What are Restricted Retained Earnings?
Restricted Retained Earnings refer to the profits of a company that are not eligible for dividend distribution to shareholders.
“Net income subject to restrictions.” -U.S. Securities & Exchange Commission
What does Restricted Retained Earnings Mean?
Restricted retained earnings, also known as restricted surplus, is the portion a company’s profits not eligible for distribution. Company profits remain as equity within a company, also referred to as retained earnings. Businesses report retained earnings in the stockholders’ equity column of a balance sheet within their financial statements.
It’s common practice to pay dividends to stockholders from company profits. A portion of a company’s retained earnings may become “restricted” for a handful of reasons such as:
Laws Protecting Creditors
In some jurisdictions laws exist to protect creditors that lend money to businesses. In certain instances, companies may be restricted from distributing all profits to shareholders and may be required to retain a certain percentage of profits. Furthermore, creditors have a right to receive payment ahead of shareholders, especially during bankruptcy proceedings.
Contractual Obligations
When making loans to companies, a creditor may require a business to retain a certain amount of profit, often known as retained earnings. In some cases, this requirement may remain in place until the loan has been repaid. Such a clause serves to protect creditors and prevents the company from distributing all retained earnings while still obligated to repay the creditor.
Board of Director Initiatives
A company may choose to voluntarily restrict retained earnings for many reasons. The board of directors may vote to allocate portions of retained earnings for purposes other than shareholder dividends such as the purchase of real estate, which shareholders may contest.
Example One
Shiny Metals Inc wishes to expand their operations in the gold mining industry. Therefore, they decide to take out a large bank loan via an installment note to fund the expansion. Upon choosing a bank to work with, Shiny Metals Inc is required to sign an agreement restricting 15 percent of their retained earnings until the loan has been fully repaid.
Over the next four years Shiny Metals Inc is profitable and has 20 million in Retained Earnings. The company decides to pay a dividend to its shareholders but is limited in the amount they can pay due to the restrictive agreement they signed with the bank. Shiny Metals Inc must restrict 15 percent of their retained earnings until they pay off the large bank loan.
15% (bank agreement) of 20 million (retained earnings) = $3,000,000 (restricted retained earnings)
Example Two
Sweet Time Inc decides to purchase a second warehouse to expand the operations of their honey business. Sales revenues recently doubled due to a competitor going out of business dramatically improving the company’s capital turnover.
The board of directors decide to restrict half of the company’s retained earnings. They wish to use the funds as a down payment on the purchase of a second warehouse. Although this will result in reduced shareholder dividends, the board believes its shareholders will understand and support improvements to the production cycle via its expansionary strategy.
Additional Resources for Restricted Retained Earnings
Other helpful articles may include:
What is a Benevolence Fund?
Understanding Liabilities
What are Assets?
