Financial statements, including the statement of retained earnings, are an essential partof financial accounting of business operations and many of them are required by law.They are created on a monthly, quarterly, and yearly basis according to generallyaccepted accounting principles (GAAP). These include the following three main reports:
- Income Statement
- Balance Sheet
- Cash Flow Statement
Statement of retained earnings as well as a statement of owner’s equity is also oftenincluded along with these financial statements, especially in larger companies. Financialstatements show account balances and their changes, as well as aggregates of severalaccounts, such as net profit.
What are Retained Earnings?
Retained earnings shown in the balance sheet and statement of retained earnings forthe reporting year are part of the net income that was not distributed by an organizationin the reporting year. Retained earnings (loss) is the sum of:
- retained earnings (loss) of previous years and
- retained earnings (loss) of the reporting year
This indicator reflects the final financial result of the organization in the reporting year.The decision on the distribution of profits is taken by the owners of the organization in ageneral meeting of shareholders (in a company or a joint-stock company) or a gatheringof participants (in an LLC).
The volume of retained earnings covers the costs of the company’s development (forexample, the purchase of new production capacity), is saved in the form of cash (forexample, cash balances) or securities. A business with debt obligations uses thisfinancial flow to repay loans and other debts; stable companies form a reserve fundfrom retained earnings to cover unexpected expenses.
What is a Statement of Retained Earnings?
The statement of retained earnings is a report detailing the direction of profitsmovement during the reporting period. The story is formed as follows: first, it shows thebeginning retained earnings (a number from previous period), then the beginningretained earnings are added to the net income for the current period and deductdividends paid. The resulting amount at the bottom of the statement of retainedearnings is retained earnings at the end of the period.
The statement is made separately from other financial statements. The title includes thecompany name (Quartz Corporation), a title of the report (Statement of RetainedEarnings) and reporting period (For the Year Ending December 31 20×9). Next, it hasretained earnings from the previous period, which are equal to $400,000 plus netincome for the current period – $115,000. The total number is the same at $515,000.
Then, dividends paid to shareholders, $35,000, are subtracted from the total sum.Bonuses are often indicated as a price per share, so it might be necessary to multiplythe price per share by the number of shares. The final amount will be the retainedearnings at the end of the current period, which is equal to $480,000 in our example.
This number represents retained earnings from the beginning of the company’soperations. You can also find retained earnings just for the current period. To do so, youwould subtract dividends paid from the net income, excluding the beginning balance ofretained earnings from the equation.
As you can see from an example above, not every statement of retained earnings looksthe same. Companies are required to report any accounting error correction in theprevious year. Thus, you might see an additional section in the Statement of Retainedearnings – Prior period adjustments.
Who Needs Retained Earnings Statement?
Statement of retained earnings is essential not only for shareholders (owners) of thecompany but also for external users (investors, bank employees, regulatory bodies).Investors are interested in information where these funds are spent. They can be spent:
- To pay dividends to shareholders;
- To pay losses from the past periods of the company operation;
- For reinvesting into the development of the company (for example the acquisitionof fixed assets, equipment, etc.);
- To increase the share capital;
- To create a reserve fund;
- For other purposes established by legislative acts.
If a loss is received, it can be repaid with the following sources:
- At the expense of shareholders own funds;
- At the expense of profits from the past periods of the company;
- Through the use (reduction) of the share capital;
- From the reserve fund.
For investors, more profit must be spent not on paying dividends, but on the companyinvestment activities. But it is also essential for them that the benefits obtained beforedistribution increase every year, not decrease. If a company closes (liquidated), then theamount of retained earnings will be distributed among the owners (shareholders) of thecompany, so they are primarily interested in a positive result of this indicator.
What Statement of Retained Earnings Can Tell You?
Looking at this financial statement, you can see how retained earnings changed fromthe last period. It allows to evaluate the operations and condition of any business andbusiness owners as well as investors, market, etc. examine it along with incomestatement and balance sheet. Statement of retained earnings gives a complete pictureof the company's profitability.
However, this financial statement can also reflect not only the profit but also theuncovered loss of the company, which is when the expenses exceed the income.Negative retained earnings appear as a debit balance in the retained earnings account.It can develop (accumulate) due to the results of the fiscal year or from previous years.
Retained Earnings Statement Connection to Other Financial Statements
The right to dispose of retained earnings belongs to the owner/s. Profit is a source ofincome payments to owners, and its presence helps to attract investment to theorganization. Retained earnings remaining at the disposal of the organization after thepayment of dividends to its shareholders is an increase in equity of the organization forthe reporting period, invested in its development.
Although retained earnings are not noted on the Income Statement, a Statement ofRetained Earnings cannot be created without the first one. As you can see in theStatement of Retained Earnings showed earlier, the second figure in it is the netincome. This number is taken from the Income Statement after all expenses and taxesare deducted from the revenues.
Statement of retained earnings takes information from the income statement and givesa different spin to it. Then, it transfers this information to the balance sheet. In thebalance sheet, you will see retained earnings under stockholder’s equity.
Another important report in financial accounting is the cash flow statement. If you look atthe cash flow statement above, you will not see retained earnings anywhere on it.Nonetheless, many companies, in a way, treat retained earnings as cash because theseare also money that is available for spending on any needs of a business.