Do You Close Retained Earnings at Year-End? How the Process Works

At the end of each fiscal year, businesses perform accounting steps to prepare their financial records for the next period. This process involves handling retained earnings — the portion of net income kept in the business rather than distributed as dividends. Understanding how retained earnings are treated at year-end helps ensure accurate financial reporting.

This article explains what happens to retained earnings during the closing process, why it matters, and how actions like paying dividends impact the final balance.

Why Retained Earnings Exist

Retained earnings represent the accumulated profits a company has kept within the business over time, rather than distributing them to shareholders. This figure reflects historical profitability and management’s decisions regarding reinvestment. It is a component of shareholders’ equity reported on the company’s balance sheet, prepared according to standards like Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).¹PwC Viewpoint. 5.8 Retained Earnings

These accumulated funds provide internal financing, allowing a company to fund activities without seeking external capital. Businesses use retained earnings for various purposes, such as:

• Purchasing new equipment or machinery (capital expenditures)
• Investing in research and development
• Expanding operations or acquiring other businesses
• Providing a financial cushion during economic downturns
• Funding day-to-day operational needs (working capital)
• Paying down existing debt

While not cash itself, a strong retained earnings balance indicates that a company has generated profits historically and possesses resources for future investments or managing liabilities. Lenders often view the level of retained earnings as an indicator of financial stability when assessing creditworthiness.

What Happens During a Closing Entry

At the end of an accounting period, businesses perform “closing entries” to prepare records for the next period. This involves resetting the balances of temporary accounts to zero, ensuring a clean start for tracking financial activity.²Penn State University. 1.15 Closing Entries – Financial and Managerial Accounting Temporary accounts include revenues, expenses, and dividends, as they track data only for the current period. Permanent accounts, like assets, liabilities, and most equity accounts found on the balance sheet, are not closed because their balances carry forward.³Lumen Learning. Closing Entries | Financial Accounting

The closing process transfers balances from temporary accounts into the permanent Retained Earnings account. Often, an intermediary temporary account called “Income Summary” is used. Revenue accounts are debited to zero, with the total credited to Income Summary. Expense accounts are credited to zero, with the total debited to Income Summary.

The Income Summary account then reflects the period’s net income (a credit balance) or net loss (a debit balance). A subsequent entry transfers this balance from Income Summary to Retained Earnings. A net income increases retained earnings, while a net loss decreases it.

Through these entries, the net income or loss earned during the period is formally incorporated into the Retained Earnings balance. The temporary revenue and expense accounts are reset to zero, ready for the next accounting cycle. This ensures financial statements accurately reflect performance for the specific period and the balance sheet carries the correct cumulative equity figure forward. Many accounting software systems automate these closing entries.

How Dividends Affect Retained Earnings

Dividends are distributions of a company’s accumulated profits to its shareholders. These payments directly reduce the retained earnings account. When a company’s board declares a dividend, it signifies a decision to return a portion of earnings to owners instead of reinvesting them.

Cash dividends result in a direct reduction of both cash and retained earnings. Accounting principles generally require recording the reduction in retained earnings when the dividend is declared, reflecting that a portion of historical profits is being paid out.⁴PwC Viewpoint. 5.11 Dividends

Companies might also issue stock dividends, distributing additional shares instead of cash. This action still reduces retained earnings. Under GAAP, the reduction for small stock dividends (typically under 20-25% of outstanding shares) is based on the fair market value of the shares.⁵Lumen Learning. Stock Dividends and Splits | Financial Accounting For large stock dividends, the reduction is often based on the par value. The amount taken from retained earnings is reclassified within shareholders’ equity, increasing accounts like common stock. While total equity might not change immediately, the retained earnings component decreases.

Dividend payments represent a distribution of wealth from the retained earnings account, separate from the generation of net income. Net income increases retained earnings, while dividends decrease it. This reduction is shown in the statement of shareholders’ equity. Laws may restrict dividends if a company lacks sufficient retained earnings.

End Balances in Retained Earnings

The ending balance of retained earnings reflects the total accumulated profits kept within the business since its inception, after accounting for all dividend distributions. It is calculated by taking the beginning balance, adding the current period’s net income (or subtracting the net loss), and subtracting any dividends declared.⁶University of Waterloo. 9.4 Retained Earnings, Stock Splits, and Dividends This final amount is reported in the shareholders’ equity section of the balance sheet.

This ending balance indicates historical financial performance and the company’s policy on profit reinvestment. A positive, growing balance generally suggests sustained profitability and reinvestment for growth or stability. It represents the portion of net worth generated internally through operations.

The retained earnings balance is an accounting measure, not a pool of available cash. Cash generated from earnings might have already been used for assets or paying liabilities. The figure shows the shareholders’ claim on net assets arising from undistributed profits.

Companies may designate portions of retained earnings for specific future uses, known as appropriations, such as planned expansions or potential legal contingencies. These restricted amounts must be disclosed, often in the footnotes to the financial statements, indicating they are not available for general dividend distribution, following guidelines from bodies like the Securities and Exchange Commission (SEC).

If cumulative losses exceed cumulative profits, the retained earnings account shows a negative balance, known as an accumulated deficit. This signifies that the company has lost more money than it has earned overall, reducing shareholders’ equity and often indicating financial difficulty.

• 1
  PwC Viewpoint. 5.8 Retained Earnings
• 2
  Penn State University. 1.15 Closing Entries – Financial and Managerial Accounting
• 3
  Lumen Learning. Closing Entries | Financial Accounting
• 4
  PwC Viewpoint. 5.11 Dividends
• 5
  Lumen Learning. Stock Dividends and Splits | Financial Accounting
• 6
  University of Waterloo. 9.4 Retained Earnings, Stock Splits, and Dividends