Understanding Retained Earnings in Accounting

Retained earnings is a critical component of a company’s financial statements, representing the company’s accumulated profits or losses over time. It reflects the amount of earnings that have been retained within the company rather than distributed to shareholders as dividends. When it comes to accounting for retained earnings, it is important to understand the relationship between debits and credits. In this article, we will examine what happens when you credit retained earnings and what gets debited in the process.

The Nature of Retained Earnings

Retained earnings are classified as equity on a company’s balance sheet. They are derived from the net income generated by the company over its operating history, less any dividends paid to shareholders. Retained earnings essentially represent the portion of net income that the company has chosen to reinvest in the business rather than distribute to its owners. This reinvestment may take the form of purchasing new assets, funding research and development initiatives, paying down debt, or simply accumulating cash reserves.
When you credit retained earnings, you increase the balance of this account, which means that the company has earned additional profits or made adjustments to the existing retained earnings balance. But what is debited? Let’s explore the different scenarios.

1. Net income or profit increase

A common scenario in which you credit retained earnings is when the company earns net income or increases its profits. Net income represents the excess of revenues over expenses during a given period. When net income is earned, it is necessary to credit retained earnings to reflect the increase in profitability. In this case, the corresponding debit entry is made to the income statement account, such as revenue or expense accounts, depending on the nature of the transaction.

For example, if a company earns $100,000 in net income for the year, it would credit retained earnings by $100,000. The corresponding debit entry would be made to various income statement accounts, such as sales, cost of goods sold, operating expenses, and so on.

2. Dividends declared

Another scenario in which you credit retained earnings is when a company declares and pays dividends to its shareholders. Dividends are the distribution of the company’s earnings to its owners. Since retained earnings represent the portion of earnings not distributed as dividends, crediting retained earnings reduces the amount available for distribution.

When dividends are declared, the company debits the retained earnings account to reduce its balance and credits the dividends payable account to reflect the obligation to pay the dividends. When the dividends are paid, the dividends payable account is debited and the cash account is credited.

3. Prior period adjustments

Sometimes errors or adjustments relating to prior periods are identified during the current accounting period. These adjustments may include corrections of accounting errors, changes in accounting policies, or the result of new information becoming available. When prior period adjustments are made, they affect the opening balance of retained earnings for the current period.
In such cases, the adjustment amount is debited or credited directly to retained earnings to correct the error or reflect the new information. For example, if it is determined that revenue was overstated in the prior year, the company would debit retained earnings to reduce the balance by the corrected amount.

4. Reversal of prior period dividends

In certain situations, an enterprise may reverse a previously declared dividend. This may occur if the company determines that it does not have sufficient retained earnings to cover the dividend payment, or if there are legal or financial restrictions that prevent the distribution. When a dividend is reversed, the company debits retained earnings to increase the balance and credits the dividends payable account to reduce the liability.

This dividend reversal allows the company to retain the funds originally intended for distribution and preserves the integrity of the retained earnings account.

Closing

Understanding the relationship between debits and credits when crediting retained earnings is essential for accurate financial reporting. Retained earnings represent the accumulation of profits over time and are affected by factors such as net income, dividends, prior period adjustments, and dividend reversals. By understanding these concepts, companies can effectively track and manage their retained earnings, providing valuable insight into the financial health and stability of the company.

FAQs

What do you debit when you credit retained earnings?

When you credit retained earnings, you typically debit another account, such as an expense or a dividend account.

Why would you credit retained earnings?

Retained earnings are credited to reflect an increase in the accumulated profits or earnings of a company. This typically occurs when the company generates net income or when it retains a portion of its earnings instead of distributing them as dividends.

What is the purpose of debiting an expense account when crediting retained earnings?

Debiting an expense account when crediting retained earnings helps to offset the increase in earnings. By debiting an expense account, the company recognizes a reduction in its profit, which in turn reduces the amount that is added to the retained earnings account.

Why would you debit a dividend account when crediting retained earnings?

Debiting a dividend account when crediting retained earnings is done when a company distributes dividends to its shareholders. By debiting the dividend account, the company recognizes the reduction in its retained earnings that occurs when dividends are paid out.

Are there any other accounts that can be debited when crediting retained earnings?

Yes, besides expense and dividend accounts, other accounts that can be debited when crediting retained earnings include contra-asset accounts, such as accumulated depreciation, or specific reserve accounts that the company may have established.