Financial statements are documents produced by a business that show its different aspects. Businesses prepare financial statements after every accounting period for several reasons. For example, financial statements help the stakeholders of business make decisions regarding their relationship with it. Similarly, even the business itself can benefit from producing financial statements as it allows it to determine how it has performed or where it stands as a result of its operations. There are a total of five financial statements that most businesses prepare. However, some jurisdictions or accounting standards require some businesses to prepare only two main financial statements.
The first financial statement is the Statement of Financial Position which shows the total assets, equity and liabilities balances of a business. The second financial statement is the Statement of Profit or Loss that shows the incomes and expenditures of a business. Next comes the Statement of Cash Flows which is a record of the total cash inflows and outflows of the business. The next financial statement is the Statement of Retained Earnings that shows the movement in retained earnings of the business. Finally, these financial statements come with Notes to the Financial Statements, considered as the fifth financial statement.
What is Statement of Retained Earnings?
The Statement of Retained Earnings is one of the financial statements that businesses prepare that shows the movement in their retained earnings balance.
There are several reasons why movements occur in the retained earnings balance. The first reason for movement in retained earnings is the profit or loss of the business. Any profits made by a business are added to the retained earnings balance and losses subtracted from it. These profits or losses are available in the Statement of Profit or Loss of the business. The profit or loss relates to the accounting period for which the statement is prepared. Another reason for movement in retained earnings balances is payments to owners or dividends. We deduct these payments from the opening balance.
How to Prepare a Statement of Retained Earnings?
To prepare a Statement of Retained Earnings is straightforward as all the required movements are already available in the other financial statements of the business. Below are the key components of Retained Earnings Statement:
The first item that appears on the statement of retained earnings is the opening balance of retained earnings. The opening balance of retained earnings is available in the Statement of Financial Position. It is the retained profit or loss carried down from prior periods.
Profit or Loss during the Year
The profit or loss during the period is available in the Statement of Profit or Loss. This is the net profit after deducting all expenses including the corporate income that incur during the course of business operation.
The amount paid to owners of a business, also known as dividends for companies, is available in the Statement of Cash Flows. This is the amount that the company declared and paid to shareholders from its retained earnings or retained profits.
Finally, the closing balance obtained from the Statement of Retained Earnings can be matched with the closing balance of Retained Earnings in the Statement of Financial Position as a check to ensure the calculation is accurate.
As mentioned above, the statement starts with an opening balance, brought forward from the last accounting period. After that, any movements in retained earnings are adjusted to the opening balance to reach the closing balance of retained earnings. The closing balance will agree with the closing balance in the Statement of Financial Position.
For most stakeholders, the Statement of Retained Earnings is crucial because it allows them a better view of the retained earnings of a business. Retained earnings is one of the most important figures in the financial statements of business because a business can use it for many different things within a business. Therefore, the higher its retained earnings of are, the more it can use its retained earnings.
Instead of the Statement of Retained Earnings, some businesses may prepare other statements such as Statement of Owners’/Shareholders’ equity or Statement of Changes in Equity. These statements also contain movements in the retained earnings balances of a business. However, they also include movements in other equity-related balances such as (Share) Capital, Revaluation Surplus, etc. However, some stakeholders may prefer the Statement of Retained Earnings as it is more detailed, and other equity balances don’t usually change. Ultimately, the jurisdiction which a business operates in or the accounting standards it follows will dictate which statements it has to prepare.
Structure of Statement of Retained Earnings
The structure of the Statement of Retained Earnings has already been discussed above. It starts from opening balances, adjusts movements to retained earnings balance and reaches a closing balance. It is presented in the following format.
|Name of Business|
|Statement of Retained Earnings|
|For the period xx-xx|
|Retained earnings at the start of the period||xxx|
|Add: Profit/(Loss) for the period||xxx/(xxx)|
|Less: Dividends paid to shareholders||(xxx)|
|Retained Earnings at the end of the period||xxx|
A company, ABC Co., has an opening retained earnings balance of $20,000 at the start of 20xx. During the year, ABC Co. made a profit of $5,000 while it paid total dividends of $2,000 to its shareholders. The closing retained earnings balance, according to its balance sheet and books of accounts, is $23,000. Therefore, we can prepare a Statement of Retained Earnings as follows.
|Statement of Retained Earnings|
|For the year 20xx|
|Retained earnings at the start of the period||$ 20,000|
|Add: Profit for the period||$ 5,000|
|Less: Dividends paid to shareholders||$ (2,000)|
|Retained Earnings at the end of the period||$ 23,000|
First of all, the above statement takes the retained earnings of ABC Co. at the start of the period and adds the profit for the period to it. This is because any profit a business makes is a part of its retained earnings. After adding the profits for the period, the dividends paid to shareholders are subtracted from the balance. This is because dividends paid to shareholders are paid directly from the retained earnings of the business, therefore, decreasing the balance.
As the closing balance in the Statement of Retained Earnings matches the closing balance in the Statement of Financial Position, which is $23,000, the calculation can be considered correct.
Uses of Retained Earnings
The retained earnings of a corporation is the accumulated retained profit as result of business activities. It is basically a source of finance for a business. It is known as internally generated source of finance.
The cost of raising funds from retained earnings is usually a lot cheaper as compare to other types of type of finance for a business.
Below are some of the areas in which a business can use its retained earnings:
A business can use its retained earnings to finance new projects. As mentioned above, the cost of retained earnings is minimum as compared to other sources such as debt or equity finance is minimum. Therefore, using retained earnings in new projects is a great way to maximize returns from projects.
For the same reason as above, a business can use retained earnings to expand into new markets or locations. Since retained earnings are low cost, the risk of failure also impacts the business less than if it uses other types of finance.
Merger or acquisition
Some businesses may also try mergers or acquisitions as a way of expanding into new markets or increasing market share. By using retained earnings as a source of finance, a business can maximize its benefits from mergers and acquisitions.
Finally, if the business has no other use for retained earnings, it can also pay dividends to its owners or shareholders. It is a great way to make the owners satisfied. Furthermore, paying more dividends also attracts new investors for the business.
Importance of Statement of Retained Earnings
The Statement of Retained Earnings is vital for the stakeholders of a business. First of all, the statement is important for the investors of a business. Any potential investors or owners of the business look at the Statement of Retained Earnings to get a summary of the changes in retained earnings. More importantly, they check it to determine how much profits the business is making and how much dividends it pays its owners. For dividend investors, the Statement of Retained Earnings helps give them a summary of the key figures they consider important.
Similarly, the Statement of Retained Earnings is also considered important by financial institutions, such as banks, that have lent money to the business. Some financial institutions may even require the business to prepare the statement even if it is not required to do so by rules and regulations. The Statement of Retained Earnings can help lenders determine whether the business can pay its debt obligations in the future. Usually, lenders look for businesses that can demonstrate the ability to pay off their debts in the future.
Finally, this statement is also important because it focuses on one of the most important balances of a business, the retained profits. The retained earnings of a business are its total accumulated profits over its lifetime. The higher the retained earnings of a business are, the more credible and well-established it is considered. Similarly, a higher retained earnings balance translates to a higher share price in the market for companies. Likewise, retained earnings have many other uses as well, as mentioned above. Therefore, the Statement of Retained Earnings is necessary to determine the movements in retained earnings.
The Statement of Retained Earnings is one of the five financial statements that businesses prepare. It has a movement of the retained earnings balance of the business. The statement takes the opening balance of retained earnings, adjusts for profits and losses and subtracts any drawings or dividends from it to reach the closing balance of retained earnings. The Statement of Retained Earnings is an important financial statement for many stakeholders, including investors and financial institutions.