Does retained earnings include investment capital?
I thought no. I thought retained earnings is cumulative net income - dividends.
However, Wikipedia says:
Ending Retained Earnings = Beginning Retained Earnings + Investments − Dividends Paid + Net Income
Why are investments included in retained earnings calculations?
On October 31, the stockholders’ equity section of Omar Company consists of common
stock $600,000 and retained earnings $900,000. Omar is considering the following two
courses of action: (1) declaring a 5% stock dividend on the 60,000, $10 par value shares outstanding,
or (2) effecting a 2-for-1 stock split that will reduce par value to $5 per share. The current
market price is $14 per share.
Instructions
Prepare a tabular summary of the effects of the alternative actions on the components of stockholders’
equity and outstanding shares. Use the following column headings: Before Action,After
Stock Dividend, and After Stock Split.
before:
common $600,000
Outstanding shares: 60,000 shares
book value per share = $10
r.e. = $900,000
Stock dividend:
Current price = $14.00 share.
5% dividend = $0.70 per share
$0.70 per share * 60,000 shares = $42,000
so....
After stock dividend:
common $642,000
shares out =64,200 shares
book value= $10
r.e. = $900,000 - $42,000 = $858,000
Split:
common $600,000
shares out =120,000
book value = $5 per share
R.e. = $900,000
You are correct that retained earnings are typically calculated as the cumulative net income minus dividends paid. However, the equation you mentioned from Wikipedia includes investments as well.
The reason investments are included in the calculation of retained earnings is because they directly impact the overall financial position of a company. When a company makes an investment, it uses its retained earnings (which are funds that have not been distributed to shareholders as dividends) to finance the investment. This reduces the amount of retained earnings available for distribution as dividends to shareholders.
So, in the equation Ending Retained Earnings = Beginning Retained Earnings + Investments - Dividends Paid + Net Income, investments are added to the beginning retained earnings because they increase the overall value of retained earnings. However, it's important to note that this equation may not be universally applicable and may vary based on specific accounting practices or regulatory requirements. Therefore, it is always a good idea to consult the relevant accounting standards or guidance for a specific context.