Ending retained earnings is transferred to the balance sheet, where it appears under the shareholders’ equity section. This transfer happens at the close of each accounting period after all temporary accounts (revenues, expenses, and dividends) have been closed out through a series of journal entries. If you’re studying the closing process in accounting, understanding how this number moves from the income statement and related accounts onto the balance sheet is essential.
How Ending Retained Earnings Reaches the Balance Sheet
Retained earnings is a permanent account, meaning its balance carries forward from one period to the next. At the end of each accounting period, the closing process funnels net income (or net loss) and dividend payments into the retained earnings account. Once that’s done, the updated balance sits on the balance sheet as a line item within shareholders’ equity, right alongside common stock and additional paid-in capital.
The formula that produces the ending balance is straightforward:
Ending Retained Earnings = Beginning Retained Earnings + Net Income − Dividends
If a company started the year with $200,000 in retained earnings, earned $80,000 in net income, and paid $15,000 in dividends, its ending retained earnings would be $265,000. That $265,000 then appears on the balance sheet and becomes the beginning balance for the next period.
The Closing Entry Process That Gets You There
Temporary accounts like revenue, expenses, and dividends exist only for a single period. At period end, their balances need to be zeroed out so the next period starts fresh. The closing process follows a specific sequence of journal entries that ultimately channels everything into retained earnings.
- Step 1: Close revenue accounts. All revenue accounts are debited (zeroed out), and the total is credited to an intermediate account called income summary.
- Step 2: Close expense accounts. All expense accounts are credited (zeroed out), and the total is debited to income summary. After this step, the income summary balance equals net income or net loss for the period.
- Step 3: Close income summary to retained earnings. If the company had net income, you debit income summary and credit retained earnings. If there was a net loss, the entry is reversed: debit retained earnings, credit income summary. Either way, income summary drops to zero.
- Step 4: Close dividends to retained earnings. The dividends account is credited (zeroed out), and retained earnings is debited by the same amount. This is the last closing entry, and it reduces retained earnings by whatever the company paid out to investors.
After all four steps, every temporary account has a zero balance, and retained earnings reflects the cumulative profits the company has kept since it began operating.
Why Income Summary Exists
You might wonder why revenues and expenses don’t just close directly into retained earnings. They can, and some companies do it that way. But the income summary account serves as a holding account that aggregates all income and expense balances in one place before transferring the net figure to retained earnings. This creates a cleaner audit trail, making it easier for accountants to verify that every revenue and expense account was properly closed. Income summary never appears on any financial statement because its balance is always zero once the closing process finishes.
Where It Shows Up on the Balance Sheet
Once the closing entries are posted, the ending retained earnings balance is reported under shareholders’ equity on the balance sheet. A typical equity section might look like this:
- Common stock: $500,000
- Additional paid-in capital: $150,000
- Retained earnings: $265,000
- Total shareholders’ equity: $915,000
If the company has accumulated losses instead of profits over time, this line will show a negative number, often labeled “accumulated deficit.” The mechanics are identical; the balance just happens to be negative.
Transfers Within Retained Earnings
Sometimes a company’s board of directors votes to set aside a portion of retained earnings for a specific purpose, like funding an acquisition, a building purchase, or a reserve against potential lawsuits. This creates what’s called appropriated retained earnings. The journal entry debits the main retained earnings account and credits a separate appropriated retained earnings account, essentially moving money from one bucket to another within equity.
For example, if a company needs $30 million for a new building, the board might appropriate that amount by debiting retained earnings for $30 million and crediting an account called “appropriated retained earnings, building fund.” This signals to shareholders that those funds are earmarked and not available for dividends. Once the project is complete, the appropriated amount is transferred back to the main retained earnings account. The total equity doesn’t change during appropriation; it’s purely an internal reclassification.
Retained Earnings vs. the Income Statement
Net income lives on the income statement for a single period. Retained earnings, by contrast, is a cumulative total that grows (or shrinks) over the life of the business. Think of the income statement as a video of one year’s performance, and the retained earnings line on the balance sheet as a running scoreboard of every year combined, minus whatever was distributed to shareholders along the way.
Many companies also prepare a separate statement of retained earnings (sometimes called a statement of changes in equity) that bridges the beginning balance to the ending balance. This statement shows beginning retained earnings, adds net income, subtracts dividends, and arrives at the ending figure that gets reported on the balance sheet. It’s a useful reconciliation tool, but the final destination is always the same: the shareholders’ equity section of the balance sheet.