Definition: Restricted retained earnings is the amount of net assets that are legally or contractually cannot be issued as dividends and must stay within the company. In other words, restricted retained earnings is the amount of equity that must stay in the company.
What Does Restricted Retained Earnings Mean?
There are several reasons why the retained earnings, or stockholders’ profits, must be held by the company and not distributed to the shareholders in the form of dividends.
In many states and countries, there are laws to protect creditors who loan money to corporations. Since during a bankruptcy the creditor has the right to be paid before any shareholder receives a return on his or her investment, some laws prevent companies from distributing all of the profits to shareholders immediately. This safeguards the creditors and ensures that the company has at least a percentage of its profits for debt repayment.
Another common reason for restricted RE is contractual obligations. Many companies enter into loan agreements that require that a minimum of RE is retained in the business. This, again, is to protect the creditors, so the company can’t pay dividends beyond a specific limit or percentage of retained earnings. Otherwise, shareholders would be able to take out a large loan and distribute out all of the RE and current year profits every year.
Let’s take a look at Dallas, Inc. It decided to expand its operations in the oil industry but needed a loan to do so. The only way a bank would loan Dallas the money is if it made a 10 percent restricted RE agreement. Dallas agreed and had a profitable next two years. By the end of the third year, Dallas had $10 million in RE and wanted to pay a large dividend to its shareholder. According to its bank contract, Dallas can only issue a dividend of $1 million. Otherwise it would be breaking its loan covenants.