Retained earnings

The retained earnings portion of stockholders’ equity typically results from accumulated earnings, reduced by net losses and dividends. Like paid-in capital, retained earnings is a source of assets received by a corporation. Paid-in capital is the actual investment by the stockholders; retained earnings is the investment by the stockholders through earnings not yet withdrawn.

The balance in the corporation’s Retained Earnings account is the corporation’s net income, less net losses, from the date the corporation began to the present, less the sum of dividends paid during this period. Net income increases Retained Earnings, while net losses and dividends decrease Retained Earnings in any given year. Thus, the balance in Retained Earnings represents the corporation’s accumulated net income not distributed to stockholders.

When the Retained Earnings account has a debit balance, a deficit exists. A company indicates a deficit by listing retained earnings with a negative amount in the stockholders’ equity section of the balance sheet. The firm need not change the title of the general ledger account even though it contains a debit balance. The most common credits and debits made to Retained Earnings are for income (or losses) and dividends. Occasionally, accountants make other entries to the Retained Earnings account.

Retained earnings appropriations

The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained earnings for several contractual or voluntary reasons. These contractual or voluntary restrictions or limitations on retained earnings are retained earnings appropriations. For example, a loan contract may state that part of a corporation’s  $100,000 of retained earnings is not available for cash dividends until the loan is paid. Or a board of directors may decide to use assets resulting from net income for plant expansion rather than for cash dividends. An example of a voluntary restriction was General Electric’s annual report statement that cash dividends were limited “to support enhanced productive capability and to provide adequate financial resources for internal and external growth opportunities”.

Companies formally record retained earnings appropriations by transferring amounts from Retained Earnings to accounts such as “Appropriation for Loan Agreement” or “Retained Earnings Appropriated for Plant Expansion”. Even though some refer to retained earnings appropriations as retained earnings reserves, using the term reserves is discouraged.

Other reasons for appropriations of retained earnings include pending litigation, debt retirement, and contingencies in general. Such appropriations do not reduce total retained earnings. They merely disclose to balance sheet readers that a portion of retained earnings is not available for cash dividends. Thus, recording these appropriations guarantees that the corporation limits its outflow of cash dividends while repaying a loan, expanding a plant, or taking on some other costly endeavor. Recording retained earnings appropriations does not involve the setting aside of cash for the indicated purpose; it merely divides retained earnings into two parts—appropriated retained earnings and unappropriated retained earnings. The establishment of a separate fund would require a specific directive from the board of directors. The only entry required to record the appropriation of $ 25,000 of retained earnings to fulfill the provisions in a loan agreement is:

Debit Credit
Retained earnings 25,000
  Retained Earnings, Appropriation per loan agreement 25,000
 To record restriction on retained earnings.

When the retained earnings appropriation has served its purpose of restricting dividends and the loan has been repaid, the board of directors may decide to return the appropriation intact to Retained Earnings. The entry to do this is:

Debit Credit
  Retained Earnings, Appropriation per loan agreement 25,000
  Retained Earnings 25,000
To return balance in appropriation per Loan Agreement to Retained earnings.

On the balance sheet, retained earnings appropriations appear in the stockholders’ equity section as follows:

Stockholders’ equity:
  Paid-in capital:
    Preferred stock – 8%, $50 par value; 500 shares authorized; issued and outstanding   $25,000
    Common stock – $5 par value; 10,000 shares authorized, issued and outstanding   50,000
     Total paid-in capital $75,000
Retained earnings:
  Appropriated:
   Per loan agreement $25,000
  Unappropriated 20,000
   Total retained earnings 45,000
     Total stockholders’ equity $120,000

Note that a retained earnings appropriation does not reduce either stockholders’ equity or total retained earnings but merely earmarks (restricts) a portion of retained earnings for a specific reason.

The formal practice of recording and reporting retained earnings appropriations is decreasing. Footnote explanations such as the following are replacing these appropriations:

Note 7. Retained earnings restrictions. According to the provisions in the loan agreement, retained earnings available for dividends are limited to  $20,000.

Such footnotes appear after the formal financial statements in “Notes to Financial Statements”. The Retained Earnings account on the balance sheet would be referenced as follows: “Retained Earnings (see note 7)… $45,000″.

Prior Period Adjustments

According to FASB Statement No. 16, prior period adjustments consist almost entirely of corrections of errors in previously published financial statements. Corrections of abnormal, nonrecurring errors that may have been caused by the improper use of an accounting principle or by mathematical mistakes are prior period adjustments. Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in accounting practice, are not treated as prior period adjustments. Also, mistakes corrected in the same year they occur are not prior period adjustments.

To illustrate a prior period adjustment, suppose that Anson purchased land in 2014 at a total cost of $200,000 and recorded this amount in an expense account instead of in the Land account. Discovery of the error on 2015 May 1, after publication of the 2014 financial statements, would require a prior period adjustment. The adjustment would be recorded directly in the Retained Earnings account. Assuming the error had resulted in an $80,000 underpayment of taxes in 2014, the entry to correct the error would be:

Debit Credit
May 1 Land 200,000
   Federal income taxes payable 80,000
   Retained earnings 120,000
To correct an accounting error expensing land.

Prior period adjustments do not appear on the income statements but in the current-year financial statements as adjustments to the opening balance of retained earnings on the statement of retained earnings as be:

Retained Earnings, Jan 1 $200,000
Less: Prior Period Adjustment -120,000
Adjusted Beginning Balance  $ 80,000

Changes in the composition of retained earnings reveal important information about a corporation to financial statement users. A separate formal statement—the statement of retained earnings—discloses such changes.

Statement of retained earnings

A statement of retained earnings is a formal statement showing the items causing changes in unappropriated and appropriated retained earnings during a stated period of time. Changes in unappropriated retained earnings usually consist of the addition of net income (or deduction of net loss) and the deduction of dividends and appropriations. Changes in appropriated retained earnings consist of increases or decreases in appropriations.

An alternative to the statement of retained earnings is the statement of stockholders’ equity.

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