A statement of retained earnings is the financial statement that reconciles a company’s retained earnings balance from the start of a reporting period to the end of it, showing the period’s net income or loss and the dividends and other distributions that moved it in between. Retained earnings is the balance itself, the cumulative net income a company has kept rather than paid out to its owners, carried as one line inside the equity section of the balance sheet. The statement explains the change, and the balance sheet reports the result.
The Roll-Forward, and What Each Term Means
Beginning retained earnings, plus net income or less net loss for the period, less dividends declared, equals ending retained earnings.
Beginning retained earnings is the closing balance of the period immediately before, carried forward untouched unless an earlier period is being corrected. Net income is the period result from the income statement, and it is the only operating figure that reaches this account. Dividends declared reduce the balance when the board declares them rather than when the cash leaves, and stock and property distributions reduce it alongside cash ones.
The corporate return states the same roll-forward as a schedule. Schedule M-2 on Form 1120 is titled Analysis of Unappropriated Retained Earnings per Books and is keyed to Schedule L, line 25. It opens on line 1 with the balance at beginning of year, adds net income (loss) per books on line 2 and other increases on line 3, totals those on line 4, then takes out distributions of cash, stock and property on line 5 and other decreases on line 6, and closes on line 8 at line 4 less line 7 (IRS, Form 1120).
The balance sheet on that same return splits the account in two. Retained earnings appropriated sits on line 24 and asks for an attached statement, and retained earnings unappropriated, the line Schedule M-2 analyzes, sits on line 25 (IRS, Form 1120).
A Worked Roll-Forward
Say a corporation’s books carry the movements below for the year.
Balance at beginning of year 620,000
Net income per books 185,000
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Subtotal 805,000
Dividends declared, cash 95,000
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Balance at end of year 710,000Nothing in that closing figure says the company is holding cash of that amount. It says only what has been earned and not distributed since the account opened, which is why a profitable year and a thin bank balance sit together so often.
Where the Statement of Retained Earnings Sits in US Practice
The disclosure is required. Presenting it as its own statement is not.
When both financial position and results of operations are presented, disclosure of changes in the separate accounts comprising stockholders’ equity, in addition to retained earnings, and of the changes in the number of shares of equity securities during at least the most recent annual fiscal period and any subsequent interim period presented is required to make the financial statements sufficiently informative, and disclosure of such changes may take the form of separate statements or may be made in the basic financial statements or notes thereto (APB Opinion No. 12, paragraph 10).
A standalone statement of retained earnings is therefore one permitted presentation of a required disclosure, not a required fifth statement. The older pairing is recorded in the same Opinion, which quotes an earlier one to the effect that the statement of income and the statement of retained earnings, separately or combined, are designed to reflect in a broad sense the results of operations (APB Opinion No. 12, paragraph 9).
Why It Is Usually Absorbed Into the Statement of Stockholders’ Equity
The disclosure reaches every equity account rather than this one alone, so a single statement covering all of them carries the retained earnings roll-forward inside it and everything else at the same time. That is why the standalone version is rarely the form you meet in a finished set, and why the other name people are usually reaching for is the statement of stockholders’ equity.
An SEC registrant has no discretion over the scope, and the base requirement is set out in owner’s equity.
The captions sitting either side of retained earnings in that equity section are set out in common stock, and the transactions in a company’s own shares that charge and credit this account directly are worked through in treasury shares.
Prior Period Adjustments Land on the Opening Balance
Correcting an earlier period does not run through the current period’s income. Any error in the financial statements of a prior period discovered after they were issued is reported as a prior-period adjustment by restating the prior-period financial statements, with the cumulative effect on periods before those presented reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented, and an offsetting adjustment, if any, made to the opening balance of retained earnings (FASB Statement No. 154, paragraph 25).
A change in accounting principle behaves the same way when it is applied retrospectively, with the cumulative effect on earlier periods put into the carrying amounts of assets and liabilities at the beginning of the first period presented and the offsetting adjustment made to the opening balance of retained earnings (FASB Statement No. 154, paragraph 7). That Statement took effect for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 (FASB Statement No. 154, paragraph 27).
What It Is Not
The statement is not the balance. One covers a stretch of time and explains a movement, the other is a single figure at a single date. Form 1120 makes the split literal, since the balance sits on Schedule L and the analysis of that balance sits on Schedule M-2 (IRS, Form 1120).
Retained earnings is not cash. It is an equity balance rather than a fund, and what it represents may already be sitting in receivables, equipment or inventory. Income reaches the account when it is earned rather than when it is banked, which is accrual accounting doing the work.
A negative balance is the same account, not a different one. Where cumulative losses and distributions have run past cumulative earnings, the figure is negative and the caption is usually renamed accumulated deficit. The arithmetic does not change, and the roll-forward still runs from the opening balance to the closing one.
A not-for-profit carries no retained earnings line at all, because the two donor-restriction classes take its place, and those are set out in net assets.
Do You Pay Tax on Retained Earnings?
Not on the balance. It is a book equity figure and no federal tax is imposed on the line itself.
The charge aimed at accumulation is a separate one. An accumulated earnings tax equal to 20 percent of the accumulated taxable income is imposed for each taxable year on each corporation described in section 532 (26 U.S.C. § 531). That description is a corporation formed or availed of for the purpose of avoiding the income tax with respect to its shareholders, or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed (26 U.S.C. § 532).
A credit sits under it, and one figure in that credit is set lower for accounting firms than for everyone else. The accumulated earnings credit is in no case less than the amount by which $250,000 exceeds the accumulated earnings and profits of the corporation at the close of the preceding taxable year, and for a corporation whose principal function is the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, that test is applied by substituting $150,000 (26 U.S.C. § 535(c)(2)).
Earnings and profits in that statute is a tax measure and not the book balance.
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