Company Reserves, Retained Earnings and Dividends: A Director's Primer

What retained earnings are

Retained earnings (also called profit and loss reserves) are the cumulative total of every profit the company has ever made, minus every loss and every dividend ever paid out. They sit in the equity section of the balance sheet and grow automatically each year a profit is made without a corresponding full dividend distribution.

Retained earnings represent value that belongs to shareholders but has been left in the company to fund future operations, service debt, or provide a financial cushion. They are not cash — the corresponding cash may have been spent on assets, used to reduce creditors, or simply not yet collected from debtors.

Distributable reserves and the legal test

Under the Companies Act 2006, a company can only pay a dividend if it has sufficient distributable reserves at the time of payment. For most companies, distributable reserves equal accumulated realised profits less accumulated realised losses — roughly equivalent to retained earnings, though certain unrealised gains (such as a revaluation surplus on property) are excluded.

This means that even if the company made a large profit this year, an historic accumulated loss from earlier years may reduce or eliminate distributable reserves. Directors must check the reserve position before declaring any dividend. Paying a dividend from insufficient reserves is unlawful under the Companies Act and may need to be repaid. Confirm the legal position with your accountant before each distribution.

Interim and final dividends

An interim dividend is declared by the directors during the financial year, typically on the basis of management accounts showing adequate reserves. A final dividend is recommended by the directors at year end and approved by shareholders at the general meeting. Both must be supported by sufficient distributable reserves at the time they are paid, not merely at the time they are declared.

For owner-managed companies where the director and shareholder are the same person, the procedural requirements — board minutes, dividend vouchers, shareholder approval — still apply. HMRC may reclassify poorly documented dividends as salary, triggering PAYE and NIC liabilities. Your accountant can advise on the correct process.

Reserves that cannot be distributed

Not all reserves on the balance sheet are distributable. The share premium account (amounts paid above nominal share value on issue) and capital redemption reserve (created when shares are bought back) are non-distributable. A revaluation reserve arising from uplifting property to market value is also generally non-distributable unless the underlying asset has been sold and the gain is realised.

• Always identify whether a reserve is distributable before relying on it for dividend purposes
• A bonus issue (capitalisation issue) can convert certain reserves into share capital — permanently non-distributable
• Share buybacks reduce distributable reserves and must be funded from the correct source
• Group companies face additional complexity — inter-company dividends and upstream loans require careful structuring