Comprehensive Guide to Retained Earnings and Trial Balance Reconciliation

Introduction to Retained Earnings and Professional Importance

• Professional Significance for Interns: Mastering the concept of retained earnings is critical for professional success. Approximately $60\%$ of all internal support tickets boil down to issues related to retained earnings.

• Learning Objectives: The goal is for interns to understand what retained earnings should be, compare that to the trial balance, and reconcile any differences.

• ABC Example: While not explored in deep detail initially, ABC is used as a primary example for future activities regarding these calculations.

The Retained Earnings Formula and Core Concepts

• Mastering the Formula: Ashley advises students to write the formula down as many as 10 to 100 times until it is fully memorized. This formula is applied to every client in both audit and business tax.

• Consequences of Error: If retained earnings do not roll correctly, it will throw off other accounts, making reconciliation impossible and creating significant frustration during the auditing process.

• The Fundamental Formula:

  • The calculation is: $\text{Prior Year Retained Earnings} + \text{Net Income} - \text{Distributions} + \text{Contributions} = \text{Ending Retained Earnings}$

  • Note on signs: While some say "minus distributions," it can also be conceptualized as "plus negative distributions."

• Formula Components:

  • Prior Year Balance: The beginning balance for the current period.

  • Net Income: The profit or loss generated during the period.

  • Distributions: Also referred to as dividends, draws, or payouts.

  • Contributions: Any owner or partner capital added to the entity.

Trial Balance Mechanics and the Year-End Closing Process

• Trial Balance (TB) Dates: Most accounts on a trial balance reported as of $12/31/25$ represent the balance specifically on that day (e.g., cash).

• The Retained Earnings Exception: In capital or retained earnings accounts (often labeled as partner's capital), the reported balance on the trial balance is actually the $1/1$ balance (beginning of the year), not the $12/31$ balance.

• Closing Process Logic:

  • At the end of the year, all income statement accounts (revenue and expenses) are closed out to the equity section.

  • If a company has $\$1,000,000$ in revenue at $12/31$, that entire amount is closed to retained earnings to reach the final year-end balance.

  • Consequently, at the very beginning of the next year ($1/1$), the revenue account balance starts at zero because the previous year's activity is already captured in the retained earnings beginning balance.

• The Concept of "Rolling": When professionals ask, "Does retained earnings roll?", they are asking if the beginning balance on the trial balance matches the prior year's ending balance adjusted for net income, contributions, and distributions.

Troubleshooting Retained Earnings Discrepancies

If the calculated amount ("what it should be") minus the trial balance amount ("what it is") does not equal zero, check the following three common areas in order:

1. Distributions/Dividends Closures: Clients often forget to close out dividends, distributions, or draws into the retained earnings account. Because these are in the equity section, they are frequently overlooked during the closing process.

2. Prior Year Adjusting Journal Entries (AJEs):

   • Auditors often provide clients with journal entries to update their books. If the client fails to record these AJEs, there will be a discrepancy between the auditor's records and the client's books.

   • Since AJEs often affect the income statement, any unrecorded entry will prevent the income statement from closing correctly into retained earnings.

3. General Ledger (GL) Detail (Activity in the Account):

   • Ideally, there should be no activity in the retained earnings account throughout the year except for the closing of net income, distributions, and contributions.

   • "Plugs": Some clients use the retained earnings account as a "miscellaneous" or "plug" account when they do not know where to code an entry. If "weird plugs" or random expenses are found, they must be reversed out and moved to the correct account.

Questions & Discussion

• Question: Why are the capital accounts on the trial balance as of January 1 instead of December 31?

• Answer: Because at the end of the year, the income statement accounts haven't been moved into them yet on the trial balance view. Once the revenue and expenses are closed out to retained earnings, that is what gets you to the ending $12/31$ balance. Since they close at the end of the year, the balance on the trial balance for the beginning of the year represents the starting point.

• Question: What if there is activity in the retained earnings account from the client?

• Answer: We check the GL details. Ideally, we shouldn't see anything. If we see activity, it's often a client using it as a plug, and we have to back those out and put them in the appropriate account.

Practical Exercises and Activity Walkthroughs

Activity 1: Missing Distributions

• Initial Findings: A difference of $\$4,800,000$ was identified between "what it should be" and "what it is."

• Analysis: Prior year journal entry (AJE #6) showed that the client failed to close out several years of distributions totaling $\$4,100,000$. The trial balance showed a distributions account balance of approximately $\$4,800,000$, matching the discrepancy.

• Proposed Journal Entry:

  • Debit: Retained Earnings

  • Credit: Distributions

• Adjustment: A secondary $\$4$ entry was required to tie out the retained earnings to the exact dollar amount.

Activity 2: Unclosed Contributions

• Initial Findings: A discrepancy of $\$11,108,000$ was identified.

• Analysis: By summing the accrued contributions accounts from the prior year, the total matched the discrepancy exactly, indicating contributions were never closed into retained earnings.

• Proposed Journal Entry:

  • Debit: Contributions ($\$11,108,000$ total across three specific sub-accounts: $\$369,432$, $\$369,528$, and $\$369,402$)

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

Activity 3: Improper GL Activity

• Initial Findings: A difference of $\$1,800,000$ was identified.

• Analysis: Review of the General Ledger (GL) showed the client was coding personal property taxes directly to the retained earnings account rather than an expense account. Retained earnings should not have expenses touching it during the year.

• Proposed Journal Entry:

  • Debit: Personal Property Tax Expense (or related tax account)

  • Credit: Retained Earnings

• Adjustment Amount: The entry involved reversing out items like $\$1.09$ and $\$5.09$ to clear the account activity and reach a zero difference.