Most companies exist to profit from their operations. These profits come when the total income for a company exceeds its expenses for a period.
Usually, the higher the income and lower the expenses are, the more earnings it will generate. Companies use these profits to fund their operations and pay their equity holders for their investment. This payment comes through dividends.
Profits are essential to the long-term survival of a company. It also helps attract more investors and obtain finance. Over time, as companies accumulate profits they must record them on the balance sheet as a balance. This balance comes in the form of retained earnings. Some people may wonder if it is current liabilities or assets. In actuality, it is none of those.
Before discussing where retained earnings fall on the balance sheet, it is crucial to understand what they are. It is easier to understand what retained earnings are after defining them.
What are Retained Earnings?
Retained earnings are a company’s accumulated profits since its inception. However, it may report those profits after subtracting other figures.
Retained earnings may also appear as a negative balance on the balance sheet. In that case, it will show the accumulated losses over time. Deductions from profits cannot change retained earnings into a negative balance. Only losses impact it adversely.
Essentially, retained earnings include all profits a company makes. This amount comes after deducting all expenses for a period from the total income. The resultant figure is the company’s profits or losses. When these amounts accumulate for several periods, they go to the retained earnings account. However, these amounts only include profits not paid to shareholders in previous periods.
Retained earnings accumulate all profits and losses from when a company starts operating. However, it also deducts dividends from those amounts before reporting them on the balance sheet. Essentially, these include the distribution of income for a period to shareholders. Some companies may choose to pay dividends while others may not. Usually, these dividends occur through cash or stock payments.
Overall, retained earnings include all profits or losses a company has made since the beginning. However, it subtracts any dividends paid to shareholders first.
Retained earnings will increase when companies make profits. On the other hand, they decrease with losses. Similarly, dividend payments also impact the figure adversely. Retained earnings also act as an internal source of finance for most companies.
How to Calculate Retained Earnings?
The calculation for retained earnings is straightforward. As mentioned above, companies accumulate their profits or losses for several periods under this balance. However, they must deduct any dividends paid to shareholders from those amounts. Once they do so, they can add the result to retained earnings. The formula for retained earnings is straightforward, as stated below.
Retained Earnings = Opening retained earnings + Profits – Losses – Dividends
In the above formula, companies may either have profits or losses during a period. Therefore, only one of those elements will apply.
Similarly, dividend payments occur after companies calculate their earnings. If a company makes losses instead, it will not pay dividends that year. Alternatively, the following retained earnings formula also provides the same result.
Retained Earnings = Opening retained earnings + Income – Expenses – Dividends
The retained earnings formula above substitutes profits or losses for income and expenses. Essentially, it is the same as the former. Subtracting expenses from income returns profits or losses for a period.
The rest of the formula for retained earnings stays similar in this version. Companies can further expand these formulas by separating cash and stock dividends. However, it is not necessary to do so.
What is the Accounting for Retained Earnings?
The accounting for retained earnings is straightforward. However, it includes various stages based on the elements of the retained earnings formula. When a company conducts business, it will generate profits or losses.
These profits and losses come from the income statement account. Companies calculate these amounts at each year-end and report them in the income statement.
From there, these amounts get transferred to the balance sheet. This process adds the profits or losses to the retained earnings balance.
Usually, companies have an existing balance in this account, which changes from the transfer. For companies starting anew, the opening balance will be nil. Nonetheless, profits or losses will increase or decrease the retained earnings balance.
Some companies may also pay a dividend from their profits. The same does not apply when companies suffer losses. In the former case, these dividends decrease the profits transferred to the retained earnings.
Alternatively, companies take the net income for the period to the retained earnings account first. Subsequently, they subtract any declared dividends from that balance.
Other transactions may also decrease the retained earnings balance. Usually, these include special dividends that differ from the year-end allotments.
Nonetheless, the accounting is similar to other deductions from the retained earnings balance. Once the transactions occur, companies will transfer the closing retained earnings balance to the upcoming year. This balance will become the opening retained earnings balance.
Are Retained Earnings Current Liabilities or Assets?
Retained earnings are a source of internal finance for companies. Therefore, some people may confuse them for assets. On top of that, retained earnings are ultimately the right of a company’s shareholders.
Companies must pay these to shareholders after liquidation. In this case, some people may confuse retained earnings for liabilities. However, this balance does not meet the definition for any of those items.
In accounting, liabilities are obligations from past events that result in outflows of economic benefits. Similarly, any of these obligations that companies must repay within 12 months are current liabilities.
Retained earnings are repayable balances as well. However, liabilities are obligations to third parties. They do not include shareholders. Retained earnings, in contract, are payable to shareholders. Therefore, they are not liabilities.
Similarly, assets in accounting are resources owned or controlled by a company. These resources result in an inflow of economic benefits in the future.
However, retained earnings do not meet this definition. Firstly, they are not resources. The first part of the asset definition does not recognize retained earnings. Secondly, retained earnings are economic benefits that have already occurred. Therefore, they aren’t assets either.
Are Retained Earnings Equity?
The only definition that retained earnings meet is that of equity. In accounting, equity is the residual amount after deducting liabilities from assets. Similarly, it denotes the shareholders’ rights to a company’s assets after liquidation. Since retained earnings meet this definition, they classify as equity on the balance sheet. It appears under shareholders’ equity on that statement.
The above definitions for the balance sheet elements clarify that retained earnings are equity. Since this balance is a type of equity, it also acts similar to other equity balances.
Companies can use retained earnings for financing purposes. However, that does not imply they are assets. Similarly, companies can repay these amounts to shareholders. This definition does not make them liabilities, though.
Essentially, retained earnings are balances accumulated due to profits or losses. They do not represent assets or cash balances that companies have kept.
If a company undergoes liquidation, it will repay the retained earnings balance to shareholders. However, other factors impact how much of this balance shareholders will receive. In some cases, they may not get any retained earnings at all.
Retained earnings represent a company’s accumulated profits or losses. However, it also subtracts dividends paid to shareholders in the past first.
The formula to calculate retained earnings encompasses those elements. Due to its definition, some people may confuse retained earnings for current liabilities or assets. However, retained earnings are an equity balance on the balance sheet.