The concept of Retained Earnings is one of the main accounting terms, which is fundamental if we want to understand the structure of the balance sheet and the means of financing by which the assets of a company are financed. This article will explore this accounting term and a practical example that will help to better understand this concept.
Considering the retained earnings term first, we need to cover the definition of equity. The owners’ equity is a residual right of the shareholders on the assets of the company. Residual means that first the companies have to pay the liabilities and only afterwards what is left can be distributed to the shareholders. So Equity is a difference between Assets and Liabilities and this can also be supported by the basic accounting equation, where Assets=Liabilities+Equity.
The heritage in turn is made up of:
- Social capital – initial investment of the shareholders in the business, and
- Retained earnings – net income obtained and remaining in the business, which has not yet been distributed to shareholders. Of course, in the event that the business incurs losses, said losses are accumulated as undistributed profits, which are negative and decreasing in the value of the Equity.
About him scale sheet These two items are listed separately to show how much shareholders have invested in the business and how much the business has accumulated in retained earnings since inception.
Relationship with the income statement
To understand the concept of Retained earnings It is better to demonstrate its relationship with the income statement. Suppose we have a company that started business on January 1, 2009. The shareholders invested $10,000 in cash at the start of business operations. Statement of income for the year 2009 is as follows (for reasons of simplicity, no tax or interest expense is expected):
Cost of goods sold_________(19,000)
Gross profit ________________6,000
Operating Expenses __________(3,000)
The shareholders decided not to distribute dividends corresponding to fiscal year 2009 and to retain all profits from the business. About him scale sheet in the Equity part you will see the following:
Then all net income from the Income Statement goes to the Balance Sheet as Retained Earnings, since this income was retained in the business.