What are Retained Earnings
Retained Earnings (RE) are the collected portion of a company’s profits that aren’t paid as dividends to shareholders and are instead set aside for reinvestment. These funds are often allocated for working capital and fixed asset acquisitions (capital expenditures) or for debt repayment.
At the conclusion of each accounting period, retained earnings are recorded on the balance sheet under the shareholder’s equity section. To calculate RE, first, add the initial RE balance to the net income (or deduct it from a net loss), then deduct dividend distributions. A summary report called a statement of retained earnings is also kept, which shows how RE has changed over time.
Retained Earnings Formula and Calculation
You’ll need to know your company’s previous retained earnings, net income, and dividends paid to calculate retained earnings.
The past retained earnings of your firm can be found on your balance sheet or statement of retained earnings. Your income statement or profit and loss statement will show your company’s net income. Dividends paid are the amounts paid to shareholders if you have them.
Retained Earnings (RE) =Beginning period RE +Net Income (or Loss) − Cash dividend − Stock dividend
Example of Retained Earnings
Assume you have $35,000 in retained earnings at the start of the year. You made a net profit of $40,000 during this accounting period. You also paid $25,000 in dividends.
Retained Earnings = $35,000 + $40,000 – $25,000
Retained Earnings = $50,000
You have a positive retained earnings account of $50,000.
Let’s look at an example of negative retained earnings. You start with $5,000 in retained earnings and a $15,000 net loss. You didn’t make any dividend payments.
Retained Earnings = $5,000 – $15,000 – $0
Retained Earnings = -10,000
At your company, you have an $8,000 deficit. Because retained earnings are cumulative, you’ll need to start the following accounting period with -$8,000 in retained earnings. To climb out of the hole, you’ll need a big net income.
Purpose of Retained Earnings (RE)
Because retained earnings are reported under shareholders’ equity, which links the two accounts, they provide a helpful connection between the income statement and the balance sheet. Retaining earnings can be used for a variety of things, such as purchasing new equipment and machinery, investing in research and development, or engaging in other activities that might help the firm expand. This investing in the business seeks to help the firm generate even more money in the future.
If a corporation does not think it can make a sufficient return on investment (i.e., earn more than its cost of capital) from its retained earnings, It may distribute earnings to shareholders in the form of dividends or share buybacks on a frequent basis.
General Entry for Retained Earnings
When you make a journal entry that increases or decreases a revenue or expense account, you must update your retained earnings account.
The profit and loss account would have a credit balance if you made a profit for the year. So the journal entry will be
Profit and loss account (Debit)
Earnings retained (Credit)
If the company, on the other hand, incurred a loss for the year, the profit and loss account would be debited. So you do the exact opposite, the journal entry will be
Retained Earnings (Debit)
Profit and loss account (Credit)
Some of you may be confused about why we will debit the profit that was previously credited to the profit and loss account. What is the reasoning behind it?
A profit has a credit balance in the Profit and Loss account. We must debit the Profit and Loss account to remove it from the Profit and Loss account.
Every debit must be accompanied by a credit entry. The credit is applied to the account of Retained Earnings.
The old credit in the Profit and Loss account is the same as the new credit in the Retained Earnings account.
To put it another way, we’re just moving profit to the new account.
It’s important to keep track of retained earnings. In most cases, you’ll record them in the equity part of your balance sheet. However, retained earnings can be recorded on a separate financial statement known as the statement of retained earnings.
Usage of Retained Earnings (RE)
The following choices offer a wide range of possibilities for how excess money might be used:
- Dividends can be dispersed (wholly or partially) to the business owners (shareholders).
- It might be used to expand existing business activities, such as boosting production capacity for existing goods or recruiting more salespeople.
- It might be used to launch a new product or variety, such as a refrigerator manufacturer branching out into air conditioners or a chocolate cookie company introducing strawberry or vanilla flavored varieties.
- The funds can be used for any potential merger, acquisition, or collaboration that may boost the company’s prospects.
- It can also be used to repurchase shares that have been sold.
- It can be used to pay off any outstanding loans (debt) owed by the company.
Limitations of Retained Earnings
As an analyst, the absolute amount of retained earnings for a given quarter or year may not provide any useful information, and its observation over time (such as five years) may merely reveal a pattern in how much money a firm keeps.
As an investor, you’d like to know much more, such as how much profit the retained earnings created and if they beat other alternatives.
Is Retained Earnings an Asset?
The equity part of the balance sheet is where the retained earnings are reported. Retained profits can be invested in assets, but they are not assets.
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