Accumulated Earnings

What are Accumulated Earnings?

Accumulated earnings, also known as undistributed profits or income reserve, are profits that are not distributed to the shareholders as cash dividends and are added Add Newto the retained earnings of the firm.

What Does Accumulated Earnings Mean?

What is the definition of accumulated earnings? The accumulated earnings of a firm are profits generated, but not distributed to the shareholders as cash dividends or as corporate profit taxes. Instead, they are retained to be reinvested in a new business opportunity, to increase inventory levels, to lower long-term debt or to increase cash reserves.

On a personal level, the accumulated earnings are the undistributed corporate profits that an individual has earned without having received. Therefore, they fall into the IEBNR category of “income earned but not received” and are deducted from national income to derive the personal income.

How Do Accumulated Earnings Work?

Let’s look at an example to illustrate:

Assume Company XYZ has been in business for five years, and it has reported the following annual net income:

  • Year 1: $10,000
  • Year 2: $5,000
  • Year 3: -$5,000
  • Year 4: $1,000
  • Year 5: -$3,000

Assuming Company XYZ paid no dividends during this time, XYZ’s accumulated earnings are the sum of its net income since inception: $10,000 + $5,000 – $5,000 + $1,000 – $3,000 = $8,000.

In subsequent years, XYZ’s accumulated earnings will change by the amount of each year’s net profit, less dividends.

The statement of accumulated earnings summarizes changes in accumulated earnings for a fiscal period, and total accumulated earnings appears in the shareholders’ equity portion of the balance sheet. This means that every dollar of accumulated earnings is essentially another dollar added to shareholders’ equity.

A company’s board of directors may “appropriate” some or all of the company’s accumulated earnings when it wants to restrict dividend distributions to shareholders. Appropriations are usually done at the board’s discretion, although bondholders may contractually require the board to do so. Appropriations appear as a special account in the accumulated earnings section. When an appropriation is no longer needed, it is transferred back to accumulated earnings. Because accumulated earnings are not cash, a company may fund appropriations by setting aside cash or marketable securities for the projects indicated in the appropriation.

Why Do Accumulated Earnings Matter?

It is important to understand that accumulated earnings do not represent extra cash or cash left over after the payment of dividends. Rather, accumulated earnings demonstrate what a company did with its profits; they are the amount of profit the company has reinvested in the business since its inception. These reinvestments are either asset purchases or liability reductions.

Accumulated earnings somewhat reflect a company’s dividend policy, because it reflects a company’s decision to either reinvest profits or pay them out to shareholders. Ultimately, most analyses of accumulated earnings focuses on evaluating which action generated or would generate the highest return for the shareholders.

Most of these analyses involve comparing accumulated earnings per share to profit per share over a specific period, or they compare the amount of accumulated earnings to the change in share price during that time. Both of these methods attempt to measure the return management generated on the profits it plowed back into the business. Look-through earnings, a method developed by Warren Buffett that accounts for taxes, is another method in this vein.

Capital-intensive industries and growing industries tend to retain more of their earnings than other industries because they require more asset investment just to operate. Also, because accumulated earnings represents the sum of profits less dividends since inception, older companies may report significantly higher accumulated earnings than identical younger ones. This is why comparison of accumulated earnings is difficult but generally most meaningful among companies of the same age and within the same industry, and the definition of “high” or “low” accumulated earnings should be made within this context.

Summary Definition

Define Accumulated Earnings: Accumulated earnings are the profits a company does not distribute to its owners and accrues year over year in the retained earnings account.

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