Financial Letter Of Advice: Board Of Carat Ltd Essay

Question:

Discuss about the Financial Letter of Advice for Board of Carat Ltd.

Answer:

To,

The Board

Carart Ltd

External Accountant

22 September 2016

Dear Nicole,

(Subject: Financial Letter of Advice)

The board of Carat Ltd is presented with this letter of advice.

The financial impact which declaration of rebate before or after 30h June can have- It was observed that one of the shareholders of Carart Ltd has efficiently contributed well over half of the annual income. For this reason, the board has considered to reward its shareholders by offering a rebate to them by $300,000, particularly as bonus for their efforts. This can be accounted for further expenses of the company and it indicated that it is fair for its stakeholders in regard to their contribution. [1]

Without Rebate Payment

Considering Rebate Payment

50% Rebate Payment

Rental Income

100000

100000

100000

Rebates

750000

750000

750000

Gross Income

850000

850000

850000

Salaries

100000

100000

100000

Rebate Paid

300000

187500

Other Expenses

210000

210000

210000

Interest

45000

45000

45000

Total Expenses

355000

655000

542500

Net Profit before Tax

495000

195000

307500

Less: Income Tax

148500

58500

92250

Net Profit after Tax

346500

136500

215250

Less Dividend

200000

78788

124242

Net Profit after Tax & Dividend

146500

57712

91008

Net Profit Margin

63.53%

28.24%

41.47%

From the above table it can be observed that if the rebate is paid before 30 June in the year 2016 then the company will not attain its required 30% net profit margin as after paying such rebate the company’s net profit after tax will decrease. However, if the company decides to pay 50% of its total rebate then it might be able to attain the desired percentage of its net profit margin. If the company maintains its net profit margin after paying considerable rebate amount then it can be gain bank funding easily.

Representation of earnings management and evaluate whether it is good or bad- Earnings management can be used by the board of Carart Ltd as it act as a tool in offering information to investors. This tool will serve as the better estimate for continuous earning power and if the market understands this, the share price of the company will rapidly reflect the internal information. The vital patterns of the earnings management those must be considered by Caret Ltd’s board include income minimization, maximization and smoothing. It is vital to consider that the board of the company can be motivated by distinct patterns of earnings management but such patterns might come under conflict. [2] For example, Carart Ltd might desire to smooth its income for borrowing needs and at the same time decrease income for certain political rationales. The board must consider use of earnings management in employing accounting techniques for generating financial statements, as it will present a positive view of the company’s business conducts and financial situation.

Earnings management avails advantage of the ways accounting rules are implemented and generate financial reports those inflate earnings, total assets and revenue. Earnings management can be considered “bad” for it might be able to decrease the financial statement information dependability. Managers might twist reported earnings for not those obvious reasons. Conversely, there is an increased dependence on earnings management for offering the company’s shareholders with internal information for the expenses of revealing internal information are quite high[3].

However, earnings management if implemented by the board of Carat Ltd can also reveal its good side that is concerned with effective contracting. At the time a contract imposes difficult or inadequate terms on manager, earnings management can offer flexibility option as long it does not consider the manager’s opportunistic motivations.[4]

Moreover, for the company, earnings management can prove to be a manner to unblock communication to the public[5]. Blocked communication persists at the time it is complex and highly expensive to translate a managers capable expertise regarding the company or its board of directors. Through efficient use of financial statements for communicating the company’s financial health, earnings management might be employed for informing Caret Ltd’s shareholders about the company’s internal information.

Earnings management is to be implemented by Caret Ltd for this will serve as long term lending contract pertains to safeguard the lender from the potentially adverse actions of the company’s board. This serves as a motivation to steer managers away from violating debt contract as such violation can be increasingly costly for the company and might affect its capability to operate the business. [6]

Recommendations on which the rebate year must be committed to pre or post 30th June- Carart Ltd can decide to pay its rebate in the year 2016 by paying 50% of the rebate amount. This decision will help the company in attain 41.47% net profit margin that is required to obtain bank funding. Based on the AAA model, decision making on the company’s rebate payment is taken that includes:

  • Establishing the facts- The financial impact of paying rebate before or after 30th June, 2016 is evaluated.
  • Recognizing the ethical concerns- Ethical payment to the stakeholders must be considered while taking any decision on payment.
  • Recognizing the norms- Decision of rebate payment is taken within its ethical, social and professional behavioral context.
  • Look for alternative course of action- From the analysis, it was gathered that there are alternative cases of rebate payment. One is not paying the rebate at all this year as it might decrease the net profit margin gradually. Another scenario is paying 50% of the rebate amount that will increase the net profit margin.
  • Considering possible consequences- Considering the payment of 50% rebate amount to be most desirable, possible consequences are increased net profit margin and effective earnings management. Another consideration is not paying the rebate whose consequence also includes increase in net profit margin.
  • Financial decision making- Based on the consequences of the decisions, the most desirable decision is considered to be payment of 50% rebate amount in the year 2016.

Kindly, consider the letter of advice offered based on several effective considerations and from these the company’s continued success in all future business conducts is expected.

Yours Sincerely,

Name

References

Ball, Ray. "Accounting informs investors and earnings management is rife: Two questionable beliefs." Accounting Horizons 27, no. 4 (2013): 847-853.

B?hren, ?yvind, Morten G. Josefsen, and P?l E. Steen. "Stakeholder conflicts and dividend policy." Journal of Banking & Finance 36, no. 10 (2012): 2852-2864.

Dechow, Patricia M., Amy P. Hutton, Jung Hoon Kim, and Richard G. Sloan. "Detecting earnings management: A new approach." Journal of Accounting Research 50, no. 2 (2012): 275-334.

Joe, Jennifer R., Diane J. Janvrin, Dereck Barr-Pulliam, Stephani Mason, Marshall K. Pitman, Zabihollah Rezaee, Kerri-Ann Sanderson, and Yi-Jing Wu. "The Auditing Standards Committee of the Auditing Section of the American Accounting Association is Pleased to Provide Comments on PCAOB Staff Consultation Paper No. 2015-01, The Auditor's Use of the Work of Specialist s: Participating Committee Members." Current Issues in Auditing 9, no. 2 (2015): C18-C37.

Li, Wilson XB, Tina T. He, and Gordon YN Tang. "Ultimate control, expropriation and dividend payments: a reputation management perspective." Journal of General Management 40, no. 2 (2014).

Watts, Ross L., and Luo Zuo. "Understanding Practice and Institutions: A Historical Perspective." Accounting Horizons 30, no. 3 (2016): 409-423.

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