Do You Debit or Credit Retained Earnings?

Retained earnings represents the accumulated net income of a company that has not been distributed to shareholders as dividends. It reflects the portion of profits a business has kept and reinvested into its operations or used to reduce debt. Understanding when and why retained earnings are debited or credited is a common point of confusion for many new to financial principles. This article aims to clarify these applications within the double-entry accounting system.

The Nature of Retained Earnings

Retained earnings is an equity account, a component of stockholders’ equity, presented on a company’s balance sheet. It indicates the total profits a business has accumulated since its inception, minus any losses and dividends paid out to owners. This account signifies the owners’ claim on company assets derived from past earnings, not direct shareholder investment. Like other equity accounts, retained earnings carries a credit balance.

Fundamentals of Debits and Credits for Equity

The accounting system relies on debits and credits to record every financial transaction, ensuring the fundamental accounting equation (Assets = Liabilities + Equity) remains balanced. For equity accounts, including retained earnings, the rules are specific. Equity accounts have a “normal balance” on the credit side. An increase in any equity account is recorded as a credit, while a decrease is recorded as a debit. This principle ensures that financial records accurately reflect changes in ownership interest within the company.

Crediting Retained Earnings

The primary scenario where retained earnings is credited is when a company generates net income, also known as profit. After all revenues and expenses are accounted for at the end of an accounting period, any positive net income increases the company’s overall wealth. This increase in accumulated earnings is then transferred to the retained earnings account.

For instance, if a business reports $100,000 in net income for the year, this amount will be added to the retained earnings balance as a credit. This action signifies that the company has chosen to keep these profits within the business rather than distributing them to shareholders.

Debiting Retained Earnings

Retained earnings is debited in two common situations: when a company incurs a net loss or when it declares and pays dividends. A net loss occurs when a company’s expenses exceed its revenues over an accounting period. Such a loss directly reduces the accumulated earnings of the business.

When a net loss of, for example, $50,000 occurs, this amount is debited from the retained earnings account to reflect the reduction in accumulated profits. Similarly, dividends represent distributions of a company’s profits to its shareholders. If a company’s board declares and pays $20,000 in dividends, this action reduces the portion of earnings kept by the company.

The payment of dividends results in a debit to the retained earnings account. This signifies that a portion of the company’s accumulated profits has been distributed to its owners, decreasing the retained earnings balance.