Which of the following accounts decrease retained earnings when closing entries are prepared?
What are Closing Entries?Closing entries are those journal entries made in a manual accounting system at the end of an accounting period to shift the balances in temporary accounts to permanent accounts. Temporary accounts are used to compile transactions that impact the profit or loss of a business during a year, while permanent accounts maintain an ongoing balance over time. Show
Examples of temporary accounts are the revenue, expense, and dividends paid accounts. Any account listed in the balance sheet (except for dividends paid) is a permanent account. A temporary account accumulates balances for a single accounting period, whereas a permanent account stores balances over multiple periods. For example, a closing entry is to transfer all revenue and expense account totals at the end of an accounting period to an income summary account, which effectively results in the net income or loss for the period being the account balance in the income summary account; then, you shift the balance in the income summary account to the retained earnings account. As a result, the temporary account balances are reset to zero, so that they can be used again to store period-specific amounts in the following accounting period, while the net income or loss for the period is accumulated in the retained earnings account. It is also possible to bypass the income summary account and simply shift the balances in all temporary accounts directly into the retained earnings account at the end of the accounting period. As an another example, you should shift any balance in the dividends paid account to the retained earnings account, which reduces the balance in the retained earnings account. This resets the balance in the dividends paid account to zero. Examples of Closing EntriesThe following journal entries show how closing entries are used: 1. Shift all $10,000 of revenues generated during the month to the income summary account: Once you have completed and posted all closing entries, the final step is to print a post-closing trial balance, and review it to ensure that all entries were made correctly. The Automation of Closing EntriesAll modern accounting software automatically generates closing entries, so these entries are no longer required of the accountant; it is usually not even apparent that these entries are being made. The accumulation of net income after dividends What are Retained Earnings?Retained Earnings (RE) are the accumulated portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations. Retained Earnings are reported on the balance sheet under the shareholder’s equity section at the end of each accounting period. To calculate RE, the beginning RE balance is added to the net income or reduced by a net loss and then dividend payouts are subtracted. A summary report called a statement of retained earnings is also maintained, outlining the changes in RE for a specific period. The Purpose of Retained EarningsRetained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements. The purpose of retaining these earnings can be varied and includes buying new equipment and machines, spending on research and development, or other activities that could potentially generate growth for the company. This reinvestment into the company aims to achieve even more earnings in the future. If a company does not believe it can earn a sufficient return on investment from those retained earnings (i.e., earn more than their cost of capital), then they will often distribute those earnings to shareholders as dividends or conduct a share buybacks. What is the Retained Earnings Formula?The RE formula is as follows: RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends Where RE = Retained Earnings Beginning of Period Retained EarningsAt the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year’s income), minus dividends paid to shareholders. In the next accounting cycle, the RE ending balance from the previous accounting period will now become the retained earnings beginning balance. The RE balance may not always be a positive number, as it may reflect that the current period’s net loss is greater than that of the RE beginning balance. Alternatively, a large distribution of dividends that exceed the retained earnings balance can cause it to go negative. How Net Income Impacts Retained EarningsAny changes or movement with net income will directly impact the RE balance. Factors such as an increase or decrease in net income and incurrence of net loss will pave the way to either business profitability or deficit. The Retained Earnings account can be negative due to large, cumulative net losses. Naturally, the same items that affect net income affect RE. Examples of these items include sales revenue, cost of goods sold, depreciation, and other operating expenses. Non-cash items such as write-downs or impairments and stock-based compensation also affect the account. Image: CFI’s Financial Modeling Course. How Dividends Impact Retained EarningsDistribution of dividends to shareholders can be in the form of cash or stock. Both forms can reduce the value of RE for the business. Cash dividends represent a cash outflow and are recorded as reductions in the cash account. These reduce the size of a company’s balance sheet and asset value as the company no longer owns part of its liquid assets. Stock dividends, however, do not require a cash outflow. Instead, they reallocate a portion of the RE to common stock and additional paid-in capital accounts. This allocation does not impact the overall size of the company’s balance sheet, but it does decrease the value of stocks per share. Learn more: how to forecast a company’s balance sheet. End of Period Retained EarningsAt the end of the period, you can calculate your final Retained Earnings balance for the balance sheet by taking the beginning period, adding any net income or net loss, and subtracting any dividends. Example CalculationIn this example, the amount of dividends paid by XYZ is unknown to us, so using the information from the Balance Sheet and the Income Statement, we can derive it remembering the formula Beginning RE – Ending RE + Net income (-loss) = Dividends We already know: Beginning RE: $77,232 Ending RE: $78,732 Net Income: $5,297 So, $77,232 – $78,732 + $5,297= $3,797 Dividends paid = $3,797 We can confirm this is correct by applying the formula of Beginning RE + Net income (loss) – dividends = Ending RE We have then $77,232 + $5,297 – $3,797 = $78,732, which is in fact our figure for Ending Retained Earnings Video Explanation of Retained EarningsBelow is a short video explanation to help you understand the importance of retained earnings from an accounting perspective. This video is taken from CFI’s Financial Analysis Fundamentals Course. Applications in Financial ModelingIn financial modeling, it’s necessary to have a separate schedule for modeling retained earnings. The schedule uses a corkscrew type calculation, where the current period opening balance is equal to the prior period closing balance. In between the opening and closing balances, the current period net income/loss is added and any dividends are deducted. Finally, the closing balance of the schedule links to the balance sheet. This helps complete the process of linking the 3 financial statements in Excel. To learn more, check out our video-based financial modeling courses. Additional ResourcesThis has been CFI’s guide to Retained Earnings. To help you advance your career, check out the additional CFI resources below:
What decreases the balance of retained earnings?Retained earnings are affected by any increases or decreases in net income and dividends paid to shareholders. As a result, any items that drive net income higher or push it lower will ultimately affect retained earnings.
Which of the following accounts would increase the retained earnings account when closed into it?Retained Earnings (Think of the account to which we transfer the balance of all revenue, expense, and dividend accounts.) The closing entry for which of the following accounts will result in an increase in retained earnings? Revenues, Think of a closing entry in which retained earnings is credited.
Which of the following accounts should be closed to retained earnings?Revenue, expense, and dividend accounts affect retained earnings and are closed so they can accumulate new balances in the next period, which is an application of the time period assumption.
How do closing entries affect retained earnings?A closing entry is a journal entry made at the end of the accounting period. It involves shifting data from temporary accounts on the income statement to permanent accounts on the balance sheet. All income statement balances are eventually transferred to retained earnings.
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