What Is an Unexplained Adjustment to Retained Earnings?
Retained earnings is the accumulated balance of your net income over time. It represents the amount of money you have to reinvest in your business or distribute to shareholders through dividend payments. An unexplained adjustment to retained earnings is an accounting method to reconcile changes that are not represented your periodic income statement.
To understand unexplained adjustments, you must first recognize the typical way in which current income flows into retained earnings. If your annual income statement shows a $225,000 net income, and your prior year's ending retained earnings balance was $1 million, your theoretical balance in retained earnings after the current year is $1,225,000. This balance is shown on the statement of owners' equity.
The unexplained adjustment comes into play when the retained earnings balance doesn't equal what it theoretically should. If your retained earnings end at $1,100,000 instead of $1,225,000, for instance, you appear to have $125,000 less in accumulated earnings than your prior year's retained earnings and current year's income statement suggest you should. In this case, you must enter an "adjustment to retained earnings" by recording a retained earnings reduction of $125,000.
Dividend payouts are among the most common reasons for a discrepancy in retained earnings. A dividend payout is a portion of the retained earnings balance that's paid to shareholders based on an amount per share. A dividend doesn't impact your income statement, but it does cause a reduction in your retained earnings balance. Retained funds are a way to reward investors. Finding and reconciling a dividend payout is fairly simple.
Several other types of financial maneuvers may affect retained earnings outside of the income statement, which makes accurate records essential to reconciling end-of-year adjustments. Some countries require businesses to keep legal reserves, or amounts set aside to handle legal judgments. If you operate in foreign countries, you may allocate a portion of retained earnings to this fund. Adjusting discrepancies in asset and liability accounts can also directly impact retained earnings. Inflation and currency exchanges are also possible unexplained adjustments.