Retained Earnings Journal Entry
In accounting, the company usually makes the journal entry for retained earnings when it makes the closing entry after transferring net income or net loss to the income summary account. However, the company may also make the journal entry that includes the retained earnings account when it needs to make the prior period adjustment.
Likewise, the net income will increase the retained earnings while the net loss will decrease the retained earnings as the result of the journal entry. On the other hand, the increase or decrease of retained earnings with prior period adjustment will depend on whether the company has understatement or overstatement of prior period net income before the adjustment.
Retained earnings at closing entry
The company can make the retained earnings journal entry when it has the net income by debiting the income summary account and crediting the retained earnings account.
On the other hand, if the company make a loss, the journal entry of retained earnings will be reversed from the above:
Income summary is a temporary account that is used at the end of the period to close all income and expenses in the income statement. In other words, all income goes to the credit of income summary while all expenses go to the debit of income summary resulting of the net amount in the income summary account as net income or net loss.
So, the amount of income summary in the journal entry above is the net income or the net loss of the company for the period. Hence, the retained earnings account will increase (credit) or decrease (debit) by the amount of net income or net loss after the journal entry.
For example, company A which is a trading company has a net income of $25,000 which all of its respective income and expenses have already been transferred to the income summary account at the end of 2020.
Hence, company A can make the retained earnings journal entry when it closes the account of 2020 as below:
Retained earnings journal entry for prior period adjustment
Prior period adjustment is made when there is an error in prior period financial statements or the company changes the accounting standard or policy that requires the retrospective adjustment. Likewise, the journal entry for prior period adjustment will include retained earnings if there is an overstatement or understatement of net income in the prior period as a result of the error or new accounting standards.
Overstatement of net income
If the prior period adjustment is to correct the overstatement of prior period net income, the company will debit the retained earnings in the journal entry as below:
Understatement of net income
Alternatively, if it is to correct the understatement of prior period net income, the company will credit the retained earnings in the journal entry instead.
For example, company B made an error in the 2019 financial statements by not recording an amortization expense of one of the intangible assets. The omission of amortization expense in 2019 amounts to $10,000. This error is found at the end of 2020.
In this case, the company needs to make a journal entry for prior period adjustment as below:
It is useful to note that although the retained earnings account has a normal balance on the credit side, the company may have the debit balance of retained earnings instead. This is the case where the company has an accumulated loss. In this case, this debit balance of retained earnings will be presented as a negative in the balance sheet.