Hi, Else here, and in this video,
we'll be exploring the statement of retained earnings.
First, let's remind ourselves of the proper order
of the financial statements.
The income statement comes first.
The profit or net loss if expenses
are greater than revenues is a measure
of a business's performance.
We covered the single step income statement
in our last video.
Next, businesses must prepare a statement of retained earnings.
This statement reports how profits and dividends
have affected equity.
It is used because the majority of changes in equity
are due to the generation and distribution of profit
earned by the business.
Information from this statement helps stakeholders
assess a business's use of profit,
how much is retained by the business for future growth,
and how much is paid out to the owners.
In order to understand the statement of retained earnings,
we must first understand what makes up the element equity.
Equity is a difficult concept to grasp,
so we're going to keep it simple right now.
Equity is equal to the wealth that
is due to the owners of the business
and is made up of two items.
First, equity is the investment owners make in the business.
It represents the amount of cash,
goods, or services a business receives
from the owners in exchange for their share of the business.
For instance, if you start a business
with $20,000 of your own cash, then you
have $20,000 of capital in the business, which
would be recorded as equity.
Second, equity is the profit that the business generates
and keeps in the business.
For instance, if the business had profit of $10,000
during the year, then the equity would go up by $10,000.
If a portion of that profit was paid out to the owners
in the form of dividends, then equity
would go up by the amount of profit and then down
by the amount of dividends.
Dividends are the profit which a business chooses to pay out
to the owners of that business.
For example, if a business had profit of $10,000
but paid out dividends of $2,000,
then equity would increase by a net amount
of $8,000 which are the profits that the business kept.
This is called retained earnings,
meaning the profit or earnings kept or retained
in the business.
So to summarize-- equity is the capital
invested by the owners plus the profit less the dividends
retained by the business.
Equity is owed to the owners of a business by the business.
Equity-- capital plus retained earnings owed to the owners.
The statement of retained earnings
focuses on how the retained earnings component of equity
is determined.
Let's take a look at the structure of this statement.
As always, the statement starts with the heading, which
must include the business name, the title
of the financial statement, and similar to the income
statement, the time period covered.
The body of the statement always starts
with the beginning or opening balance of retained earnings.
This balance is always the closing or ending balance
from the prior period statement of retained earnings.
Think about opening a retained earnings the way
you would about the balance in your bank account.
The balance in your account at the end of one
day, say December 31, is the opening balance
your bank account the very next morning on January 1st.
Opening retained earnings is exactly the same.
The ending balance on December 31st in one period
would be the opening balance on January 1st in the next period.
Note that if a business has just started
the opening balance would be 0 since they have never been
in business before.
In the example we're using in this video,
the profit from all prior periods
less the dividends paid out in all prior periods
is equal to $92,400.
Next, the profit from the income statement
is added to the beginning balance from retained earnings.
If the business has a net loss, it
would reduce the prior year's retained earnings balance.
In this case, we have a profit, so we
would add $17,100 to the opening balance of $92,400.
Note that the amount, $17,100, is from the income
statement in our last video.
This shows the connection between the two statements.
Profit from the income statement is used
to calculate retained earnings.
Next, we have to deduct the dividends paid to the owners.
Dividends are a distribution of the wealth to the owners
by the business.
Remember that the wealth of a business
made up of owner's capital and retained
earnings is owed to the owners.
By paying out dividends, the business
is reducing retained earnings and by extension equity.
What is owed to the owners is therefore decreased.
The total at the bottom of the statement
is the ending retained earnings, the amount that
will be transferred to the equity section of the balance
sheet.
Pretty simple statement, but important to understand.
Let's just summarize what we learned.
The opening balance for retained earnings
comes from the prior year's statement of retained earnings.
Profit comes from the bottom of the income statement.
Dividends are what has been paid to the owners of the business,
a distribution of wealth.
The ending balance is the amount that
will be carried to the equity section of the balance sheet.
This amount will also become the opening balance
at the top of the statement of retained earnings next period.
Pause the video to answer this check your understanding
question.
What would be the business' ending retained earnings
given the amounts provided?
A is incorrect.
You remembered the opening balance, revenues,
and expenses, but you forgot to deduct the dividends.
C is incorrect because it includes the contribution
by owners, which is part of equity
but definitely not part of retained earnings.
D is incorrect because you deducted expenses,
but you added in the dividends when you
should have subtracted them.
B is the correct answer because it
includes only the opening retained earnings
plus the revenues less the expenses
and less the dividends paid.
How do stakeholders use the statement of retained earnings?
Owners use information about retained earnings
to help predict future dividend payments.
They also use it to see if the business is
retaining enough of their profit for future expansion.
Lenders, such as banks, use it to determine
if dividend payouts are appropriate
and leave enough cash for debt repayment.
Other creditors use retained earnings information
to see if the earnings are invested back
into the business' future.
As you already know, the statement of retained earnings
is connected to the balance sheet,
providing the ending balance and retained earnings,
which is then used in the equity section of the balance
sheet, which is the topic of our next video.