A company that makes a fortune by consistently producing top-quality items braces itself for an uncertain tomorrow by putting cash aside -- or, as accountants call it, "retaining income." Negative retained earnings, or accumulated losses, adversely affect a company's profitability equation and financial condition, especially with long-term performance management.
Retained earnings represent profits a company hasn't distributed for years, preferring to keep them in its coffers to fund operating activities or constitute rainy-day funds. When a company's loses consistently over a long stretch, it reports negative retained earnings, the kind that portray an unflattering image of the business in investor quarters. Finance people often use the term "cumulative losses" when referring to negative retained earnings, which typically relate to a company's statement of profit and loss -- also called an income statement, P&L or report on income.
Negative Retained Earnings vs. Income Statement
"Negative retained earnings" and "income statement" are distinct concepts, but they interrelate in an organization's record-keeping process. An income statement reports data about corporate revenues -- also called income items -- and expenses, the kind of administrative and production costs that accountants call "operating charges." Income items include every activity that helps a company make money, whether it be selling merchandise, providing services or both. Operating charges include material expenses as well as selling, general and administrative expenses. SG&A costs run the gamut from salaries and commissions to rent, insurance, office supplies and litigation.
If left uncorrected, negative retained earnings gradually bring a company's equity amount down. Equity consists of money investors put in the business and touches on items as varied as common stock, preferred shares and additional paid-in capital, also known as surplus capital. To understand why accumulated losses make a numerical dent in retained earnings, it's helpful to make sense of entries accountants post after closing a corporation's books. If the business declares net income, they credit the retained earnings account and debit the income summary account. If the entity posts negative results, accountants post the opposite entry. As an equity item, a credit entry to the retained earnings account means increasing the account's balance.
Effect on Other Financial Statements
Besides the retained earnings master account, cumulative losses decrease a company's net worth -- which equals total assets minus total debts -- and balance sheet. Also known as a statement of financial position or report on financial condition, a balance sheet is the synopsis in which a business reports the resources it relies on to make money, as well as where it finds the cash to buy these assets. Negative retained earnings also reduce money flowing into corporate coffers and, therefore, adversely affect the statement of cash flows.
- Wiley: Chapter 16 -- Stockholders’ Equity: Retained Earnings
- Real Life Accounting; Theme: Understanding Equity Accounts; John W. Day
- The American Institute of Professional Bookkeepers: Why Owners Love Their Retained Earnings Account -- How to Handle It
- NetMBA: The Accounting Process (The Accounting Cycle)
- U.S. Securities and Exchange Commission. "How to Read a 10-K." Accessed May 10, 2020.
Marquis Codjia is a New York-based freelance writer, investor and banker. He has authored articles since 2000, covering topics such as politics, technology and business. A certified public accountant and certified financial manager, Codjia received a Master of Business Administration from Rutgers University, majoring in investment analysis and financial management.