Certified Energy Manager Practice Exam

What is a significant component of calculating retained earnings?

1. Total expenses for the year

2. Annual profits and losses

3. Dividends distributed to shareholders

4. External financing received

The correct answer is: Annual profits and losses

The calculation of retained earnings fundamentally revolves around the concept of annual profits and losses. Retained earnings represent the cumulative amount of net income that a company has retained, rather than distributed to shareholders as dividends. The basic formula for calculating retained earnings is: Retained Earnings = Previous Retained Earnings + Net Income (or Loss) - Dividends Distributed In this formula, the net income or loss for a given period directly affects the retained earnings. If a company generates profits, these will increase the retained earnings; conversely, if it incurs losses, the retained earnings will decrease. This highlights the pivotal role that annual profits and losses play in determining the overall financial health and growth potential of a company, as retained earnings can be reinvested into the business for expansion, modernization, or paying down debt. While total expenses, dividends, and external financing are relevant to a company's overall financial picture, they do not singularly affect the retained earnings calculation as significantly as the net income or losses incurred during the year. Total expenses help to determine net income, dividends are subtracted from retained earnings after profits are accounted for, and external financing does not relate directly to the calculation of retained earnings.