Meaning of retained earnings

The company operates in a business environment and strives to obtain higher and higher profits each year. The net profit is obtained by deducting the expenses from the revenues. These net profits are appropriated to reserves and surplus.

Such profits when transferred to reserves and surplus after paying off the dividend to equity and preference shareholders. Retained earnings are shown under reserves and surplus under the equity side of the balance sheet. It is also reported in the statement of changes in equity of the entity at the end of the reporting period.

Meaning of dividends

Dividend depicts the payment of earnings as a distribution of its earnings. Preference shareholders have coupons attached to them and they are paid dividends firstly before equity shareholders.

Common shareholders are paid the dividend and then all the earnings after equity dividends are transferred to retained earnings.

The relation between dividends and retained earnings

Dividends and retained earnings are closely related to each other through net profit as :

ParticularsAmount ($)
Net ProfitXXX
Less: DividendXX
Earnings transferred to retained earningsXXX

The earnings that are retained are transferred to Retained Earnings. The proportion dividend paid to net profit is called dividend payout ration. The proportion of earnings retained to net profit is the retention ratio.

Both dividend and retained earnings form part of the same coin. Hence, these items should be audited in tandem and not separately.

Audit assertions for retained earnings and dividends

The audit workings regarding the retained earnings and dividends would be about the review and analysis of the statement of changes in retained earnings.

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These come from two transactions as when net income is transferred from profit and loss statement to the retained earnings after payment of dividend if any. Hence, dividends should be audited as part of the bigger picture that would be auditing the retained earnings. The audit assertions would be completeness, existence and presentation, and disclosure.

CompletenessThe transactions that are related to retained earnings such as dividends paid to equity shareholders or preference shareholders and all other prior year adjustment items should be recorded.
ExistenceThe dividends that arise out of deduction of retained earnings shall be approved and declared in the board meetings.
Presentation and disclosureThe appropriate disclosures should be made with respect to restrictions on retained earnings, dividend preference, dividend rate, dividends in arrears in the notes to financial statements.

Risks for retained earnings and dividends

The inherent risk and control risk occur in presentation and disclosure which forms the risk of material misstatement. The risk of being susceptible to misstatement due to the nature of the dividend payout is the inherent risk related to dividends.

Control risk occurs when the internal control system of the client fails to prevent or detect material misstatement in the statement of changes in retained earnings.

To name some risks, unauthorized transactions without approval by board meetings, wrong recording of retained earnings, and non-confirmation with accounting standards and company regulations in case of buybacks and other corporate announcements are some material misstatements.

Unauthorized transaction rarely happens in case of retained earnings. Since retained earnings are reserve which can be manipulated carefully in order to carry out corporate announcements such as dividends and buybacks and rights issue, the auditor needs to carefully check if all the items related to retained earnings are properly approved in board minutes.

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Audit procedures for retained earnings and dividends

The audit procedures with respect to audit assertions are explained briefly below:

AssertionsAudit Procedures
CompletenessTaking note of each of the board minutes of the client. Inspecting the supporting documents for declaration of dividend Tracing the dividend declaration to the general ledger. Tracing back all the prior period items with supporting documents with respect to retained earnings. Verifying that dividends are recorded in the current accounting period
ExistenceVerifying all the dividend transactions declared and paid through bank accounts that occur in the accounting period. Vouch for all those dividend transactions to board minutes for the evidence of approval and declaration. Verifying that dividends are recorded in the current accounting period
Presentation and disclosureEnsuring that retained earnings are disclosed under the headings reserves and surplus under liabilities side of the balance sheet. The disclosures with respect to various restrictions placed on retained earnings by the client’s bank, bondholders, or creditors shall be made in the notes as an integral part of the financial statements. Examine the restrictions placed and the nature of the restrictions on retained earnings. The disclosures with respect to dividend rate, preference dividend, and arrears of dividend shall also be made in the financial statements.