This video explains what the retained earnings account is in the context of financial accounting and provides an example.
Retained Earnings represents the profits a corporation has accumulated since its inception, minus any dividends it has paid out to its shareholders. Let’s say that Self-driving Truckers Inc. has the following results from its first five years of operations:
|Year||Net Income (Loss)||Dividends Paid|
After Self-driving Truckers’ Inc. closes its books at the end of year five, it will have a Retained Earnings balance of $75. This was calculated by: (1) adding the Net Income from years 1, 3, and 5, (2) subtracting the Net Losses from years 2 and 4, and (3) subtracting the dividends paid out from year 3 [100 + 50 + 10 – 25 – 50 – 10 = 75]. Thus, if we were to look at the Balance Sheet for Self-driving Truckers Inc. as of the last day of the fiscal year for year five, we would see a Retained Earnings balance of $75 in the Stockholders’ Equity section.
Can Retained Earnings be negative?
Yes. When Retained Earnings is negative, we call the account, “Accumulated Deficit.” Returning to the example above, let’s say that Self-driving Truckers had posted a Net Loss of $100 in year 1 instead of Net Income of $100 in year 1. If everything else remained the same, the balance in Retained Earnings at the end of year five would be –25. Thus, if we were to look at the Balance Sheet for Self-driving Truckers Inc. as of the last day of the fiscal year for year five, we would see negative 25 for the account Accumulated Deficit.
Is there a handy formula to understand how the Retained Earnings account changes?
Retained Earnings (beginning) + Net Income – Net Loss – Dividends Declared = Retained Earnings (ending)
Can a company go bankrupt if it has Retained Earnings? How is this possible?
Yes, a company can go bankrupt even if it has Retained Earnings. Let’s return to the example for Self-driving Trucks. If the company’s positive Net Income in years 1, 3, and 5 was due entirely to credit sales and it couldn’t collect the cash (or obtain cash from other means), Self-driving Trucks would be unable to pay its suppliers, employees, etc. and would go bankrupt. Alternatively, if Self-driving Trucks had collected the cash but used it to purchase a new asset, and then couldn’t raise additional cash to pay suppliers, employees, etc. it would go bankrupt.