Retained Earnings

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Retained Earnings?

A statement of retained earnings is a financial statement that shows how the retained earnings have changed during the financial period and provide details of the beginning balance of retained earnings, ending balance, and other information required for reconciliation. These funds can be used towards the development of the company such as research and development or infrastructure development.

statement of retained earnings

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Source: Retained Earnings (wallstreetmojo.com)

They are reported as shareholders’ equity in the balance sheet as they are considered a type of equity. Although they are not assets per se, they can be used to purchase inventory or other investments. On the contrary, they can also be accounted purely as liabilities if the profits are to be divided and distributed among shareholders as dividends.

Retained Earnings Explained

Retained earnings are the amount the company has accumulated over the years from the net income after paying dividends to the shareholders. Retained earnings statement provides details of the earnings, net income, dividend aid, and the ending balance of the it. Below are few pointers that explain how the retained earnings calculation helps and organization, its investors, and how it acts as an indicator of the company’s financial health.

  • Retained earnings are part of the net income retained by the company after dividend payments to the shareholders. Retained earnings are also called ‘retained surplus’ or ‘accumulated earnings.
  • A company retains a part of its net profit earned in the financial year for future growth, which could be by launching new products, R&D investments, acquiring other businesses, or paying off its debt.

Explanation of Retained Earnings in Video

 

Formula

The formula for retained earnings calculation is as follows:

retained earnnings formula

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How to Calculate?

The retained earnings calculation consists of various steps and involving different departments and stakeholders of the organization. Let us understand the step-by-step process through the discussion below.

Steps of Statement of Retained Earnings

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Below are the steps to prepare statement of retained earnings –

  1. Headings

    Its’ heading comprises three lines:

    – Name of the Company
    – The second line gives the ‘Statement of retained earnings.’
    – The third line represents the financial year for the retained earnings numbers that have been prepared, i.e., ‘Financial Year Ended 2018’ etc.

  2. Retained Earnings Balance from the Previous Year

    The first entry on the statement is the previous year’s carried-over balance. This entry can be taken from the previous year’s balance sheet or the ending balance of the previous year’s retained earnings. This is also called the beginning of retained earnings.

    Let us consider the previous years retained earnings balance or the beginning retained earnings of a Company ABC Inc. is $ 500000.

    Thus, the first entry will be:

    Retained Earnings for the year ended 2017: $ 50000

  3. Net Income Addition

    Net income is added to the income statement. It comes as the second entry to the retained earnings. Therefore, to record net income in the statement, the company should prepare the income statement first and then the retained earnings statement.

    Let’s assume the Company ABC Inc. had a net income of $ 100000.

    Thus, it will be

    Retained Earnings for the year ended 2017: $ 500000
    Plus, Net Income 2018: $ 100000
    Total: $ 600000

  4. Subtract Dividend Payments

    A dividend is any payment made by the company to its shareholders. It is subtracted from the net income for the year, as the remaining part is the retained earnings for that year. For example, let us say the Company ABC Inc. paid a dividend of $ 50000 to the shareholders.

    Thus, it is:

    – Retained Earnings for the year ended 2017: $ 500000
    – Plus, Net Income 2018: $ 100000
    – Total: $ 600000
    – Minus: Dividend $ 50000

  5. Ending Retained Earnings

    After subtracting the dividend from the net income, we arrive at the ending retained earnings, which becomes the last entry to this statement.

    – Retained Earnings for the year ended 2017: $ 500000
    – Plus, Net Income 2018: $ 100000
    – Total: $ 600000
    – Minus: Dividend $ 50000
    – Ending retained earnings: $ 550000

    Thus, the above entries are shown on the Statement of Retained Earnings.

  6. Additional Information

    Although this statement is pretty straightforward, additional information can be provided in the footnotes to the statement. This additional information can provide details about the stock purchase, new issuance of stock or rights issue, etc. All these corporate actions affect the dividend payment. Hence additional information can be provided to the investors.

Examples

Let us understand how retained income statement is useful for an organization and what it indicated about the financial health of the organization through a couple of examples.

Example #1

Let us summarize the above example and prepare the Statement of Retained Earnings for the Company ABC Inc. The beginning retained earnings of the Company ABC Inc. is $ 500000, the company had a net income of $ 100000 and paid a dividend of $ 50000 to the shareholders.

The Statement at the end of the financial year is as below:

Example #2

The below snapshot shows the Consolidated shareholder’s equity statement for Apple Inc. for the year ended 2018.

Statement of Retained Earnings Example 1

source: Apple SEC Filings

All figures below are in thousands.

Apple’s Retained Earnings in FY2016 = $92,284 +  $45,687 – $12,188 – $29,000 -$419 = $96,364

Relevance and Uses

The retained earnings statement is very helpful to investors. Investors who have invested in a Company gain either from dividend payments or the share price increase. A mature firm is expected to pay a regular dividend. In contrast, a growing Company is expected to retain the income and invest in future business, thus expecting an increase in the share price.

Hence, it helps investors in both ways:

  • It shows dividend payments to the investors or helps them predict future dividends based on the earnings.
  • From retained earnings, the investors can analyze how much money is reinvested in the business, which may lead to a future increase in the share price.

Also, it can be used by investors to compare companies in similar kinds of business. However, it is not always prudent to compare two Companies only based on the retained earnings as retained earnings depend on various factors like the company’s age, dividend policy, and the business’s nature, thus affecting the dividend policyDividend PolicyDividend policy is the policy that the company adopts for paying out the dividends to the company's shareholders, which includes the percentage of the amount at which the dividend is to be paid out to the stockholders and how frequent the company pays the dividend amount.read more of the Company, and the nature of the business, thus affecting the profitability of the Company.

This article has been a guide to what are Retained Earnings. Here we explain its formula, how to calculate, examples, relevance, and uses in detail. You may learn more about accounting from the following articles –

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