After companies deduct the costs of business from sales revenue, retained earnings represent the remaining funds on financial statements. However, those earnings do not necessarily go straight to shareholders. This is because earnings themselves are sometimes slated for specific purposes, such as reinvestment into business projects. In such cases these earnings are designated as appropriated or restricted retained earnings; in other instances, earnings are considered unappropriated.
Earnings
Since unappropriated earnings have no designated business use, they become available to business owners. What unappropriated earnings numbers do not specify, however, are circumstances surrounding the earnings. In order to comply with accounting rules, businesses must include specifics on relevant information that affects earnings, in the form of notes on corporate documents. For example, if a small business experiences reduced retained earnings because it changes its accounting method, this should be noted within company reports.
Shareholders
Unappropriated earnings can be distributed to common shareholders if no restrictions are in place. If money is due to different classes of shareholders, and in accordance with those shareholders' rights, they have a priority over common shareholders. In such cases, unappropriated retained earnings are restricted. Moreover, when business earnings are not appropriated, but dividend obligations to parties other than common shareholders exist, the earnings are restricted.
Dividends
If unappropriated retained earnings are to be distributed to common shareholders, they are called dividends. Dividend distributions are paid out of unappropriated retained earnings. These dividends typically take the form of cash disbursements, but can also be additional shares, in which case they are defined as stock dividends. If those dividends are from U.S. businesses, they are qualified to be treated as capital gains rather than income by shareholders.
The whole point of financial statements is to satisfy the information needs of users. Stockholders are a major group of users, and it would be reasonable to expect that they would want to know if part of the retained earnings account will not be available for dividend payouts.
The board of directors has the power to designate part of retained earnings for a specific purpose. This is called appropriation. It has no real meaning to managers and other entity decision makers - it is merely used as a communication tool to let stockholders know about an internal restriction on a portion of retained earnings. It also has no real meaning in the case of an event such as bankruptcy. Appropriated retained earnings are not legally restricted, and so creditors and stockholders have full access to the funds.
The accounting procedure is simple - once the board of directors votes to appropriate a certain amount of retained earnings, the following journal entry would be made. Let’s assume that the board is setting aside funds to purchase a building next year.
Account Names
|
Debits
|
Credits
|
Unappropriated Retained Earnings
|
2,000,000
| |
Appropriated Retained Earnings – Building Purchase
|
2,000,000
|
OR
Account Names
|
Debits
|
Credits
|
Retained Earnings
|
2,000,000
| |
Reserve for Building Purchase
|
2,000,000
|
Informative
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