12.5 Retained earnings
5 min read•august 20, 2024
Retained earnings represent a company's cumulative profits minus paid. This crucial financial metric appears on the as part of shareholders' equity, reflecting a firm's historical profitability and dividend policy.
Understanding retained earnings is essential for assessing a company's financial health and growth potential. It involves analyzing components like , dividends, and , while considering factors such as revenue, expenses, and comprehensive income.
Components of retained earnings
- Retained earnings represent the cumulative net income earned by a company since its inception, less any dividends paid out to shareholders
- Consists of the beginning retained earnings balance, plus net income (or minus net loss) for the current period, minus dividends declared during the period
- Provides insights into a company's historical profitability and dividend policy
Impact on financial statements
- Retained earnings appear on the balance sheet as a component of shareholders' equity
- Changes in retained earnings during a period are reported on the
- Net income from the income statement flows into retained earnings, while dividends declared reduce retained earnings
Factors affecting retained earnings
Revenue and expenses
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- Revenue increases retained earnings, while expenses decrease retained earnings
- Profitability directly impacts the amount of earnings available for retention or distribution to shareholders
- Examples of revenue include sales revenue and interest income, while expenses include cost of goods sold, operating expenses, and income taxes
Dividends to shareholders
- Dividends declared and paid to shareholders reduce retained earnings
- Board of directors determines the dividend amount and timing of payments
- Cash dividends decrease retained earnings and cash, while decrease retained earnings and increase common stock
Retained earnings vs net income
- Net income represents the profit earned by a company during a specific period, while retained earnings represent the cumulative profits earned and retained over the life of the company
- Net income is reported on the income statement, while retained earnings are reported on the balance sheet
- Retained earnings include net income, but also consider dividends and prior period adjustments
Statement of retained earnings
Format and preparation
- Begins with the beginning retained earnings balance, adds net income (or subtracts net loss), subtracts dividends declared, and ends with the ending retained earnings balance
- Prepared after the income statement, as net income is a required input
- Can be presented as a separate financial statement or combined with the statement of shareholders' equity
Relationship to other statements
- Net income from the income statement flows into the statement of retained earnings
- Ending retained earnings balance from the statement of retained earnings appears on the balance sheet as a component of shareholders' equity
- Dividends declared on the statement of retained earnings impact cash on the balance sheet and are reported on the statement of cash flows
Analyzing retained earnings
Retention ratio and payout ratio
- Retention ratio indicates the percentage of net income retained by the company ()
- Payout ratio represents the percentage of net income paid out as dividends ()
- Higher retention ratios suggest a company is reinvesting more of its earnings for growth, while higher payout ratios indicate a focus on returning profits to shareholders
Evaluating business performance
- Growing retained earnings over time generally indicates profitable operations and financial stability
- Comparing retained earnings to total assets or shareholders' equity provides insights into a company's reliance on debt financing and efficiency in generating profits
- Analyzing trends in retained earnings can help assess a company's dividend policy consistency and sustainability
Limitations of retained earnings
- Retained earnings do not necessarily represent cash available for investments or dividends, as profits may be tied up in non-cash assets
- Negative retained earnings (accumulated deficit) may indicate a history of losses or aggressive dividend payments
- Retained earnings can be influenced by accounting choices (depreciation methods, inventory valuation) and may not fully reflect economic reality
Accounting for prior period adjustments
Changes in accounting principles
- Retrospective adjustments to retained earnings are required when a company changes an accounting principle (LIFO to FIFO inventory valuation)
- Cumulative effect of the change is recorded as an adjustment to beginning retained earnings in the earliest period presented
- Enhances comparability of financial statements across periods
Correction of errors
- Material errors discovered in previously issued financial statements require a prior period adjustment to retained earnings
- Cumulative effect of the error correction is recorded as an adjustment to beginning retained earnings in the earliest period presented
- Restating prior period financial statements ensures accuracy and reliability of the information
Reporting comprehensive income
Other comprehensive income (OCI)
- OCI includes gains and losses not reported on the income statement (unrealized gains/losses on available-for-sale securities, foreign currency translation adjustments)
- Reported on the statement of comprehensive income, which reconciles net income to comprehensive income
- Provides a more complete picture of a company's financial performance
Accumulated OCI on balance sheet
- Accumulated OCI appears as a separate component of shareholders' equity on the balance sheet
- Represents the cumulative balance of OCI items over the life of the company
- Allows users to assess the impact of OCI items on a company's financial position
Disclosure requirements
- Companies must disclose the components of retained earnings, including beginning balance, net income, dividends, prior period adjustments, and ending balance
- Changes in accounting principles and error corrections require disclosure of the nature, justification, and impact on financial statements
- Comprehensive income reporting requires disclosure of OCI items and their impact on shareholders' equity
Importance for financial analysis
Earnings management considerations
- Management may use discretionary accounting choices to manipulate retained earnings and influence financial ratios
- Analysts should be aware of potential earnings management techniques (aggressive , understatement of expenses) and adjust their analysis accordingly
- Comparing retained earnings across companies requires consideration of differences in accounting policies and potential manipulation
Comparability across companies
- Differences in dividend policies, accounting principles, and OCI items can impact the comparability of retained earnings across companies
- Analysts should consider industry norms, company-specific factors, and the impact of accounting choices when comparing retained earnings
- Adjusting for non-recurring items and differences in accounting policies can enhance comparability and provide a clearer picture of a company's underlying financial performance
Key Terms to Review (16)
Accumulated Other Comprehensive Income: Accumulated other comprehensive income (AOCI) represents a component of shareholders' equity that includes gains and losses not yet realized and not included in net income. This can arise from various sources, such as changes in the fair value of available-for-sale securities, foreign currency translation adjustments, and pension plan adjustments. AOCI helps provide a more comprehensive view of a company's overall financial performance by capturing these unrealized effects, showing their potential impact on owners' equity over time.
Appropriated Retained Earnings: Appropriated retained earnings refer to a portion of a company's retained earnings that has been set aside for a specific purpose, rather than being available for dividends or other distributions to shareholders. This practice allows a company to allocate funds for future investments, debt repayment, or specific projects while maintaining transparency with stakeholders about the intended use of these funds.
Balance Sheet: A balance sheet is a financial statement that presents a company's financial position at a specific point in time, detailing its assets, liabilities, and equity. This essential report helps stakeholders assess the company's net worth, liquidity, and overall financial health, making it crucial for understanding how investing activities impact the balance of assets and liabilities.
Declaration of dividends: The declaration of dividends is the formal announcement made by a company's board of directors to distribute a portion of the company's earnings to shareholders, usually in the form of cash or stock. This decision impacts retained earnings as it reduces the amount available for reinvestment in the business, reflecting a company's profitability and financial health. Once declared, the dividend becomes a legal obligation for the company, meaning it must be paid to shareholders on the specified payment date.
Dividends: Dividends are payments made by a corporation to its shareholders, typically as a distribution of profits. They represent a return on investment for shareholders and can be issued in cash or additional shares of stock. The decision to pay dividends affects the company's retained earnings and owners' equity, reflecting the company's financial health and strategy regarding profit distribution.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a collection of commonly followed accounting rules and standards for financial reporting. It establishes a framework for consistent financial reporting, ensuring that companies present their financial statements in a way that is understandable and comparable across different organizations. This standardization is crucial for investors, regulators, and other stakeholders who rely on accurate financial information to make informed decisions.
IFRS: International Financial Reporting Standards (IFRS) are accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. These standards provide a common global language for business affairs so that financial statements are comparable across international boundaries, promoting cross-border investment and economic growth.
Matching principle: The matching principle is an accounting concept that requires expenses to be matched with the revenues they help to generate in the same period. This principle ensures that a company's financial statements accurately reflect its profitability and financial performance by aligning income and related expenses within the same time frame.
Net Income: Net income is the total profit of a company after all expenses, taxes, and costs have been deducted from total revenue. It represents the financial health of a business and serves as a key indicator of its profitability. Understanding net income is essential as it influences decisions regarding dividend distributions and reflects how efficiently a company is being managed.
Prior Period Adjustments: Prior period adjustments refer to the corrections made to the financial statements of previous periods due to errors or changes in accounting principles. These adjustments ensure that the financial statements are accurate and reflect the true financial position of the entity. Such corrections are necessary for maintaining the reliability of financial reporting and have a direct impact on retained earnings by correcting previously reported figures.
Revenue recognition: Revenue recognition is the accounting principle that determines when revenue is to be recorded in the financial statements. This principle ensures that income is recognized in the period it is earned, regardless of when cash is received, making it crucial for accurately reflecting a company's financial performance. Proper revenue recognition affects long-term contracts, measurement concepts, elements of financial statements, and retained earnings as it helps businesses align their reported revenues with actual economic activities.
Statement of retained earnings: The statement of retained earnings is a financial report that outlines the changes in a company's retained earnings over a specific period. This statement connects the net income earned during the period and any dividends paid out to shareholders, showing how much profit has been reinvested back into the company versus what has been distributed. It plays a crucial role in understanding a company's overall financial health and its ability to reinvest in growth.
Stock dividends: Stock dividends are payments made by a corporation to its shareholders in the form of additional shares instead of cash. This method allows companies to reward investors without depleting cash reserves, which can be especially important for businesses aiming to reinvest profits for growth while still providing value to shareholders.
Stock Repurchase: Stock repurchase, also known as share buyback, occurs when a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This can positively impact earnings per share (EPS) and return on equity (ROE) by increasing these metrics through a smaller share base, and it may also reflect management's confidence in the company's future prospects.
Total equity: Total equity is the residual interest in the assets of an entity after deducting liabilities, representing the ownership value held by shareholders. It serves as an important indicator of a company's financial health and stability, reflecting the net worth that belongs to the owners after all debts have been settled. Total equity encompasses several components, including retained earnings, common stock, additional paid-in capital, and other comprehensive income.
Unappropriated Retained Earnings: Unappropriated retained earnings refer to the portion of a company's profits that have not been allocated for specific purposes and are available for distribution as dividends or reinvestment. This term highlights the company's ability to utilize its earnings freely, distinguishing it from appropriated retained earnings, which are earmarked for certain expenditures or obligations. Understanding this concept is crucial for analyzing a company's financial health and its potential to reward shareholders through dividends.