The financial statement that explains the changes in retained earnings between two dates is the Statement of Comprehensive Income (or Income Statement) and the Statement of Shareholders' Equity (or Equity Statement). These two statements, when analyzed together, provide a clear picture of how retained earnings have changed over a specific period.
Retained earnings represent the portion of a company's net income that is not distributed to shareholders as dividends but is reinvested into the business. Understanding how retained earnings change is crucial for assessing a company's financial performance and its ability to generate future earnings.
The Statement of Comprehensive Income
The Statement of Comprehensive Income reports a company's revenues, expenses, and net income (or loss) for a specific period. It begins with revenues, subtracts expenses, and ends with net income, which is then added to retained earnings on the Statement of Shareholders' Equity.
To understand the change in retained earnings, you need to compare the net income (or loss) from two different periods on the Statement of Comprehensive Income. The difference in net income will directly impact the change in retained earnings.
Revenue and Expenses
Revenue and expenses are the primary components of the Statement of Comprehensive Income. Changes in these line items between two dates will directly affect the net income and, consequently, retained earnings. For example, an increase in revenue or a decrease in expenses will lead to an increase in net income and retained earnings.
To illustrate, consider a company that generates $100,000 in revenue and incurs $60,000 in expenses in Year 1. In Year 2, revenue increases to $120,000, and expenses decrease to $50,000. The change in net income (from $40,000 to $70,000) will be reflected in the change in retained earnings on the Statement of Shareholders' Equity.
Dividends
Dividends are a component of the Statement of Comprehensive Income that directly impacts retained earnings. When a company pays dividends, it is distributing a portion of its retained earnings to shareholders. The amount paid in dividends reduces retained earnings on the Statement of Shareholders' Equity.
For instance, if a company pays $20,000 in dividends in Year 1 and $30,000 in Year 2, the change in retained earnings will be affected by this difference. The increase in dividends paid will result in a decrease in retained earnings, assuming net income remains constant.
The Statement of Shareholders' Equity
The Statement of Shareholders' Equity reports the changes in a company's equity accounts, including retained earnings, over a specific period. It begins with the opening balance of retained earnings, adds net income, subtracts dividends, and ends with the closing balance of retained earnings.
To determine the change in retained earnings between two dates, compare the opening and closing balances on the Statement of Shareholders' Equity for the respective periods. The difference between these two balances represents the change in retained earnings.
Opening and Closing Balances
The opening and closing balances of retained earnings are the primary components of the Statement of Shareholders' Equity. The change in these balances between two dates will reflect the net income, dividends, and other comprehensive income (or loss) for the period.
For example, if the opening balance of retained earnings is $100,000 in Year 1 and the closing balance is $150,000 in Year 2, the change in retained earnings is $50,000. This change is the result of net income, dividends, and other comprehensive income (or loss) for the year.
Other Comprehensive Income (or Loss)
Other comprehensive income (or loss) is a component of the Statement of Shareholders' Equity that can also impact retained earnings. This line item includes items such as foreign currency gains or losses, unrealized gains or losses on available-for-sale securities, and pension plan changes that are not recognized in net income.
For instance, if a company has a $10,000 unrealized gain on available-for-sale securities in Year 1 and a $15,000 unrealized loss in Year 2, the change in other comprehensive income will affect the change in retained earnings. The decrease in other comprehensive income will result in a decrease in retained earnings, assuming net income and dividends remain constant.
Understanding the change in retained earnings between two dates is essential for analyzing a company's financial performance and making informed investment decisions. By examining the Statement of Comprehensive Income and the Statement of Shareholders' Equity, investors can gain valuable insights into a company's earnings trends and its ability to generate future earnings.