Retained earnings is a balance sheet item included in the equity section; it is the accumulation of all the profits of a company from the point of its commencement minus the profit which has been distributed to the shareholders as dividends.
This is assuming that entity making profits.
However, most companies making losses at the starting point of their business and there is not retained earnings but accumulated losses.
The remaining profit after the distribution is reinvested in the business or is set aside as a reserve for a specific purpose such as the expansion of the business or repayment of debt. It is calculated by the following formula.
Description
$
Opening retained earnings
XXX
Profit/(Loss) for the year
XXX/(XXX)
Cash dividends
(XXX)
Stock dividends
(XXX)
Closing retained earnings
XXX
The above movement in the account of retained earnings is also shown in the statement of changes in equity; this statement is also part of the final accounts of a company.
Total assets are the total amount of items of economic value owned by a person or an entity that is used for a probable flow of income.
Retained earnings to total assets is a ratio which helps in measuring the profitability of the assets of an entity.
It illustrates how much profits over all the years since inception were generated from $1 of total assets. This ratio also gives the company an idea of how much it relies on debt for the funding of its total assets.
Explanation:
A business can finance its operations through
equity or debt. Debt includes loans which are to be repaid after a certain
amount of time usually with an amount of interest whereas in equity a business
raises capital by offering its shares to the public in stock exchange or to the
private individuals; it can also increase its retained earnings by announcing
dividends at a lower rate or by cutting cost and increasing profits.
Funds raised through equity do not require to be paid off later but the stake of the company is relinquished from the owners to more shareholders through shares.
Retained earnings to total assets depict the financial leverage of the entities, it indicates how assets were financed from retention of profit instead of paying profit out as dividends and acquiring loans.
Formula:
Retained earnings total asset ratio = Retained earnings / Total assets
Below is the calculation of the ratio.
Example:
XYZ Ltd Balance sheet
$
$
Non-current assets
Current
Liabilities
Property, Plant and equipment
470,000
Trade Payables
65,000
Current Assets
Non-current
liabilities
Cash
35,000
Debentures
150,000
Trade Receivables
50,000
Equity
Inventory
45,000
Ordinary share capital
250,000
Retained earnings
135,000
Total Assets
600,000
Total
Liabilities and Equities
600,000
From the above balance sheet retained earnings to the
total assets is calculated as follows
Retained earnings total asset ratio = 135,000/600,000
=22.5%
In this case, the ratio ascertains that 22.5% of the total assets used for operations are funded by the retained earnings, the rest of 77.5% are financed by share capital and debts.
It also shows that for every $1 of assets, a $0.225 accumulated profit has occurred. Therefore, it also measures the profitability of the assets.
The higher the ratio
the better because it shows that the entity was successful enough to generate
high profits and was able to retain the profits to reinvest in the business.
This is one of the types of equity financing and the most prominent advantage of high retained earnings is that the funds are not required to be payback; no monthly payments, interest payments, unlike debt finance which means the business is most likely to have healthy liquidity position and better cash flows.
If the equity
section of the balance sheet is less than the liability section and the
retained earnings to total assets ratio is quite low as compared to the
industry’s ratios; this will show an alarming situation, the company will be
seen as highly geared, which means the company relies mostly on debt for
financing it activities.
The investors may not prefer this because most of the proportion of the profit will be used to cover the interest payments and fewer profits will be remained for dividends and for retained earnings. Interest payments can become burdensome and can create cash flow problems.
This can also
affect the credit score of the company with too many short term liabilities,
unable to settle these can also lead to bankruptcy.
There are no ideal retained earnings to total assets ratio for all the entities, usually, a high ratio is desirable but the ideality of the ratio will vary from industry to industry and from newly commenced businesses to well-established companies, for a better comparison industry’s benchmark ratios must be determined and comparisons must be made with the similar business at the same stage.
Following is the illustration is given to differentiate between the retained earnings of unalike industries.
According to the balance sheets as of 2017 of Apple Inc.
Total assets equaled $375,319 and the retained
earnings amounted $98,330 (all in millions)
RE/TA = 98,330/375,319
= 26.20%
Whereas in the balance sheets as of 2017 of Amazon
Total assets were $131,310 and the retained earnings
equaled $8,636 (all in millions)
RE/TA = 8,636/131,310
= 6.58%
The calculations show that Apple has more retained earnings and can easily fund internally whereas Amazon will need to acquire debt.
However, both entities are operating in different industries comparing them to measure how successful they are will not give suitable conclusions.
Mostly new startup business has few retained earnings and usually losses in the beginning years, there retained earnings to assets ratio can be too low or negative as well but gradually as the small businesses progress and become profitable the ratio then also goes up.
This shows growth and investors prefer putting their money in these businesses.
However, if any business experiences a downfall in their ratio overtime this will portray that the company is having problems maintaining or increasing its profitability from its operations and it can also mean that it is paying off a lot of dividends to the equity holders reinvesting profits.
Retained Earnings also called accumulated earnings, retained capital or earned surplus appears in the shareholder equity section of the statement of financial position more commonly known as Balance Sheet.
It is the sum of profits and losses at the end of the accounting period after deducting the amount of dividends. Retained earnings (ending balance) can be calculated by using the following formula:
As the above equation shows, retained earnings is the profit reinvested in the business after paying dividends to the shareholders of the company.
Normally these funds are used to acquire
non-currents assets like property, plant and equipment or to pay off a long
term debt.
Non-Profit Organizations:
A non-profit organization (NPO) has the objective of serving the public or it can seek to carry out a certain mission. As the name suggests, their mission cannot simply be to earn profits like other profit-oriented organizations.
Their objective may include fulfilling the needs of the society by working on areas like religion, education, and health clubs, and wild-life preservation.
As they work for the betterment of the society, NPOs are granted tax exemptions given in most cases that they fulfill certain requirements as per the law of the country they operate in.
Another important feature of an NPO is that the profit earned by an NPO is not distributed to any owner but rather it is reinvested into the organization so that it can be used for their objective.
The profits that these organizations earn may also include donations and grants from people, other organizations, or even the government who wish to support their cause.
Retained earnings for NPO:
Due to a major difference in the objectives of a profit-oriented organization and a non-profit organization, the term accumulated funds are used instead of retained earnings, and net assets are used for equity while preparing the financial statements of the NPO.
Accumulated funds are the name of a capital fund of a non-profit organization, the amount that is added in this is a surplus resulting when the revenue generated is greater than the expenditure and the amount that reduces this fund is a deficit which occurs when the expenditure is higher than the revenue generated.
Thus, it is an accumulation of surplus and deficits overall the years since the inception of NPO.
NPO such as clubs and societies earn from annual subscriptions paid by its members who can also sign up for life subscriptions. Life subscription is a liability and a particular amount is transferred to the income annually.
But on the death of any member, the remaining amount is credited in the capital fund.
At the commencement of a non-trading business, there is no capital fund, any surplus earned during the first year of operation establishes as the accumulation fund.
And in the following years, if there is a budgetary deficit, the accumulated fund can serve as a liquidity provider.
Example:
Following is an example in which a balance
sheet of a non-profit organization is shown. It is similar to the balance sheet
of a trading organization with slight changes to provide simple and not so
complex calculations of the net assets.
NPO Balance Sheet
$
Assets
Property, plant and equipment
200,000
Cash and cash equivalents
50,000
Subscription receivables
20,000
Total Assets
270,000
Liabilities
Payables
35,000
Expenses
2,000
Subscription in advance
40,000
Loan
43,000
Total Liabilities
120,000
Net Assets
150,000
Accumulated Funds
Opening balance
100,000
Surplus
50,000
Closing balance
150,000
In the example above the retained earnings for an NPO are calculated by adding the surplus amount which must have arisen as a result of receipts being more than the expenditure, in the opening balance.
The opening balance of the accumulated fund
is the sum of profits of all the years since commencement after withdrawing any
losses.
The Financial Accounting Standards Board
(FASB) requires the non-profit organization to show two classes of net assets.
Donations with restrictions
Donations without restrictions.
Donations with restrictions:
These donations are restricted to a specific purpose or project and
the organization are bound to use these funds for that specific purpose and to
meet the specific expenses.
The donor may restrict the use of his donations through an agreement
with the NPO. These funds are then classified separately as special funds.
Therefore, any income which is derived from this particular purpose special funds or if any profit or loss occurred from the sale of such investments will not be included in the accumulated fund but it will be credited to the special fund account.
For example, donation received for the completion of a building, funds for a clean water project.
Donations without restrictions:
These donations are not restricted and the
organization may use it on any project or a purpose of their picking.
The change in net assets or accumulated
funds can be calculated by using the statement of activities which works in a
similar way to the income statement. It is one of the main parts of the
financial statements of a non-profit organization
The revenues generated and donations received are divided between donation without restrictions and donation with restrictions and the expenses incurred in generating the income are allocated to the respective class.
The following is an example of a statement
of activity
Revenues
With restrictions
Without restrictions
Total
Donation
80,000
100,000
180,000
Membership
–
500,000
500,000
Expenses
Administrative
20,000
50,000
70,000
Operating
40,000
5,000
45,000
Change in net assets
20,000
545,000
565,000
Add opening balance
10,000
300,000
310,000
Closing balance
30,000
845,000
875,000
Accumulated funds can also convert into accumulated loss if, over several periods of years, the non-profit organization faces a deficit in its statement of activities.
This states that the NPO is expending more
money than it can raise through donations and receipts, this can lead to
liquidity problems and is also an indicator of bankruptcy.
The organizations will then have to acquire loans to further continue the activities or it will have to cater to events that will encourage an inflow of funds in the form of donations and subscriptions.
Retained earnings and shareholder’s equity are both balance sheet items. They are recording in the equity section and the increases are on the credit side which is different from the increasing of assets.
Retained earnings and equity both are not recording in the income statement, but they are presented in the statement of change in equity.
Shareholders’ equity is the residual amount of assets after deducting liabilities. Retained earnings are what the entity keeps from earnings since the beginning. Retained earnings are decreased when the company makes losses or dividends are distributed to the shareholders or owner of the company.
In this article, you will learn the difference between retained earnings and shareholder equity.
Shareholders’ equity:
Shareholder’s equity referring to the residual amounts that are remaining from entity total assets less total liabilities of an entity at the end of the reporting date. Normally, at the starting date operation of the entity, where there are no liabilities and operation incurred yet, assets are equal to equity or shares capital.
In order words, the money that shareholders inject into the company is both records in the assets and equity the same amounts. You can double-check this with the accounting equation.
The entity then starts the operation, revenue, expenses, and liabilities incurred. Then equity is equal to total assets less total liabilities. Equity at this time might be increased or decrease because of the operating losses or profits. Retained earnings or accumulate losses are normally used to records this in the equity section.
Total shareholders’ equity can be found in two statements such as balance sheet and statement of change in equity. Under the equity section, you can find shareholder’s capital, retained earnings, and other reserves.
Retained Earnings:
Retained earnings on the other hand are the sub-element of shareholders’ equity. As explained above, in the equity section, you can see the invested capital (Shareholders’ capital), retained earnings, reserves, and other adjustments.
Retained earnings are the accumulation of profit that entity made since the starting of business after deducting the dividend payments to the shareholders.
The entity could make dividend payments from its retained earnings only if it reaches the amounts that allowed by law and it is approved by the board of directors.
The entity might choose not to distribute the retained earnings to the shareholders if they need funds to expand its operation.
Is retained earnings equity?
Base on the explanation above, total equity is equal to total assets less total liabilities or total equity is equal to shareholder capital plus total retained earnings or accumulated losses and total reserve.
That mean total retained earnings or accumulated losses are part of total equity. However, it is not part of the share capital or reserve.
Retained earnings are the balance sheet items and reviewing or auditing this item is not much different from other items.
As we all know, these earnings are what left from the entity’s net income, dividend payments and other adjustments since the entity starts its operation.
Before reviewing, it is important to know the formula of retained earnings as well as its elements. For example, retained earnings at the end of the years should include the opening balance, dividend payments, and net income of the current year.
To ensure that the earnings are correctly reports and present, the following are the key items that we need to review:
Understanding the formula and nature:
Retained earnings can be reported in three different statements including balance sheet, statement of change in equity, and statement of retained earnings.
The formula that used to calculate it is we need to add the opening balance with current year net income and less dividend payment or declaration.
All of these things need to include in the calculation and if we note that some items are missing, we may need to question management.
Review the opening balance:
As retained earnings are the balance sheet items that reporting the balance of items at the end of the reporting date, the year-end retained earnings need to include the opening balance.
We need to make sure that this balance is correctly brought forwards from previous year audit audited financial statements or working papers.
In order words, we need to cross-check with previous year audit working paper and audited financial statements.
Review the net income:
Net income or net losses is what retained earnings affected by. If this amount is not correctly brought forward, then the accumulated earnings are also not correctly calculated, prepare and present.
Reviewing net income is not only reviewing the net income items but also the other main element in the income statement. Those elements including sales, gross profits, operating expenses, and other incomes that might affect net income.
For an entity that makes operating losses, then the accumulation of net loses will increase and make equity decrease.
In some cases, if the entity makes losses in a long time and equity reaches the amounts that require to make more capital injection, shareholders might need to make more capital injection.
Otherwise, the entity might get the penalty from the local authority or suspend the license.
Review the adjustment:
When reviewing retained earnings, it is important to review the adjustments made by management during the years. For adjustments that significantly affect net income, we need to substantively review on those items.
The explanation may require the entity management team if reviewing documents is not satisfy.
Adjustment should also need to clarify with accounting standards to make sure the adjustments they follow accounting standards. Some adjustments might not affect net income, but other comprehensive income.
Review the dividend payments:
Dividend declaration during the year should take into accounts when calculating retained earnings even though they are not making the distribution to the shareholders yet.
We can review board meeting minutes to see if there any decision made by the board of directors to make the dividend payments. If so, we need to check if accounting records take this into accounts.
Retained earnings are the balance sheet items that record under equity sections. This account is used to records entity net income cumulatively since the starting operation.
If the entity operation generates net income, then retained earnings are positive, and if the entity makes operating losses then retained earnings will turn to negative. Sometimes it is called accumulated losses.
When retained earnings turn into negative, total equity is also decreasing. In some countries, if the equity turns to the level that is below the requirement, shareholders or owners are normally required to inject more funds.
Negative return earnings are not the positive sign for the entity and potential investors might concern about this seriously.
However, there are many factors that we can look into in detail. For example, the ages of the entity, nature of the industry that entity operating in, and other internal factors.
If an entity does just start its operation, then the entity would not make profits and most likely make losses.
However, it will turn into operating profits when entity operation runs smoothly, the brand name is well known and sales significantly increase.
And if the entity is operating in some industry like the insurance industry, the entity might spend some more time than others to breakeven and make profits.
Excessive dividend payments could also cause retained earnings into negative however it is not often that we can see this.
A large amount of negative earnings and long-run operating losses indicates that entity might face going concern or bankrupt.
This is not a negative impact on potential investors but other potential stakeholders like bankers, creditors, large customers, suppliers, and staff also reluctantly rely on the entity.
These are the main factors that can lead retained earning into negative and there are many other factors like sales, cost of goods sold, and operating expenses are also the factors that need to consider.
There are many factors that affect an entity’s retained earnings and these effects could make it increase or decrease accordingly. The primary elements that affect retained earnings are net income/ net loss and dividend payments.
If the entity makes a lot of profit and subsequently net income, then the earnings will be increased eventually.
Other factors that affect retained earnings are sales, cost of goods sold, interest expenses, and some adjustments that could affect the opening balance of retained earnings.
Main Factors:
Net income/ Net Loses is directly affect the entity’s retained earnings. Normally, net income or net loss is reporting in the entity income statement. Sometimes called the bottom line. If an entity makes operational profits, then the amounts that it takes from income statement to retained earnings statement will be big and earnings will be increased subsequently. Yet, if the entity does not make a profit but adversely makes a loss then the entity’s earnings will be reduced. Please noted that accumulated earnings are increasing credit and decreasing in debit.
Dividend payments made during the year to entity’s shareholders would make the accumulated earnings decrease. And when calculating year-end yet income, we must deduct the declare dividend payments amount from the calculation. The deduction can be before or after the addition of net income. If the declaration is not made and the board of directors, as well as authority, is not approved yet, the dividend is not qualified for the deduction.
Others Factors
There are many other factors that indirectly affect the entity retained earnings, and those factors also include the accounting adjustments that might be happened when current year auditors recommend that the adjustment should be made to the opening balance. The following are those factors:
Sales growth is the importance that directly affects net income. If sales growth with a positive gross profit margin, then the entity would make profits. These factors significantly affect net income. It is also subsequently affect accumulated earnings.
The cost of goods sold also directly affects net income and if it is increasing or decreases consistently with sales, then net income will also increase or decrease and do so earnings.
Interest expenses are depending on the entity’s financing strategy. Some entities may choose to finance their operation through loan and some entities might choose to finance through equity. If the entity’s has financial leverage is highly on loan then the entity will face high-interest expenses. This will affect retained earnings. And if the entity has less loan then the entity will not be spending much on interest expenses and the remaining will forwarding to accumulated earnings.
Adjustments that propose by current year auditors might also affect the opening balances. It is depending on the nature of adjustment and if the adjustment is made then affect the opening balance, some of them might affect the opening balance of retained earnings.
