When a company is formed, the main objectives behind setting up a business are earning profits and expanding the business in the future. Profits are the lifeblood of any business, either sole proprietorship, partnership, or corporation.
A business owner can expand the business by reinvesting his profits. A partnership or a corporation can invest in different projects having growth potential in the future. It can be used to pay out the company’s debt, diversify its investment portfolio, etc.
A shareholder invests in a company with hopes of earning profit(dividends) on his investment. How can a company use the profit when they are liable to pay it to the business owners(shareholders)?
Most companies retain a part of their earnings for reinvesting or other purposes. It is called retained earnings, and this article will be all about retained earnings, recognition, calculation, measurement, and classification.
What are retained earnings?
Retained earnings can be defined as,
Accumulation of a company’s historical revenues for reinvestment, loan payment, reserves, etc., is called retained earnings. Retained earnings are a portion of every year’s net profit retained after payment of tax and dividend payout.
Retained earnings are considered an important concept concerning a company’s financial statements. There is not separate International Accounting Standard dictating the disclosure & recognition of retained earnings.
However, the comprehensive income, Preparation of Financial statements, and Presentation of Financial Statements dictate the measurement, classification, and recognition of a company’s retained earnings.
The purpose of retained earnings is loan repayment, investing back in business(installing a new plant, expanding warehouse facility, the launch of a new product, research and development, etc.), reserves for contingencies, investment in other securities, etc.
Net income vs. retained earnings
Retained earnings and net income both are the revenue of a business entity. However, there is a difference between the two. Net income is recorded in the income statement of a business entity in every financial period. Net income is the profit of a company that is calculated after payment of all the recurring expenses.
Retained earnings are a part of net income, but it does not correspond to only the income of the current financial period. It is an accumulation of all the historical profits percentages kept in the company’s reserves for different purposes.
The concept of retained earnings is similar to a saving account or an emergency fund kept to pay the long-term expenses of a company or a large purchase. The retained earnings of a company are recorded in the shareholder’s equity section of the balance sheet.
Classification of retained earnings
Retained earnings are the profits of a business entity that have not been disbursed to the shareholders. The recording of retained earnings is done on the balance sheet of a company. Sometimes a separate statement for the recording of retained earnings is also prepared.
In the shareholder’s equity of a company, the retained earnings are recorded by adding each year’s undistributed profits. Retained earnings are recorded in shareholder’s equity because any profit earned by a business is the owners’ property. In a company, the shareholders are the business owners. Either disbursed or not, all the profit belongs to the shareholders.
The management has retained the amount for business purposes. However, it remains the property of the owners. That’s why retained earnings are recorded in the shareholder’s equity section of a balance sheet. A company might pay out a dividend from the retained earnings if they have no reinvestment plans.
Recognition of retained earnings
The retained earnings of a company are recognized after the calculation of all the profits, taxes, and dividends. The net profit is calculated by subtracting the costs of goods sold, operating expenses, administration & marketing expenses, taxes, etc., from the revenues of the business entity.
The next step is a calculation of any dividend that has to be paid out. After paying dividends, the remaining value is added to the balance of retained earnings continuing from previous financial years. The retained earnings recorded in the company’s balance sheet are part of the entity’s book value.
The recognition of retained earnings by a company is for different purposes. We have discussed some of them briefly. However, the other uses of retained earnings can be as follow:
- Investment in a new market opportunity that has high growth potentials
- Keeping a reserve for future contingencies, litigations, economic downturns, or losses
- Investing money in Research and Development for improving an existing product or launching a new one.
- Upgrading or purchasing the capital assets for future profits
- Improving the marketing assets and CRM
- Introducing new technology in the company.
There can be different purposes of retained earnings depending on the nature of the business. However, every purpose is common because it will bring economic or financial benefits to the company in the future.
Calculation of retained earnings
The retained earnings are calculated by the following formula:
Retained Earnings = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
The period beginning retained earnings is a cumulative balance of all the retained earnings from prior periods. The net income or loss relates to the current year’s operations and corresponds to the net income of loss of the company. Cash dividends are paid to the shareholders, and stock dividends are bonus shares issued to the shareholders.
Corrections In Retained Earnings
According to International Accounting Standard 8,
Retained earnings can be corrected and updated in the following two cases:
The error of correction related to the prior accounting period
The disclosure related to accounting errors made in prior years must be corrected and reflected in the retained earning balance carried forward. If the error made does not has a financial value or practical restatement, there must be added notes about the explanation of the error and how it has been corrected.
Determine the type of error made in the prior period and find the correction required. It can be additional journal entries, or sometimes it requires adjustment in retained earnings. Revise and restate the financial statements of previous years to reflect the changes.
Clay & Clay Corporation’s management found that depreciation expenses and salaries were not recorded correctly. Depreciation expense was understated by 40,000 whereas there were unrecognized accrued salaries of 5000 in books of accounts. The depreciation error was made in financial starting from Jan 1, 2018, and ending on Dec 31, 2018. The current financial period is 2020.
The unadjusted retained earnings starting balance was $130,000 on Jan 1, 2018. The income of 2018 was $55,000 before errors discovery.
Following entries and adjustments will be made to reflect the correction:
The impact of these entries in the retained earnings statement of the company will be as follow
Impacts of changes in accounting policies
Any change in the accounting policies of a business entity must be reflected in the financial statements. Consequently, any adjusting entries must be recorded to complete the effect of change. However, if the change in accounting policy is immaterial, does not imply circumstances of past transactions, unfeasible or impractical accounting estimate, etc., the recording of changes is exempted by IFRS.
It also requires the following disclosures in the financial statements:
- Nature of the change in accounting policy
- Reasons why an accounting policy is being transitioned
- Amounts of adjustment in current and prior accounting periods
Statement of retained earnings
Some business entities make a separate financial statement for the appropriation of the retained earnings. It is the financial statement representing all the changes in retained earnings of the company over the financial periods.
There are many other names for the statement of retained earnings. It is also called a statement of shareholder’s equity, an equity statement, or the statement of owner’s equity.
Most commonly, the statement of retained earnings record beginning year balance, net income, any dividends declared or paid out. There can be further segregation of dividends paid on preferred stock and common stock. The retained earnings are calculated as the formula discussed above. The closing balance is reported as the last item in the statement of retained earnings.
Here is an example of calculating a company’s retained earnings.
The beginning year balance of the retained earnings for the year 2019 is $80,000. The net income of the company is $50,000. The company has paid a cash dividend of $30,000. What will be the retained earnings balance of the company at the end of the financial year 2019?
This article comprehensively covered the accounting treatment, disclosure, recording, recognition, and appropriation of retained earnings for any business entity. We hope it will help you understand the purpose and use of the retained earnings in any business entity.