How to Prepare a Statement of Retained Earnings

A statement of retained earnings is a financial document that details the changes in a company’s accumulated profits or losses over a specific accounting period. This statement serves to connect the income statement and the balance sheet, illustrating how earnings generated by a business are either reinvested into the company or distributed to its shareholders. The statement ultimately shows the portion of a company’s earnings that has been kept within the business rather than paid out as dividends.

Understanding the Key Elements

Preparing a statement of retained earnings requires an understanding of its core components. The starting point for this statement is the beginning retained earnings balance. This amount represents the cumulative profits that a company has accumulated and retained from all prior periods, essentially serving as the ending balance from the previous accounting cycle.

Net income or net loss for the period is another crucial element. Net income, derived from the income statement, reflects the company’s profitability after all expenses have been deducted from revenues. When a company generates net income, it increases the retained earnings. Conversely, a net loss reduces the retained earnings balance.

Dividends declared or paid during the period also directly impact retained earnings. Dividends represent distributions of a company’s earnings to its shareholders. These payments decrease the retained earnings balance, as they are paid out rather than reinvested. Both cash dividends and stock dividends reduce retained earnings.

Constructing the Statement

The construction of a statement of retained earnings follows a standard format, systematically adjusting the beginning balance with the period’s net income or loss and any dividends. The statement prominently displays the company’s name, the title “Statement of Retained Earnings,” and the specific accounting period it covers.

The process starts with the beginning retained earnings balance, which is the retained earnings amount from the end of the prior accounting period. This figure typically originates from the previous period’s balance sheet or the company’s general ledger. If it is the first time a company prepares this statement, the beginning balance would be zero.

Subsequently, the net income for the current period is added to this beginning balance. In cases where the company incurred a net loss, this amount is subtracted from the beginning retained earnings.

Following the adjustment for net income or loss, any dividends declared or paid to shareholders during the period are subtracted. After performing these calculations, the resulting figure is the ending retained earnings balance for the current period. This ending balance then carries over to the shareholders’ equity section of the balance sheet.

Interpreting the Results

The ending retained earnings balance and the statement as a whole provide valuable insights into a company’s financial strategies and performance. A growing retained earnings balance often indicates consistent profitability and a policy of reinvesting earnings back into the business for future growth. This can signal financial strength and a commitment to expansion, which can be attractive to investors and lenders.

The statement also illuminates a company’s dividend policy, showing how much profit is distributed to shareholders versus retained for internal use. Companies focused on growth may retain a larger portion of earnings, while more mature companies might distribute more as dividends. This balance between reinvestment and distribution is a key decision for management.

Management and investors utilize this statement to assess financial health, evaluate dividend policy, and gauge a company’s ability to fund its operations and future projects internally. It provides a historical perspective on how a company has managed its profits, offering a comprehensive view of its financial trajectory.