What are 'Retained Earnings'
Retained earnings refer to the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business, or to pay debt. It is recorded under shareholders' equity on the balance sheet. The formula calculates retained earnings by adding net income to, or subtracting any net losses from, beginning retained earnings, and subtracting any dividends paid to shareholders.
BREAKING DOWN 'Retained Earnings'The formula for retained earnings is as follows:
Retained Earnings (RE) = Beginning RE + Net Income - Dividends, also known as the "retention ratio" or "retained surplus."
In most cases, companies retain earnings in order to invest them into areas where the company can create growth opportunities, such as buying new machinery or spending the money on more research and development. Should a net loss be greater than beginning retained earnings, the retained earnings can become negative, creating a deficit. The retained earnings general ledger account is adjusted every time a journal entry is made to a revenue or expense account.
Retained earnings are reported at the end of an accounting period as the accumulated amount of a company's prior earnings, net of dividends. They can show a positive earnings accumulation or can turn negative and have a deficit if a current period's net loss exceeds the period's beginning retained earnings. Even though changes in retained earnings during each accounting period are not explicitly reported, they can be inferred by comparing the amounts of beginning and ending retained earnings of the period. An increase or decrease in accumulated retained earnings during an accounting period is the direct result of the amounts of net income or loss and dividend payouts for that period.
Net income or loss adds to retained earnings by way of recording certain closing entries in accounting. The accounts to record net income, revenues and expenses are periodic and temporary accounts used repeatedly during each accounting period. Their balances must be closed at period end, allowing the accounts to be reused in the next period. Revenues and expenses are closed to an account called income summary, which displays the amount of net income or loss. They are subsequently closed to retained earnings, with net income increasing earnings, and loss decreasing them. Thus, the effect of net income on retained earnings derives from the integral effects of revenues and expenses on retained earnings.
Dividends can be in cash or stock, and both forms of dividends reduce retained earnings. Cash dividends are paid out from a company's earnings or net income, and the more dividends distributed, the less earnings retained. The dividend account is also a temporary account because dividend payments are a periodic recurrence, and are closed to retained earnings at period end, effectively reducing retained earnings. Companies may issue additional shares of its stock as dividends, increasing the amounts of both common-stock and additional-paid-in-capital accounts in the balance sheet. To keep the balance sheet balanced, the account of retained earnings is decreased by the same amounts.