How to roll Retained Earnings
Retained Earnings explained
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What is the meaning of the term retained earnings?
Where do retained earnings show up in the financial statements?
What makes retained earnings go up or down?
In this video we walk through the definition of retained earnings, analyze two real-life
examples of well-known companies to understand how retained earnings get accounted for, and
provide bonus tips above and beyond what other videos and textbooks would give you on things
you should know about retained earnings.
To retain means to keep, and earnings means profit.
Retained earnings is commonly defined as that part of a company's cumulative historical
profits that has not been distributed to shareholders through a dividend.
Retained earnings are one of the items that connect the income statement and the balance sheet.
The income statement, or profit and loss statement, is like a movie about profitability during
a period (usually a month, a quarter or a year).
The balance sheet, or statement of financial position, is like a picture at a point in
time (usually the end of a month, a quarter, or a year) of what a company owns and what it owes.
You start a new income statement at the start of every new year.
In order to "close out" the year, and make the balance sheet balance at the end of the
year, you add the profit that was made during the year to shareholder's equity.
Retained earnings is a component of equity, as we will see in the upcoming examples.
Why is retained earnings on the credit or right-hand side of the balance sheet?
Two ways to think about that.
One: you owe retained earnings to the shareholders, and the right-hand side of the balance sheet
is an overview of what a company owes.
Two: if you are profitable as a company, you grow the assets (left-hand) side of the balance
sheet quicker than the liabilities (right-hand) side of the balance sheet, therefore you need
to "plug" an amount in equity to make the balance sheet balance.
The concept of retained earnings becomes a lot more clear if we walk through an example.
Here is the overview of telecom company Verizon's equity balance
at the end of 2015 and the end of 2016.
Equity was $17.8 billion at the end of 2015 (on the right)
and $24 billion at the end of 2016 (on the left).
Equity consists of many line items, as you see in the overview.
One of the largest items in equity is retained earnings: $11.2 billion at the end of 2015,
and $15.1 billion at the end of 2016.
Verizon actually calls this "reinvested earnings" rather than "retained earnings", indicating
that if you do not distribute all your earnings to shareholders, then you can reinvest them
in the business.
Let's review how the account balance has increased year-over-year.
Beginning retained earnings plus net income minus dividends equal ending retained earnings.
In the case of Verizon 2016: reinvested earnings of $11.2 billion at the start of the year,
plus net income of $13.1 billion, minus dividends of $9.3 billion equal reinvested earnings
of $15.1 billion at the end of the year.
The interesting element here is that only "net income attributable to Verizon"
is taken into account.
If you look at Verizon's income statement for 2016, you see revenue of $126 billion
at the top and net income of $13.6 billion at the bottom.
That total net income of $13.6 billion is split between about $500 million of net income
attributable to noncontrolling interests (related to Wireless partnership entities where Verizon
is not the 100% owner), and $13.1 billion of net income attributable to Verizon.
Noncontrolling interests is a line item in equity.
You can make a "walk" from beginning balance to ending balance,
just like with retained earnings.
Beginning noncontrolling interests balance plus net income attributable to noncontrolling
interests, minus distributions, equals ending balance.
A second example to understand the concept of retained earnings better:
Apple Inc fiscal year 2017.
Equity was $128.2 billion at the end of fiscal 2016 on the right,
and $134 billion at the end of fiscal 2017 on the left.
Retained earnings grew from $96.4 billion on the right to $98.3 billion on the left.
This more detailed overview shows how the equity balance, and its components, have developed
year-over-year.
For retained earnings, 2016's balance of $96.4 billion is at the top, and 2017's balance
of $98.3 billion is at the bottom.
Same as in the previous example, net income makes retained earnings go up, and dividends
paid to shareholders makes it go down.
Additionally, the repurchase of common stock has an effect on retained earnings.
In the case of Apple, the repurchase of common stock is not considered treasury stock, as
the shares received are retired in the periods they are delivered.
What is the opposite of retained earnings?
Empty pockets!
The retained earnings account contains both the gains earned and losses incurred by a
business, so it nets together the two balances.
Ongoing losses erode any historical positive retained earnings balance.
It could get worse, if you have a negative retained earnings balance, in other words
net retained losses.
Negative retained earnings would appear as a debit balance in the retained earnings account,
as "Accumulated Deficit", rather than the credit balance that normally appears for a
profitable corporation.
A company could be in an imminent danger of bankruptcy if the accumulated deficit has
exceeded the amount of contributed capital.
That wraps up our retained earnings discussion: concept and definition, real-life examples,
accounting, and bonus tips.
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