Retained earnings, a balance-sheet account, is a form of income that a company has earned over time. But unlike accounts in the income statement, which are temporary accounts subject to closure at the end of an accounting period, the account of retained earnings is a permanent account. While companies prepare their new income statement each year without using any earlier information, they must use the retained earnings from the previous year to calculate the retained earnings in the new balance sheet.
Retained earnings come from income accumulation over all previous years. Companies may also distribute part of the accumulated income from time to time, retaining the rest within the business. Any distributions reduce the total amount of retained earnings. Therefore, "retained earnings" from the previous year becomes the beginning balance of retained earnings for the next year. Income and distribution during the year is added to and subtracted from the beginning balance to arrive at the end balance of current retained earnings.
Revenues and expenses from the income statement are the main sources of changes in retained earnings. Revenues and expenses increase and decrease retained earnings respectively through income. As temporary accounts, revenues and expenses are closed into the income-summary account at the end of a year. Subsequently, income summary is closed into retained earnings, increasing or decreasing existing retained earnings depending on whether the income summary represents a profit or loss.
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Companies may make dividend distributions during the year based on their level of existing retained earnings. Dividend distribution, or dividend expense, directly reduces a company’s cash account at the time of a distribution and later its retained earnings. Because dividend expense is not tax deductible with dividend distribution using after-tax income, dividend expense is not an element in the income statement. As a result, dividend expense is separately closed into the account of retained earnings as a subtraction from the beginning balance of the retained earnings.
Retained earnings is an equity account in the balance sheet. All balance-sheet accounts are permanent accounts, which accumulate in value over time. While the income statement records related accounts’ activities during a period of time, the balance sheet shows related accounts’ value at a particular point in time. Retained earnings as a balance-sheet account represent the total amount up to a given point in time. Thus, retained earnings at the end of this year is the sum of retained earnings at the end of previous year and income earned during the current year, minus dividends distributed.