How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

Chapter 12. NET INCOME AND RETAINED EARNINGS; EARNINGS PER SHARE (EPS)

Net Income into Retained Earnings

Exhibit 12.1 at the start of the chapter highlights the connection from net income in the income statement to retained earnings in the balance sheet, and from net income to a new item that I show for the first time—earnings per share (EPS). This chapter explains that earning profit increases the retained earnings account. Also, I introduce earnings per share (EPS).

Suppose a business has $10 million total assets and $3 million total liabilities (including both non-interest-bearing operating liabilities and interest-bearing notes payable). Over the years, its owners have invested $4 million capital in the business. So, liabilities and owners' equity provide $7 million of the company's total assets. Now, where did the other $3 million of assets come from?

Assets don't just drop down like "manna from heaven." (My old accounting professor was the first person I heard use this phrase, and I've never forgotten it.) The other $3 million of assets must have come from profit the business earned but did not distribute—from retained earnings.

Two basic owners' equity accounts are needed—one for capital invested by the owners and one for retained earnings. When a business distributes money to its owners, it must distinguish between returning capital they have invested in the business (which is not taxable to them) versus dividing profit among them (which is taxable). A business corporation is ...