Retained earnings is one of those accounts that reads backwards the first time you meet it. The money it represents has already been spent, lent, or turned into inventory, and yet there it sits on the balance sheet looking like a pile of cash. The confusion usually arrives as one of two questions: is it a debit or a credit, and where did the money actually go?
Both questions have short answers, and both answers follow from the same place in the accounting equation. What follows sets out the classification, the entries that move the balance in each direction, and the formula that ties one year to the next.
Key Takeaways
- Retained earnings is an equity account, and equity accounts carry a normal credit balance, so a profitable year increases the retained earnings balance through a credit to retained earnings.
- Retained earnings is reduced by a debit in three situations: a net loss for the year, a dividend or owner distribution, and a prior period adjustment.
- Retained earnings is neither an asset nor a quantity of cash, which is the reason a large retained earnings balance can be reported alongside a very small cash balance.
- Ending retained earnings equals beginning retained earnings plus net income minus dividends and distributions.
- A debit balance in retained earnings is described as an accumulated deficit, which is ordinary in the early years of a business and significant in an established one.
Is retained earnings a debit or credit?
Retained earnings is classified as an equity account, and equity accounts carry a normal credit balance. The answer to the question of whether retained earnings is a debit or a credit is therefore credit.
The rule underneath that classification is the accounting equation, under which assets are equal to liabilities plus equity. Assets are recorded on the left side of the ledger and assets are increased by debits. Liabilities and equity are recorded on the right side of the ledger and liabilities and equity are increased by credits. Retained earnings is classified within equity, so a credit to retained earnings increases the retained earnings balance and a debit to retained earnings decreases the retained earnings balance.
The classification of every account type is set out in the debits and credits cheat sheet.
The transaction that credits retained earnings
At the end of each fiscal year, the closing entry transfers the profit for the year out of the temporary revenue and expense accounts and into retained earnings. Where net income for the year is $40,000, the closing entry is recorded as a debit to income summary of $40,000 and a credit to retained earnings of $40,000. That credit to retained earnings is the only routine transaction by which the retained earnings balance is increased.
The transactions that debit retained earnings
A net loss for the year reverses the direction of the closing entry, so that retained earnings is debited for the amount of the net loss and income summary is credited for the amount of the net loss.
A dividend or an owner distribution is recorded at the point of declaration as a debit to retained earnings and a credit to dividends payable, and the subsequent payment is recorded as a debit to dividends payable and a credit to cash. Money that leaves the business permanently is required to be charged against accumulated profit rather than against the income statement for the current year.
A prior period adjustment corrects a material error contained in a financial statement that was issued in an earlier period. A prior period adjustment is not recorded through the income statement for the current year. A prior period adjustment is posted directly to retained earnings, in whichever direction corrects the error that was made in the earlier period.
Is retained earnings an asset?
Retained earnings is not an asset, and retained earnings is instead a component of equity, and the distinction between an asset and a component of equity carries practical consequences.
An asset is a resource that the business owns, and equity is a claim against the assets that the business owns. Retained earnings reports how much of the asset base of the business was funded by profits that the owners left in the business, rather than funded by borrowing or funded by contributions from the owners. Retained earnings reports nothing at all about the form those assets took.
A business can therefore report a retained earnings balance of $200,000 and a cash balance of $3,000 in the same set of financial statements. Over a period of several years the profit was converted into equipment, into inventory, into a receivables balance that customers have not yet settled, and into repayments of loan principal. The earnings were retained by the business, and the earnings were not retained by the business in the form of cash.
The form the assets took is reported on the balance sheet, and a completed balance sheet is set out line by line in the balance sheet example for a small business.
The retained earnings formula
Beginning retained earnings plus net income minus dividends and distributions equals ending retained earnings.
Consider a business that begins the year with a retained earnings balance of $85,000, earns net income of $42,000 during the year, and pays distributions to the owners of $15,000 during the year. Beginning retained earnings of $85,000 plus net income of $42,000 minus distributions of $15,000 produces ending retained earnings of $112,000.
Three characteristics of the formula are worth recording. The beginning retained earnings balance is the ending retained earnings balance of the prior year, carried forward without adjustment, which is the reason an error in one year is carried into every year that follows it. Net income is the figure reported at the bottom of the income statement after tax, and net income is neither revenue nor gross profit. Distributions are subtracted in the year of declaration whether or not the distributions were paid in cash during that year, because the declaration of a distribution creates the obligation.
Presentation on the balance sheet
Retained earnings is presented within the equity section of the balance sheet, ordinarily as the final line before total equity is reported. A simple equity section for a corporation is presented below.
| Line | Amount |
|---|---|
| Common stock | $5,000 |
| Additional paid-in capital | $45,000 |
| Retained earnings | $112,000 |
| Total equity | $162,000 |
Scroll sideways to see all columns.
Paid-in capital reports the amounts contributed by the owners. Retained earnings reports the profit that the business generated and did not distribute. Paid-in capital and retained earnings together report the total stake held by the owners.
The equivalent account in an LLC or a sole proprietorship
Retained earnings is a term used by corporations. The books of a limited liability company ordinarily report member equity, and the books of a sole proprietorship ordinarily report owner equity. Distributions in a limited liability company and in a sole proprietorship are ordinarily recorded as owner draws rather than as dividends.
The mechanics of the account do not change with the label. Profit for the year credits the equity account, draws debit the equity account, and the ending balance of the equity account is carried forward into the following year. The label changes because the legal structure changes, and not because the bookkeeping changes.
Negative retained earnings
A debit balance in retained earnings is described as an accumulated deficit. An accumulated deficit reports that cumulative losses and cumulative distributions since the business was formed have exceeded cumulative profit since the business was formed.
An accumulated deficit is ordinary in the first two or three years of a business and is not significant on its own in those years. An accumulated deficit reported by an established business is significant, particularly where the accumulated deficit is growing while revenue is flat. An accumulated deficit also carries a practical consequence, because lenders and investors examine the equity section closely and an accumulated deficit ordinarily prompts questions about how the losses were funded.
If retained earnings has drifted out of step with what the business actually owns, the cause is almost always upstream: distributions recorded as expenses, a prior year never properly closed, or draws and contributions landing in the same account. GlassJar keeps the equity accounts separated and closes the year for you, so the balance carried forward is the one you can defend. See how it works.
Frequently asked questions
Is retained earnings a debit or credit?
Retained earnings carries a normal credit balance because retained earnings is an equity account. Retained earnings is debited only for a net loss, for a dividend or owner distribution, or for a prior period adjustment.
Is retained earnings an asset?
Retained earnings is not an asset. Retained earnings is a component of equity and represents a claim against the assets of the business, which is the reason a large retained earnings balance can be reported alongside a small cash balance.
How is retained earnings calculated?
Beginning retained earnings plus net income minus dividends and distributions equals ending retained earnings. The beginning retained earnings balance is the ending retained earnings balance reported for the prior year.
What type of account is retained earnings?
Retained earnings is a permanent equity account. Unlike the revenue accounts and the expense accounts, retained earnings is not closed out at the end of the year, and the retained earnings balance is carried forward for the life of the business.
Can retained earnings be negative?
Retained earnings can carry a debit balance, which is described as an accumulated deficit. An accumulated deficit reports that total losses and total distributions since formation have exceeded total profits since formation.
