How Accumulated Earnings and Profits Work

Accumulated Earnings are also referred to as retained earnings or revenue reserves and are reported in the Statement of financial affairs of a company, also known as a balance sheet. Among the financial statements that a company must maintain are the Statement of Financial Affairs (Balance Sheet) and the Income Statement (Profit and Loss Account).

The income statement is a report of the income and the expenditures of a company for a financial period, usually a year. The net profit is the bottom line, which is the difference between revenues and all expenses for the year, including taxes. The net profit or loss for the year is then aggregated with the accumulated earnings from the previous year and is reported alongside capital and other reserves.

Accumulated Earnings and Profits, therefore, form part of the capital or equity of the business. Like capital, accumulated earnings are usually expressed as a credit balance, with a debit balance implying a negative accumulated earnings position.

Negative Accumulated Earnings

For companies that declare and pay dividends, accumulated earnings are derived from profits after paying dividends. Accumulated Earnings can also be a negative figure. Negative retained earnings usually occur if the company has posted more losses than profits over the past years. A negative accumulated earnings position means that due to past losses incurred by the company, the company's capital has been eroded by the accumulated losses.

Example of Accumulated Earnings and Profits

Suppose a company has an initial capital of $1,000, reports a loss of $200 in the first year, and a further loss of $500 in the second year, and then returns a profit of $300 in the third year. The company's accumulated earnings will be negative accumulated earnings of $400, being the aggregation of -$200, -$500, and +300.

In this instance, the negative accumulated earnings will be referred to as accumulated losses. From the above scenario, the company will have eaten into the company's equity by $400. It will require to post profits exceeding $400 in subsequent years to restore the equity to the initial $1,000.

Traditionally, companies do not pay dividends if they are in a negative reserve or accumulated earnings position. Paying dividends in such a case would mean that the company is further eroding its capital at the expense of working capital or other priority payments required for the business to continue as a going concern.

Significance of Accumulate Earnings and Profits?

A company usually keeps accumulated earnings to shield the company from the uncertainty of earnings in the future or for expansion or reinvestment into the business. A company with a healthy accumulated earnings position will be able to pay dividends to its shareholders even in years where it has posted losses in its operations. A company with enough accumulated earnings will also be able to expand quickly without resorting to borrowing.

Accumulation of earnings is an integral part of the prudent management of a company's financial resources. It is considered imprudent for a company to distribute all its profits as dividends. Successful companies accumulate significant reserves to buffer them from the inevitable periods of poor financial performance. Such retained earnings can be considered savings that a company keeps for future redistribution or re-investing into the company.

Accumulated Earnings vs. Accumulated Profits

However, it is important to understand that profits and cash flow are two different things in accounting. It is, therefore, possible for a company to have accumulated earnings in its books of accounts but have no cash. Such scenarios can happen, for instance, where a company has earned income but not receive the money from its debtors. Accounting rules and conventions require that revenue is booked when earned and not when received, hence the possibility of reporting a profit even before money is received.

This position can be further complicated by bad debts, where profits are already declared, but the debt becomes uncollectable. In such instances, a bad debt expense will have to be incurred to write off the debt. However, this bad debt write-off will usually be in subsequent years and rarely within the same accounting period.