Does Retained Earnings Go on the Cash Flow Statement?
Clarify common financial reporting questions. Understand the distinct roles of a company's accumulated equity and its actual cash transactions.
Financial statements provide a structured view into a company’s financial health and performance. These documents serve as critical tools for various stakeholders, including investors, creditors, and management, to assess a company’s past activities and future prospects. Understanding how different financial elements are presented across these statements is essential for a comprehensive financial picture. This often leads to questions about the relationship between specific accounts, such as retained earnings, and various financial reports like the cash flow statement.
Understanding Retained Earnings
Retained earnings represent the cumulative net income a company has kept within the business rather than distributed to shareholders as dividends. It is a component of the shareholders’ equity section on the balance sheet. The calculation of retained earnings involves taking the beginning retained earnings balance, adding the net income (or subtracting a net loss) for the period, and then subtracting any cash dividends paid. This figure reflects accumulated profits reinvested into operations.
While retained earnings are a measure of accumulated profits, they do not signify a specific amount of cash held by the company. Instead, they represent a claim against the company’s assets, indicating how much of the company’s equity has been generated from past earnings. Companies often use these retained profits for purposes like funding expansion, acquiring new assets, reducing debt, or investing in research and development.
Understanding the Cash Flow Statement
The cash flow statement (CFS) details the cash generated and used by a company over a specific period. Its primary purpose is to explain the changes in a company’s cash and cash equivalents from one accounting period to the next. It categorizes cash inflows and outflows into three main activities: operating, investing, and financing.
Operating activities encompass cash flows from a company’s regular business operations, such as cash received from customers and cash paid to suppliers or employees. Investing activities involve cash flows related to the purchase or sale of long-term assets, or investments in other companies. Financing activities include cash flows from debt and equity transactions, such as issuing stock, borrowing money, or paying dividends. The CFS focuses on the movement of cash, providing insights into a company’s liquidity and solvency. Guidance for the cash flow statement is provided by Accounting Standards Codification (ASC) 230.
Why Retained Earnings Does Not Directly Appear on the Cash Flow Statement
Retained earnings do not directly appear on the cash flow statement because they are fundamentally different in nature and purpose. Retained earnings are an accrual accounting concept, representing a portion of a company’s equity on the balance sheet. The balance sheet provides a snapshot of a company’s financial position at a single point in time, reflecting assets, liabilities, and equity based on accrual principles. Under accrual accounting, revenues are recognized when earned and expenses when incurred, regardless of when cash changes hands.
In contrast, the cash flow statement operates on a cash basis, focusing on the actual inflows and outflows of cash over a period. Retained earnings, as an accumulated figure of non-cash profits, do not represent a tangible cash balance. These accumulated profits might have been used to purchase non-cash assets, such as inventory or equipment, or to reduce liabilities. Such uses are not direct cash transactions reported as a single line item on the cash flow statement. Therefore, a direct line item for “retained earnings” on the cash flow statement would misrepresent the nature of cash movements. The cash flow statement reports actual cash, distinguishing it from the accrual-based balance sheet where retained earnings reside.
How Components of Retained Earnings Impact Cash Flow
While retained earnings does not appear as a direct line item on the cash flow statement, its underlying components significantly influence the statement. The most prominent connection is net income, the starting point for calculating cash flow from operating activities, particularly when using the indirect method. Net income, reported on the income statement, flows into the retained earnings calculation.
When preparing the cash flow statement using the indirect method, non-cash expenses, such as depreciation and amortization, are added back to net income. Depreciation reduces net income but does not involve an actual cash outlay, thus it is added back to reconcile net income to cash from operations. Changes in working capital accounts, such as accounts receivable and accounts payable, also adjust net income to arrive at cash generated from operations.
Dividends paid to shareholders also impact the cash flow statement. Cash dividends reduce retained earnings on the balance sheet. When a company distributes cash dividends, this action represents a direct cash outflow and is reported under the financing activities section of the cash flow statement. This demonstrates how decisions affecting retained earnings, specifically the distribution of profits, translate into cash movements reported on the cash flow statement.