Uncovered loss or retained earnings in the balance sheet or statement of retainedearnings are an indicator showing the company's performance over the entire period ofits existence. It is calculated cumulatively at the end of each defined reporting period.Here, we will tell you how the retained earnings statement is formed, where they arereflected in the balance sheet and what is involved in its calculation. A statement ofretained earnings example will help you to to grasp all the information better.
What are Retained Earnings?
Retained earnings – net income, which (as the name implies) was not distributed amongthe participants/shareholders of the company. It is also often referred to as retainedincome, accumulated profits, or undistributed revenue. In other words, retained earningsare cumulative net income minus cumulative dividends paid to shareholders. Netincome is considered a part of the income from the sale and non-sales operations,which remained after payment of taxes.
The main difference between retained earnings from net profit is that it is alwayscalculated not only for a specific period but also for the total period of the existence ofthe enterprise whereas net profit is determined only for the reporting period. But for theyear, which is logical, both indicators can be the same.
Retained earnings serve to show investors and market how the company is doing andhow much it can reinvest into any part of its operations. It is usually higher for new,rapidly growing companies who choose to spend the profits on company growth and/orcovering the debts instead of paying a portion to the shareholders. This, in turn, oftenincreases their price per share. However, if the company believes that the reinvestmentof the money will not give good returns, then they will distribute these funds amongcompany shareholders.
What determines the size of retained earnings?
The number in the retained earnings account may differ in different reporting periods.Such factors as the influence it
- the amount of dividends paid to the owners of the company;
- net profit change;
- increase or decrease in the value of commodity assets;
- overhead change;
- tax review;
- change in the business strategy of the company.
The decision on how to distribute this income is made solely by the owners.Traditionally, the question of retained earnings is put on the agenda of the annualmeeting of the company's owners. The decision is written down based on the results ofthe general meeting of participants/shareholders. The main ways of spending retainedearnings include the following:
- to pay dividends to participants/shareholders;
- repayment of past losses;
- replenishment (creation) of reserve capital;
- other goals formulated by owners.
What is Retained Earnings Formula?
Retained earnings for the reporting period can be calculated by simply subtracting thedividends paid to shareholders of the company from its net income. Usually, suchcalculations are performed by an accountant (this is an essential part of their work). Butyou can determine the amount yourself using the following retained earnings formula:
+ Beginning retained earnings
+ Net income during the period
– Cash/Stock dividends paid
= Ending retained earnings
For example, Smart Home has $600,000 of net profits in its current year, pays out$100,000 for dividends, and has a beginning retained earnings balance of $1,400,000.Its retained earnings calculation is:
+ $1,400,000 Beginning retained earnings
+ $600,000 Net income
– $100,000 Dividends paid
= $1,900,000 Ending retained earnings
How are retained earnings calculated?
Retained earnings increase the liabilities side of the balance sheet and, consequently,the equity capital of the enterprise. If you do not have the retained earnings value, youcan perform the calculation according to the following process:
- First, the company needs to find a gross profit. It is reflected in the incomestatement, and it can be determined by taking away the cost of the goods orservices that are sold from the income from these sales.
- Now, calculate the operating income – what remained after covering the costs ofsales and current expenses (for example, wages). Right from the gross profit inaddition to the cost of goods sold, you also need to deduct operating expenses.
- Next, you will subtract taxes and add the retained earnings amount from the lastyear to a total sum.
- Now, you need to deduct dividends. The net profit is already cleared from theexpenses of the company, and you deduct dividends that are paid toshareholders.
You can calculate the current retained earnings balance in the account, which reflectsthe retained earnings. Do not forget that this is a cumulative account, and all changes inretained earnings are accumulated in it from the very moment when the company wasformed to the present. Thus, the amount that was at the end of the previous reportingyear is being added to the retained earnings for the current period. As a result, a newretained earnings balance will be created.
This calculation is necessary when calculating the exact amount of dividends for theowners or in the redistribution of the company's income for its own needs. Therefore,awareness of how it is carried out is necessary not only for the accountant but also forthe entrepreneur.
The Purpose of Retained Earnings Statement
Statement of retained earnings is one of the most important financial statements. It linksthe income statement to the balance sheet, showing how the period's income statement profits either transfer to the balance sheet as retained earnings or shareholders asdividends. The statement of retained earnings reflects all changes that occurred inretained earnings during the reporting period.This financial statement must necessarily take into account the retained earnings of theprevious reporting period. Typically, an account “Retained earnings” has a creditbalance. If this is a debit balance, the company has a loss, which is also indicated in theequity capital section of the balance sheet, reducing its value.This report may be submitted separately or as part of an income statement and retainedearnings. Generally accepted accounting principles require that this type of report becompiled whenever a balance sheet and income statement are presented.
Statement of retained earnings helps shareholders and investors to evaluate theoperations of the firm and predict future growth. This is important in decision making,whether to hold, buy, or sell company shares. They can also see the percentage of netincome that is paid in dividends, which helps them to decide whether the company willbe a good source of dividend income or if the prices of its shares will grow in the future.
Statement of Retained Earnings Example
A balance sheet includes a retained earnings account. However, you can also presentretained earnings as a separate Statement of Retained Earnings. Public companiesmust publish their statement of retained earnings along with other financial statementsquarterly and the end of each year to allow shareholders to make informed decisions. Itis prepared following generally accepted accounting principles (GAAP).
Below, you can see an official statement of retained earnings example. This financialstatement includes a heading which consists of the company’s name, name of thefinancial statement and the period for which the statement is created. Next, you will addnet income for the fiscal year to the previous retained earnings balance.
You will subtract the dividends paid (both on preferred stocks and common stocks) fromthe total amount. This will give you a new value for retained earnings balance, which willalso be indicated in the balance sheet statement, increasing the shareholder’s equityaccount.
Retained Earnings on Financial Statements
Aside from having its statement of retained earnings, you might wonder where else thisfigure is included in other financial statements. Some believe that it should be includedin the cash flow statement; however, this is not correct. This is because retainedearnings, just like profits, do not represent cash. The cash flow statement only showscash items – cash flows coming in and cash flows going out.
On the other hand, the two are intimately connected because a company can spendretained earnings on operating, investing, and financing activities just like it would dowith cash. The final figure in the income statement – net profit, is included in thecalculation of retained earnings and the statement of retained earnings itself and thebalance sheet. As it was mentioned earlier, retained earnings are shown on the balancesheet under the owner's equity section at the end of each accounting period.