Equity and Retained Earnings might be confusing terms for those unfamiliar with accounting, but it is easy to break them down to be easily understood by all. The most common definition of equity for most laypeople is the amount of their home that they own. In other words, the portion of their mortgage that has been paid off is equity.
So if their house is appraised at $400,000 and they owe $300,000 on their mortgage, they have $100,000 of equity in their home. That equity can become negative if the value of their home drops below that $300,000 mortgage. For instance a drop in appraisal of their house to $250,000 would leave them with a negative equity of $50,000. This can cause many problems, the biggest being the inability to sell that house until the market recovers.
Retained Earnings Is the Accumulation of Profit and Loss
Retained Earnings (RE) is handled the same way. A new business starts with no RE, since they haven't made anything yet. At the end of its first year, the company's Income Statement will either show a profit or loss. That amount will become Retained Earnings on the first day of the new fiscal year. Fiscal is used, since some companies do not use a calendar year for their finances. The major reason for using a fiscal year is to make filing taxes easier and quicker.
So if the company's fiscal year ends on September 30th, the profit or loss will convert to RE on October 1st. As an example, let's say the company had a profit of $20,000 in year one. It would start the second year of business with an RE of $20,000. After another year of business, the company ends its second year with a loss of $30,000.
Negative Equity Is the Result of Investment Less Loss
That loss is netted against the previous year's income, leaving a negative RE of $10,000. Again, accounting uses basic math: 20,000 income less 30,000 loss equals negative 10,000 Retained Earnings (20,000 - 30,000 = -10,000). To further illustrate this example, if after the third year of business, the company gets hit with another loss of $30,000, the RE would increase to a negative $40,000 (-10,000 - 30,000 = -40,000).
This company would require a profit of at least $40,000 to get its Retained Earnings back to a positive number (or zero). Since Equity is the total of investment and RE, the company's equity could still be positive if the initial investment (owner or stock funded) is higher than the accumulated loss (RE).
Retained Earnings Broken Down to its Basics
The simplest definition of Retained Earnings is that it is a plug figure from the Income Statement to keep the accounting equation in balance. It is the best way of merging the Income Statement to the Balance Sheet at year end. If Retained Earnings didn't exist, there would be no other way to account for the profit or loss of previous years on the Balance Statement.
Judith Lee - Judith has been a writer for over two decades. She is also a blogger and book/movie reviewer.
