Where Do Retained Earnings Go on the Income Statement?

The income statement and retained earnings are fundamental components of a company’s financial reporting. The income statement summarizes a company’s financial performance over a specific period, detailing revenues and expenses. Retained earnings represent the accumulated profits of a company not distributed to shareholders. These two financial concepts are intricately linked, often leading to questions about their relationship and reporting.

Understanding the Income Statement

The income statement, also known as the profit and loss (P&L) statement, provides a clear picture of a company’s financial performance over a defined period. Its primary purpose is to show whether a company generated a profit or incurred a loss during that time. This financial document illustrates the economic activity that occurred over the reporting period.

Key components of the income statement include revenues, which are total sales from goods or services, and various expenses. After accounting for all revenues and subtracting all expenses, the income statement culminates in net income or net loss. This “bottom line” indicates the company’s profitability and is a metric for investors and management alike.

Understanding Retained Earnings

Retained earnings represent the portion of a company’s cumulative net income that has been kept within the business rather than being paid out as dividends to shareholders. These are accumulated profits that a company chooses to reinvest in its operations. Unlike the income statement, which covers a period, retained earnings are a “stock” figure, reflecting a cumulative balance at a specific point in time.

Retained earnings are a component of shareholders’ equity and are reported on the balance sheet, not the income statement. They signify the company’s historical profitability that has been reinvested, contributing to the overall equity of the business.

The Connection Between Income Statement and Retained Earnings

While retained earnings do not directly appear on the income statement, the two financial statements are closely linked through the net income figure. The net income (or net loss) calculated on the income statement for a specific period is directly transferred to the retained earnings account. A positive net income increases the retained earnings balance, signifying an addition to the company’s accumulated profits. Conversely, a net loss reduces retained earnings.

This connection highlights a core aspect of the accounting cycle, where temporary accounts from the income statement are closed out at the end of an accounting period. The balance of these temporary accounts, representing the period’s net income or loss, is then moved to the permanent retained earnings account on the balance sheet. Additionally, any dividends paid to shareholders during the period also reduce the retained earnings balance, as these are distributions of profit.

The Retained Earnings Statement

To illustrate the changes in retained earnings from one period to the next, companies prepare a separate financial statement known as the Retained Earnings Statement. This statement serves as a bridge, explicitly showing how the income statement’s result impacts the balance sheet’s retained earnings figure.

The Retained Earnings Statement provides a concise summary of the changes in a company’s accumulated earnings over a specific accounting period. It starts with the retained earnings balance from the beginning of the period. It then adds the net income (or subtracts the net loss) derived directly from the income statement, as this represents the profit generated that is available for retention.

From this subtotal, any dividends paid out to shareholders during the period are subtracted. Dividends are distributions of profits and thus reduce the amount of earnings retained by the company. The final result is the ending retained earnings balance, which is then carried over and reported in the shareholders’ equity section of the balance sheet for that period. This statement effectively reconciles the profitability shown on the income statement with the accumulated earnings reported on the balance sheet.