Perils of Not Understanding Retained Earnings

Fully comprehending the item on financial statements called Retained Earnings accretes knowledge that significantly rewards business owners. As one of the equity accounts on a Balance Sheet, increases or reductions in Retained Earnings correspond to changes in assets. Increased assets – such as cash or accounts receivable – are triggered by business profits. Profit growth therefore raises Retained Earnings. Business losses cause a reverse impact.

This change in Retained Earnings only occurs at the close of an accounting cycle, which is typically year-end. Throughout the year, Retained Earnings does not change. Instead, the Balance Sheet has another equity account for Current Year Profit or Loss. Only when the year is complete does the balance in the current year account pour over into Retained Earnings.

Retained Earnings throughout the current year should continuously match the same figure as the end of last year. If you increase Retained Earnings to a different figure than the balance at the previous year-end, your tax accountant has no choice other than adjusting the current year profit. You will pay income tax on an additional amount that was not really income. Should Retained Earnings mysteriously decline, the tax accountant will record the change as a non-deductible distribution or dividend rather than deductible expense.

To assure accounting records that promote insight rather than confusion, never record a transaction that alters Retained Earnings. Use different equity accounts for recording distributions or capital contributions. Those events are changes in cash assets that are not a consequence of business earnings.

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