Principles of Financial Accounting: Stockholders' Equity - Retained Earnings and Restrictions

What It Is

Retained Earnings (RE) represents the accumulated profits of a company that are not distributed to shareholders as dividends. It's a critical component of a company's equity and is reported on the Balance Sheet. If a company earns $50,000 in net income and pays $10,000 in dividends, its Retained Earnings would increase by $40,000.

Key Concepts & Formulas

• Retained Earnings (RE): The accumulated profits of a company that are not distributed to shareholders as dividends. Example: If a company has $100,000 in RE and distributes $20,000 in dividends, its new RE balance would be $80,000.
• Dividend Distribution: The amount of net income distributed to shareholders as dividends. Example: If a company distributes 20% of its net income as dividends, and its net income is $100,000, the dividend distribution would be $20,000.
• Retained Earnings Formula: RE = Beginning RE + Net Income - Dividends Example: If a company has $100,000 in Beginning RE, earns $50,000 in net income, and distributes $20,000 in dividends, its new RE balance would be $130,000.
• Normal Balance of Retained Earnings: Debit (asset) - Retained Earnings increases with a debit and decreases with a credit. Example: If a company distributes $10,000 in dividends, the journal entry would be: Dr. Retained Earnings $10,000 Cr. Cash $10,000
• Restrictions on Retained Earnings: Certain restrictions may be placed on Retained Earnings, such as a dividend restriction or a capital reserve restriction. Example: If a company has a dividend restriction of $20,000, it cannot distribute more than $20,000 in dividends, even if its net income is higher.

Journal Entry Examples

1. Distribution of Dividends: A company distributes $10,000 in dividends. Dr. Retained Earnings $10,000 Cr. Cash $10,000
2. Increase in Retained Earnings: A company earns $20,000 in net income. Dr. Retained Earnings $20,000 Cr. Net Income $20,000
3. Decrease in Retained Earnings: A company distributes $15,000 in dividends. Dr. Cash $15,000 Cr. Retained Earnings $15,000

Common Mistakes

1. Mistake: Confusing debits and credits for Retained Earnings. Correction: Remember that Retained Earnings increases with a debit and decreases with a credit.
2. Mistake: Not considering restrictions on Retained Earnings. Correction: Always check for any restrictions on Retained Earnings before making a distribution or increase.
3. Mistake: Not using the correct formula for Retained Earnings. Correction: Use the formula RE = Beginning RE + Net Income - Dividends to calculate the new Retained Earnings balance.

Exam Tips

1. Tip: Remember that Retained Earnings increases with a debit and decreases with a credit.
2. Tip: Always check for any restrictions on Retained Earnings before making a distribution or increase.
3. Tip: Use the formula RE = Beginning RE + Net Income - Dividends to calculate the new Retained Earnings balance.

Quick Practice

1. Problem: A company has $50,000 in Beginning Retained Earnings and earns $30,000 in net income. It distributes $10,000 in dividends. What is the new Retained Earnings balance? Answer: $70,000 (RE = $50,000 + $30,000 - $10,000)
2. Problem: A company has a dividend restriction of $20,000. It earns $40,000 in net income and distributes $25,000 in dividends. What is the new Retained Earnings balance? Answer: $55,000 (RE = $40,000 - $25,000, but restricted to $20,000, so new RE balance is $20,000 + $35,000 = $55,000)
3. Problem: A company has $100,000 in Beginning Retained Earnings and distributes $15,000 in dividends. What is the new Retained Earnings balance? Answer: $85,000 (RE = $100,000 - $15,000)

Last-Minute Cram Sheet

1. Retained Earnings (RE) increases with a debit and decreases with a credit.
2. The formula for Retained Earnings is RE = Beginning RE + Net Income - Dividends.
3. Always check for any restrictions on Retained Earnings before making a distribution or increase.
4. Dividends are not an expense, they go directly to Retained Earnings.
5. Retained Earnings cannot be negative.
6. Dividend restrictions must be considered when making a distribution.
7. The normal balance of Retained Earnings is a debit (asset).
8. Retained Earnings is reported on the Balance Sheet.
9. The Retained Earnings account is a contra-equity account.
10. Retained Earnings cannot be used to pay off liabilities.