To roll retained earnings, take the prior period’s ending balance, add current-period net income (or subtract a net loss), subtract any dividends declared, and post closing journal entries that move revenue, expense, and dividend account balances into the retained earnings account. The formula is Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings. The mechanics are simple; the care goes into pulling the right inputs, handling adjustments, and tying the result back to the tax return.
The Three Inputs You Need
Every roll depends on three figures.
Beginning retained earnings. Pull this from the prior period’s balance sheet, under shareholders’ equity. It represents cumulative profits kept since inception, less every distribution ever paid out.
Net income or loss. This comes off the current period’s income statement, the single bottom-line figure after all revenue and expenses.
Dividends declared. Check the general ledger and board minutes for the period. Corporate bylaws typically dictate how and when dividends are declared, and every declared dollar has to be captured. If a distribution is missing from your records, ending retained earnings will overstate equity.
Add net income to the beginning balance (or subtract a loss), then subtract dividends. The result is your ending retained earnings, which becomes next period’s opening balance and lands on the balance sheet under shareholders’ equity.
Recording the Closing Entries
The roll itself happens through closing journal entries at period-end. These entries sweep temporary account balances into the permanent retained earnings account. Most companies route the flow through an income summary account:
- Close revenue accounts. Debit each revenue account for its balance and credit income summary. Revenue accounts now sit at zero.
- Close expense accounts. Credit each expense account for its balance and debit income summary. Expense accounts now sit at zero.
- Transfer net income or loss. If income summary carries a credit balance (profit), debit income summary and credit retained earnings. If it carries a debit balance (loss), debit retained earnings and credit income summary.
- Close dividends. Credit the dividends account for its balance and debit retained earnings for the same amount.
After the entries post, every temporary account sits at zero and retained earnings reflects the updated cumulative total. Modern accounting software automates the sequence through a year-end close function, but the logic is identical whether you run it manually or electronically.
Before sealing the books, run a post-closing trial balance. It should show every temporary account at zero and the balance sheet in balance. This is where missed dividend entries, revenue accounts left out of the close, and misposted prior-period adjustments tend to surface. Catching them here is far easier than reversing them next period.
Adjustments That Change the Roll
Prior-Period Error Corrections
If last year’s numbers were wrong, the correction doesn’t flow through this year’s net income. Under U.S. accounting standards, you restate the prior-period statements and adjust the opening balance of retained earnings for the earliest period presented. The cumulative effect on periods before those presented is reflected in the carrying amounts of assets and liabilities at the start of the first period shown, with the offsetting entry to opening retained earnings.
For the roll, this means your beginning retained earnings figure may shift after a restatement. If you find a prior-year error while closing the current year, fix the opening balance before you add net income and subtract dividends. Skipping this step carries the old error forward indefinitely.
Stock Dividends
Cash dividends are the simple case: the board declares a dollar amount, and that total comes out of retained earnings. Stock dividends reduce retained earnings too, but the measurement differs by size:
- Small stock dividends, under about 20–25% of shares outstanding, are recorded at the fair market value of the new shares on the declaration date. Retained earnings drops by that market value.
- Large stock dividends, 20–25% or more, are recorded at par or stated value. Retained earnings drops by only the par value, which is usually much smaller.
If the company declared stock dividends during the period, confirm which measurement applies before finalizing the roll. Using the wrong basis misstates ending equity.
Tying the Ending Balance to the Tax Return
C corporations filing Form 1120 must complete Schedule M-2, “Analysis of Unappropriated Retained Earnings per Books,” unless total receipts and total assets at year-end are both below $250,000.1Internal Revenue Service. Instructions for Form 1120 (2025) Schedule M-2 walks the same logic as the retained earnings formula:
- Line 1: Balance at beginning of year
- Line 2: Net income (loss) per books
- Line 3: Other increases
- Line 5: Distributions (cash, stock, or property)
- Line 6: Other decreases
- Line 8: Balance at end of year
Line 8 must tie to Line 25 on Schedule L, the balance sheet section of the return.2Internal Revenue Service. U.S. Corporation Income Tax Return (Form 1120) When the two don’t match, the usual causes are dividends recorded in the ledger but omitted from the return, book-tax differences that weren’t tracked, or prior-period adjustments that changed the opening balance without an update to Schedule M-2.
S corporations use a different version of the schedule on Form 1120-S. Column (c) of the S corporation Schedule M-2 tracks accumulated earnings and profits, which exist only if the company was previously a C corporation or picked up C corporation earnings through a reorganization.3Internal Revenue Service. Instructions for Form 1120-S An S corporation with leftover accumulated earnings and profits can be liable for tax on excess net passive income, so the balance still matters even though S corps generally pass income through to shareholders.
Two Limits Worth Checking Before You Close
The roll itself is an accounting exercise, but two legal boundaries can turn what you find on the ending line into a problem. Neither is triggered by the closing entries themselves, and both are worth knowing before decisions get made about the resulting balance.
Limits on Distributions
State corporation laws restrict dividends and other distributions to protect creditors. Most states follow some version of two tests drawn from the Model Business Corporation Act:
- Equity insolvency test: the corporation cannot make a distribution if, afterward, it would be unable to pay its debts as they come due in the ordinary course of business.
- Balance sheet test: the corporation cannot make a distribution if its total assets afterward would be less than total liabilities plus the amount needed to satisfy any shareholders with preferential liquidation rights.
Both tests must be satisfied. A company can carry a large retained earnings balance on paper and still fail the equity insolvency test if cash is too tight to cover upcoming obligations. Directors who approve distributions that violate the tests can face personal liability, which is why the roll needs to be right before anyone votes on a dividend.
Accumulated Earnings Tax
If retained earnings climbs and the company isn’t paying dividends, the accumulated earnings tax can apply. It adds a 20% levy on top of the regular corporate tax, imposed on “accumulated taxable income” for the year.4Office of the Law Revision Counsel. 26 USC 531 – Imposition of Accumulated Earnings Tax The tax targets C corporations formed or used to avoid shareholder-level income tax by accumulating earnings rather than distributing them.5Office of the Law Revision Counsel. 26 U.S. Code 532 – Corporations Subject to Accumulated Earnings Tax
Most corporations can accumulate up to $250,000 in earnings and profits without triggering the tax. Certain service corporations in fields like health, law, engineering, accounting, and consulting have a lower threshold of $150,000.6Office of the Law Revision Counsel. 26 USC 535 – Accumulated Taxable Income Beyond the credit amount, the corporation needs to show that retained earnings serve a reasonable business purpose, backed by specific, definite, and feasible plans. Vague intentions to grow the business someday won’t hold up.7eCFR. 26 CFR 1.537-1 – Reasonable Needs of the Business If your ending balance is well past the threshold and the company hasn’t been paying dividends, a board resolution tying the accumulation to a concrete plan is the standard defense.