What Is Accumulated Income?
Accumulated income, commonly referred to as retained earnings, includes the portion of net income that is retained by a corporation over time, rather than being distributed as dividends. Any accumulated income is typically used by the corporation to reinvest in its principal business or to pay down its debt.
- Accumulated income is the amount retained by a company to either reinvest in its principal operations or invest in capital expenditures.
- Accumulated income is located under shareholder's equity on a company's balance sheet and is often referred to as retained earnings.
- Capital structure and budgeting decisions rely heavily on accumulated income.
Understanding Accumulated Income
Accumulated income refers to the portion of net income that is accumulated and used for reinvestment purposes or to pay down debt rather than being paid out in the form of dividends. Accumulated income is often invested in areas within the corporation that will create growth opportunities, such as research and development (R&D), new technology or machinery, and other forms of capital expenditures.
Accumulated income appears under the shareholder's equity section on the corporation's balance sheet. It is calculated by adding net income (or loss) from the income statement to the beginning retained earnings balance. Any paid dividends, including cash and stock dividends, are subtracted from that sum. If a company has a net loss exceeding the initial accumulated income balance, there will be a deficit, impacting investing, and capital spending.
How Accumulated Income Is Used
A business needs accumulated income to help fund its operations. This is especially important for a growing business, which typically requires a substantial amount of working capital to pay for its ongoing investments in receivables and inventory, as well as fixed asset purchases. The amount of accumulated income tends to be lowest in slow-growth businesses, where the management team has no internal use for the money and so elects to send it to investors in the form of dividends.
From a theoretical perspective, accumulated income or retained earnings plays a central role in capital structure and capital budgeting decisions. When the dust settles at the end of the year, a business can generally do one of two things with excess cash. It can either plow it back into the business to improve or grow organically or it can return capital to its rightful owners, whether they are equity shareholders or creditors.
Businesses with growth prospects greater than their cost of capital should, in theory, put the money back into the business to generate capital investment growth. If the shareholders are satisfied with growth given a level of risk, they do not raise their cost of funds. However, when a business is facing deteriorating financial prospects, investors frown upon these businesses retaining too much cash because it often gets wasted on risky ventures and frivolous pet projects.
Example of Accumulated Income
Company A recorded a net income of $500,000 for the current year, and it had a beginning retained earnings balance of $250,000. To its investors, it paid stock dividends totaling $300,000. The new retained earnings balance, or the accumulated income at the end of the current year, is $450,000 ($250,000 beginning balance + $500,000 net income - $300,000 dividends paid out). Company A allocates the accumulated income to purchase new equipment and invest in its research and development initiatives.