Learning of the accounting theory and practice starts from the selection of the appropriate accounting courses, which also must include a topic about the calculation of retained earnings. This article explores this concept and calculation process together with a simple practical example. Worth to mention, that the analyzed accounting term is closely related with the two main financial statements – Income Statement and Balance Sheet. Data of these statements is used in the calculation process.
Essence
Exploring the term of question, Retained Earnings represent profit not distributed to the shareholders as dividends and retained in the company for the future business activities. In case business activities are loss making, accumulated loss is also attributed to the balance of accumulated earnings reducing it.
Starting from the establishment of the business and its activities profit earned (if it is not distributed to the shareholders as dividends) accumulates and is used by the business in the future or is distributed to the shareholders as dividends during the coming accounting periods.
Profit for the certain accounting period is reflected in the Income Statement and it represents a difference between revenues earned and expenses incurred to earn revenues. This amount is reduced by dividends if there are any and the residual amount is transferred to the Balance Sheet account, which is called Retained Earnings. This account is a part of Equity since it belongs to the shareholders.
During the next accounting period calculation of accumulated earnings continues with the addition of the current period net profit to the balance already accumulated on the Balance Sheet.
Example
To illustrate the subject of this article practically, let us explore the following example. Newly established company ABC has the following data on the Income Statement for the current year:
Revenues $9,500
Expenses ($4,900)
Net Profit $4,600
No dividends were paid during this year. Since ABC company was just established Retained Earnings balance is 0, share capital equals to $10,000. At the end of the accounting period Equity part of the Balance Sheet will look as follows:
Share Capital $10,000
Retained Earnings $4,600 (transferred from the Income Statement)
Total Equity $14,600
During the next accounting period balance of $4,600 will be increased by the next period net profit. Of course if the business will generate loss, this loss will decrease $4,600 balance.
Next year Income Statement has the following data:
Revenues $15,600
Expenses ($9,800)
Net Profit $5,800
Dividends $1,000
Profit Retained $4,800
Only profit retained after dividends were paid is added to the accumulated earnings account, i.e. $4,600 (accumulated balance on the Balance Sheet)+$4,800 (current year retained net profit)=$9,400. At the end of the accounting period Equity part of the Balance Sheet will look as follows:
Share Capital $10,000
Retained Earnings $9,400
Total Equity $19,400
