Jan 31, 2024

The Founder’s Guide to Finance: Statement of Retained Earnings

Arc Team

Go-To-Market

An overview of the statement of retained earnings

The statement of retained earnings is a financial statement that tracks changes in a company's retained earnings over a specific reporting period. It is essential to understand how a company utilizes its profits. It provides stakeholders with insights into the portion of earnings reinvested in the business for growth, debt repayment, or dividend distributions. Additionally, it serves as a bridge between the income statement and the balance sheet, illustrating the flow of profits from one period to the next.

The components of the statement of retained earnings

Opening balance - represents the accumulated profits retained in the company from previous periods. It serves as the starting point for the current reporting period.
Net income - derived from the income statement, this represents the total profits earned by the company during the reporting period. It contributes to the increase in retained earnings unless distributed to shareholders as dividends.
Dividends - represent the portion of profits distributed to shareholders. When dividends are declared and paid, they reduce retained earnings.
Adjustments - these include any changes to retained earnings that are not related to net income or dividends, such as corrections of errors, accounting changes, or reclassifications.
Closing balance - represents is the ending balance for the reporting period, calculated by adding the net income, deducting dividends, and adjusting for any other changes during the period.

The uses of the statement of retained earnings

Shareholder perspective - shareholders use this document to assess how the company manages its profits and whether it prioritizes reinvestment for growth or distributions to shareholders as dividends.
Internal decision-making - management relies on this document to make strategic decisions regarding capital allocation, investment opportunities, and dividend policies. It helps in planning for future growth and managing financial resources effectively.
External reporting requirements - regulatory authorities and investors use this document to evaluate the company's financial health, stability, and long-term sustainability. It provides insights into the company's ability to generate profits and manage cash flows.

Preparation of the statement of retained earnings

Compliance with accounting standards and regulation - startups must adhere to relevant accounting standards (e.g., GAAP, IFRS) and regulatory requirements when preparing and presenting the Statement of Retained Earnings. Compliance ensures transparency and consistency in financial reporting.
Frequency of reporting - Startups typically prepare this document on a quarterly and annual basis, providing stakeholders with regular updates on changes in retained earnings.
Format and structure - the statement of retained earnings follows a standardized format, presenting the opening balance, net income, dividends, adjustments, and closing balance in a structured manner.
Disclosure requirements - additional disclosures may be required to provide further insights into significant changes or transactions impacting retained earnings. This may include explanations of unusual items, changes in accounting policies, or significant events affecting the company's financial position.

Comparing the statement of retained earnings to other documents

Statement of Retained Earnings vs Income Statement

The statement of retained earnings reflects the cumulative net profits retained in the business over time after accounting for dividends, whereas the income statement shows the revenues, expenses, and net income or net loss of a company over a specific period, usually a quarter or a year. While the statement of retained earnings shows the opening balance of retained earnings, net income, dividends, and adjustments, the income statement shows the revenues, cost of goods sold, gross profit, operating expenses, operating income, non-operating income, taxes, and net income. The outcome from the income statement (net profit or loss) is used in the statement of retained earnings.

Statement of Retained Earnings vs Profit and Loss Statement

The statement of retained earnings represents the cumulative profits retained in the business over time, whereas the profit and loss statement (P&L) shows the revenues, expenses, and net income or net loss of a company over a specific period. While retained earnings are reported on the balance sheet under shareholders' equity, the profit and loss statement is a standalone financial document.

Statement of Retained Earnings vs Statement of Stockholders' Equity

The statement of retained earnings represents the cumulative profits retained in the business over time, appearing as a component of stockholders' equity, whereas the statement of stockholders' equity: Includes various components such as common stock, additional paid-in capital, retained earnings, and other comprehensive income. While the statement of retained earnings reflects the portion of net income that has been reinvested back into the business rather than distributed to shareholders, the statement of stockholders' equity provides a comprehensive view of changes in equity over time, including retained earnings, capital contributions, and distributions to shareholders.

Commonly faced pitfalls when preparing the statement of retained earnings

Misclassification of items: Misclassifying transactions such as dividends, adjustments, or other changes in retained earnings can distort the accuracy of the statement.
Omission of transactions: Failing to include all relevant transactions affecting retained earnings, such as dividends declared or adjustments made during the reporting period, can result in an incomplete and misleading statement.
Failure to account for changes in accounting policies: Changes in accounting policies or corrections of prior period errors may impact retained earnings. Failure to appropriately account for such changes can lead to discrepancies in the statement.
Inadequate disclosures: Lack of sufficient disclosure regarding significant transactions, events, or changes impacting retained earnings can hinder stakeholders' understanding of the financial position and performance of the company.
Failure to reconcile with other financial statements: The statement of retained earnings should reconcile with other financial statements, such as the income statement and balance sheet.
Overlooking prior period adjustments: Neglecting to incorporate prior period adjustments or corrections of errors can result in inaccuracies in the statement of retained earnings.
Lack of documentation and audit trail: Insufficient documentation and audit trail for transactions impacting retained earnings can hinder transparency and accountability. Maintain detailed records and documentation to support entries and adjustments in the statement of retained earnings.

Wrap-up - the statement of retained earnings

Preparing an accurate statement of retained earnings is crucial for decision-making. By acting as a between the income statement and the balance sheet, it can help illustrate how profits flow from one period to the next. Make sure that when you prepare your statement of retained earnings you classify all items correctly, include all relevant transactions, provide all of the necessary disclosures, and reconcile it with your other financial statements. If you have additional questions or would like an introduction to one of our partners, who can help you prepare your statement of retained earnings, get in touch.