3 minutes to understand retained earnings and how to account for them

Retained earnings are one of the options available to a company's shareholders when distributing profits at the end of an accounting period.

What exactly does this concept mean? How does it appear on the balance sheet and how should it be accounted for?

Find out how it sheds light on your company's financial management, as well as a practical case study to illustrate the point.

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What is retained earnings?

At the end of the financial year, within 6 months, the partners or shareholders of a company meet at an Ordinary General Meeting (AGM) to :

• approve the annual accounts
• vote on the appropriation of profits
• and close the accounts.

At this meeting, they decide :

• to distribute profits in the form of dividends, in part or in full, i.e. to remunerate investors in the company ;
  
  
• and/or to invest profits in reserves (in part or in full, particularly when the Articles of Association require the constitution of reserves in addition to the legal reserve);
  
  
• and/or, in the event of profits or losses, to defer their decision to a future general meeting. This is knownas retained earnings.

In the last two cases, the aim is to create a source of internal funding.

Retained earnings is therefore an accounting entry that acts as a reserve for unallocated profits pending arbitration.

☝️ Good to know: retained earnings may be distributed, or subtracted from distributable profits, over a period limited to 10 years. Retained earnings can therefore accumulate (be added to or subtracted from each other) over several years.

Retained earnings on the balance sheet

Whether positive or negative, retained earnings appear at the top of the liabilities side of the balance sheet, because they form part of the company'sequity.

Negative retained earnings

Negative retained earnings means that losses have been generated by negative results in previous financial years, and are therefore deducted from :

• shareholders' equity,
• or the dividends to be paid to shareholders if subsequent results are positive, with priority given to debt repayment.

Positive retained earnings

When a company makes a profit at the end of its financial year, its shareholders may decide to allocate part of the profit to retained earnings.

At future AGMs, they may decide :

• either to distribute all or part ofthe profits as dividends to the shareholders;
• or to transfer it to reserves (legal or statutory), thereby creating a financial cushion capable of absorbing future losses;
• or postpone the decision until a future AGM.

How do you calculate net asset value? A practical example

Here is the formula for retained earnings:

retained earnings = net profit for the year +/- previous year's net profit - allocation to reserves - dividends paid out

☝️ It is compulsory to allocate 5% of profits each year to the legal reserve, as long as it has not reached 10% of the share capital.

Example: if, at 31/12/2020, we obtain this balance sheet before appropriation (equity section) ;

And if the decision taken at the AGM is :

• to place €5 per share in reserve, in accordance with the Articles of Association;
• not to put any money into the optional reserve;
• to grant shareholders a statutory interest of 8% of the amount of the capital;
• to pay members a superdividend of €20 per share;
• carry forward the unallocated balance;

This results in the following appropriation of profits:

How is retained earnings recognised?

If retained earnings are in credit

It is recorded as follows:

1. debit account 120 - Profit for the year,
2. and credit account 110 of the General Chart of Accounts - Credit balance carried forward.

If retained earnings are in debit

This is accounted for as follows:

1. debit account 119 of the general chart of accounts - Retained earnings debit balance,
2. and credit account 129 - Profit for the year (loss).

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What is the point of carrying forward positive profits?

A company may decide not to redistribute all or part of its profits to shareholders or to add to its reserves.

Why not? By recording profits in retained earnings, the company increases its assets and enhances its value without incurring debt.

A positive balance carried forward is a sign of a healthy company, because it :

• demonstrates a solid capacity for self-financing;
• offers financial security in the event of losses in future years;
• provides an indication of the absence of losses in previous years.