## 2. Example of calculating retained earnings

Let’s look at a simple example. Assume that Friends RE Company (a fictitious entity) had the following balance sheet as of December 31, 20X2:

 Friends RE Company Balance Sheet December 31, 20X2 Assets Cash \$ 20,000 Accounts receivable (net) 30,000 Inventory 40,000 Buildings (net) 80,000 Land 20,000 Other assets 10,000 Total assets \$ 200,000 Liabilities Accounts payable 22,000 Notes payable 33,000 Total liabilities 55,000 Total stockholders’ equity Common stock 50,000 Paid-in capital 60,000 Retained earnings 35,000 Total stockholders’ equity 145,000 Total stockholders’ equity and liabilities \$ 200,000

In 20X3, the company’s revenues and expenses (including tax) were \$100,000 and \$70,000, respectively (see below). The company paid \$15,000 in cash dividends.

 Friends RE Company Income Statement For the Year Ended December 31, 20X3 Revenues \$ 100,000 – Expenses (70,000) Net Income \$ 30,000

From the balance sheet above, we know that that 20X3 beginning balance in retained earnings was \$35,000 (i.e., it’s the same as the ending balance in 20X2). To calculate the 20X3 ending balance in retained earnings, we need to add the net income earned in 20X3 and deduct the cash dividends paid in 20X3.

 Friends RE Company Statement of Retained Earnings For the Year Ended December 31, 20X3 Beginning balance \$ 35,000 + Net income 30,000 – Dividends (15,000) Ending balance \$ 50,000

To see the links between different financial statements, see the illustration below:

What if Friends RE Company made a mistake in applying an accounting principle in 20X2 but only discovered the error in 20X3? Let’s assume that in 20X2 the company understated the cost of goods sold account by \$10,000 (net of tax). As the result, the company overstated both the net income and retained earnings accounts by \$10,000 in 20X2. The company discovered the error before issuing the 20X3 financial statements.

Such an error can be corrected by adjusting the beginning balance in the retained earnings account (i.e., prior period adjustment). Friends RE Company would report the following statement of retained earnings in 20X3:

 Friends RE Company Statement of Retained Earnings For the Year Ended December 31, 20X3 Beginning balance, as previously stated \$ 35,000 Prior period adjustment – error correction (10,000) Beginning balance, as restated 25,000 + Net income 30,000 – Dividends (15,000) Ending balance \$ 40,000
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