What Is a Retained Earnings Restriction?

Retained earnings are the accumulated net income retained by a publicly traded company for reinvestment in its operations. In other words, retained earnings are earnings that are not paid out as dividends to shareholders. Retained earnings represent the accumulated profits, undivided profits, undistributed profits or earned surplus.

Net Income and Dividends

Paid-in capital is the shareholders' initial investment in a company. In order to provide a return on the investment, the company pays the shareholders a dividend, typically in cash. Dividends are a distribution of a portion of assets the company has earned. Most companies view retained earnings as the amount available for dividends. If dividends exceed the company´s earnings, the dividend would in effect return to the shareholders a portion of their initial investment rather than a return on the investment.

Retention of Net Income

Shareholders not only earn a return on their investment though dividends, they also benefit when share prices rise. As a consequence, many companies never pay dividends but re-invest all their earnings to accommodate more rapid expansion and increase the market price of their stocks. The decision made by a company to retain the net income or pay it out as dividends depends mainly on the funds required for reinvestment in the corporation, the retention.

Undistributed Profits

A company normally reinvests its retained earnings into its core business. In order to investigate if a firm has increased or decreased its rate of reinvestment, you need to analyze the ratio of undistributed profits to dividends. Accumulated profits ultimately form part of the company's equity and belong to the stockholders. A company can use retained net income for acquisitions, repurchase of outstanding shares, acquisition of additional assets or debt payoff. The board of directors authorizes decisions on using the retained surplus and records it under the shareholders' equity on the balance sheet.

Restriction of Retained Earnings

When a corporation generates a profit, its management can either pay the profit out to shareholders as a cash dividend or retain the earnings by reinvesting them into the business. Appropriation or restriction of retained earnings means a reduction in the amount of earnings available for payment as dividends. This type of restriction either results from a voluntary measure enacted by the company´s board of directors to accumulate the net profit for a specific purpose, such as to pay off debt or purchase a capital asset, or due to contractual requirements, such as a restrictive covenant in a loan agreement.

References

  • "Financial Statements"; Thomas R. Ittelson; 2009
  • "Principles of Finance"; Scott Besley and Eugene Brigham; 2008

About the Author

Brian Bass has written about accountancy-related topics and accounting trends for "Account Today." He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Bass hold a master's degree in accounting from the University of Utah.