What are Accumulated Earnings?
How Do Accumulated Earnings Work?
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 accumulated earnings are the sum of its net income since inception: $10,000 + $5,000 - $5,000 + $1,000 - $3,000 = $8,000.
The statement of accumulated earnings summarizes changes in accumulated earnings for a fiscal period, and total accumulated earnings appears in the shareholders' equity portion of the balance sheet. This means that every dollar of accumulated earnings is essentially another dollar added to shareholders' equity.
A company's board of directors may "appropriate" some or all of the company's accumulated earnings 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 accumulated earnings section. When an appropriation is no longer needed, it is transferred back to accumulated earnings. Because accumulated earnings are not cash, a company may fund appropriations by setting aside cash or marketable securities for the projects indicated in the appropriation.
Why Do Accumulated Earnings Matter?
It is important to understand that accumulated earnings do not represent extra cash or cash left over after the payment of dividends. Rather, accumulated earnings demonstrate 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.
Accumulated earnings somewhat reflect 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 accumulated earnings focuses on evaluating which action generated or would generate the highest return for the shareholders.
Most of these analyses involve comparing accumulated earnings per share to profit per share over a specific period, or they compare the amount of accumulated earnings 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 accumulated earnings represents the sum of profits less dividends since inception, older companies may report significantly higher accumulated earnings than identical younger ones. This is why comparison of accumulated earnings is difficult but generally most meaningful among companies of the same age and within the same industry, and the definition of "high" or "low" accumulated earnings should be made within this context.