12.5 Retained earnings

Components of Retained Earnings

Retained earnings represent the cumulative net income a company has earned since inception, minus all dividends declared to shareholders. Think of it as the running total of profits the company has chosen to keep rather than distribute.

The basic formula is:

$\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends Declared}$

If the company had a net loss instead of net income, you subtract that loss. This balance sits on the balance sheet as a component of stockholders' equity and reflects the company's historical profitability and dividend decisions over its entire life.

Impact on Financial Statements

Retained earnings connect several financial statements together:

• Balance sheet: Retained earnings appear within stockholders' equity
• Statement of retained earnings: Reports the changes in retained earnings during the period (beginning balance → net income/loss → dividends → ending balance)
• Income statement: Net income flows directly into retained earnings at the end of each period

This linkage is why the statements must be prepared in a specific order. You need the income statement first to get net income, then the statement of retained earnings, and finally the balance sheet.

Factors Affecting Retained Earnings

Revenue and Expenses

Revenue increases net income, which in turn increases retained earnings. Expenses decrease net income, which decreases retained earnings. Sales revenue, service revenue, and interest income all contribute positively. Cost of goods sold, operating expenses, and income tax expense all reduce the amount available for retention.

The key point: profitability directly determines how much a company can retain or distribute.

Dividends to Shareholders

Dividends declared reduce retained earnings regardless of whether they've been paid yet. The board of directors decides the amount and timing.

Different types of dividends affect the accounts differently:

• Cash dividends reduce retained earnings and (when paid) reduce cash
• Stock dividends reduce retained earnings and increase paid-in capital accounts (common stock and/or additional paid-in capital)
• Stock splits do not affect retained earnings at all; they only change the par value and number of shares

Retained Earnings vs. Net Income

These two concepts are related but distinct:

Net income feeds into retained earnings each period, but retained earnings also reflect dividends declared and any prior period adjustments that bypass the income statement entirely.

Statement of Retained Earnings

Format and Preparation

The statement follows a straightforward structure:

1. Start with beginning retained earnings balance
2. Add net income (or subtract net loss)
3. Subtract dividends declared
4. Add or subtract any prior period adjustments (these adjust the beginning balance)
5. Arrive at ending retained earnings

This statement is prepared after the income statement, since net income is a required input. Companies can present it as a standalone statement or incorporate it into a broader statement of stockholders' equity.

Relationship to Other Statements

The statement of retained earnings serves as a bridge:

• Net income comes from the income statement
• The ending retained earnings balance goes to the balance sheet under stockholders' equity
• Dividends declared here also affect liabilities (dividends payable) on the balance sheet and, once paid, appear on the statement of cash flows as a financing activity

Analyzing Retained Earnings

Retention Ratio and Payout Ratio

Two ratios help you evaluate a company's dividend strategy:

$\text{Retention Ratio} = \frac{\text{Net Income} - \text{Dividends}}{\text{Net Income}}$

$\text{Payout Ratio} = \frac{\text{Dividends}}{\text{Net Income}}$

These two ratios always sum to 1 (or 100%). A company with a 70% retention ratio and 30% payout ratio is reinvesting most of its earnings for growth. A mature company paying out 80% of earnings is prioritizing shareholder returns over reinvestment.

Evaluating Business Performance

• Steadily growing retained earnings generally signals profitable operations and financial stability
• Comparing retained earnings to total assets or total stockholders' equity shows how much of the company's funding comes from accumulated profits versus external sources
• Tracking trends over multiple periods helps you assess whether dividend policy is consistent and sustainable

Limitations of Retained Earnings

• Retained earnings do not equal cash on hand. Profits may be invested in inventory, equipment, or receivables, so a large retained earnings balance doesn't mean the company can easily pay dividends or fund new projects.
• A negative retained earnings balance (called an accumulated deficit) may indicate a history of net losses, excessive dividend payments, or both.
• Accounting policy choices affect the number. Two identical companies using different depreciation methods or inventory valuation methods (FIFO vs. weighted average) will report different retained earnings, even with the same underlying economics.

Accounting for Prior Period Adjustments

Prior period adjustments modify the beginning retained earnings balance rather than flowing through current-period net income. There are two main causes.

Changes in Accounting Principles

When a company voluntarily changes an accounting principle (for example, switching from LIFO to FIFO for inventory valuation), ASC 250 generally requires retrospective application:

1. Calculate the cumulative effect of the change on all prior periods
2. Adjust the beginning retained earnings balance in the earliest period presented
3. Restate prior period comparative financial statements as if the new principle had always been used

This approach preserves comparability across periods.

Correction of Errors

When a material error is discovered in previously issued financial statements:

1. Calculate the cumulative effect of the error on prior periods
2. Adjust beginning retained earnings in the earliest period presented
3. Restate the prior period financial statements to correct the error

Both types of prior period adjustments require prominent disclosure so users understand why the beginning balance changed.

Reporting Comprehensive Income

Other Comprehensive Income (OCI)

OCI captures certain gains and losses that bypass the income statement under GAAP. Common OCI items include:

• Unrealized gains/losses on available-for-sale debt securities
• Foreign currency translation adjustments
• Certain pension adjustments
• Unrealized gains/losses on cash flow hedges

OCI is reported on the statement of comprehensive income, which starts with net income and adjusts for OCI items to arrive at total comprehensive income.

Accumulated OCI on the Balance Sheet

Accumulated other comprehensive income (AOCI) appears as a separate line within stockholders' equity on the balance sheet. It's the cumulative total of all OCI items over the company's life.

AOCI is distinct from retained earnings. Retained earnings accumulates net income minus dividends. AOCI accumulates the items that went through OCI instead of the income statement. Together, they (along with contributed capital) make up total stockholders' equity.

Disclosure Requirements

Companies must disclose:

• The components of the retained earnings reconciliation: beginning balance, net income, dividends, prior period adjustments, and ending balance
• For changes in accounting principles: the nature of the change, justification, and financial impact
• For error corrections: the nature of the error and its effect on previously reported amounts
• OCI items and their cumulative impact on stockholders' equity

Importance for Financial Analysis

Earnings Management Considerations

Management has discretion over certain accounting choices that directly affect reported net income and, by extension, retained earnings. Aggressive revenue recognition, understating allowances for doubtful accounts, or changing depreciation estimates can all inflate or deflate retained earnings.

Analysts should watch for unusual patterns: sudden jumps in retained earnings growth, frequent changes in accounting estimates, or retained earnings trends that diverge from cash flow trends.

Comparability Across Companies

Comparing retained earnings across companies requires caution because differences in dividend policies, accounting methods, and OCI items can all distort the comparison. A company with low retained earnings isn't necessarily less profitable; it may simply pay higher dividends.

To improve comparability, analysts often adjust for non-recurring items and normalize for differences in accounting policies. Looking at retention ratios and payout ratios alongside retained earnings gives a more complete picture than the raw balance alone.