Retained earnings represent the cumulative amount of net income that a company has retained, rather than distributed as dividends to shareholders. The retained earnings account is a key equity account on the balance sheet and is impacted by several transactions, such as net income, dividends, and prior period adjustments. Below are examples of journal entries involving retained earnings.
1. Closing Entry to Retained Earnings
At the end of an accounting period, net income (or net loss) is transferred to retained earnings. This is done through closing entries, which close out the revenue and expense accounts to retained earnings.
Example Scenario:
A company has a net income of $20,000 for the year ending December 31, 2024.
Journal Entry to Close Revenue Accounts:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2024 | Revenue A/c Debit | 20,000 | |
| 12-31-2024 | To Retained Earnings A/c | 20,000 |
Explanation:
- Revenue will debited to close out the revenue account for the period.
- Retained Earnings will credited to increase retained earnings by the amount of net income.
Journal Entry to Close Expense Accounts:
Assume the company had total expenses of $15,000 for the same period.
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2024 | Retained Earnings A/c Debit | 15,000 | |
| 12-31-2024 | To Expenses A/c | 15,000 |
Explanation:
- Retained Earnings will debited to decrease retained earnings by the amount of expenses.
- Expenses will credited to close out the expense accounts.
2. Dividends Declared from Retained Earnings
When a company declares dividends, it reduces retained earnings and increases dividends payable.
Example Scenario:
On March 1, 2024, a company declares $5,000 in cash dividends.
Journal Entry for Declaration of Dividends:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 03-01-2024 | Retained Earnings A/c Debit | 5,000 | |
| 03-01-2024 | To Dividends Payable A/c | 5,000 |
Explanation:
- Retained Earnings will debited to decrease the retained earnings by the amount of dividends declared.
- Dividends Payable will credited to record the liability for the dividends.
3. Prior Period Adjustment
Occasionally, companies discover errors in financial statements from previous years. These errors are corrected by adjusting retained earnings.
Example Scenario:
In 2024, a company discovers that depreciation expense was understated by $2,000 in 2023.
Journal Entry to Correct the Error:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 01-01-2024 | Retained Earnings A/c Debit | 2,000 | |
| 01-01-2024 | To Accumulated Depreciation A/c | 2,000 |
Explanation:
- Retained Earnings will debited to reduce the retained earnings by the amount of the error.
- Accumulated Depreciation will credited to adjust the asset’s accumulated depreciation.
4. Stock Dividend Impacting Retained Earnings
When a company declares a stock dividend, retained earnings are reduced, and common stock and additional paid-in capital accounts are increased.
Example Scenario:
A company declares a 10% stock dividend on its 10,000 shares outstanding, with a par value of $1 per share. The market value of the stock is $10 per share.
Journal Entry for Stock Dividend Declaration:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 04-01-2024 | Retained Earnings A/c Debit | 10,000 | |
| 04-01-2024 | To Common Stock Dividend A/c | 1,000 | |
| 04-01-2024 | To Additional Paid-In Capital A/c | 9,000 |
Explanation:
- Retained Earnings will debited to decrease the earnings available for dividends.
- Common Stock Dividend and Additional Paid-In Capital are credited to reflect the new shares issued at par value and the excess over par value, respectively.
5. Loss Impact on Retained Earnings
If a company incurs a net loss, it reduces retained earnings when closing the accounts.
Example Scenario:
A company incurs a net loss of $8,000 for the year ending December 31, 2024.
Journal Entry to Close Accounts with Loss:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2024 | Retained Earnings A/c Debit | 8,000 | |
| 12-31-2024 | To Income Summary A/c | 8,000 |
Explanation:
- Retained Earnings will debited to reflect the reduction in equity due to the net loss.
- Income Summary will credited to close the loss for the period.
These examples demonstrate the various ways retained earnings are impacted by business activities, including the distribution of dividends, correction of errors, and end-of-period closing entries. Retained earnings play a crucial role in reflecting the cumulative earnings and losses of a company over time.