What are retained earnings?
Retained earnings (RE) represent the portion of the business profit that the company retains within the business. It is the profit that has not been paid out as dividends or transferred to any other reserve. A company may retain all of its net profit for business expansion, or it may distribute a portion or all of its net profit to shareholders as dividends.
The terms as undistributed profit, retained profit and accumulated profit are most often used as synonyms to retained earnings.
Purpose of retained earnings
Different companies have different policies relating to dividend distribution. Many Companies retain a portion or all of its business profit for the sake of reinvestment. So, the purpose of RE in this case includes buying capital assets (equipments, machinery), spending on research and development, or more other activities that potentially improve the growth of business entity.
In contrast, other companies who do not earn a sufficient return on reinvestment, decide to distribute dividends of entire profit to shareholders of the company.
Accounting for retained earnings
Retained earnings account has a credit nature, while a debit balance on the RE account indicates that the company has accumulated losses. To calculate Retained earnings, the net profit or loss is added to the opening balance of RE and then dividends are subtracted. The retained earnings formula is as follows.
Retained earnings(RE)= Beginning RE + Net profits – Dividends
Retained earnings are reported under the shareholder’s equity section of balance sheet.
Impact of net profit and dividends on RE
Net profit has a direct impact on RE, all the elements that affect the net profit also affect the RE. The examples of these elements are sales, cost of goods sold, and other operating expenses.
Distribution of dividends is, generally, in the form of cash or stock. Distribution of dividends in either form reduces the RE balance.
Restriction on retained earnings
The balance in RE account is generally available for dividend declarations. However, restrictions on RE make the portion of that earnings unavailable for dividends. Companies generally disclose these restrictions in the notes to the financial statements.
Let’s see the causes why these restrictions take place.
- Legal restrictions
Many states require a corporation to restrict retained earnings for the cost of treasury stock purchased. When the company sells the treasury stock, the restriction is lifted.
- Contractual restrictions
There might be a condition in long-term contracts to restrict RE in order to avail the credit payments.The restriction limits the use of corporate assets for payment of dividends. As a result, the company is more likely to collect the necessary credit payments.
- Voluntary restrictions
The board of directors may voluntarily create retained earnings restrictions for specific purposes. For instance, the board may authorize a restriction for future plant expansion. By restricting the the distribution of dividends, the company makes more cash available for future business expansion.