For any commercial organization, the main goal is to maximize profit from theiractivities. For this reason, owners are always interested in the value of the retainedearnings. Retained earnings are an inevitable part of every business. These are themeans that the company can distribute between the founders or save on the accountsof the company for its subsequent development.
This remaining profit is essential for any company, therefore, in this article we willdiscuss how it is reflected in the balance sheet and what are the nuances associatedwith it, including its normal balance and what makes retained earnings go up and down.
After all, company managers should be aware of what is included in retained earningsand how they are recorded, although this is more likely to be related to the work of anaccountant. But it is this line in the balance sheet that has a significant influence on thedevelopment of the company, helps it to move forward. Retained earnings are an ideallong-term source of business financing.
What are Retained Earnings?
Retained means to keep and earnings mean income, thus retained earnings is thepercentage or amount of net income that was not paid in the form of dividends but wasleft in the company to reinvest in operating activities or pay debt obligations. Thesereserves earnings are a very flexible internal source of business financing becausestockholders are in complete control.
Retained earnings are part of the stockholder’s equity on the balance sheet. It is afinancing activity, and it is earned the capital portion of the stockholder’s equity. Theyare also one of the items that connect the balance sheet and the income statement.This account is affected by net income, which involves all the activities that encompassinvesting business and liabilities that are part of the financing activity, and dividendspaid.
The retained earnings are calculated by adding retained earnings of a past period to thenet income of the current period (or deducting in case of losses), as well as subtractingthe dividends paid. As you can see, this is a cumulative amount – it accumulates sincethe company starts to the current date. It should be noted that this amount can becalculated after all of a company’s obligations have been met and paid, including thedividends it has declared for this period/year.
Retained earnings formula:
+ Beginning retained earnings (taken from previous retained earnings statement orbalance sheet)
+ Net income during the period (taken from the net income statement for the currentperiod)
– Dividends paid (based on what’s declared)
= Ending retained earnings
In most cases, companies maintain a surplus of income to invest in those investmentopportunities where the company can generate growth, for example, investments suchas the purchase of new equipment or the cost of research and development of existingproducts can have a significant effect on the growth of the company. The amount ofretained earnings is adjusted every time an adjustment is made to income or expenses.
What is the opposite for retained earnings? The answer would be empty pocketsbecause they can also be harmful. This may be because the loss ratio of the currentfinancial year is higher than the retained earnings of previous years. Ongoing losseserode any historical positive retained earnings balance. In such cases, the indicator ofretained earnings is usually called deficit and has a debit balance. In instances where acompany has a debit balance that exceeds the amount of contributed capital instead ofa normal balance, which is credit, it faces a risk of bankruptcy.
Net Income vs. Retained Earnings
Net income- part of the balance sheet profit of the enterprise remaining at its disposalafter payment of taxes, fees, deductions, and other obligatory payments. Net income isused to increase the working capital of the enterprise, the formation of funds andreserves, and reinvestment in production. The volume of net income depends on thesize of gross profit and the amount of taxes; based on the quantity of net income,dividends to shareholders of the enterprise are calculated.
Retained earnings can be invested in fixed assets, can also be stored in the form ofcash balances or suitable for circulation on the securities market, used to finance theabsorption of other companies, to extend loans to customers, to repay loans or toincrease liquid assets. Retained earnings of the reporting year are part of the net profitthat was not distributed by the organization in the reporting year. This indicator reflectsthe final financial result of the organization in the reporting year. The benefits anddrawback of reserved income are as follows:
- Business owners in control
- Low cost
- Can be substantial
- A drain on finance is loss-making
- The danger of hoarding profits
- The opportunity cost for shareholders
Retained Earnings on Balance Sheet
A balance sheet is an essential component of the organization’s annual reporting. Thebalance sheet is one of the five components of the annual accounting statements. Thebalance sheet contains data on the assets, liabilities, and equity of the organization. Atits core, it is a document that reflects the property and financial condition in a certainperiod.
The balance consists of two parts – asset and liability. The asset reflects all the propertythat belongs to the organization and the debts of the counterparties (fixed assets,intangible assets, inventories, receivables, cash, etc.). In the liabilities, a section is thesources from which assets appeared (equity, borrowed funds, and external liabilities).
Retained earnings in the balance sheet are a liability because the value of this indicatorshows the direct debit of the organization to its founders. Ideally, this amount isdistributed among the shareholders and invested in the further development of thebusiness. The company does not have the right to dispose of its retained earnings untilthe owners of the organization make an appropriate decision.
On the balance sheet, this account falls under Stockholders Equity. Stockholders equityis the aggregate of all the assets of the company that is in its ownership. It is theamount of authorized, reserve and additional capital, as well as retained earnings.
Typically, retained earnings balance increases as net income that is left after payingdividends are being added. However, this is not always the case. It is worth noting thatthe net loss should also be located in the liabilities side of the balance sheet, but in thiscase, we are talking about a negative value, and therefore the number will need to betaken in parentheses. But what is retained earnings normal balance?
How Is Retained Earnings Account Decreased and Increased?
So, what increases and decreases an account? It depends on the account. Someaccounts increase with debits, while other accounts increase with credits. An exampleof statements that increase with assets includes assets, expenses, and withdrawals.Other reports, on the other hand, increase with loans, and this would consist of revenueaccounts, liability accounts, and capital accounts.
When an account increases with a credit, we can say that its normal balance is credit.The normal balance in the retained earnings account is a credit. This means that if youwant to increase the retained earnings account, you will make a credit journal entry. Adebit journal entry will decrease this account. What are possible transactions that canaffect retained earnings account?
- Net loss
- Cash or scrip dividends
- Prior period adjustments (error corrections, etc. correct overstated income)
- Specific changes in accounting principle that results in previous years incomeoverstatement
- Stock and Property dividends
- Extraordinary losses
- Treasury Stock and Stock retirement transactions
- Net Gain
- Prior period adjustments (error corrections, etc. correct understated income)
- Specific changes in accounting principle that understates previous years income
- Adjustments due to quasi-reorganization
- Extraordinary gains
- Appropriated retained earnings
- Differences from cost method to equity method to account for investments
In summary, the two main activities that affect retained earnings are net income for theyear or period and any dividends paid. Let’s look at how net income affects retainedearnings. Net income consists of revenues, expenses, and cost of goods sold. Forexample, if a company had revenues of $1,000, $100 in payments and the cost ofgoods sold equals to $200, then net income will equal to 1,000 – 100 – 200 = $700.
The $700 gain will increase the retained earnings by crediting the account. If the netincome were a loss, the retained earnings account would be debited to decrease it.Now, let’s look at the other factor – dividends paid. As you are already aware, dividendspayout reduces the retained earnings account. Thus, if a company declares dividends,say $300, then this amount will be debited to the retained earnings account, decreasingit.
What do we have as a result? Let’s say the company had $200 retained earnings fromthe previous period, then we credited $700 of net income and debited $300 of dividendspaid. Thus, we get a net amount of $600 – a credit balance, which is a normal balancefor this account. If the company had a net loss higher than $200, the result would benegative retained earnings, accumulated deficit, that appear as a debit balance in theretained earnings account, rather than the credit balance that appears typically for aprofitable company.