Retained earnings debit or credit?
Retained earnings debit or credit? Retained earnings are usually recorded on the right column of a company’s balance sheet under the equity section along with the company’s share capital and paid-in capital. Businesses are generally run with the hope of generating profits from the goods and services provided. These profits are an integral part of the business’s operations and future growth projects such as purchases of assets, expansion to new territories, settlement of debt as well as paying distributions to shareholders.
Retained earnings refer to the net income of a company after it has paid dividends to its shareholders. Hence any amount remaining after the payment of shareholder’s dividends is considered retained earnings.
Generally, a company’s earnings can be either positive or negative. If a company’s earnings are positive, it means the company has been able to generate profits from the goods and services they offer. If a company’s earnings are negative, the company has incurred losses from its operations. Usually, it is companies with positive earnings that have retained earnings. This is because they were able to cover their cost of goods sold and other operational expenses, pay dividends and still have some amount leftover that can be referred to as retained earnings.
The amount of retained earnings a company has generally indicates that the company is profitable and is therefore an indication of the positive performance of the company. However, there are a lot of profitable businesses that might have a low balance in their retained earnings account. This is especially true for companies that have a large number of shareholders to pay dividends to, those with a high dividend payment rate, or those who often reinvest profits back into the business.
In addition to the company’s income statement, statement of cash flows, and balance sheet, a statement of retained earnings is usually required by lenders, banks, and financial institutions when a company seeks funds from them. Here, we shall discuss retained earnings, debit, and credit so that we can understand how the retained earnings are recorded and if they are debit or credit.
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Understanding retained earnings debit or credit
In order for us to effectively answer the question of retained earnings being debit or credit, we first have to understand what retained earnings are and further take a look at the meaning of debit and credit.
Retained earnings explained
When businesses operate, they generate income from the various goods or services they offer their customers. This income is used by the company to settle the expenses associated with providing the goods or services. One way that most companies raise funds for various projects such as expansion, asset purchases, debt settlement, research and development of new products or services, etc. is through offering preferred or common stock for sale.
The amount a company gets for the stocks sold at par value is the share capital while any additional amount realized is the paid-in capital. Part of the benefits investors receive for purchasing shares in a company is the payment of dividends that they receive either quarterly or yearly depending on how often the company declares distributions. Whenever a company declares distributions, the amount used to pay the shareholder dividends is deducted from the retained earnings account. Hence, retained earnings are the portion of a company’s net income that is set aside by the company for various operational purposes after dividend payments to its shareholders.
The retained earnings are reported on the company’s balance sheet under its stockholder’s equity section. This amount is usually held in a reserve by the company and could be used to increase the company’s asset base or reduce some of its liabilities. Retained earnings are the company’s net income after dividend payments. A company’s net income is the amount remaining from its revenue after it has deducted its operational expenses and made dividend payments. Thus, the leftover amount that the company was able to generate within the accounting period in view is usually transferred to the retained earnings account.
Companies whose revenues and gains are higher than their losses and expenses usually have a positive net income. This positive net income increases the company’s retained earnings. If on the other hand, the company incurred more losses and expenses than its revenue and gains could cover, then, the company will have a negative net income. The negative net income affects the retained earnings account by reducing it. Another factor that affects the balance of the retained earnings account is the declaration of distributions that are paid to the company’s shareholders.
Retained earnings in simple terms
Retained earnings are a company’s cumulative earnings since its inception after the subtraction of the cumulative amount that has been paid out as dividends to shareholders. Hence retained earnings are the company’s past earnings that have been kept by the company instead of being distributed to shareholders as dividends.
Factors that affect a company’s retained earnings
- Assets depreciation
- Cost of goods sold
- Dividend payments
- Operating expenses
- Revenue
Since a company’s retained earnings are determined by its net income, the factors that affect its net income also affect its retained earnings by extension. We shall discuss these factors which make a company’s retained earnings increase or decrease below
Assets depreciation
When companies purchase assets, their useful lifespan is determined. The useful lifespan of an asset is the time it will take from its purchase to when it will no longer be efficient. The cost of the asset is then spread over the useful lifespan of the assets and accounted for as depreciation. When the depreciation account balance is high, it decreases the amount that will be left over as retained earnings.
Cost of goods sold
The cost of goods sold (COGS) is the cost associated with the production of the goods that a company offers. This includes the direct labor costs and the cost of materials that were used to produce the goods. If production costs are high, it reduces the company’s net income, thus impacting the potential amount that could be leftover as retained earnings too.
Dividend payments
When companies declare dividends, the amount is deducted from their retained earnings. Therefore, the more often a company pays dividends to its shareholders, the more its retained earnings balance gets reduced. In order to maintain their retained earnings, some companies do not pay dividends to their shareholders.
Operating expenses
A company’s operating expenses include the costs associated with its business operations such as marketing, research and development (R & D), rent, inventory cost, insurance, etc. These also have an impact on retained earnings.
Revenue
The total amount realized by a company from the sales of goods or services rendered is its revenue. This amount includes all income that has been generated before the deduction of expenses and it is commonly referred to as gross sale. When the company is able to generate considerable revenue, it will be able to comfortably settle its expenses and other obligations while still having a considerable amount left over as retained earnings.
Debit and credit
When companies keep a record of their transactions, they do so using the double-entry bookkeeping system. With this system, every transaction has at least two entries made for it with one being debit and another being credit. Debits are usually placed on the left side of the accounting entry while credits are placed on the right-hand side.
Retained earnings are part of a company’s equity account and a debit to this account decreases the balance while a credit increases it. In order for the company’s financial books to balance, when a debit is made to the retained earnings account, a corresponding credit has to be made to another account. If a credit is made to the retained earnings account, a corresponding debit has to be made to another account.
For instance, if a company’s net income at the end of 2022 is $970, the income summary account will be debited while the retained earnings account will be credited as follows
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $970 | |
| Retained earnings | $970 |
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Are retained earnings debit or credit?
Retained earnings normal balance is usually a credit, this indicates that the company has generated profits from its inception to the time when the retained earnings balance is checked. Since dividend payments are usually deducted from a company’s retained earnings, the retained earnings balance of most companies is relatively low even if the company has a good financial standing. Thus, the retained earnings balance does not perfectly portray the level of success or profitability of a company. Instead, if a company’s success is to be analyzed, the various income statement ratios or business valuation methods could be used. They aid in ascertaining the profitability and value of a company respectively.
When the retained earnings balance of a company is negative, it indicates that the company has generated losses instead of profits over the period of its existence. In this case, the retained earnings will be a debit. Most companies that have a negative retained earnings balance are usually startups. This is because, at the beginning of the life of a business, it is most likely to incur losses due to the fact that its products and services have not yet gained market recognition. Thus, they do not have sufficient patronage to ensure their profitability yet.
Retained earnings debit or credit: Journal entries
As mentioned earlier, retained earnings are part of the equity segment of a company’s balance sheet which shows the accumulated profits the company made in past and current periods that were kept instead of being distributed to its shareholders. This amount originates from the net income of the company that is found on its income statement.
Journal entries for retained earnings are made when the company transfers its net income to the income summary account and when dividends are paid out. The income summary is a temporary account that is used to close the income and expenses of a company for each accounting period. If the net income is a profit, it is a credit to the retained earnings. If it is a loss, it is a debit to the retained earnings.
For example, if a company made profits of $200,650 in the accounting period in view, its income summary account will be debited of this amount while its retained earnings account will be credited with an equal amount as shown below.
Retained earnings debit and credit journal entry for profits
| Account | Debit | Credit |
|---|---|---|
| Income summary | $200,650 | |
| Retained earnings | $200,650 |
If at the end of the accounting period the company experiences losses instead of profits, the journal entry will be reversed with a debit to the retained earnings account and a credit to the income summary account.
If for instance, the company incurred losses of $100,000 the journal entry for the loss will be recorded as shown below.
Retained earnings debit and credit journal entry for losses
| Account | Debit | Credit |
|---|---|---|
| Retained earnings | $100,000 | |
| Income summary | $100,000 |
When distributions are declared by a company, the amount that will be paid as dividends to its shareholder is usually taken out of its retained earnings account on the date of the declaration. Hence if a company declares $8,950 in dividends to its shareholders on October 28, 2022, the journal entry to record this dividend payment will be as the one below.
Retained earnings debit and credit journal entry for dividend payments
| Date | Account | Debit | Credit |
|---|---|---|---|
| 20/10/2022 | Retained earnings | $100,000 | |
| Dividends payable | $100,000 |
Conclusion
From our discussion, we have seen that retained earnings are usually a credit and not a debit. Retained earnings are the company’s net income that it keeps for future business operations instead of paying out as dividends to its shareholders. The higher a company’s retained earnings, the more financially stable it is. This indicates that the company generates adequate revenue that covers its expenses and dividend payments while still having some leftover money to reinvest in the business. Some factors that can affect a company’s retained earnings include depreciation, COGS, dividends, etc.
