What are retained earnings?

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:

Retaind earnings statement

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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