14.4 Compare and Contrast Owners’ Equity versus Retained Earnings

Owners' Equity and Retained Earnings

Owners' equity vs retained earnings

These two terms get mixed up constantly, but the relationship is straightforward: retained earnings is part of owners' equity, not a separate thing. Think of owners' equity as the whole pie, and retained earnings as one slice of it.

Owners' equity (called stockholders' equity in corporations) represents the owners' residual claim on a company's assets after deducting all liabilities. Its composition depends on the business structure:

• Sole proprietorship: consists of the owner's capital account, which tracks cash investments, equipment contributions, and withdrawals
• Partnership: consists of each partner's capital account, reflecting initial investments, additional contributions, and draws
• Corporation: consists of two main pieces:
  • Contributed capital, which includes common stock (shares issued to investors) and additional paid-in capital (amounts investors paid above par value)
  • Retained earnings

Retained earnings (sometimes called accumulated earnings) represents the cumulative net income a corporation has earned but not distributed to shareholders as dividends. A few key points:

• Retained earnings increases with net income and decreases with net losses and dividend payments
• It does not exist in sole proprietorships or partnerships, because in those structures net income flows directly into the owners' capital accounts
• Repurchasing a company's own stock (treasury stock) can also reduce retained earnings indirectly by reducing total stockholders' equity

Components of retained earnings statement

The statement of retained earnings is a financial statement that reconciles the beginning and ending balances of retained earnings for a specific period, usually a fiscal year. It acts as a bridge between the income statement and the balance sheet, showing exactly how profits flowed from one into the other.

The statement follows this structure:

1. Beginning retained earnings balance (carried over from the prior period's balance sheet)
2. Plus or minus: Net income or net loss for the period (transferred from the income statement)
3. Minus: Dividends declared during the period (cash or stock distributions to shareholders)
4. Plus or minus: Prior period adjustments, if any (corrections of errors or changes in accounting principles)
5. Equals: Ending retained earnings balance (reported on the current period's balance sheet)

Why does this statement matter?

• It shows stakeholders exactly what changed retained earnings during the period and why
• It demonstrates the direct link between the income statement and the balance sheet: net income doesn't just disappear after the income statement; it accumulates in retained earnings
• Investors use it to evaluate dividend policies and to calculate metrics like earnings per share

Prior period adjustments in reporting

Prior period adjustments are corrections of errors found in previously issued financial statements. They can arise from:

• Errors in prior statements, such as misclassifying an expense, omitting revenue, or miscalculating depreciation
• Retrospective application of a change in accounting principle, such as switching from LIFO to FIFO for inventory valuation

How they affect retained earnings:

Prior period adjustments bypass the current period's income statement entirely. Instead, they adjust the beginning balance of retained earnings directly. Whether the adjustment increases or decreases that balance depends on the nature of the error:

• If expenses were understated in a prior period, net income was overstated, so beginning retained earnings gets decreased
• If revenue was understated in a prior period, net income was understated, so beginning retained earnings gets increased

If cumulative losses and adjustments are large enough, a company may report a retained deficit (negative retained earnings) instead of a positive balance.

Financial reporting requirements:

• The company must restate the previously issued financial statements to correct the error
• Restated statements should be clearly labeled and include footnote disclosures explaining the nature and dollar impact of the adjustment
• When presenting comparative financial statements (showing multiple years side by side), all affected periods must show the restated amounts so the numbers remain comparable

Types of retained earnings

Not all retained earnings are treated the same. Corporations can split retained earnings into two categories:

• Appropriated retained earnings: a portion the board of directors has set aside (or "restricted") for a specific purpose, such as funding a future expansion, repaying long-term debt, or covering potential legal liabilities. This signals to shareholders that those funds are not available for dividends.
• Unappropriated retained earnings: the remaining portion that has not been designated for any specific use and is theoretically available for dividend distribution.

These classifications don't involve moving cash into a separate account. They're simply a way to communicate the company's intentions to stakeholders on the balance sheet.