LO 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings

Three Forms of Business Ownership

Businesses operate in one of three forms—sole proprietorships, partnerships, or corporations. Sole proprietorships utilize a single account in owners’ equity in which the owner’s investments and net income of the company are accumulated and distributions to the owner are withdrawn. Partnerships utilize a separate capital account for each partner, with each capital account holding the respective partner’s investments and the partner’s respective share of net income, with reductions for the distributions to the respective partners. Corporations differ from sole proprietorships and partnerships in that their operations are more complex, often due to size. Unlike these other entity forms, owners of a corporation usually change continuously.

The stockholders’ equity section of the balance sheet for corporations contains two primary categories of accounts. The first is paid-in capital, or contributed capital—consisting of amounts paid in by owners. The second category is earned capital, consisting of amounts earned by the corporation as part of business operations. On the balance sheet, retained earnings is a key component of the earned capital section, while the stock accounts such as common stock, preferred stock, and additional paid-in capital are the primary components of the contributed capital section.

Characteristics and Functions of the Retained Earnings Account

Retained earnings is the primary component of a company’s earned capital. It generally consists of the cumulative net income minus any cumulative losses less dividends declared. A basic statement of retained earnings is referred to as an analysis of retained earnings because it shows the changes in the retained earnings account during the period. A company preparing a full set of financial statements may choose between preparing a statement of retained earnings, if the activity in its stock accounts is negligible, or a statement of stockholders’ equity, for corporations with activity in their stock accounts. A statement of retained earnings for Clay Corporation for its second year of operations The figure below shows the company generated more net income than the amount of dividends it declared.

When the retained earnings balance drops below zero, this negative or debit balance is referred to as a deficit in retained earnings.

Statement of Stockholders’ Equity

The statement of retained earnings is a subsection of the statement of stockholders’ equity. While the retained earnings statement shows the changes between the beginning and ending balances of the retained earnings account during the period, the statement of stockholders’ equity provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts, including retained earnings. The format typically displays a separate column for each stockholders’ equity account, as shown for Clay Corporation below. The key events that occurred during the year—including net income, stock issuances, and dividends—are listed vertically. The stockholders’ equity section of the company’s balance sheet displays only the ending balances of the accounts and does not provide the activity or changes during the period.

Nearly all public companies report a statement of stockholders’ equity rather than a statement of retained earnings because GAAP requires disclosure of the changes in stockholders’ equity accounts during each accounting period. It is significantly easier to see the changes in the accounts on a statement of stockholders’ equity rather than as a paragraph note to the financial statements.

Prior Period Adjustments

Prior period adjustments are corrections of errors that appeared on previous periods’ financial statements. These errors can stem from mathematical errors, misinterpretation of GAAP, or a misunderstanding of facts at the time the financial statements were prepared. Many errors impact the retained earnings account whose balance is carried forward from the previous period. Since the financial statements have already been issued, they must be corrected. The correction involves changing the financial statement amounts to the amounts they would have been had no errors occurred, a process known as restatement. The correction may impact both balance sheet and income statement accounts, requiring the company to record a transaction that corrects both. Since income statement accounts are closed at the end of every period, the journal entry will contain an entry to the Retained Earnings account. As such, prior period adjustments are reported on a company’s statement of retained earnings as an adjustment to the beginning balance of retained earnings. By directly adjusting beginning retained earnings, the adjustment has no effect on current period net income. The goal is to separate the error correction from the current period’s net income to avoid distorting the current period’s profitability. In other words, prior period adjustments are a way to go back and correct past financial statements that were misstated because of a reporting error.

To illustrate how to correct an error requiring a prior period adjustment, assume that in early 2020, Clay Corporation’s controller determined it had made an error when calculating depreciation in the preceding year, resulting in an understatement of depreciation of $1,000. The entry to correct the error contains a decrease to Retained Earnings on the statement of retained earnings for $1,000. Depreciation expense would have been $1,000 higher if the correct depreciation had been recorded. The entry to Retained Earnings adds an additional debit to the total debits that were previously part of the closing entry for the previous year. The credit is to the balance sheet account in which the $1,000 would have been recorded had the correct depreciation entry occurred, in this case, Accumulated Depreciation.

Because the adjustment to retained earnings is due to an income statement amount that was recorded incorrectly, there will also be an income tax effect. The tax effect is shown in the statement of retained earnings in presenting the prior period adjustment. Assuming that Clay Corporation’s income tax rate is 30%, the tax effect of the $1,000 is a $300 (30% × $1,000) reduction in income taxes. The increase in expenses in the amount of $1,000 combined with the $300 decrease in income tax expense results in a net $700 decrease in net income for the prior period. The $700 prior period correction is reported as an adjustment to beginning retained earnings, net of income taxes, as shown below.

Generally accepted accounting principles (GAAP), the set of accounting rules that companies are required to follow for financial reporting, requires companies to disclose in the notes to the financial statements the nature of any prior period adjustment and the related impact on the financial statement amounts.