The financial statements of companies are a kind of guideline for investors and anessential aspect of financing and the economy as a whole. After all, the financialcondition of the largest national companies of any country is, first of all, the balance andprosperity of the entire economy of the country. For a small business, however, financialstatements are just as important.
Any company regularly generates standard financial reports: balance sheet, incomestatement, cash flow statement, and statement of shareholders' equity. Thesestatements are usually accompanied by an extended version of the shareholder’ equitystatement – statement of retained earnings.
Relationship Between Financial Statements
Let’s consider the purpose of the leading financial statements and how they relate toeach other.
The balance sheet of the company provides information on the financial position of thecompany and is required to assess the financial state of the company, the structure ofsources of financial resources and the liquidity of the assets of the enterprise andsolvency. The retained earnings account and dividends amount are the same as endingretained earnings and dividends paid in the statement of retained earnings
The income (profit and loss) statement provides information on the results of theenterprise for a specified period. It allows assessing the profitability and efficiency ofresources use and business activity. The net income value from this report is used inthe preparation of the statement of retained earnings.
The cash flow statement provides information on changes in the financial position of theenterprise and is required to assess the operational, investment and commercialactivities, the ability to create cash and cash equivalents and company’s needs in cash.
The statement of shareholder’s equity shows the total change in the capital of thecompany due to changes in assets and liabilities. It is required to assess changes inequity, the dividend policy of the company, changes in the capital due to additionalmoney from the revaluation of fixed assets and share premium and assessment of thecompany's policies in the distribution of profits.
Preparing Retained Earnings Statement – Example
Although the statement of retained earnings is not as important for example balancesheet and cash flow statement, it is valuable for several reasons, so knowing how it isprepared and what makes up the retained earnings statement is essential even if youare not a bookkeeper.
Statement of retained earnings will tell the owners and investors how well a company isdoing. Investors will be able to decide whether to sell, keep, or buy company shares.Owners will be able to see how much retained earnings have accumulated and howthey changed from the previous year.
The first thing that you will write when preparing the retained earnings statement is theheading. The heading will include the report name, company’s name, and the period forwhich the report is ready. In our case, this is Statement of Retained Earnings, De GraffCorporation and Year ended December 31, 20×5. This is the most natural part of thestatement of retained earnings preparation.
Beginning Retained Earnings
To be able to prepare your statement of retained earnings, you will need a value forbeginning retained earnings. This number can be found by looking at the retainedearnings report from the previous year. It will be the ending retained earnings value inthe prior year that is carried over to the current year.
Another place to look for beginning retained earnings is the balance sheet for theprevious year. It will be included in the shareholder’s equity section under retainedearnings. This is the first number that will be included in our statement and endingretained earnings calculation.
Although financial statements are prepared with utmost attention to accuracy, mistakes,and even fraud do happen, and adjustments are necessary to make corrections. Priorperiod adjustments can be made if the company under or overestimated its expenses,made simple mathematical mistakes or mistakes in applying accounting policies.
Another case when an adjustment to the beginning retained earnings would benecessary is when a company realized income tax benefits. If no corrections arerequired, this line is excluded from the retained earnings statement.
Net income is a profit that is received after paying taxes on it. The company's netincome is calculated before dividends are paid, as the difference between the gain fromthe sale of a service or product and the money spent on production, depreciation,business expenses, payment of wages and other expenses, including tax expenses.
To calculate ending retained earnings, net income value is required. As we mentionedearlier, several financial statements are prepared at the ends of the reporting year. Anincome statement is one of them. Thus, you can get the number required for filling theNet income line in the retained earnings statement from the income.
Alternatively, you can calculate net income yourself. Net income = gross revenue -(fixed costs + variable costs) – tax payments. To find out net income, you need tosubtract the total amount of expenses from the total amount of income. The higher thedifference between them, the better. If the resulting figure is less than zero, then overthe past time, the organization received a net loss, which will be noted in the statementof retained earnings by placing the number in parenthesis.
In the retained earnings statement, net income is being added to the beginning balanceof retained earnings because retained earnings are the portion of income that acompany set aside in previous years after paying dividends, if necessary. A subtotalamount will be indicated underneath.
Dividends are part of the corporation’s profits to be distributed to shareholders. Dividendpayments reduced retained earnings. Each shareholder receives assets, usually cash,in proportion to the number of their shares. Declaring dividends is the power of theboard of directors only.
Dividends can be paid quarterly, every six months, annually or at other times bydecision of the board of directors. In most countries, the board cannot declare dividendsabove retained earnings. When profits over retained earnings are reported, thecompany pays out to the shareholders a portion of their equity.
Such dividends are called liquidation dividends and are usually paid when the companyceases to operate, or its operations are reduced. However, the presence of a significantamount of retained earnings is not in itself a basis for the distribution of dividends. Abusiness entity may not have sufficient cash or assets in any other convenient form fordelivery. In this case, to pay dividends, it will have to take a loan. Most board directorstry to avoid this.
The Declared cash dividends account is a temporary shareholder’s equity account,which is closed at the end of the accounting period by debiting the Retained earningsaccount and crediting the Declared cash dividends account. Thus, retained earnings arereduced by the total amount of dividends declared in this accounting period.
In some companies, dividends are not paid often. This is because the company eitherdoes not make a profit, or the benefit is used for other purposes, possibly to expandproduction. Investors investing in growing companies expect to receive income on theirinvestments in the form of an increase in the market value of their shares.
However, if it is decided that dividends will be paid this year and dividend payment wasdeclared officially, then the amount of dividends paid is subtracted from the subtotal wereceive by adding net income to the beginning retained earnings. As you can see fromthe retained earnings statement example above, there are several types of dividendsbeing paid. In an earlier retained earnings statement example, this section was notexpanded and just had Dividend declared line. Both versions are acceptable.
Ending Retained Earnings
After subtracting dividends, you will get the ending retained earnings balance or in otherwords, a total balance of earnings at the end of the year. This is the number that willshow under the retained earnings account and in the balance sheet. It is also thenumber that will be used for the beginning retained earnings value in the next year’sretained earnings statement. Thus, it is essential that this value is calculated correctly.