How to Prepare a Statement of Retained Earnings

A statement of retained earnings is an essential financial document that summarizes the changes in retained earnings for a specific period. Retained earnings represent the cumulative amount of net income that a company has reinvested in its business, rather than distributing it to shareholders as dividends. This statement provides valuable insight into a company’s financial health and its ability to reinvest profits for growth. In this tutorial, we will walk you through the process of preparing a statement of retained earnings, step by step.

Understanding Retained Earnings

Before diving into the preparation of the statement, it is crucial to understand what retained earnings are and why they are important. Retained earnings are the portion of net income that a company retains after distributing dividends to shareholders. They are recorded under the equity section of the balance sheet and can be used for various purposes, including expanding operations, paying off debt, or investing in new projects.

Components of the Statement of Retained Earnings

The statement of retained earnings typically includes the following components:

Beginning Retained Earnings: The balance of retained earnings at the start of the period.
Net Income: The net profit or loss for the period.
Dividends Paid: The total dividends distributed to shareholders during the period.
Adjustments: Any prior period adjustments, corrections, or other changes affecting retained earnings.
Ending Retained Earnings: The balance of retained earnings at the end of the period.

Step-by-Step Guide to Preparing the Statement

Step 1: Gather Necessary Information

To prepare the statement of retained earnings, you need the following information:

The retained earnings balance at the beginning of the period.
The net income (or net loss) for the period from the income statement.
The total dividends declared and paid during the period.
Any adjustments required to correct prior period errors or changes in accounting principles.

Step 2: Calculate the Beginning Retained Earnings

The beginning retained earnings are typically the ending retained earnings from the previous period. This amount can be found on the previous period’s statement of retained earnings or balance sheet.

For example, let’s assume the beginning retained earnings for the period are $50,000.

Step 3: Add Net Income (or Subtract Net Loss)

Next, add the net income for the period to the beginning retained earnings. If the company incurred a net loss, subtract the net loss from the beginning retained earnings. The net income can be obtained from the income statement.

For example, if the company earned a net income of $20,000 for the period, the calculation would be as follows:

$\text{Adjusted Beginning Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income}$

$\text{Adjusted Beginning Retained Earnings} = \$50,000 + \$20,000 = \$70,000$

Step 4: Subtract Dividends Paid

Subtract the total dividends declared and paid during the period from the adjusted beginning retained earnings. Dividends represent the distribution of profits to shareholders and reduce retained earnings.

For example, if the company paid $10,000 in dividends during the period, the calculation would be as follows:

$\text{Adjusted Retained Earnings} = \text{Adjusted Beginning Retained Earnings} - \text{Dividends Paid}$

$\text{Adjusted Retained Earnings} = \$70,000 - \$10,000 = \$60,000$

Step 5: Account for Adjustments

If there are any adjustments required for prior period errors or changes in accounting principles, these should be added or subtracted from the adjusted retained earnings. These adjustments ensure that the retained earnings reflect the true financial position of the company.

For example, if there is a prior period adjustment of $5,000 (an increase), the calculation would be as follows:

$\text{Ending Retained Earnings} = \text{Adjusted Retained Earnings} + \text{Adjustment}$

$\text{Ending Retained Earnings} = \$60,000 + \$5,000 = \$65,000$

Step 6: Prepare the Statement

Finally, prepare the statement of retained earnings by summarizing the information in a clear and organized format. Here is an example of how the statement should look:

Company Name
Statement of Retained Earnings
For the Period Ended [Date]

Description	Amount
Beginning Retained Earnings	$50,000
Add: Net Income	$20,000
Adjusted Beginning Retained Earnings	$70,000
Less: Dividends Paid	$10,000
Adjusted Retained Earnings	$60,000
Add: Adjustment	$5,000
Ending Retained Earnings	$65,000

Additional Considerations

Prior Period Adjustments

Prior period adjustments are corrections of errors made in previous financial statements. These adjustments can arise from mistakes in calculations, misstatements, or changes in accounting principles. It is important to properly document and explain any adjustments made to retained earnings to ensure transparency and accuracy in financial reporting.

Impact of Changes in Accounting Principles

When a company changes its accounting principles, it must adjust retained earnings to reflect the cumulative effect of the change. For example, if a company changes its method of inventory valuation from FIFO (First-In, First-Out) to LIFO (Last-In, First-Out), it needs to adjust retained earnings for the cumulative difference in inventory valuation between the two methods.

Restrictions on Retained Earnings

In some cases, retained earnings may be restricted or appropriated for specific purposes. For example, a company may set aside a portion of retained earnings for future expansion projects or to comply with legal requirements. These restricted amounts should be disclosed in the notes to the financial statements.

Example of Preparing a Statement of Retained Earnings

Let’s go through a comprehensive example to illustrate the preparation of a statement of retained earnings.

Example:

ABC Corporation has the following information for the year ended December 31, 2023:

Beginning Retained Earnings: $80,000
Net Income: $50,000
Dividends Paid: $15,000
Prior Period Adjustment (increase): $3,000

Calculate the Adjusted Beginning Retained Earnings:

$\text{Adjusted Beginning Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income}$

$\text{Adjusted Beginning Retained Earnings} = \$80,000 + \$50,000 = \$130,000$

Subtract Dividends Paid:

$\text{Adjusted Retained Earnings} = \text{Adjusted Beginning Retained Earnings} - \text{Dividends Paid}$

$\text{Adjusted Retained Earnings} = \$130,000 - \$15,000 = \$115,000$

Add Prior Period Adjustment:

$\text{Ending Retained Earnings} = \text{Adjusted Retained Earnings} + \text{Prior Period Adjustment}$

$\text{Ending Retained Earnings} = \$115,000 + \$3,000 = \$118,000$

Prepare the Statement of Retained Earnings:

ABC Corporation
Statement of Retained Earnings
For the Year Ended December 31, 2023

Description	Amount
Beginning Retained Earnings	$80,000
Add: Net Income	$50,000
Adjusted Beginning Retained Earnings	$130,000
Less: Dividends Paid	$15,000
Adjusted Retained Earnings	$115,000
Add: Prior Period Adjustment	$3,000
Ending Retained Earnings	$118,000

Importance of the Statement of Retained Earnings

The statement of retained earnings provides several key benefits for stakeholders:

Insight into Profit Reinvestment: It shows how much of the net income is being reinvested into the company versus distributed to shareholders.
Indicator of Financial Health: A growing retained earnings balance indicates a company is profitable and retains enough earnings to support future growth.
Dividend Policy Analysis: Stakeholders can assess the company’s dividend policy and its commitment to returning profits to shareholders.
Decision Making: It aids management in making informed decisions about future investments, expansion, and debt management.

Common Mistakes to Avoid

When preparing a statement of retained earnings, it’s important to avoid common mistakes that can lead to inaccurate financial reporting:

Ignoring Adjustments: Failing to account for prior period adjustments can misrepresent the financial health of the company.
Misclassifying Dividends: Ensure that dividends are correctly recorded and subtracted from retained earnings.
Overlooking Restrictions: Disclose any restrictions on retained earnings to provide a complete financial picture.
Inconsistent Reporting: Use consistent methods and principles for calculating and reporting retained earnings to maintain accuracy over time.

Tips for Accurate Preparation

Regular Review: Regularly review and update the statement of retained earnings to ensure it reflects the most current financial data.
Detailed Documentation: Keep detailed records of all adjustments, net income calculations, and dividend payments.
Clear Communication: Clearly communicate any changes in accounting principles or policies that impact retained earnings.
Professional Guidance: Consult with financial professionals or accountants to ensure compliance with accounting standards and accuracy in reporting.

Conclusion

Preparing a statement of retained earnings is a crucial aspect of financial reporting that provides valuable insights into a company’s profitability and financial health. By following the steps outlined in this tutorial, you can accurately calculate and report retained earnings, ensuring transparency and reliability in your financial statements. Remember to gather all necessary information, account for adjustments, and clearly document your calculations to maintain accuracy and credibility in your financial reporting.

Practice Exercise: Complex Statement of Retained Earnings

Scenario:

XYZ Corporation is preparing its financial statements for the year ended December 31, 2023. The following information is available:

Beginning retained earnings on January 1, 2023: $120,000
Net income for the year ended December 31, 2023: $85,000
Dividends declared and paid during 2023: $25,000
A prior period adjustment (correction of an error in revenue recognition) resulting in an increase of $10,000
Change in accounting policy for depreciation from straight-line to declining balance, resulting in a cumulative decrease in retained earnings of $8,000
A revaluation surplus of $15,000 was transferred to retained earnings during the year.
Dividends for preferred stock: $5,000
XYZ Corporation issued additional shares and recorded a capital surplus of $20,000, which was partially used to cover a special dividend of $10,000.
The company recorded a loss from discontinued operations amounting to $12,000.

Prepare the statement of retained earnings for XYZ Corporation for the year ended December 31, 2023.

Solution:

Step 1: Calculate the Adjusted Beginning Retained Earnings

The beginning retained earnings on January 1, 2023, were $120,000. We need to account for the prior period adjustment, which increases retained earnings by $10,000.

$\text{Adjusted Beginning Retained Earnings} = \text{Beginning Retained Earnings} + \text{Prior Period Adjustment}$

$\text{Adjusted Beginning Retained Earnings} = \$120,000 + \$10,000 = \$130,000$

Step 2: Add Net Income

The net income for the year is $85,000.

$\text{Total After Net Income} = \text{Adjusted Beginning Retained Earnings} + \text{Net Income}$

$\text{Total After Net Income} = \$130,000 + \$85,000 = \$215,000$

Step 3: Subtract Dividends Paid

Dividends declared and paid during the year amount to $25,000.

$\text{Total After Dividends} = \text{Total After Net Income} - \text{Dividends Paid}$

$\text{Total After Dividends} = \$215,000 - \$25,000 = \$190,000$

Step 4: Subtract Preferred Stock Dividends

Dividends for preferred stock amount to $5,000.

$\text{Total After Preferred Stock Dividends} = \text{Total After Dividends} - \text{Preferred Stock Dividends}$

$\text{Total After Preferred Stock Dividends} = \$190,000 - \$5,000 = \$185,000$

Step 5: Account for Change in Accounting Policy

The change in accounting policy for depreciation results in a decrease of $8,000.

$\text{Total After Accounting Policy Change} = \text{Total After Preferred Stock Dividends} - \text{Decrease Due to Accounting Policy Change}$

$\text{Total After Accounting Policy Change} = \$185,000 - \$8,000 = \$177,000$

Step 6: Add Revaluation Surplus

A revaluation surplus of $15,000 was transferred to retained earnings.

$\text{Total After Revaluation Surplus} = \text{Total After Accounting Policy Change} + \text{Revaluation Surplus}$

$\text{Total After Revaluation Surplus} = \$177,000 + \$15,000 = \$192,000$

Step 7: Subtract Special Dividend

The company paid a special dividend of $10,000.

$\text{Total After Special Dividend} = \text{Total After Revaluation Surplus} - \text{Special Dividend}$

$\text{Total After Special Dividend} = \$192,000 - \$10,000 = \$182,000$

Step 8: Subtract Loss from Discontinued Operations

The loss from discontinued operations is $12,000.

$\text{Ending Retained Earnings} = \text{Total After Special Dividend} - \text{Loss from Discontinued Operations}$

$\text{Ending Retained Earnings} = \$182,000 - \$12,000 = \$170,000$

Step 9: Prepare the Statement of Retained Earnings

XYZ Corporation
Statement of Retained Earnings
For the Year Ended December 31, 2023

Description	Amount
Beginning Retained Earnings	$120,000
Add: Prior Period Adjustment	$10,000
Adjusted Beginning Retained Earnings	$130,000
Add: Net Income	$85,000
Total After Net Income	$215,000
Less: Dividends Paid	$25,000
Total After Dividends	$190,000
Less: Preferred Stock Dividends	$5,000
Total After Preferred Stock Dividends	$185,000
Less: Decrease Due to Accounting Policy Change	$8,000
Total After Accounting Policy Change	$177,000
Add: Revaluation Surplus	$15,000
Total After Revaluation Surplus	$192,000
Less: Special Dividend	$10,000
Total After Special Dividend	$182,000
Less: Loss from Discontinued Operations	$12,000
Ending Retained Earnings	$170,000

This exercise demonstrates the comprehensive process of preparing a statement of retained earnings, including adjustments for prior period corrections, changes in accounting policies, and other significant financial events.