Is Retained Earnings a Debit or a Credit?

Retained earnings are a key component of a company’s financial statements, representing the accumulated profits a company has earned since its inception, less any dividends paid to shareholders. This figure is important as it reflects the portion of a company’s earnings that has been reinvested back into the business, rather than distributed to its owners. It can signal a company’s capacity for growth, its financial resilience, and its ability to fund future operations or expansion.

The Language of Accounting: Debits and Credits

These terms are not inherently positive or negative; instead, they represent the left and right sides of an accounting entry. Every financial transaction involves at least two accounts, with a debit to one or more accounts and an equal credit to one or more other accounts, ensuring the accounting equation remains balanced.

The accounting equation, Assets = Liabilities + Equity, is the bedrock of this system. Assets are resources owned by the company, liabilities are obligations owed to others, and equity represents the owners’ residual claim on the company’s assets. Each account type has a “normal balance,” which is the side (debit or credit) that increases its balance. Assets increase with debits and decrease with credits.

Conversely, liabilities and equity accounts increase with credits and decrease with debits because they appear on the right side of the accounting equation. Revenue accounts, which increase equity, also have a normal credit balance. Expense accounts, which decrease equity, have a normal debit balance. This dual-entry system ensures that for every transaction, total debits always equal total credits.

Retained Earnings Explained

Retained earnings are part of the equity section on a company’s balance sheet. They represent the cumulative net income that a company has chosen to keep and reinvest in its operations, rather than distributing it as dividends to shareholders. This cumulative amount reflects the company’s historical profitability and its strategy for growth.

It begins with the retained earnings balance from the previous period, adds the net income (or subtracts a net loss) for the current period, and then subtracts any dividends paid out to shareholders. This calculation is performed at the end of each accounting period, such as monthly, quarterly, or annually. The resulting figure is then reported within the shareholders’ equity section of the balance sheet, providing a continuous link between a company’s income statement and its balance sheet.

How Transactions Affect Retained Earnings

As an equity account, retained earnings carry a credit normal balance. An increase in retained earnings is recorded with a credit entry, while a decrease is recorded with a debit entry.

Net income impacts retained earnings. When a company generates net income, this profit increases its accumulated earnings. Therefore, net income is recorded as a credit to the retained earnings account, increasing its balance. Conversely, if a company incurs a net loss, this loss reduces the accumulated earnings, and it is recorded as a debit to retained earnings, thereby decreasing the balance.

Dividends paid to shareholders affect retained earnings. When a company distributes cash or stock dividends, it is essentially returning a portion of its accumulated profits to its owners. This distribution reduces the amount of earnings retained by the business. Consequently, dividend payments are recorded as a debit to the retained earnings account, decreasing its balance. For example, if a company has $100,000 in retained earnings and earns $20,000 in net income, retained earnings would be credited, increasing the balance to $120,000. If the company then pays $5,000 in dividends, retained earnings would be debited, reducing the balance to $115,000.