Retained earning is referred to profit retained by the business. It’s the profit that has not been distributed among shareholders; instead, it has been reinvested in the business. It may be reinvested to purchase capital assets or finance working capital management.
Mainly, there are two sources of finance that include debt financing and equity financing. Debt financing comes with an obligation to pay back in the future. Further, equity finance is raised by selling a proportion of the business. Hence, there is dilution in the business controls. These both are external sources of financing.
However, there are internal finance sources and one of which is retained earning. This is the profit earned by a business in the past and used in the operations/expansions. It’s the cheapest source of financing as no money is to be paid back in the future (as opposed to debt financing), and no controls are diluted (as opposed external equity financing). Hence, it’s the best option; the same concept is discussed in the pecking order theory.
Classification of retained earning in the balance sheet.
Retained earning is presented in the equity section of the balance sheet. Usually, it’s a last line in the equity section and keeps changing if profit or loss is added in the balance of retained earnings. It’s important to note that profit/loss from the income statement is recorded in the retained earnings. So, if there is a profit, retained earnings increases. On the other hand, if there is a loss, the retained earnings decreases.
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It’s equally important to note that retained earnings may be converted to accumulated losses if the business had more losses than profit in the past. Further, the dividend paid by the business is deducted from retained earning. This accounting can be reflected as follows.
Given entry is posted in the accounting system when the dividend is paid. The debit impact of the transaction is a decrease of retained earning as profit/retained earning has been paid to the shareholders. On the other hand, the credit impact of the transaction is a decrease in the cash balance.
Retained earning is profit retained in the past. It’s created when a business does not pay a dividend. It’s the cheapest source of finance because financial leverage does not increase, and there is no control dilution as in the case of debt and equity financing, respectively.
Retained earning is classified in the equity section of the balance sheet. If a business makes a profit and does not distribute, it increases retained earnings. On the other hand, if the business makes a loss, it decreases retained earnings. Likewise, if losses are higher, it might lead to an accumulated loss in the balance sheet instead of retained earning.