How to Review Retained Earnings

By Maire Loughran from Auditing For Dummies

During your audit, you shouldn’t have to deal with much activity going on in the retained earnings account, so you generally audit all the transactions rather than sample and test. Inherently this is just not a high activity account like revenue and expenses. Three common items affect retained earnings: net income or loss, dividends, and prior-period adjustments.

You start off your audit by confirming the retained earnings beginning balance, which is normally the ending balance from the prior year. If your audit client is on a calendar year-end, the beginning balance on January 1 should be the same as the ending balance on December 31 from the prior year. Should this not be the case, discuss the issue with the client to see what happened, and then discuss the problem with your audit team leader.

If the client is a continuing one, the ending balance can be found in the prior year’s workpapers. If the client is new, use the balance sheet figure from the prior year.

You want to confirm any changes that affect the beginning balance. To do so, follow these steps:

Get a schedule from your client that shows how the client got from beginning to ending retained earnings for the year under audit.
Trace the net income or loss adjustment to the client’s income statement.
Verify cash or stock dividends.
If the client reflects any prior-period adjustments, confirm that these are indeed errors that can be corrected by making an adjustment to retained earnings.

Generally accepted accounting principles (GAAP) are your guide in this arena. One example of a prior-period adjustment is if the client didn’t properly accrue payroll expense at year-end to reflect wages earned but not yet paid.

Although the clients you handle as a newer auditor may have these types of transactions, you probably won’t be assigned to them. Retained earnings can also be adjusted for valuation of marketable securities, foreign currency translations, and changes in appropriation of retained earnings. Basically, it means changing the way the client reports investments on the balance sheet. Foreign currency translations take place if your client has a foreign subsidiary and its financial statements are combined with the U.S. parent company. Appropriations of retained earnings place restrictions on the declaration of dividends. An example may be if the company has future plans for expansion.