Retained Earnings: Definition, Formula, and Statement
Definition
Retained Earnings is the cumulative total of net income a company has earned since inception, minus all dividends declared to shareholders. It represents the portion of profits reinvested in the business rather than distributed to owners.
How It Works
Retained Earnings is an equity account on the balance sheet that accumulates over time. At the end of each accounting period, the closing process transfers net income (or net loss) from the income statement to Retained Earnings. When dividends are declared, Retained Earnings is reduced. The balance represents the total earnings retained in the business across its entire history. A positive balance means the company has been profitable overall; a negative balance (called a deficit) means cumulative losses exceed cumulative profits.
Formula
Ending Retained Earnings = Beginning Retained Earnings + Net Income − Dividends Declared
Example
Company Z starts the year with Retained Earnings of $500,000. During the year, it earns net income of $120,000 and declares dividends of $30,000. Ending Retained Earnings = $500,000 + $120,000 − $30,000 = $590,000. This $590,000 appears in the stockholders' equity section of the balance sheet.
Journal Entry Example
Closing entry to transfer net income to Retained Earnings (simplified).
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $120,000 | |
| Retained Earnings | $120,000 |
Common Misconceptions
- ✗Retained Earnings is cash — it is not. It's an equity account representing earnings reinvested in the business, which may have been used to buy assets, pay off debt, or fund operations. The company may have high retained earnings and low cash.
- ✗Retained Earnings equals total profit this year — it's the CUMULATIVE total since the company was founded, not just the current year.
- ✗A company with high retained earnings must be doing well — not necessarily. A company could have high retained earnings from past years but be currently unprofitable.
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Common questions about Retained Earnings
Yes. A negative retained earnings balance is called an 'accumulated deficit.' It means the company has lost more money over its lifetime than it has earned. This is common for startups and companies that have experienced significant losses.
It's a financial statement that shows the changes in Retained Earnings during a period. It starts with the beginning balance, adds net income (or subtracts net loss), subtracts dividends declared, and arrives at the ending balance. It connects the income statement to the balance sheet.
Companies retain earnings to fund growth (new equipment, expansion), pay down debt, build cash reserves, and invest in research and development. The decision to retain vs. distribute is based on growth opportunities, cash needs, and shareholder expectations.