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Accounting Terms – Exploring Retained Earnings

The concept of retained earnings is one of the key accounting terms, which finance business assets if we want to understand the structure of the balance sheet and understand the meaning of financing. This article will explore these accounting terms and a practical example to better understand the concept.

concept

Considering the term retained earnings, we first need to include the definition of equity. Owners’ equity is the shareholders’ residual claim on the assets of the business. Residual means that first the business must repay the liabilities and only then what is left can be distributed to the shareholders. Equity is therefore the difference between assets and liabilities and can also be supported by the basic accounting equation, where Assets = Liabilities + Equity.

Equity in turn includes:

• share capital – The initial investment of shareholders in the business and
• Earnings retained – Net profit earned and remaining in business, which has not yet been distributed to shareholders. Of course if the business incurs losses, such losses are accumulated as retained earnings, which is negative and reduces the value of equity.

above balance sheet These two items are indicated separately to show how much the shareholders have invested in the business and how much the business has accumulated in distributed profits since the beginning of operations.

Relation to Income Statement

To understand the concept of Earnings retained Its relationship with the income statement should be better shown. Assume we have a company, which started its business on 1st January 2009. Shareholders invest $10,000 in cash at the start of business operations. Income statement For the year 2009 is as follows (no tax or interest expense provided for simplicity):

Revenue____________________25,000

Cost of goods sold_________(19,000)

Gross profit_____________6,000

Operating Expenses __________(3,000)

Net Profit______________________3,000

The shareholders decided not to distribute dividends for the year 2009 and to retain all the profits of their business. above balance sheet here Equity Part you will see below:

Share Capital______10,000

Retained earnings____3,000

Total Equity________13,000

So all the net profit in the income statement goes as retained earnings in the balance sheet, because the profit was retained in the business.

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