Retained earnings explained: where your company's profit lives.

If you own a corporation, there's a line on your balance sheet called retained earnings. It's often the biggest number in the equity section, and most owners have no idea where it comes from. With retained earnings explained in plain terms, you'll know what it means, how dividends affect it, and why your accountant cares so much that it matches last year's financial statements.

This guide uses a three-year worked example, shows the journal entries behind it, and covers the QuickBooks Online mistakes we see when we take over books for small corporations around Edmonton.

1What retained earnings actually are

Every year, a corporation earns a profit or a loss. That result doesn't vanish when the year ends. It gets added to a running total in equity called retained earnings. When the corporation pays a dividend to its shareholders, the dividend comes out of that total.

• Profit increases retained earnings.
• A loss reduces it.
• Dividends reduce it.
• Salary paid to you doesn't touch it directly. Salary is an expense, so it reduces profit before profit reaches retained earnings.

Retained earnings sit alongside share capital (what shareholders paid for their shares, often as little as $1 or $100 in a small corporation). Together they make up the corporation's equity. For the bigger picture of where equity sits, see how to read a balance sheet.

2Retained earnings explained with a three-year example

Say you incorporate a consulting business. The figures below are hypothetical.

In year 1 you kept everything in the company, so retained earnings equal the year's profit. In year 2 you earned $45,000 and paid yourself a $20,000 dividend, so retained earnings grew by $25,000. In year 3 the business lost $10,000, and you still took a $15,000 dividend, paid out of profit kept from earlier years. Retained earnings fell back to $30,000.

Notice what this tells you: across three years, the business earned $65,000 in total and paid out $35,000. The $30,000 left is the profit still inside the company, whether it's in the bank, in equipment, or owed by customers.

3The journal entries behind retained earnings

Closing the year

At year-end, income and expense accounts are "closed" to retained earnings, so next year starts at zero. For year 2, with $180,000 of revenue and $135,000 of expenses, the closing entry looks like this:

QuickBooks Online doesn't make you post this. It does the closing automatically behind the scenes on the first day of your new fiscal year: the prior year's net income simply rolls into retained earnings on the balance sheet.

Declaring and paying a dividend

The $20,000 dividend in year 2 takes two steps when the declaration and payment happen on different days:

Many small corporations declare a dividend at year-end to clear what the owner has drawn during the year. In that case the credit goes to the shareholder loan account instead of chequing. Either way, the dividend is never an expense. It doesn't reduce profit or corporate tax.

4Why retained earnings aren't cash

This is the misunderstanding that causes the most trouble. Say your retained earnings are $55,000 but the bank has $12,000. Where did the rest go? Some common places:

• Equipment or a vehicle the company bought
• Loan principal paid down
• Customer invoices not yet collected
• Money you took out that's sitting in the shareholder loan account

That's why you can't decide on a dividend by looking at retained earnings alone. You need the cash too. The cash flow statement shows exactly where the gap came from.

5When retained earnings go negative

If a corporation's losses and dividends add up to more than its profits, retained earnings turn negative. Accountants call that a deficit. It's common in a company's first year or two, especially if it had startup costs, and it isn't automatically a problem.

What a deficit does tell you:

• There's no accumulated profit to pay dividends from. Paying a dividend while in a deficit needs a hard look from your accountant first.
• Losses may be useful later. A corporation's non-capital losses can often be carried to other years to reduce taxable income. Your accountant tracks those on the tax return, separately from the books.
• Lenders will notice. A deficit funded by a shareholder loan the company owes you reads very differently from a deficit funded by bank debt.

Your year-end financial statements usually include a short statement of retained earnings: opening balance, plus net income or minus a loss, minus dividends, equals closing balance. It's the three-year table above, one row at a time. Read it every year alongside the balance sheet.

6Common retained earnings mistakes

• Posting transactions directly to retained earnings. Expenses or deposits coded straight to retained earnings skip the P&L, so your profit is wrong and CRA never sees them as income or expenses.
• Editing a year that's already filed. Change a transaction from last year and last year's profit changes, so this year's opening retained earnings no longer match the T2 your accountant filed.
• Not posting the accountant's year-end adjustments. If your CPA adjusts amortization, accruals or tax, those entries need to be in your books too.
• Recording dividends as an expense. It makes profit look lower and confuses the tax return.
• Leaving opening balance equity in place. Amounts that belong in retained earnings sometimes get stranded in opening balance equity during setup.
• Declaring dividends larger than retained earnings without advice. That can create a deficit and legal questions.

7Retained earnings in QuickBooks Online

QuickBooks Online creates a Retained Earnings account automatically. On the balance sheet you'll see it above a separate Net Income line for the current year. When your new fiscal year starts, the Net Income figure moves into Retained Earnings without any entry from you.

To protect it:

• Check your fiscal year under Settings, Account and settings, Advanced. If it's wrong, net income rolls over on the wrong date.
• Close the books after your accountant files. In the same Advanced settings, turn on "Close the books" with a closing date and password, so nobody edits a filed year by accident.
• Tie it out every year. Opening retained earnings in QuickBooks should match closing retained earnings on last year's financial statements.

8Canadian rules worth knowing

Retained earnings are a corporation concept. Corporations file a T2 return each year with balance sheet and income statement information, and retained earnings is a key line in that balance sheet information. CRA's view of your opening retained earnings is whatever was on last year's filing, which is why tying out matters.

Sole proprietors don't have retained earnings. Profit is taxed to you personally on the T2125 each year, and your equity is tracked through capital and owner draws. If you're deciding how to take money from a corporation, our guide to salary vs dividends in Alberta covers the trade-offs.

9Year-end retained earnings check

If your retained earnings don't match last year's financial statements, Plum can trace the difference and fix it before your next year-end. We work with small corporations in Edmonton, Sherwood Park, St. Albert and Spruce Grove. Book a call to get started.

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This article is general information for Alberta businesses and isn't tax or legal advice. Rules and thresholds change, so confirm your situation with your accountant or CRA.