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2018

Retained Earnings and its Accounting Treatment

RETAINED EARNINGS 1

You might have often heard the word "Retained Earnings" and wondered what it means? Just like individuals save a portion of their salary to meet future contingencies, companies also do the same.Companies keep a portion of their profits aside for various purposes like paying debts, as contingency fund or to be reinvested into core business for expansion. Such savings are called "Retained Earnings" in accounting terminology.

  1. Retained earnings are the profits not distributed to the shareholders. That is why they are called "Retained" as against distributed.
  2. Retained Earnings is a cumulative figure. This implies that the amount of retained earning shows total of all profits which are retained by the company till date. Hence, it is not specific to only one financial year but pertains to all financial years till date.
  3. Retained Earnings are shown on the liability side of Balance Sheet. Retained Earnings decrease when loss occurs and increase when there is a profit.
  4. Retained earnings are also known as accumulated profit, accumulated surplus, undistributed earnings, accumulated earnings, accumulated income, earned surplus or undivided profits


Formula for Retained Earnings:

Generally speaking, retained earnings is the total amount of profits earned by a company since its inception minus any losses suffered and amount of profit distributed to shareholders. The figure of retained earnings may also be a negative number. This happens when total losses till date increase profits. Such accumulated losses are also called accumulated deficit.

Formula for Retained Earnings for a given period is as follows:

(BEGINNING RETAINED EARNINGS + NET INCOME DURING THE PERIOD) ‐ DIVIDENDS DISTRIBUTED = ENDING RETAINED EARNINGS

Note: This is also known as the "retention ratio" or "retained surplus."

The amount shown in the balance sheet as Retained Earning at the end of reporting period is the amount indicated as "Ending Retained Earnings".

Accounting Treatment of Retained Earnings:

Retained earnings are reported on the liability side of the balance sheet at the end of accounting period. The amount represents accumulated amount of net earnings by a company since its inception. Hence, amount of retained earning can be a positive or a negative number.

Changes in the retained earnings in the current accounting period as compared to prior accounting period is not explicitly stated in the balance sheet. However, current year's retained earnings can be calculated by deducting previous years closing retained earnings with current year's closing retained earnings.
In cases where there is any change in accounting policy or practices adopted by the company in the current financial year, the company may restate beginning retained earnings as well. The purpose of this practice is to report changes in retained earnings in the current accounting cycle due to change in policy.

Reasons for Negative Retained Earnings:

There can be two reasons for negative retained earnings:

  • The accumulated losses of the company exceeds the accumulated profits since inception
  • The company has distributed large amount of dividends keeping little reserve as retained earnings.


Capitalization of Retained Earnings:

A company may also capitalize its retained earnings by issuing bonus shares. The remaining portion of retained earnings not capitalized may be distributed as dividend or may be carry forwarded as retained earnings to next accounting cycle.

Factors affecting Retaining Earnings:

Age of the company: Longer the life time of a company, higher the retained earnings. A company will have more retained earnings if it is an old company as it has more time to compile accumulated profits.
Dividend policy: A company having a generous policy for dividend distribution will have lesser retained earnings. Such company distributes dividends more frequently as compared to a company with conservative dividend distribution policy.
Profitability: A business with higher profit margin would normally have higher retained earnings as these companies earn more and consequently can save higher amounts as retained earnings.

Statement Of Retained Earnings:

  1. As no explicit information is provided regarding changes in retained earnings in the balance sheet, a separate statement called "Statement of Retained Earnings" may be prepared by companies. The purpose of this statement is to outline changes in retained earnings for given accounting period. This statement is prepared in line with applicable accounting standards such as GAAP, IND AS or IFRS.
  2. This statement performs reconciliation for beginning and ending retained earnings for the period.
  3. This statement uses information such as net income for current accounting period, opening balance of retained earnings, dividend distributed in current period etc.
  4. Statement of Retained Earnings can be published as a separate statement or may be appended with balance sheet or income statement.

 

Particulars Amount
Opening Balance of Retained  ******
Net Income + ******
Dividends - ******
Ending Retained Earnings = ******

 

Example:


Arvind Limited has net profit of Rs. 85,00,000 in its current year. It distributes Rs. 54,00,000 as dividends to the share holders. Beginning retained earnings balance of Arvind Limited is Rs. 5,87,29,000. Retained earnings for Arvind Limited may be calculated in following way:

 

Particulars Amount
Opening Balance of Retained  5,87,29,000
Net Income + 85,00,000
Dividends - 54,00,000
Ending Retained Earnings = 6,18,29,000

 

Important Note: Though reported at the end of accounting cycle, the amount of retained earnings is volatile in nature. It changes every day because any change in income statement would affect amount of retained earnings for the current accounting period.

Retention Ratio:

Retention ratio indicates proportion of a company's accumulated earnings which are not distributed as divided. Retention Ratio may expressed as percentage also. It is opposite to Dividend Payout Ratio.

Formula for Retention ratio:

Retention Ratio = 1 − Dividend Payout Ratio

Note: The payout ratio is the amount of dividends the company pays out divided by the net income. This formula can be rearranged to show that the retention ratio plus payout ratio equals 1, or essentially 100%. That is to say that the amount paid out in dividends plus the amount kept by the company comprises all of net income.

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