Why Is Retained Earnings a Credit?
Understand why retained earnings, a key component of a company's financial standing, consistently carries a credit balance.
Retained earnings represent the portion of a company’s accumulated net income not distributed to shareholders as dividends. It serves as an internal source of financing, often reinvested to support growth, pay down debt, or fund future operations. Understanding retained earnings is important for assessing a company’s financial health and capacity for future investment. This article explains why retained earnings carry a credit balance on financial statements.
The Accounting Equation and Equity
The foundation of financial accounting rests on the accounting equation: Assets = Liabilities + Equity. Assets are what a company owns, such as cash, inventory, and equipment. Liabilities are what it owes to others, like accounts payable or loans. Equity represents the owners’ residual claim on the company’s assets after all liabilities have been satisfied.
In the double-entry accounting system, every transaction affects at least two accounts, with debits always equaling credits. For asset accounts, a debit increases the balance, and a credit decreases it. Conversely, for liability and equity accounts, a credit increases the balance, and a debit decreases it. Since retained earnings is a component of the equity section, any increase in retained earnings is recorded as a credit, aligning with the rules for all equity accounts.
How Retained Earnings Accumulate
Building on the understanding of equity accounts, retained earnings primarily accumulate through a company’s profitability. When a business generates net income (revenue minus expenses), this profit increases the owners’ claim on the company’s assets. Because net income directly boosts equity, the amount earned during an accounting period is transferred to the retained earnings account as a credit, increasing its balance.
Conversely, when a company distributes profits to shareholders as dividends, this action reduces the owners’ claim on the company’s assets. These dividend distributions are recorded as a debit to retained earnings, counteracting credits from net income. Accumulated net income credits generally exceed dividend debits over time, resulting in a positive, accumulating credit balance.
Balance Sheet Presentation
On the balance sheet, retained earnings is presented within the shareholders’ equity section. This section, along with liabilities, makes up the right-hand side of the balance sheet, representing the sources of financing for the company’s assets.
The placement of retained earnings on the credit side of the balance sheet visually signifies its role as a funding source for the company’s assets. It indicates that a portion of the company’s assets has been financed through accumulated profits kept within the business rather than distributed. This presentation aligns with its credit balance, reflecting an increase in the owners’ stake in the company.