Is Retained Earnings Temporary or Permanent?
Understand the enduring nature of a company's accumulated profits and how they reflect its financial health over time.
Retained earnings, an important component of a company’s equity, often lead to questions about their nature. Understanding this distinction is fundamental to comprehending how a company manages its profits over time and its financial structure. This article clarifies why retained earnings are considered a permanent account in accounting and how they reflect a company’s accumulated profitability and reinvestment strategies.
What are Retained Earnings?
Retained earnings represent the cumulative net earnings or profits a company has kept after distributing dividends to its shareholders. The term “retained” directly refers to the fact that these earnings have been kept within the company.
This accumulated amount is presented within the shareholders’ equity section of a company’s balance sheet. While retained earnings are not assets themselves, they signify a portion of equity that can be used to acquire assets, fund operations, or pay down debt. They serve as a vital link between a company’s income statement, which shows profitability over a period, and its balance sheet, which provides a snapshot of its financial position at a specific point.
Classifying Retained Earnings as Permanent
In accounting, accounts are broadly categorized as either temporary (nominal) or permanent (real). This classification determines how their balances are treated at the end of an accounting period. Temporary accounts, such as revenues, expenses, and dividends, are closed out at the end of each fiscal period, typically annually, and their balances are reset to zero. Their purpose is to measure financial performance within a specific timeframe, like a quarter or a year.
Permanent accounts, in contrast, carry their balances forward from one accounting period to the next. These accounts include assets, liabilities, and equity accounts. Retained earnings fall into this permanent category because their balance is cumulative; it does not reset to zero at the end of a fiscal year. Instead, the ending balance of retained earnings from one period becomes the beginning balance for the subsequent period. This continuous accumulation highlights their role in reflecting a company’s long-term financial history and ongoing progress, providing a comprehensive view of how profits have been managed over the company’s existence.
How Retained Earnings Change Over Time
Retained earnings are influenced by a company’s financial performance and its decisions regarding profit distribution. The primary factors that cause changes in the retained earnings balance are net income, net loss, and dividends. These movements are reflected in the statement of retained earnings, which details the changes over a specific period.
Net income directly increases retained earnings. When a company generates a profit, this positive net income is added to the existing retained earnings balance. Conversely, a net loss, which occurs when expenses exceed revenues, will decrease retained earnings. This reduction reflects the consumption of prior accumulated profits.
Dividends declared by the company also reduce retained earnings. Whether paid in cash or as additional shares, dividends represent a distribution of accumulated profits to shareholders, thereby decreasing the amount of earnings retained by the business. For instance, if a company has $1 million in retained earnings and issues a $0.50 dividend for 500,000 outstanding shares, the retained earnings would decrease by $250,000. Less common, but also impacting retained earnings, are prior period adjustments. These are corrections made to the beginning balance of retained earnings to fix significant errors or reflect changes in accounting principles from previous financial statements. For example, an unrecorded expense from a prior year would necessitate a reduction in the beginning retained earnings balance.