Retained earnings
Retained earnings represent the cumulative net income of a corporation that has not been distributed to shareholders as dividends, serving as a key component of shareholders' equity on the balance sheet.[1] This figure reflects the portion of profits reinvested in the business to support operations, growth, or debt repayment, rather than being paid out.[2] Under U.S. Generally Accepted Accounting Principles (GAAP), retained earnings are calculated by adding the current period's net income (or subtracting net loss) to the beginning balance of retained earnings and then deducting any dividends declared or paid during the period. A similar calculation applies under International Financial Reporting Standards (IFRS), though presentation may integrate it into a broader statement of changes in equity.[3][4] Adjustments may also include prior period corrections or changes in accounting principles, which are applied retrospectively to the opening balance.[5] Retained earnings provide insight into a company's financial health and management efficiency, as positive and growing retained earnings signal profitability and the capacity for self-sustained expansion without relying heavily on external financing.[1] Conversely, declining or negative retained earnings may indicate ongoing losses or excessive dividend payouts relative to earnings, potentially raising concerns about liquidity or solvency.[6] In financial reporting, GAAP requires disclosure of changes in retained earnings, often through a separate statement that reconciles the beginning and ending balances.[7]Definition and Fundamentals
Definition
Retained earnings represent the cumulative net income of a company that has not been distributed as dividends to shareholders but is instead reinvested in the business.[2] This accumulation reflects the portion of profits generated through operations that the company chooses to retain for internal use, building a reservoir of capital over time.[1] As a measure of self-generated funding, retained earnings provide resources that support ongoing operations, facilitate business expansion, or enable debt repayment without relying on external financing.[1] They embody the company's ability to sustain and grow from its own profitability, distinguishing them from borrowed funds or new equity issuances. Unlike other equity components, such as paid-in capital—which stems from shareholder contributions in exchange for stock—retained earnings are earnings-generated and arise solely from the company's post-tax profits after dividend payouts.[8] This internal origin underscores retained earnings as a reflection of operational success rather than investor capital injections.[9] For example, if a company reports $100,000 in net income and pays out $30,000 in dividends, the remaining $70,000 is retained and added to the existing retained earnings balance.[2] Retained earnings form a core part of stockholders' equity on the balance sheet.[1]Historical Context
The concept of retained earnings emerged in the early 20th century with the expansion of modern corporations, where double-entry bookkeeping—formalized in the 15th century but widely adopted by large firms by this period—enabled precise tracking of accumulated net income separate from paid-in capital. This development coincided with the growth of industrial enterprises like those in steel and manufacturing, which separated ownership from management and relied on internal funds for expansion rather than solely on external equity or debt. By the 1920s, financial reporting for public companies increasingly distinguished undistributed profits as a key component of equity, reflecting the shift toward managerial control over dividend policies.[10] In 19th-century accounting, undistributed profits were typically recorded in broad "surplus" accounts that combined earned income with other non-capital contributions, often leading to opaque distinctions in balance sheets amid varying state laws on dividends. The Great Depression of the 1930s exposed vulnerabilities in these practices, as speculative manipulations of surplus accounts contributed to investor losses and corporate failures. Post-Depression reforms, including recapitalizations and asset write-downs, promoted clearer separation of earned surplus (accumulated net income from operations) from contributed or capital surplus, reducing opportunities for earnings inflation; the modern term "retained earnings" (synonymous with "earned surplus") became preferred in mid-20th century accounting to further enhance clarity.[11][12][13] The U.S. Securities Exchange Act of 1934 formalized the reporting of financial statements, including stockholders' equity components such as undistributed profits, by mandating audited periodic filings for publicly traded companies to restore investor confidence after the market crash. This legislation, enforced by the newly created Securities and Exchange Commission, required quarterly and annual reports that detailed equity to highlight a firm's financial health and reinvestment capacity.[14] World War II further shaped retention policies, as wartime demands for production prompted corporations to retain substantial earnings for reinvestment in facilities, machinery, and research to meet government contracts, rather than distributing them as dividends. Tax incentives and excess profits taxes during the war encouraged this approach, with retained earnings rising sharply; for instance, after-tax corporate profits reached $22.8 billion in 1950, the majority of which remained undistributed to fuel post-war industrial recovery and growth.[15]Calculation and Accounting Treatment
Basic Formula
The basic formula for calculating retained earnings at the end of an accounting period under U.S. Generally Accepted Accounting Principles (GAAP) is expressed as: \text{Retained Earnings (Ending)} = \text{Retained Earnings (Beginning)} + \text{[Net Income](/page/Net_income) (or Loss)} - \text{Dividends Declared} [6][2] This equation captures the cumulative effect of a company's profitability and distributions to shareholders, forming the core of retained earnings computation as outlined in ASC 505-10 of the FASB Accounting Standards Codification.[6] The beginning retained earnings balance represents the accumulated undistributed earnings carried forward from the prior period's balance sheet.[2] Net income, or loss if applicable, is the bottom-line figure from the current period's income statement, reflecting revenues minus expenses after taxes.[3] Dividends declared denote the portion of earnings distributed to shareholders, typically as cash or stock, which reduces the retained balance.[2] To derive the ending retained earnings step by step, begin with the prior period's retained earnings balance as the starting point. Next, add the current period's net income to incorporate fresh profits, or subtract a net loss to account for deficits. Finally, deduct any dividends declared during the period to reflect shareholder payouts, yielding the updated retained earnings figure for the balance sheet.[3][6] For illustration, consider a company with beginning retained earnings of $500,000, net income of $200,000, and dividends declared of $50,000. Applying the formula results in ending retained earnings of $650,000 ($500,000 + $200,000 - $50,000).[2] This example demonstrates how positive net income increases the balance while dividends decrease it, maintaining the integrity of the equity section on the balance sheet.[3]Adjustments and Variations
Under U.S. GAAP, prior period errors, such as omissions or misstatements in financial statements arising from failure to use reliable information, require retrospective restatement, with the cumulative effect adjusted directly to the opening balance of retained earnings for the earliest period presented.[16] Similarly, voluntary changes in accounting principles are applied retrospectively, adjusting prior period financial statements and recognizing the cumulative effect in opening retained earnings, unless impracticable.[16] Restatements for these items ensure comparability, with disclosures explaining the nature and impact of the adjustments.[17] Under IFRS, IAS 8 mandates retrospective restatement for prior period errors, adjusting the opening balance of retained earnings for the earliest prior period presented, after reassessing the impact on each financial statement line item.[18] Changes in accounting policies also require retrospective application, with the cumulative effect adjusted to opening retained earnings, except when impracticable, to enhance the relevance and reliability of financial statements.[19] For instance, if prior net income was overstated by $10,000 due to an error in revenue recognition, the correction would reduce retained earnings by that amount in the opening balance of the restated period.[20] Under U.S. GAAP, small stock dividends (less than 20-25% of outstanding shares) involve transferring the fair value of the shares issued from retained earnings to common stock and additional paid-in capital, while large stock dividends (greater than 20-25% of outstanding shares) are typically accounted for at par value, without any cash outflow from the company.[21] In contrast, stock splits do not affect retained earnings, as they merely adjust the par value per share and increase the number of shares outstanding proportionally, preserving total equity.[22] Treasury stock transactions, such as retirement of repurchased shares, may reduce retained earnings if the cost exceeds the original issuance proceeds, but repurchases themselves are recorded as a contra-equity account without initially impacting retained earnings.[23] Accumulated other comprehensive income (AOCI) represents unrealized gains and losses in equity separate from retained earnings, but reclassifications occur when items are realized, such as transferring foreign currency translation adjustments to earnings upon disposal of a foreign operation.[24] Under U.S. GAAP, ASU 2018-02 provides an optional one-time reclassification of stranded tax effects in AOCI—resulting from the Tax Cuts and Jobs Act—to retained earnings, eliminating disproportionate tax impacts in equity without affecting net income. In IFRS, IAS 16 allows the revaluation surplus in AOCI for property, plant, and equipment to be transferred directly to retained earnings as the asset is used or upon derecognition, bypassing profit or loss.Presentation in Financial Statements
Balance Sheet Integration
Retained earnings are presented as a separate line item within the stockholders' equity section of the balance sheet, typically positioned below paid-in capital accounts such as common stock and additional paid-in capital.[6] This placement reflects their role as accumulated earnings reinvested in the business rather than distributed to shareholders, distinguishing them from initial capital contributions. Under U.S. GAAP, stockholders' equity must clearly delineate these components to provide transparency into the sources of equity financing.[6] The relationship between retained earnings and total equity is integral, as total stockholders' equity comprises contributed capital (from share issuances), retained earnings, accumulated other comprehensive income (AOCI) or other reserves, and adjustments such as treasury stock. The formula is expressed as: Total Stockholders' Equity = Contributed Capital + Retained Earnings + AOCI/Other Reserves - Treasury Stock.[25] This composition highlights retained earnings as the portion of equity generated internally through operations, contributing to the residual interest of shareholders after liabilities are deducted from assets.[26] To illustrate, consider a simplified excerpt from a balance sheet's equity section:| Stockholders' Equity | Amount ($) |
|---|---|
| Common Stock | 100,000 |
| Additional Paid-in Capital | 200,000 |
| Retained Earnings | 150,000 |
| Accumulated Other Comprehensive Income | 20,000 |
| Less: Treasury Stock | (30,000) |
| Total Stockholders' Equity | 440,000 |
Retained Earnings Statement
The retained earnings statement, also known as the statement of changes in retained earnings, serves to reconcile the beginning and ending balances of retained earnings over a specific accounting period, thereby linking the income statement's net income to the balance sheet's equity section.[29] This financial document provides transparency into how a company's profits are either reinvested or distributed, offering stakeholders insight into management's allocation decisions.[30] The standard format of the retained earnings statement begins with the prior period's ending retained earnings balance, adds the current period's net income (or subtracts a net loss), deducts dividends declared and paid, and incorporates any other adjustments such as prior-period corrections or changes due to accounting policy adoptions.[29] The resulting figure represents the ending retained earnings balance, which carries forward to the next period's equity reporting.[31] This straightforward structure ensures a clear audit trail for equity changes attributable to operations and distributions.[32] Under U.S. GAAP, public companies must disclose changes in stockholders' equity, including detailed reconciliations of retained earnings, either in a separate statement or in the notes to the financial statements, as required by SEC Regulation S-X Rule 3-04.[33] Similarly, under IFRS, IAS 1 mandates that entities present a complete statement of changes in equity for each period, explicitly showing movements in retained earnings alongside other equity components such as comprehensive income, owner transactions, and restatements.[34] These requirements apply to public companies to enhance comparability and investor understanding of equity dynamics.[4] For illustration, consider a hypothetical company with the following retained earnings statement for the year ended December 31, 2025:| Item | Amount ($) |
|---|---|
| Retained Earnings, January 1, 2025 | 400,000 |
| Add: Net Income | 150,000 |
| Less: Dividends Declared | (40,000) |
| Retained Earnings, December 31, 2025 | 510,000 |