Retained earnings play an essential role in how a business runs, regardless of size, which is why it is essential to understand its relationship to shareholder distributions. What is a shareholder distribution, and what does it matter to the retained earnings?
What Is a Shareholder Distribution?
If you're unsure of the relationship between shareholder distributions and retained earnings, you first need to answer the question, “What is a shareholder distribution?” According to the writers at Leo Berwick, shareholder distributions can take the form of dividends, capital returns or gains; however, they are most often distributed as dividends, provided they do not exceed the company’s earnings and profits.
Shareholder dividends are taxed. While the corporate shareholders are taxed at the corporate rate of 21 percent, individual shareholders’ tax rate depends on whether the dividend is considered a qualified dividend.
Qualified dividends are paid by either a U.S. corporation, a corporation in the U.S. (which is not necessarily the same as a U.S. corporation), a non-U.S. corporation under a tax treaty maintained by a U.S. resident jurisdiction or a non-U.S. company with stock traded on a major U.S. stock exchange. The shareholder must hold the stock for more than 60 days during the 121-day period that began 60 days before the ex-dividend date for the dividend to be a qualified dividend.
How Do Shareholder Distributions Affect Retained Earnings?
Retained earnings refer to the company’s remaining net income once all profit distributions are paid to the appropriate shareholders. According to the writers at Business.com, it equals the company’s gross revenue minus the expenses and dividends paid in stock or cash. Shareholder distributions affect retained earnings by offsetting the amount of retained earnings in the balance sheet’s equity section. According to AccountingTools, if a company pays a dollar to each of its 250,000 shareholders, the retained earnings accounts are reduced by $250,000.
The writers at the Corporate Finance Institute explain that retained earnings represent the connection between the income statement and the balance sheet because they are recorded under the shareholders’ equity. The retained earnings can then be used to reinvest into the company, such as buying new equipment, applying funds towards research and development, or spending on other activities that can grow the company.
Suppose, for whatever reason, the company feels it will not see a sufficient return on investment from the retained earnings. In that case, the earnings will be distributed to the shareholders as dividends or share buybacks.
Can Negative Equity Affect Retained Earnings?
To calculate shareholder equity, you subtract the total liability from total assets. However, in some cases, negative shareholder equity can occur, which causes problems for the company. Investors often consider this negative equity to be a red flag since it indicates the liabilities outweigh the assets. While negative assets on balance sheets are hardly a happy sight, there are many situations where such a thing can occur and not mark coming bankruptcy.
For example, when negative distributions on balance sheets occur, it can be because the company acquired another entity, amortizing the intangible assets as part of the acquisition, and ultimately overwhelming the existing stockholders’ equity, according to AccountingTools.
Negative shareholder equity can also occur when the company experiences periods of massive loss offsetting the shareholder’s equity. To remedy the situation, the company may prefer to counter the loss with debt, creating more liability instead of selling more stock, which would have increased the shareholder’s equity. In some cases, large dividend payments to the shareholders can deplete retained earnings and, ultimately, the shareholders’ equity.
As an enthusiast with a deep understanding of corporate finance and accounting, I've delved extensively into the complex interplay between retained earnings, shareholder distributions, and their impact on a company's financial health. I've studied various authoritative sources, including AccountingTools, Corporate Finance Institute, and Business.com, which have all highlighted crucial aspects of these concepts.
Shareholder distributions encompass dividends, capital returns, or gains disbursed among stakeholders, primarily taking the form of dividends, provided they align with the company's earnings and profits. The taxation of these distributions varies based on whether they are considered qualified dividends, impacting both corporate and individual shareholders differently.
Retained earnings, on the other hand, represent the net income that remains after dividends and other distributions have been allocated to shareholders. It's a critical metric in a company's balance sheet, affecting equity. When a company issues distributions to shareholders, it directly reduces retained earnings, impacting the equity section of the balance sheet. For instance, if a company pays out a dollar per share to its shareholders, the retained earnings decrease by the total amount distributed.
This reduction in retained earnings isn't inherently negative; instead, it reflects the utilization of profits for various purposes, such as reinvestment in the company for growth, R&D initiatives, or other strategic ventures. However, if a company anticipates inadequate returns from these retained earnings, it might opt to distribute them as dividends or conduct share buybacks to benefit shareholders.
Negative shareholder equity, where liabilities surpass assets, can indeed pose concerns for investors. Such scenarios might arise due to various reasons, including mergers or acquisitions that amortize intangible assets, substantial losses, or significant dividend payments depleting retained earnings and shareholder equity. Companies might seek remedies by taking on additional debt or strategizing to offset losses without diluting shareholder equity further.
Understanding these dynamics is crucial for evaluating a company's financial health and the implications of its decisions on shareholders, making the relationship between retained earnings, shareholder distributions, and equity a cornerstone in financial analysis.
