What are ‘Retained Earnings’
Retained earnings are the cumulative net earnings or profit of a firm after accounting for dividends — some people refer to them as earnings surplus. Retained earnings are the net earnings after dividends that are available reinvestment in the company’s core business or to pay down its debt. Companies record retained earnings under shareholders’ equity on the balance sheet. The formula calculates retained earnings by adding net income to or subtracting any net losses from beginning retained earnings and subtracting any dividends paid to shareholders.
BREAKING DOWN ‘Retained Earnings’
We can summarize the formula for retained earnings as follows:
Retained Earnings (RE) = Beginning RE + Net Income – Dividends, also known as the “retention ratio” or “retained surplus.”
In most cases, companies retain earnings to invest them into areas where they can create growth opportunities, such as buying new machinery or spending the money on more research and development. Should a net loss be greater than beginning retained earnings, the retained earnings can become negative, creating a deficit. Companies adjust the retained earnings general ledger account every time they make journal entries to a revenue or expense account.
Reporting Retained Earnings
Companies report retained earnings at the end of an accounting period as the accumulated amount of a company’s prior earnings, net of dividends. They can show a positive earnings accumulation or can turn negative and have a deficit if a current period’s net loss exceeds the period’s beginning retained earnings. Even though companies do not explicitly report changes in retained earnings during each accounting period, they can be inferred by comparing the amounts of beginning and ending retained earnings of the period. An increase or decrease in accumulated retained earnings during an accounting period directly results from the amounts of net income or loss and dividend payouts for that period.
How Net Income Affects Retained Earnings
Net income or loss adds to retained earnings by way of recording certain closing entries in accounting. The accounts to record net income, revenues and expenses are periodic and temporary accounts used repeatedly during each accounting period. Their balances must be closed at period end, allowing the company to reuse the accounts in the next period. Revenues and expenses are closed to an account called income summary, which displays the amount of net income or loss. They are subsequently closed to retained earnings with net income increasing earnings and loss decreasing them. Thus, the effect of net income on retained earnings derives from the integral effects of revenues and expenses on retained earnings.
Dividends can be in cash or stock, and both forms of dividends reduce retained earnings. A company pays cash dividends from its earnings or net income, and the more dividends it distributes, the less earnings retained. The dividend account is also a temporary account because dividend payments are a periodic recurrence, and are closed to retained earnings at period end, reducing retained earnings. Companies may issue additional shares of its stock as dividends, increasing the amounts of both common-stock and additional-paid-in-capital accounts in the balance sheet. To keep the balance sheet balanced, the company decreases the retained earnings account by the same amounts.