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How to Calculate Retained Earnings

Calculate Retained Earnings

The concept of retained earnings is applicable in cases where the enterprise is a company, corporation or a company where dividend is paid as a reward to the investors, owners and shareholders of the company. Thus the formula of retained earnings is also applicable for partnerships or sole trading concerns which share profits with their investors.

Significance of Retained Earnings

Retained earnings have a progressing formula, that is, such earnings are calculated by subtracting losses/expenditures from profit/incomes and then, the dividend or rather profit is subtracted from the same. This leaves behind the figure of retained earnings. Depicting retained earnings in the balance sheet final accounts, is a compliance as per some Accounting Standards and some Generally Accepted Accounting Policies (GAAP). The significance of this left over money is that it is used for reinvestment or for investing into other operations, such as expansion or in some cases, it is simply put in to a proper growing investment fund or even a bank account. Basically, this kind of surplus constitutes the savings of the company.

Retained earnings are to be depicted in the balance sheet, in a format as prescribed by law. This compliance is basically an accountability compliance, as it gives a fair picture to the shareholders, who are after all owners of the capital of the company or business.

How to Calculate Retained Earnings?

The calculation of retained earnings is a four step process. Now when it comes to computation of retained earnings, the retained earnings of the previous year are also included. However for the first year of the business, which known as 'Beginning Retained Earnings' or Beginning RE, is not included. The formula, never the less remains the same. So here goes…

Step 1
In the first step the 'profit' or rather the revenue that has been generated and earned by the organization is calculated. This involves income of the company and the total expenditure, which gives the total earnings of that very accounting period. The formula goes as:

Total Earnings = Profit (-) Loss or, Income (-) Expenditure

The total earnings is often also known as gross profit. There is however a bit of a debate over the use of the term 'gross'. As gross does imply income minus expenditures, however there are some additional inputs into the formula such as taxes and duties or depreciation of sales inventory on the expenditure side of the formula. Hence total earnings is used. In some cases, the earnings are also computed by subtracting direct expenditures from sales. The formals differ from company to company and the method or formula that is more convenient is taken up.

Step 2
The next step involves the computation of certain compulsory deductions that have to be subtracted from the total earnings. These principally include, depreciation, taxes, duties and other deductions. This gives us the net income or net profit. Th formula goes as:

Net Income = Total Earnings (-) Depreciation (-) Taxes (-) Other Deductions

The word 'net' implies that the depreciation and taxes have been deducted. As per some conventional systems and regional accounting standards and policies, retained apart from taxes and depreciation a lot many deductions are connoted in the net earnings. For example, overheads, defaulted debts, etc.

Step 3
In this step, the dividends paid, interest (such as bonds and debentures) as under profit sharing schemes, and other transactions where profit is shared are deducted. The procedure depends upon the working system of the company, the current issue of dividend, bonus shares, preferential stock treatment, etc. In real life this is the most crucial and also the most difficult step, owing to the fact that there is a lot of compliance involved. Securities governance bodies, such as United States Securities and Exchange Commission, legislation's governing the business, taxation norms and other laws and compliance that are involved are not just important but are crucial. The rate at which the dividend is supposed to be issued is ascertained by the broad of directors, who are elected by the shareholders themselves.

Step 4
This is of course the last step, here following final formula for retained earnings is applied.

Retained Earnings (for accounting period …) = Beginning RE + Net Income (-) Dividends and Profit Sharing

For the first year of course, retained earnings would be computed without the Beginning RE. In some cases the figure is also converted into a percentage. There is no limits with regards to the accounting period for which the formula can be applied, it can be applied for weeks, months, days, etc. On an average it is applied to an year. In mammoth sized companies, a retained earnings statement is prepared and analyzed by the management on a daily basis.

As mentioned above the figure of retained earnings is depicted in the final accounts of several companies. This is due to the fact that these earnings depict to the shareholders the total amount of surplus cash that the company. From the management and company's point of perspective, retained earnings depict the total amount of cash that it has in its pocket to spare. This helps the management to assess performance, make plans for the future and map out future strategies, and make provisions for the welfare of the employees themselves. I hope that the elaboration on retained earnings is resourceful.


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