Retained Earnings – Definition
Retained earnings are created as stockholder claims against the corporation because it has achieved profits. Like all other equity claims, RE is not associated with any particular assets and certainly do not constitute a pool of cash or other assets. Four things can occur that change the amount of retained earnings; they can be:
The total earnings of a business house are distributed:
(a) To Government in the form of taxes.
(b) To shareholders in the form of Dividend.
(c) The rest (balance) is carried to Retained Earning Account.
The last two are related to a management decision, wherein it is decided how much to be distributed in the form of Dividend and how much to be retained. The higher rate of dividend will lower the amount of retained earnings. The management always takes a judicious decision with regard to Dividend and retained earnings.
Retained earnings are future Rain-coat to the company during hard days. These can be used for expansion, modernization and replacement of assets. The retained earnings is a good source of internal finance used by all organizations. It is also known as plowing back of profits.
Formula to calculate RE
(i) Internal Source: The main feature of retained earnings is that it is a good source of internal finance that does not create any long term liability.
(ii) Uses of Retained earnings. The retained earnings is a good source of expansion, modernization, and replacement of properties.
(iii) Freedom to use. The retained earning can be used in a very free way no fixed date of return and no cost to the company.
(iv) Capital addition. The retained earnings increase the base of business this helps the company for more borrowings.
(v) Indirect benefits to shareholders. The retained earnings offer the tax benefit to shareholders. The company need not to pay interest as the cost of borrowed capital.
(vi) Addition in Goodwill. More and more retained earnings is an index of business efficiency and more profitability thus, the top management can use it for expansion and modernization.
Factors affecting the size of Retained Earnings
The quantum of money which should be kept for future emergencies depends upon the following points.
1. Nature of the Company. No set rule can be recommended to all companies about retained earnings it differs from organization to organization. Growing companies have high retained earnings.
2. Quantity of Profits. The quantity of profit will also decide the amount of RE, larger profit, larger can be the amount of retained earnings.
3. Depreciation Policy. The management should follow such depreciation policy which makes a larger amount of depreciation in the initial years.
4. Class of Shareholder. The retained earnings will be affected by the classification of shareholders, low-income group shareholder always prefer more dividend rather than RE. High-income group will not insist on more dividend but more wealth maximization.
5. Government tax Policy. The earnings are affected by tax policies, higher taxation will reduce retained earnings.
6. Degree of Competition. The high degree competition will reduce the amount of RE.
7. Credit Standing. The companies having better credit standing can secure loan at cheaper rate and their earning will go up.
8. Age of Company. The long period standing company has a high rate of profitability thus, RE will be high. In general, newly established companies have low rate of profitability while companies of long standing have more chances of high rate of dividend as their retained earnings are more.
Satisfaction of retained earnings
Retained earnings claims can be satisfied by the distribution of assets to the stockholders through a dividend. The act of satisfaction involves three dates of significance:
- Date of declaration—the day on which the board of directors announces its intent to pay dividends and specifies the amount per share and other details.
- Date of record—the day on which the recipients of the dividend are identified; owners of stock at the close of business on the date of record will receive the payment; for traded securities, an ex-dividend date precedes the date of record by five days to permit the stockholder list to be updated and serves effectively as the date of record.
- Date of payment—the day on which the assets are distributed to the stockholders of record.
Distributions that actually satisfy owners’ claims are cash, property, and liability dividends.
Appropriation of retained earnings (Journal entries)
For various reasons, some firms appropriate part of their retained earnings. This action merely results in disclosing that a portion of the stockholders’ claims temporarily will not be satisfied by a dividend. It should be understood that the claims remain part of RE. The appropriation may be established as part of a statutory requirement, primarily related to treasury stock acquisitions.
Although the laws of virtually all states limit dividends to an amount equal to the balance of retained earnings less the cost of treasury shares, few actually impose a requirement for formal appropriation. An appropriation may also be established in compliance with an agreement associated with major debt financing. While the intent of the appropriation requirement is to maintain the debtor’s solvency, it does not work nearly as well as the more specific restrictions.
Some firms disclose contingencies by appropriating RE. Prior to GAAP, this disclosure was often considered sufficient and some firms debited contingency losses to the appropriation and did not report them on the income statement. GAAP specifically prohibits this practice and requires that any appropriations of RE appear as part of stockholders’ equity. Any probable and estimable contingencies must appear as liabilities or asset impairments rather than an appropriation of retained earnings.
A fourth reason for appropriating RE arises when management wishes to disclose voluntary dividend restrictions that have been created to assist the accomplishment of plans. For example, a firm may pass up a dividend in order to preserve its cash for the acquisition of a new factory. This journal entry would be made if the amount is $1,000,000:
The act of appropriation does not increase the cash available for the acquisition and is thus unnecessary. It may be done, however, if management believes that it will help the stockholders accept the nonpayment of dividends. These Journal entries would be prepared if the factory is acquired for $1,200,000:
To naive investors who think the appropriation established a fund of cash, this second entry will produce an apparent increase in RE and an apparent improved ability to pay a dividend. In fact, the purchase will have depleted the available cash and the firm will be less able to pay a dividend than before the purchase was accomplished.
Restating retained earnings
Many firms restated (or adjusted) the balance of the Retained Earnings account as they recorded the effects of events that had their origins in earlier reporting periods. GAAP greatly restricted this use of the prior period adjustment, but abuse apparently continued to occur as items affecting stockholders’ equity were not being reported on the income statement. It generally limits the use of the prior period adjustment to the correction of errors that occurred in earlier years.
When a prior period adjustment is used, it appears as a correction of the beginning balance of RE and is fully described. The relative infrequency of material errors, the use of this type of adjustment has been virtually eliminated.
A second situation in which an adjustment can be entered directly in the Retained Earnings account and thus bypass the income statement is the quasi-reorganization.
Reclassification of retained earnings
Retained earnings are reclassified as one or more types of paid-in capital under two general circumstances. The most common of these, the distribution of a stock dividend. The other is an action on the part of the board of directors to increase paid-in capital by reducing RE. One occasion for this decision would be the desire to remove a voluntary appropriation without causing net inappropriate RE to increase.
Problems/Dangers/Demerits of Excess Retained Earnings
In the above portion, an attempt is made to high light the importance of retained earnings but there are following dangers too.
(A) Loss to Shareholders
(i) Lesser dividend. When retained of profit policy is followed in such case the shareholder will get lesser dividend and the value of their shares will fall.
(ii) Change in Ownership. When the management decides to have a high rate of earnings for RE in such a situation the shareholder dispose of their shares.
(B) Loss to the Company
(i) Over-Capitalization. When a company has a sufficient amount in retained earnings account, the company will issue bonus-shares which will result in over-capitalization.
(ii) Low-Rate Dividend. Excess RE reduces the future rate of dividend.
(iii) Lesser loan facilities. The company having high RE will disturb shareholders, they will sell their shares and goodwill of such companies suffer which ultimately suffer their loan taking facility.