The primary reason why shareholders invest in a company is the returns they get. While capital gains on share prices are crucial, dividends make a more stable type of earning. For most shareholders, these returns provide more certainty on their earnings.
However, these distributions are usually at a company’s management or board of directors’ discretion.
Dividends represent the distribution of profits among shareholders. The process involves a company’s management deciding on how much it should be. After that, it requires approval from its board of directors.
Once done, companies announce these payments and reduce them from their retained earnings. However, it does not impact appropriate retained earnings, which is different. Before that, it is crucial to understand retained earnings.
What are Retained Earnings?
When a company generates profits, it may decide to make dividend payments to shareholders. Some stable companies may distribute all their earnings.
However, other companies may choose not to do so. Instead, they will only make a specific portion of those earnings available to the shareholders as dividends. The rest, they will keep as finance to fund operations or other uses.
Retained earnings represent profits that companies choose to keep instead of paying off as dividends.
In other words, it refers to the total profits that companies don’t distribute as dividends. These earnings represent a company’s internal finance that it generates from its operations. Similarly, it is a part of its reserves that contributes to the shareholders’ equity balance.
Other names for retained earnings also include accumulated profits. However, these may also include accrued losses.
Either way, the account holds the balance of a company’s net profits or losses throughout the years. Companies will report this amount on the balance sheet under the shareholders’ equity section. Therefore, retained earnings will form a part of a company’s equity balances.
Overall, retained earnings represent the accumulation of a company’s profits throughout its years of operations. Usually, these earnings represent funds that companies can use for working capital or fixed asset investments. Before accumulating these profits, however, companies also reduce the dividend payments made to shareholders. Therefore, retained earnings represent profits not distributed to shareholders over the years.
What is the purpose of Retained Earnings?
The retained earnings account is significantly crucial in accounting and for companies. In accounting, it represents the account where a company transfers its income statement events.
As mentioned, any profits that companies don’t distribute to shareholders get transferred into this account. Therefore, the retained earnings account serves as a crucial link between a company’s income statement and balance sheet.
The retained earnings balance is the only account that allows companies to carry over income statement activities. The income statement is a periodical account statement. Every accounting period, companies provide updated figures in this statement.
However, the balance sheet includes an overall picture of a company’s operations. The retained earnings account helps link both statements through the transfer of profits.
For companies, the retained earnings balance provides a source of internal finance. In most cases, companies rely on external finance to fund their operations.
This external finance usually includes equity or debt and comes with an additional cost. However, retained earnings do not bear any additional costs. Instead, these are almost free for companies.
The purpose of retained earnings may differ from one company to another. Usually, companies use this account to fund short-term needs, for example, working capital.
However, it may also help finance larger projects, such as the acquisition of assets or investments. The purpose of these activities is to provide company funds to grow and generate further profits.
The retained earnings account is also crucial for shareholders. Since it includes distributable profits, it represents potential income for them.
When a company does not have any upcoming projects or need funds, it can use retained earnings to pay off shareholders. Therefore, it also provides shareholders with potential returns in the future.
What is Appropriated Retained Earnings?
When companies hold off profits, they form a part of the retained earnings account. Usually, companies may have a use for these profits or keep them for emergencies.
Sometimes, however, they will also have a specific purpose for holding retained earnings. Appropriated retained earnings are any profits kept aside for specific goals or projects.
The appropriated retained earnings represent any reserves and funds held off for a specific purpose. The objective of this account is not to make these funds available to shareholders.
With retained earnings, investors can still get a portion of the funds in the future. However, the appropriated retained earnings do not have a chance of future distribution.
Appropriated retained earnings include profits not made available for distribution by the board of directors. There are several reasons why it may choose to do so.
For example, the board may set aside funds for acquisitions, debt repayments, new projects, stock buybacks, etc., in this account. Due to the specific use attached to this account, the company cannot use it for dividend payments.
The appropriated retained earnings may become available in some cases, for example, liquidation. In those cases, this account will become available for payouts to creditors or investors. Therefore, it does not have a legal purpose. Instead, it only represents the separation of funds to a different account for specific future use.
Overall, the appropriated retained earnings account is used to allocate funds for specific uses. It is at a company’s board of directors’ discretion to add or remove appropriation to it.
When companies make profits, they get transferred to the retained earnings account. From there, the board has the authority to take funds and add them to the appropriated retained earnings account. They can also remove them when they want.
What is the accounting for Appropriated Retained Earnings?
The accounting for appropriated retained earnings begins from a company’s income statement. Companies transfer their profits from this statement to the retained earnings account. The accounting treatment for this transfer is usually more complex. In essence, the journal entries translate to as follows.
|Income Statement Account||XXXX|
The income statement in the above transaction is usually a temporary account that holds a company’s expenses and income. The difference between both gets transferred to the retained earnings account. When the board of directors decides on created appropriated retained earnings, they will need funds. These funds come from the company’s retained earnings account.
Therefore, the accounting for appropriated retained earnings involves the transfer of funds from the retained earnings. The journal entries will be as follows.
|Appropriated Retained Earnings||XXXX|
This transfer is straightforward. Any residual amount in the retained earnings account will be available for distribution to shareholders. However, the funds transferred to the appropriated retained earnings will stay off-limits.
A company, ABC Co., made profits of $10 million during an accounting period. The company already has a retained earnings balance of $100 million. The company transferred its profits to the retained earnings account as follows.
|Income Statement Account||$10 million|
|Retained Earnings||$10 million|
During the year, the company identified a project that can provide profits in the future. For that, ABC Co.’s board of directors decided to hold off some funds from the retained earnings account. The total cost for the project is $5 million, which is the same amount for the transfer. This transfer represents appropriated retained earnings.
Therefore, the accounting treatment for the appropriated retained earnings will be as follows.
|Retained Earnings||$5 million|
|Appropriated Retained Earnings||$5 million|
ABC Co.’s balance sheet will report the appropriated retained earnings of $5 million since the account had no prior balance. Its retained earnings account balance will be $105 million.
Retained earnings represent any accumulated profits that companies don’t distribute to shareholders over the years. It also includes any funds that are distributable to the shareholders.
Sometimes, however, companies may hold off funds for specific projects or uses. These funds will be a part of the appropriated retained earnings account.