Retained Earnings

Retained earnings (also known as accumulated earnings) is a component of shareholders equity which represents the amount of net income left-over with the company since its incorporation after periodic distribution to shareholders in the form of dividends. Retained earnings belong to the shareholders of the company and the company’s board of directors can decide to pay them out as dividends, in part or whole.

For a company that is continuously making losses, retained earnings is replaced by accumulated losses, which is an equity component representing the total amount of loss made by the company since its incorporation. However, it is quite possible that a company may have retained earnings in spite of a net loss for a particular period. This is because retained earnings is sum of net income or loss over more than one periods.

Adjusted retained earnings

Opening retained earnings are adjusted for any changes in accounting policies and accounting errors. It is because changes in accounting policies and rectification of accounting errors are required to be reflected in the financial statements retrospectively, which means that historical asset, liability, equity, revenue and expense figures are changed as if the new policy has been always applicable or the accounting error never took place. Since comparative income statement is presented for only one year, changes to prior period revenue and expenses are reflected in opening retained earnings.

Formula

Opening retained earnings
Add/(Less)Adjustment due to changes in accounting policies and errors
Add/(Less)Net income (loss) for a period
LessDividends
EqualsClosing retained earnings

Statement of retained earnings

Statement of retained earnings is a report that reconciles the retained earnings of a company at the start of an accounting period to retained earnings at the end of the accounting period. It reports figures for any adjustment to opening retained earnings, net income or net loss for the period and cash dividends or stock dividends (i.e. bonus shares).

Example & journal entries

GJ Coffees, Inc. retained earnings as at 1 January 2014 were $20 million. During the year, the company generated net income of $8 million and declared dividends of $5 million. The external auditors of the company identified an accounting error dating back to 2007. Closing inventories were overvalued as at 31 December 2007 by $2 million. Applicable tax rate is 30%. Prepare statement of retained earnings for GJ Coffees, Inc. as at 31 December 2014.

Solution

Retained earnings as at 1 January 2014$20.0 million
Less: adjustment on account of rectification of accounting error$1.6 million
Add: net income for the period$8.0 million
Less: dividends$5.0 million
Retained earnings as at 31 December 2014$21.4 million

At the end of financial year 2007, inventories were overvalued by $2 million, which means that the cost of goods sold was simultaneously understated. Undervaluation of cost of goods sold in turn overstated the profit before taxes by $2 million, overstated taxes by $0.6 million ($2 million * 0.3) and overstated both net income and closing retained earnings for 2007 by $1.4 million. In order to rectify the error, the opening retained earnings must be reduced by this amount.

Adjustment for rectification of error is journalized as follows:

Retained earnings$1.4 million
Income tax payable$0.6 million
Inventories$2 million

Transfer of net income to retained earnings during the closing process involves the income and expense summary account:

Income & expense summary$8 million
Retained earnings$8 million

Assuming the company generated net loss of equal amount, the journal entry would be exactly opposite:

Retained earnings$8 million
Income and expense summary$8 million

Dividends are recognized as follows:

Retained earnings$5 million
Dividends payable$5 million

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