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Statement of Retained Earnings

An overview of the changes in retained earnings during a specific accounting cycle

What is the Statement of Retained Earnings?

The statement of retained earnings provides an overview of the changes in retained earnings during a specific accounting cycle. It is structured as an equation, such that it opens with the retained earnings at the beginning of the reporting period, makes adjustments for items such as net income and dividends, and closes with the retained earnings balance for that accounting cycle. The closing balance forms the opening balance for the next accounting period of the company.

 

Statement of Retained Earnings

 

The statement of retained earnings can be created as a standalone document or appended to another financial statement such as the balance sheet or income statement. The statement can be prepared to cover a specified cycle, either monthly, quarterly or annually. It follows the Generally Accepted Accounting Principles (GAAP).

The statement of retained earnings is mainly prepared for outside parties such as investors and lenders since internal stakeholders can already access the retained earnings information. Some of the information that external stakeholders are interested in is the net income that is distributed as dividends to investors.

 

Uses of Retained Earnings

Retained earnings are the profits that the company keeps for use internally or when the need arises. The profits may be reinvested into certain revenue-generating activities of the company or used to make debt repayments. Other possible uses of retained earnings include:

 

1. Expansion

The company may use the retained earnings to fund an expansion of its operations. The funds may go into building a new plant, upgrading the current infrastructure, or hiring more staff to support the expansion.

 

2. New product launch

A company may also use the retained earnings to finance a new product launch to increase the company’s list of product offering. For example, a beverage processing company may introduce a new flavor of its current products or launch a completely different product that boosts its competitive advantage.

 

3. Dividend payments

The surplus can be distributed to the company’s shareholders according to the number of shares they own in the company.

 

4. Merger or acquisition

During the growth phase of the business, the management may be seeking new strategic partnerships that will increase the company’s dominance and control in the market.

A merger occurs when the company combines its operations with another related company with the goal of increasing its product offering, infrastructure, and customer base. An acquisition occurs when the company takes over a same-size or smaller company within its industry.

 

Setting up a Statement of Retained Earnings

The statement of retained earnings is usually condensed and does not include as many information as other financial statements. The following are the main steps involved when calculating the retained earnings balance at the end of the reporting period:

 

1. Get beginning balance

The starting balance in the statement of retained earnings is carried over from the retained earnings balance of the previous year. The beginning balance is obtained from the balance sheet of the previous year. For example, assume that the retained earnings balance for the previous year is $100,000. The figure will be recorded as follows:

Beginning Retained Earnings Balance:  $100,000

 

2. Add net income

The next step is to add the net income (or net loss) for the current accounting period. The net income is obtained from the company’s income statement, which is prepared first before the statement of retained earnings. Assume that the net income for the current period is $50,000.

Beginning Retained Earnings Balance:  $100,000

Add: Net Income                                         $50,000

Note: If the company incurred a net loss of $50,000, the amount should be deducted from the beginning balance.

 

3. Deduct dividends paid out

If the company paid dividends to investors in the current year, then the amount of dividends paid should be deducted from the total obtained from adding the starting retained earnings balance and the net income. If the company did not pay any dividends, you should indicate the value as $0. In our case, let us assume that the company paid $30,000 in dividends out of the net income.

Beginning Retained Earnings Balance:  $100,000

Add: Net Income                                         $50,000

Less: Dividends                                          ($30,000)

 

4.  Calculate ending retained earnings balance

Finally, calculate the amount of retained earnings for the period, by adding the net income and subtracting the amount of dividends paid out. The ending retained earnings balance is the amount posted to the retained earnings in the current year’s balance sheet.

Beginning Retained Earnings Balance:  $100,000

Add: Net Income                                         $50,000

Total:                                                           $150,000

Less: Dividends                                         ($30,000)

Ending Retained Earnings Balance        $120,000

 

Who Uses the Statement of Retained Earnings

The following are the two main users of the statement of retained earnings:

 

1. Investors

As shareholders of the company, investors are looking to benefit from increased dividends or a rising share price due to the company’s continued profitability. Investors look at the current year’s and previous year’s retained earnings balance to predict future dividend payments and growth in the company’s share price.

 

2. Lenders

Lenders are interested in knowing the company’s ability to honor its debt obligations in the future. Lenders want to lend to established and profitable companies that retain some of their reported earnings for future use. Even if the company is experiencing a slowdown in business activities, it can still use the retained earnings to pay its debt obligations.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Cash Flow Statement
  • Earnings Per Share (EPS)
  • Projecting Balance Sheet Line Items
  • Projecting Income Statement Line Items

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