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A Simple Formula
Retained earnings are the accumulation of net income, less any dividends or distributions made to owners, over the life of a business. It is presented as an equity account on the Balance Sheet and is equal to total assets less total liabilities. The Statement of Retained Earnings, one of four basic financial statements, details changes in the retained earnings account from one reporting period to the next.
Retained Earnings = Total Assets - Total Liabilities
Cash is not set aside in an amount equal to retain earnings. Instead, a variety of assets, such as fixed assets and inventory, comprise the offset to total liabilities. Regardless, when a company reports an increase in retained earnings as a result of net income, owners and investors expect to benefit from the positive results. If the company has a history of paying dividends each year, then an expectation develops that this payment will continue. In addition, tax laws may penalize a company that does not distribute accumulated earnings.
But, what if management has a significant project or expense on the horizon? How would a financial statement user, such as a shareholder or investor, know of the company's intended use of earnings? Financial statements are a primary tool used to communicate with these interested parties.
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When should a business appropriate retained earnings?
When a company expects to hold on to earnings for a future use, rather than distribute them to owners or shareholders, then an appropriation of retained earnings should be reported. This action is voluntarily taken and is a way of presenting a complete picture to financial statement users. Possible reasons for appropriation include expansion, a requirement of a loan covenant, a pending legal matter or other contingency. Only unappropriated retained earnings are available for dividend distribution.
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How do you appropriate retained earnings?
The most common way to report an appropriation of retained earnings is by disclosing the matter in the notes to the financial statements. The note would include the amount and reason for the appropriation as well as applicable dates if available.
The following example is taken from the Notes to the Financial Statement of Tektronix, Inc.:
Certain of the Company's debt agreements require compliance with debt covenants. Management believes that the Company is in compliance with such requirements for the fiscal year ended may 26, 2001. The Company has unrestricted retained earnings of $223.8 million after meeting those requirements.
A lesser-used way to record the restriction is to make the following journal entry for the amount of the appropriation:
Dr Retained Earnings
.....Cr Appropriated Retained Earnings.
Both accounts are reflected on the Balance Sheet and in the Statement of Retained Earnings. When the appropriation is no longer needed it is reversed.
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References: Kimmel, Paul D., Jerry J. Weygandt, and Donald E. Kieso. Financial Accounting: Tools for Business Decision Making. New York, NY: Wiley, 2008. Print.