At the end of an accounting period, Revenue, Expense, and Dividend (or Drawing) accounts are closed to Retained Earnings (or Capital), transferring their balances to prepare for the next period; this process moves net income (or loss) and owner withdrawals into the permanent equity account.
The accounts closed in the retained earnings are:
The temporary accounts get closed at the end of an accounting year. Temporary accounts include all of the income statement accounts (revenues, expenses, gains, losses), the sole proprietor's drawing account, the income summary account, and any other account that is used for keeping a tally of the current year amounts.
Retained earnings are the portion of income that a business keeps for internal operations rather than paying out to shareholders as dividends. Retained earnings are directly impacted by the same items that impact net income. These include revenues, cost of goods sold, operating expenses, and depreciation.
The Retained Earnings account can be negative due to large, cumulative net losses. Naturally, the same items that affect net income affect RE. Examples of these items include sales revenue, cost of goods sold, depreciation, and other operating expenses.
The most common credits and debits made to Retained Earnings are for income (or losses) and dividends. Occasionally, accountants make other entries to the Retained Earnings account.
The retained earnings line item is recorded in the shareholders' equity section of the balance sheet. The retained earnings formula starts with the prior period's retained earnings balance, adds the current period's net income, and then subtracts shareholder dividends.
Net income (when revenue exceeds expenses) increases retained earnings. Conversely, dividends and net losses (when expenses exceed revenue) reduce retained earnings.
Q: Is Retained Earnings a debit or credit? A: Retained Earnings is a credit balance account. It increases with a credit entry when the company earns profits and decreases with a debit entry when the company distributes dividends or incurs losses.
In fact, additional paid-in capital will usually reflect a large majority of shareholder equity immediately after a company's IPO, as retained earnings may have yet to accumulate. IPO Example: A company goes public with 5 million shares at $20 each, par value $0.01: Total proceeds: $100 million.
In contrast, permanent accounts are not closed but carry their balances forward. Reporting: Temporary accounts contribute to the preparation of income statements, which show the net income or loss for a specific period.
Banks are required by law to monitor accounts for signs of fraud, money laundering, or illegal transactions. If unusual deposits, large cash transfers, or other red-flag behaviors are detected, the account may be frozen or closed without warning.
Revenue, expense, and dividend accounts affect retained earnings and are closed so they can accumulate new balances in the next period, which is an application of the time period assumption.
The correct order for closing accounts is: First, close revenue accounts to income summary. Second, close expense accounts to income summary. Third, close income summary to retained earnings.
An expense will decrease a corporation's retained earnings (which is part of stockholders' equity) or will decrease a sole proprietor's capital account (which is part of owner's equity).
The year-end balances for all assets, liabilities, and capital accounts are carried forward to the next year but all year-end totals for revenue and expenses accounts are posted to the set retained earnings account.
The total Retained Earnings in your company is a capital distribution, on which you are taxed under the Capital Gains Tax (CGT) rules instead of the dividend tax rules (which are significantly higher for higher rate tax payers – see our blog for more info);
Tip: Avoid posting directly to retained earnings, document adjustments thoroughly, and consult an accountant if correcting prior-year financials.
Adjustments and reserves affect retained earnings
Anything that increases or decreases net income is included: revenue, cost of goods sold, depreciation, operating expenses, and stock buybacks. However, the year-end retained earnings adjustments below are beyond the basic formula.
If you want the Retained Earnings account to represent the net profit for the current year only and begin the new year with a zero balance in the Retained Earnings account, a journal entry can be entered to move the balance as of the end of the year (for example, December 2023) to a different owner equity account.
Where Is Retained Earnings on a Balance Sheet? Retained earnings can typically be found on a company's balance sheet in the shareholders' equity section. Retained earnings are calculated by taking the beginning-period retained earnings, adding the net income (or loss), and subtracting dividend payouts.
The company's retained earnings are generally not transferred to the buyer, since they are considered part of the business's net worth. Impact on Retained Earnings: The seller retains ownership of the company's retained earnings after the sale.
While you can use retained earnings to buy assets, they aren't an asset. Retained earnings are actually considered a liability to a company because they are a sum of money set aside to pay stockholders in the event of a sale or buyout of the business.