Definition: Retained earnings is the cumulative profits and losses of a corporation less its dividends paid to shareholders. In other words, it’s the cumulative amount of money left over after all of the expenses and dividends are paid. Notice I said cumulative. This means the retained earnings account is a permanent equity account that doesn’t get closed out at the end of each accounting period. It stays open and acts like a running tally of the profits and losses the corporation has ever made or incurred in its history.
What Does Retained Earnings Mean?
Since the retained earnings account is an equity account, it has a credit balance. Thus, credits increase the account and debits decrease the account balance. When I was first learning accounting, it took me a little while to understand exactly what the RE account was. Think of it like this. It’s just an account where the net income or net loss for each year is stored eternally, so it’s just the total net income or loss the corporation has achieved in its existence.
With only a few exceptions, the retained earnings account only gets credited or debited when closing out an accounting period. It might be helpful to look at an example.
Josh, Inc. sells music and has a net income for year 1 of $10,000. After all the closing entries have been made, Josh would debit the income summary account for $10,000 and credit the retained earnings account for the same.
In year two, Josh had $25,000 of net income, so after his closing entries he credited retained earnings for $25,000.
Year three wasn’t a good year. Another music store moved in across the street and Josh had a net loss of $5,000 for the year. The loss reduces retained earnings with a debit.
At the end of year three, Josh, Inc. has a $30,000 balance in its RE account (10,000 + 25,000 – 5,000). See how it’s a cumulative running tally of the corporate earnings and losses? The retained earnings account is never closed and will always maintain a balance even if it has a deficit.