Statement of Retained Earnings: A Comprehensive Guide

Statement of Retained Earnings: A Comprehensive Guide

What is the Statement of Retained Earnings?

The statement of retained earnings gives a summary of the changes in retained earnings of a company during a specific accounting period.

Statement of retained earnings is structured as an equation, in a way that it begins with the retained earnings at the beginning of the reporting period, with few adjustments for items like net income and dividends, and ends with the retained earnings balance for that accounting period. 

The closing balance for that accounting period will be used as opening balance for the next accounting period of the company. It can also be written as retained earnings brought forward (b/f)

The statement of retained earnings can be prepared as a stand-alone document or be attached to another financial statement, such as the balance sheet or income statement (profit or loss account). The statement can be prepared to cover a specified cycle which can be either monthly, quarterly or yearly as the case may be. 

In the United States, it is mandatory to follow the Generally Accepted Accounting Principles (GAAP) when preparing the statement of retained earnings. Any statement not following the GAAP shall be invalidated.

The statement of retained earnings is prepared mainly for outside parties such as investors and lenders, since internal stakeholders of the company can already access the retained earnings information. The major information that external stakeholders are interested in is the net profit which is distributed as dividends to investors or shareholders.

Uses of Retained Earnings

Retained earnings are the profits kept aside by a company for internal use or for when a need arises. The profits may be used to reinvest into some revenue-generating businesses, acquiring more business assets or used to repay debts. Other uses of retained earnings are:

1. Expansion

Retained earnings can be used to fund an expansion of operations by a company. The funds may be used to build new plant, upgrade current infrastructure, or hire more personnel to support the company's expansion. Example of expansion are; opening new branch, buying new assets, etc.

2. New product launch

Retained earnings can also be used to finance a new product launch to increase the company’s list of product offerings. For instance, a laptop producing company may introduce a new phone or launch a completely different product that will enhance its competitive position in the marketplace.

3. Dividend payments

The surplus can be distributed to the shareholders of the company based on the number of shares they have in the company.

4. Merger or acquisition

During the growth period of the business, the management may look for new strategic partnerships so as to increase the company’s dominance and control in the market.

A merger happens when a company combines its operations with another related company with the aim of increasing its product offerings, assets, and customer base. An acquisition on the other hand is when the company takes over a smaller company within its industry.

Format of statement of retained earnings

Below is the comprehensive format for preparing a statement of retained earnings

Statement of Retained Earnings: A Comprehensive Guide

Based on the format above, the important information that you should have to enable you prepare this statement are:

  1. Opening balance retained earnings
  2. Net income of the current year
  3. Dividend declaration and payments

Setting up a Statement of Retained Earnings: How to prepare a statement of retained earnings

The statement of retained earnings is generally condensed and doesn't contain so much information like other financial statements. To be condensed, I mean the statement of retained earnings is decrease in size or volume because it concentrates on the essence unlike other financial statements.

In this segment, we will learn about the important steps involved in calculating the retained earnings balance of a company at the end of the reporting period. The steps are:

  1. Getting beginning balance
  2. Add net income
  3. Less divided payed out
  4. Calculate ending retained earning balance

The steps listed above will be briefly explained below with examples.

1. Get beginning balance

The beginning balance in the statement of retained earnings is brought forward from the retained earnings balance of the previous period. It can be written as retained earnings brought forward (b/f). The beginning balance is obtained from the balance sheet of the previous year, you need not to calculate anything in the current year to ascertain the beginning balance unless stated otherwise. For example, let us assume that the retained earnings balance for the previous year is $100,000. The figure will be recorded in the current year's statement as follows:

Beginning Retained Earnings Balance:  $100,000

2. Add net income

The next step involved in calculating the retained earnings balance is to add the net income (or net loss) for the current accounting period. The net income is obtained from the income statement (profit and loss account), which is prepared first before the statement of retained earnings. Assume that the net income for the current year is $50,000.

Beginning Retained Earnings Balance:  $100,000
Add: Net Income $50,000

Note: If the company made a net loss of $50,000 for the reporting year, the amount should be subtracted from the beginning balance.

3. Subtract dividends paid out

If the company paid dividends to shareholders in the current year, the amount of dividends paid should be deducted from the total obtained from adding the starting retained earnings balance and net income (step 2). In the case where the company did not pay out any dividends to investors, the value should be indicated as $0. Assuming the company paid out $30,000 in dividends from the net profit. It will be represented as;

Beginning Retained Earnings Balance:  $100,000
Add: Net Income  $50,000
Less: Dividends  ($30,000)

4. Calculate ending retained earnings balance

Lastly, calculating the retained earnings amount of a company for the period can be done by adding net profit and subtracting the amount of dividends paid out. The ending retained earnings balance will be posted to the retained earnings on the current year’s balance sheet.

This can be illustrated below

Beginning Retained Earnings Balance:  $100,000
Add: Net Income   $50,000
Total:                     $150,000
Less: Dividends    ($30,000)
Ending Retained Earnings Balance $120,000


Statement of Retained Earnings: A Comprehensive Guide
An income statement showing retained earnings

Who are the users of Statement of Retained Earnings?

There are two main users of statement of retained earnings. They are the investors and lenders We will explain them below and how they use retained earnings to forecast the growth and profitability of a company.

1. Investors

As shareholders of the company, investors are looking forward to benefiting from increased dividends or increase in share price as a result of the company’s continued profitability. Investors look at the balance of current year’s and previous year’s retained earnings to forecast future dividend payments and growth in the share price of the company.

2. Lenders

Lenders are interested in knowing the ability of the company to honor its future debt obligations. Lenders want to lend money to established and profitable companies that retain some of their reported profits for future use. Even if the firm is passing through a slowdown in business activities, the retained earnings can still be used to settle its debt obligations.

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