Study Notes: Retained Earnings Concepts and Troubleshooting

Introduction to Retained Earnings

  • Importance of the Concept:

    • Retained earnings (RE) issues account for approximately 60%60\% of help tickets handled by the team.

    • Mastering this concept is essential for interns in both audit and business tax.

    • Understanding RE is crucial because if it does not "roll," it throws off other accounts, making reconciliation impossible and frustrating.

  • Definition of Retained Earnings:

    • Retained earnings represent the portion of a company's profit that is held or retained and saved for investment back into the company.

The Retained Earnings Formula

  • Core Formula Components:

    • You must commit this formula to memory. It is a fundamental check performed on every client engagement.

    • Prior Year Beginning Balance+Net Income+Contributions−Distributions=Ending Retained Earnings\text{Prior Year Beginning Balance} + \text{Net Income} + \text{Contributions} - \text{Distributions} = \text{Ending Retained Earnings}

    • Note: The speaker describes it as "plus negative," meaning you add the negative value of distributions.

  • The Concept of "Rolling":

    • When people ask "Does retained earnings roll?", they are asking if the current beginning balance matches the calculated ending balance from the prior year adjustments.

    • This is one of the first tasks performed when starting journal entries: checking what the RE should be versus what it currently is on the Trial Balance (TB).

Trial Balance Dynamics and Timing

  • Reporting Dates:

    • Most accounts on a Trial Balance (e.g., Cash) show the balance as of the year-end (e.g., 12/31/202512/31/2025).

    • The Retained Earnings accounts (often labeled as Capital or Partner's Capital) are the exception; they show the 1/11/1 (beginning of the year) balance.

  • The Closing Process:

    • Income statement accounts (Revenue and Expenses) are temporary accounts.

    • At the end of every fiscal year, these accounts are closed out to Retained Earnings to arrive at the ending balance for the period.

    • This explains why Revenue accounts start at zero (00) at the beginning of every new year.

Troubleshooting: Why Retained Earnings Doesn't Roll

When the calculated RE ("What it should be") does not match the Trial Balance ("What it is"), check the following three areas in order:

  1. Distributions/Dividends:

    • Clients frequently forget to close out the distribution, draws, or dividend accounts to Retained Earnings. Because these accounts are in the equity section, they are often overlooked.

  2. Adjusting Journal Entries (AJEs):

    • When accountants provide AJEs to a client at the end of an engagement, the client is expected to book those entries on their own system. If they fail to do so, there will be a discrepancy between the firm's books and the client's books.

    • Since AJEs affect the income statement and the income statement closes to RE, failure to book AJEs will cause the RE balance to be off.

  3. General Ledger (GL) Activity ("Weird Plugs"):

    • Ideally, there should be no direct activity in the RE account throughout the year other than the standard closing entries (Net Income, Distributions, Contributions).

    • Some clients use RE as a "plug" account for transactions they don't understand, such as personal property taxes.

    • Accountants must review the GL detail for any "weird plugs," back them out, and move them to the appropriate account.

Practical Activity Walkthroughs

Activity 1: Missing Distributions

  • Discovery:

    • The difference between "what it should be" and "what it is" was identified as $4,800,000\$4,800,000.

    • The Distributions account on the Trial Balance showed a balance of $4,800,000\$4,800,000, indicating it had not been closed from the prior year.

  • Resolution:

    • Check for tiny discrepancies; in this case, there was a $4\$4 difference found in miscellaneous adjustments compared to the prior year.

  • Proposed Journal Entry:

    • Debit: Retained Earnings

    • Credit: Distributions (to zero out the account)

    • A second entry may be needed to credit Retained Earnings by $4\$4 to tie out the balance perfectly.

Activity 2: Unclosed Contributions

  • Discovery:

    • The difference was identified as $11,108,000\$11,108,000.

    • Reviewing the prior year column showed that accrued contributions accounts had not been closed out to RE.

  • Proposed Journal Entry:

    • Credit: Retained Earnings $11,108,000\$11,108,000

    • Debit: Contributions accounts (various accounts like $369,432\$369,432, $369,528\$369,528, and $369,402\$369,402) to clear their credit balances.

Activity 3: Improper GL Activity

  • Discovery:

    • The initial difference was $1,800,000\$1,800,000.

    • Investigation revealed $1,800,000\$1,800,000 in unclosed distributions and a specific improper entry in the RE account for personal property taxes amounting to $1,095.08\$1,095.08.

  • Resolution:

    • RE should not have expenses touching it during the year.

  • Proposed Journal Entry:

    • Reverse the tax expense: Debit Personal Property Tax Expense and credit Retained Earnings for $1,095.08\$1,095.08 (or adjusted to $1,095.09\$1,095.09 to round/match).

    • Close the distributions as per the standard process.