BUS103: Introduction to Financial Accounting

The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained earnings for several contractual or voluntary reasons. These contractual or voluntary restrictions or limitations on retained earnings are retained earnings appropriations. For example, a loan contract may state that part of a corporation's USD 100,000 of retained earnings is not available for cash dividends until the loan is paid. Or a board of directors may decide to use assets resulting from net income for plant expansion rather than for cash dividends. An example of a voluntary restriction was General Electric's annual report statement that cash dividends were limited "to support enhanced productive capability and to provide adequate financial resources for internal and external growth opportunities". Companies formally record retained earnings appropriations by transferring amounts from Retained Earnings to accounts such as "Appropriation for Loan Agreement" or "Retained Earnings Appropriated for Plant Expansion". Even though some refer to retained earnings appropriations as retained earnings reserves, using the term reserves is discouraged.

Other reasons for appropriations of retained earnings include pending litigation, debt retirement, and contingencies in general. Such appropriations do not reduce total retained earnings. They merely disclose to balance sheet readers that a portion of retained earnings is not available for cash dividends. Thus, recording these appropriations guarantees that the corporation limits its outflow of cash dividends while repaying a loan, expanding a plant, or taking on some other costly endeavor. Recording retained earnings appropriations does not involve the setting aside of cash for the indicated purpose; it merely divides retained earnings into two parts - appropriated retained earnings and unappropriated retained earnings. The establishment of a separate fund would require a specific directive from the board of directors. The only entry required to record the appropriation of USD 25,000 of retained earnings to fulfill the provisions in a loan agreement is:

Retained earnings (-SE)                                 25,000
Appropriation per loan agreement (+SE)    25,000

When the retained earnings appropriation has served its purpose of restricting dividends and the loan has been repaid, the board of directors may decide to return the appropriation intact to Retained Earnings. The entry to do this is:

Appropriation per loan agreement(-SE)    25,000
Retained earnings (+SE)                              25,000
To return balance in appropriation per Loan

On the balance sheet, retained earnings appropriations appear in the stockholders' equity section as follows:

Stockholders' equity:
Paid-in capital: Preferred stock – 8%, $50 par value; 500 shares authorized; issued and outstanding	$25,000
Common stock - $5 par value; 10,000 shares authorized, issued and outstanding	50,000
Total paid-in capital	$75,000
Retained earnings:
Appropriated:
Per loan agreement	$25,000
Unappropriated	20,000
Total retained earnings	45,000
Total stockholders' equity	$120,000

Note that a retained earnings appropriation does not reduce either stockholders' equity or total retained earnings but merely earmarks (restricts) a portion of retained earnings for a specific reason.

The formal practice of recording and reporting retained earnings appropriations is decreasing. Footnote explanations such as the following are replacing these appropriations:

Note 7. Retained earnings restrictions. According to the provisions in the loan agreement, retained earnings available for dividends are limited to USD 20,000. Such footnotes appear after the formal financial statements in "Notes to Financial Statements". The Retained Earnings account on the balance sheet would be referenced as follows: "Retained Earnings ... USD 45,000".

Changes in the composition of retained earnings reveal important information about a corporation to financial statement users. A separate formal statement - the statement of retained earnings - discloses such changes.