What Kind of Account Is Retained Earnings?
Understand the nature of retained earnings, an essential equity account reflecting a company's reinvested profits and financial strength.
Retained earnings represent the cumulative net earnings a company has kept after distributing dividends to its shareholders. This highlights the portion of profits a business has chosen to reinvest.
Understanding the Retained Earnings Account
Retained earnings are classified as an equity account, appearing within the stockholders’ or owners’ equity section of a company’s balance sheet. This account accumulates a company’s net income over its operational life, with any dividends paid to shareholders subtracted from this total. It essentially represents the portion of profits that a company has chosen to keep and reinvest into the business, rather than distributing them to its owners.
This account is considered a permanent, or “real,” account, meaning its balance is carried forward from one accounting period to the next. The retained earnings balance continues to grow or shrink based on ongoing profitability and dividend decisions. Therefore, a positive and growing retained earnings balance indicates a company’s sustained profitability and its strategy of reinvesting profits to strengthen its financial position and foster growth.
How Retained Earnings Change
The balance of retained earnings primarily changes due to net income (or net loss) and dividends. Net income, which is the profit a company earns after all expenses and taxes, directly increases the retained earnings balance. Conversely, a net loss, where expenses exceed revenues, will decrease retained earnings.
Dividends paid to shareholders also reduce the retained earnings balance. When a company distributes earnings to its owners, either as cash dividends or stock dividends, it reduces the amount of profit that remains within the business. For example, if a company earns $100,000 in net income and pays out $30,000 in dividends, its retained earnings will increase by $70,000. Other less common adjustments, such as corrections for errors in prior financial periods or certain changes in accounting principles, can also impact retained earnings.
Showing Retained Earnings on Financial Statements
Retained earnings are displayed on a company’s financial reports, primarily within the equity section of the balance sheet. On the balance sheet, it represents the cumulative profits retained by the business since its inception, reflecting the portion of owners’ equity that has been generated through operations rather than direct capital contributions. The ending retained earnings balance from one period becomes the beginning balance for the next, linking financial periods.
Beyond the balance sheet, a more detailed reconciliation of retained earnings is presented in the Statement of Retained Earnings, sometimes referred to as the Statement of Changes in Equity. This statement provides a clear picture of how the retained earnings balance changed over a specific accounting period. It typically begins with the retained earnings balance at the start of the period, adds the net income (or subtracts a net loss) for that period, and then subtracts any dividends paid, arriving at the ending retained earnings balance. This statement helps stakeholders understand how a company utilizes its profits, whether by reinvesting them or distributing them to shareholders.