Retained earnings is the amount earned through profitable operations of corporations and that is kept in the corporation. It represents the amount of the assets that are generated through profitable operations of corporations and are not distributed to the shareholders in the form of dividend. 

To understand the retained earnings account, recall the closing process at the end of the accounting period. A corporation closes its revenue accounts and expense accounts. To close all the revenue accounts, they should be debited while Income Summary account is credited with the total amount of the revenues. Thus, the total amount of revenues for an accounting period could be seen on the credit side of the Income Summary account. Contrarily, to close all the expense accounts they should be credited while the Income Summary account is debited with the total amount of the expenses. Thus, the total amount of expenses for an accounting period could be seen on the debit side of the Income Summary account. In the end, the financial result of the corporation (net income or net loss) for a specific accounting period could be seen on the balance of the Income Summary account. The balance of the Income Summary account is close to the Retained Earnings account. Thus, it means a net income increases the retained earnings but net loss decreases the retained earnings. 

If there is a debit balance in Retained Earnings, this is called a deficit (debit balance) in Retained Earnings. A deficit is shown in the shareholder’s equity part of the balance sheet as a deduction from contributed capital.

A dividend is a distribution of some portion of earnings to the shareholders by a corporation. Profitable corporations may make distributions to their shareholders in the form of dividends. Dividends are distributions of cash, other property, or share of the business to the shareholders of a corporation on a pro rata (proportional to ownership) basis. In other words, a dividend is a distribution of some portion of earnings to the shareholders by a corporation. 

A cash dividend is a cash distribution of earnings by a corporation to its shareholders. Although dividends may be paid in other assets or properties, cash dividends are the most common types of dividends. If a corporation wants to pay cash dividends, three conditions required are as follows:

1. Sufficient retained earnings

2. Adequate cash

3. Declared dividends by the board of directors. 

The legality of a cash dividend depends on the laws of the country in which the company is incorporated.

If a corporation has already issued both common and preferred shares, the shareholders who have preferred shares should receive dividends at first. After the preferred shareholders receive cash dividends, the common shareholders may receive cash if there is still any remaining amount from the total amount of dividends. Because preferred shares have some priorities over the common shares.

If a corporation cannot pay any dividends, the preferred share is called dividend in arrears.

A cumulative preferred share is a preferred share that can also receive all dividends in arrears while receiving a new preferred dividend.

The second popular way to distributing dividends to the shareholders is to share dividends. In this case, the distributed item is different than cash dividends. Share dividend is a distribution of a corporation’s own shares to the shareholders as dividends. It must be an effective alternative to conserve cash while continuing to distribute a dividend to the shareholders and reward them. Besides distributions of share, dividends may provide some advantages by reducing the market price of shares.

After the decision of paying share dividends, similar to the cash dividends distributions, three dates are important for a corporation. These are: Declaration date, Record date and Distribution date. At first, on the declaration date, the corporation has declared its intention to distribute its shares. A journal entry is required to show the change between shareholders’ equity items. Secondly, the corporation determines the shareholders who receive share dividends separately on the record date. In this case, a new journal entry is not required. Because this determination has no financial effect. Finally, the corporation distributes the dividend that is determined to the shareholders on the distribution date and a new journal entry should be prepared. Briefly, on the declaration date and distribution date journal entries are required in the process of accounting for cash dividends.

Th e recording process for the transactions about the distribution of share dividends is based on the number of dividends. According to the size of the dividends, share dividends transactions are usually divided into two groups:

• Small share dividends: These are the dividends which are less than 20%–25% of the corporation’s issued shares. To record small share dividends fair market value should be used. Th is practice is based on the assumption that a small share dividend will have little effect on the market price of the shares previously outstanding.

• Large share dividends: These are the dividends which are greater than 20%–25% of the corporation’s issued shares. These types of dividends are rare. But, if a corporation decides on a large share dividend, par value or stated value should be used to record related transactions instead of market value because of the possible important effect of this transaction on the market price of the shares

A share split is increasing the number of issued and outstanding shares of a corporation that results in decreasing of shares’ par value. share splits have no financial effect on any account balance. Thus no classical journal entry is required. It should be recorded in a memorandum entry that represents a note without any balance.

In a share split the par value per share is decreasing in the determined proportion. But recall that in a share dividend the par value per share doesn’t change.

A restriction on retained earnings is an amount of retained earnings that is unavailable for dividends.

To reserve cash or to be conservative about possible risks or some specific reasons such as loan agreements, to distribute the regular amount of dividends etc. there may be some restrictions on retained earnings. Thus, some amount of retained earnings may be defined as restricted retained earnings. Restricted retained earnings amount presents the amount of that is unavailable for distribution to the shareholders. In other words, restricted retained earnings show a reduction from a possible amount of dividends. On the footnotes of the financial statements, all of the details should be explained clearly. 

Usually, the restrictions may occur in three different types: Legal restrictions, contractual restrictions, and voluntary restrictions.

Because of some transactions that have been already discussed until this part of the chapter, shareholders’ equity may change over time. For shareholders, it is very important to understand the changes in shareholders’ equity to decide on their investment plans. Besides, these changes are important for other financial statement users to analyze the financial strength, performance, and position of the corporation. Hence, the requirements for the information about the change in the shareholders’ equity could be changed according to different parties. For this reason, on the balance sheet, the most basic and general information should be represented as a summary. Then on the footnotes of the balance sheet, the financial statement users who need some more information can find many details about different items of the balance sheet.

Because of the importance of the information about the changes in shareholders’ equity especially for the investors, another specific financial statement named Statement of Shareholder’s Equity is prepared by the corporations. Corporations prepare the statement of equity to provide more information about the change in the shareholders’ equity. This statement starts with the beginning balances of different components of Shareholders’ Equity, and additions and subtractions.

Comprehensive income components are as follows:

• Unrealized gains or losses

• Foreign-currency translation adjustments

• Gains (losses) from post-retirement benefit plans

• Deferred gains (losses) derivatives.

One of the ratios that is used for analysis is the Return on Equity (ROE). It measures a corporation’s profitability by presenting how much profit it generates with each item (TL) of shareholders’ equity.

Earnings Per Share presents how much income is earned by a corporation for each common share.

Another ratio that may be considered is book value per share. This ratio is used to calculate the per share value of a corporation. In other words, it represents the amount of the owner’s equity on the corporation’s books for each common share. Some investors want to have shares whose market price is below book value.