Ask three people what retained earnings is and you'll often get three answers: "it's the company's savings," "it's the cash we've kept," "it's where the leftovers go." The first is close, the second is wrong (retained earnings is not cash), and the third is how books get broken.
Retained earnings has one clean definition and a very short list of things that are allowed to move it. Almost every bookkeeping disagreement about it comes from treating it as a flexible "plug" — a place to drop an amount so the balance sheet balances — instead of the disciplined account it actually is. The good news: this isn't a judgment call. The accounting standard for private companies (ASPE) spells out what belongs there.
- Retained earnings = every dollar of net income the company has ever earned, minus every dividend it has ever declared. It is accumulated profit, not cash in the bank.
- Only a few things legitimately move it: the period's net income or loss, dividends declared, and retrospective corrections of prior-period errors or accounting-policy changes. That's essentially the whole list.
- It is not a plug. Posting an expense, a payment, or an unexplained difference straight to retained earnings to make the balance sheet balance is the single most common way books get quietly broken.
- The accrual rule is what people miss: an expense belongs to the year it was incurred, not the year it was paid. A cost you forgot to accrue doesn't get "fixed" by dropping the later payment into retained earnings.
- A real and common version: a prior year's corporate tax was never accrued, then paid two years later and posted against retained earnings. That hides a prior-period error instead of correcting it — and ASPE has a defined way to handle it.
Read on for what retained earnings actually is, the short list of what's allowed to move it, what absolutely doesn't belong, the accrual principle, and a real Canadian example.
What retained earnings actually is
Retained earnings is part of equity — the owners' stake in the company. Specifically, it's the running total of all the profit the business has earned since it started, less everything it has paid out to shareholders as dividends. Each year, the bottom line of the income statement (net income or loss) closes into retained earnings, and any dividends declared come out of it.
Under ASPE, that movement is shown in a statement of retained earnings (which small companies often tack onto the bottom of the income statement). It starts with the opening balance, adds net income, subtracts dividends, and lands on the closing balance.
Notice what's not on this list: rent, payroll, a tax payment, an asset purchase, or "the difference." Those never touch retained earnings directly.
Source: ASPE Section 3251, Equity (statement of retained earnings); BDO Canada, ASPE at a Glance — Sections 3240/3251/3260/3610.
The only things that legitimately move retained earnings
This is the part worth memorizing, because it's short. Under ASPE, retained earnings is moved directly by:
- Net income or net loss for the period. The income statement closes into retained earnings. This is the main event.
- Dividends declared. When the directors declare a dividend, it reduces retained earnings (whether or not it's paid in cash yet).
- Retrospective corrections of prior-period errors and retrospective changes in accounting policy. These adjust the opening retained earnings of the earliest period presented — and they come with required disclosure.
- Certain capital transactions (for example, amounts arising on some share redemptions) that the standards specifically direct to retained earnings.
That's it. If a proposed entry to retained earnings isn't one of these four, it's almost certainly wrong — and #3 is the one that does the heavy lifting when something from a past year was missed.
Source: ASPE Section 3251, Equity; ASPE Section 1506, Accounting Changes (prior-period errors and policy changes — retrospective treatment).
What does not belong in retained earnings
Everything that breaks books has the same shape: an amount gets posted to retained earnings to make a number work, instead of flowing through the account where it actually belongs.
| Tempting (and wrong) | Where it actually belongs |
|---|---|
| A current-year expense booked straight to retained earnings | The income statement (it reduces this year's net income) |
| A payment of a bill posted to retained earnings to clear cash | Against the liability it settles (or as an expense, if never recorded) |
| "The difference" that makes the balance sheet balance | Nowhere — find the real error; never plug equity |
| An owner's personal draw from a corporation | Shareholder loan, salary, or dividends — not a retained-earnings plug |
| A forgotten prior-year cost, dropped in silently | A prior-period error correction under ASPE 1506, with disclosure |
The throughline: retained earnings is a result, not an input. You don't decide what goes in it; it's whatever's left after income, losses, and dividends have done their work. The moment someone is "posting something to retained earnings" to fix a balance, that's the red flag.
Accrual: expenses belong to the year incurred, not the year paid
Here's the principle underneath the most common retained-earnings mistake. Under accrual accounting — which corporations must use, both for their financial statements and for tax — an expense is recorded in the period it was incurred, regardless of when the cash actually leaves. If your company earned the profit in 2023, the costs that relate to that profit (including the income tax on it) belong in 2023, even if some of them aren't paid until later.
The mechanism for "incurred but not yet paid" is an accrual: you record the expense and a matching liability (a payable) in the year it belongs to. When the cash goes out later, it simply clears the payable — it does not create a new expense, and it certainly doesn't touch retained earnings.
When an accrual is missed entirely, the later cash payment has no liability to clear, so it "floats." That's the moment the temptation appears: just post it to retained earnings and move on. But that hides the fact that a past year was wrong — which is precisely the situation ASPE's prior-period-error rules exist to handle.
Source: Income Tax Act, s. 9 (profit computed on ordinary commercial/accrual principles for tax purposes); ASPE Section 1506 (correcting prior-period errors).
The tax bill that ended up in retained earnings
Meet Curtis, who runs Birchwood Contracting Inc., a small renovation company in Kingston, Ontario. 2023 was his best year ever: after everything, the corporation earned about $90,000 of profit before tax. Busy with jobs, Curtis filed the T2 late and — crucially — his books for 2023 never recorded any income tax expense or payable. The year-end statements showed the full $90,000 flowing into retained earnings, untaxed on paper.
The corporation's actual tax on that income, at the small-business rate, was roughly $11,000. Because nothing was accrued, that liability simply wasn't on the books.
Fast-forward to 2025. The CRA balance for 2023 finally gets paid: $11,000 out of the bank account. Curtis's bookkeeper looks for a tax payable to clear, finds none, and does the thing that makes the bank reconciliation work — debits retained earnings $11,000, credits cash. The books balance. Everyone moves on.
The entry that makes the bank rec balance is not the same as the entry that's correct. Retained earnings is where the difference goes to hide.
Three things are now quietly wrong:
- 2023 was overstated. Net income and retained earnings for 2023 were too high by $11,000, because the tax expense that belonged to that year was never recorded.
- 2025 tells you nothing. An $11,000 cost vanished straight into equity with no expense, no liability, and no note — so neither year's income statement reflects it.
- There's no trail. Anyone reading the financials later (a lender, a buyer, the CRA) sees an unexplained drop in retained earnings and no story behind it.
What should have happened
- In 2023, accrue the corporate tax: debit income tax expense, credit income taxes payable ~$11,000 — putting the cost in the year that earned the profit.
- In 2025, paying the bill simply clears the liability: debit income taxes payable, credit cash. No new expense, nothing to retained earnings.
- If the miss is only discovered later and it's material, correct it as a prior-period error under ASPE 1506 — restate 2023 (adjusting opening retained earnings) and disclose the correction.
- If the amount is genuinely immaterial, record it as an expense in the current year's income statement — still never as a silent plug to equity.
Either correct route leaves a clear story. The plug leaves a mystery — and mysteries in equity are exactly what cost owners money when it's time to borrow, sell, or get audited.
Is your retained earnings clean?
- Does your statement of retained earnings reconcile with only three moving parts — net income, dividends, and (rarely) a disclosed prior-period correction?
- Are there any direct entries to retained earnings during the year that aren't dividends or a formal restatement? Each one needs an explanation.
- Were income taxes accrued in the year the profit was earned — not booked whenever the CRA was paid?
- Are owner withdrawals going to shareholder loan/dividends, not plugged into equity?
- If a past year was wrong, was it corrected and disclosed — or quietly absorbed?
A clean retained-earnings account is one of the clearest signals that the books behind it are trustworthy — and untangling a messy one is exactly the kind of work that's part of every CDL plan. You can estimate the cost in about a minute.
A result, not a parking spot
Retained earnings earns its mystique by sounding like a vault of saved-up cash. It isn't. It's a scoreboard: total profits earned, minus total dividends paid, full stop. Only net income, dividends, and properly disclosed prior-period corrections are allowed to move it — and the fastest way to corrupt a set of books is to treat it as the place where awkward amounts go to disappear.
The accrual discipline underneath it is the same idea in another form: costs belong to the year they were incurred. Get that right — especially with income tax — and you'll never be tempted to drop a stray payment into equity to make the bank rec balance.
Not sure what's hiding in your retained earnings?
An unexplained swing in equity, or a tax payment that never hit your income statement, is usually a sign of a missed accrual. Twenty minutes is often enough to spot it — and to know how to fix it properly.
Book a Free 20-Minute CallThis article is for informational purposes only and does not constitute accounting or tax advice. Accounting standards (ASPE), materiality judgments, and the right way to correct a past error depend on your specific facts. Consult a qualified professional before restating financial statements or adjusting retained earnings.
Primary and authoritative sources, linked so you can read them yourself. The ASPE standards themselves live in the CPA Canada Handbook (subscription); the summaries below are free, publicly available explanations of those sections. The Income Tax Act link opens on the official Justice Laws website.
- ASPE Section 3251 — Equity (Deloitte IAS Plus summary) — defines the statement of retained earnings
- ASPE Section 1506 — Accounting Changes (Deloitte IAS Plus summary) — correcting prior-period errors and changes in policy, retrospectively through opening retained earnings
- BDO Canada — ASPE at a Glance, Sections 3240/3251/3260/3610 (PDF)
- BDO Canada — ASPE at a Glance, Section 1506 Accounting Changes (PDF)
- Income Tax Act, s. 9 — income (profit) computed on accrual/commercial principles, Justice Laws
- Related reading: The $500 Myth (capitalize vs. expense) and Capital Cost Allowance — two more places where book and tax treatment diverge.