What are Retained Earnings?
Retained earnings are the portion of a company’s profits that are kept by the company rather than distributed as dividends to shareholders. Over time, a company can accumulate significant amounts of retained earnings, which can be used to finance future growth and development. However, in some cases, a company may choose to convert some or all of its retained earnings into paid-up capital. This process is known as the capitalization of retained earnings.
How Capitalization of Retained Earnings Works
The process of capitalizing retained earnings is typically accomplished by a board resolution that authorizes the transfer of a specified amount of retained earnings into paid-up capital. The exact process can vary depending on the laws and regulations in the jurisdiction where the company is incorporated. However, in most cases, the process involves a journal entry that debits the retained earnings account and credits the paid-up capital account.
The journal entry is typically accompanied by the issuance of new shares to existing shareholders, in proportion to the number of shares that each shareholder already owns. For example, if a company has 100,000 shares outstanding and capitalizes $100,000 of retained earnings, each shareholder would receive an additional 1 share for every 10 shares that they already own.