Retained Earnings
‘Retained earnings’ is the reserve account for retained profits.
The retained earnings represent profits after tax earned by the company over its history and not distributed by way of dividend or appropriated to another reserve. It generally increases from year to year as most companies do not distribute all of their profits.
Statement of Changes in Equity
For company accounts, profit for the year is not carried over directly from the Profit and Loss Account to the bottom half of the Balance Sheet. Instead, it is carried over into a separate calculation, the Statement of Changes in Equity (the ‘SoCiE’).
Dividends
Dividends are paid or payable out of profits generated in the current or previous accounting periods. Any company can make a distribution (e.g. a dividend) provided that it has ‘profits available for the purpose’ (s.830(1) CA 2006). It is only after the financial statements have been completed that the profits generated in a given accounting period can finally be determined.
In ALCIE terminology, dividends are recorded in a capital account as they are transactions between the business and its owner(s). For this reason, dividends do not belong on a Profit and Loss account. When a company declares a dividend, this will show up in the SoCiE.
Ordinary Shares
There are two types of dividend that can be paid on ordinary shares; a final or an interim dividend. Both are calculated in exactly the same way, the only difference between the two being that:
- the final dividend is declared after the year end and paid some time thereafter; and
- the interim dividend is paid during, and in respect of, the current accounting period.
Final dividend
The size of the final dividend is declared by the company’s directors in the Directors’ Report, and approved by the company’s shareholders by ordinary resolution, typically passed at the Annual General Meeting (AGM) if the company has one.
If the directors have recommended a final dividend, but the shareholders have not yet approved it, the dividend is called a proposed dividend. A proposed dividend does not constitute a debt enforceable by the relevant shareholders until it is approved i.e. declared by an ordinary resolution of the shareholders. Therefore, any final dividend which is proposed but which has not been approved will not appear in the accounts of that accounting period.
Example:
A company with an accounting period of a year ending on 31 December 2020 wishes to pay a final dividend in respect of that accounting period. The directors of the company tell you that the final dividend will be approved by an ordinary resolution of the shareholders at a general meeting which is due to take place in March 2021. If the final dividend is declared by ordinary resolution at the general meeting, it will appear in the accounts for the period ending 31 December 2021.
A final dividend that has been approved by the shareholders is called a declared dividend. A declared dividend constitutes a debt of the company enforceable by the relevant shareholders. A declared dividend will be taken into account in the SoCiE, as a deduction in calculating the Retained Earnings (profit and loss carried forward) which will appear in the bottom half of the Balance Sheet.
If the declared dividend has not yet been paid to shareholders by the time the accounts for that year have been prepared, it will appear in the Balance Sheet at the end of the year in which it was declared (as part of ‘current liabilities’). It will also be taken into account in the SoCiE at that year-end.
A declared dividend which has been paid to shareholders before that year end will only be taken into account in the SoCiE.
Interim dividend
The articles of a company normally give the directors the power to decide to pay interim dividends. Interim dividends can therefore be paid without the need for an ordinary resolution of the shareholders. Any board resolution to pay an interim dividend may be rescinded before the interim dividend is paid, so an unpaid interim dividend is not a debt that the shareholders are legally entitled to sue upon.
For this reason, the accounting treatment of interim dividends is different to the treatment of final dividends. Interim dividends will only be reflected in a company’s accounts if they have actually been paid. When an interim dividend has been paid in any year the amount of the dividend will have been deducted from the assets, i.e. cash and cash equivalents, and will be shown as an item on the trial balance. A dividend is an allocation of profit and not an expense of the company so it will not be shown in the Profit and Loss Account. The interim dividend will be taken into account in the SoCiE (in this respect, interim dividends are treated the same as declared (and paid) dividends).
Any profits after tax not paid to shareholders as dividends are retained in the company.
Preference shares
Preference dividends are usually paid in two instalments each year. Because of the nature of preference shares, the amount of the dividend will already be known each year.
Example:
A company which has issued 200,000 non-redeemable non-cumulative 6% preference shares of £1 each pays an annual dividend of 6 pence on each preference share (subject to there being sufficient profits to do so). If part of that dividend has already been paid to preference shareholders as an interim dividend in any year, that part will not appear on the top half of the company’s Balance Sheet for the relevant year. However, it will appear as a deduction in the SoCiE to calculate the Retained Earnings in the bottom half of the Balance Sheet. The remainder of the preference dividend is declared by the shareholders, and though paid after the year end, will appear in the SoCiE to calculate retained earnings and be shown as a Current liability in the top half of the Balance Sheet.
Legal treatment of dividends for ordinary shares
It is important to understand the differences between the legal and accounting treatment of dividends, based on the type of dividend and its status. These are summarised in the table below
| Legal treatment | Accounting treatment | |
| Final dividend – proposed | Not a legal debt, cannot be enforced by shareholders. | Dividend does not appear in the company accounts. |
| Final dividend – declared, but not paid | Legal debt enforceable by shareholders. | Dividend will be taken into account in the SoCiE at the end of the accounting period in which it is declared. In the unlikely event that the dividend has been declared but not paid as at the date of the Balance Sheet, it will also appear in the Balance Sheet as part of ‘Current liabilities’. |
| Final dividend – declared and paid | Legal debt enforceable by shareholders. | The assets of the company will have been reduced by the amount of the dividend and the dividend will feature as an item in the trial balance. The dividend will be taken into account in the SoCiE at the end of the accounting period in which it is declared and will impact on the Retained Earnings (profit and loss carried forward) in the Balance Sheet. |
| Interim dividend – declared and paid | The interim dividend becomes a legal debt once it has been paid to the shareholders. | The assets of the company will have been reduced by the amount of the dividend and the dividend will feature as an item in the trial balance. The dividend will be taken into account in the SoCiE at the end of the accounting period in which it is paid and will impact on the Retained Earnings (profit and loss carried forward) in the Balance Sheet. |