Financial Impact Analysis: Carart Ltd. Bonus Declaration Report

This report analyzes the financial implications of Carart Ltd.'s decision to declare a bonus of $300,000 to a shareholder. It examines the impact on the company's financial statements, including assets, liabilities, income, and equity. The analysis reveals that the bonus declaration would result in ...Read More

Accounting Theory and
Analysis
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TABLE OF CONTENTS
LETTER OF ADVICE.........................................................................................................................3
REFERENCES.....................................................................................................................................6
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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:
Assets Income
Current assets Rental income 100000
cash at bank 250000 Rebates 750000
Rebates receivables 750000 gross income 850000
Total current assets 1000000 Less; Expenditures
Non-current assets Salaries 100000
Land and building 1000000 Rebates paid 300000
Total non-current assets 1000000 other expenses 210000
Total assets 2000000 Interest 45000
Total 655000
Current liabilities Net profit 195000
Staff remunerations 25000 Less: income tax (30%) ( see working) 58500
Dividends payable 200000 Net profit after tax 136500
Rebates payable 300000 Less: Dividends 200000
Total current liabilities 525000 Net profit after tax and dividend -63500
Non-current liabilities
Bank loan 650000
Total liabilities 1175000
Net assets 825000
Financed by equity
Share capital 40000
retained earnings 785000
Total equity capital 825000
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
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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
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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.
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REFERENCES
Books and Journals
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.
Maham, K. and Najafi, A., 2015. The influence of earning management and audit quality on over
investment. MULTITEMAS. 26(4). pp. 14-23.
Ojaghi, M. A. and et.al., 2016. The effect of management ability on earning quality: Case study of
Tehran Stock Exchange. International Journal of Humanities and Cultural Studies (IJHCS).
14(4). pp. 1070-1077.
Tabassum, N., Kaleem, A. and Nazir, M. S., 2015. Real Earnings Management and Future
Performance. Global Business Review. 16(1). pp. 21-34.
Titman, S., Keown, A. J. and Martin, J. D., 2015. Financial management: Principles and
applications. Pearson.
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