Skip to main content
Pearson+ LogoPearson+ Logo
Start typing, then use the up and down arrows to select an option from the list.

Retained Earnings and the BASE Formula

Brian Krogol
Was this helpful?
Alright now let's discuss another equity account, retained earnings in a little more detail. So we've discussed retained earnings all throughout this course, right? And remember that its net income from previous periods. So we've been making income over the years and we haven't paid it all out as dividends. So its net income that we've that we've earned in previous periods but have not distributed as dividends. Okay. So whenever we pay dividends that comes out of the retained earnings and now it's very important to note, a lot of students get confused with this is that the retained earnings is not equal to cash, right? Just because we earned income, right? Just because we earned some income, it doesn't mean that it's all in cash. Remember we can have revenue, we could have sold something and not received cash yet. We could have had accounts receivable for that sale and things like that. They're not gonna be equal and they're not the same thing. And another thing that happens is even if we did receive it in cash, well, it doesn't mean that we have these retained earnings and it's all just sitting there as cash. No, we could have taken that cash that we received and invested it in other assets. We could have bought machinery, fixed assets with this, we could have bought anything right, inventory. Um So it's not necessarily that we've earned this income and we just have it readily available as cash. It could just be invested in the business. So a company can have a positive retained earnings, they could have a retained earnings account with a balance but not enough cash to pay a dividend, right? Because they're not the same thing. They could have that cash invested in other things and just not have enough cash on hand for a dividend payment. Okay, so that's a main thing you really want to focus on when you think about the retained earnings account, is that it doesn't necessarily mean that there's just that much cash on hand. Cool. All right. So we talked about this before but I wanted to bring it up again here with the base formula. The base formula. We've used it throughout this course and we've used it uh in the tea account format. And it's the best way to think about how to view the increases and decreases in an account. So remember the base formula it stands for the beginning balance plus the additions minus the subtractions equals well we have two subtractions in this case, so we might have more than one subtraction, more than one addition will equal the ending balance. Okay, so this is always how it's gonna be beginning balance plus any additions to an account minus any subtractions to an account equals the ending balance. And remember this works for any account we're gonna do it here for retained earnings. But you can have a based formula for inventory based formula for accounts receivable accounts payable, right? Common stock, any account, there's things that increase the account and things that decrease the account. Cool. So let's go ahead and see how the base formula works here with retained earnings. We're gonna have the beginning balance in the account which is the net income from previous periods. Just like we talked about, there's gonna be some amount in the account that has been accumulated and that we have not paid out as dividends. Right? Finally we're gonna have additions and that's this year's net income. Right? So that's what's gonna increase our retained earnings balance. We're gonna have subtractions from the account. And when do we take away from retained earnings? Well that's when we declare dividends right where we tell our stockholders we're gonna pay them a dividend. Well that means that we're going to reduce our retained earnings by those dividends. And another thing that can subtract from the account would be if we don't have net income but instead have a net loss. Right? And that makes sense because if we have a net loss, that's gonna decrease retained earnings or net income increases retained earnings right? It's just the opposite we have a negative net income. Well that's going to decrease the retained earnings. And finally we're gonna end up with our ending balance right? So here we have our be beginning balance plus editions minus subtractions equals our ending balance right? And sometimes you have multiple editions or multiple subtractions. You need to keep track of. Cool. So we can see the same thing as a T. Account. And I want to draw it as a T. Account over here just so you can see the same idea. So I'm gonna put retained earnings, this is the retained earnings T. Account. And we're gonna have some beginning balance as a credit right? We would have some credit balance in the account and then what increases the account, our net income. So any net income that we have would increase the account and then a subtraction would be dividends. Right? If we had any dividends, so those would be debits to the account and then I'll put in parentheses net loss just in case that comes up it would decrease the account and after everything for the period we would end up with our ending balance as a credit balance there. Right now. I want to make a special note. There's could be a very special case where you end up with a retained deficit instead of retained earnings. Well what do you think that means that means we've been losing money right If the company has been losing money year after year, well you can have a retained deficit that means you've had accumulated net losses or you've just paid too much in dividends right? Because all these things that are reducing the retained earnings account. Well if you end up with a negative balance in that retained earnings account, it's gonna have a debit balance which is reducing your equity, right? So this is a very rare case that you might see a retained deficit because that clearly is a red flag that the business is in trouble if it has a retained deficit. Now, sometimes it's common for a startup company to have retained deficits, right? Because they're investing a lot into the company and maybe they don't have sales yet, right. Maybe their sales haven't really kicked off yet and they've been investing into the company and having expenses, but no revenues. So they could have a retained deficit. But it could be a temporary thing because they're expecting once they kick off the sales that they're going to make all that money back. Okay, So that might be one of the more common cases, you might see a retained deficit, but in general, you're going to see a retained earnings account, especially in this course. Alright, so let's pause real quick and we'll do a practice problem where we're going to discuss the based formula here in the retained earnings and then you guys can try one after that. Alright, let's do that. Now