Restricted retained earnings definition
/What is Restricted Retained Earnings?
Restricted retained earnings refers to that amount of a company's retained earnings that are not available for distribution to shareholders as dividends. The primary reason why retained earnings are restricted is that a company is in arrears in its payment of dividends that were due in the past; if so, the amount of the restriction will match the cumulative amount of unpaid dividends. The restriction will then decline as the dividends are paid off. Another reason is that a lender will not allow the company to pay any dividends until a loan has been paid off, thereby improving the odds of loan repayment.
It is possible that the board of directors of a business will vote to restrict other portions of retained earnings that do not relate to cumulative unpaid dividends, such as for funds to construct a building. However, these restrictions may not be legally binding if investors are determined to be paid a dividend.
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Accounting for Restricted Retained Earnings
The accounting for restricted retained earnings is to move the designated amount into a restricted retained earnings account, which is still part of the equity cluster of general ledger accounts. The restriction of retained earnings does not represent a transfer of cash; it is only a journal entry recorded in the accounting records.
Example of Restricted Retained Earnings
Arbitrary Outcomes Corporation, which provides state lottery consulting services, wants to acquire an artificial intelligence engine that will allow it to model a variety of lottery outcomes for its clients. This engine is very expensive, with a price tag of $10 million. The company’s investors are routinely demanding dividends from the company, so the board of directors decides to set aside $7 million of the firm’s retained earnings immediately with a restriction, thereby shielding this cash from any dividend payouts. The board expects Arbitrary to earn another $3 million of profits in the current year, which it can then combine with the restricted retained earnings and spend to acquire the artificial intelligence engine.
The company’s controller adds a footnote to the firm’s annual financial statements, noting the reason for the restriction on $7 million of its retained earnings.
Presentation of Restricted Retained Earnings
The amount of any restricted retained earnings should be stated separately as a line item on the balance sheet, and should also be stated in the disclosures that accompany the financial statements.
Terms Similar to Restricted Retained Earnings
Restricted retained earnings is also known as restricted surplus.