Is Retained Earnings a Permanent or Temporary Account?

In financial accounting, accurately classifying accounts is fundamental for clear and reliable financial reporting. This classification is crucial for preparing financial statements that provide a true picture of a company’s financial health and performance, impacting how financial information is organized, processed, and presented to stakeholders.

Understanding Account Types

Financial accounts are broadly categorized into two main types: permanent accounts and temporary accounts, sometimes referred to as real and nominal accounts. This distinction is important for the accounting cycle and how balances are handled at the end of an accounting period.

Permanent accounts are those whose balances carry forward from one accounting period to the next. These accounts represent a company’s financial position at a specific point in time and are found on the balance sheet. Examples include assets like Cash, Accounts Receivable, and Equipment, liabilities such as Accounts Payable and Notes Payable, and most equity accounts like Common Stock.

Conversely, temporary accounts track financial activity over a defined period and are then closed out. These accounts are used to measure a company’s performance during that specific period and primarily appear on the income statement. Examples include revenue accounts like Sales Revenue, various expense accounts such as Rent Expense and Salaries Expense, and the Dividends account. At the end of the accounting period, the balances of temporary accounts are transferred to an equity account, resetting them to zero for the start of the next period. This process, known as closing entries, ensures each new period begins with a clean slate.

The Role of Retained Earnings

Retained earnings represent the cumulative net income of a company that has been kept within the business rather than distributed to shareholders as dividends. It reflects the portion of profits a company has chosen to reinvest or hold for future activities since its inception, serving as a significant component of a company’s equity.

The balance of retained earnings is directly impacted by a company’s financial performance and dividend policies. It increases with net income (or decreases with a net loss) and is reduced by any dividends paid out to shareholders. The basic formula illustrates this relationship: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings. This account is presented in the shareholders’ equity section of the balance sheet.

Retained Earnings: A Permanent Account

Retained earnings is classified as a permanent account in accounting. Its balance does not reset to zero at the end of an accounting period; instead, the ending balance from one period becomes the beginning balance for the next. This aligns it with other balance sheet accounts like assets and liabilities.

The cumulative nature of retained earnings is reinforced by the closing process, where the net effect of temporary accounts is transferred into it. Revenue and expense accounts, which measure performance for a specific period, are closed to an income summary account, and the resulting net income or loss is then transferred to retained earnings. Similarly, the Dividends account, also a temporary account, is closed directly into retained earnings, reducing its balance. This flow ensures that while individual period revenues, expenses, and dividends are reset, their ultimate impact on the company’s cumulative profitability is captured within the retained earnings account.