Davis Company was started on January 1, 2012. During the month of January, Davis earned $4,600 of revenue and incurred $3,000 of expense. Davis closes its books on December 31 of each year. Required a. Determine the balance in the Retained Earnings account as of January 31, 2012. b. Comment on whether retained earnings is an element of financial statements or an account. c. What happens to the Retained Earnings account at the time expenses are recognized?

Question

Davis Company was started on January 1, 2012. During the month of January, Davis earned $4,600 of revenue and incurred $3,000 of expense. Davis closes its books on December 31 of each year. Required a. Determine the balance in the Retained Earnings account as of January 31, 2012. b. Comment on whether retained earnings is an element of financial statements or an account. c. What happens to the Retained Earnings account at the time expenses are recognized?

Answer 1

a. To determine the balance in the Retained Earnings account as of January 31, 2012, we need to consider the formula for calculating retained earnings. Retained Earnings are calculated as the beginning balance of retained earnings plus net income or loss, minus dividends.

Since Davis Company was started on January 1, 2012, we assume it had no beginning balance in the Retained Earnings account. Therefore, the net income for January 2012 will be the revenue earned minus the expenses incurred. In this case, the net income for January 2012 is $4,600 - $3,000 = $1,600.

Since Davis Company is a new business, we assume it did not distribute any dividends yet. Therefore, the formula simplifies to Retained Earnings = Beginning Balance + Net Income.

Given that there is no beginning balance, the Retained Earnings account balance as of January 31, 2012, is $1,600.

b. Retained earnings is not an element of financial statements but rather an account. It is a component of the Stockholders' Equity section of the balance sheet, which is one of the financial statements. Retained earnings represent the cumulative net income or loss of a business since its inception, minus any dividends paid to owners.

c. When expenses are recognized, they reduce the net income, which in turn decreases the Retained Earnings account balance. This occurs because expenses are subtracted from revenue to calculate net income. Since retained earnings track the cumulative net income of a business, recognizing expenses reduces the overall net income and consequently decreases the balance in the Retained Earnings account.