The concept of Retained Income is one of the main accounting terms, fundamental if we want to understand the structure of the balance sheet and the means of financing with which the assets of a company are financed. This article will explore this accounting term and a practical example that will help to better understand this concept.
Taking into account the term of retained earnings, we must first cover the definition of capital. The owners’ equity is a residual right of the shareholders on the assets of the company. Residual means that the first company has to return the liabilities and only after that what is left can be distributed to the shareholders. So equity is a difference between assets and liabilities and this can also be supported by the basic accounting equation, where Assets = Liabilities + Equity.
Equity in turn is made up of:
- Social capital – initial investment by shareholders in the company, and
- Retained earnings – Net profit obtained and remained in business, which has not yet been distributed to shareholders. Of course, in case the company has losses, said loss is accumulated as undistributed profits, which are a negative and decreasing value of capital.
That Balance sheet These two items are listed separately to show how much shareholders invested in the business and how much the business has accumulated in undistributed earnings since inception of operations.
Relationship with the income statement
To understand the concept of Retained earnings it is better to demonstrate its relationship with the income statement. Let’s say we have a company that started business on January 1, 2009. Shareholders invested $ 10,000 in cash at the start of business. Statement of income for 2009 it is as follows (for simplicity, no taxes or interest expense are provided):
Income ___________________ 25,000
Cost of goods sold _________ (19,000)
Gross profit ________________ 6,000
Operating expenses __________ (3,000)
Net profit __________________ 3,000
The shareholders decided not to distribute dividends for 2009 and to retain all profits in the business. That Balance sheet at Capital part you will see the following:
Share capital _______ 10,000
Retained earnings ____ 3,000
Total equity ________ 13,000
So all the net profit from the income statement goes to the balance sheet as retained earnings, since this profit was retained in the business.