A company's retained earnings are displayed as a line item on a balance sheet. The item represents income that a company decides to save. If a business instead decides to distribute those profits, retained earnings decrease. Once the income is earned, a company decides whether to distribute the proceeds to investors in the form of a dividend, or retain the money to reinvest in the company's ongoing operations.
For a company to have any earnings to use, its income must be higher than any financial obligations. When income is greater, a company is left with a choice on how to use the proceeds. If the management team decides to use the profits for cash dividends, the income is deducted from the retained earnings and directed to the cash line item on a balance sheet for accounting purposes. Common stock dividends are deducted from retained earnings, but credited to the stock column on a balance sheet.
Companies are taxed for profits earned. The tax rules vary depending on the way that a corporation is structured and the region in which the business is located. In 2011, Taiwan-based electronics giant Hon Hai Precision, which makes mainstream mobile devices used around the world, suffered a steep decline in profits in its second quarter. The company blamed taxes that were applied to its retained earnings. The taxes would not have been as severe if the company instead opted to pay dividends to investors.
The concept behind dividend distributions is to reward investors with income when there is no more compelling option. Otherwise, corporate management attempts to create additional value for investors on its own. Berkshire Hathaway, which is run by Warren Buffett, has not directed retained earnings toward investor dividends in more than 40 years. If Buffett were ever to agree to pay dividends, it could indicate the business had stopped expanding.
In the U.S., corporate dividends are essentially taxed twice. Corporations are taxed on profits and investors are taxed on dividends. A dividend tax can be prevented if a company opts to hold onto profits as part of retained earnings and gain access to capital in other ways. An unintended consequence of allowing retained earnings to escalate is that investors could become restless and decide to instead direct assets toward companies that are using capital to promote expansion.
- American Institute of Professional Bookkeepers: Why Owners Love Their Retained Earnings Account - How To Handle It
- "The Wall Street Journal;" Hon Hai Precision Second-quarter Net Profit Falls 23% On Higher Taxes; Lorraine Luk; August 2011
- BalancedPolitics.org: Should The Individual Tax On Dividends Be Eliminated?
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