How Do Common Stocks Affect Retained Earnings?

There is a world of difference between common stock and retained earnings and what they are. However, these two things are also related in some ways. Common stock shares represent ownership in an issuing company’s equity holdings. Companies usually issue shares of stock as a means for acquiring capital or cash for investment purposes.

In return, the owners of common stock obtain voting rights that are directly proportional to the number of shares they own. In addition, they can enjoy the company’s success through dividends or capital appreciation. Within the financial accounting process, accountants include common stock as part of a company’s equity holdings.

On the other hand, retained earnings refer to the company’s net income after it pays common stock holders their share of dividends. The profits are usually reinvested back into the company to improve business operations and enable purchase of assets. So, it is safe to say that stock dividend payments reduce the amount of retained earnings held by a company.

Use of Financial Reports

Businesses keep an ongoing record of financial reports that reflect profits, losses and equity holdings. Three of the primary reports they use include the income statement, balance sheet and statement of retained earnings.

Information on the income statement lists revenues and expenses incurred within an accounting cycle, which can run anywhere from one to 12 months. Meanwhile, balance sheet records keep track of a company’s asset and liability amounts at different points in time based on data recorded from each accounting cycle. Lastly, the statement of retained earnings keeps a running record of profits incurred within each accounting cycle.

While common stock represents a type of equity holding, dividend payments increase shareholder earnings rather than the company’s earnings.

Company Profit Distributions

Profits earned within an accounting cycle appear as the net income amount on a company’s income statement ledger. And these profit distributions occur when accountants transfer net income amounts from the income statement onto the balance sheet, or onto the statement of retained earnings.

As balance sheets track owner and shareholder equity holdings, common stock dividend payments must be deducted from owner equity to determine the amount of retained earnings made within an accounting cycle.

In effect, retained earnings are equal to the net income minus stock dividends paid. Whatever is left over after deducting dividend payments is transferred onto the statement of retained earnings ledger for that period.

Common Stock Records

The total number of common stock shares represents the amount of equity shareholders have in an issuing company. And businesses keep track of the capital raised through stock share issues when completing balance sheet ledgers.

The capital provided by stock shares enables a company to generate the profits that contribute to its retained earnings amount. As a result, accountants separate shareholder equity amounts into two categories that appear as contributed capital and retained earnings.

Company balance sheets include these two categories to determine how stockholder equity amounts are generated. This means, for example, that a balance sheet showing 30 percent contributed capital and 70 percent retained earnings indicates most of the stockholders’ equity comes from profits earned by the company.

Debits and Credits

Financial accounting practices use a debit and credit system – also known as double-entry bookkeeping – to track how common stock dividends affect a company’s retained earnings amounts.

As companies can pay out dividends in the form of stocks or cash payments, shareholders can receive additional stock shares dividends or cash as dividend payments. For stock- and cash-type dividends, the debit and credit system uses two separate accounts for each financial transaction. This means that cash or stock dividends paid appear as a debit in the retained earnings category of a balance sheet, and appear as a credit under the shareholder equity category.

In effect, a company’s net retained earnings appear on the statement of retained earnings after deducting shareholder equity amounts.

Understanding the difference between common stock and retained earnings, and how they are related will help you interpret financial statements better. And then, you can make the correct decisions when investing in various companies.