Is Retained Earnings a Revenue Account?
Demystify retained earnings. Learn its fundamental role in business finance, its clear distinction from revenue, and its impact on company equity.
Understanding a business’s financial position requires deciphering various accounts. This article clarifies the nature of retained earnings and its connection to revenue, a common area of confusion for those new to business finance.
Understanding Retained Earnings
Retained earnings is an equity account, not a revenue account. It represents the cumulative net earnings a company has accumulated and chosen to keep within the business rather than distribute to shareholders. This accumulated profit is reserved for reinvestment, such as funding new equipment, research and development, or marketing initiatives.
Revenue, by contrast, is the total income generated from a company’s primary operations, such as selling goods or services, during a specific accounting period. Revenue is a “top-line” figure on the income statement, reflecting sales before expenses. Retained earnings, on the other hand, is a balance sheet account that reflects profits kept over time, linking the income statement to the balance sheet.
How Revenue Impacts Retained Earnings
Revenue does not directly impact retained earnings; instead, its influence is indirect, flowing through the calculation of net income. Revenue and expenses are recorded on the income statement, which reports a company’s financial performance over a specific period. The difference between revenues and expenses, after accounting for taxes, results in net income or net loss.
Net income is the profit a company earns after all costs and taxes have been deducted. This net income figure is then transferred to the retained earnings account at the end of an accounting period. Therefore, an increase in revenue, assuming expenses remain constant, leads to a higher net income, which subsequently increases retained earnings.
Key Adjustments to Retained Earnings
The retained earnings balance changes primarily due to two types of adjustments: net income and dividends. Net income, representing the company’s profitability for a given period, increases the retained earnings balance.
Conversely, dividends paid to shareholders decrease the retained earnings balance. Dividends are distributions of a company’s profits to its owners. While they represent a payout of earnings, they do not affect the company’s net income directly; they are a reduction of the accumulated profits that were available for reinvestment.
Retained Earnings in Financial Statements
Retained earnings appears on a company’s balance sheet within the shareholders’ equity section. This placement highlights its role as part of the owners’ claim on the company’s assets.
In addition to the balance sheet, changes in retained earnings are detailed in the statement of retained earnings, sometimes called the statement of changes in equity. This statement outlines the beginning retained earnings balance, adds net income (or subtracts net loss) for the period, and then subtracts any dividends paid, arriving at the ending retained earnings balance.