Definition: A retained earnings deficit, also called an accumulated deficit, happens when cumulative losses are greater than cumulative profits causing the account to have a negative or debit balance. In other words, an RE deficit is a negative retained earnings account. This means the corporation has incurred more losses in its existence than profits. So basically, it’s not a good sign.
What Does Retained Earnings Deficit Mean?
Why don’t they call it a negative retained earnings account? Well, it doesn’t really make sense. How can you have negative earnings? You can’t really make negative profits, so we say there is just a deficiency in the retained earnings account.
A retained earnings deficit can also occur if the corporation issues more dividends than its current retained earnings balance. Most states have laws that don’t allow corporations to issue dividends if they don’t have the RE to cover them. This protects creditors from the shareholders liquidating the company through dividends. Some states do, however, allow this.
A dividend issued from a deficit account is called a liquidating dividend or liquidating cash dividend. Since there are no cumulated earnings left in the company, the shareholders are just taking their original investment back. In a sense, they are reducing the size of the corporation through dividends while maintaining the number of outstanding shares.
Let’s take a look at an example.
Guitars, Inc. has 1,000 outstanding shares and a beginning retained earnings balance of $20,000. In year one, it earns $10,000 of net income and issues a $15 dividend per share.
The net income would increase the RE account by $10,000 and the dividend would reduce it by $15,000. At the end of year one, Guitars, Inc. would have $15,000 in its retained earnings account.
Year 2 was a bad year. Sales were down and Guitars, Inc. lost $40,000. This would reduce the $15,000 positive RE balance to a negative $25,000. The -$25,000 balance in retained earnings is considered a deficit.