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In accounting, retained earnings refers to the portion of net income of a corporation that is retained by the corporation rather than distributed to shareholders as dividends. Similarly, if the corporation incurs a loss, then that loss reduces the corporation's retained earnings balance. If the balance of the retained earnings account is negative it may be called retained losses, accumulated losses or accumulated deficit, or similar terminology. Retained earnings and losses are cumulative from year to year.
Retained earnings are reported in the shareholders' equity section of the corporation's balance sheet. Corporations with net accumulated losses may refer to negative shareholders' equity as positive shareholders' deficit. A report of the movements in retained earnings or losses are presented in the Statement of Retained Earnings or Statement of Retained Losses.
Due to the nature of double-entry accrual accounting, retained earnings do not represent surplus cash available to a company. Rather, they represent how the company has managed its profits (ie whether it has distributed them as dividends or reinvested them in the business). When reinvested, those retained earnings are reflected as increases to assets (which could include cash) or reductions to liabilities on the balance sheet.
When total assets are greater than total liabilities, stockholders have a positive equity (positive book value). Conversely, when total liabilities are greater than total assets, stockholders have a negative stockholders' equity (negative book value) — also sometimes called stockholders' deficit. A stockholders' deficit does not mean that stockholders owe money to the corporation as they own only its net assets and are not accountable for its liabilities, though it is one of the definitions of insolvency. It means that the value of the assets of the company must rise above its liabilities before the stockholders hold positive equity value in the company.
Retained earnings = net profit from p&l a/c - dividends paid
The decision of whether a corporation should retain net income or have it paid out as dividends depends on several factors including, but not limited to:
- Tax treatment of dividends; and
- Funds required for reinvestment in the corporation (called retention).
A number of factors affect the decision of the amount of profit that a corporation should retain, including:
- Quantum of net profit.
- Age of the business enterprise
- Dividend policy of the corporation
- Future plan regarding modernization and expansion.