review someterms that are used in this formula. The first term is net income. Many people who arefar from business consider “profit” and “income” to be synonyms. There is the logic here(where rent is, there is perhaps profit), but a person engaged in business shouldunderstand the difference between these concepts.
Net income (net profit) refers to all the revenues and other income streams that anindividual, or legal entity, state or organization receives during a specific period minusall expenses that the business had. These expenses will include operating expenses,manufacturing expenses, depreciation and amortization, interest paid, taxes, etc. Inother words, net income includes all the cash flows in and out of the company.
Profit is a financial result. In other words, these are funds that remain with theindividual/legal entity after the costs of goods sold is deducted from the amountreceived as a result of the sale of the product or service. One can also calculateoperating profit by even subtracting operating expenses. So, back to the definitions. Netincome is the difference between revenue (i.e., income) and all possible costs. Profit isall money received by an entrepreneur/enterprise for any period minus some expenses,such as cost of goods sold.
Dividends are another item in the formula. Bonuses are payments that shareholdersreceive at the expense of the net profit of the corporation based on the results of itswork and depending on the number and types of shares owned by them. The source ofdividends is the company's profit from economic activities, and the form of payment iscash. Amount using the property of the company is possible if such a method isprovided for by the charter. An essential body decides to pay dividends of thecorporation – the general meeting of shareholders.

What is the Retained Earnings Formula?

What is the Retained Earnings Formula?

So, we found out that retained earnings are the number of funds left at the disposal ofthe company owners after all tax and other mandatory contributions are paid. Thisindicator can be calculated using a retained earnings formula. The retained earningformula used to calculate ending retained earnings adds net income to the first retainedearnings and subtracts the dividends that are paid to shareholders.
Basic retained earnings formula is RE 1 = RE 0 + NI – D
Where:

  • RE 1 – a surplus of net income at the end of the reporting period;
  • RE 0 – the same indicator at the beginning of the period;
  • NI – net income minus income tax;
  • D – dividends distributed for the reporting period.

Note: A calendar year is usually used as the reporting period.
Retained earnings formula example
But how do you use this retained earnings formula in real life to calculate the endingvalue? Let’s put the retained earnings formula above to use in an example. Let’s saythat we have a startup company. It’s their very first year of operations, so they will havezero retained earnings to start.
RE ending balance = 0 +NI – D
Then, over their first year of operations, they have a net profit of $36,000, and theydeclared dividends of $10,000. We add these numbers into the retained earningsformula and get the following:
RE ending balance = 0 + 36,000 – 10,000
RE ending balance = $26,000
Let’s walk through this formula step by step. Since the company did not have anyretained earnings at the beginning of the period, we put a zero, and then we add the netprofit of $36,000 they had over the period. Next, we subtract the dividends the companydeclared, which equates to $10,000. We are left with the ending balance of retainedearnings of $26,000, which will then be used as a beginning balance for the next year’sretained earnings calculation.
Thus, if the company makes $50,000 net income during the second year and declaresdividends of $10,000, then the retained earnings formula will look like this:
RE ending balance = 26,000 + 50,000 – 10,000
RE ending balance = $66,000
Retained earnings formula – net loss exampleIf for the current period the company received a net loss instead of profit, the formulatakes on a slightly different form:
RE 1 = RE 0 – NL – D
Where:

  • RE 1 – a surplus of net income at the end of the reporting period;
  • RE 0 – the same indicator at the beginning of the period;
  • NL – net loss;
  • D – dividends distributed for the reporting period.

Now, we are going to review a case when the company has a loss during the secondyear instead of a profit. For this, we will use a second variation of the retained earningsformula above. Let’s assume that during the second year, the startup suffered a lossequaling $24,000 and still decided to distribute $5,000 in dividend payments. Howwould this affect the ending balance of retained earnings?
RE ending balance = 26,000 – 24,000 – 5,000
RE ending balance = ($ 3,000)
Retained earnings retained from previous years ($26,000) can be seen in the previousyear’s balance sheet and statement of retained earnings. It is worth noting that duringthe year, there should be no movement in this account since the profit in theorganization is traditionally distributed after the results of the annual meeting of thefounders are summed up. It is also the time when adjustments to the previous retainedearnings are made (more on that later).
So, we subtract the net loss of $24,000 from the previous retained earnings, which canbe found on the net income statement, and also deduct the dividends paid. As you cansee, the company has negative retained earnings of $3,000, which are also oftenreferred to as an accumulated deficit.
Adjustments and other changes
First, we want to review what affects retained earnings (accumulated deficit). The threemain items are net income, net loss and dividends. As you learned earlier, the netincome will increase the retained earnings amount, while net loss, and dividends (cash,scrip, property, and stock) will decrease this account.
There is another item that can affect the accumulated earnings/loss, and this is priorperiod adjustments. This would include an error in the financial statements. This couldbe a mathematical mistake or an oversight of some kind. When such an error isdiscovered, an adjustment entry is made. This entry can both decrease or increase theamount of prior RE.
Specific changes in accounting principles, such as switching from the FIFO method toLIFO method or go from completed contract method to the percentage of completionmethod, would also lead to changes. What one would need to do is show thecumulative effect on the retained earnings as of the beginning of the earliest periodshown in the financial statement. This would mean that you might have to go backseveral years, and the ending result can either make retained earnings go up or down.
Another item that can increase retained earnings would be a quasi-reorganization,which is when the company wants to get rid of the accumulated deficit by restatingassets, liabilities, and equity. Selling treasury stock below cost will first reduce the paid-in capital account, and if it does not have enough funds to cover the difference, thenretained earnings will be reduced by the remaining amount.
How would common stock affect retained earnings? The holder of common stock is theoutstanding owner of the company since their claims extend to all the assets andincome of the company that are not subject to the requirements of preferredshareholders and lenders, who enjoy priority. Common stockholders have voting rightsand collect dividends, which in turn will decrease the accumulated earnings. The sale ofcommon stocks itself does not affect retained earnings.

How are retained earnings distributed?

How are retained earnings distributed?

The owners of a company can withdraw profits in the form of dividends from thecompany every year at an amount equivalent to the net income acquired during theyear. However, if the owners consider it profitable to set it aside in favor of a substantialincrease in the capital of the company in the future, then they can keep the net profit ofthe organization.
In this case, we are talking about reinvesting profits. Profits of owners will begin to grownot on the acquisition of current income, but due to an increase in their share in thecompany. Thus, the company has the opportunity to increase the scale of operationsand, therefore, future profit growth.
The diversified economic activity of the enterprise is fraught with danger, in other words,with possible losses from management decisions. To ensure the stability of economicdevelopment, each company should put a specific part of the funds received as profitinto a reserve. In many organizations, not all income is shared among shareholders.Benefits that are left after dividends are paid the companies sometimes allocate to thereserve fund as a source of financing for the business activities.
Usually, retained earnings are saved to cover their financial obligations. Retainedearnings are considered an internal source of financing for the company, so itsmanagement is always interested in feeding this source. The more accumulatedearnings remain in the organization’s reserve funds, the more significant are theguarantees about a constant and long-term source. If you determine what to do withretained earnings at the end of the year, then it is indicated under shareholder’s equity.


What has retained earnings in the balance sheet?

The organization’s balance sheet contains many critical financial indicators thatcharacterize the company’s operations, including the retained earnings. Retainedearnings is a liability account on the balance sheet. The owners of the company havethe right to distribute accumulated profit.
Of all the other components of shareholders equity, accumulated profit is the easiest touse because it has an extensive list of areas of its expenses. Despite all that, oneshould not forget that this circumstance does not allow the company to freely, withoutthe desire of shareholders, spend retained for purposes that are not fixed by the specificdocuments of the company.

Financial statements and their relationships

Financial statements and their relationships

In conclusion, let’s take a look at what retained earnings play in financial statementsand how these statements relate to each other. The income statement is the firststatement that you have to prepares so that we will review it first. Just like any otherstatement, it has a title that gives readers information about what kind of report they arelooking. The income statement covers a specific period, such as a month, quarter or ayear.
The income statement contains two parts: revenues and expenses. Expenses (salaryexpense, rent expense, utility expenses, etc.) are subtracted from revenues to get netincome or net loss if costs exceed revenues. Taxes cause an increase in retainedearnings from delivering goods and services to customers, while expenses decreasethem.
The statement of retained earnings also has the same title as income statement andcovers a period. How are these two statements related? Retained earnings are affectedby net income. Net income is taken from the income statement and used in thestatement of retained earnings. Once the net income is added to the beginning retainedearnings and dividends are subtracted, you get ending retained earnings.
The third financial statement we will create is the balance sheet, which represents anaccounting equation – assets equal liabilities plus stockholder’s equity. The endingbalance of retained earnings will be included in the balance sheet in the stockholder’sequity section. Once we add up all the assets, they should equal liabilities plus ourstockholder’s equity. It should be noted that the balance sheet is prepared as of aspecific day in time, not for a while.
The fourth and final financial statement is the cash flow statement. Just like the incomestatement and statement of retained earnings, it is prepared for some time. It reflectsthe company’s cash flow and contains three sections: operating activities, investingactivities, and financing activities. The total of these three sections gives the amount ofnet increase or decrease in cash. The ending cash flow statement balance is the sameas the amount of money that appears on the balance sheet.

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