Retained Earnings concept is one of the main accounting terms, which is essential if we want to understand the structure of the balance sheet and financing means by which assets of a business are being financed. This article will explore this accounting term and practical example helping to understand this concept better.
Considering the term of Retained Earnings first we need to cover Equity definition. Owners’ equity is a residual claim of the shareholders to the assets of the business. Residual means that first business have to pay back liabilities and only afterwards what is left can be distributed to the shareholders. So Equity is a difference between Assets and Liabilities and this also can be supported by the basic accounting equation, where Assets=Liabilities+Equity.
Equity in its turn is comprised of:
- Share Capital – initial investment of the shareholders to the business, and
- Retained Earnings – net profit earned and remained in the business, which was not yet distributed to the shareholders. Of course in case business makes loss, such loss is accumulated as not distributed earnings, which are negative and decreasing value of Equity.
On the Balance Sheet these two items are indicated separately to demonstrate how much shareholders invested into the business and how much the business has accumulated in not distributed profit since start of the operations.
Relation With Income Statement
To understand the concept of Retained Earnings better the relation of it with the income statement should be demonstrated. Assume we have a company, which started its business on 1 January 2009. Shareholders invested $10,000 as cash at the start of business operations. Income Statement for the year 2009 is as follows (for simplicity purposes there are no taxes or interest expenses provided):
Cost Of Goods Sold_________(19,000)
Operating Expenses __________(3,000)
Shareholders decided not to distribute dividends for the year 2009 and retain all the profit in he business. On the Balance Sheet at the Equity part you will see the following:
So all the net profit from the Income Statement goes to the Balance Sheet as Retained Earnings, since this profit was retained in the business.