Introduction to Statement of Retained Earnings
Retained earnings are portions of profit that is not distributed to the shareholders but is rather reinvested in the business or is kept aside as a reserve for a particular purpose. A statement of retained earnings is a depiction of the movement in retained earnings in a given period. It outlines the earnings that were present at the beginning of the year, the portion that was transferred from the current year’s profits and thus resulting in the earnings as at the year-end. Some of the examples which depict the statement of retained earnings and the calculations that are involved are described below:
Examples of Statement of Retained Earnings (With Excel Template)
Let’s take an example to understand the calculation of Statement of Retained Earnings in a better manner.
Statement of Retained Earnings – 1
FRY ltd had an opening retained earnings balance of $14,000 carried forward from the year 2017. In 2018, it earned an additional $54,000 after all expenses were paid. It was then decided that $30,000 was to be paid to the shareholders as dividends. Below is the calculation involved to check the retained earnings at the end of the year 2018:
FRY Ltd
The concern shows a good propensity to retain the majority of the profits in the current year. The earnings help in strengthening the owner’s equity. Also, given that the funds are obtained from within the organization there is no dilution in the ownership and the decision-making process of the shareholders will not be affected. There is also no cost involved in sourcing the funds through this medium. Another advantage of a healthy retained earnings is there is no involvement of external agencies to source the funds from outside. Unless an exception arises it should continue to retain earnings as the chief form of sourcing of funds.
Statement of Retained Earnings – 2
Chan ltd started 2015 with an opening retained earnings balance of $2,340. It earned a net income of $14,890 during the year and paid a dividend to preferred shareholders amounting to $4,210 and to the equity shareholders worth $3,640. There was also a prior period adjustment of $2,400. The retained earnings at the end of the year 2015 will be calculated as below:
The entity does not consider retaining earnings as a major sourcing of funds. From the profit that it earned during a year, it had a dual obligation to both the preferred and the equity shareholders which brought down the amount that could have been retained. Also, prior period adjustments play a part in the ultimate retention. Prior period adjustments are any items that were erroneously passed in the previous year and have to be rectified in the current year. They could either bring down or increase the profit in the present year.
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Statement of Retained Earnings – 3
For a statement of retained earnings, apart from arriving at the closing earnings balance through opening earnings and profits for the year, it is also useful if one could calculate the cost of retained earnings. Surprisingly as it may sound, there is an opportunity cost associated with retaining the profits instead of distributing it to the shareholders in the form of dividends. Also, if an entity retains earnings instead of distributing it to the shareholders it runs the risk of displeasing them. Therefore, it is imperative that a good return may come up using the earnings.
In general, if there are no other specific factors and variables mentioned, the cost of retained earnings is equal to the cost of equity multiplied by a reduction in shareholder’s personal rate of tax. This is assuming that there is no floatation cost involved
Cost of Retained Earnings = Cost of Equity * (1-Shareholders Personal Rate of Tax)
This cost of retained earnings should be compared with the cost of raising debt from the market and the decision to limit the percentage of retention should be taken accordingly. In case, the cost of raising debt is lower, the funds are easily available and unlike retained earnings, it provides the taxation benefit to the entity then the preferred method of obtaining funds should be from the external sources.
Conclusion
The statement of retained earnings is a good indicator of the health of the company and the ability to be independent for the future. Organic growth using the funds generated by itself is always a preferred form of growth than utilizing funds from outside. But, the quantum of the earnings cannot also be a definitive conclusion too. Some of the industries which are capital intensive depend a lot more on the retained earnings portion than the outside funds.
Retention is also a direct factor of the policy of the entity. Many times, even with adequate profits there is limited retained earnings since the majority of the funds are distributed amongst the shareholders as dividends. Again, market conditions give a direction to the retained earnings. If the borrowing becomes expensive, there would be a greater emphasis on the retained earnings even with limited profits.
Generally the following become determinants in the retained earnings policy
- The debt cost associated with raising funds from external sources
- The dividend policy needs to be adopted in the foreseeable future. If the policy is a populist catering to large dividends the entity has to cut down on the portion of retention.
- For many concerns the government or regulatory policies which govern the entity become a primary source of check to see if the retained earnings are within limits.
- Lastly, the nature of the industry to which the entity belongs and the traditional method of getting the funds plays a major role in taking the decision with regards to retention.
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