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Retained earnings could be the most misunderstood accounting entry of all time! It sounds wonderful, a pool of undistributed profits just sitting there, ripe for dividends. In fact, there is even a tax on “excess retained earnings” (for “C” corporations), so they have to be valuable, right?
Why? Accounting 101: The balance sheet has two columns. On the left are assets – what is owned – listed in decreasing order of nearness to cash or liquidity. On the right are liabilities and equity, what is owed, listed the same way. Cash is at the top of the left column, nice and liquid, and retained earnings are near the bottom of the right column, meaning that they are far from cash and liquidity. In fact, it is the precise opposite! Retained earnings are owned by shareholders. They are NOT cash!
Accounting 201: Retained earnings help tie the income statement to the balance sheet. Whenever the books are closed, earnings for the period (minus dividends paid or declared) are added to retained earnings. As such, retained earnings are the cumulative total of undistributed profits.
Accounting 301: Graduates of 201 will see that retained earnings have nothing to do with cash, which is an asset. A profitable business might have to spend all of its “earnings” (cash) on equipment, inventory, and payables. It might have to borrow to fund all of these needs, even if it is profitable. Earnings and cash flow are two very different animals.
Accounting 401: Retained earnings are one of several accounts that comprise shareholders’ equity, the owners’ total claims on the assets of the business AFTER all liabilities have been paid off. When a business appraiser adjusts assets and liabilities to market value, the net change has to be offset with a corresponding, equal entry to shareholders equity. In effect, retained earnings bear the brunt of this adjustment.
The bottom line (which is where retained earnings appear on the balance sheet!) is that retained earnings are an accounting item that bears no relationship to the actual value of a business.
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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.
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