What is a Statement of Retained Earnings?

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Definition:

A statement of retained earnings is part of a company’s financial statement, which explains any change in retained earnings during an accounting period.

🤔 Understanding statements of retained earnings

A statement of retained earnings is a disclosure to shareholders regarding any change in the amount of funds a company has in reserve during the accounting period. Retained earnings are part of shareholder equity (assets minus liabilities), which appear on the company’s balance sheet (the financial statement that lists assets and liabilities). Retained earnings increase if the company generates a positive net income (revenues are greater than expenses) during the period, and the company elects to retain rather than distribute those earnings. Retained earnings decrease if the company experiences an operating loss — or if it allocates more in dividends (distributions to shareholders) than its net income for the accounting period.

Example

Proctor and Gamble (an American corporation) reported sales of $67.7B during 2019. After subtracting operating expenses, there was $5.5B left. Once accounting for non-operating income and expenses and subtracting taxes, the company showed a net income of $3.9B. In 2019, Proctor and Gamble distributed $7.3B to owners of common stock as a dividend. The statement of retained earnings shows that the balance of the retained earnings went from $98.6B at the beginning of the year to $94.9B at the end of the year. The reduction of $3.7B mostly came from paying more out in dividends than the company generated in net income.

Takeaway

A statement of retained earnings is like a bank statement for a savings account…

If you look at the bank statement for your savings account, it explains how your balance changed during the month. It shows all of the deposits (net income) and withdraws (dividends) that occurred during the month. Taking the balance at the beginning of the month, adding the deposits, and subtracting the withdraws would result in the balance at the end of the month.

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What is a Statement of Retained Earnings?

In corporate finance, a statement of retained earnings explains changes in the retained earnings balance between accounting periods. Retained earnings appear on the company’s balance sheet, located under the shareholder equity (aka stockholders' equity or owner equity) section. Businesses may report changes in retained earnings as part of a consolidated statement of shareholder equity, or as a separate statement of retained earnings. In some situations, the company might not directly explain changes in retained earnings. However, the information to understand how the retained earnings balance changed is available within the financial statements.

What is included in a statement of retained earnings?

A statement of retained earnings should include the net income (aka net earnings or net profit) from the income statement (aka earnings statement) and any dividend payments. Dividend payments can come in several forms. Typically, this category contains cash dividends to owners of common stock, but would also include any stock dividends. The statement of retained earnings also consists of any outflows to owners of preferred stock and some impacts from changes in employee stock and stock option plans.

What is the difference between retained earnings and net income?

Net income that isn’t distributed to shareholders becomes retained earnings. Net income is the money a company makes that exceeds the costs of doing business during the accounting period. The net income calculation shows up on the company’s income statement. It starts with all of the revenue the company generates. It then subtracts the cost of goods sold (how much the company paid for the things that go into its products), selling, general, and administrative (SG&A) expenses, taxes, and a few other accounting deductions. The result is the earnings of the company over the specified period of time.

Net income is money the company can use as reinvestment in growth activities, to pay down debt, or to hold in reserve for future expenses. Otherwise, it can choose to distribute those earnings to its owners, which is called paying a dividend. The company retains any earnings that are not distributed to owners for future use or dividend payments. Therefore, the following retained earnings formula shows the relationship between net income and retained earnings:

Change in Retained Earnings = Net Income – Dividends

Retained earnings carry forward each accounting period. Therefore, the retained earnings value on the balance sheet is a running total of additional gains minus dividends. The difference between the beginning balance and the ending balance indicates the change in retained earnings during the accounting period.

What does it mean to have negative retained earnings?

Retained earnings can be less than zero during an accounting period — If dividend payments are greater than profits, or profits are negative. Retained earnings during a month, quarter, or year is the revenue the company collected beyond its expenses, which it did not distribute to owners. It is possible for a company not to raise enough revenues to cover its costs. In that case, the company operated at a net loss rather than a net profit for the accounting period. That loss, which is a negative profit, would translate to negative retained earnings.

The other way retained earnings can be negative comes from the fact that earnings retained from a previous accounting period can be paid as dividends in the current period. Therefore, dividend payouts can exceed profits, resulting in negative retained earnings for the period.

Is retained earnings a debit or a credit?

Retained earnings are listed on the balance sheet under shareholder equity, making it a credit account. Therefore, an increase in retained earnings is a credit entry. The concept of debits and credits is different in accounting than the way those words get used in everyday life. In accounting, debits and credits are references to the side of the ledger on which an entry gets made. Debit means the left side; credit means the right side.

Every entry in the ledger must have balanced entries of each side — a process called double-entry accounting. Retained earnings increase when the company earns a profit during the accounting period. Those profits increase the amount of cash a company has at its disposal.

Because profits belong to the owners, retained earnings increase the amount of equity the owners have in the business. Shareholders’ equity is on the right side of the balance sheet. Adding value on the right side is a credit transaction.

How do you calculate retained earnings?

Retained earnings are profits that are not distributed. Therefore, calculating retained earnings during an accounting period is simply the difference between net income and dividends.

Change in Retained Earnings = Net Income – Dividends

Those profits belong to the owners of the business. They just haven’t been paid out yet. That is why the retained earnings account shows up under the owner's equity on the balance sheet. It is the running balance of undistributed profits. Total shareholder equity is easy to find. It’s what is left if you use the company’s assets to pay off all of the company's liabilities.

Shareholder Equity = Total Assets – Total Liabilities

But not all of the shareholder’s equity is made up of profits that haven’t been distributed. There is also money that investors paid for their stake in the first place. Those initial investments are called paid-in capital. But the company may buy-back some of those shares, which reduces the value of paid-in capital. Any such stock buy-backs might show up as a negative number on the balance sheet in an account called treasury stock.

Finally, there may be some accumulated gains or losses from parts of the business that don’t show up in the retained earnings account. If you had all of this other information, you could calculate a pretty good estimate of the retained earnings balance.

Retained Earnings = Assets – Liability – Paid-In Capital + Treasury Stock – Other Accumulated Income/(Loss)

How do you prepare a statement of retained earnings?

A statement of retained earnings has five sections.

On the top line, the beginning period balance of retained earnings appears. This number carries directly from the ending balance of retained earning on the balance sheet of the preceding accounting period.

Next, any adjustments to correct the prior balance must be made. These adjustments could correct errors or rectify incorrect estimates that were used in the preceding accounting period.

Then, the net income from the current year income statement gets carried over to the statement of retained earnings. If the company was profitable, it appears as an addition. If the business suffered a loss, a negative value shows up as net income.

Fourth, the amount of dividends are reported as subtractions. There may be several lines to detail the form of dividends that are paid. Finally, the last line will show the end-of-period balance of the retained earnings account. The statement of retained earnings is the fourth part of a company’s financial statements. It ties the income statement to the balance sheet. The net income from the income statement appears on the statement of retained earnings. Then, the ending balance of retained earnings appears on the balance sheet under the shareholders' equity section.

However, the statement of retained earnings could be considered the most junior of all the statements. Much of the information on the statement of retained earnings can be inferred from the other statements. Some companies may not provide the statement of retained earnings except for in its audited financial statement package.

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