How to Read a Financial Report, 10th Edition

15NET INCOME, RETAINED EARNINGS, AND EARNINGS PER SHARE (EPS)

Net Income into Retained Earnings

Exhibit 15.1 highlights the connection from net income in the income statement to retained earnings in the balance sheet, and from net income to a piece of information that I show for the first time, earnings per share (EPS). In short, this chapter explains that earning profit increases the retained earnings account. Then, I introduce earnings per share (EPS).

Suppose a business has $10 million total assets and $3 million total liabilities (including both noninterest-bearing operating liabilities such as accounts payable and interest-bearing notes payable). Over the years, its owners invested $4 million capital in the business. Therefore, liabilities plus capital from owners provide a total of $7 million of the company’s total assets. Where did the other $3 million of assets come from?

Assets don’t just drop down like manna from heaven. All assets have a source, and one job of accountants is to keep track of the sources of assets of the business. The source of the other $3 million in assets must be from profit the business earned but did not distribute (via dividends or distributions of earnings over the years). This is called retained earnings.

Two basic types of owners’ equity accounts are needed for every business—one for capital invested by the owners and one for retained earnings. In our example, the business is organized legally as a corporation, and issues capital stock shares ...