Three components constitute a company's retained earnings. First, all corporations over 1 year old have a retained earnings balance based on accumulated earnings since their birth. Second is the current year's net income after taxes. The third component is any dividends paid to stockholders or owner withdrawals, not salary or wages. You need only basic mathematical skill to calculate even the largest corporation's retained earnings.
Prior Years' Retained Earnings
The first key component is always the beginning balance in the retained earnings from prior years. The only corporations missing this component will be startups at the end of their first year. Although some corporations might have a negative balance, few organizations can exist indefinitely without a positive balance in retained earnings. Over time, this component is often used for research and development, adding new products and replacing obsolete assets.
Current Period Net Income
The corporation's net income after taxes for the current period, typically one year, is the second key component of retained earnings. Current-year after-tax net profit indicates the efficiency of corporate operations and the success of management strategies, along with prevailing corporate tax rates. After-tax net income is always used as this component of retained earnings.
Corporations may declare dividends for their stockholders. Regardless of the magnitude of their net profit, the corporation's board of directors is under no obligation to pay dividends. Once a dividend is declared, the cost must be removed from the corporation's retained earnings. It doesn't matter when the dividends are paid. As soon as the board declares and authorizes the dividend, that amount immediately reduces the retained earnings balance for accounting purposes.
Small companies with only a few owners may substitute withdrawals by owners for formal dividend declaration. However, for accounting purposes, these withdrawals are identical to stockholder dividends. The amount of withdrawals is subtracted from the accumulated retained earnings balance, just like dividends are.
Statement of Retained Earnings
The statement of retained earnings -- along with the balance sheet, income statement, cash flow statement and statement of changes in owner's equity -- is is a staple of corporate quarterly and annual financial statement presentation. The calculation starts with the retained earnings balance at the beginning of the period. The current period net after tax income is added to the beginning retained earnings balance. Dividends or owners' withdrawals are then subtracted from the new retained earnings balance. The resulting amount, with all three key components, is the ending retained earnings balance for the period.
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