September 09, 2019

Retained Earnings Explained

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Retained Earnings Explained

From users of financial statements, including the balance sheet, the most significant indicator is retained earnings (uncovered loss). Retained earnings are the final financial result of the organization. In this article, you will find out not only what retained earnings are and how to calculate their amount, but also what they are required for and what changes in retained earnings mean for the owners and investors.

What are Retained Earnings?

Retained earnings (loss) of the reporting year is an essential indicator of the company productivity. It is considered undistributed part of the profit remaining in the company balance after making payments and so far, not aimed either at the development of capacities or the payment of dividends. Thus, retained earnings are part of the shareholder’s equity. Distribution of profits is the privilege of the owners of the company, and this happens based on the meeting of shareholders minutes, where the corresponding decision is recorded.
There is an opinion that retained earnings are the same as net profit. This is true if the company did not accrue dividends in the reporting year and has no deferred tax liabilities. So, what are retained earnings? However, retained earnings are a result of the company’s work for the entire period of the company’s existence and the reporting year, while net profit is what the company made during the current period. Retained earnings can be found in the shareholder’s equity section of the balance sheet.
Purpose
Retained earnings is an internal source of long-term financing, so the goal of financial management is to ensure its accumulation. Owners form a reserve of financial resources for future industrial development from retained earnings. Besides reinvesting earnings surplus back into the company, it can also use them to pay off debts.
Without placing some of the income into a reserve that will be spent either in case of unexpected expenses or will be reinvested back into the company for research and development, better equipment, training/hiring skilled employees, etc., a business will not be able to grow, and it will be harder to attract investors.
At the same time, it is essential not to place too much value into the retained earnings and forget about dividends. If all the profits go into the employed capital, the shareholders and investors will lose interest in the company.
Calculation
When calculating the number for retained earnings (uncovered loss) that will be recorded in the equity section of the balance sheet as well as in its statement of retained earnings, the values of its amount at the beginning of the year, net income (or loss) for the year, and the number of dividends paid to owners are taken into account. For JSCs, these are payments to shareholders; for LLCs, to founders.
Depending on the final result of the company’s activity, the calculation formula (retained earnings formula) is slightly modified:

  • With profit, it looks as follows – RE = RE 0 + NI – D, where RE and RE 0 are the values of retained earnings at the beginning and end of the period, NI is net income and D is the payment to owners;
  • In case of a loss during the reporting year, the formula will be adjusted as follows- RE = RE 0 – L – D, where L is the loss for the current year.

What affects retained earnings?

What affects retained earnings?

In different reporting periods, the retained earnings may differ. Such factors as the influence it

  • the number of dividends paid to the owners of the company;
  • change in net profit;
  • increase or decrease in the value of commodity assets;
  • change in overhead costs;
  • revision of tax rates;
  • change in the business strategy of the company.

Wise Distribution of Profits

Wise Distribution of Profits

Distribution of company profits, as well as the decision of what expenses should be made at its payment, can be carried out only by the owners of organizations – owners or shareholders. Therefore, the accounting decisions of shareholders will depend on the instructions recorded in the minutes of the general meeting given to the management of the company.
The use of retained earnings is possible in the following ways:
1) Reserve funds. Some businesses are required by law to form a reserve fund using net profit, while others do it at their own decision. The funds of the reserve are used to cover losses and repurchase of public shares, covering liabilities. The reserve fund can be considered a specific pillow of financial security in the organization.
These funds are also intended for essential, unforeseen expenses, including the money necessary to replace failed equipment or components. Another portion of this reserve is set aside for the scheduled update of assets as well as for launching new activities.
2) Dividends. The profit that remains after the formation of the reserve fund can be used by owners to pay dividends. It must be taken into account that this is the most typical and widespread variation in spending the profit. When accruing dividends, a decrease in retained earnings occurs. When paying dividends, the assets of the company are reduced.

Retained earnings analysis

When analyzing the retained earnings, the change in its share in the amount of equity should be assessed. The decrease in retained earnings indicates a reduction in business activity of the company. However, before making such conclusions, it is necessary to study the structure of equity capital and take into account the fact that the size of the retained earnings in many aspects is determined by the adopted accounting policy of the company. Also, the decrease in retained earnings is often preceded by the identification of errors that led to an overstatement of income, and, accordingly, a decline in retained earnings.
But, if retained earnings increased, this suggests:

  • RE accumulation (but if it is not put into circulation by investing in projects or stimulating the investors, then the company’s income may soon be reduced due to reduced competitiveness of manufactured goods, depreciation of equipment, loss of attractiveness, etc.);
  • Errors in reports that increase costs;
  • The presence of unclaimed dividends, since the accrual of which more than six years have passed.

The most attractive for investors company is one that invests the remaining funds after dividend payment in its development because such a company will improve and expand with time and in turn will bring more significant dividends to its shareholders in the future. In a way, shareholders reinvest their bonuses money back into the company in hopes of receiving more substantial returns.

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