Retained Earnings

 

What is Retained Earnings? 

The concept of retained earnings revolves around the idea of the profits an entity decides to keep and reinvest into its own operations rather than distributing them to its shareholders as dividends. These earnings accumulate over time, reflecting the net income the entity has generated since its establishment, minus any dividends paid out. 

Retained earnings serve as a flexible pool of funds that the entity can utilise for various purposes, depending on its needs and strategic goals. These purposes may include financing expansion initiatives, supporting research and development efforts, reducing debt obligations, or establishing a financial buffer to weather unforeseen challenges. 

Under the Australian Accounting Standards Board (AASB) framework, particularly AASB 101, retained earnings are a key component of an entity’s equity, reflecting profits that have been reinvested in the entity rather than distributed as dividends 

It’s crucial to understand that a positive balance in retained earnings signifies that the entity has been consistently profitable over its operational history. Conversely, a negative balance, often termed as an accumulated deficit, indicates that the entity has experienced more losses than profits over time. 

However, it’s essential to recognise that a sizable retained earnings balance alone doesn’t necessarily indicate a financially sound entity. While it may suggest profitability, the entity could be holding onto excess cash instead of using it to pursue growth opportunities or address existing debts.  

Therefore, while retained earnings are a vital measure of an entity’s financial performance, they must be assessed in conjunction with other financial indicators to gauge the entity’s overall health and sustainability. 

Components of Retained Earnings

Retained earnings, for an entity, consist of four main components:

AASB 108 plays a crucial role in how entities adjust retained earnings for prior period errors and changes in accounting policies.  

Similarly, AASB 112 Income Taxes affects retained earnings through its guidance on accounting for income taxes, which directly impacts the Profit After Tax (PAT) component 

It is the responsibility of the entity to utilise retained earnings wisely and effectively. Here are several ways in which the entity may choose to invest these earnings: 

How to Calculate Retained Earnings

The calculation of retained earnings follows a simple formula, tracking changes over a specific period for the entity. It begins with the retained earnings balance at the start of that period. Then, it adds the net income (or loss) generated during that time and subtracts any dividends distributed to shareholders.

Mathematically, it appears as:

Retained Earnings = Beginning Retained Earnings + Net Income/Loss – Dividends

This formula provides a snapshot of how the entity’s retained earnings have evolved during the specified timeframe. It’s important to note that net income represents the amount left after deducting expenses from revenues, while dividends signify the portion of earnings paid out to shareholders.

Thus, this calculation offers insight into how much of the entity’s earnings have been retained and reinvested into its operations versus distributed to shareholders as dividends over the period.

Retained Earnings on the Balance Sheet

On the balance sheet of an entity, retained earnings are categorised under the shareholders’ equity section. They are presented in accordance with AASB 101, which requires a statement of changes in equity to disclose movements in retained earnings among other equity components

Essentially, it represents what shareholders would hypothetically receive if all assets were sold off and all debts were settled. Retained earnings, alongside common stock and additional paid in capital, constitute the primary components of shareholders’ equity.

The balance sheet offers a snapshot of the entity’s financial position at a specific moment, displaying its assets, liabilities, and shareholders’ equity. The figure for retained earnings on the balance sheet reflects the entity’s accumulated net income, after accounting for dividends, since its inception.

This figure is a pivotal indicator of the entity’s capacity to generate profits and enhance value for shareholders over time.

To interpret the retained earnings figure on the balance sheet effectively, one must grasp its context. A substantial retained earnings balance might suggest an entity that has consistently generated profits and chosen to reinvest them back into the business, hinting at robust growth potential.

Conversely, a low or negative retained earnings balance could imply an entity that has struggled to turn a profit or one that has distributed a significant portion of its profits as dividends.

Nevertheless, it’s crucial not to analyse the retained earnings figure in isolation. Other financial indicators and the entity’s overall financial performance must also be taken into account. For instance, an entity with high retained earnings but substantial debt levels may not be as financially robust as it appears.

Similarly, an entity with modest retained earnings but strong cash flow could still present a promising investment opportunity.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.