Updated: Jun 3
Retained earnings may appear to be a mysterious account but it's really not.
Homework assignment! This assignment primarily applies to those of you that have an outside CPA provide a compilation, review or audit of your financial statements.
Generate a trial balance as of 12/31/19 from your accounting software and look up the balance in your retained earnings account. Jot it down. Now, take your net income from 2019 and add it to the retained earnings balance you just wrote down.
The next step is to look at the financial statements as of 12/31/19, provided by your outside CPA. Does the sum from first two steps agree to the retained earnings line item on the financial statements??? You roll! In it's simplest form, the only activity in your retained earnings account will be your prior year net income.
Are the balances different? That can mean one of two things, generally.
Scenario 1) You still roll but...: Your retained earnings roll, it's just that you may need to factor in distributions. You may have a separate trial balance account for distributions that you would need to combine with your retained earnings balance to match your financials.
Scenario 2) You don't roll: Something is off. Your outside CPA may have given you journal entries that were either incorrectly recorded on your books or not recorded at all. Pull up the 2019 journal entries from your accounting software and compare them to your CPA's to see if they match. If the journal entries match, you'll want to compare the balance sheet per your accounting software for 2019 to the balance sheet on the same 2019 financial statements mentioned in the previous paragraph.
Find a difference?! You may have recorded a transaction after the fact which is causing a difference in net income. For example, you may have recorded a billing which debited (increased) accounts receivable and credited (increased) revenue or deleted a payable which debited (decreased) accounts payable and credited (decreased) costs. Chances are you'll want to adjust your end to match the prior year financials. But double check with your CPA!
Suppose you didn't record a payable as of 12/31/19 that you should have. You received an invoice in January for services provided in the previous year and your outside CPA caught it! Well it's 2020 and 2019 is closed out and we don't want to open it back up. On the financial statements you have an liability of $5,000 that you don't have on your books as of 12/31/19. So the the retained earnings per the CPA issued financial statements is $5,000 less than on your books. To fix this, you need to record the following entry:
JE#1: To roll retained earnings
Retained Earnings $5,000
Accounts Payable (5,000)
Why the entry to retained earnings? That $5,000 expense already flowed through net income to retained earnings per the financial statements last year so we don't want it to do it again this year. That's why we just jump to recording the entry to retained earnings first.
So now you have a $5,000 liability on your books in 2020 but you had already recorded that very same $5,000 expense and liability and the invoice is paid off. You're left with no liability but an expense. What do ya do?! You record an additional entry in 2020.
JE#2: To reverse payable
Accounts Payable $5,000
Office Expense (5,000)
Now the liability is off your books and so is the expense. Essentially, the outside CPA recognized an expense in 2019 that you recognized in 2020. To avoid re-recognizing the same expense you have to make JE#2!
Clear as mud? Any questions? Feel free to reach out to me at firstname.lastname@example.org!