Introduction

Retained earnings, a crucial component of a company's equity, represent the cumulative net income that has been kept for reinvestment rather than distributed to shareholders in the form of dividends. They appear on the balance sheet, specifically under equity shareholders' section, after each accounting period. This article delves into the process of calculating retained earnings and their significance in financial reporting.

What are Retained Earnings?

Retained earnings are the portion of a company#8217;s net income that is not distributed to shareholders as dividends but is instead kept within the business to fund its operations, pay off debts, or reinvest in growth. Unlike dividends, which are distributed to shareholders, retained earnings are retained by the company and become part of its equity on the balance sheet.

Calculating Retained Earnings

The calculation of retained earnings involves a few straightforward steps:

1. Starting Balance

The process begins with the retained earnings balance from the previous accounting period. This figure is either provided in the balance sheet or taken from the previous period's income statement.

2. Net Income (or Loss)

Next, add the net income (or loss) for the current period. Net income is the balance derived by subtracting expenses from revenues. If a company incurs a loss, this negative figure is subtracted. Essentially, net income represents the company's profitability for that period.

3. Adjustments and Deductions

Subtract any dividends that have been declared and paid during the period. These dividends are typically listed on the income statement and represent the distribution of profits to shareholders.

Formula:

Retained Earnings Previous Retained Earnings Net Income / Loss Gains / Losses - Dividends

Employing a Trial Balance

For a more detailed calculation, you can utilize a trial balance, a list of all accounts from the general ledger up to the point of closing, to reconcile all amounts. This includes recognizing adjustments like accumulated depreciation, prepaid rent, and other prepaid expenses or accrued liabilities.

Steps:

Start with the unadjusted trial balance. Include accumulated depreciation and other adjustments in the trial balance. Maintain any prepaid expenses and accrued liabilities in the trial balance. Transfer the temporary accounts (such as dividends, expenses, and revenues) to the income statement. Calculate net income by subtracting expenses from revenues. Transfer the net income to the statement of shareholders' equity. Add the net income to the previous retained earnings and subtract dividends.

Example Calculation

Assume the beginning retained earnings balance is $100,000. The company reported a net income of $50,000 and declared dividends of $15,000. The calculation would be as follows:

Retained Earnings $100,000 $50,000 - $15,000

Retained Earnings $135,000

Conclusion

Retained earnings are an essential metric that reflects a company's financial health and its ability to reinvest profits for growth. Understanding the calculation process can help investors, analysts, and stakeholders make informed decisions regarding the company's future. By following the outlined steps, you can accurately determine and report the retained earnings on the balance sheet.