Retained earnings constitute accumulated profits (less losses) made by the company and can be distributed to shareholders as dividends. They too belong to the shareholders, and so are a claim on the resources of the company.
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Statements of financial position do not always balance on the first attempt, as all accountants know! However, once errors are corrected, all statements of financial position balance. This is because in double entry bookkeeping every transaction recorded has a dual effect. Assets are always equal to liabilities plus capital and so capital is always equal to assets less liabilities. This makes sense as the owners of the business are entitled to the net assets of the business as representing their capital plus accumulated surpluses (or less accumulated deficit).
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The statement of financial position is not intended as a statement of a business's worth at a given point in time. This is because, except where some attempt is made to adjust for the effects of rising prices, assets and liabilities are recorded at historical cost and on a prudent basis. For example, if there is any doubt about the recoverability of a debt, then the value in the accounts must be reduced to the likely recoverable amount. In addition, where non-current assets have a finite useful life, their cost is gradually written off to reflect the use being made of them.
Sometimes non-current assets are revalued to their market value but this revaluation then goes out of date as few assets are revalued every year.
The figure in the statement of financial position for capital and reserves therefore bears no relationship to the market value of shares. Market values are the product of a large number of factors, including general economic conditions, alternative investment returns (eg interest rates), likely future profits and dividends and, not least, market sentiment.
16: Presentation of published financial statements Financial Reporting
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