Accounting in one form or another had existed for a very long time and appeared around the time when people began to engage in trade. Accounting is an integral part of entrepreneurial activity. It is essential that accounting is maintained accurately and on time. To do so, one must know how to make entries to each account, including retained earnings account.
In this article, you will not only find an answer to the question “What is the normal balance for retained earnings: debit or credit balance?”, but also get an overview of retained earnings. To better understand the debit and credit entries, you will learn what makes up the preserved and where they belong in the accounting balance.
Understanding Stockholder’s Equity and Retained Earnings
Stockholder’s equity is a difference between total assets and total liabilities. Equity indicator consists of the following elements:
- additional paid-in capital (formed as a result of the revaluation of assets, share premiums, etc.);
- authorized capital (paid-in capital);
- reserve capital (reserve fund, which is created from net profit and so on);
- retained earnings (form due to the efficient operation of the enterprise, remain at the disposal).
Owners can direct net income towards:
- payment of dividends;
- increase of reserve capital and retained earnings;
- repayment of losses;
- other purposes based on the decision of the owners.
Income is subject to distribution based on the decision of the general meeting of shareholders in a joint-stock company, a gathering of participants in a limited liability company. The company’s profit distribution policy is characterized by an indicator of the dividend payout ratio, which shows the share of net profit intended for dividend payments to stockholders. The higher this indicator, the lower the growth rate of equity, the smaller the ability to channel funds into developing business activities, and the less retained earnings a company has.
Retained earnings are an integral part of equity. Retained earnings are a total of all the accumulated profits that a company has received and has not distributed or spent otherwise. Accumulated earnings of the organization for the reporting year is the final financial result of its activities fewer dividends paid. In the balance sheet, retained earnings are shown as the total amount for the reporting period and previous years. It should be noted that the income statement and cash flow statement does not have retained earnings in them.
The dynamics of this indicator allows us to judge the growth rate of internal sources of equity and the company’s ability to develop. If the company gets closed (liquidated), then the amount of accumulated profit will be distributed between the owners (shareholders) of the company, so they are interested in a positive result of this indicator.
Retained Earnings Account
Retained earnings (uncovered loss) account is included under stockholder’s equity in the balance sheet. It reflects information on the amount of net profit that remained at the disposal of the company after dividends distribution according to a decision of the general meeting of shareholders. As mentioned earlier, a retained earnings account is an accumulated amount and can be used as financial support for the development of the company and other similar measures for the acquisition of new property/assets. Let’s review the main components that affect the retained earnings next.
Net Income or Loss
Profit is the difference between the revenue from the sale of goods/services and some expenses, depending on what kind of benefit, such as operating profit one is trying to get. Net income or net profit, on the other hand, is the total revenue minus all expenses. It is an important economic indicator that serves to reflect the effectiveness of the entrepreneurial activity.
Net profit is the money that remains with the company after various deductions, expenses, taxes, and other payments. Net profit is a source of financing of production processes. It also forms reserve funds, and it is precisely at the expense of it that working capital increases. The main factors affecting the amount of net profit are:
- amount of tax and other payments;
- company income from the sale of goods/services;
- cost of goods.
Net income is the amount of money that dividends can be paid from and retained earnings formed. Net income is the source of retained earnings, which can also be phrased as reserved income.
Dividends are a portion of the profit received by the company that is distributed between the owners of shares or securities. If the company received a loss, then most often, shareholders should not count on dividend payment. But there are exceptions: sometimes the top management of a company may decide to pay dividends from retained earnings of previous years or even borrow to please its shareholders.
Holders of ordinary shares in the company receive the income that remains after the payment of expenses, taxes, and dividends on preferred shares. The company has a choice: invest them further or distribute them. The decision should be based on opportunity costs: if the company can provide a return not lower than the opportunity costs of shareholders in the market with equivalent risk, then it needs to reinvest and vice versa.
Prior Period Adjustments
Accountants and companies try to do their best to prevent errors, yet they do happen from time to time. According to the Generally Accepted Accounting Principles, one should update retained earnings at the end of each year if there were any changes to the previous years’ net income or dividends. Adjusting entries can be made to correct any errors during the last years.. These could be simple human mathematical errors or fraud attempts. An overstatement or understatement of income for the previous year will also affect retained earnings, so adjusting entries should account for any discrepancies.
Debit and Credit Entries
An accounting balance means that the assets are equal to liabilities, plus stockholder’s equity and debits should equal to credits. The balance sheet asset part comprises of two sections:
- Long-term assets
- Current assets
Current assets are considered more liquid than long-term because they can be converted into cash more accessible and faster. If the Assets demonstrate what the company owns, then the Liabilities and Stockholder’s equity tell the sources these assets. These two items are on the opposite side of the assets in the accounting equation and include the following:
- Capital and reserves
- Long-term liabilities
- Short-term liabilities
In double-entry accounting, entries reflect where the money comes from and where it goes with two accounts increasing or decreasing accordingly. Some accounts grow when they are debited. These would be Assets and Expenses accounts. Liabilities, Revenue, and Equity accounts, on the other hand, increase when they are credited. If you make a credit entry to any account under Expenses or Assets, they will decrease. To decrease Liabilities, Revenue, and Equity accounts, you would make an entry on the debit side.
The side of the accounting journal that will lead to an increase in a particular account is called the accounts’ normal balance. Is a reasonable balance for retained earnings debit or credit? As you have learned earlier in this article, retained earnings are part of the Stockholders Equity, which suggests that their normal balance is a credit balance.
In other words, when a company has retained earnings for the current period, it would credit entry to the Retained Earnings account to increase it. What if the company overstated its net income in the previous period and needs to make an adjusting entry? To decrease the retained earnings account, it will be debited. A debit entry would also be essential if the company would take from retained earnings to pay for something.