Question

What do retained earnings represent? Dividends are sometimes said to have been paid "out of retained earnings." What is the error, if any, in this statement? For what reasons might a company restrict a portion of its retained earnings? How are those restrictions reported?

Answer 1

What do retained earnings represent?

Retained earnings represent the accumulated profits of the business over the years. It the excess profits that is left to the corporation after the dividends are paid off.

Dividends are sometimes said to have been paid "out of retained earnings." What is the error, if any, in this statement?

Dividends i.e. cash dividends are paid out of the cash balance that the company has and not out of retained earnings balance. A balance in the retained earnings is necessary for legal distribution of dividends but a balance in the retained earnings does not define the ability of the company to pay dividends. The cash position of the company determines the firm's ability to pay dividends.

For what reasons might a company restrict a portion of its retained earnings? How are those restrictions reported?

Reasons why a company might restrict a portion of its retained earnings:

1. To indicate that the retained earnings balance is not available for dividend distribution

2. Depending on the state that the corporation is operating in, certain states require the companies to restrict a portion of the retained earnings when it acquires treasury stock. The cost of the treasury stock is reduced from the retained earnings balance.

3. The retained earnings can be restricted due to a contractual agreement as well. For instance when the company issues long term bonds , the balance may be restricted to satisfy bond holders claims in the future.

The restrictions are reported by way of a note to the financial statements. A clear description of the restriction i.e. legal or contractual must be stated.