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 |
|
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 |
|
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 |
|
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 |
|
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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