Accounting Terms – Exploring retained earnings

The concept of retained earnings is one of the most important accounting concepts that is essential if we are to understand the structure of the balance sheet and the funds that are used to fund a company’s assets. This article explores this accounting term and a practical example to help better understand this concept.

concept

In considering the concept of retained earnings, we must first address the definition of equity. Equity is a residual claim of the shareholders on the assets of the company. Residual means that companies first have to repay liabilities and only then can the rest be distributed to shareholders. So equity is a difference between assets and liabilities and this can also be backed by the basic accounting equation where Assets = Liabilities + Equity.

Equity, in turn, consists of:

  • share capital – Initial investment by shareholders in the company and
  • retained earnings – Net profit generated and retained by the company that has not yet been distributed to shareholders. Of course, if the company makes a loss, that loss is accumulated as undistributed earnings, which are negative and reduce the value of equity.

On the balance sheet These two items are reported separately to show how much shareholders have invested in the company and how much the company has accumulated in undistributed earnings since it began operations.

Relationship to the income statement

To understand the concept of retained earnings the connection with the profit and loss account should be shown better. Suppose we have a company that started operations on January 1, 2009. Shareholders invested $10,000 in cash at the start of operations. income statement for 2009 as follows (no tax or interest expense shown for simplicity):

Income______25,000

Cost of Goods Sold_________(19,000)

Gross Profit__6,000

Operating costs __________(3,000)

Net profit______3,000

Shareholders decided not to pay a dividend for 2009 and to keep all profits in the company. On the balance sheet In the Equity capital part you will see the following:

Share capital_______10,000

Retained Winnings____3,000

Total Capital________13,000

So all the net income from the income statement goes on the balance sheet as retained earnings because that earnings was retained in the company.