What are Accumulated Earnings, Profits, and Taxes?

Accumulated earnings and profits (E&P), are the profits retained by a company after it pays dividends to stockholders. It measures the ability of a company to pay cash distributions. E&P is an accounting term that is used to refer to the stockholders of corporations. These retained earnings, which are not paid to shareholders as dividends, appear in the equity section of the shareholder in the financial report of the company. These retained profits are used by companies to finance their operations and facilitate expansions.

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Calculating the Accumulated Earnings

The formula for calculating retained earnings (RE) is: 

RE = Initial RE + net income dividends. 

For example, let's assume a certain company has $100,000 in accumulated earnings at the beginning of the year. The company made $700,000 in net profits and paid dividends worth $300,000 in the same year. The retained earnings will be, ($100,000 + $700,000) - $300,000 = $500,000 This figure is recorded in the financial report at the years end in the accumulated earnings item. 

Net Income 

When the net profits of a company increase, the accumulated earnings also increase. The company pays the accumulated earnings account to increase it and charges it if the accumulated earnings decrease since this account has a favorable balance. The reason why companies prepare the financial report after the income report is because the net income of the income report has to be transferred to the financial statement to calculate retained earnings. 

Cash Dividends 

When a board of directors declares a cash dividend, accumulated profits reduce. When these dividends are declared in cash, they create a current liability that must be settled. In account for this declaration, a company typically pays the dividend payable account and charges the retained earnings account. When the dividends in cash are paid, the dividend payable account is charged and the cash account credited. 

Dividends in shares 

Sometimes, shareholders are rewarded with additional shares instead of cash. Even though this reduces the accumulated earnings, the total shareholder capital, assets and total liabilities are not affected. When a declaration of dividends is made, the company debits the accumulated earnings account and then pays the distributable dividend account and the paid-in capital account of the nominal account. When the distribution is done, the company charges the dividend account distributable in shares and pays the ordinary shares account. 

Accumulated Earnings Tax 

This is a federal tax charged to companies considered invalid and which have excess earnings that exceed the average rate. This tax is used to discourage companies from retaining profits but to pay dividends. When the amount of retained earnings in a company exceed a certain amount and is not distributed as dividends to shareholders, the company is taxed on the accumulated income The US Internal Revenue Service allows for companies to accumulate profits of up to $250,000 without paying tax since it believes that an amount exceeding this goes over the reasonable requirements of the company. 20% of the income is deductible from the surplus. If the company fails to distribute profits, the government issues taxes to ensure that dividends decision to a non-investment company will have a negative impact. Companies retaining profits have a higher stock rating which is good for shareholders but because the capital gains tax is lower than the dividend tax, the tax decreases and this is not good for the government. When additional taxes are added to the company's retained earnings, the company is convinced by tax officers to pay more or not to pay tax or pay dividends from the company. The government can then attempt to raise funds from shareholders. For a company to avoid this tax, it must prove that the retained earnings do not exceed the reasonable business requirement limits. Companies do not tax accumulated income because the income of these companies is taxable to shareholders and investors in spite of whether the company is distributed.