The statement of retained earnings is a sub-section of a broader statement of stockholder’s equity, which shows changes from year to year of all equity accounts.
Why You Need a Statement of Retained Earnings
Businesses need to prepare a statement of retained earnings for both internal decision making and for the dissemination of information to external interested parties.
Internal Decision-Making
A statement of retained earnings is necessary for business owners to keep track of their accumulated retained earnings or the portion of net income allocated to retained earnings since the beginning of the life of the business. The statement of retained earnings is also important for business management as it allows the firm to determine its retention ratio. The retention ratio is the percentage of net income that is retained. For example, if 60% of net income is paid out as dividends, that means 40% of net income is retained. The dividend payout ratio is the opposite of the retention ratio.
For Creditors
If you have used debt financing, you have creditors or institutions that have loaned you money. A statement of retained earnings shows creditors that the firm has been prosperous enough to have money available to repay your debts.
For Investors
Money that is funneled back into the business for growth is a good sign of company health for investors. If a company is expecting growth, then its stock price may rise. Investors watch for the business’s stock price to increase because this means the latter’s management is focused on maximizing the wealth of shareholders.
Preparing a Statement of Retained Earnings
A statement of retained earnings consists of a few components and takes a series of steps to prepare. See the outline below.
The Heading
A statement of retained earnings should have a three-line header to identify it. On the first line, put the name of the company. The second line simply says, “Statement of Retained Earnings.”
State the Retained Earnings Balance From the Prior Year
The first item on the statement of retained earnings should be the balance of retained earnings you’re carrying over from the prior year. This figure comes from the prior year’s balance sheet. If the balance of retained earnings for a hypothetical firm were $20,000, the first line for the statement of retained earnings would look like this:
Add Net Income From the Income Statement
The second item entered is net income or loss. If the same hypothetical company had a net income of $10,000 for the current year, the retained earnings statement now looks like this:
Retained Earnings: December 31, 2019 $20,000Plus: Net Income 2020 +10,000Total: $30,000
Subtract Dividends That Your Company Pays Out to Investors
If the hypothetical company pays dividends, subtract the amount of dividends it pays from net income. If it does not pay dividends, then subtract $0. If the company’s dividend policy is to pay 50% of its net income out to its investors, $5,000 would be paid out as dividends and subtracted from the current total. Here is the layout below:
Retained Earnings, December 31, 2019 $20,000Plus: Net Income 2020 +10,000Total: $30,000Minus: Dividends (5,000)
Dividends are treated as a debit, or reduction, in the retained earnings account whether they’ve been paid or not. If, for instance, Widget Corporation’s board of directors declares a dividend of $5.00/share on 10,000 shares stock, $50,000 is then deducted from the company’s retained earnings even if the dividend has not yet been paid.
Prepare the Final Total for Retained Earnings
Subtract the dividends, if paid, and then calculate a total for the statement of retained earnings. This is the amount of retained earnings that is posted to the retained earnings account on the 2020 balance sheet.
Retained Earnings, December 31, 2019 $20,000 Plus: Net Income 2020 $10,000 Total: $30,000 Minus: Dividends Paid ($5,000) Retained Earnings, December 31, 2020 $25,000
Additional Information
Although preparing the statement of retained earnings is relatively straightforward, there are often a few more details shown in an actual retained earnings statement than in the example. The par value of the stock (its declared value at issuance) is sometimes indicated as a deeper level of detail. When filling out any financial statements, always check with your accountant or your business’s financial planner to make sure you are in compliance with the most updated formats and generally accepted accounting principles.
What items don’t appear on a statement of retained earnings?
Cash flow does not appear on a statement of retained earnings.
Which financial statement is used by corporations instead of a statement of retained earnings?
Corporations can instead use the Statement of Stockholder’s Equity.
Which items appear on both a statement of retained earnings and a balance sheet?
The accumulated retained earnings balance for the previous year, which is the first line item on the statement of retained earnings, is on both the balance sheet and statement of retained earnings.
