Like an individual, companies also set aside a part of their profits to meet future requirements of capital. Companies keep these savings in various accounts such as General Reserve, Debenture Redemption Reserve and Dividend Equalization Reserve etc. These reserves can be used to meet long term financial requirements.
The portion of the profits which is not distributed among the shareholders but is retained and is used in business is called retained earnings or ploughing back of profits. As per Indian Companies Act., companies are required to transfer a part of their profits in reserves. The amount so kept in reserve may be used to buy fixed assets. This is called internal financing.
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends
A company that has experienced more losses than gains to date, or which has distributed more dividends than it had in the retained earnings balance, will have a negative balance in the retained earnings account. If so, this negative balance is called an accumulated deficit.
Following are the advantages and disadvantages of retained earnings:
Advantages of Retained Earnings
- No expenses are incurred when capital is available from this source. There is no obligation on the part of the company either to pay interest or pay back the money. It can safely be used for expansion and modernization of business.
- A company which has enough reserves can face ups and downs in business. Such companies can continue with their business even in depression, thus building up its goodwill.
- Shareholders may get dividend out of reserves even if the company does not earn enough profit. Due to reserves, there is capital appreciation, i.e. the value of shares goes up in the share market.
- Through ploughing back of profits, companies increase their financial strength. Companies may throw out their competitors from the market and monopolize their position.
Disadvantages of Retained Earnings
- This method of financing is possible only when there are huge profits and that too for many years.
- When funds accumulate in reserves, bonus shares are issued to the shareholders to capitalize such funds. Hence the company has to pay more dividends. By retained earnings the real capital does not increase while the liability increases. In case bonus shares are not issued, it may create a situation of under-capitalization because the rate of dividend will be much higher as compared to other companies.
- Capital accumulated through retained earnings encourages management to spend carelessly.
Statement of Retained Earnings
The statement of retained earnings is one of the four primary financial accounting reports published quarterly and annually by publicly held companies (companies that sell shares of stock to the public). The other three are the income statement, balance sheet, and statement of changes in financial position (SCFP).
The statement of retained earnings is sometimes described as a bridge between the Income statement and balance sheet. The statement shows how profits from the period (from the Income statement) are either transferred to the balance sheet, as retained earnings, or to the company’s owners (shareholders) as dividends. The statement breaks down changes in the owner’s interest in the organization, and in the application of retained profit or surplus from one accounting period to the next. Line items for the retained earnings statement typically include profits or losses from operations, dividends paid, issue or redemption of stock, and any other items charged or credited to retained earnings. . The Statement of Shareholder’s Equity shows the inflows and outflows of capital, including treasury stock purchases, employee stock options and secondary equity issuance.
The retained earnings statement may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule. Retained earnings are part of the balance sheet under Stockholders Equity (Shareholders Equity) and are mostly affected by net income earned by the company during a specified period, less any dividends paid to the company’s owners/stockholders. The retained earnings account on the balance sheet represents an accumulation of earnings since net profits and losses are added/subtracted from the account from period to period. Retained Earnings are part of the Statement of Changes in Equity and are a component of shareholder’s equity.