Consider the accounting equation again: Assets = Liabilities + Equity. If a company is profitable, then the assets will grow relative to the liabilities (for example: the company’s bank account increases, or the company invests in new products/markets, or debt is repaid). If the company retains the profit within the firm (as opposed to paying it out as a dividend), equity will also increase (as there is no claim of others on profits; profits do not increase liabilities) with the amount of profits withheld in the firm.
The statement of retained earnings shows the breakdown of retained earnings. Net income for the year is added to the beginning of year balance, and dividends are subtracted. This results in the end of year balance for retained earnings.
Remember that expenses, revenues and dividends impact retained earnings. Since net income equals revenues minus expenses, we need to include dividends when computing end of period retained earnings. I.e., end of period retained earnings equals beginning of period retained earnings, plus net income and minus dividends.
Statement of Retained Earnings Example
The statement of retained earnings for the sample firm ABCD Inc. used in this lesson is as follows:
The information about retained earnings can also be included in a broader statement, where additional information is presented. Consider for example the statement of owner’s equity of Google end of 2008, which presents the changes in the different parts of equity, including retained earnings. The changes in retained earnings are presented in the 2nd column from the right. As Google has a policy of not paying any dividend, retained earnings is increasing in net income while no dividends have been subtracted. At the end of 2008, cumulative retained profits amount to $13.6 billion.
A sole proprietorship is a business owned and ran by a single individual with no separate legal entity for the business as opposed to for example a corporation. While the accounting is practically the same, some differences exist.
For a corporation, the profits that are retained in the company are separately recorded from the amount received when the shares were issued. For sole proprietorships this distinction is not made, both items are added and presented as ‘capital’.
In addition, profit distributions are named differently. For corporations, a profit distribution is called a dividend and subtracted from retained earnings. For a sole proprietorship such a distribution is called a withdrawal, which is subtracted from capital, since retained earnings is not separately recorded for these companies.
Retained Earnings Statement Explained
– the equality of the accounting equation (Assets = Liabilities + Equity) implies that when assets increase with profitable transactions, equity also must increase
– by adding net income to retained earnings, the balance sheet remains balanced
– retained earnings equals all past earnings which have not been paid out as a dividend, in other words, retained earnings increases with net income and decreases with dividends
– the information in this statement is often included in the statement of owner’s equity which also shows changes in other components of equity
– for sole proprietorships, a profit distribution is called a withdrawal; also paid-in capital and retained earnings are not separately shown, but added and presented as ‘capital’