What are retained earnings? How does its balance change?

Retained earnings represent cumulative net income retained in the business (not distributed as dividends). It increases with net income and decreases with net losses and dividends.

What are Retained Earnings?

Retained earnings represent the cumulative amount of a company's net income that has been kept (retained) in the business rather than distributed to shareholders as dividends.

Key Points:

Part of shareholders' equity on the balance sheet
Cumulative total of all profits kept since company started
Source of internal financing for growth and operations
Not the same as cash - it's an accounting concept

Basic Formula:

Ending Retained Earnings = Beginning Retained Earnings + Net Income - Dividends

How Retained Earnings Balance Changes

Increases (Additions to Retained Earnings):

Net Income: When company makes profit
- Added to retained earnings at year-end
- Example: Net income of $500,000 increases RE by $500,000
Prior Period Adjustments: Corrections of previous accounting errors
- Added if previous income was understated
- Rare occurrence

Decreases (Deductions from Retained Earnings):

Net Loss: When company loses money
- Subtracted from retained earnings
- Example: Net loss of $200,000 decreases RE by $200,000
Dividends: Payments to shareholders
- Cash Dividends: Reduce RE when declared
- Stock Dividends: Transfer from RE to share capital

Example Calculation:

Beginning Retained Earnings: $1,000,000
Add: Net Income for the year: $300,000
Less: Cash dividends paid: ($100,000)
Less: Stock dividends declared: ($50,000)
Ending Retained Earnings: $1,150,000

Accounting Journal Entries

Closing Net Income to Retained Earnings:

At year-end, close income statement accounts:

Close revenues and expenses to Income Summary
Close Income Summary to Retained Earnings:
- If profit: Dr Income Summary, Cr Retained Earnings
- If loss: Dr Retained Earnings, Cr Income Summary

Recording Dividends:

Cash Dividend Declaration:

Dr Retained Earnings
Cr Dividends Payable

Stock Dividend Declaration:

Dr Retained Earnings
Cr Common Stock (and Additional Paid-in Capital if applicable)

Special Situations:

Negative Retained Earnings: Called "accumulated deficit" - occurs when cumulative losses exceed cumulative profits
Legal Restrictions: Some jurisdictions restrict dividend payments if RE is negative or below certain level
Appropriated Retained Earnings: Portion set aside for specific purposes (shown separately)

Important Notes:

Retained earnings ≠ Cash (company can have high RE but low cash)
Dividends reduce RE but are not expenses (not on income statement)
RE changes are shown in Statement of Changes in Equity
Beginning RE comes from previous period's ending RE