If you’ve spent time matching accounts across financial statements, then you know the importance of retained earnings. Without them, your balance sheet would fall out of equilibrium with every sale you make, and expense you incur.
In fact, they are so critical to accounting entries that we could say retained earnings are to liabilities & equity what cash is to assets — it’s what tracks company performance on the balance sheet.
But this is a high-level view. Retained earnings is part of almost every transaction — whether operational, investing, or financing — so how do we summarize these relationships? In short, with net profit.
Net profit is the corresponding entries of retained earnings, and because net profit changes with cycles in sales, expenses, investing, and financing, we can say that retained earnings correspond to these cycles in the following ways:
1. In the Sales cycle with [ΔCash from sale + ΔInventory]
2. In the Expenses cycle [ΔCash for expense]
3. In the Investing cycle [ΔCurrent Depreciation]
4. In the Financing cycle [ΔCash paid for interest]
In this article, we’ll look at each of these cycles from start to finish, with specific focus on how these entries ultimately impact retained earnings (RE), and thus how they can be considered corresponding accounts to RE.
I’ll show the simple accounting steps used to follow the movement of cash and goods & services into and out of a company, with images of the financial statements and credits and debits. I will highlight all entries involving net profit and retained earnings in blue.
Remember, at the end of the day, accounting is nothing more than following cash and goods & services in a company — the rest is details. When you understand how retained earnings works, you understand how all accounting works. Let’s get started with the Sales Cycle.
Retained Earnings in the Sales Cycle
The sales cycle shows — you guessed it — how sales are made in a company. It consists of only 5 entries on the financial statements.
- Dr Accounts payable & Cr Sales
- Dr Net profit & Cr retained earnings
- Dr Cost of Goods Sold & Cr Inventory
- Dr Retained earnings & Cr Net Profit
- Dr Cash & Cr Accounts payable
If this feels slightly confusing, don’t worry. Understanding these entries is tricky for everyone at the start, but once you understand financial statement dynamics, it’s easier. Let’s look at how these entries appear on the financial statements and add some commentary.
Step 1. We are recording a sale made but not yet paid for. For example, imagine we’re running a wholesale watch company, and we sold a group of watches for $1,000. However, the buyer has 30 days to pay us for this. Our statements would look like this:
Step 2. Now that we’ve recorded the sale on the P&L and the balance sheet, our balance sheet is out of balance. To rectify this, we need to record the sale in retained earnings. Since the corresponding entry for retained earnings is net profit, we need to increase net profit by the amount of our sale. Here’s what it looks like:
Now our balance sheet is in balance!
Always remember: when we have an accounting entry in which only one side involves the income statement, you must use net profit and retained earnings to create equilibrium on the balance sheet.
Step 3. Since we’ve made a sale, the matching principle of accounting states that we need to also record the direct costs associated with this transaction at the same time. That’s why in the sales cycle we also record the cost item called Cost of Sales (CoS). This includes any and all direct costs associated with the sale of our watches.
For the purposes of this explanation let’s assume the only direct cost we have is inventory (although labor is also included in some instances). Let’s assume that we purchased the watches sold in step 1 for $600. It would look like this:
Step 4. Now that we’ve added the drop in inventory, our balance sheet is out of balance. We need to perform a similar transaction to the one we used to stabilize the B/S after the sale — debit retained earnings and debit net income:
Step 5. Finally, the customer has actually paid for the product he/she purchased in Step 1. Note that this transaction shows a movement of one asset account to another — it does not involve the P&L statement. To show this change, we simply need to move the $1,000 we made from accounts receivable to cash:
Now we have fully moved a sale across the financial statements. Our balance sheet is in equilibrium, and our net profit of $400 matches our retained earnings.
NOTE: net profit is not really an account — it’s the difference between income and expense accounts. This means that retained earnings are nothing more than a way to stabilize the balance sheet with the excess accounts receivable or cash made from operations, as well as depreciation reducing long term assets, and interests payments flowing out of the cash account.
Net Profit and Retained Earnings Do Not (Entirely) Represent Cash
It’s important to note that net profit and retained earnings are not representative of cash. This is precisely because, at any given time, accounts receivable and accounts payable may be the balance sheet equivalent of a sale or CoS. If no cash has been exchanges, the net-profit and retained earnings entries represent earnings, but not cash.
Retained Earnings in the Expenses Cycle
Notice that in the sales cycle we did not touch the expense account, even though we debited the Cost of Sales. This is because Cost of Sales is inherently linked to sales and therefore varies with business performance, while expenses are non-variable — they do not fluctuate with business performance.
Expenses include items such as cost of administrative salaries (lawyers, finance, human resources), as well as building rent, lighting, water, and other overhead charges.
Contrary to sales, expenses begin their balance sheet journey on the liabilities side of the balance sheet. Here are the journal entries:
- Dr Expenses & Cr Accounts Payable
- Dr Retained Earnings & Cr Net Profit
- Dr Accounts Payable & Cr Cash
As you can see, the full cycle of one expense includes three total entries — we load up the balance sheet on accounts payable, correct the imbalance with retained earnings and net profit, then record the payment of cash.
Step 1. We need to begin the expense cycle by recording it on the P&L. However, since we haven’t paid anything out yet, we must record the transaction on our liabilities as accounts payable. Imagine we need to pay rent for $100. Here’s what it looks like:
Step 2. Now that we’ve recorded the expense on the income statement and the corresponding entry in liabilities, our balance sheet is unbalanced. We need to therefore make the entry for net profit and retained earnings:
Step 3. The final step is the same as the sales cycle. We need to move the value of the expense from accounts payable into cash when we make the payment.
Some people get confused at this step because, contrary to the asset-to-asset transfer from accounts receivable to cash, the transfer is from liabilities to cash.
But remember, we’re transferring a positive liability to a negative asset — there is no net change to the balance sheet. Here’s how it looks:
Now we’ve completed the expense cycle. Our balance sheet is in balance and our net profit equals retained earnings. The corresponding accounts are equal.
Retained Earnings in the Investing Cycle
The investing cycle is different from sales and expense cycles because it is concerned with an entirely non-cash expense: depreciation. Depreciation is the amount by which an asset loses value in a given period of time, almost always a year. We record this on the income statement, even though it does not have an impact on cash after the initial purchase.
For example, imagine our wholesale watch company purchases a metal working machine. We pay for it up-front, but we use it over time. It would be inaccurate to show the entire expense in one year since this would vastly decrease our net profit in year 1, and the absence of costs in following years would inflate our performance. That’s where depreciation comes in.
Depreciation is a corresponding account to retained earnings because it shows year-over-year impact on net profit and therefore retained earnings, even though it’s not a direct cash item (just like accounts receivable and payable as discussed above).
In the first year, the account entries would be:
- Dr Cash & Cr Long-term assets
- Dr Depreciation expense & Cr Current depreciation
- Dr Net profit & Cr Retained earnings
The important thing to note here is that we’re reducing the total asset value by crediting current depreciation. This leads to an imbalance on the balance sheet that must be corrected.
This is easier to understand with an example. Let’s look at depreciation in the first year of purchasing our big machine. Imagine it costs $100,000.
Step 1. In step 1, we need to show the huge cash outflow from the company used to fund the big asset. This is an asset-asset transfer.
Step 2. Now we need to show the current depreciation (as well as the net asset value) on both the assets and income statement. Let’s assume the asset depreciates at a rate of $10,000 over 10 years:
Now we’ve correctly made the income statement entry to track our asset. You may be wondering why there is an accumulated depreciation account. In short, it’s a way of tracking the sum of current depreciation over time. We’re only looking at year 1 in this example, but in year two, the current depreciation will be -$10,000, but the accumulated depreciation will be -$20,000 to account for both years.
(NOTE: our total assets are only negative because we assumed a starting value of $0 in cash. In a normal company, the cash would have to be positive to pay for the machine. We’ll look at this closer in the financing cycle section, but don’t worry about it for now.)
Now we’ve recognized current depreciation on the income statement, and we decreased our net assets to -$10,000 ($100,000 + -$10,000).
This means we now need to bring our balance sheet back into equilibrium by recording the -$10,000 in net profit and retained earnings. It would look like this:
Now we’ve seen the entire investment cycle through. Our balance sheet is in balance, and net profit is equal to retained earnings.
Retained Earnings in the Financing Cycle
In the above example we bought a big machine asset, which required $100,000 in cash that we didn’t have. That’s why our cash account went negative. In the real world, a company cannot have negative cash, or it would be out of business. Either the company builds up its cash reserves from cash generated with sales, or it needs to get external funding.
One kind of funding is equity, but equity funding does not touch the income statement and therefore has no relationship to retained earnings. This puts it outside the scope of this article.
The other kind of funding is money from the financing cycle – debt. Debt repayments consist of two parts: a principle amount and an interest amount. The principle amount is recorded as a long term liability on the balance sheet. The interest payment, on the other hand, is recorded as interest payable, a short term liability on the balance sheet AND an expense account on the income statement.
This means debt payment are quite dynamic. On the one hand, the principle amount is a balance-sheet only cycle, whereas the interest payment includes both financial statements. Here are the account entries:
- Dr Cash & Cr Long-term Debt
- Dr Long-term debt & Cr Cash
- Dr Interest expense & Cr Interest payable
- Dr Retained earnings & Cr Net profit
- Dr Interest payable & Cr Cash
For example, imagine you take out a 10-year loan for $150,000 that you need to pay both principle and interest payments on immediately. Our payments are installments of $10,000, and the first one is $8,000 in principle and $2,000 in interest (amounts made up for simplicity’s sake).
Since we’ve gone step-by-step in the previous cycles, we don’t need to break down this financing cycle in multiple visualizations. The whole transaction would look like the following:
Our balance sheet is in balance, and our net profit equals our retained earnings. This means we have correctly completed the financing cycle.
As you can see, retained earnings is only a corresponding entry for the interest part of the loan. This is because the principle portion is a balance-sheet only transaction.
Conclusion
Don’t worry if you don’t grasp all of these movements immediately. Even the most experienced accountants have to revise the full cycles from time to time. The key takeaways should be:
- Net profit is the corresponding account to retained earnings.
- Any transaction on the income statement has only one modification to the balance sheet. This means you will need to use the net profit corresponding account to create balance with retained earnings.
- The sales cycle always includes the special Cost of Sales cycle within it.
- The expense cycle starts with the liabilities side of the balance sheet.
- Current depreciation lowers net profit and liabilities, which must be corrected for with retained earnings.
- Only the interest payment of a lone affects retained earnings.
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