Hey friends. The Fall season is already upon us. Of course, we know that Thanksgiving and Christmas will also be upon us soon. Yes, time races by as the Scripture says. May God bless you with His wisdom in your comings and goings.

Today, we’ll ponder an account on the balance sheet, namely Retained Earnings. Now, this account isn’t on the balance sheet of businesses formed as sole proprietorships or of partnerships. In those businesses, the equivalent account is regarded as a capital account, like John Doe, Capital, for example. Retained Earnings is on the balance sheet of a corporation. Now, there are legal variations of the basic forms of business, but for the purpose of this post, we won’t delve into those weeds.

Retained Earnings is an equity account and part of Stockholders’ Equity. To define it is a bit tricky. It is true that it represents income accrued since the birth of a business less all dividends paid — thus “earnings retained in the business.” Some say it is the account from which dividends are paid. Some say that isn’t true; they say, in fact, dividends are paid from assets. Actually, a true dividend is one that reduces both assets and retained earnings. Remember, accounting is a double entry system.

The main thing to remember is that retained earnings is the account to which earnings activity is collapsed (closed) at the end of each successive accounting period. You see, the equality reflected by the balance sheet  (Assets = Liabilities + Equity) only exists after each accounting period ends. This occurs quarterly if we are considering publicly-traded corporations under the regulator, the Securities and Exchange Commission (SEC). That is, the balance sheet is not “balanced” DURING an accounting period. A host of temporary accounts proxy for retained earnings during an accounting period. These accounts are necessary to detail earnings activity; accounts like “sales,” “cost of goods sold,” “depreciation expense,” etc.

For every financial event, there is a debit side to the event and a credit side. During an accounting period, only one side of an earnings event is recorded to affect the balance sheet. The other side goes to a temporary account. This means the balance sheet is unbalanced during the accounting period. At the end of the accounting period, all the temporary accounts are tallied and presented on the income (earnings) statement. The accountant then closes all those temporary accounts into retained earnings, bringing the balance sheet back into balance and making the updated balance sheet ready to reveal.

So, when you look at those earnings (revenue and expense) accounts like “sales,” or “income tax expense,” think “retained earnings.” Retained Earnings then is that account on the balance sheet to collect the summation of a company’s operating activity as measured by accrual accounting, period by period by period. If a company pays out a dividend, it gives out an asset (most often, cash) and reduces retained earnings for the payout of some of the past earnings accrued.

This is the type of blog post one might expect from an accounting professor, even a retired one. If it seems boring, I surely understand it’s not everyone’s cup of tea. But, the better the grasp of the balance sheet, the better the understanding of any investment. My book, Choose Stocks Wisely, reflects an attempt to explain the balance sheet in a practical way relative to investing in common stocks.

See you next time.