What are Retained Earnings?Definition Retained EarningsContributed capital is the other main section of owners equity, or stockholders equity, which represents capital contributions in the form of owner investments or paid –in capital from stock purchases. Under the owners equity section, the accounting equation shows that there are two ways to increase owners equity:
Retained earnings, a subsection of shareholders equity, can be increased or reduced by affecting net assets or another equity account. Economic events that affect retained earnings are as follows:
QuickBooks Online Edition – Starting as low as $9.99 a month The Statement of Retained EarningsCompanies show the changes in the retained earnings account from period to period on the statement of retained earnings. Net Income (loss)When a company operates at a profit, net assets are increased, and the net earnings are carried to the balance sheet by crediting the retained earnings account. When a company operates at a loss, the net loss reduces net assets and the loss is carried to the balance sheet by debiting retained earnings. Net profits or losses are rolled into the retained earnings account when closing entries are made at the end of the accounting cycle. Net profits and losses are the primary economic activity that affects the retained earnings account. In fact, for most companies retained earnings makes up the most significant portion of stockholders equity. Percentage of Retained Earnings to Stockholders Equity
Dividends (Cash and Stock)Distribution of assets such as cash or other assets reduce net assets, and in turn decrease the retained earnings account. For example, a cash dividend (or owner withdrawal for private companies) reduces both net assets and retained earnings. When a company declares a dividend, it creates a current liability on the balance sheet because the corporation is legally required to pay the dividend when declared, decreasing net assets by increasing a liability account: dividends payable.
When the dividend is paid, the liability account is brought to zero, and the asset account is reduced, in this case cash. This double entry accounting process keeps the accounting equation in balance by reducing net assets along with retained earnings. Paying a Dividend Reduces an Asset
The final result on the accounting equation is as follows:
Stock DividendsUnlike a cash dividend, a stock dividend does not decrease an asset. This is because a company’s own stock is not an asset. A stock dividend reduces retained earnings, but not owners equity. Instead, equity is simply moved from retained earnings to contributed capital. For example, at the end of the year, Sunny Sunglasses Shop has the following equity balance on the accounting balance sheet:
If Sunny Sunglasses Shop declared and issued 10 percent stock dividend, then the total number of shares will increase by the amount of the stock dividend, or 10%. Since there are currently 25,000 shares outstanding (determined by dividing common or preferred stock/par value or original value), a 10% stock dividend increases the total number of shares by 2,500 (25,000 x 10% = 2,500). Assuming the current market price is $5 per share, a 10% stock dividend reduces retained earnings and increases stockholders equity as follows:
Sunny Sunglasses Shop Stockholders Equity after 10% Stock Dividend
Notice that the total balance of stockholders equity remains the same, but retained earnings was reduced. Since neither assets nor liabilities are affected with a stock dividend, and therefore net assets remains the same, the accounting equation remains in balance by simply shifting the stock dividend within the total equity account: Effect of a Stock Dividend on the Accounting Equation
GAAP distinguishes between small stock dividends and large stock dividends. Small stock dividends are less than approximately 20 to 25 percent of the shares outstanding, and are recorded at the fair market value (as in the above example). Conversely, large stock dividends, defined as stock dividends greater than 20 to 25 percent of the shares outstanding, are recorded at the par value. The reasoning behind this method is that a small stock dividend may not affect the market price, and the benefit of the higher market value of the dividend should be recorded in retained earnings. A large stock dividend, on the other hand, does not produce extra value because the market price should decline with the larger pool of stock. Therefore, the retained earnings account is debited only to the extent of the legal capital of the additional stock, or the par value of the stock. In the example above, had Sunny declared and issued a 50% stock dividend, then total shares would increase by 12,500 (25,000 x 50%). This amount would reduce retained earnings by the par value of the additional stock, or $12,500, and increase common stock at par by $12,500 (12,500 x $1 par value). The additional paid-in capital account is not affected in a large stock dividend, since the current market price is not recognized for larger stock dividends.
Treasury StockPrior Period AdjustmentFrom Retained Earnings to Owners Equity Back to Accounting Terms Back to the Basic Accounting Principles for Small Business Accounting Home Page
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