A number of different circumstances could turn a positive retained earnings balance into a retained earnings deficit. When a deficit becomes too large, the company can utilize an accounting trick known as quasi-reorganization to get back on the right track.

1. Problems associated with a retained earnings deficit

New corporations commonly operate at a loss for a few years after inception. This is a time where the sales team makes contacts, workers are trained, processes are improved on and streamlined, and brand recognition is low. By the time the company turns its first profit, a significant retained earnings deficit may exist. Along the same line of thinking, a lengthy recession could turn a profitable company into a company with a retained earnings deficit.

So what’s the big deal? The main issue is that dividends are generally paid out of retained earnings, and paying dividends in the presence of a deficit is generally illegal or contrary to a debt covenant. A deficit could depress the company’s stock value or scare away potential investors who might worry about a lack of dividends in the near future.

Corporations desiring a “fresh start” can employ an accounting tool called a quasi-reorganization. This is not a legal term, and it does not involve some kind of official filing or declaration – it is simply a method of moving corporate equity from paid-in capital to retained earnings.

2. Quasi-reorganization procedure

The main goal of a quasi-reorganization is to bring the retained earnings balance to zero. First, overvalued assets should be written down to fair value with a direct reduction to retained earnings. Although this increases the deficit momentarily, it will reduce future depreciation expense. Liabilities are also restated to their fair values with any resulting offsets going to the retained earnings deficit.

Once assets have been reduced to fair value, either additional paid-in capital or the par value of common stock is reduced in order to balance out the elimination of the retained earnings deficit. Companies have some flexibility when deciding how to proceed with the quasi-reorganization – it is possible to reduce par value, increase additional paid-in capital, and zero out retained earnings at the same time.

There is no effect on the equity section of the reorganized company’s balance sheet. The balances have simply been reshuffled in order to allow for the payment of dividends after the next profitable period (or during the current period if income is expected).

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