Retained earnings is the running total of every profit and loss a company has made since it started, after tax, less everything it has paid out as dividends. In the balance sheet of a UK company it appears under capital and reserves as the profit and loss account, which confuses people because the same words describe the income statement. In the nominal ledger it is a single equity account that almost nobody should post to directly.
What moves the balance
Only a handful of things should ever change it. A year’s movements for a small company might look like this:
| £ | |
|---|---|
| Balance at start of year, as previously reported | 84,300 |
| Correction of a material prior-period error | (2,400) |
| Balance at start of year, restated | 81,900 |
| Profit for the year after corporation tax | 41,750 |
| Dividends paid during the year | (30,000) |
| Balance at end of year | 93,650 |
If your ledger shows anything else here, such as a director’s expense, a write-off or a “balancing figure”, someone has used the account as a fix and it needs correcting.
The year-end transfer
During the year, income and expenses build up in the profit and loss accounts. At the year end they are closed off and the net result is moved into retained earnings, so the new year starts every profit and loss account at nil. In most current software this happens automatically when you move into a new financial year: the reports show a “current year earnings” figure during the year and fold it into retained earnings at the year-end date. Done as a journal, with profit after tax of £41,750:
| Account | Debit | Credit |
|---|---|---|
| Profit and loss summary (current year earnings) | £41,750 | |
| Retained earnings | £41,750 |
Before relying on it, check that the corporation tax charge for the year has been posted, because profit after tax is what transfers. Then lock the old year. A late invoice posted into a closed year changes the retained earnings brought forward without anyone noticing. How the closing process works in detail is covered in closing the profit and loss accounts at year end, and the follow-on check that the new year starts from the filed figures in closing profit and loss accounts at year end.
Dividends come out of this account
A dividend is a distribution of retained profit, not an expense, so it never goes through the profit and loss account. Many businesses use a separate dividends equity account during the year and close it to retained earnings at the year end, which shows the year’s dividends at a glance. Paying an interim dividend of £10,000 to shareholders:
| Account | Debit | Credit |
|---|---|---|
| Dividends (equity) | £10,000 | |
| Bank | £10,000 |
If the dividend is credited to a director’s loan account instead of paid in cash, credit that account. Timing matters: an interim dividend declared by the directors is recognised when it is paid, while a final dividend is recognised once shareholders approve it. The board minutes, vouchers and approvals are set out in the company dividend procedure.
How much can legally be paid out
Part 23 of the Companies Act 2006 controls distributions. Under section 830, a company may pay a dividend only out of profits available for distribution: accumulated realised profits not previously distributed or capitalised, less accumulated realised losses not previously written off.
In practice this means:
- Use the right accounts. The test is made by reference to the last annual accounts or, if they do not show enough, interim accounts drawn up to a recent date that allow a reasonable judgement. For a mid-year dividend, up-to-date management accounts with the corporation tax accrued are the minimum.
- Unrealised gains do not count. A revaluation reserve from revaluing a property is not distributable, which is one reason it is kept in its own account.
- Share capital and share premium are not profit, however much cash came in with them.
- A negative balance blocks dividends until enough later profit has wiped it out.
A dividend paid without enough distributable profit is unlawful. A shareholder who knew or had reasonable grounds to believe it breached the rules must repay it, and directors who approved it can be personally liable. For a director-shareholder, the amount is often treated as a debt on the director’s loan account.
Correcting a mistake from an earlier year
Errors found after the accounts have been filed fall into two groups under FRS 102.
A material prior-period error, one that would have changed the view given by the accounts, is corrected retrospectively: the comparatives are restated and the correction goes to opening retained earnings, not through this year’s profit. That is the £2,400 line in the table above. Typical examples are stock double counted at the previous year end, or a large invoice recorded in the wrong year.
Anything immaterial, and any change in an accounting estimate (a revised useful life, an updated bad debt provision), goes through the current year’s profit and loss account as normal.
Post a prior-period adjustment only with your accountant’s agreement and a note of what is being corrected and why. Journals to retained earnings are exactly the sort of entry a reviewer looks for; the approach to documenting them is in correcting journals and reclassifications.
A quick annual check
- The opening balance equals the closing balance in the last filed accounts, adjusted only for documented prior-period corrections.
- The increase equals profit after tax as reported for the year.
- Total dividends charged agree to board minutes and dividend vouchers.
- No other postings appear on the account.