Accounting Terms – Retained Earnings Exploration

The concept of Retained Earnings is one of the main accounting terms, which is fundamental if we want to understand the structure of the balance sheet and the financing means by which the assets of a company are financed. This article will explore this accounting term and a practical example that will help to better understand this concept.

Concept

Considering the retained earnings term first, we need to cover the definition of equity. Owners’ equity is a residual shareholder claim on the company’s assets. Residual means that first companies have to pay off liabilities and only then what is left can be distributed to shareholders. So Equity is a difference between Assets and Liabilities and this can also be supported by the basic accounting equation, where Assets=Liabilities+Equity.

The patrimony in turn is composed of:

• Social capital – shareholders’ initial investment in the business, and
• Retained earnings – net profit obtained and remaining in the business, which has not yet been distributed to shareholders. Of course, in the event that the business incurs losses, such losses are accumulated as undistributed profits, which are negative and decreasing in the value of the Equity.

About him scale sheet These two items are listed separately to show how much shareholders invested in the business and how much the business has accumulated in retained earnings since the start of operations.

Relation to the income statement

To understand the concept of Retained earnings it should be better to demonstrate its relationship with the income statement. Suppose we have a company that started operations on January 1, 2009. Shareholders invested $10,000 in cash at the start of business operations. Statement of income for the year 2009 is the following (for reasons of simplicity, no tax or interest expenses are foreseen):

Income___________________25,000

Cost of goods sold_________(19,000)

Gross profit ________________6,000

Operating Expenses __________(3,000)

Net Income__________________3,000

The shareholders decided not to distribute dividends corresponding to the year 2009 and to retain all the profits of the business. About him scale sheet in the Equity part you will see the following:

Share Capital_______10,000

Retained earnings____3,000

Total Equity_________13,000

Then all of the net income from the Income Statement goes to the Balance Sheet as Retained Earnings, since this income was retained in the business.