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Letter of Advice
To: Nicole/Board members of Carart Ltd.
From: External accountant
Date: 19th September 2016
Subject: Advice for declaration of Bonus
1) Financial impact
According to the case, board of Carart Ltd. is considering to reward one of the shareholders by providing them a rebate of $300,000 as a bonus for their best efforts. Main reason for such bonus declaration is that this shareholder has contributed more than half of rebate income of Carart ltd. If company decides to declare dividend than its total operational expenditures will be increased by $300,000.
Major reason behind this is that profitability statement is prepared on the basis of accrual accounting concept in which all revenues and expenses of the current year either paid in cash or not are reported (Kim and et.al., 2016). At the same time, because rebate amount is not yet paid, henceforth, it will also improve total current liability by the same amount. If Carart Ltd. decides to declare this bonus before 30th June 2016 then its financial impact will be as follows:
From the presented statement, it can be seen that if Cararta Ltd. declared bonus of $300,000 than company will bear loss amounted to $63500 and also, its CL will be increased from $225,000 to 525,000. Due to this, total net assets will be decreased from $1,125,000 to $825000.
Working: Income tax is taken to 30% which is calculated by ($148,500/$495,000)*100 = 30%
Therefore, current income tax = $195,000*30% = $58,500
2) Earning management
It is essential for Carart Ltd. and all the other business entities to manage their earnings so as to reflect a favourable impression to the investors about its operational performance (Titman, S., Keown and Martin, 2015). In other words, earning management is the process of reporting profits in P&L account through use of accounting techniques so that a positive image can be built towards the organization (Haque, Mughal and Zahid, 2016). It enables business entrepreneur to raise money, satisfy stakeholders and create a sound reputation. As per the scenario, company is planning to give rebate as a bonus of $300,000 to a shareholder. As per the above reported financial statement, it can be seen that if company distributes bonus then positive net profit of $146500 will be converted to the loss of $63,500.
Thus, it reflects that Carart Ltd. did not manage its earnings. It will give a negative impression to the stakeholders such as investors, lenders, employees and many others. Due to this, investors will not wish to invest more funds in business because of inability of Carart Ltd. to distribute dividends to the shareholders (Koo, Song and Paik, 2015). However, employees will not be willing to render their efforts to company because of negative yield through operations. However, lenders such as bank will not desire to give additional debt to the firm because of inability to bear more debt burden.
According to the cited case of Carart Ltd, it has been given that company took a loan of $650,000 to buy building costing worth $1m. In this respect, bank imposed debt covenants to the firm that it is necessary for company to maintain net profit margin to the minimum level of 30%. It will be calculated by dividing earnings before interest and tax to the gross income of organization (Ojaghi and et.al., 2016).
In this respect, above presented table reflects that in case of distributing bonus to the shareholders, EBIT of Carart Ltd will be $195,000+$45,000 = $240,000. At this level, percentage of EBIT on gross earning of the firm is ($240,000/$850,000)*100 = 28.23% which is below the requirement of 30%. It indicates that by providing rebate to shareholders, Carart Ltd. management cannot fulfil the debt condition imposed by bank (Iraya, Mwangi and Muchoki, 2015). Due to this, company will not be able to raise money through additional debt which may bring financial trouble (Tabassum, Kaleem and Nazir, 2015). Moreover, net loss amounted to $63500 will affect stakeholders adversely. Therefore, it becomes clear that it is a sign of worst earning management by the board members (Alzoubi and Selamat, 2012).
3) Recommendation and justification
By taking into account all results, it becomes clear that if board members decide to pay rebate to the shareholders before 30th June 2016 then it will surely have loss which would affect the corporate’s image negatively. According to AAA model, before making any business decision, management must examine the profitability, legality, fairness and sustainability so that effective decisions can be carried out by the directors (Faria and Amaral, 2015). In the cited case, if Carart Ltd. distributes bonus before 30th June, 2016 then loss will be $63500. As a result of the same, management will not be able to pay dividend to the investor which is not good. After this, according to the debt covenants, it is a mandatory requirement for the management to maintain minimum set net profit margin (EBIT/gross earnings) of 30%.
However, in the given situation, it has been identified that it will be comparatively shorter to 28.23%. Henceforth, the legal obligations of debt cannot be complied (Maham and Najafi, 2015). Apart from this, it will not be fair for Carart Ltd. because all fund providers, employees and lenders will be adversely affected and would not be interested to provide money to company. Further, due to having loss position, its strategic capability, competitive strength and market reputation will be adversely affected. Thus, it cannot run operations successfully in tough competition. This in turn creates a negative effect to the long-run sustainability of firm. Due to all these identified facts and figures, it can be advised to the board of directors that they should not declare rebate in this period and hence, it must be declared after 30th June.
- Alzoubi, E. S. S. and Selamat, M. H., 2012. The effectiveness of corporate governance mechanisms on constraining earning management: literature review and proposed framework. International Journal of Global Business. 5(1). pp. 17-35.
- Faria, B. R. and Amaral, H. F., 2015. EARNING MANAGEMENT THROUGH INCOME SMOOTHING AND THE RELATIONSHIP WITH THE RISK OF SHARES: EMPIRICAL STUDY WITH IBOVESPA'S COMPANIES. REVISTA CONTABILIDADE E CONTROLADORIA-RC C. 7(1). pp. 25-42.
- Haque, A., Mughal, A. and Zahid, Z., 2016. Earning Management and the Role of Accounting Conservatism at Firm Level. International Journal of Economics and Finance. 8(2). pp.197-230.
- Iraya, C., Mwangi, M. and Muchoki, G. W., 2015. The effect of corporate governance practices on earnings management of companies listed at the Nairobi securities exchange. European Scientific Journal. 11(1). pp. 16-25.
- Kim, J. B. and et.al., 2016. Financial statement comparability and expected crash risk. Journal of Accounting and Economics. 61(2). pp. 294-312.
- Koo, J. H., Song, S. A. and Paik, T. Y., 2015. Earning Management and Cost Stickiness. Advanced Science and Technology Letters. 84(15). pp.40-44.