What effect does revenue have on retained earnings?
A Decreases
B No effect
C Increases
The correct answer and explanation is:
The correct answer is C: Increases.
Revenue directly impacts retained earnings by increasing them. Retained earnings represent the portion of net income that a company retains, rather than distributing it as dividends to shareholders. It is a key part of the equity section on the balance sheet.
When a company earns revenue, it typically results in an increase in net income, assuming expenses are less than the revenue generated. Net income is then transferred to the retained earnings account at the end of the accounting period. This means that higher revenue generally leads to higher net income, which, in turn, increases retained earnings. Retained earnings are a cumulative measure of a company’s net income over time, minus any dividends paid to shareholders.
If the company decides to reinvest its revenue (through capital expenditures or expansion), it can use the retained earnings to finance those activities. This accumulation of retained earnings helps the company fund its operations and growth without the need to take on external debt or issue more equity.
However, it is important to note that while revenue increases retained earnings, the effect can be reduced if the company incurs significant expenses or decides to distribute large dividends. In those cases, a portion of the earnings is paid out, leaving less to be retained in the company.
Therefore, the direct relationship between revenue and retained earnings is that as revenue increases, retained earnings also increase, assuming no other factors like losses or dividend payouts interfere.