Also known as an appropriation of net income or an allocation of profits, an appropriation of earnings is a type of accounting strategy that seeks to document the connection that exists between the retained earnings generated by a company within a specified time frame, and the amount of net income that is generated within that same period. This type of calculation is often helpful when it comes to identifying the amount of those net profits that will be set aside for paying dividends to investors. One of the benefits of this approach is that it allows the company to set aside or appropriate funds that would normally have been used for paying dividends, but are being diverted to cover other obligations in accordance with the terms and conditions that apply to the stock issues.
One common example of how an appropriation of earnings works is to consider a situation in which a company takes out a loan that contains certain provisions regarding repayment and the use of company funds for dividends for the duration of that loan. In this scenario, the loan terms would include what is known as a restrictive covenant, essentially providing the lender with a priority status that supersedes the priority of the shareholders. Over the course of the loan, funds will be withheld or appropriated from the profits of the business to settle the loan, effectively reducing the amount of profits that is used to calculate dividends paid to shareholders for as long as the loan is in effect.
An appropriation of earnings may also occur in other situations, based on the provisions included in the founding documents of the company. In some cases, it may be possible to allocate some of the profits for certain projects, deducting that amount from the amount used to determine the amount of dividend payments. Typically, situations of this type will require approval by a board of directors or similar body and in some instances may even require a vote of the shareholders to approve the project. Since investment laws and regulations vary somewhat from one country to the next, the situations in which an appropriation of earnings may occur must be in compliance with those current regulations.
While in the short term, an appropriation of earnings may seem to reduce the amount of benefit that investors receive from holding shares, this strategy aids companies in remaining viable in the marketplace and financially solid. Over time, this tends to actually help investors, since a company that trades well in the market will generate higher profits over a longer period of time. This means that investors can enjoy a steady flow of dividends over that longer time frame.