How to Calculate Retained Earnings in 6 Steps

Learning how to calculate retained earnings can benefit your growing business. The calculation tells you how much profit your business has accumulated over time, minus what you've distributed to owners. It's an indicator of your company's financial health. Strong retained earnings can help you attract investors or secure loans. They can also serve as a financial cushion for unexpected expenses. You can use your retained earnings statements to plan for the future and make informed business decisions. This guide explains how to calculate retained earnings with easy-to-follow examples.

What are Retained Earnings?

Retained earnings are the cumulative net income your company has kept in the business instead of distributing it to owners as dividends. This figure sits in the equity section of your balance sheet and gets updated each accounting period. Here's the formula for calculating retained earnings:

Ending Retained Earnings = Beginning Retained Earnings + Net Income (or - Net Loss) - Dividends +/- Prior Period Adjustments

Getting each component right requires attention to detail. Let's walk through the process step by step.

Step 1: Determine the Beginning Balance

Your starting point for any retained earnings calculation is the ending balance from your previous period. If you're calculating retained earnings for Q2, you'll use Q1's ending retained earnings as your beginning balance. If this is your company's first reporting period, your beginning balance equals zero.

• Find the Amount: Pull this number from your prior period's balance sheet or statement of retained earnings.

• Double Check: The beginning balance should match what's in your general ledger. Even minor discrepancies can compound over time.

Step 2: Calculate Net Income or Net Loss

Net income represents your company's total revenue minus all your expenses for the period. This number flows from your profit and loss statement (also known as the income statement) to your retained earnings calculation.

• Follow the Process: Complete all revenue recognition and expense entries for the period, then run your income statement. The bottom line shows your net income (positive) or net loss (negative).

• Be Thorough: Ensure you record all accruals and adjustments before finalizing net income. Missing expenses or unrecorded revenue will throw off your retained earnings.

Step 3: Identify Dividends Declared

Dividends represent the profits distributed to owners rather than money kept in the business. They reduce your retained earnings. Track any dividends declared during the period, whether you paid them immediately or scheduled them for future payment.

• Document Everything: Keep all board resolutions and dividend declarations. The same applies to owner distribution authorizations.

• Consider Tax Regulations: For corporations, dividends are subject to specific tax reporting requirements. The IRS requires Form 1099-DIV for dividend reporting. The proper classification affects both the company's and shareholders' taxes.

Step 4: Account for Prior Period Adjustments

Sometimes you discover errors from previous periods or need to implement accounting changes that affect past results. These adjustments may affect retained earnings rather than your current period income. Document the nature and amount of any adjustment and present it net of tax effects, meaning after subtracting the tax impact.

Examples of Adjustments

• Material Errors: Previously omitted expenses or overstated revenue

• Changes to Accounting Principle: Switching depreciation methods with retrospective application

• Tax Adjustments: Corrections to prior year tax provisions

Step 5: Apply the Formula for Calculating Retained Earnings

Once you've gathered all the information, you're ready to calculate retained earnings with the formula provided above. Plug in all the components, and check your numbers. Let's work through an example:

Calculation Components:

• Beginning Retained Earnings: $75,000

• Net Income for the Period: $22,000

• Dividends Declared: $8,000

• Prior Period Adjustment: -$1,500 (understated depreciation)

Calculation:

1. Adjust the beginning balance. $75,000 - $1,500 = $73,500

2. Add the net income. $73,500 + $22,000 = $95,500

3. Subtract the dividends. $95,500 - $8,000 = $87,500

According to the numbers in this example, your ending retained earnings for the period equal $87,500. Transfer this ending balance to the equity section of your balance sheet. It will become the beginning balance for your next retained earnings calculation.

Step 6: Prepare the Retained Earnings Statement

Creating and analyzing financial statements, such as the income statement and balance sheet, helps your business remain compliant and financially healthy. A formal retained earnings statement shows how your company's retained earnings changed during the prior period. This statement usually follows your income statement and precedes the balance sheet. Here's an example of a basic statement format:

Steering Clear of Common Mistakes

Here are some examples of mistakes to avoid:

• Confusing Retained Earnings With Cash: Your company's retained earnings might be $100,000, but that doesn't mean you have $100,000 in the bank. Profits often get reinvested in inventory or equipment.

• Missing Prior Period Adjustments: Failing to record error corrections or accounting changes can distort your financial picture and trigger audits.

• Misclassifying Owner Distributions: Different business entities have different rules. The tax requirements for corporate dividends differ from those for LLC member distributions.

• Forgetting the Tax Impact: When recording prior period adjustments, remember to calculate and disclose the related tax effects.

Small Business Implications

Your retained earnings calculations can directly impact your business decisions. If you're considering salary raises or high-quality benefits packages for your employees, you first need to distinguish between cash flow and retained earnings. Strong retained earnings don't guarantee sufficient cash for increased payroll expenses.

Before making any significant changes, analyze the trends in your company's retained earnings. Assess whether benefit improvements are financially sustainable as part of your growth planning. You should also balance owner distributions against your company's reinvestment needs to ensure you're making strategic choices that support long-term success.

Simplifying Financial Management with Justworks

Accurate financial reporting is the cornerstone of financial management, including the calculation of retained earnings. Managing these financial complexities becomes easier with the proper support.

Partnering with a Professional Employer Organization, such as Justworks PEO, helps small businesses streamline payroll processing and HR tasks. Our payroll services integrate seamlessly with your accounting systems, freeing up time for you to focus on strategic decisions rather than manual calculations. Get started with Justworks today.