Accumulated Earnings and Profits - Explained
What is Accumulated Earnings and Profits?
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Table of ContentsWhat is Accumulated Earnings and Profits?Example of How Accumulated Earnings and Profits Works?What Necessitates Companies to Retain Accumulated EarningsWhy Accumulated Earnings and Profits are ImportantKey TakeawaysAcademics Research on Accumulated Earnings and Profits
What is Accumulated Earnings and Profits?
Accumulated earnings and profits is an accounting terminology that applies to a company's stockholders. It refers to the company's net earnings after paying the stockholders their dividend. Retained earning is also another term referring to accumulated E & P.
Generally, accumulated E & P is an essential financial tool when working on your financial accounts. Therefore, calculating E & P remains an important task for any business company. This is because it is one of the vital financial metrics that companies rely on during financial transactions. When preparing a company financial report, income, as well as losses, must be reflected in the balance sheet. It is important since they are part of the E & P in any trading period. Also, E & P as a financial tool is not used when reporting income tax. However, it can be used to determine some income tax elements.
Back to: ACCOUNTING, TAX, & REPORTING
Example of How Accumulated Earnings and Profits Works?
Lets assume that Company ABC has been trading for five years, and the following are its annual net income report: 1st Year-$20,000 2nd Year-$10,000 3rd Year-$10,000 4th Year-$2,000 5th Year-$6,000 Now, lets also assume that Company ABC did not pay dividends during this trading period. In this case, Company ABCs accumulated earnings will include the total net income for the entire trading period (5 years): $20,000 + $10,000 -10,000 + $2,000 - $6,000 = $16,000. Note that in the years that follow, there will be a change in company ABCs accumulated earnings. The change will be by every years net earnings amount minus the dividends. Generally, accumulated E & P summarizes any changes in accumulated earnings for a financial period. In the balance sheet, the entire accumulated earnings are reflected in the stockholders equity share. In other words, every amount of accumulated earnings is basically an additional amount to the stockholders equity. Also, the company's board of directors may see a need to appropriate part or the entire company's accumulated earnings. This happens when dividend payment to the shareholders wants to be restricted by the board. Note that the decision to appropriate lies solely with the company's board. However, the bondholders may sometimes require the board to implement it. Appropriation is usually reflected in the accumulated earnings segment in the form of a special account. When the appropriation is not needed anymore, it is moved back to the accumulated earnings.
What Necessitates Companies to Retain Accumulated Earnings
The following are reasons why most companies may find it necessary to maintain a substantial amount of its earnings:
Companies experiencing rapid growth in their businesses may need a lot of capital to be able to operate efficiently. This is because they need additional cash to be able to support the rapid growth they are experiencing.
- Debt payment
For companies operating on a large debt, they may want to retain earnings for them to be able to pay the debt. This then minimizes the risk of the company's capital.
If a company is operating under self-insurance where it has to cover itself against certain loses, then, retained earnings become essential. This is an amount that a company must pay to the insuring company without defaulting. So, the company may want to retain the earnings for this purpose.
When there is a need to expand or have own assets, the board of directors of a company may decide to appropriate part of or the entire accumulated earnings. It sets aside whatever amount it has decided to retain in order to use it for a specific company's project(s).
Reserve apply to earnings retained for the purpose of rescuing the business should there be a decline in profits. The company may, therefore, find it necessary to retain some significant amount of its earnings so that it can save the company business from such situations in the future. Generally, accumulated retained earnings may be a good thing for investors, especially when it is being used to expand the company's business. This means that they will be expecting higher returns when the company eventually starts paying them their dividends. However, it may not go well with the investors especially where there are lots of accumulated retained earnings because of poor management. Note that bad management of the company may lead to a decline in profit earnings. So, if the profits are being retained to cover such, then there will be a big problem between the two parties.
Why Accumulated Earnings and Profits are Important
Note that the accumulated earnings do not represent additional cash, but rather, it shows where the company reinvested the profits. So, the accumulated earnings are important as it enables the company to reinvest for the well being of the company. The reinvestment can be either of the following: To purchase additional assets e.g. machines and self-owned structure in order to expand the business. To reduce liability e.g. paying a company loan(s) so as to reduce the companys capital risk. Also, we can say that accumulated earnings somehow reflect the firms decision to pay dividends or to reinvest it. This is because it is from the accumulated earning that the board bases its decision on whether to pay out the dividend or to invest it. In general, most accumulated earnings analyses aim at evaluating the action which is likely to generate the greatest returns to its shareholders. In addition, most of the analyses important since it helps to compare the sum of accumulated earnings to share prices changes in a specific trading period. In other words, the analyses measure the profits the company was able to generate from the profits it reinvested. Generally, it is those capital intensive companies and the fast-growing companies that happen to retain most of their earnings. This is because they need to invest more in assets so that they can continue operating effectively. As a result of this, older big companies may report substantially high accumulated earnings compared to other small young companies.
- Accumulated earnings refer to the company's net earnings after paying the stockholders dividend.
- Accumulated earnings do not represent additional or extra cash. Rather it shows where it was invested.
- Most companies maintain a substantial amount of retained earnings for reserve, self-insurance, debt payment, appropriation, and growth purposes.
Academics Research on Accumulated Earnings and Profits
- "Out of Its Earnings and Profits": Some Reflections on the Taxation of Dividends, Andrews, W. D. (1956). " Out of Its Earnings and Profits": Some Reflections on the Taxation of Dividends. Harvard Law Review, 69(8), 1403-1439.
- Dividends and Earnings or Profits Under the Income Tax Law: Corporate Nonliquidating Distributions, Rudick, H. J. (1940). Dividends and Earnings or Profits Under the Income Tax Law: Corporate Nonliquidating Distributions. U. Pa. L. Rev., 89, 865.
- Stock Redemptions and the Accumulated Earnings Tax, Herwitz, D. R. (1960). Stock Redemptions and the Accumulated Earnings Tax. Harv. L. Rev., 74, 866.
- Dividends and Earnings or Profits, Albrecht, A. R. (1951). Dividends and Earnings or Profits. Tax L. Rev., 7, 157.
- The Impact of Redemption and Liquidation Distributions on Earnings and Profits: Tax Accounting Aberrations Under Section 312 (e), Edelstein, H., & Korbel, H. J. (1964). The Impact of Redemption and Liquidation Distributions on Earnings and Profits: Tax Accounting Aberrations Under Section 312 (e). Tax L. Rev., 20, 479.