How to Properly Record Retained Earnings

Retained earnings represent the accumulated net income a company keeps rather than distributing to its shareholders as dividends. This accumulated amount reflects a company’s financial health and its capacity to reinvest profits back into the business for future growth or other strategic initiatives. Understanding how to accurately record and report retained earnings is fundamental to financial accounting.

Components and Calculation of Retained Earnings

Retained earnings are directly influenced by a company’s financial performance and its profit distribution decisions. The balance of retained earnings increases with net income, which is the profit remaining after all expenses and taxes. Conversely, a net loss will decrease retained earnings.

Dividends declared by the company also reduce the retained earnings balance. Dividends represent a distribution of profits to shareholders. The basic formula to calculate ending retained earnings for a period is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings. The beginning retained earnings balance is the ending balance from the previous accounting period.

Journal Entries for Retained Earnings

The recording of retained earnings primarily occurs through closing entries at the end of an accounting period, which transfer temporary account balances to permanent accounts. This process ensures that revenue and expense accounts are reset to zero for the next period. The net effect of these closing entries is to update the retained earnings account with the period’s net income or loss.

To close net income, revenue accounts are debited and the Income Summary account is credited. Then, expense accounts are credited and the Income Summary account is debited. The balance of the Income Summary account, representing the net income (or loss), is then closed to Retained Earnings. For net income, the Income Summary account is debited and Retained Earnings is credited. For a net loss, Retained Earnings is debited and Income Summary credited.

Recording dividends involves two main journal entries: one for the declaration and another for the payment. When a company declares a dividend, it creates a legal obligation to pay shareholders. This declaration is recorded by debiting Retained Earnings and crediting Dividends Payable. When the dividends are paid, the Dividends Payable account is debited to eliminate the liability, and the Cash account is credited.

Reporting Retained Earnings on Financial Statements

Retained earnings are a significant component displayed on a company’s financial statements, providing insight into its profitability and reinvestment strategies. The Statement of Retained Earnings details the changes in the retained earnings balance over an accounting period. This statement begins with the retained earnings balance from the start of the period, adds the net income (or subtracts a net loss) for the period, and then subtracts any dividends declared. The result is the ending retained earnings balance.

The ending balance of retained earnings is also presented on the Balance Sheet, which provides a snapshot of a company’s financial position. On the Balance Sheet, retained earnings appear within the shareholders’ equity section. This placement reflects that retained earnings are a portion of the company’s cumulative profits kept within the business, contributing to its overall equity.