Definition:
Retained Earnings (Retained Profits, Ploughed-back Profits, Retentions): The amount of net profit left within a company after distributions to shareholders. This sum is retained for reinvestment in business operations and is recorded in the profit and loss reserve.
Detailed Explanation:
Retained earnings are an essential component of a company’s equity and represent the accumulated profits that a business has reinvested, rather than distributed as dividends. They are reported in the shareholders’ equity section of the balance sheet and serve as a measure of the company’s ability to generate profit over time.
Key Aspects of Retained Earnings:
- Accumulation: Retained earnings accumulate over periods, increasing with net income and decreasing with dividends and losses.
- Profit Reinvestment: The primary use of retained earnings is reinvestment in business expansion, debt repayment, or purchasing assets.
- Shareholders’ Equity: As part of shareholders’ equity, retained earnings provide crucial insight into the company’s sustainability and growth potential.
Examples:
- Company A reports a net profit of $500,000 for the year. It decides to distribute $200,000 as dividends to its shareholders. The remaining $300,000 is added to the retained earnings.
- Company B had retained earnings of $1,000,000 at the beginning of the year. After earning a net profit of $150,000 and distributing $50,000 in dividends, its retained earnings increase to $1,100,000 by the year’s end.
Frequently Asked Questions (FAQs):
What are retained earnings?
Retained earnings refer to the portion of net income that is retained by a company instead of being distributed to its shareholders as dividends. They are used for reinvestment in the company’s operations.
How are retained earnings calculated?
Retained earnings are calculated by adding net profit to previous retained earnings and then subtracting any dividends distributed to shareholders.
Why are retained earnings important?
Retained earnings are crucial as they provide a source of internal financing. They help in funding business expansion, innovation, and other operational needs without the need to raise external capital.
How do retained earnings impact a company’s balance sheet?
On the balance sheet, retained earnings are part of shareholders’ equity. An increase in retained earnings enhances the equity, while a reduction (due to dividends or losses) will decrease it.
Can retained earnings be negative?
Yes, retained earnings can be negative, which is referred to as an accumulated deficit. This occurs if a company has incurred more losses and distributed more dividends than its net profits.
Related Terms:
- Net Profit: The amount remaining after all expenses and taxes have been subtracted from total revenue.
- Distribution: The allocation of profits to shareholders in the form of dividends.
- Shareholders’ Equity: The owners’ claim after liabilities are subtracted from assets, including retained earnings.
- Dividends: The portion of profits distributed to shareholders in return for their investment.
- Profit and Loss Reserve: A reserve created from retained earnings to hedge against future uncertainties and business exigencies.
Online References:
Suggested Books for Further Studies:
- “Financial Accounting: An Introduction” by Pauline Weetman - Provides foundational insights into financial accounting principles, including retained earnings.
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield - Detailed explanations and problems on various accounting concepts, covering retained earnings comprehensively.
- “Accounting: Tools for Business Decision Making” by Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso - A resourceful guide on making informed business decisions, carefully explaining retained earnings and their importance.
Accounting Basics: “Retained Earnings” Fundamentals Quiz
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