Retained earnings represent a company's cumulative profits minus dividends paid. This crucial financial metric appears on the balance sheet as part of shareholders' equity, reflecting a firm's historical profitability and dividend policy.

Understanding retained earnings is essential for assessing a company's financial health and growth potential. It involves analyzing components like net income, dividends, and prior period adjustments, while considering factors such as revenue, expenses, and comprehensive income.

Components of retained earnings

• Retained earnings represent the cumulative net income earned by a company since its inception, less any dividends paid out to shareholders
• Consists of the beginning retained earnings balance, plus net income (or minus net loss) for the current period, minus dividends declared during the period
• Provides insights into a company's historical profitability and dividend policy

Impact on financial statements

• Retained earnings appear on the balance sheet as a component of shareholders' equity
• Changes in retained earnings during a period are reported on the statement of retained earnings
• Net income from the income statement flows into retained earnings, while dividends declared reduce retained earnings

Factors affecting retained earnings

Revenue and expenses

• Revenue increases retained earnings, while expenses decrease retained earnings
• Profitability directly impacts the amount of earnings available for retention or distribution to shareholders
• Examples of revenue include sales revenue and interest income, while expenses include cost of goods sold, operating expenses, and income taxes

Dividends to shareholders

• Dividends declared and paid to shareholders reduce retained earnings
• Board of directors determines the dividend amount and timing of payments
• Cash dividends decrease retained earnings and cash, while stock dividends decrease retained earnings and increase common stock

Retained earnings vs net income

• Net income represents the profit earned by a company during a specific period, while retained earnings represent the cumulative profits earned and retained over the life of the company
• Net income is reported on the income statement, while retained earnings are reported on the balance sheet
• Retained earnings include net income, but also consider dividends and prior period adjustments

Statement of retained earnings

Format and preparation

• Begins with the beginning retained earnings balance, adds net income (or subtracts net loss), subtracts dividends declared, and ends with the ending retained earnings balance
• Prepared after the income statement, as net income is a required input
• Can be presented as a separate financial statement or combined with the statement of shareholders' equity

Relationship to other statements

• Net income from the income statement flows into the statement of retained earnings
• Ending retained earnings balance from the statement of retained earnings appears on the balance sheet as a component of shareholders' equity
• Dividends declared on the statement of retained earnings impact cash on the balance sheet and are reported on the statement of cash flows

Analyzing retained earnings

Retention ratio and payout ratio

• Retention ratio indicates the percentage of net income retained by the company ($\text{Retention Ratio} = \frac{\text{Net Income - Dividends}}{\text{Net Income}}$)
• Payout ratio represents the percentage of net income paid out as dividends ($\text{Payout Ratio} = \frac{\text{Dividends}}{\text{Net Income}}$)
• Higher retention ratios suggest a company is reinvesting more of its earnings for growth, while higher payout ratios indicate a focus on returning profits to shareholders

Evaluating business performance

• Growing retained earnings over time generally indicates profitable operations and financial stability
• Comparing retained earnings to total assets or shareholders' equity provides insights into a company's reliance on debt financing and efficiency in generating profits
• Analyzing trends in retained earnings can help assess a company's dividend policy consistency and sustainability

Limitations of retained earnings

• Retained earnings do not necessarily represent cash available for investments or dividends, as profits may be tied up in non-cash assets
• Negative retained earnings (accumulated deficit) may indicate a history of losses or aggressive dividend payments
• Retained earnings can be influenced by accounting choices (depreciation methods, inventory valuation) and may not fully reflect economic reality

Accounting for prior period adjustments

Changes in accounting principles

• Retrospective adjustments to retained earnings are required when a company changes an accounting principle (LIFO to FIFO inventory valuation)
• Cumulative effect of the change is recorded as an adjustment to beginning retained earnings in the earliest period presented
• Enhances comparability of financial statements across periods

Correction of errors

• Material errors discovered in previously issued financial statements require a prior period adjustment to retained earnings
• Cumulative effect of the error correction is recorded as an adjustment to beginning retained earnings in the earliest period presented
• Restating prior period financial statements ensures accuracy and reliability of the information

Reporting comprehensive income

Other comprehensive income (OCI)

• OCI includes gains and losses not reported on the income statement (unrealized gains/losses on available-for-sale securities, foreign currency translation adjustments)
• Reported on the statement of comprehensive income, which reconciles net income to comprehensive income
• Provides a more complete picture of a company's financial performance

Accumulated OCI on balance sheet

• Accumulated OCI appears as a separate component of shareholders' equity on the balance sheet
• Represents the cumulative balance of OCI items over the life of the company
• Allows users to assess the impact of OCI items on a company's financial position

Disclosure requirements

• Companies must disclose the components of retained earnings, including beginning balance, net income, dividends, prior period adjustments, and ending balance
• Changes in accounting principles and error corrections require disclosure of the nature, justification, and impact on financial statements
• Comprehensive income reporting requires disclosure of OCI items and their impact on shareholders' equity

Importance for financial analysis

Earnings management considerations

• Management may use discretionary accounting choices to manipulate retained earnings and influence financial ratios
• Analysts should be aware of potential earnings management techniques (aggressive revenue recognition, understatement of expenses) and adjust their analysis accordingly
• Comparing retained earnings across companies requires consideration of differences in accounting policies and potential manipulation

Comparability across companies

• Differences in dividend policies, accounting principles, and OCI items can impact the comparability of retained earnings across companies
• Analysts should consider industry norms, company-specific factors, and the impact of accounting choices when comparing retained earnings
• Adjusting for non-recurring items and differences in accounting policies can enhance comparability and provide a clearer picture of a company's underlying financial performance