Posted by Unifirst Financials & Tax Advisors

Things to Know About Accumulated Earnings

Things to Know About Accumulated Earnings

What are Accumulated Earnings?

Since the inception of the company, the sum of a company’s profit, after dividend payments is called accumulated earnings. It is also known as earned surplus, retained capital, or retained earnings.

By What Means So Accumulated Earnings Work?

Let us see the example below to illustrate:

Let us assume that Company XYZ has operated for five years, and the company has narrated the following annual net income:

1st Year: $10,000

2nd Year: $5,000

3rd Year: -$5,000

4th Year: $1,000

5th Year: -$3,000

Let us assume that Company XYZ had not paid any dividends during this time, the accumulated earnings of Company XYZ are the sum of its net income since the company’s inception which is $10,000 + $5,000 - $5,000 + $1,000 - $3,000 = $8,000. 

In the succeeding years, the accumulated earnings of Company XYZ will change depending on the amount of each year’s net profit minus the dividends.

The statement report of the accumulated earnings summarizes the modifications in accumulated earnings for the economic year or fiscal period, and the overall accumulated earnings are shown in the portion of the shareholders’ equity of the balance sheet. This signifies that every single dollar of the accumulated earnings is basically another dollar added to the equity of the shareholder.

The board of directors of the company may “appropriate” certain or all of the accumulated earnings of the company when it wants to confine to shareholders the dividend distribution. Usually, appropriations are done at the discretion of the board, although the board is required to do so contractually by the bondholders. Appropriations in the accumulated earnings section appear as a special account. The appropriation is transferred back to accumulated earning when it is no longer needed. Since accumulated earnings are not cash, appropriations may be funded by the company by setting aside marketable securities or cash for the projects specified in the appropriation. 

Why is that the Accumulated Earnings is Important?

Understanding that accumulated earnings does not signify extra cash or cash left over after dividends payment is important. To be more precise, accumulated earnings shows how the company’s profit is being used; they are the sum of the profit of the company being reinvested in the business since the company’s conception. These reinvestments can either be liability reductions or asset purchases.

The company’s dividend policy is somewhat reflected in the accumulated earnings since it reflects the company’s decision to either pay out all profits to the shareholders or reinvest profits. In the end, accumulated earning analysis mostly focuses on assessing which action generated or would generate the highest profit for the shareholders.

For the most part, these analyses include the comparison between the accumulated earnings per share to profit per share over a certain period, or they compare to the change in share price the sum of accumulated earnings during that time. Both methods try to assess or compute the return generated by the management on the profits it reinvested into the business. There is another method in this vein developed by Warren Buffett that accounts for taxes.

The growing industries and capital-intensive industries have a tendency to retain more of their earnings compared to other industries since they entail more asset investment to be able to operate. Moreover, since the accumulated earnings signify the sum of profits minus dividends since inception, companies that are older may significantly report higher accumulated earnings compared to the identical younger companies. This is the reason why the comparison of accumulated earnings is challenging but mostly meaningful between companies of the same age and on the same industry, and the meaning of "high" or "low" accumulated earnings ought to be made within this context.

Example

In the company’s balance sheet, the earnings retained are accounted for under the equity of the shareholder. In a statement of earnings retained, the company reports the beginning balance of the earnings retained, which are the profits that are not distributed of the previous economic year or fiscal year, the net income, the cash dividends amount distributed to shareholders and the ending balance of earnings retained, after deducting the dividends paid.

In this illustration, the beginning balance of Company ABC is $3.3 billion and the company’s net income is $2.7 million. And so, the company’s total beginning balance is $6.0 billion. Shareholders are paid in the amount of $272.5 million as dividends of preferred and common stocks. As a result, Company ABC’s undistributed profiles for the fiscal period or economic year 2015 are $6.0 billion – $272.5 million = $5.7 billion. The accumulated earnings amount may be spent to reduce the long-term debt or can be used in launching a new product.

At any rate, nevertheless, it should be compared to the company’s shareholder equity. If the company had been able to increase shareholder's equity, keeping its earnings is a beneficial strategy.

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