Retained Earnings - Online Tutor, Practice Problems & Exam Prep

Retained earnings represent the net income a company has accumulated over time, minus any dividends paid. It's crucial to understand that retained earnings do not equate to cash; income may be tied up in assets or accounts receivable. The base formula for retained earnings is: $\mathrm{Beginning\; Balance}+\mathrm{Additions}-\mathrm{Subtractions}=\mathrm{Ending\; Balance}$. A retained deficit indicates accumulated losses, often a red flag for financial health, particularly in startups investing heavily without immediate revenue.

Retained Earnings and the BASE Formula

Alright. Now let's discuss another equity account, retained earnings, in a little more detail. So we've discussed retained earnings throughout this course, right? Remember that it's net income from previous periods. We've been making income over the years and haven't paid it all out as dividends. So, it's net income that we've earned in previous periods but have not distributed as dividends, okay? Whenever we pay dividends, that comes out of the retained earnings. Now, it's very important to note, as a lot of students get confused with this, is that the retained earnings is not equal to cash. Just because we earned income, it doesn't mean that it's all in cash. Remember, we can have revenue; we could have sold something and not received cash yet. We could have had accounts receivable for that sale and things like that. They're not going to be equal and they're not the same thing. Even if we did receive it in cash, well it doesn't mean that we have these retained earnings all just sitting there as cash. No. We could have taken that cash that we received and invested it in other assets. We could have bought machinery, fixed assets with this, or inventory. So it's not necessarily that we've earned this income and we just have it readily available as cash. It could just be invested in the business. So a company can have positive retained earnings, have a retained earnings account with a balance, but not enough cash to pay a dividend, right? Because they're not the same thing. They could have that cash invested in other things and just not have enough cash on hand for a dividend payment. Okay? So, that's a main thing you really want to focus on when you think about the retained earnings account, is that it doesn't necessarily mean that there's just that much cash on hand. Cool?

Alright. So we've talked about this before, but I wanted to bring it up again here with the base formula. We've used the base formula throughout this course in the T account format, and it's the best way to think about how to view the increases and decreases. Well, we have two subtractions in this case, so we might have more than one subtraction, more than one addition which will equal the ending balance, okay? So this is always how it's going to be. Beginning balance plus any additions to an account minus any subtractions to an account equals the ending balance, and remember, this works for any account. We're going to do it here for retained earnings, but you can have a base formula for inventory, accounts receivable, accounts payable, right? Common stock, any account, there are things that increase the account and things that decrease the account. Cool? So let's go ahead and see how the base formula works here with retained earnings. We're going to have the beginning balance in the account, which is the net income from previous periods just like we talked about. There's going to be some amount in the account that has been accumulated and that we have not paid out as dividends, right? Finally, we're going to have additions and that's this year's net income, right? So that's what's going to increase our retained earnings balance. We're going to have subtractions from the account and when do we take away from retained earnings? Well, that's when we declare dividends, right? Where we tell our stockholders we're going to pay them a dividend. Well, that means that we're going to reduce our retained earnings by those dividends and another thing that can subtract from the account would be if we don't have net income, but instead have a net loss, right? And that makes sense because if we have a net loss, that's going to decrease retained earnings where net income increases retained earnings, right? It's just the opposite. If we have a negative net income, that's going to decrease the retained earnings. And finally, we're going to end up with our ending balance, right? So here we have our beginning balance plus additions minus subtractions equals our ending balance, right? And sometimes you have multiple additions or multiple subtractions you need to keep track of. Cool? So we could see the same thing as a T account and I want to draw it as a T account over here just so you can see the same idea. So I'm going to put retained earnings. This is the retained earnings T account and we're going to have some beginning balance as a credit, right? We would have some credit balance in the account, and then what increases the account? Our net income. So any net income that we have would increase the account, and then a subtraction would be dividends, right? If we had any dividends, so those would be debits to the account. And then I'll put in parenthesis net loss just in case that comes up. It would decrease the account and after everything for the period, we would end up with our ending balance as our credit balance there, right? Now, I want to make a special note. There could be a very special case where you end up with a retained deficit instead of retained earnings. Well, what do you think that means? That means we've been losing money, right? If the company's been losing money year after year, well, you could have a retained deficit. That means you've had accumulated net losses or you've just paid too much in dividends, right? Because all these things that are reducing the retained earnings account, well, if you end up with a negative balance in that retained earnings account, it's going to have a debit balance, which is reducing your equity, right? So this is a very rare case that you might see a retained deficit because that clearly is a red flag that the business is in trouble if it has a retained deficit. Now sometimes it's common for a startup company to have retained deficits, right? Because they're investing a lot into the company and maybe they don't have sales yet, right? Maybe their sales haven't really kicked off yet and they've been investing into the company and having expenses but no revenues. So they could have a retained deficit, but it could be a temporary thing because they're expecting once they kick off the sales that they're going to make all that money back. Okay? So that might be one of the more common cases you might see a retained deficit, but in general, you're going to see a retained earnings account, especially in this course. Alright? So let's pause real quick and we'll do a practice problem where we're going to discuss the base formula here in the retained earnings, and then you guys can try one after that, alright? Let's do that now.

Retained Earnings and the BASE Formula

Alright, let's try this example right here. During the current year, ABC Company had net income of $530,000 and paid dividends of $2 per share. The ending balance in retained earnings was $1,240,000. If the company had 100,000 shares of common stock issued and outstanding, what was the beginning balance in retained earnings? Notice they are asking us for the beginning balance; they must have given us the rest of the information in our base equation. So, what's going on here is we are talking about this base equation where we have our beginning balance plus the additions to the account minus subtractions to the account equals the ending balance. So, how does that work out? Well, we're going to have this beginning balance, right? Plus any net income—this is how retained earnings work, right? Minus any dividends—and any net losses, but in this case, we don't have any net losses. That's going to equal our ending balance, right? That's how we would use our base formula to solve this equation. We would plug in what we know and solve for what we're looking for, the beginning balance. Another way we could set this up is to use a T account; if we know our T account, just like we did above, we have a retained earnings T account. We would have our beginning balance as a credit, then we would add any net income, subtract any dividends, and then what's left over after all those numbers is our ending balance. So, I usually like to use the T account because it's a little more visual of what's happening with the credits and the debits, but if you're more comfortable with the base formula and using the algebraic function right there, go ahead and do it that way too. Alright? So let's go ahead and solve this problem.

They told us that we had net income of $530,000, so we have to look for what they did tell us. They told us net income is $530,000. I'm going to put $530k for $530,000, and that dividends were $2 per share. Right? They didn't tell us the total amount of dividends. They didn't just pay $2. They paid $2 per share, and we see that we had 100,000 shares. So we'll need that information to figure out dividends. So we'll do that in a second, but what else did they tell us? They told us the ending balance was $1,240,000. Right? So we know that our ending balance is going to be $1,240,000, which I'll put as $1.240M, the M being those three extra zeros. So what else do we have? We need to figure out those dividends, right? If we figure out the dividends, then we have 3 out of our 4 variables and we can solve for beginning balance. So, our dividends, they weren't given to us directly in total. What did we have? We had 100,000 shares that each received $2 as a dividend. So we're going to have $200,000 in dividends, right? So, our subtraction from the account, we would subtract $200,000 here from dividends. Okay? So, with that information, we're just about ready to solve for our beginning balance, right? We're solving for this beginning balance.

So, let's simplify. We've got beginning balance plus $530k minus $200k. Oops. Oh, boy. What happened here? One second. Okay. Minus $200k. That was more work than I expected. So we'll get beginning balance plus $330k equals $1.240M. Right? We're just doing a little bit of algebra to simplify. We're going to subtract $330k from both sides, and that'll leave us with our answer. So the beginning balance in the account is going to equal $910,000, right, $910,000 is the beginning balance in the account. So, notice with the T account, we could have done the same thing, right? We knew our net income was $530,000, our dividends were $200,000, and our ending balance was $1,240,000, right? So, with that information, well, we could find what number we need that would make this work out, right? A number, add $530 to it, minus $200 equals $1,240. So, either way you do it, you can come up with the $910,000 that is our beginning balance. Right? So, either way that makes more sense to you, use that—use the T account or the base formula to solve for that beginning balance. Cool? Alright. That's about it. Why don't you guys try the practice problem that's coming up?

On January 1, 2018, XYZ Company had a balance of retained earnings of $420,000. During 2018, the company earned net income of $205,000 and also paid dividends. If the balance of retained earnings on December 31, 2018 was $340,000, how much was paid in dividends?

• A. $80,000
• B. $125,000
• C. $205,000
• D. $285,000

Here’s what students ask on this topic:

What are retained earnings and how are they calculated?

Retained earnings represent the net income a company has accumulated over time, minus any dividends paid to shareholders. They are calculated using the base formula: $\mathrm{Beginning\; Balance}+\mathrm{Additions}-\mathrm{Subtractions}=\mathrm{Ending\; Balance}$. Additions typically include the current year's net income, while subtractions include dividends paid and any net losses. This formula helps track the changes in retained earnings over a specific period.

Why are retained earnings not the same as cash?

Retained earnings are not the same as cash because they represent accumulated net income, which may be tied up in various assets or accounts receivable. For example, a company might have earned revenue but not yet received the cash, or it might have invested the cash in machinery, inventory, or other assets. Therefore, a company can have positive retained earnings but not enough cash on hand to pay dividends.

What is a retained deficit and what does it indicate?

A retained deficit occurs when a company's retained earnings account has a negative balance, indicating accumulated net losses or excessive dividend payments. This is often a red flag for financial health, suggesting the company has been losing money over time. However, it can be common in startups that are heavily investing in their business without immediate revenue, expecting future profits to offset the deficit.

How do dividends affect retained earnings?

Dividends reduce retained earnings because they represent a distribution of a company's accumulated net income to its shareholders. When a company declares dividends, the amount is subtracted from the retained earnings account. This is reflected in the base formula for retained earnings: $\mathrm{Beginning\; Balance}+\mathrm{Additions}-\mathrm{Subtractions}=\mathrm{Ending\; Balance}$, where dividends are considered subtractions.

Can a company have positive retained earnings but not enough cash to pay dividends?

Yes, a company can have positive retained earnings but not enough cash to pay dividends. This is because retained earnings represent accumulated net income, which may be invested in various assets or tied up in accounts receivable. The cash might be used for purchasing machinery, inventory, or other investments, leaving the company with insufficient liquid cash to distribute as dividends.