In corporate finance and accounting, what are retained earnings in a company balance sheet?

Introduction / Context:
Retained earnings appear in the equity section of a company balance sheet and are frequently discussed in finance and accounting interviews. They represent a key source of internal financing for future growth. Understanding what retained earnings are and how they arise helps explain how companies reinvest profits, finance projects and strengthen their capital base without always issuing new shares or taking on additional debt.

Given Data / Assumptions:

• A company earns net profit or net loss each accounting period.
• Part of the profit may be distributed to shareholders as dividends, while the remainder is kept in the business.
• Over time, profits retained in the business accumulate in a separate equity account.
• The question asks for the correct definition of this retained portion of profits.

Concept / Approach:
Retained earnings are the cumulative net profits of a company after deducting dividends paid to shareholders. Each year, net profit (or loss) is transferred from the profit and loss account to the retained earnings account, adjusted for dividends and other appropriations. Retained earnings are not the same as cash; they are an equity account representing profits reinvested in the business in the form of assets, working capital or debt reduction. They provide an important internal source of finance, reducing the need for external borrowing or new equity issues.

Step-by-Step Solution:
Step 1: Start from net profit after tax for an accounting period. Step 2: Deduct any dividends declared or paid to shareholders from that net profit. Step 3: The remaining amount is added to the existing retained earnings balance from previous years. Step 4: Over time, this accumulation of undistributed profits forms the retained earnings figure shown in the equity section of the balance sheet. Step 5: Recognise that retained earnings belong to shareholders collectively but are currently kept in the business to support operations and growth instead of being returned as dividends.

Verification / Alternative check:
Assume a company earns net profit of Rs 20 lakh in a year and decides to pay Rs 5 lakh as dividends. The remaining Rs 15 lakh is not distributed but left in the business. This Rs 15 lakh is added to the previous retained earnings balance. In the next year, if profit is again retained fully or partially, the balance grows further. The company may use these retained funds to buy equipment, increase inventory or repay loans. This example confirms that retained earnings are accumulated profits kept in the company rather than paid out to shareholders.

Why Other Options Are Wrong:
Option B incorrectly restricts retained earnings to physical cash stored in a safe, ignoring that retained earnings can be invested in many assets. Option C confuses retained earnings with share capital, which represents the original and additional contributions by owners, not earned profits. Option D limits retained earnings to interest on bank deposits, which is only one possible component of net profit. Option E describes borrowed funds, which are liabilities, not equity. Only option A captures the correct meaning of retained earnings as accumulated, undistributed profits in the equity section.

Common Pitfalls:
A common misunderstanding is to think that retained earnings equal cash available for dividends. In reality, many retained profits are tied up in non cash assets like property, plant, equipment or receivables. Another pitfall is to assume that large retained earnings always indicate surplus cash, when they may simply reflect historical profitability. In interviews, emphasise that retained earnings are cumulative, represent reinvested profits and form part of shareholders equity. This clear explanation demonstrates a solid grasp of basic financial statements.

Final Answer:
Retained earnings are the accumulated portion of net profits that have been kept in the business over time instead of being distributed as dividends to shareholders.