Statement of Retained Earnings
The bridge between profit and equity. Understand where your earnings go and how equity grows over time.
Why This Matters
Here's a question that stumps most people:
"Where did the owner's profit go?"
Last year, the business earned $100,000 profit. But the owner's equity only increased by $40,000. Where's the other $60,000?
The answer: The owner took it out as dividends.
The statement of retained earnings answers this question. It's the bridge between profit and what the owner actually has.
The Simple Formula
This ending balance appears on the balance sheet. It's the bridge between the income statement (profit) and the balance sheet (equity).
The Three Components
Important Distinction: Salary vs. Dividends
Salary (Expense)
Owner is paid as an employee
- • Appears on the Income Statement
- • Reduces Net Income
- • Deductible business expense
Dividends (Distribution)
Owner takes profit out
- • Appears on Retained Earnings Statement
- • Reduces Equity directly
- • NOT a business expense
Real-World Example: ABC Coffee Shop
Let's follow ABC Coffee Shop through its first three years to see how retained earnings accumulate.
ABC COFFEE SHOP
Statement of Retained Earnings
For the Year Ended December 31, 2024
New business, no prior history
Year 1 profit
Owner took $5,000 out
ABC COFFEE SHOP
Statement of Retained Earnings
For the Year Ended December 31, 2025
From Year 1
Year 2 profit, growing!
Owner took more out
ABC COFFEE SHOP
Statement of Retained Earnings
For the Year Ended December 31, 2026
From Year 2
Year 3 profit
Owner withdrew more cash
The Three-Year Story
$91,250
Total Accumulated Profit
$30,000
Total Dividends Paid
$61,250
Remaining in Business
This is the story retained earnings tells. Every dollar of profit either stays in the business or goes to the owner.
Owner's Capital vs. Retained Earnings
Owner's Capital
- What it is: Initial investment by the owner
- Changes: Rarely (only if owner invests additional capital)
- Represents: The owner's "seed money"
"I invested $50,000 to start the business"
Retained Earnings
- What it is: Accumulated profits minus accumulated dividends
- Changes: Every year (profit and distributions)
- Represents: The owner's "stake from success"
"The business has earned $91,250 in profits over three years"
Owner's Capital = "What I put in"
Retained Earnings = "What the business earned and kept"
Total Equity = What I'm worth
Variations by Business Type
Sole Proprietor
Partnership
Corporation
Dividend Policies
How much profit should be distributed vs. reinvested? Here are three common approaches:
Conservative (Growth)
10%Reinvesting most profit for growth. Young companies building for the future.
Moderate (Balanced)
40%Sharing profits while maintaining growth. Balancing owner reward with reinvestment.
Liberal (Mature)
70%Returning most profit to owners. Established companies with limited growth needs.
How All Four Statements Connect
Income Statement
Revenue: $170,000 − Expenses: $143,750 = Net Income: $26,250
Statement of Retained Earnings
Beginning: $50,000 + Net Income: $26,250 − Dividends: $15,000 = Ending RE: $61,250
Balance Sheet (Equity Section)
Owner's Capital: $50,000 + Retained Earnings: $61,250 = Total Equity: $111,250
Statement of Cash Flows (Financing)
Financing Activities: Dividends Paid: ($15,000)
Reading the Patterns
Growing Company
Pattern:
Large profits, small dividends
Story: Building equity for growth
Mature Company
Pattern:
Stable profits, large dividends
Story: Returning profits to owner
Struggling Company
Pattern:
Losses, no dividends
Story: Equity being eroded
Key Takeaway
The statement of retained earnings is the bridge between the income statement (profit) and the balance sheet (equity). It shows how much profit was reinvested versus distributed as dividends. By tracking retained earnings over years, you can see if the business is building sustainable equity or destroying it through losses or excessive distributions. Total equity equals the owner's initial investment plus all accumulated retained earnings—the true measure of what the owner is worth.
Test Your Understanding
If a company has Beginning Retained Earnings of $50,000, Net Income of $30,000, and pays $10,000 in dividends, what is Ending Retained Earnings?
What is the difference between Owner's Capital and Retained Earnings?
A company has Net Income of $100,000 and Retained Earnings increase by only $30,000. What happened to the other $70,000?
What does a negative Retained Earnings balance on the Balance Sheet indicate?
True or False: Salary paid to the owner appears as a dividend on the Statement of Retained Earnings.
Ready to Practice?
You now understand how retained earnings connect the statements and why equity grows or shrinks. The Practice Lab is where you'll prepare complete statement packages.
Try the Practice Lab