Retained earnings explained: formula and examples

What retained earnings are

Retained earnings are the cumulative profits a company has earned since it started, less the losses it has made and the dividends it has paid to shareholders. They form part of equity on the balance sheet. Retained earnings matter because they show how much of the company's growth has been funded by its own profits, and in most countries they limit how much can legally be paid out as dividends.

Retained earnings are a source of funding, not a pile of cash. The profit retained has already been spent on inventory, equipment, receivables or debt repayment, so a company can report large retained earnings and still have little money in the bank. On the balance sheet they sit in equity alongside share capital, share premium and other reserves, sometimes labelled accumulated profits, retained profits or, when negative, accumulated deficit or accumulated losses.

Retained earnings are also the bridge between the income statement and the balance sheet. Every year's profit or loss ends up in them through the year-end close, which is why opening retained earnings that do not agree to last year's audited closing figure usually point to a closing entry that failed, was posted twice or was reversed.

The retained earnings formula

The closing balance of retained earnings is built from the opening balance and the year's movements. For most small companies only the first three lines apply; the others appear when policies change, errors are corrected or reserves are released.

• Opening retained earnings
• plus profit for the year, or minus loss for the year
• minus dividends declared to shareholders
• plus or minus adjustments for a change in accounting policy or correction of a prior-period error (IAS 8), made to the opening balance
• plus transfers from other reserves, such as revaluation surplus realised as an asset is used or sold
• minus amounts capitalised into share capital through a bonus issue, where local law allows
• equals closing retained earnings

A worked roll-forward in EUR

A company reported retained earnings of EUR 400,000 at the end of last year. During the current year it discovers that a EUR 20,000 expense belonging to last year was never recorded, an error that is material to its accounts. Under IAS 8 para 42 a material prior-period error is corrected retrospectively by restating the comparatives and, for periods before those presented, the opening balances. For simplicity the correction is shown net of any tax effect, and opening retained earnings are restated to EUR 380,000.

The company earns a profit of EUR 150,000 for the year and declares dividends of EUR 60,000. It carries a property at a revalued amount and, as IAS 16 para 41 permits, transfers EUR 5,000 of revaluation surplus directly to retained earnings, representing the extra depreciation on the revalued amount. That transfer does not pass through profit or loss.

• Opening retained earnings as previously reported: 400,000
• Correction of prior-period error: (20,000)
• Restated opening retained earnings: 380,000
• Profit for the year: 150,000
• Dividends declared: (60,000)
• Transfer from revaluation surplus: 5,000
• Closing retained earnings: 475,000

How profit reaches retained earnings: closing entries

Revenue and expense accounts are temporary accounts. At year end their balances are closed so the new year starts at zero, and the net result is transferred to retained earnings, a permanent account. In a manual system this uses an income summary account; many systems post directly from each income statement account to retained earnings.

For the company above, revenue for the year was EUR 900,000 and total expenses, including tax, were EUR 750,000. The closing entries below leave both revenue and expenses at zero and move the EUR 150,000 profit into retained earnings. If the year had produced a loss, the last entry would reverse: Dr Retained earnings / Cr Income summary.

• Close revenue: Dr Revenue 900,000 / Cr Income summary 900,000
• Close expenses: Dr Income summary 750,000 / Cr Expenses 750,000
• Transfer profit: Dr Income summary 150,000 / Cr Retained earnings 150,000
• Declare dividend: Dr Retained earnings 60,000 / Cr Dividends payable 60,000
• Pay dividend: Dr Dividends payable 60,000 / Cr Bank 60,000
• Revaluation surplus transfer: Dr Revaluation surplus 5,000 / Cr Retained earnings 5,000

Dividends: when they reduce retained earnings

A dividend reduces retained earnings when it is declared, meaning when it is appropriately authorised and no longer at the company's discretion, not when the cash is paid. A final dividend proposed by the directors after the year end and approved by shareholders later is not a liability at the reporting date. IAS 10 paras 12 and 13 require such dividends to be disclosed in the notes, not recognised.

The dividend payout ratio compares dividends with profit: EUR 60,000 divided by EUR 150,000 is 40 percent. The retention ratio is the remainder, 60 percent, which is the share of profit reinvested in the business. Growth companies often retain everything; mature companies with fewer investment opportunities distribute more.

Dividends are a distribution to owners, not an expense, so they never appear in profit or loss. They appear in the statement of changes in equity and, when paid, as a financing cash outflow in the cash flow statement under most entities' policies.

Legal limits on distributions in Europe and Canada

Retained earnings in the accounts are not automatically available to pay out. Company law in most jurisdictions restricts distributions to protect creditors, and the tests differ. Directors should take advice before declaring a dividend, especially when retained earnings are small or the company has made recent losses.

• United Kingdom: the Companies Act 2006, section 830, allows a company to make a distribution only out of profits available for the purpose, broadly accumulated realised profits less accumulated realised losses.
• France: the Commercial Code (article L232-10) requires companies to transfer at least 5 percent of each year's profit, after deducting prior losses, to a legal reserve until it reaches 10 percent of share capital.
• Germany: the Stock Corporation Act (AktG, section 150) requires public limited companies to transfer 5 percent of annual net income to a legal reserve until statutory reserves reach 10 percent of share capital or a higher amount set in the articles.
• Canada: the Canada Business Corporations Act prohibits a dividend when there are reasonable grounds to believe the corporation would be unable to pay its liabilities as they become due, or its realisable assets would fall below its liabilities and stated capital. Provincial corporate statutes contain similar solvency tests.
• In every case the relevant accounts are the entity's own individual accounts, not the consolidated group accounts.

Negative retained earnings: an accumulated deficit

When cumulative losses and dividends exceed cumulative profits, retained earnings become negative and are described as an accumulated deficit or accumulated losses. A company with retained earnings of EUR 30,000 that makes a loss of EUR 50,000 closes the year with an accumulated deficit of EUR 20,000. If its share capital is EUR 100,000, total equity is EUR 80,000.

A deficit is common in start-ups that are investing ahead of revenue, and it is not in itself a sign of insolvency. It does mean dividends are normally blocked until the deficit is eliminated, and in some jurisdictions a serious loss of capital triggers legal duties. EU company law requires a public limited company to call a general meeting when it suffers a serious loss of subscribed capital, and member states may not set that threshold higher than half of the subscribed capital. Lenders also watch the deficit through equity or net worth covenants.

The statement of changes in equity

Retained earnings are reported in a column of the statement of changes in equity, one of the primary financial statements required by IAS 1 para 106 and carried forward by IFRS 18. The statement reconciles the opening and closing balance of each component of equity, showing profit or loss, other comprehensive income, transactions with owners such as dividends and share issues, and the effect of retrospective restatements.

For the worked example, with share capital of EUR 100,000 unchanged and a revaluation surplus of EUR 50,000 at the start of the year, the statement reads as follows. Total equity moves from EUR 530,000 restated to EUR 620,000, equal to the restated opening balance plus profit of 150,000 minus dividends of 60,000. The revaluation transfer moves amounts between columns without changing the total.

• Opening as previously reported: share capital 100,000; revaluation surplus 50,000; retained earnings 400,000; total 550,000
• Correction of error: retained earnings (20,000); total (20,000)
• Restated opening: share capital 100,000; revaluation surplus 50,000; retained earnings 380,000; total 530,000
• Profit for the year: retained earnings 150,000; total 150,000
• Dividends: retained earnings (60,000); total (60,000)
• Transfer of revaluation surplus: revaluation surplus (5,000); retained earnings 5,000; total nil
• Closing: share capital 100,000; revaluation surplus 45,000; retained earnings 475,000; total 620,000

Retained earnings and year-end close in Skyline Nexus ERP

In Skyline Nexus ERP the year-end transfer to retained earnings is part of closing the fiscal year. Under Fiscal Authority, Fiscal Periods, Close Fiscal Year posts closing entries that zero revenue and expense accounts to the Income Summary account and then to Retained Earnings, inside one transaction, and locks all periods of the year; if the closing entries fail, nothing is closed. The close is refused while any journal or voucher in the year is not posted or cancelled, and it needs the Income Summary Account and Retained Earnings Account set in Settings, where a Dividends Account can also be named.

After the close, the Balance Sheet shows Retained Earnings within equity, and the Changes in Equity report sits with the other financial statements under Fiscal Authority, Reports. Because a locked period cannot be reopened, a prior-period error found after the close is corrected with a journal in an open period rather than by editing the closed year. Create next year's fiscal year before the old one ends, since postings are refused for dates with no fiscal period.

Common retained earnings mistakes

Retained earnings should move only for a small number of reasons, so any other entry deserves a question. Check for each of these errors when reviewing equity.

• Posting dividends as an expense in profit or loss instead of directly to retained earnings.
• Using retained earnings as a plug to force a balance sheet to balance after migration or a failed close.
• Correcting a prior-period error through current-year profit when it is material and should be restated.
• Recognising a dividend proposed after the year end as a liability at the year end.
• Paying a dividend based on consolidated retained earnings when the paying company's own reserves are insufficient.
• Opening balances in a new system that do not agree to the audited closing retained earnings.