3 minutes to understand and account for retained earnings

Retained earnings are one of the options available to a company's shareholders when distributing profits at the end of an accounting period.

What exactly does this concept mean? How does it appear on the balance sheet, and how should it be accounted for?

Find out how it sheds light on your company's financial management, with a case study to illustrate.

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What is retained earnings?

At the end of a financial year, within 6 months, the associates or shareholders of a company meet at an Ordinary General Meeting (AGM) to :

• approve the annual financial statements,
• vote on the appropriation of profits,
• and close the accounts.

On this occasion, they decide :

• to distribute profits as dividends, in full or in part, i.e., to remunerate investors in the company ;
  
  
• and/or to invest profits in reserves (in whole or in part, particularly when the company's bylaws require the creation of reserves in addition to the legal reserve) ;
  
  
• and/or, in the event of profits or losses, to postpone their decision until the next Annual General Meeting. This is called retained earnings.

In the latter two cases, the aim is to create a source of internal financing.

Retained earnings are therefore an accounting entry which acts as a reserve for unallocated earnings, pending arbitration.

☝️ Good to know: retained earnings can be distributed, or subtracted from distributable profits, over a period limited to 10 years. Retained earnings can therefore accumulate (be added to or subtracted from each other) over several years.

Retained earnings on the balance sheet

Whether positive or negative, retained earnings appear at the top of the liabilities side of the balance sheet, as part of the company'sshareholders' equity.

Negative retained earnings

Negative retained earnings means that losses have been generated by negative results in previous financial years, and are therefore deducted from :

• shareholders' equity,
• or the dividends to be paid to shareholders if subsequent results are positive, with priority given to debt repayment.

Positive retained earnings

When a company makes a profit at the end of its financial year, its shareholders may decide to allocate part of the profits to retained earnings.

At future AGMs, they may decide :

• either to distribute all or part ofthe profits as dividends to associates;
• or to place it in reserves (legal or statutory), thus creating a financial cushion capable of absorbing future losses;
• or postpone the decision until a subsequent AGM.

How to calculate RAN? A practical example

Here's the formula for retained earnings:

RAN = net profit for the year +/- previous RAN - allocation to reserves - dividends paid out

☝️ It is compulsory to allocate 5% of profits each year to the legal reserve, until it reaches 10% of share capital.

Example: if on 12/31/2020, we obtain this balance sheet before appropriation (equity section);

And if the decision taken at the AGM is :

• to place €5 per share in reserve, in accordance with the Articles of Association;
• to put no money into the optional reserve;
• to grant associates a statutory interest of 8% of the capital amount;
• Allocate a superdividend of €20 per share;
• carry forward the unappropriated balance;

This results in the following appropriation of earnings:

How to account for retained earnings

If retained earnings are in credit

This is accounted for as follows:

1. debit account 120 - Profit for the year,
2. and credit account 110 of the general chart of accounts - Retained earnings credit balance.

If retained earnings are in debit

This is accounted for as follows:

1. debit general chart of accounts account 119 - Retained earnings debit balance,
2. and credit account 129 - Profit for the year (loss).

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What's the point of carrying forward positive results?

A company may decide not to redistribute all or part of its profits to its associates, or to add to its reserves.

Why not? By recording profits in retained earnings, the company increases its assets and enhances its value without incurring debt.

In this way, positive retained earnings reveal the health of the company, as they :

• demonstrates a solid capacity for self-financing;
• offers financial security in the event of losses in future years;
• sheds light on the absence of losses in previous years.