Many bookkeepers are faced with the “Retained Earnings” account on the equity section of the balance sheet and question it for understanding. While the concept of retained earnings is not pivotal for good, general bookkeeping, it is a concept in accounting worthy of knowing.
First off, here is the definition of retained earnings. Retained Earnings (RE) are the accumulated portion of business profits that are not distributed as dividends to shareholders but are reserved for reinvestment back into the business.
Retained earnings are also often defined by its formula.
Beginning retained earnings + / – net income (loss) – distributions = ending retained earnings
Understanding the formula components will ultimately help you perceive its basic definition. So let’s get started with net income (loss).
Income statement accounts are temporary accounts.
Income statement (or profit & loss) accounts consist of income and expense accounts. Income statement accounts are temporary accounts because the account transactions are only recorded for one calendar or fiscal year and do not roll over from year to year.
A new statement with each accounting cycle.
The income statement is an annual statement that begins afresh with each accounting cycle. If your accounting runs on a calendar year, you will start a new income statement in January, and it will end on the last day of December.
Closed period income statements.
Do not confuse this that the data is no longer there. We often refer to income statements from several years for comparison and planning purposes, but they are for closed periods. Closing the income statement accounts helps us avoid mixing data between accounting periods. If you pull a year-to-date income statement at the very beginning of an accounting period, you will see very little activity because the year just started. The idea is you begin with a zero income statement each period. Calendar companies have just experienced this with the new year, 2022.
Closing entry.
Now, the question becomes, where do all the income and expense accounts go? We can’t just erase a profit & loss from last year because it is time to start a new one. Erasing P&L accounts will cause entries to become out of balance, with the missing information screwing the accounting records.
Balance sheet accounts are permanent accounts.
All the income statement accounts are closed out to RE at the end of the reporting period. Retained earnings (and all balance sheet accounts) are permanent accounts. The annual closing entry is done automatically in most accounting systems. Some systems take the income statement’s bottom line (net income or net loss) and make one net closing entry; others create a separate closing entry for each account. More so, others pull all transactions separately into the retained earnings account. Whichever way your software does it, the results are the same.
If the income statement had a net loss, retained earnings decrease, while a net income will increase retained earnings.
“Retaining” income.
Knowing that the ultimate effect of closing the temporary accounts to RE transfers the net income or loss to the RE account, we can now better understand the account name in simple terms. The retained earnings account has the word retain for this account is meant to “retain” or keep all the prior earning from the company.
Income from the current period.
In most accounting systems, earnings from the present period are reflected in net income (as the bottom line on the P&L and in the equity section) until the end of the year when it gets into the RE account. This cycle repeats at the close of every year.
Taking money out of the business.
Wait, what happens when companies have a lot of RE from prior years’ income, but owners draw money from the company, or there are official dividends? The company is NOT retaining the income anymore!
The drawing account affects retained earnings.
The “owners draw” account, which is typically an equity account, is used to record distributions to the owners. At the end of the year, we need to create a journal entry that takes the total of the draws and reclassifies it into the RE account. In other words, we need to close the withdrawal account to RE.
Not “retaining” all income.
This entry translates into meaning that, although we had income closed out to the RE account, we had the owners take out money, so we don’t “retain” or keep all this income.
Bottom line.
In summary, the income statement and draw accounts get closed out to RE at the end of each accounting period. The RE account reflects how much income is retained after all dividends or distributions.
Here is an example to illustrate this concept.
Suppose we have a new company that started in January of 2020. Their income statement in December 2020 shows $1MM in net income. The equity section on the company’s balance sheet shows “net income” of $1MM. We do not see a retained earnings account because it is a new company for this year and therefore does not retain anything from a prior period. Additionally, the owners did not take any draws during 2020 because it’s a new company, and they wanted to keep as much capital in the company for future growth. Here is our formula.
Beginning retained earnings + / – net income (loss) – distributions = ending retained earnings
$0 + $1,000,000 – $0 = $1,000,000
A balance sheet as of January 2021 will show the retained earnings account has a balance of $1MM. The net income account (assuming no entries were made yet in the new year) will be $0.
Let us continue with our example. Things didn’t go for the company as planned in 2021. They couldn’t keep up some customer relationships, which resulted in lost sales, but they did invest in marketing and had a lot of general expenses. The year ended with a net loss of $200,000. Additionally, because things didn’t look good, the owners wanted to take as much money from the business. They withdrew a total of $300,000 in 2021 that was posted in the “owners draw” account. Here is our formula.
Beginning retained earnings + / – net income (loss) – distributions = ending retained earnings
$1,000,000 – $200,000 – $300,000 = $500,000
Following the trends of retained earnings for a couple of years could tell a lot if a company is profitable and how much it distributes. A negative retained earnings in the early years of business is common, but as the company gets out of startup (2-3 years from inception), negative retained earnings may be a sign of trouble. Furthermore, if retained earnings show a trend of decline, it indicates (in most situations) one of the two factors:
- The owners take too many distributions
- The company isn’t profitable
Solution?
- Limit the distributions to a certain percentage each year (maximum of 30% of the profit)
- Review your income and expenses (focus on operating segments that are more profitable, revisit your pricing structure, cut overhead costs, other). Contact us if you need assistance.
Ready for the challenge question? Where is all the income from a company retained? Retained Earnings!
