Retained earnings refer to the amount of income that a company keeps for use within the business. This money helps the business operate smoothly and finance expansion. There are several factors that can cause the retained earnings of the business to reduce. These factors can sometimes leave the business facing negative retained earnings.
Net Income/Net Loss
When a company’s income statement reports net income, the amount kept as retained earnings is listed under equities on the balance sheet. A similar adjustment is made on the assets side of the balance sheet. An increase in net income leads to an increase in retained earnings and vice versa. There are instances when the company reports a net loss on its income statement. This leads to the company having negative retained earnings, which are usually listed under liabilities on the balance sheet.
When a company reports a net income in its income statement, management can decide to keep the money as retained earnings or it can pay it out to shareholders as dividends. Some companies do both with their net income. This means that there would be an increase in retained earnings if the company did not pay out dividends for the previous financial year or if it allocated a lesser amount of the net income for the same purpose. However, when a company decides to pay dividends to its shareholders, the retained earnings will be reduced. Cash dividends, property dividends and stock dividends contribute to the reduction of a company’s retained earnings.
A company can discover along the way that there were discrepancies in its financial books, leading it to make the necessary adjustments to the income statement of the periods that were misreported. These adjustments are necessitated by errors that are discovered in early reporting. An upward adjustment to the earlier reported net income can come as a result of exaggerated expenses or understated revenues and this would lead to an increase in retained earnings. However, if the earlier report had understated expenses or overstated revenues, the necessary adjustments will reduce the net income, which will consequently result in a reduction in retained earnings.
Accounting reorganization is an accounting procedure through which companies make changes to their balance sheet by studying the changes in the fair market value of their assets and liabilities. If the fair market value of an asset increases, the company can increase the asset’s value in the balance sheet, which increases the retained earnings. If the fair market value of a liability increases, the adjustment to the balance sheet causes a reduction of the retained earnings.