The retained earnings formula is a calculation that derives the balance in the retained earnings account as of the end of a reporting period. Retained earnings is that portion of the profits of a business that have not been distributed to shareholders; instead, it is retained for investments in working capital and/or fixed assets, as well as to pay down any liabilities outstanding. The retained earnings calculation is:
+ Beginning retained earnings
+ Net income during the period
- Dividends paid
= Ending retained earnings
It is also possible that a change in accounting principle will require that a company restate its beginning retained earnings balance to account for retroactive changes to its financial statements. This will alter the beginning balance portion of the formula.
It is quite possible that a company will have negative retained earnings. This can be caused by the distribution of a large dividend that exceeds the balance in the retained earnings account, or by the incurrence of large losses that more than offset the normal balance in the retained earnings account.
There may be pressure from investors to issue a dividend if a company has built up a large balance in its retained earnings account over time, though this argument is not necessarily valid if the company still has profitable opportunities in which it can invest the excess funds (which is frequently the case in an expanding market).
For example, ABC International has $500,000 of net profits in its current year, pays out $150,000 for dividends, and has a beginning retained earnings balance of $1,200,000. Its retained earnings calculation is:
+ $1,200,000 Beginning retained earnings
+ $500,000 Net income
- $150,000 Dividends
= $1,550,000 Ending retained earnings
Because all profits and losses flow through retained earnings, essentially any activity on the income statement will impact the net income portion of the retained earnings formula. Thus, the retained earnings balance is changing every day.
The retained earnings formula is also known as the retained earnings equation and the retained earnings calculation.
The Balance Sheet
The Income Statement
The Interpretation of Financial Statements
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