Every business owner would want their business to consistently generate profits.
It is a confirmation of his/her efforts and that s/he made the right choice in starting a business.
Isn’t it satisfying to see the thing you worked so hard for finally bear fruit?
But that is just a part of the process.
The next step is to know what to do with what your business has earned.
Are you going to distribute it between you and your co-owners?
Or are you going to reinvest it in your business?
In a corporate setting, it is the management/board of directors that decides what to do with the net income that the corporation earns.
They could decide to either distribute it as dividends to shareholders or to keep all of it for reinvestment.
They can also decide to do a combination of both – distribute some of the net income as dividends while reinvesting the rest.
When a corporation declares and distributes cash dividends, its net assets decrease.
When it declares and distributes stock dividends, its net assets stay as-is.
However, what happens if it decides to not distribute dividends?
What happens to the undistributed net income?
If you’ve come across a corporation’s financial statements, particularly its balance sheet, you’ve probably noticed an account titled “retained earnings”.
This account is where all the undistributed net income goes.
Let’s learn more.
What are Retained Earnings?
Retained earnings refer to the accumulated amount of earnings that the corporation earned minus the total dividends it declared and distributed ever since it was formed.
In other words, when a corporation has any undistributed net income, it goes to its retained earnings.
A newly formed corporation will not have any retained earnings yet.
A corporation can use its retained earnings for various purposes.
For example, it can set aside a portion of it for capital expenses (e.g. planned expansion, purchase of new and improved machinery and equipment, etc.), to pay for debt obligations, or pay for general expenses (e.g. operating expenses, cost of sales).
There is only one way to normally increase retained earnings: by having any undistributed net income.
Retained earnings will decrease if a corporation declares and distributes any form of dividends (be it cash, property, or stocks) and if the corporation had a net loss in any given year.
Of course, any adjusting entries made to retained earnings may increase or decrease its balance depending on the adjustments made.
For example, if your corporation earned a total of $30,000 net income and distributed $10,000 of it as dividends to shareholders, then the remaining $20,000 is retained by the corporation and goes to its retained earnings.
On the other hand, if your corporation reported a net loss of $30,000 instead, then the net loss will decrease its retained earnings balance by the same amount.
If dividends were declared and distributed despite the loss, then the retained earnings will be reduced further by the amount of dividends declared.
Since we’re already talking about computations, this might be the right time to lay down the formula for computing retained earnings:
Retained Earnings = Retained Earnings (beginning balance) + Net Income –Dividends
If a corporation has a positive balance on retained earnings, then that would mean that it’s generally profitable during its existence.
However, if it was reporting losses more than earnings, then the corporation would probably have a negative balance on retained earnings.
Negative retained earnings: what does it mean for a corporation?
If a corporation has negative retained earnings, it’s probably because it either reported more losses than earnings ever since it was formed, it declared dividends greater than its accumulated earnings, or a combination of both.
This negative balance on retained earnings is what we refer to as the accumulated deficit.
A corporation that has an accumulated deficit for consecutive years may indicate that it is going bankrupt.
It could also indicate that the corporation is using its borrowed funds to distribute dividends to its shareholders.
Both are not a picture of a sustainable business.
If your corporation has an accumulated deficit, it’s not advisable to declare any dividends as it will set the corporation back even further.
Instead, earn as much as you can to bring back the balance to a positive, and only then can you think about distributing dividends.
Dividends and Retained Earnings
A corporation (or rather its management/board of directors) will have to decide what to do with its net income: distribute it as dividends to shareholders -or- keep it as retained earnings.
Dividends can be paid in different ways but the two most common ways of dividend payment are in the form of cash (cash dividends) or stocks (stock dividends).
Each affects a corporation’s balance sheet differently.
If a cash dividend is declared and distributed, then the net assets of the corporation decrease.
If a stock dividend is declared and distributed, the net assets do not increase.
What happens instead is a redistribution of equity, from retained earnings to share capital.
Whether a company declares and distributes cash or stock dividends, the end result to retained earnings is still the same -it decreases.
While it may seem that declaring stock dividends may be more advantageous since it doesn’t reduce the corporation’s net assets unlike cash dividends, it does come with its own caveats.
For one, there is a limit to the number of stocks a corporation can issue (authorized share capital).
Another is that it dilutes the value of each share.
For example, if a corporation that has a $15/share value declares a 6% stock dividend, the value of each share would go down to $14.15.
A corporation that is focused on growth would typically retain its earnings rather than declare and distribute dividends.
By having retained earnings, the corporation has another source of funding for its growth.
The corporation can use its retained earnings for expansions, acquisitions, capital expenditures, research and development, or anything else that can facilitate its growth.
Retained earning can also be used as working capital (to fund operating costs and expenses).
There’s also the option to use retained earnings for paying off its debt obligations.
Another purpose of retained earnings is to use them as a shield against future losses.
When a corporation reports a net loss, it eats away at its retained earnings before an accumulated deficit account is recognized.
There are plenty of reasons why a consistently profitable business unexpectedly reports a net loss such as a very huge impairment loss, an expected loss from a lawsuit, or a lesser than favorable result from the sale of a subsidiary.
When a corporation has already established itself where it matures and its growth slows down, then it would have less need for its retained earnings.
As such, an established corporation is more inclined to distribute its net income (and maybe some of its retained earnings) as dividends to its shareholders.
Restricted Retained Earnings
By default, a corporation’s retained earnings can be used for whatever purpose its management/board of directors decides on.
That makes the default retained earnings unrestricted in the sense that it can be used for any purpose (as long as its legal)– declare and distribute dividends, capital expenses, pay for operating costs and expenses, etc.
But did you know that a corporation management/board of directors can restrict some of its retrained earnings for specific purposes?
These retained earnings that are restricted are appropriately called restricted retained earnings (also referred to as appropriated retained earnings… no pun intended).
As the name same suggests, restricted retained earnings refer to the portion of retained earnings that is restricted for a specific purpose.
What the purpose is would depend on what the corporation’s management/board of directors decides.
It could be because a creditor required the corporation to restrict some of its retained earnings for the repayment of loans.
It could also be because the law required the corporation to restrict some of its retained earnings when it repurchases its outstanding shares (treasury stock).
If a corporation has a high amount of restricted retained earnings, it might signify that it is planning for major growth (by expanding or acquiring capital assets).
It could also signify that it is planning to pay off a huge debt.
Restrictions on retained earnings can be classified into three classifications: legal, contractual, and discretionary.
Legal restrictions are those that are required by law. For example, state laws may require a corporation to restrict a portion of its retained earnings equal to the cost of its treasury stock.
Contractual restrictions are those that arise from contracts. For example, before a creditor grants you a loan, they might require your corporation to restrict a portion of your retained earnings. Unlike unrestricted retained earnings, restricted retained earnings cannot be used for the distribution of dividends (unless it is its stated purpose). This way, the creditor is more assured that the corporation would likely have funds to pay off the loan.
Discretionary restrictions are those decided upon by the corporation’s management/board of directors. For example, if there is a planned expansion, the board of directors may decide to restrict a portion of its retained earnings to fund the expansion.
If a corporation has to recognize restricted retained earnings, the journal would be like:
For example, if a corporation’s board of directors decided to restrict $30,000 of its retained earnings for a plant expansion, the journal entry would be like this:
In the event of liquidation or bankruptcy, the whole amount of retained earnings would be used to settle the financial obligations of the corporation (creditors first, then shareholders next).
That means that both restricted and unrestricted retained earnings would be used.
Retained Earnings VS Revenue
While both retained earnings and revenue both provide us insights into a company’s financial performance, they are not the same thing.
For starters, retained earnings is a balance sheet item while revenue is an income statement item, so you won’t be seeing the two in the same financial statement.
Revenue refers to the sales made by a business and is the first line item you’ll see in an income statement.
It is the income generated by a business before deducting the cost of sales, operating expenses, and non-operating expenses.
On the other hand, retained earnings refer to the accumulated earnings (or more like net income and losses) of the business from the day it was formed, minus total dividends declared and distributed. Retained earnings are more related to a business’s net income rather than its revenue.
Revenue gives us insight into a business’s financial performance for a given period.
Retained earnings give us insight into a business’s historical financial performance… to an extent that is.
If a corporation has a positive balance on retained earnings, you can tell that it has been profitable for at least one period.
Frequently Asked Questions
Is a corporation required to have Retained Earnings?
There really is no law that requires a corporation to have retained earnings.
A corporation’s management/board of directors can decide to declare and distribute all of its earnings as dividends, and it still wouldn’t be violating any laws.
So short answer: no, a corporation is not required to have retained earnings.
Do Sole-Proprietorships, Partnerships, and LLC have Retained Earnings?
The term “retained earnings” is exclusive to corporations.
A sole-proprietorship does not maintain a retained earnings account but rather all of its retained earnings go to its owner’s equity.
It’s the same with a partnership, although it uses the account title “partner’s equity” instead of owner’s equity.
For LLCs, it’s the “members’ equity” (unless the LLC is treated as a corporation).
In short, corporations have “retained earnings”, sole-proprietorships have “owner’s equity”, partnerships have “partners’ equity”, and LLCs have “members’ equity”.
Are Retained Earnings an asset?
No, retained earnings are not an asset but rather an equity account.
They can be used to purchase assets such as capital assets (e.g. machinery, equipment, building, etc.), inventory, or other assets.
Statement of Retained Earnings
The statement of retained earnings (also referred to as retained earnings statement) is a type of financial statement.
It gives us information regarding any changes to a corporation’s retained earnings in a given period.
It provides us the corporation’s beginning and ending balance of retained earnings, and any reconciling items (e.g. net income or loss, dividends, any adjustments made to retained earnings, etc).
The statement of retained earnings may also be incorporated in a corporation’s statement of shareholder’s equity which shows the changes to all equity accounts (including retained earnings) for a given period.
An example of such a financial statement is as follows:
Source: Intel Corporation 10-K
Along with the three main financial statements (balance sheet, income statement, and cash flow statement), a statement of retained earnings (or statement of shareholder’s equity) will be required for all audited financial statements.
Banks and other creditors will typically require a corporation’s audited financial statements (including a statement of retained earnings) before they would grant a loan.
Investors would want to look at a corporation’s financial statements before they invest their money in it.
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Santa Clara University "How to Calculate and Manage Retained Earnings" Page 1. November 2, 2021
Brigham Young University "Income, Retained Earnings Statement, Balance Sheet Part 1" Video. November 2, 2021
Columbia Business School "9 Chapter 1: Review of Financial Reporting" White paper. November 2, 2021