What Accounts Affect Retained Earnings?

Retained earnings represent the cumulative profits a company has accumulated over time that have not been distributed to its shareholders. This figure reflects the portion of a business’s earnings kept and reinvested into operations or saved for future use. Retained earnings are a valuable indicator of a company’s financial health, demonstrating its capacity to generate profits and its strategy for growth, whether through reinvestment or by providing returns to its owners. They are a significant component of a company’s equity.

Understanding Retained Earnings

Retained earnings are an accounting concept, not a direct measure of cash held by a company. They are reported within the shareholders’ equity section of a company’s balance sheet, signifying the portion of equity financed by past earnings. This figure shows how much of the company’s historical net income has been “retained” within the business.

The calculation of retained earnings connects a company’s profitability, as shown on its income statement, with its balance sheet. The basic formula for determining the ending balance of retained earnings for a period is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings. The ending balance from one accounting period becomes the beginning balance for the next, illustrating the ongoing accumulation or reduction of earnings over time.

Accounts That Increase Retained Earnings

The primary account that directly increases retained earnings is net income. Net income, also known as net profit, represents the money a company earns after deducting all operating expenses, interest, and taxes from its revenues. When a company generates a profit, this positive net income is added to the existing balance of retained earnings, assuming it is not distributed to shareholders.

Factors that boost revenue or reduce expenses, such as increased sales, efficient cost management, or lower operating costs, contribute to higher net income and, consequently, an increase in retained earnings. Positive prior period adjustments can also increase retained earnings. These adjustments correct errors from previous financial periods, such as unrecorded revenue or overstated expenses, ensuring accuracy in financial reporting.

Accounts That Decrease Retained Earnings

Several accounts can reduce a company’s retained earnings. The most common reduction comes from dividends distributed to shareholders. Dividends represent a portion of a company’s profits paid out to its owners, directly decreasing the earnings retained by the business.

Dividends can take various forms, including cash dividends, which involve a direct outflow of cash, or stock dividends, which reallocate a portion of retained earnings to common stock and additional paid-in capital accounts without a cash outflow. A net loss also decreases retained earnings, occurring when a company’s expenses exceed its revenues. A net loss directly reduces the retained earnings balance, and a series of losses can lead to a negative retained earnings balance, often called an accumulated deficit. Negative prior period adjustments, which correct past accounting errors that may have overstated income or understated expenses, also decrease retained earnings.

The Statement of Retained Earnings

All movements in retained earnings are formally presented in the Statement of Retained Earnings. This statement reconciles the retained earnings balance from the beginning of an accounting period to its end, illustrating how net income, net losses, and dividends collectively impact the balance.

The statement typically begins with the retained earnings balance from the close of the previous period. It then adds net income (or subtracts net loss) generated during the current period. Finally, any dividends declared and paid are subtracted to arrive at the ending retained earnings balance. This statement provides a clear overview of how a company’s profits have been managed, whether reinvested into the business or distributed to shareholders, offering insights into its financial policies and growth strategies.