Retained earnings reflect the amount of net income a business has left over after dividends have been paid to shareholders. Anything that affects net income, such as operating expenses, depreciation, and cost of goods sold, will affect the statement of retained earnings.
Retained earnings can be used to pay additional dividends, finance business growth, invest in a new product line, or even pay back a loan. Most companies with a healthy retained earnings balance will try to strike the right combination of making shareholders happy while also financing business growth.
Overview: What are retained earnings?
Retained earnings are part of the profit that your business earns that is retained for future use. In publicly held companies, retained earnings reflects the profit a business has earned that has not been distributed to shareholders.
Retained earnings can be used for a variety of purposes and are derived from a company’s net income. Any time a company has net income, the retained earnings account will increase, while a net loss will decrease the amount of retained earnings.
For those recording accounting transactions in manual ledgers, you should be sure closing entries have been completed in order to properly calculate retained earnings. Those using accounting software will have their retained earnings balance calculated without the need for additional journal entries.
Keep in mind that if your company experiences a net loss, you may also have a negative retained earnings balance, depending on the beginning balance used when creating the retained earnings statement.
Along with an income statement/profit and loss statement, balance sheet, and statement of cash flows, a statement of retained earnings is required for all audited financial statements, which are typically required by banks, financial institutions, lenders, as well as public companies.
How to prepare a retained earnings statement
In order to prepare a retained earnings statement, you or your bookkeeper should use the retained earnings formula:
Beginning Retained Earning + Net Income/Loss – Dividends Paid = Retained Earnings
Here are the steps you should follow in order to create a retained earnings statement:
Step 1: Obtain the beginning retained earnings balance
You’ll need to access the beginning balance of retained earnings. This information is usually found on the previous year’s balance sheet as an ending balance.
Tips for obtaining the opening balance
The best way to obtain your opening balance is to have access to the correct financial statements. These include:
Step 2: Add net income/loss total from income statement
The next step in preparing your retained earnings statement is to calculate your net income or loss for the year.
Tips for locating net income/loss
Here are a few tips to ensure accuracy when adding your net income or loss:
Step 3: Subtract dividends
This is an easy step. If your business currently pays shareholder dividends, you simply need to subtract them from your net income. If you don’t pay dividends, you can skip this step.
Tips for subtracting dividends
- Skip this step if you don’t have investors: Only businesses that currently have shareholders or investors need to worry about Step 3. All other businesses can ignore it.
- Determine how you want to pay dividends: If you do pay shareholders dividends, you can pay them based on retained earnings or by using a percentage of income. Either way, anytime you pay dividends, the amount will have to be deducted from your net income to determine your retained earnings.
Step 4: Calculate your year-end retained earnings balance
This is the final step, which will also be used as your beginning balance when calculating next year’s retained earnings.
Tips for calculating your retained earnings
Here are a few tips for calculating you retained earnings for the year:
- Follow the formula: Take your beginning balance, add your net income, subtract any dividends paid, and you’ll have your retained earnings for the year.
- Create your retained earnings statement: Below is an example of a retained earnings statement.
For example, Midway Writing had a retained earnings balance of $27,500 on their balance sheet as of December 31, 2019. Their total net income for 2020 was $31,000, and they paid dividends to shareholders in the amount of $19,250.
Here is how this information would appear on their retained earnings statement:
Statement of Retained Earnings
December 31, 2020
Retained earnings is an important marker for your business
It’s also important to investors and financial institutions. You’ll also need to produce a retained earnings statement if you’re following GAAP accounting standards.
Your retained earnings can be useful in a variety of ways such as when estimating financial projections or creating a yearly budget for your business. However, the easiest way to create an accurate retained earnings statement is to use accounting software.
If you’re still posting transactions into multiple ledgers manually or using spreadsheet software, why not check out The Blueprint’s accounting software reviews to see what options are available?
View more information: https://www.fool.com/the-blueprint/retained-earnings/