What are retained earnings?

Definition

Retained earnings is the cumulative profit that stayed in the shop after owners were paid. On the books, this is an Equity account on the Balance Sheet, not cash in the bank and not this year's profit alone.

Each period's net income is added after the close. Distributions and dividends are subtracted.

Cash-basis and accrual books both keep this cumulative total. Accrual net income includes sales not yet collected and expenses not yet paid, so this line can rise even when the checking account does not.

This line is kept profit, not a vault. A bookstore can show a large balance here while cash is tied up in shelves of books.

Where it shows up

Balance Sheet: Located in the equity section.

P&L: Related to cumulative net income kept in the business.

Cash flow: Decreases when profits are paid out, reported cash from financing activities decreases.

See also: Net Income · Equity · Closing Entries

When you look at your Balance Sheet, this line sits in the equity section with the other residual accounts. The total is cumulative kept profit through that date, after payouts.

When the balance is high, the shop has kept more profit over its life. When the balance is low or negative, profits have been paid out, or losses have piled up as an accumulated deficit.

The profit and loss statement does not list this account as a line. This year's net income is what will flow here after closing entries; the P&L is still the period's revenue and expenses.

The Statement of Changes in Equity walks this line from beginning to ending balance. A Retained Earnings Roll-Forward is the schedule that proves the same walk.

On the Statement of Cash Flows, paying out profit is a financing outflow. That payout lowers this line; earning the profit does not by itself move cash.

How it works

The balance comes in through closing entries. Revenue and expense accounts are cleared, and the net amount is posted here.

That close is usually a year-end step, with a similar monthly close into the same account. After it posts, the P&L accounts start the next period at zero, and this line holds the history.

A net loss reduces the balance. Enough losses turn the line into an accumulated deficit, which is still in Equity, just negative.

Owners taking profit out also reduce it. A distribution or dividend is not an expense; it is equity leaving the business.

This line is not a cash asset. Keeping profit might mean more books on the shelf, a paid-down loan, or unpaid invoices, not more dollars in the bank.

The Retained Earnings Roll-Forward is how you prove the ending number. Beginning balance, plus net income, minus distributions, should equal the Balance Sheet line.

Beginning retained earnings is last period's ending balance. If that opening number does not match last year's issued snapshot, the walk cannot tie out.

Stay with this account when you read the close. The Income Statement explains one period's profit; this line keeps every period that was not paid out.

Example

A bookstore begins the year with $12,000 of retained earnings. During the year it earns $9,000 of net income and the owner takes a $3,000 distribution.

After the close, this line is $18,000, which is $12,000 plus $9,000 minus $3,000. Cash may or may not have moved by those same amounts, depending on collections and other spending.

The year-end close into this account is recorded:

Debit: Income summary $9,000

Credit: Retained earnings $9,000

This line rises by $9,000, and the P&L accounts are cleared. The Income Statement still showed the $9,000 as net income for the year; this entry is what parks that result in Equity.

The $3,000 distribution reduces cash and reduces this line. It does not reduce net income.

The Balance Sheet equity section now prints $18,000 here. If it prints a different number, the close or the distribution was missed.

Common mix-ups

Retained earnings is not cash in the bank. This line is cumulative kept profit; cash is an asset.

This line is not this year's net income. Net income is the period result on the P&L; this line is that result plus every prior year, minus payouts.

Equity is not only this account. Equity is the whole residual section; retained earnings is the kept-profit piece inside it.

Related terms

• Net Income: What is left from revenue after every expense, including interest and taxes, is subtracted.
• Equity: The owners' residual claim on the business after liabilities are subtracted from assets.
• Closing Entries: The year-end entries that clear income and expense accounts into retained earnings.
• Retained Earnings Roll-Forward: A schedule tying beginning retained earnings to the ending balance through income and distributions.
• Distributions: Payments of profit out to owners or shareholders.
• Accumulated Deficit: The negative retained earnings balance created by cumulative losses.
• Balance Sheet: A statement showing what a business owns, what it owes, and what is left for owners at a single point in time.
• Year-End Close: The heavier close at fiscal year end, including closing entries and audit preparation.