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 is left from the entity’s net income, dividend payments, and other adjustments since the entity start 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 current year’s opening balance, dividend payments, and net income.
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: balance sheet, statement of change in equity, and statement of retained earnings. The formula used to calculate it is to add the opening balance with the current year’s 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 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 ensure that this balance is correctly brought forward from the previous year’s audit audited financial statements or working papers. In order words, we need to cross-check with the previous year’s audit working paper and audited financial statements.
Review the net income:
Net income or net losses is what retained earnings are 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 reviewing the net income items and 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, the accumulation of net losses will increase and decrease equity.
In some cases, if the entity makes losses in a long time and equity reaches the amounts required 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 review those items substantively. 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 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.