Retained Earnings - Part 1
I acknowledge my indebtedness to the late Joey, Suzanne, Lisa, Joe and many others and to Sleeter’s Consultant’s Reference Guide in preparing this note, and the note is dedicated to the memory of the late Joey who is sorely missed but whose work we will endeavour to carry on. I have drawn extensively on their wisdom, but any remaining mistakes are my own.
Retained Earnings is a complex subject, due in large measure to inept programming in QB. Over 200 posts that refer to Retained Earnings testify to this complexity. The textbooks on QB seem to generally steer clear of any in-depth discussion of Retained Earnings, despite the complexity of the subject.
I understand that the newer, higher versions of QB have made a start on addressing some of the weaknesses in the Retained Earnings Account (which I will call the RE Account), but otherwise what follows should, I think, apply to all versions of QB, although I have not considered the position of non-profits.
Some experts – eg Sleeter - recommend that in the case of a sole proprietorship the RE Account be renamed Owner’s Equity, but I do not subscribe to this view because in my view the account has such limited functionality – see below – that it is an unsuitable vehicle for this or any other purpose.
I’ve written on the subject of Retained Earnings before but my views have developed and changed to some extent in the process, so please ignore what I’ve said before.
This note will focus on a business making a profit but similar principles apply to a business making a loss.
MEANING OF RETAINED EARNINGS
“Retained Earnings” are profit that has been earned but not yet distributed. It may still be distributed, either sooner or later, or may be retained as additional capital. It will be seen however that this is not necessarily how QB uses the expression.
The RE Account is an Equity Account created automatically by QB. The first entry to the RE Account on transfer of a business’ existing books of account onto QB should be a manual journal entry transferring the balance in the Opening Balance Equity Account to the RE Account. Thereafter, at the end of each financial year QB automatically transfers the net profit (or loss) for the year into the RE Account, albeit invisibly. The further manual entries required each year to the account are discussed below.
LIMITED & ERRATIC FUNCTIONALITY OF RE ACCOUNT
The RE Account has limited and erratic functionality in that:
• It has no register and the balance in the account does not show in the Chart of Accounts, and
• Reports on the account do not show the net profit transferred into the account and they do not even show all the transfers out of the account without considerable, unexpected tweaking.
Because the net profit is not shown, the breakdown of how it is made up is also not shown. This is not uncommon accounting practice, but a computerised accounting program could so easily show it – even if only by drilling down - that it seems a pity that it doesn’t show the breakdown. One must instead take out a Profit & Loss Report to get the breakdown.
REPORTS ON RETAINED EARNINGS
A QuickReport on the RE Account shows only one figure with the description “Total Retained Earnings”. In fact, the amount is the exact opposite of the description, ie the amount is the amount not retained but transferred out of the RE Account to close off any distribution accounts such as Owner’s Draws or Dividends. The programmers, having made the strange decision not to show the net profit in the RE Account, apparently then became confused as to what they were showing in the account. As will be seen, this confusion is carried through to the balance sheet too, where further confusion is sown. So don’t feel too bad if you are also a bit confused!
The QuickReport correctly shows the total amount transferred out of the RE Account as a positive number, ie as a debit, but this conveys nothing in QB, which carelessly fluctuates between showing debits and credits as positive and negative numbers.
One can get a fuller QuickReport by filtering it to show the Split Detail, but what the fuller QuickReport will show depends on the chance circumstance of whether in transferring amounts out of the account by journal entry one entered the debit to the RE Account first or only after the corresponding credit. In the former case the debits to the account are shown in the QuickReport, in the latter case not.
What were the programmers thinking? First one gets only the debits and not the credits of the net income and then one finds that it is a matter of chance whether or not one gets all the debits.
A more reliable way of getting the details of the amounts transferred out of the RE Account – but still not the credits of the net income - is as follows:
Reports + Custom Transaction Detail Report + Under Display & Column, select Debit and Credit + Under Display & Total By, select Total Only + Under Display & Sort By, select Num + Under Filter & Account, select Retained Earnings
CONCLUSION AND SOLUTION
In short, the RE Account has very limited and unreliable functionality: it has no register, the balance in the account does not show in the Chart of Accounts, the account confuses amounts drawn out of net profit with the net profit itself, it uses incorrect descriptions and it gives erratic, incomplete and misleading reports. Such an account is, I suggest, unsuitable for use for any purpose as far as this can be avoided. The approach I recommend in what follows is therefore based on minimising the use of the RE Account as far as possible.
The solution I recommend is that where:
• It is intended to leave a balance in the RE Account, or
• There will be a number of entries to the RE Account at each year-end,
is rather to create a second account called, say, RE #2 Account. The net profit will then be transferred from the RE Account to the RE #2 Account. The RE #2 Account, being a normal account, will be fully functional and transparent so that you can at any time readily see exactly what has gone on in the account.
APPLICATION TO DIFFERENT BUSINESS STRUCTURES
At year-end QB automatically transfers the net profit or loss into the RE Account, albeit invisibly. What needs to happen next depends largely on the type of business structure you are using and the Equity Accounts you have chosen to open. I’ll discuss three common examples:
• A sole proprietor who has, say, only one Equity Account called Owner’s Equity could simply transfer the net profit by journal entry direct from the RE Account to the Owner’s Equity Account. An RE #2 Account could be created but this is not really necessary because there is only one entry equal to the (invisible) net profit;
• A partnership in which each partner has, say, a Partner’s Capital/Contribution Account and a Partner’s Draws Account could transfer each partner’s share of the net profit direct from the RE Account to his Partner’s Draws Account, but this would result in at least as many entries in the RE Account as there are partners, and one would not be able to see at a glance that the total of the transfers equals the net profit.
I therefore suggest that this is a case where it is desirable that the net profit first be transferred out of the RE Account into an RE #2 Account and then transferred from there on to the Partner's Draws Accounts.
If it is desired to capitalise some of the net profit and retain it in the business to increase the capital base of the business, this is, I suggest, best done by doing what I have described and then transferring each Partner’s share of the amount to be capitalised from his Partner’s Draws Account to his Partner’s Capital/Contribution Account; however, a direct transfer from the RE #2 Account to the Partner’s Capital/Contribution Accounts is also a possibility;
• A (C) corporation which has, say, a Dividends Account and a Distributable Reserve Account would, I suggest, be particularly unwise to use the RE Account as the Distributable Reserve Account but should rather open a separate Distributable Reserve Account (ie in effect an RE #2 Account).
The corporation would then at year-end transfer the net profit out of the RE Account into the Distributable Reserve Account and would transfer an amount out of the Distributable Reserve Account to the Dividends Account equal to the debit balance in the Dividends Account (arising from the distributions of dividends that have already taken place during the financial year).
The balance of the net profit remaining in the Distributable Reserve Account would remain available for future dividends.
(Continued in Part 2)
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