Restricted retained earnings definition

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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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Characteristics of Restricted Retained Earnings

Here are the key characteristics of restricted retained earnings:

  • Legal or contractual restrictions. Often mandated by legal requirements, loan agreements, or corporate bylaws. These restrictions may arise from state laws or debt covenants imposed by lenders.

  • Not freely distributable. Cannot be distributed as dividends to shareholders until the restriction is lifted. The restriction ensures that funds are preserved for specific obligations or contingencies.

  • Purpose-driven allocation. Reserved for specific purposes, such as repaying debt, meeting minimum capital requirements, or funding asset acquisitions.

  • Presented separately in the financial statements. Disclosed separately in the equity section of the balance sheet or in the notes to financial statements.

  • Time-bound or conditional. Restrictions may be temporary or conditional, ending once specific criteria are met (e.g., repaying a loan or completing a project). Permanent restrictions may exist in some cases, depending on the legal or contractual terms.

  • No impact on total retained earnings. The restriction only affects the usability of the retained earnings, not the total amount reported.

  • Maintains financial stability. Ensures funds are available for critical obligations, thereby reducing financial risk.

  • Reflects long-term planning. Indicates that a company is actively planning for future obligations and contingencies.

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.