Accounting theory and analysis

Earnings Management 4

Letter of Transmittal

A&S Certified Public Accountants,

P.O BOX 456 ABC Place 00300,

Westpac Lane.

18th August 2016,

The Chairman,

The Board of Directors,

Carart Limited,

PO Box 367 Gladesville NSW 2345

Kindly accept the accompanying report titled “Declaration of rebate to shareholders” in fulfilment of the assignment by Carart Limited’s board of directors.

The report begins with an overview of the implication of declaration of the rebate either before or after June 30th. The second section explains the reason why the company might be engaging in earnings management and why I think it would be bad earnings management. The last part gives recommendation regarding whether the company should commit to the rebate pre or post June 30th.

As a results of the calculations carried out regarding the issue of the rebate, the report concludes that the implication of declaring rebate before June 30th June would be to flaut the covenant with the bank. Though declaring the rebate after 30th June is seen as the better option, the report explains that this is bad earnings management as it is likely to mislead the bank to believe the earnings are as per the covenant. Finally, the report recommends committing to the rebate after June 30th in a bid to avoid defaulting on the covenant though it is also recommended that a less amount of rebate be declared to avoid the bad earnings management.

I hope that the board will find this report useful in making its decision regarding the declaration of the rebate.

Thank you so much for the assistance accorded to us by the board.

Yours Faithfully,

Jared Harington,

Declaration of Rebate to Shareholders

A&S Certified Public Accountants,

P.O BOX 456 ABC Place 00300,

Westpac Lane.

18th August 2016,

The Chairman,

The Board of Directors,

Carart Limited,

PO Box 367 Gladesville NSW 2345.

Dear Sir,

RE: DECLARATION OF REBATE TO SHAREHOLDERS.

This letter addresses the issues of concern to you regarding the proposed declaration of $300,000 rebate to the shareholders.

  1. The financial impact that declaring the rebate before or after 30th June will have:

In gauging the impact of declaring the rebate on or before 30th June, we must bear in mind the requirement by the bank which is an external shareholder regarding the company’s net income. The bank in funding the company has imposed a debt covenant to the effect that net profit margin for Carart Ltd be at least 30%. Thus, this should guide the company in declaring rebate in that the reported net profit margin for the year ended 30th June 2016 should be 30%. Thus, if declaring the rebate on 30th June does not affect the bank covenant, then the company should opt for this. However, if this will affect the covenant with the bank by making the net profit margin less than 30%, then the company will have no option but to declare the rebate after 30th June to ensure its earnings are in line with the covenant (Ray, 2013). The impact of both scenarios on the company’s net profit is calculated as follows;

Projected net profit margin = projected EBIT/ Gross Profit

EBIT = Net profit = $495,000

Add Interest = $45,000

EBIT = $540,000

Gross profit = $850,000

Thus, net profit margin for the year ended 30th June 2016 should be at least 30% × 850,000 = $255,000

If rebate is declared before 30th June, then net profit margin reported on 30th June will be;

EBIT = $540,000-$300,000 = $240,000

Net profit margin = ($240,000/850,000) *100% = 28.24%

If Rebate is declared after 30th June, then net profit margin reported on 30th June will be;

Net profit margin = ($540,000/850,000)*100% = 63.53%

Thus, the calculations reveal that the effect of declaring the rebate before 30th June will be to flout the covenant with the bank as the profit margin in this case will be 28.24% which is below the profit margin required by the covenant of 30%. On the other hand, declaring the rebate after 30th June will not have an impact on the company’s relation with the bank as the profit margin in this case will be 63.53% which is way above the bank covenant requirement of 30% and hence it does not flout the covenant (Jessen, 2012).

  1. Whether or not this represents earnings management and if it is good or bad earnings management

Earnings management has been defined as a purposeful intervention in the external financial reporting process with the aim of obtaining a certain target (Bishop, 2001). Earnings management occurs when the management use judgement in their financial reporting practices and structure transactions so as to alter financial reports with an aim of either misleading some stakeholder on the company’s financial performance or in an attempt to influence contractual outcomes that are dependent on reported income (Dechow, 2005). In this case, Carart limited is faced with a contractual covenant of ensuring that the reported net profit margin is at least 30%. If the reported net profit margin is less than 30%, then the company will be deemed to have flouted the covenant and this may be detrimental to the company’s relationship with the bank. Thus, the company’s management finds themselves obligated to report net profit margins that are in line with the covenant. If the company declares the rebate but reports it after 30th June with an aim of achieving the 30% net profit margin requirement by the bank, then this will mean delaying recognition of the expense to future periods in a bid to portray a picture of a better financial performance by the company in the current period and hence stay within the covenant requirements (Schipper, 2003). In this case, I would consider this to be earnings management by the company since it would mean that the net profit reported to the external stakeholder (bank) is not the actual net profit since a big expense of $300,000 will have been delayed to the post June 30 period. The effect will be reporting a net profit of $540,000 while the correct position would be $240,000 net profit.

Earnings management is considered bad if it is abused by the management using their discretion to mislead stakeholders about the company’s performance or in ensuring contractual obligations are met. Beneish, (2006) states that management engage in earnings management with an aim of raising return or keeping away from contractual defaults among other reasons. In this case, the company may result to earnings management with an aim of avoiding flouting of the covenant with the bank and hence avoid the consequences that may result from such default (Steven, 2013). In real sense however, the bank will have been misled to believe that the bank reported a net profit margin of 63.53% way above the covenant requirement of 30%. The company has the option of declaring a less amount of rebate in a bid to avoid defaulting on the covenant without necessarily involving itself in earnings management. As such, I am of the opinion that the company will be involved in bad earnings management if it delays declaring the rebate to post 30th June period. In my opinion, the board should consider reducing the rebate declared so as to ensure the net profit reported by the company is actually 30% instead of resulting to earnings management that would mislead the bank.

  1. Recommendations as to which year the rebate should be committed to pre or post 30th June

In deciding which year the rebate should be committed to-pre or post 30th June, the major factor that the company ought to consider is the interest of all stakeholders (Ziv, 2008). In this case, the company has a covenant with the bank to the effect that the company’s net profit should be at least 30% and this condition was imposed when the company secured funding from the bank. Flouting this covenant could negatively impact on the relationship between the company and the bank and could even result in the bank changing the terms of the loan or denying the company funding in future (Burgstahler, 2007). Thus, the bank ought to bear this in mind in deciding when to commit the rebate. In addition, the company ought to be careful to avoid dishonesty in reporting as this would be against the law. This means that the company ought to commit to the rebate when it is actually paid.

From the calculations above and bearing in mind the factors above, the company ought to commit post 30th June since this will not break the covenant with the bank since the net profit margin will be 63.53% which is way above the required 30% for the covenant (Ronen, 2008). However, if the company commits to the rebate pre 30th June, the company will flout the covenant with the bank since the net profit margin will be 28.24% slightly below the required 30%. It is to be noted that the net profit reported on 30th June does not allow the company to commit the rebate pre-30th June as this will flout the agreement with the bank as discussed above. Committing the rebate post 30th June ought not to be a problem as the company has enough retained earnings to cater for the rebate requirement of $300,000. Thus, I would recommend that the company commits to the rebate post 30th June.

This report has addressed the management’s concern regarding the impact of the declaration of rebate before or after June 30th. The report finds that the company would be involved in earnings management which is bad. It is hoped that the management would find the report useful in making decisions on whether or not and when to declare and commit to the rebate.

Yours Sincerely,

Jared Harington,

References:

Ray, B2013, Accounting informs investors and earnings management is rife: Two questionable beliefs, Accounting Horizons, vol. 27, no. 4, PP. 847-851.

Jessen, H2012, Analyzing speech to detect financial misreporting, Journal of Accounting Research, vol. 50, no. 2 pp. 350- 376.

Beneish, M2006, Earnings management: A perspective, Managerial Finance, vol. 27, no. 12, pp. 3-17.

Bishop, T2001, Auditing for fraud: Implications of current market trends and potential responses, The Auditor’s Report, vol. 24, pp. 13-15.

Dechow, R2005, Earnings management: Reconciling the views of accounting academics, practitioners and regulators, Accounting Horizons, vol. 14, no.2, pp. 237-240.

Schipper, K2003, Earnings quality, London, Rutledge.

Steven, C2013, Financial accounting for dummies, New York, Taylor & Francis.

Ziv, A2008, Discussion of earnings management and the revelation principle, Review of Accounting Studies, vol. 3, pp. 35-40.

Burgstahler, D2007, Earnings management to avoid earnings decreases and losses, Journal of Accounting and Economics, vol. 24, no.1, pp. 100-120.

Ronen, J2008, Earnings management: Emerging insights in theory, practice and research, London, Rutledge.