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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The Balance Sheet

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.