How to create a retained earnings statement
Creating a statement of your business’ retained earnings is a key step of your accounting process.
But there’s more to it than a simple yearly check-box activity.
In this article, we discuss what are retained earnings, why this matters, and how to prepare a statement of retained earnings using a retained earning formula.
Let’s get started.
What are retained earnings?
In its simplest form, retained earnings demonstrate your business’ profit from the previous accounting year after all your obligations have been satisfied. They’re the funds that your business has generated that haven’t been distributed in dividends to your shareholders.
Your retained earnings is money that your business is able to use for yourself. They can be utilised for reinvestment back into your business, into income-generating assets, or can be used to reduce your business’ liabilities.
What is a statement of retained earnings?
A statement of retained earnings is an important part of your accounting process. The statement is a document that you use to show your business’ income growth over time.
Your retained earnings statement can be added as a line at the bottom of your business’ balance sheet. But it can also be prepared as its own standalone document, which has its own benefits.
Why a statement of retained earnings is necessary
Your retained earnings statement is a necessary business document—and not just for general accounting purposes.
It’s an important tool for startups and early growth businesses, which you can use to demonstrate to potential lenders and investors that your business is actively working towards your growth goals. This is why it can be beneficial to create a standalone document, which you can hand to interested parties without divulging any other financial information.
Comparing historical retained earnings over your business’ history enables investors to predict future growth, potential dividend payments, and improvements on your business’ share price. It’s a defined document that demonstrates to investors and shareholders a solid return on investment.
Your statement of retained earnings can be used to compare your business against others and prove that your business has legs. It shows that you’re able to make good on credit payments and settle your debt.
Essentially, it acts as a road map to prove that your business has the potential to scale.
Why you need to demonstrate retained earnings
Retained earnings are a useful tool to provide a link between your business’ income statement and your balance sheet. They’re recorded under your shareholder’s equity, which connects these two statements.
But your retained earnings isn’t just a number. It’s a tangible, practical pool of money that can be used to pay for future business expenses. For example, it can be used to purchase new business assets such as machinery or equipment, funnelled into research and development, or used in other ways to promote growth for your business
Retained earnings are there to be used to help your business grow. If you don’t think you’re able to generate a reasonable return on investment for your retained earnings, businesses typically choose to distribute the earnings back to their shareholders as dividends.
How to calculate retained earnings
Your retained earnings balance is added to any net income or loss, and dividend payouts are subtracted on top of this. This paints a clear picture of your business’ income, and outlines any changes to these earnings for a specific period.
There’s a simple retained earning formula you can use to calculate your retained earnings:
(Beginning period Retained Earnings) + (Your business’ net income OR loss) - (Cash dividends paid) - (Stock dividends paid)
It works like this.
Take the beginning period retained earnings, that is, those reported on your balance sheet from the previous year, which includes the current year’s income.
Then, subtract any dividends you pay to your shareholders and any stocks.
You’ll then land in your current retained earnings, which in turn is used for the beginning period retained earnings for the next accounting year.
How to prepare a statement of retained earnings in 5 easy steps
1. Create a heading
This covers three lines on your balance sheet. The first line must include your business name, and the second line should provide a succinct title for your document. The third line defines the year in which this statement is being lodged.
My Exciting Business
Statement of Retained Earnings
For the Financial Year Ended 2020
2. Record the balance of retained earnings from the previous year
This is the first line item of your statement, also known as your beginning retained earnings.
If you’ve prepared a statement in years prior this will carry over from the previous year. If it’s your first year doing this, your starting balance will be zero.
Let’s start with an example of $500,000 as your previous year’s retained earnings.
3. Add your net income addition
The second entry in your retained earnings statement is adding in the net income from your prepared income statement.
For example, if your net income for the year was $100,000, you would add this to your retained earnings of $500,000.
4. Subtract any dividend your company has paid to its shareholders
Any payment made by your company to its shareholders is considered a dividend. The sum of these payments is then subtracted from the net income for that year. If your company doesn’t pay any dividends, this amount is $0.
For example, your company paid $50,000 to its shareholders. This is subtracted from the previous total figure of $600,000.
5. Calculate the ending retained earnings
Once you’ve subtracted your company’s dividend payments from your net income, you will arrive at your ending retained earnings amount. This is the final entry in your retained earnings statement, which gets reported on your retained earnings account for the next accounting year’s balance sheet.
To tie this example together, let’s look at it in total.
Your previous year’s retained earnings were $500,000
Add on your net income of $100,000
Subtract your dividends of $50,000
Therefore, your total retained earnings are $550,000
This is the entry you will lodge for your statement of retained earnings.
What a retained earnings statement looks like
Put together, here’s what your simple retained earnings statement may look like.
Creating a retained earnings statement is easy, in theory. It just takes a solid understanding of your business’ incomings and outgoings, and a good brain for math.
When drafting your retained earnings statement, how you do it is up to you. It can be as simple or as detailed as you’d like. If necessary, you can also provide additional information such as details of any stock purchases, or issues of stock.
But it’s important to remember that this is also a sensitive document, so to make sure that you’re portraying the correct information, it’s always best to run these figures by your accountant first.
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