September 09, 2019

Retained Earnings Explained

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Retained Earnings Explained

From users of financial statements, including the balance sheet, the most significantindicator is retained earnings (uncovered loss). Retained earnings are the final financialresult of the organization. In this article, you will find out not only what retained earningsare and how to calculate their amount, but also what they are required for and whatchanges 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'sproductivity. It is considered undistributed part of the profit remaining in the company’sbalance after making payments and so far, not aimed either at the development ofcapacities or the payment of dividends. Thus, retained earnings are part of theshareholder’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 thecorresponding decision is recorded.
There is an opinion that retained earnings are the same as net profit. This is true if thecompany did not accrue dividends in the reporting year and has no deferred taxliabilities. However, retained earnings are a result of the company’s work for the entireperiod of the company’s existence and the reporting year, while net profit is what thecompany made during the current period. Retained earnings can be found in theshareholder’s equity section of the balance sheet.
Purpose
Retained earnings is an internal source of long-term financing, so the goal of financialmanagement is to ensure its accumulation. Owners form a reserve of financialresources for future industrial development from retained earnings. Besides reinvestingearnings 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 ofunexpected expenses or will be reinvested back into the company for research anddevelopment, better equipment, training/hiring skilled employees, etc., a business willnot 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 earningsand forget about dividends. If all the profits go into the employed capital, theshareholders and investors will lose interest in the company.
Calculation
When calculating the number for retained earnings (uncovered loss) that will berecorded in the equity section of the balance sheet as well as in its statement ofretained earnings, the values of its amount at the beginning of the year, net income (orloss) 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 is slightlymodified:

  • With profit, it looks as follows – RE = RE 0 + NI – D, where RE and RE 0 are thevalues of retained earnings at the beginning and end of the period, NI is netincome 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 theinfluence 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 bemade at its payment, can be carried out only by the owners of organizations – owners orshareholders. Therefore, accounting decisions of shareholders will depend on theinstructions recorded in the minutes of the general meeting given to the management ofthe 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 fundusing net profit, while others do it at their own decision. The funds of the reserveare used to cover losses and repurchase of public shares, covering liabilities.The reserve fund can be considered a specific pillow of financial security in theorganization.
These funds are also intended for essential, unforeseen expenses, including the moneynecessary to replace failed equipment or components. Another portion of thisreserve is set aside for the scheduled update of assets as well as for launchingnew activities.
2) Dividends. The profit that remains after the formation of the reserve fund can beused by owners to pay dividends. It must be taken into account that this is themost typical and widespread variation in spending the profit. When accruingdividends, a decrease in retained earnings occurs. When paying dividends, theassets of the company are reduced.

Retained earnings analysis

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

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

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

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