Retained Earnings - A Part of the Capital Equation
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Index:
Introduction
As a corporation is organized, a number of people invest
money or property in the new enterprise. In exchange for the
investment, shares of ownership are issued to the investors.
The expectation of these stockholders is that the company
will be successful, meaning profitable, and that the value
of their shares will increase.
Supposing that the enterprise is successful, a profit (net
income) is generated each year. The corporation has the option
of giving a portion, or the even the entire profit, back to
the investors in the form of dividends.
Many corporations find it advantageous to withhold a portion
of the profit within the company. These "retained earnings"
are added to the capital investment of investors. These two
balances - outstanding stock and retained earnings - represent
the equity of the corporation. Absent intangible values assessed
to the corporation (such as company potential), along with
the assumption that all other accounting balances are valued
correctly, the equity of the company represents the corporation's
real value. As a result, the greater the retained earnings,
the greater the value of the corporation.
A major purpose for withholding, or retaining, a portion
of the yearly profit is to provide necessary cash and equity
for the growth of the company. A growing company generally
requires a broader base of capital on which to build its future.
This capital base is increased either by issuing more stock
in exchange for cash, or by the retention of some of the yearly
earnings. Because an increase in the number of outstanding
shares can potentially dilute the overall value of each share,
the retention of earnings might be the preferred method of
increasing the capital base.
Capital in a Financial Corporation
While the above discussion is very much applicable to financial
corporations as well, capital accumulation serves not only
as a base upon which future growth can be built, but more
importantly, it serves as a safety net for those people who
place their savings into the institution.
In the 1800's, it was not uncommon for a bank to have an
80% capital ratio. This simply meant that before a citizen
was willing to place $20.00 into the bank as a deposit, he
wanted to see that the banker had placed $80.00 of his own
money into the bank as capital, or seed money.
Today, the capital structure of a safe institution might
be in the range of 7-10% of the total deposits.
What has changed? The advent of federal deposit insurance
dramatically increased the confidence level of average citizens.
The ultimate burden of providing safety for the savings deposits
of the nation shifted from the financial institution, to the
federal government. In Utah, every financial institution is
insured by an agency of the federal government. Credit unions
are insured by NCUSIF, while banks and savings and loans are
insured by the FDIC. Both of these agencies work in a similar
manner and offer the same degree of protection to the consumer.
One of the trade-offs that comes with federal deposit insurance
is the requirement that sufficient capital be on hand, within
the institutions themselves, to act as a buffer.
During the period of 1980 to 1995, a large number of banks
and savings and loans did not have sufficient capital to protect
the deposits of their customers. Once an institution ran out
of its own capital, demand was placed on the insuring agency
to pay the remaining deposits owed to customers. The number
of institutions that found themselves in this predicament
was so large that the federal government had to loan approximately
$300 billion to the insuring agencies of the banks and savings
and loans in order to meet depositors demands.
In order to prevent a similar disaster in the future, the
federal insuring agencies insist on an appropriate amount
of capital to be held in each institution, so that no such
call on government resources will be necessary in the future.
Bank Capital
An institution's capital, or equity position, generally
consists of two broad categories - outstanding stock and retained
earnings.
A bank, therefore, has two fundamental methods by which
it can maintain its' correct capital position:
1. A bank can retain some of its yearly earnings.
2. A bank can issue, or sell, an additional number of shares
of its' stock.
Credit Union Capital
A credit union is member owned. As a result, there are no
outside owners, no stockholders.
A credit union, therefore, has one method by which it can
maintain its' correct capital position:
1. A credit union must retain some its earnings.
An Example or Three
Federal law requires federally insured credit unions to
have at least 7% capital, or equity. In fact, in order to
keep the examiners of the insuring agency from getting nervous,
credit unions are given the highest rating only when these
reserves are in the 9-10% range.
In order to maintain this level of safety - safety that
is extended to the deposits of the institution - consider
the following:
John Q. just retired and decided to take his retirement
in a lump sum. Because of the dismal performance of the
stock market in recent months, John decided to place the
entire $500,000 into his credit union.
If the credit union desires to keep its reserve level at
the current 10% level, it will be necessary for the credit
union to place an additional $50,000 into its reserve (capital,
equity, reserve) account.
Because the credit union does not sell stock, it procures
the needed $50,000 by RETAINING the money from the dividends
that normally would flow back to the members.
If the credit union is large - the process is the same -
the requirement is the same. The only difference is that the
numbers are larger.
Credit Union ABC increased its deposit base by 15% in the
year 2001. This amounted to $260 million dollars of new
deposits coming into the institution from its members.
In order to maintain the required and desired buffer (reserves
or level of capital) of 10%, the credit union retained $26
million dollars of its annual earnings.
The retention of this $26 million did NOT enrich any person,
but rather it simply kept the reserve ratio at the same
desired level as it was at the first of the year.
If the credit union is not generating enough new income,
could this stifle the growth of the credit union?
Credit union XYZ has a capital ratio of just over 7%. As
a result, federal examiners are beginning to pay attention
to the credit union on a more frequent basis.
For every $100,000 of new deposits the credit union takes
in, it must be able to generate $7,000 of profit (retained
earnings).
John Q. decides to make his deposit of $500,000 with this
credit union. This means the credit union must immediately
place $35,000 (7% of $500,000) into reserves.
The credit union recognizes that it cannot generate enough
income during the year to meet the reserve requirement.
If it accepts the $500,000 deposit, their equity ratio will
fall below the 7% requirement.
In order to keep peace with the insuring agency, the credit
union tells the member it cannot accept the deposit.
A bank, finding itself in the same position, could simply
decide to sell more stock in order to meet their capital requirements.
What Are Retained Earnings Used For?
Hopefully, earlier sections have given some enlightenment
into the value and purposes of retaining a portion of each
year's earnings.
For a financial institution, retained earnings are first
and foremost a requirement of the law. They act as a safety
net for the deposits of the member or customer. Specifically,
required credit union reserves can only be used to offset
the charge-off (loss) of loans that are not repaid. If the
reserves were not adequate to meet these losses, (see past
banking history) the savings of the depositor would be at
risk.
Secondary to the safety factor, in a very practical manner,
retained earnings in a credit union represent a pool of money
that, until called upon for that unforeseen emergency, is
not owned by any particular member, but rather, the membership
as a whole. As a result, the earnings from these monies can
be used, in a general way, to increase the level of service
given to the members.
In the case of the bank, stockholders recognized that retained
earnings are used to calculate the value of the stock. The
stockholders have some options as it relates to these retained
earnings. For example - greater retained earnings increases
the value of the stock, which in turn would increase the profit
made on the sale of that stock. Such an option does not exist
for a credit union member.
What Are Credit Union Retained Earnings
NOT Used For?
As already stated, retained earnings provide safety for
the depositor and stability to the credit union. At the same
time, it is obvious that retained earnings represent monies
that have no cost associated to them. As a result, earnings
from these monies can be used to cover day to day expenses
of the institution.
CONTRARY to several recent banker rants, retained earnings
are NOT used to build new buildings, to buy new technology,
or to pay executive bonuses.
Because credit unions follow generally accepted accounting
principles, such practices DO NOT occur.
Each credit union has income and it has expenses. New buildings
and most technology purchases are generally capitalized -
which means that they are expensed (depreciated) over a period
of years that closely represent the useful life of the item
in question.
Each month, the credit union prepares a statement of profit
and loss, which lists the income from various sources, as
well as the expenses. Three of those expense items would be
- building expense, computer expense and employee expense.
If a credit union does not have sufficient current income
to meet these expenses, or to meet the expenses of a new building
or new computer, the purchase is generally not made. Likewise
with employee expenses - they depend upon current income and
not upon monies that were retained in previous years.
Why Do Credit Union Retained Earnings Escape
Taxation?
The simple answer is - they DO NOT escape taxation.
- Is the income you make and then contribute to your 401k,
taxed to you in the year you earned the money? NO!
- Has this contribution escaped taxation for the present?
YES!
- Has this contribution escaped taxation for ever and ever?
NO!
- Will taxes be paid when you begin to use your 401k? YES!
- Your company contributes to your retirement. Are these
contributions used as tax reducing expenses by your company?
YES!
- Are you required to report these contributions on your
personal taxes in the same year as the company claims the
deduction? NO!
- Has this contribution escaped taxation for the present?
YES!
- Has this contribution escaped taxation for ever and ever?
NO!
- Will taxes be paid when you begin to receive your pension?
YES!
Perhaps it can be agreed that no one wants to pay taxes on
something they have NO access to or have not received. Income
taxes are generally not levied on a future event or future
receipt of income.
Because NO individual member of the credit union can access
or gain personal, individual advantage of the retained earnings,
no income tax is accessed against those earnings.
As a result, in a manner similar to many retirement accounts,
retained earnings are allowed to accumulate tax-free until
they are distributed to the members, at which time all applicable
income taxes are paid.
When a credit union closes its' doors and calls it quits,
the entire amount of retained earnings are distributed as
dividends to the members, who in turn are taxed. In the case
of two credit unions merging, examples can be cited where
a portion of the retained earnings were distributed back to
members prior to the merger, and taxed. In most cases, the
retained earnings of both merging credit unions are retained
in the new institution.
There is NO permanent escape from the taxman.
NO ONE, NO GROUP, is getting anything for free as a result
of the credit union tax exemption.
Credit union's tax exemption was debated by the House on November
24, 1937 and recorded in the Congressional Record. Senate
Bill 2675 was the bill to amend the Federal Credit Union Act.
"The system has no element of profit making whatever"
said Rep. Robert Luce, R-Mass.
Why Are Bank Profits Taxed Before Distribution
to Stockholders, Resulting In a Form of Double Taxation?
An understanding of the basic difference between a credit
union and a bank is essential.
Hopefully, the above discussion about credit union membership
gives the reader an understanding of the relationship a member
has with the retained earnings of the credit union.
Banks have stockholders. Only these relatively few people
have call on the current and past earnings of the bank.
Consider the following:
A credit union has a profit at the end of the year. Remember
- NO person, NO group of persons has personal access to
those funds. NO ONE can personally benefit from the earnings.
When those earnings are actually made available to the member,
a tax will be levied.
A bank has a profit at the end of the year. Pretend that
no corporate tax is levied against these earnings.
Question: Is there anyone associated with the bank who
can benefit from the increased value of the banks retained
earnings, or capital position? Hopefully, the reader recognizes
the advantageous position of each and every stockholder.
Question: Is there anyway for the stockholder to take
advantage of this increased value of the bank without
paying taxes on the increase?
Answer: Absolutely. If you had stock that had increased
in value, and you wanted to sell it now in order to take
advantage of the increase, what tax options do you have?
- If you have owned the stock for a short period of
time, sell the stock and pay taxes on the gain at your
marginal tax rate.
- If you have owned the stock for a longer period of
time, sell the stock and pay taxes on the gain at the
lower capital gains rate.
- Donate the stock to your favorite charity or religious
organization. You pay NO taxes on the donation. In turn,
you receive a receipt from the charity or church for
the full value of the stock, which you can in turn use
as a taxable deduction on your next income tax return.
Question: If corporations were NOT taxed on their current
income, does the possibility exist that NO taxes would
EVER be paid on all, or at least a portion of that income?
Bottom Line
Credit unions and banks are different. Purpose wise, they
are different. Structurally, they are different. The fact
that they both offer the same services, does not make them
the same.
Legislators and everyday citizens should take the time to
study these differences. Decisions made absent this analysis
could lead to a replay of the demise of the savings and loan
industry. Sadly, few are inclined to believe that was an error,
but rather a well-conceived, well-legislated execution of
a banking competitor.
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