By Chron Contributor Updated September 24, 2020
Retained earnings are primary components of a company’s shareholders’ equity. The account balance in retained earnings often is a positive credit balance from income accumulation over time. Retained earnings are also affected by dividend distributions. Moreover, a company’s accumulated losses can reduce retained earnings to a negative balance, commonly referred to as accumulated deficit. Incorporation laws often prohibit companies from paying dividends before they can eliminate any deficit in retained earnings.
Understanding Retained Earnings
Retained earnings are the total net income that a company has accumulated from the date of its inception to the current financial reporting date minus any dividends that the company has distributed over time. Companies report retained earnings in the shareholders’ equity section of the balance sheet. As profits grow over time, the amount of retained earnings may exceed the total contributed capital by company shareholders and become the primary source of capital used to absorb any asset losses, reports the Corporate Finance Institute.
Dividends and Losses
In addition to using retained earnings to finance asset investments, companies also rely on retained earnings to make dividend payments. While dividend distributions reduce the amount of outstanding retained earnings, losses from asset investments and operations further diminish retained earnings. When a company has sustained significant losses over time, it can deplete its retained earnings that it has accumulated so far and potentially cause a negative account balance.
Deficit on Balance Sheet
Companies report negative retained earnings as accumulated deficit in the balance sheet. The accumulated deficit is a note to the original retained earnings account. For any more asset and operation losses, companies continue to report them in retained earnings to increase the accumulated deficit, while maintaining the balances of other capital accounts as initially recorded. However, the accumulated deficit is compared to balances of the contributed capital accounts, reports Accounting Tools. A company could be in an imminent danger of bankruptcy if the negative assets on the balance sheet has exceeded the amount of contributed capital.
Deficit Elimination
Negative retained earnings, or accumulated deficit, affect companies and their shareholders negatively. Unless negative retained earnings are restored to a positive balance, companies cannot pay out any dividends to shareholders. One way to eliminate the accumulated deficit is for companies to earn enough profits, but it can take a long time and may require additional funds. An alternative way of deficit elimination is to use certain accounting measures.
For example, companies can write up the values of their assets to the fair market values and add the net increases to negative retained earnings to reduce and eventually eliminate the accumulated deficit.
