Accounting terms – Study of retained earnings
The concept of retained earnings is one of the basic accounting terms that is essential if we want to understand the structure of the balance sheet and the means of financing through which the assets of a business are financed. This article will explore this accounting term and a practical example that helps to better understand this concept.
Concept
Considering the term retained earnings, we first need to cover the definition of equity. Equity is the shareholders’ residual claim to the assets of the business. Residual means that the business must first pay its debts and only then what is left can be distributed to shareholders. So equity is the difference between assets and liabilities and this can also be supported by the basic accounting equation where Assets=Liabilities+Equity.
Equity, in turn, consists of:
- Share capital – initial investment of the shareholders in the business, and
- Retained earnings – net profit earned and remaining in the business that has not yet been distributed to shareholders. Of course, in the event that the business makes a loss, that loss accumulates as retained earnings, which is a negative and diminishing value of equity.
On The balance these two items are stated separately to show how much shareholders have invested in the business and how much retained earnings the business has accumulated since inception.
Link to income statement
To understand the concept of Retained earnings its relationship to the income statement should be better demonstrated. Let’s say we have a company that started operations on January 1, 2009. The shareholders invested $10,000 in cash at the start of business operations. Income and expenditure statement for 2009 is as follows (no taxes or interest expense provided for simplicity):
Income__________________25,000
Cost of goods sold_________(19,000)
Gross profit______________6,000
Operating expenses __________(3000)
Net profit______________________3,000
The shareholders decided not to distribute dividends for 2009 and to keep all profits in the business. On The balance at Equity part you will see the following:
Share capital_______10,000
Retained earnings____3,000
Total equity________13,000
So all of the net profit on the income statement goes on the balance sheet as retained earnings because that profit was retained in the business.
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