A market economy is always characterized by the competitive relationships of various enterprises with each other. In the financial statements, the most crucial factor is profit. The work efficiency of a business entity reflects its positive dynamics in comparison with other economic features. This can be seen and analyzed with the help of its financial statements, namely the balance sheet, profit and loss statement, statement of retained earnings, and cash flow statement.
In the future, the development will be affected by the correct distribution of profits, which has been preserved for use by the owners of the company. Resolving this issue, management will set goals and plans for at least the coming year. These goals are likely to be fully or at least partially financed by the accumulated earnings. In this article, you will not only learn where retained earnings come from and how they are used but also learn retained earnings equation and how to use it to calculate retained earnings.
What is Retained Earnings?
When a company’s operations bring a profit, the Board of Directors can manage it in two ways:
- Income is reinvested in the company with the hope of making even more profit and, consequently, increasing the stock price.
- Payment of part of the profit to shareholders in the form of dividends. The board can also buy back part of the company’s shares from the market, which is also beneficial for shareholders.
Often during the meeting of shareholders, it is decided to leave part of the profit at the disposal of the enterprise instead of spending it on dividend payments. Retained earnings are the amount of net income that is dispersed among stockholders as dividends. This profit remaining at the disposal of the enterprise is spent on its development and increase of working capital.
Only owners of an enterprise can manage retained profits. The decision on the distribution of income or loss is made by its owners, drawn up by the protocol following the results of the general meeting of shareholders or participants.
The total retained earnings is a balance of accumulated net profit for all the past reporting years that the company operated. From the balance sheet, they translate into an annual increase (or decrease with a net loss) in the stockholder’s equity. A growth with credit entries and decrease, showing a loss, with debit entries will be shown in the retained earnings account.
Retained earnings account, as a business’ own source of financing, can grow annually and ensure business development. The main areas of retained earnings distribution are:
- Dividend payments;
- Elimination of past losses;
- Increase of reserve and working capital;
- Acquisition of assets;
- Other activities associated with development and growth.
Retained earnings equation
The result from the sale and/or provision of services may be positive or negative. Since net income is part of the retained earnings equation, this fact is taken into account. As you can see in the retained earnings formula below, one either adds the profit or subtracts the loss. As mentioned earlier, damages are mainly covered with accumulated benefit for previous years or the reserve fund.
RE = Beginning period RE + Net Income (Loss) – Cash Dividends − Stock Dividends
Let’s put the retained earnings formula above to practice with the help of the data from the financial statements above. We will assume that the company just started operating, so it does not have any retained earnings. If the company has been working for some time, the beginning retained earnings could have been taken from the previous year’s retained earnings statement or balance sheet. So, we input $0 for the beginning retained earnings.
RE = 0 + Net Income (or – Loss) – C – S
Since the company did not have any accumulated profits for the previous year, no adjustments are needed for the beginning value. Otherwise, if there were any errors that could affect retained earnings reported earlier, corrections should be made now. Thus, we can proceed to the next step and take net income value from the current period’s Income Statement. As you can see, in our example, the company made a profit, and it is equal to $2,860. Let’s add it to our formula.
RE = 0 + 2,860 – C – S
Now, all we have left to do is subtract any dividends paid. In our case, $500 was paid in cash dividends.
RE = 0 + 2,860 – 500
RE = $ 2,360
The total amount of accumulated earnings, which is equal to $2,360, will be the final number in the retained earnings statement and will also be included in the balance sheet financial statement. Next year, this company will use it as the beginning retained earnings in its calculations. As you can see, if you have all the data on hand, calculating the retained earnings and even creating a statement of retained earnings is easier than it might seem.
What Increases and Decreases Retained Earnings?
As you can see from the retained earnings formula, there are many items affect retained earnings. These are the net income and dividends. Below we want to review what goes into each piece and whether a particular situation or action increases or decreases the retained earnings. We also include adjustments to the beginning retained earnings because this item is also part of the retained earnings calculation.
The primary source of capital gains is net income (profit). Based on it, the owners determine the dividend and investment policy, subsequently carried out by the company taking into account the prospects for its development. This indicator depends on the amount of revenue from sales, the costs, the financial results of business activities, the amount of income tax, and other mandatory payments and expenses.
Net income is calculated as a difference between all income and total expenses. The so-called “extraordinary” income and fees are also included in this calculation. These include revenues or costs associated with the occurrence of emergencies (fire, flood). The resulting number may be positive. Then, the result is recorded as net profit and can, in turn, increase the number of accumulated profits. When the total expenses exceed income, the difference becomes negative. Then, the result is recorded as a net loss and retained earnings decrease.
Dividends are a part of the company’s profit distributed among shareholders by the number and type of shares held by them. The procedure for paying dividends is determined by the Board of Directors of the company. Typically, dividends on shares are paid once a year based on the company’s performance for the previous year. Dividends are usually paid in cash or additionally issued shares/stocks.
To pay dividends, the company must receive a net profit, which will be distributed among shareholders. Whether it will be distributed and how much is decided by the company’s management and shareholders.
It should be borne in mind that dividends are not always paid on all shares, and their size may vary depending on the type of securities. There are preferred and common shares. Preferred shares owners can rely on dividends on a priority basis, and often at a higher rate, but are denied the right to vote at meetings of shareholders. Holders of common shares can also count on dividends, albeit to a lesser extent, but they have the right to vote.
- Cash dividends
Cash dividends are one of the most common forms of payment. Dividends are paid at the expense of net profit after tax, and the amount of fees is determined at the general meeting of shareholders and cannot exceed the amount recommended by the Board of Directors.
- Stock dividends
The payment of stock dividends implies that shareholders, instead of money, receive additional shares of the company. Profits in the shares form are paid by distributing the other issue of shares among existing investors. For example, if an investor owns 1,000 shares, then with a declared 15% dividend on stocks, he will receive 150 additional shares of the company.
At the same time, the nominal value of the shares will not change, but their number in circulation will increase. As a result of the increase in the total number of shares, such indicators as earnings per share, dividend per share, will decrease. The payment of significant dividends in the form of shares is undesirable since it can adversely affect their price. For shareholders, receiving dividends in the form of shares may be attractive due to the ability to transfer the earned profit into cash. This form of payment is much less common than cash dividends.
The reasons for using this form may be different:
- The company is overgrowing, and it needs funds for development, so a decision is made to pay dividends through an additional issue of shares, which will save cash flows to maintain growth;
- The financial position of the company is unstable, and there are problems with cash, so the company issues shares and pays them in the form of dividends to shareholders;
- Dividends are paid in the way of shares to stimulate and encourage the management of the company.
Liabilities and assets of the company will stay unchanged when using this method since there is no distribution of funds. The payment of dividends using the stock dividend method only leads to a change in the capital structure. This dividend payment method does not affect the total amount of equity.
Prior period adjustments
Net income and financial position can change significantly due to changes in accounting principles, for example, changes in methods for estimating inventories or depreciation. This, in turn, will affect the beginning value of the accumulated earnings. Any intentional or unintentional error in any item on the income statement or dividend payments for the previous period will need to be taken into account. An adjusting entry will need to be made in the case when net income stated in the earlier retained earnings statement has changed no matter what the reason is.
Retained earnings for external users
Retained earnings are essential not only to the shareholders (owners) of the company but also to external users (investors, creditors, regulatory authorities). Investors are interested in the moment where this indicator is spent. It can be paid:
- on payment of dividends to shareholders;
- to cover losses from past periods of the company;
- to inject investment flows into the development of the company (for example the acquisition of fixed assets, equipment, etc.);
- to increase the authorized capital;
- to create a reserve fund;
- for other purposes established by the law.
If a loss is received, then it can be covered with the following sources:
- at the expense of shareholders own funds;
- the profit from the past periods of the company (retained earnings);
- the use (reduction) of the authorized capital;
- the purpose (decrease) of the reserve fund.
Investors are interested in seeing the profit not being spent mostly on paying dividends but on the investment activities of the company. But it is also essential for them to that the benefit received before dividends distribution increases every year rather than decreases. Retained earnings, in turn, will also be increasing.