Appropriation of retained earnings

Appropriation of retained earnings
See also

The appropriation of retained earnings shall be understood as is the allotment of the company's net profit which includes a portion retained in order to invest into the further development of the company. The primary function of retained earnings as supplementary capital is to cover possible losses, but it also functions as a kind of support and stabilisation for a company (Irdha Yusra, Rizka Hadya, Rhini Fatmasari, 2019, pp. 216-220).

Definition of retained earnings

The retained earnings are the result of the appropriation of the net profit earned by a company in a given financial year into the portion paid to the owners and the portion that is retained in order to undertake investments for the company's future development. It is the difference between the net profit and the amount of dividends paid. Retained profit informs about the ability of an economic entity for self-financing. It is a component of the equity of a company. It can be distinguished from core capital by the fact that it is disposable, whereas core capital is long-term and static (Georgios Papanastasopoulos, Dimitrios Thomakos, Tao Wang, 2010).

Appropriation of retained earnings

The retained earnings in a company can be divided into the following capital categories:

  • supplementary capital – it is obligatory in a joint-stock company, while optional in a limited liability company. If the company has made a profit in a given financial year, it must transfer 8% of the annual net profit until the supplementary capital reaches a third of the core capital. It is qualified as the retained profit.
  • reserve capital - it is generated optionally from the company's profit. It is created for various purposes, usually to cover possible future losses or expenditures of the company. It may also include special purpose funds. The fact that this capital is created solely from the company's profit makes it possible to associate this category with retained profit as well.
  • current reserves – includes undistributed profits from previous years. The amount of undistributed profit increases the profit from previous years, therefore it is treated as retained profit.

The net profit made by an enterprise in a given year is usually allocated to one of the above-mentioned categories. It is often considered that retained earnings should be identified with the value of undistributed profits, but this is a much wider term. It is because the amounts which have been allocated by the company to the supplementary capital and reserve capital must also be taken into consideration (Georgios Papanastasopoulos, Dimitrios Thomakos, Tao Wang, 2010).

Dividend policy versus retained profit

The amount of retained earnings, i.e. the capital generated from net profit distributions, illustrates the owners' contribution to the growth of the company's capital, thus increasing its income potential. Therefore, retained earnings are primarily used by a company for the purpose of self-financing. In the long term, thanks to the retained earnings company has more prospects for further development. The company's dividend policy is closely connected with the idea of retained profit. The dividend is paid out of the company's net profit and therefore influences how much money remains in the company after the owners’ or general meeting's decision about the appropriation of profits. If owners create large financial reserves in the form of retained earnings, thus paying dividends sporadically, there exists a high risk of weakening the bonds between shareholders and the company. This can, in extreme cases, lead to investors retreating. That is exactly why it is vital to choose the appropriate strategy in the company's divided policy. Dividend payment strategies:

  • Fixed dividend policy,
  • Fixed dividend payment rate policy,
  • Surplus dividend policy,
  • Company's target payout ratio (Lintner's model),
  • 100% dividend payment rate policy,
  • 0% ratio dividend payment rate policy (Irdha Yusra, Rizka Hadya, Rhini Fatmasari, 2019, pp. 216-220).

References

Author: Sylwia Pasternak