How to calculate retained earnings

Each year a company makes a profit or a loss. Whatever profit it doesn't pay out to shareholders as dividends stays in the business and adds to retained earnings. Losses reduce the balance. Over time, the figure records the company's accumulated profits and losses, less everything paid out.

On the balance sheet, retained earnings sit in equity alongside share capital. business.gov.au's glossary describes equity as what the owners' stake in the business is worth, worked out as assets less liabilities, and gives owner's equity and shareholders' equity as other names for net assets.

Closing retained earnings equal opening retained earnings, plus the net profit for the year or less the net loss, less dividends for the year. Each input has its own source:

• Opening retained earnings: the closing figure on last year's balance sheet.
• Net profit or loss: the bottom line of this year's finalised profit and loss statement. Your accountant usually makes year-end adjustments before that figure is final, so wait for them.
• Dividends: those declared or paid to shareholders during the year. Which dividends belong in which year is a question for your accountant.

The closing figure for the first year becomes the opening figure for the second. The loss in the second year reduced the balance, and no dividend was paid. If losses ever outweigh the profits kept, the balance goes below zero, which is often described as accumulated losses.

During the year, profit builds up in the income and expense accounts. At year end those accounts are closed off: the year's profit or loss moves into retained earnings, and the income and expense accounts start the new year from nil. Asset, liability and equity balances carry straight on.

A balance sheet prepared partway through a year usually shows the current year's profit on its own line, with retained earnings from earlier years beside it. Make sure the current year's profit is counted only once, either on that line or inside retained earnings, never both.

Apart from that close, the balance usually moves only when your accountant records a payment to the owners against it, or puts through a correction to an earlier year's figures after that year was finalised. Everyday sales and expenses go to their own accounts, not straight to retained earnings.

Total equity should equal net assets, which business.gov.au calculates as total assets less total liabilities. If they don't agree, an entry is missing or in the wrong place.

If you don't have last year's figure to start from, you can work retained earnings out from a balance sheet. Net assets equal total equity, so take total liabilities from total assets, then take away share capital and any other equity accounts. Some companies keep reserves, or set part of their profits aside in a separate equity account; take those out as well, and ask your accountant what each one holds. What is left is the equity built up from profits. The example below is a different company from the one above, shown at two dates: straight after one financial year was closed, and halfway through the next.

At 30 June the year's profit already counts as part of retained earnings, so there is no current-year profit to separate out, and retained earnings are the whole 73,700.00, even if your software shows that year's profit on its own line until 1 July. By 31 December the same subtraction gives 87,400.00, but that includes 13,700.00 of profit made since 1 July. The books usually hold that on a line of its own until the year is closed. Take it out and retained earnings from earlier years are still 73,700.00, which is what you would expect when nothing was paid out to the owners in between.

If money was taken out of the business by its owners during those six months, the earlier-years figure may have fallen too. Whether a particular payment reduces retained earnings at all, and how it is recorded, is something your accountant sets.

A trial balance gets you there more directly. It lists the retained earnings account's balance, which covers the closed years, and the income and expense accounts, whose difference is the current year's profit or loss so far. The shortcut only works if every asset and liability is in the books, so reconcile the bank, loan and card accounts first.

Retained earnings normally carry a credit balance, like the other equity accounts. In double-entry bookkeeping every transaction is recorded twice, as a debit in one account and a credit in another, and business.gov.au's glossary places debits on the left-hand side, where assets and expenses sit. Liabilities, equity and income sit on the credit side.

When a year's profit is closed off into retained earnings, it goes in as a credit and the balance grows. A loss goes in as a debit and the balance shrinks. If the account ends up with a debit balance overall, the company has accumulated losses.

The same logic explains why retained earnings are equity, not a liability or an asset. They aren't owed to a lender or a supplier, so they aren't a liability. They aren't something the business holds, such as cash or stock, so they aren't an asset. They are part of the owners' claim on the net assets, built up from profits rather than from the money the owners paid in for their shares.

A large retained earnings balance doesn't mean the company has that much in the bank. The profits kept over the years may have gone into stock, equipment, loan repayments or customers who haven't paid yet. To see where it went, look at the cash flow statement; business.gov.au says it tracks money as it enters and leaves the business.

A cash dividend uses money the business needs to have available. Whether a company can pay a dividend is a legal and accounting question, so check with your accountant before any dividend is declared.

Retained earnings go below zero when a company's losses since it started are larger than the profits it has kept. There are three common routes: losses in the first years of trading before the business finds its feet, one bad year that wipes out earlier profits, or more paid out to the owners over time than the company earned.

On the balance sheet, a negative balance is often labelled accumulated losses and shown as a deduction within equity. Total equity then comes out lower than the share capital the owners put in. If the losses are large enough, total equity falls below zero, which by business.gov.au's definition of equity, assets less liabilities, means the company owes more than it owns.

A negative balance isn't an error in itself. It is a prompt to look at the trend in the profit and loss statements and at whether the company can pay its debts as they fall due. Among the signs of poor profitability, business.gov.au includes needing borrowed money to keep the business running and profits that stay flat while costs climb. Raise a negative or falling balance with your accountant early.

Each of these errors throws the figure out, and each has a quick way to spot and fix it.

• The opening balance doesn't match last year's finalised figure. Spot it by comparing retained earnings at 1 July in your books with the closing figure on the balance sheet your accountant finalised. A gap usually means their adjusting entries never made it into the books. Fix it by asking your accountant for those entries and entering them as they set out.
• A closed year was changed after it was finalised. A late supplier bill or a deleted invoice dated before 30 June alters that year's profit, and with it this year's opening retained earnings. Spot it when a report for a closed year no longer agrees with the copy you filed. Fix it by reversing the change and asking your accountant how the item should be recorded instead. If your software lets you set a lock date for closed periods, use it.
• Everyday entries coded straight to retained earnings. A payment or correction posted there skips the profit and loss statement, so the year's profit is wrong even though the balance sheet still balances. Spot it by listing the transactions in the retained earnings account: apart from each year's close and anything your accountant has entered, there shouldn't be any. Fix it by moving each item to the account it belongs in, and ask your accountant about any item that isn't an everyday sale or expense.
• Money paid for shares recorded as income. What the owners pay the company for their shares belongs in share capital. If it lands in sales or other income, the year's profit is overstated and retained earnings with it, even though total equity looks right. Spot it by checking that share capital on the balance sheet equals what the owners actually paid for their shares. Fix it by asking your accountant to move the amount to share capital.
• Payments to the owners recorded without knowing what they are. Money a company pays its owners might be pay for work, a loan or a share of the profits, and each is recorded differently. Spot it by listing every payment to an owner in the period and checking each has a clear description. Fix it by asking your accountant how each one should be recorded.

In accounting software, retained earnings are usually worked out from the closed years rather than typed in, with the current year's profit shown separately until the new year begins. In a spreadsheet you carry each year's closing figure to the next year's opening line yourself, so check that link every time you start a new year.

Retained earnings are a company idea. A sole trader's profit usually adds to the owner's equity, and drawings reduce it; in business.gov.au's glossary, drawings are the owner's personal costs paid from the business's account. A partnership keeps a similar account for each partner. Trusts and other structures have their own arrangements, so ask your accountant how yours is recorded.

Section 286 of the Corporations Act 2001 also requires a company's records to be complete enough that true and fair financial statements could be built from them and audited. Its definition of financial records reaches the working papers behind year-end adjustments as well.

Those records must be held for 7 years from when the transactions in them are completed. In practice, filing each year's finalised statements, adjustment workings and dividend records together makes the retained earnings figure easy to trace.