To record retained earnings with journal entries, you close the period’s revenue, expense, and dividend accounts into Retained Earnings through an Income Summary account, using a fixed three-step sequence of debits and credits. Done correctly, the ledger balance in Retained Earnings will equal beginning retained earnings plus net income (or minus a net loss), minus dividends declared. If it doesn’t, something went wrong during the period and needs to be traced before the books close.
The entries themselves are mechanical. Getting them right depends on knowing which accounts feed which, in what order, and how dividends, treasury stock reissuances, and prior period errors change what you post.
The Formula the Entries Have to Produce
Every closing entry exists to move a temporary account balance into Retained Earnings so that the ending balance satisfies this equation:
Ending Retained Earnings = Beginning Retained Earnings + Net Income (or − Net Loss) − Dividends Declared
Three figures feed in, and each comes from a specific place:
- Beginning retained earnings sits in the shareholders’ equity section of the prior period’s balance sheet.
- Net income or net loss is the bottom line of the current period’s income statement.
- Dividends declared is the total the board authorized during the period, found in the general ledger’s dividends account and matched to board minutes.
Use dividends declared, not dividends paid. A dividend reduces retained earnings on the declaration date, not the payment date. If the board declares a dividend in December but doesn’t mail checks until January, it still hits the current year’s calculation.
The Three Closing Entries
At period-end, temporary accounts (revenue, expenses, dividends) need to be zeroed so they’re ready for the next cycle. Most companies route revenue and expenses through an intermediate account called Income Summary before transferring the net result to Retained Earnings.
Entry 1: Close Revenues and Expenses to Income Summary
Revenue accounts carry credit balances. To zero them out, debit each revenue account and credit Income Summary for the total.
Expense accounts carry debit balances. To zero them out, credit each expense account and debit Income Summary for the total.
Once both postings are done, Income Summary holds a credit balance equal to net income, or a debit balance equal to net loss.
Entry 2: Close Income Summary to Retained Earnings
If the company earned a profit, Income Summary has a credit balance. Debit Income Summary and credit Retained Earnings for the same amount. Retained earnings goes up.
If the company posted a net loss, reverse the entry. Debit Retained Earnings and credit Income Summary. Retained earnings goes down.
Entry 3: Close the Dividends Account to Retained Earnings
The dividends account carries a debit balance because it reduces equity. To close it, debit Retained Earnings and credit the Dividends account for the total declared during the period. Retained earnings takes the reduction, and the dividends account resets to zero.
After all three entries post, every temporary account is at zero, and the Retained Earnings ledger balance should equal the figure the formula produces. If cumulative losses exceed cumulative profits, the balance is negative, called a retained earnings deficit, and it appears as a reduction in total shareholders’ equity.
Recording Dividends by Type
The dividends account closes the same way regardless of dividend type, but what you post into it at declaration depends on the form of the distribution.
Cash Dividends
On the declaration date, debit Retained Earnings (or a Dividends Declared account that later closes to Retained Earnings) and credit Dividends Payable. When the cash goes out, debit Dividends Payable and credit Cash. The retained earnings impact happens entirely at declaration.
Stock Dividends
Stock dividends distribute additional shares instead of cash. They still reduce retained earnings, but the amount depends on the size of the distribution. Under GAAP, the dividing line is roughly 20 to 25 percent of previously outstanding shares.
A distribution below that threshold is a small stock dividend, recorded at the shares’ market value. A distribution above that threshold is treated more like a stock split and recorded at par value. The dollar hit to retained earnings is much larger for a small stock dividend.
If a company with stock trading at $50 per share issues a small stock dividend of 1,000 shares with a $1 par value, retained earnings drops by $50,000. If the same company issues a large stock dividend, retained earnings only drops by $1,000, with the rest going to additional paid-in capital. Neither type changes total shareholders’ equity; both shift amounts between equity accounts.
Property Dividends
When a company distributes non-cash assets, the dividend is measured at the fair value of the property. If the asset’s carrying value differs from its fair value, the company first recognizes a gain or loss on the disposition, then records the dividend. The retained earnings reduction equals fair value, not book value. Distributions that are part of a spinoff or corporate reorganization are typically recorded at existing book value instead.
Treasury Stock Reissued Below Cost
Buying back treasury stock doesn’t directly reduce retained earnings. But retained earnings can take a hit when the company resells that treasury stock below what it originally paid.
Under the cost method, if treasury shares are reissued at a price below the repurchase cost, the shortfall first reduces any balance in the Paid-in Capital from Treasury Stock account. If that account doesn’t have enough to absorb the difference, the remainder is debited to Retained Earnings.
Repurchasing shares at $40 and reissuing them at $30 creates a $10-per-share deficit that has to land somewhere. When paid-in capital from prior treasury stock transactions can’t absorb it, retained earnings shrinks. The reverse doesn’t apply. Reissuing treasury stock above cost credits Paid-in Capital from Treasury Stock, never Retained Earnings, because the transaction isn’t treated as generating income.
Correcting Prior Period Errors
When a material error from a prior year surfaces, the correction does not run through the current period’s income statement. It goes directly to the opening balance of retained earnings for the earliest period presented in the comparative financial statements.
The mechanics: adjust the carrying amounts of the affected assets and liabilities as of the beginning of the earliest period shown, with a corresponding adjustment to opening retained earnings. If comparative statements are presented, each prior period column gets restated and labeled “As Restated.” The company must also disclose the nature of the error, its effect on each financial statement line item, and the cumulative effect on retained earnings.
Even immaterial errors can require this treatment if correcting them in the current period would materially distort current-period results. The question is whether leaving the error alone would mislead someone reading the statements.
Presenting the Ending Balance
Retained earnings appears in the shareholders’ equity section of the balance sheet, typically listed after common stock and additional paid-in capital. A separate Statement of Retained Earnings reconciles the beginning balance to the ending balance, showing each component on its own line: beginning balance, net income or loss, dividends declared, prior period adjustments, and the ending balance.
Appropriated Retained Earnings
Companies sometimes set aside a portion of retained earnings for a specific purpose, such as covering potential litigation losses or meeting a contractual obligation. This carve-out is called an appropriation. It doesn’t move cash and doesn’t change total retained earnings. It reclassifies part of the balance from unappropriated to appropriated, signaling that those funds aren’t available for dividends.
SEC rules under Regulation S-X require public companies to show appropriated and unappropriated retained earnings as separate line items within shareholders’ equity. Companies cannot charge costs or losses directly against an appropriated balance, and they cannot transfer any part of it to income. When the restriction ends, the appropriated amount is reclassified back to unappropriated retained earnings.
What Doesn’t Go Through Retained Earnings
Certain unrealized gains and losses bypass the income statement entirely and accumulate in a separate equity account called Accumulated Other Comprehensive Income. This includes items like unrealized gains or losses on certain investment securities and remeasurement adjustments for defined benefit pension plans. These sit in their own equity bucket, not in retained earnings, even though both represent accumulated results over time. When you close the books, none of these amounts run through your closing entries into Retained Earnings.