Retained Earnings: Debit or Credit? | Simple accounting (2023)

Accounting in one form or another has been around for a very long time, appearing around the time people started trading. Accounting is an essential part of entrepreneurial activity. It is important that accounting is kept correctly and on time. This requires knowing how to make postings to each account including the retained earnings account. In this article you will not only find an answer to the question "What is the normal balance for retained earnings: debit or credit?", but also get an overview of retained earnings. To better understand debits and credits, learn what inventory preservation is and where it belongs in the invoice balance.

Understand Equity and Retained Earnings

Equity is the difference between total assets and total liabilities. The equity indicator consists of the following elements:

• additional paid-in capital (arising from asset revaluation, premiums, etc.);
• authorized capital (paid-up capital);
• reserve capital (reserve fund formed from net profit, etc.);
• retained earnings (formed due to the efficient operation of the company, remain available).

The owners can direct the net income towards:

• payment of dividends;
• increase in reserve capital and retained earnings;
• reimbursement of losses;
• other purposes based on the decision of the owners.

The income is subject to distribution based on the decision of the general meeting of shareholders of a joint-stock company, a meeting of members of a limited liability company. The Company's earnings distribution policy is characterized by a dividend payout ratio ratio, which indicates the portion of net income that is earmarked for dividend payments to shareholders. The higher this indicator, the lower the growth rate of equity, the lower the ability to direct funds to the development of business activities, and the less retained earnings a company has. Retained earnings are an essential part of equity. Retained earnings are the sum of all accumulated earnings received by a company that have not been distributed or otherwise spent. The cumulative result of the organization for the reporting year is the final financial result of its activities minus the dividends paid. In the balance sheet, retained earnings are shown as the total amount for the reporting period and previous years. It should be noted that the income statement and cash flow statement do not include retained earnings. The dynamics of this indicator allows us to assess the growth rate of internal sources of equity and the company's ability to develop. When the company is closed (liquidated), the amount of accumulated profit is distributed among the owners (shareholders) of the company, so they are interested in a positive result of this indicator.

Retained Earnings Account

The retained earnings (uncovered loss) account is included in equity on the balance sheet. It reflects information on the amount of net profit available to the company after the distribution of dividends according to a resolution of the general meeting. As mentioned earlier, a retained earnings account is an accumulated amount and can be used as financial support for business development and other similar new real estate/asset acquisition activities. Next, let's look at the main components that affect retained earnings.

net income or loss

Profit is the difference between the revenue from the sale of goods/services and some expense, depending on the type of benefit, such as B. operating profit, is sought. Net income or net profit, on the other hand, is total sales minus all expenses. It is an important economic indicator that serves to reflect the effectiveness of entrepreneurial activity. Net income is the money remaining in the business after various deductions, expenses, taxes, and other payments. Net profit is a source of financing production processes. It also forms reserve funds, and it is at its expense that working capital increases. The main factors affecting the size of the net profit are:

• Amount of taxes and other charges;
• business revenue from the sale of goods/services;
• goods cost.

Net income is the amount of money that can be used to pay dividends and accumulate retained earnings. Net income is the source of retained earnings, which can also be referred to as reserve income.

dividends

Dividends are a part of the profit received by the company, which is distributed between the owners of stocks or securities. Most of the time, if the company has suffered a loss, shareholders shouldn't expect to pay a dividend. But there are exceptions: sometimes a company's top management may decide to pay dividends from retained earnings from previous years or even borrow to please its shareholders. Holders of common stock in the company receive the income remaining after paying expenses and taxes, and dividends on preferred stock. The company has a choice: invest further or distribute. The decision should be based on opportunity cost: if the company can achieve a return no lower than the opportunity cost of shareholders in the market with equal risk, it must reinvest and vice versa.

Prior period adjustments

Accountants and companies try to do their best to avoid mistakes, yet they happen from time to time. According to generally accepted accounting principles, retained earnings should be updated at the end of each year if there have been any changes to previous years' net income or dividends. Correction postings can be made to correct mistakes made in recent years. These can be simple human calculation errors or attempts at fraud. Over- or underestimating income for the prior year also affects retained earnings, so adjustment entries should account for any discrepancies.

debit and credit postings

A balance sheet means that assets equal liabilities, plus equity and debits should equal credits. The part of the balance sheet assets consists of two sections:

• Non-current Assets
• current assets

Short-term assets are considered more liquid than long-term ones because they are more accessible and can be converted into cash more quickly. If the assets show what the company owns, then the liabilities and equity tell those assets to the sources. These two items are on the opposite side of assets in the accounting equation and include the following:

• capital and reserves
• Long-term liabilities
• Current Liabilities

With double-entry bookkeeping, entries reflect where money is coming from and where it is going, with two accounts rising or falling accordingly. Some accounts grow when debited. These would be asset and expense accounts. Liability, income and equity accounts, on the other hand, increase as they are credited. When you credit an account under Expenses or Credits, they decrease. To decrease liabilities, income, and equity accounts, you would make an entry on the debit side. The page of the accounting journal that results in an increase in a particular account is called the normal account balance. Is an Appropriate Balance for Retained Earnings Debit or Credit? As you have already learned from this article, retained earnings are part of shareholders' equity, suggesting that their normal balance is a balance of retained earnings account to increase it. What if the company overstated its net income in the previous period and needs to make an adjustment entry? In order to reduce the retained earnings account, it is debited. A charge entry would also be essential if the company took something out of retained earnings to pay for something.