Statement of Retained Earnings - Comprehensive Notes

Retained earnings - overview

• Retained earnings (RE) is one of the stockholders' equity accounts.
• It reports the profits that have accumulated in the company over time.
• Retained earnings is a cumulative amount of earnings kept in the company for its use, not a cash pile.
• Profits come from revenues minus expenses, i.e., $ext{Net Income} = ext{Revenues} - ext{Expenses}$.
• Most or all earnings are used to fund ongoing operations and growth (pay employees, buy inventory, purchase equipment, expand locations, etc.).
• The only thing that is not retained for company use is the dividends paid to stockholders.
• Common misconception: retained earnings are cash; they are not a cash balance but cumulative profits kept in the business.
• Key idea: retained earnings represent profits kept in the company to fund operations and growth.

How retained earnings is calculated

• The ending balance depends on two types of activity: net income (or net loss) and dividends.
• Beginning retained earnings (beg RE) is the starting point for the period.
  • For Year 1, beg RE = 0.
  • For Year 2 and beyond, beg RE = prior year ending retained earnings.
• Add net income for the year to beg RE.
• If the company incurs a net loss, subtract the amount of the net loss (equivalently, add a negative net income).
• Subtract any dividends declared during the year.
• The fundamental formula:
  • $ext{Ending RE} = ext{Beginning RE} + ext{Net Income} - ext{Dividends}$
• There are only two factors that affect retained earnings: net income and dividends.
• The ending balance carries over to the next year as the beginning balance.

Statement format and presentation

• The statement has a heading identifying the company, the title of the statement, and the period covered.
  • Example heading: Catch and Waves Incorporated, Statement of Retained Earnings, year ended December 31.
• For the first year, there is no beginning retained earnings due to no prior period.
• The statement shows the effect of net income and dividends on retained earnings.
• In the example, dividends are shown as a negative amount because they decrease retained earnings.
• The ending balance in retained earnings is the amount that carries to the balance sheet.
• The statement demonstrates that net income appears on both the income statement (as the bottom line) and on the statement of retained earnings.
• The ending retained earnings figure on this statement is also reported on the balance sheet.
• The statement provides a bridge: it links the income statement to the balance sheet by showing how earnings and distributions affect the financial position.
• In actual practice, many firms use a broader format called the Statement of Stockholders' Equity, which includes changes to stock accounts as well as retained earnings.

Example: Catch and Waves Incorporated, Year 1

• Net income for the year: $2{,}400$
• Dividends declared and paid: $2{,}000$
• Beginning retained earnings: $0$ (first year)
• Ending retained earnings: $400$
• Calculation: $ext{Ending RE} = 0 + 2{,}400 - 2{,}000 = 400$
• Note: Dividends are reported as a negative amount because they decrease retained earnings.
• The ending balance of $400$ carries over to the balance sheet.
• Net income (the bottom line on the income statement) is also reported on the statement of retained earnings, illustrating the bridge concept.

Example: Two-year scenario

• Year 1:
  • Beginning RE: $0$
  • Net income: $40{,}000$
  • Dividends: $15{,}000$
  • Ending RE: $25{,}000$
  • Calculation: $0 + 40{,}000 - 15{,}000 = 25{,}000$
• Year 2:
  • Beginning RE: $25{,}000$ (end of Year 1)
  • Net income: $45{,}000$
  • Dividends: $20{,}000$
  • Ending RE: $50{,}000$
  • Calculation: $25{,}000 + 45{,}000 - 20{,}000 = 50{,}000$
• Key takeaway: The ending balance of Year 1 becomes the beginning balance of Year 2.

Relationship to other financial statements

• The statement of retained earnings is a bridge between the income statement and the balance sheet.
• Net income appears as the bottom line on the income statement and is also reported on the statement of retained earnings.
• The ending retained earnings balance is reported on the balance sheet.
• This flow ensures consistency: information moves from income statement → retained earnings → balance sheet.

Real-world considerations and structure

• In practice, many companies present a more expanded version: the Statement of Stockholders' Equity, which includes changes in both retained earnings and stock accounts.
• Despite the expanded version, the fundamental concept remains the same: retained earnings show cumulative profits kept in the company after distributions.

Practical implications

• Retained earnings indicate how profits are allocated between reinvestment and distributions to shareholders.
• The cumulative nature means RE grows over time if net income exceeds dividends, enabling funding for growth projects.
• It is not identical to cash; retained earnings reflect accumulated profits that may be invested or used for other purposes, not necessarily the cash available.
• Understanding RE helps assess long-term profitability and capital structure).

Summary of key points

• Retained earnings is a stockholders' equity account representing cumulative profits retained for use in the business.
• Only two items affect RE: Net Income (increase) and Dividends (decrease). In a loss year, Net Income is negative, which reduces RE.
• Retained earnings are cumulative; the ending balance becomes the beginning balance for the next period.
• The standard statement format includes company name, statement title, and period; Year 1 has no beginning RE.
• Net income appears on both the income statement and the statement of retained earnings; Ending RE appears on the balance sheet.
• In practice, the broader Statement of Stockholders' Equity may be used to show changes in additional equity accounts beyond retained earnings.
• The key formula: $ext{Ending RE} = ext{Beginning RE} + ext{Net Income} - ext{Dividends}$