Retained earnings are the portion of a company's net income which is kept by the company instead of being paid out as dividends to equity holders. This money is usually reinvested into the company, becoming the primary fuel for the firm's continued growth, or used to pay off debts. Calculating retained earnings and preparing a statement of retained earnings is an important part of an accountant's job. Usually, retained earnings for a given reporting period is found by subtracting the dividends a company has paid to stockholders from its net income.
Part 1 - Understanding Retained Earnings
1.Know where a business's retained earnings are recorded. Retained earnings is a permanent account that appears on a business's balance sheet under the Stockholder's Equity heading. The account balance represents the company's cumulative earnings since formation that have not been distributed to shareholders in the form of dividends. If the retained earnings account has a negative balance, it is called "accumulated deficit."
2.Understand the relationship between a company's investors and its retained earnings. A profitable company's investors will expect a return on their investment paid in the form of dividends. However, investors also want the company to grow and become more profitable so that its share price will rise, earning the investors more money in the long run. For a company to effectively grow, it needs to invest its retained earnings back into itself. Usually, this means using retained earnings to improve efficiency and/or expand the business. If successful, this re-investment causes the company to grow, raising its profitability and share price and earning the investors more money than if they had initially demanded greater dividends.
3.Know the forces that affect retained earnings. A company's retained earnings can fluctuate from one reporting period to the next. However, this isn't always the result of a change in a company's revenue flow. Below are factors that can affect a company's retained earnings balance:
Part 2 - Calculating a Company's Retained Earnings
1.If you can, gather the necessary data from the company's financial statements.Companies are required to officially document their financial history. If you can manage, it's usually easiest to calculate current retained earnings by using these official values for a company's retained earnings to date, net income, and dividends paid out, rather than calculating these by hand. A company's retained earnings up to the most recent recording period and its own equity should appear on the current balance sheet, while its net income should appear on a current income statement.
2.If you don't have access to net income information, begin by calculating gross margin. If you don't have access to a single, definitive value for net income, you can calculate a business's retained earnings manually through a slightly longer process. Begin by finding the company's gross margin. Gross margin is a figure presented on a multiple-step income statement and is determined by subtracting the costs of a company's goods sold from the money generated from the sales.
3.Calculate operating income. Operating income represents a company's income after all sales expenses and operating (ongoing) expenses, like wages, have been paid. To calculate it, subtract a business's operating expenses (besides the cost of goods sold) from the gross margin.
4.Calculate pre-tax net income. To do this, subtract expenses due to interest, depreciation, and amortization from the company's operating income. Depreciation and amortization - the reduction in value of assets (tangible and intangible) over their life - are recorded as expenses on income statements. If a company buys a $10,000 piece of equipment with a 10-year lifespan, it would result in a $1,000 depreciation expense each year, assuming its value depreciates at an even rate.
5.Calculate after-tax net income. The final expense we must account for is taxes. To do this, first, apply the company's tax rate to their pre-tax net income (by multiplying them together). Then, to get after-tax net income, subtract this amount from the pre-tax figure.
6.Finally, subtract dividends paid. Now that we've found our company's net income after all expenses have been accounted for, we have a value we can use to find retained earnings for the current recording period. To find this value, subtract dividends paid from the after-tax net income.
In our example, let's assume we paid out $10,000 to our investors this quarter. The current period's retained earnings would be $26,268 - $10,000 or $16,268.
7.Calculate the present balance of the retained earnings account. Don't forget that retained earnings is a cumulative account that accounts for the net change in retained earnings from a business's formation to the present. To arrive at the overall retained earnings, add the current period's retained earnings to the account's balance as of the end of the last accounting period.