Retained earnings refer to the amount of net income that a business has after it has paid out dividends to its shareholders. Businesses generate earnings that are either positive or negative. Positive earnings are more commonly referred to as profits, while negative earnings are more commonly referred to as losses. The retained earnings normal balance is the money a company has after calculating its net income and dispersing dividends.
Profits can be used by a business in several ways. These positive earnings can be reinvested back into the company and used to help it grow, but a significant amount of the profits are paid out to shareholders. Whatever amount of the profits that is not paid out to shareholders is deemed retained earnings.
Retained earnings are a positive sign of the company’s performance, with growth-focused companies often focusing on maximizing these earnings. However, there are some cases in which businesses need to adjust their retained earnings using debit and credit methods.
Retained Earnings Versus Dividends
Dividends redistribute the company’s profits to shareholders. When a company issues common and preferred stock, the value investors pay for that stock is called paid-in capital. The amount of this capital is equal to the amount the investor pays for the stock in addition to the face value of the share itself.
Additional paid-in capital is the value of a stock above its face value, and this additional value does not impact retained earnings. However, this form of capital reflects higher available equity that may generate higher long-term revenues and, indirectly, increased retained earnings.
There is no requirement for companies to issue dividends on common shares of stock, although companies may try to attract investors by paying yearly dividends. Dividends can be paid in either stock or cash. Stock dividends are payments made in the form of additional shares paid out to investors. Cash dividends are payments distributed in money.
Retained Earnings on Balance Sheets
Both stock and cash dividends represent a loss to the company’s profits. A corporate balance sheet includes a shareholders’ equity section, which documents the company’s retained earnings. Retained earnings can only be calculated after all of a company’s obligations have been paid, including the dividends it is paying out..
After those obligations are paid, a company can determine whether it has positive or negative retained earnings. A straightforward way of visualizing all additions and subtractions is using a retained earnings t account, which records losses to an account in a left hand column and additions to that account in the right hand column.
Negative Retained Earnings
Negative retained earnings occur if the dividends a company pays out are greater than the amount of its earnings generated since the foundation of the company. Retained earnings are an equity account and appear as a credit balance. Negative retained earnings, on the other hand, appear as a debit balance.
Retained Earnings, Debit and Credit
A retained earnings balance is increased when using a credit and decreased with a debit. If you need to reduce your stated retained earnings, then you debit the earnings. Typically you would not change the amount recorded in your retained earnings unless you are adjusting a previous accounting error.
Adjustments to retained earnings are made by first calculating the amount that needs adjustment. Afterward, you post the debited amount to the dividends issued. Next, the amount deducted from your retained earnings is recorded as a line item on your balance sheet. This reflects a reduction in your retained earnings.
However, once you debit the amount from dividends, that money still needs to be credited to the appropriate account. These values need to be equal to show where money was deducted and added. Credit the amount to the appropriate account and write a correction entry noting the reason for the adjustment on your balance sheet. Finally, restate your earnings statement to reflect the corrected retained earnings normal balance.
