disadvantages of retained earnings ( 5 marks )
Answers
what is retained earnings......
Net income of a company has two elements: Dividend and Retained earnings. After paying dividend to the shareholder, a portion of income is kept by the hand of corporation, this portion of profit is called retained earnings.
It is a source of internal financing. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities.
Under the retained earnings sources of finance, a part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:
1. Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.
3. Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.
Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.
4. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.