Retained earnings are a fuzzy concept, after all you can’t drop them on your foot or use them in any way. And yet retained earnings are the glue that hold your accounting reports together, if you don’t maintain the integrity of the retained earnings then your balance sheet is just a piece of paper with funny marks on it. Calculating retained earnings is an intellectually simple process that is easy in concept but can cause many complications in practice.
A Rose by Any Other Name
Depending on where you are from and what accounting system you use retained earnings could alternatively be called accumulated earnings, accumulated profit, accumulated income, accumulated surplus, earned surplus, undistributed earning, or undivided profit. It’s the same animal, and this article applies to all equally.
The Beauty that Is Retained Earnings
As the web’s renowned and self-proclaimed “unrepentant nerd for numbers” I could wax gloriously on about the beauty of accumulated income and it’s vital role in the maintaining of the symmetry of the balance sheet or about their unsung glory in ushering in first the Age of Discovery and essential role in the Industrial Revolution but you don’t give a fig about that, you only care about why it is essential that you as a business person understand the concept of retained earnings, so here goes. Accumulated Earnings are the link between last year’s balance sheet and this year’s. In fact, the basic formula for 95% of all businesses, large or small, is this: last year’s retained earnings +/(-) this year’s income/(loss) – distributions of money to owners + contributions of money from owners = this year’s retained earnings. You will see accumulated earnings as part of the equity section on the balance sheet and basically it makes up the difference between your assets and your liabilities. Simple! “But Tyler,” you ask, “why is it so important that I understand this?” Hmm, I see my job isn’t done yet, allow me to elaborate
So Darn Important
If your business files a tax return as an independent entity or makes financial statements of any kind then you have retained earnings and you need to absolutely respect the Universal First Law of Retained Earnings: do not change or cause any change to last year’s retained earnings unless you have the written authority of God or your accountant. I mean that, I’m not even cracking a smile as I write this. You see, all business tax returns and financial statements are comparative, that is nerdy accountant talk for saying that they show at minimum two years at a time. Think of your balance sheet as a snapshot of your business’s resources and obligations at a given moment in time, say last December 31 at 11:59 on the dot. Well, snapshots are nice and all for the family reunion but what you really want is a motion picture of your business’s operations, say for the past year.
What the balance sheet does is take a snapshot on December 31 of last year and then another snapshot on the December 31 just ended. The income statement is the motion picture of what went on between those two snapshots, focused through the lens of accumulated earnings. Well, your trial balance may show neat little columns of debits and credits all happily equaling each other at the bottom, but, using the formula above, your net income plus or minus any distributions or contributions of capital must explain the difference between the two balance sheets or you are out of balance. This will cause an enormous red flag kasegu-hyouban001 for the IRS or whoever your tax collector may be and, if you are having financial statements audited, reviewed, or compiled, it will cause your accountant to run screaming for the liquor cabinet.
What They Ain’t
A common misconception is that the amount of retained earnings is somehow an indicator of how strong your business is. This is absolute hogwash. In a traditional, industrial business huge amounts of cash often had to be raised to build ships or highways or widgets and it was considered nice to have a “cushion” of accumulated earnings however, in modern business, profits (net earnings) are the meat in the business hamburger. I have clients with very profitable businesses that require fairly low requirements for capital and merrily distribute their profits to the shareholders every year, think internet companies or businesses dealing in information, and I have manufacturing companies with lots of retained earnings but little or negative profits.
When Your Retained Earnings Goes FUBAR and How to Fix It
If you get to the end of the year and you notice that your retained earnings is out of balance, that is, when you take last year’s retained earnings as reported on your tax return or financial statement and add this year’s income (or subtract this year’s losses) and you don’t get the number that you show for this year’s retained earnings, then take a big stick and whack yourself on the head five times. Afterward take two Tylenol get down to the dirty business of fixing the problem. Go down the balance sheet line by line, starting with cash, and make sure each line makes sense. After you have verified the balances on all your loans you only have one account left, retained earnings. Going back to the formula above you must have either not recorded income right or you have made a distribution without recording it properly.
Now, I will tell what happens 97.26% of the time; in January after you have already prepared your taxes or sent your trial balance to your accountant for her to prepare you find that you forgot to pay a bill that is dated from December, or you found a check from a customer you forgot to deposit or something along those lines. So what do you do? If you are using accounting software like QuickBooks you record the transaction at the date it happened. “No, no, NO!” as my two year old son would say. Once that trial balance has gone out, all activity must be recorded in the subsequent period, unless you have the express authority from your accountant. The solution? Well, as your accountant I would either increase income or an expense until retained earnings is back in harmony with the universe.