Where Does Net Income Go on the Balance Sheet?
Learn how a company's profitability from the income statement is accurately reflected on its balance sheet.
Two primary financial statements are the Income Statement and the Balance Sheet. The Income Statement summarizes a company’s revenues and expenses to arrive at net income, which represents profit or loss over a period. While net income does not directly appear on the Balance Sheet, it significantly influences it through owners’ equity.
Net Income and Its Impact
Net income, or net profit, is the financial result when a company’s total revenues exceed its total expenses during an accounting period. This figure indicates profitability and the ability to generate wealth. A positive net income signifies increased financial resources.
Conversely, a net loss occurs when expenses outweigh revenues, indicating reduced financial strength. This profit or loss directly impacts owners’ equity. A profit increases the owners’ stake, while a loss diminishes it.
Retained Earnings: The Bridge
Net income does not transfer directly to the Balance Sheet as a standalone item. Instead, it flows into an equity account known as Retained Earnings. This account represents the accumulation of a company’s net income kept within the business rather than distributed to its shareholders as dividends.
Retained earnings serve as a link between the Income Statement, which shows profitability, and the Balance Sheet, which presents financial position. It acts as a reservoir for past profits, allowing the company to reinvest them or fund future growth.
Calculating Retained Earnings
The calculation of retained earnings starts with the previous period’s balance. To this, the current period’s net income is added, or a net loss is subtracted.
Any dividends paid out to shareholders during the period are then subtracted. Dividends represent a distribution of accumulated profits, reducing the earnings retained by the company. The resulting figure is the ending retained earnings balance for the current period.
Where Retained Earnings Appear
The Retained Earnings account is displayed within the “Shareholders’ Equity” or “Owners’ Equity” section of the Balance Sheet. This section represents the owners’ claim on the company’s assets after all liabilities have been accounted for. Other common accounts found in this section include Common Stock and Additional Paid-in Capital.
The ending balance of retained earnings, derived from the calculation, is the specific amount reported on the Balance Sheet at the end of an accounting period. This highlights how a company’s accumulated profitability contributes directly to its overall equity.
Illustrative Example
Consider a hypothetical company with a beginning retained earnings balance of $50,000. During the year, the company generates a net income of $20,000. The company also distributes $5,000 in dividends.
To determine the ending retained earnings balance, net income is added to the beginning balance, and dividends are subtracted. The calculation is: $50,000 (Beginning Retained Earnings) + $20,000 (Net Income) – $5,000 (Dividends) = $65,000. This $65,000 is reported as Retained Earnings on the Balance Sheet.