At the end of the accounting cycle, a business must make adjustments to close out all of its temporary accounts and prepare final financial statements for the period. A part of this process involves the adjustments made to retained earnings. Reading an income statement becomes a little easier when you can understand the basics of these retained earnings adjustments.
The retained earnings account is a permanent account that records a business's total profits still owed to its shareholders. Any profits at the end of the fiscal period that are not distributed to shareholders as dividends are reinvested in the company as retained earnings. This account is useful to distinguish between equity represented by shareholders' original investment and equity resulting from the long-term growth of the business. When dividends are paid, they are also drawn out of the retained earnings account.
End-of-Period Adjusting Entries
Before retained earnings is adjusted on the income statement, the business must first make all necessary adjustments to its expense and revenue accounts to record the activity of the financial period, which includes adjustments for expenses that accumulate over time, such as depreciation or accrued rent and salaries. In essence, the adjusting entries basically recognize expenses and revenue that have accrued as a result of the passage of time.
With balance sheet adjustments complete, the business reports on the income statement all of the adjustments made to retained earnings necessary to end the accounting cycle. Before reporting the company's final balance sheet and net income or loss, the company closes all of its expense and revenue accounts and transfers their balances to a temporary income summary account. In a final adjustment, this account is closed and the balance is transferred to the retained earnings account. This is called the closing process and is necessary to get an accurate and up-to-date picture of the business's performance for the period.
Prior Period Adjustments
In some cases, the discovery of errors make a retained earnings adjustment necessary to correct mistakes. This kind of adjustment is called a prior period adjustment because it represents a change resulting from the activity or the records of a prior accounting cycle. Unlike the adjusting and closing entries for the current financial period, these entries are not reported on the income statement because they would distort the picture of the current period's performance. They are instead reported on the statement of retained earnings and adjust the retained earnings account's beginning balance.