Understanding Retained Earnings

 

Retained Earnings is an important piece of the balance sheet and can often be misunderstood. We often hear clients mention that they see it as completely normal to post items to Retained Earnings on a daily basis. This is a complete misunderstanding of what this account means and why it exists on every balance sheet in the world. Let me explain why.

 

 

Retained Earnings is made up of three main pieces: 1.) prior year results, 2.) current year activity, 3.) less any distributions to shareholders/members. This is found on several different accounts on the balance sheet. It is usually displayed as “Retained Earnings,” “Net Income” and “Distributions.”  Retained Earnings is calculated by taking the aggregate Net Income from all prior years minus any dividends paid out to shareholders. It’s all of the earnings that are reinvested into the company from all prior years of business. If retained earnings are negative, it means one of two things: 1) more money has been distributed out than earned or 2) the business has an aggregate Net Loss from operations.

With the exception of some extraordinary event, retained earnings should only change once a year. At year end, the current year Net Income is closed into Retained Earnings in preparation of the next year. The net balance posts to the balance sheet and should stay consistent for the entire year.

 

Most accounting systems will post this transaction automatically when you close out the fiscal year. This keeps “Retained Earnings” as a controlled account and is designed to prevent journal entries or improper posting to that account. It is important to have a clear and stable balance sheet. Retained Earnings is a snapshot into the previous year success and capital re-investment into the company. It can be a critical component to making financial decisions about your future.

Written by:
Ashley Peth
TGG Accounting
 
 

 

 

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