What it is:
How it works (Example):
Let's look at an example to illustrate.
Assume Company XYZ has been in business for five years, and it has reported the following annual net income:
Year 1: $10,000
Year 2: $5,000
Year 3: -$5,000
Year 4: $1,000
Year 5: -$3,000
Assuming Company XYZ paid no dividends during this time, XYZ's earned surplus is the sum of its net profits since inception: $10,000 + $5,000 - $5,000 + $1,000 - $3,000 = $8,000.
The statement of earned surplus summarizes changes in earned surplus for a fiscal period, and total earned surplus appears in the shareholders' equity portion of the balance sheet. This means that every dollar of earned surplus is essentially another dollar of shareholders' equity.
A company's board of directors may "appropriate" some or all of the company's earned surplus when it wants to restrict dividend distributions to shareholders. Appropriations are usually done at the board's discretion, although bondholders may contractually require the board to do so. Appropriations appear as a special account in the earned surplus section. When an appropriation is no longer needed, it is transferred back to earned surplus. Because earned surplus is not cash, a company may fund appropriations by setting aside cash or marketable securities for the projects indicated in the appropriation.
Why it Matters:
It is important to understand that earned surplus does not represent extra cash or cash left over after the payment of dividends. Rather, earned surplus demonstrates what a company did with its profits; they are the amount of profit the company has reinvested in the business since its inception. These reinvestments are either asset purchases or liability reductions.
Earned surplus somewhat reflects a company's dividend policy, because it reflects a company's decision to either reinvest profits or pay them out to shareholders. Ultimately, most analyses of earned surplus focuses on evaluating which action generated or would generate the highest return for the shareholders.
Most of these analyses involve comparing earned surplus per share to profit per share over a specific period, or they compare the amount of capital retained to the change in share price during that time. Both of these methods attempt to measure the return management generated on the profits it plowed back into the business. Look-through earnings, a method developed by Warren Buffett that accounts for taxes, is another method in this vein.
Capital-intensive industries and growing industries tend to retain more of their earnings than other industries because they require more asset investment just to operate. Also, because earned surplus represents the sum of profits less dividends since inception, older companies may report significantly higher earned surplus than identical younger ones.
This is why comparison of earned surplus is difficult but generally most meaningful among companies of the same age and within the same industry, and the definition of "high" or "low" earned surplus should be made within this context.