One item on your financial statements that can provide you with really useful information is called “retained earnings.” So it pays to understand it.
As one of the equity accounts on a balance sheet, retained earnings accounts show changes in assets. Most commonly, business profits trigger increasing cash or accounts receivable – both of which are assets. Profit growth raises retained earnings; on the other hand, business losses have the reverse effect.
Changes in retained earnings only occur at the close of an accounting cycle, which is typically at year-end. Throughout the year, the retained earnings account doesn’t change. Instead, the balance sheet has another equity account for current year profit or loss. Only when the year is complete does the balance in the current year account flow over into retained earnings.
Throughout the current year, retained earnings should continuously match last year’s final number. If you increase retained earnings to a figure that’s greater than the balance at the previous year-end, your tax accountant has no choice other than to adjust the current year’s profit; you’ll pay income tax on an additional amount that wasn’t really income. If retained earnings decline, the tax accountant must record the change as a non-deductible distribution or dividend rather than a deductible expense.
Never record a transaction that alters retained earnings. Distributions or capital contributions are changes in cash assets that are not a consequence of business earnings. If you want to record these events correctly, use different equity accounts – not your retained earnings account!