Does Retained Earnings Have a Credit Balance?
Demystify retained earnings. Understand its normal credit balance, what influences it, and its role in a company's financial picture.
Retained earnings represent the accumulated profits a company has kept and reinvested in its business, rather than distributing them to shareholders as dividends. This financial figure plays a significant role in understanding a company’s financial health. In accounting, retained earnings typically carry a credit balance, reflecting their nature as a component of owner’s equity.
Understanding Debits and Credits
In accounting, financial transactions are recorded using a system of debits and credits. Every transaction involves at least one debit and one credit, ensuring that the accounting equation—assets equal liabilities plus owner’s equity—remains balanced. Debits are positioned on the left side of an accounting entry, while credits are on the right side.
The effect of debits and credits depends on the type of account being adjusted. Asset accounts, such as cash or equipment, increase with debits and decrease with credits. Conversely, liability accounts, like accounts payable or loans, and equity accounts, including retained earnings, increase with credits and decrease with debits. This established pattern for each account type is known as its “normal balance.”
For equity accounts, a normal credit balance signifies that an increase in equity is recorded as a credit, and a decrease is recorded as a debit. Since retained earnings represent a portion of the owner’s equity, an increase in these accumulated profits is recorded as a credit, aligning with the normal balance convention for equity accounts.
Factors Affecting Retained Earnings
Several key financial events directly influence the balance of retained earnings. The primary factor that increases retained earnings is a company’s net income, which is the profit remaining after all expenses have been deducted from revenues for a specific accounting period. When a company earns net income, these profits are eventually added to the retained earnings balance, thereby increasing its credit balance.
Conversely, a net loss incurred by a company will decrease retained earnings. A net loss occurs when expenses exceed revenues, effectively reducing the accumulated profits available within the business. This reduction is recorded as a debit to the retained earnings account, diminishing its credit balance.
Another significant factor that reduces retained earnings is the declaration and payment of dividends to shareholders. Dividends represent a distribution of a company’s profits to its owners. When dividends are declared, the company commits to paying out a portion of its accumulated earnings, which results in a debit to the retained earnings account, thereby lowering its balance.
Retained Earnings on Financial Statements
Retained earnings holds a prominent position on a company’s financial statements, providing insight into its financial health and historical profitability. It is reported as a distinct component within the owner’s equity section of the balance sheet. On this statement, retained earnings represents the cumulative profits accumulated over its operating history, minus any losses and dividends.
Beyond the balance sheet, retained earnings is also a central element of the Statement of Retained Earnings, or often, the broader Statement of Changes in Equity. This specific financial statement details the changes in the retained earnings balance from the beginning to the end of an accounting period. It begins with the retained earnings balance from the prior period, adds the current period’s net income (or subtracts a net loss), and then subtracts any dividends declared during the period.
The resulting figure is the ending retained earnings balance, which then carries forward to the balance sheet for the close of the period. This statement effectively reconciles the starting and ending amounts, offering transparency into how profits are managed—either reinvested to fuel future growth or distributed to shareholders. The amount of retained earnings can inform stakeholders about a company’s capacity for internal financing and its dividend policy.