DQ 6x
Q1: The principal considerations of a board of directors in making decisions involving dividend declarations
There are three principal considerations of a board of directors in making decisions involving dividend declarations: the dividend policy; the type of dividend; and the source of dividend.
Dividend policy: The Board must decide between two main policies in dividend declaration: progressive policy and payout ratio policy. Progressive policy may be in any of the three common methods: (1) increase or at least sustained; (2) increasing steadily (at a defined rate); and (3) increasing in real value (Financial Reporting Council [FRC], 2015). Conversely, payout ratio policy involves the determination of the amount of dividends as a percentage of a specific metrical basis (e.g. revenues, gross or net earnings, free cash flow, etc.)
Type of dividend: The Board must decide the type of dividend to declare: cash, stock, or property (Ashcroft & Ashcroft, 1999). Cash dividends are distributed as dividend checks. Stock dividends can be in the company’s own stocks or in stocks of its subsidiary. Properties (e.g. manufactured properties) dividends seldom happen though.
Source of dividend: The Board must know with certainty that there are adequate resources available for dividend declaration and how much are these resources. It is a generally accepted rule that dividends, cash or stock, should be declared out of the retained earnings, specifically unrestricted retained earnings, of the company for the current fiscal year. Both cash and stock dividends may also be obtained from paid-in surplus. However, stock dividends from the company’s own stocks may not be declared in the absence of surplus of any kind (Ashcroft & Ashcroft, 1999).
Q2: Equity method: What disclosures should be made in the investor’s financial statements?
There are four disclosures that should be reported under the equity method in the parent company’s financial statement: the net income; the net assets; the cash flows; and the “off-balance-sheet” operating and financial results.
Net income: The equity method requires that the share of the investor’s share of the net income of a subsidiary must be incorporated in the parent company’s net income report (White, Sondhi, & Fried, 1998). This policy applies when this share of the net income is received either in the form dividend or a share of the reinvested income. Revsine, Collins, and Johnson (1999) contended that dividends should not be reported as parent’s income. Instead, it should be reported to cash or dividends receivable (debit) and a decrease (credit) to the investment account.
Net assets: Similarly, the equity method requires that the parent’s share of net assets of the subsidiary be incorporated to the reported net assets of the parent company (White, Sondhi, & Fried, 1998).
Cash flows: Under the equity method, the parent company should only incorporate the capital cash flows it transacted with the subsidiary. These capital cash flow items include additional investments, dividends, and redemptions (White, Sondhi, & Fried, 1998).
Off-balance sheet items: The equity method readily recognizes significant characteristics in its operating and financial results, which are reported as “off-balance-sheet” items (White, Sondhi, & Fried, 1998).
White, Sondhi, and Fried (1998) insisted that revenues should not be recognized when there is no reasonable basis for strong certainty in the collectability of the sales payments. Similarly, recognition at the time of sale should not also be done when there are valid reasons in believing that payment problems can occur (Revsine, Collins, and Johnson, 1999).
Consequently, installment sales should only be reported on the income statement when received as cash or cash equivalents (White, Sondhi, & Fried, 1998). Although, this approach will delay revenue recognition of the full sales value at the time of sale, it ensures a more accurate reporting of cash receipts.
The installment method involves the recognition of gross profit only in proportion to cash payments received, not the total sales value as reflected in the sales receivable (White, Sondhi, & Fried, 1998). With regards to the recognition of the interest charged on the installment payments, GAAP requires that the interest component be reported separately as interest income (Revsine, Collins, and Johnson, 1999).
In relation to income taxation, this method does not inflict income tax liabilities on the entire uncollected sales payment before the payment receipt unlike recognizing revenue at the time of sale or delivery as it recognizes only the cash payments received (Revsine, Collins, and Johnson, 1999).
Q4: What controversy relates to the accounting for net operating loss carryforwards? (Opinion)
The net operating loss carryforwards allows a company, which incurred operating losses in the current fiscal year to carry forward this loss and offset it against future taxable income in the next 20 years (Revsine, Collins, & Johnson, 1999). The controversy comes from its effect in erasing this loss within the next 20 years, including a consequent tax break (i.e. a tax credit) annually on the amount of amortized loss annually.
Thus, in view of this consequent tax credit, this accounting practice has been referred to as “tax-loss carry forward” (Wall Street Journal, 2009).
This is particularly profitable when companies take over losing companies and assume their net operating losses. In fact, it can become a motivation for taking over distressed companies or those in bankruptcy or about to file for bankruptcy. This forced Congress in the past to pass laws to limit takeovers motivated by carrying forward net operating losses, and therefore the associated tax credits, of target companies. In 2009, this controversy stroke fire when General Motors filed bankruptcy but interestingly chose the so-called “363 sale”, which ended up with the federal government owning a majority (60.8%) of the automaker and one of the big-three automakers in the United States (Wall Street Journal, 2009). The “363 sale” option speeds the sale of the bankrupt of GM’s interest to the government without paying off the creditors. However, instead of erasing the $16 billion net operating loss, which justified the bankruptcy filing and the consequent writing off payables, GM instead got to carry forward its net operating loss to be offset in its future taxable income. In effect, did not get to pay off its debts, converted to future income its net operating loss, and received tax credits from the net operation loss in installment in the next 20 years. That’s a profitable bankruptcy, so to say.
Q5: Mallard Company’s lease accounting
Mallard Company rents a warehouse on a month-to-month basis for the storage of its excess inventory. The company periodically must rent space whenever its production greatly exceeds actual sales. For several years, the company executives have discussed building their own storage facility, but this enthusiasm wavers when sales increase sufficiently to absorb excess inventory.
What is the nature of this type of lease arrangement, and what accounting treatment should be accorded it, in your view?
Mallard Company’s lease arrangement is called operating lease method (White, Sondhi, & Fried, 1998; Revsine, Collins, and Johnson, 1999). Operating leases create no obligation or asset; thus, it is not reported in the company’s financial statements on the basis that no purchase transaction took place. However, it does report annual rental expense. SFAS 13 requires the use of the straight-line method in recognizing the periodic (e.g. monthly, quarterly, semi-monthly, or annually) payments.
Q6: Some believe that iGAAP provides too many choices within its accounting guidance. Is this a possible concern in the area of cash flow reporting? (Opinion)
This problem with iGAAP is particularly true in the hedge accounting requirements of IAS 39, which provided too many rules what are without relevance to a company’s risk management reality. For instance, IAS 39 treats hedge accounting as an exceptional methodology and not as a normal recognition and measurement requirements in IFRS. Instead, it should be approached as a means of describing the company’s approach to managing risk (Deloitte, 2012). Thus, companies find it a challenge to explain hedging results in the context of its business and risk management policy.
Cash flow is one of the three approaches to hedge accounting (the others are fair value and net investment hedges). The method used in determining the level of ineffectiveness in recognizing cash flow hedges, called “lower of test” remained unchanged (Deloitte, 2012). However, there is an additional restriction imposed wherein cash flow hedges of net positions must be offset cash flows exposed to the hedged risk in order to maintain impact on profit or loss, but only limited to the current reporting period. Although the intention of this restriction was to avoid accounting anomaly, specifically the grossing up of a net gain or loss of a single hedging contract and recognized in different periods. Many, however, believed that this restriction is not compatible with how risks are managed.
References
Ashcroft, J.D. & Ashcroft, J.E. (1999). Law for business. 13th ed. Cincinnati: West Educational
Publishing Company.
Deloitte. (2012, September). Hedge accounting draft: A closer reflection of risk management.
iGAAP Alert, 1-9.
Financial Reporting Council. (2015, November). Lab project report: Disclosure of dividends –
Policy and practice. London: Financial Reporting Council.
Revsine, L., Collins, D.W., & Johnson, W.B. (1999). Financial reporting & analysis. Upper
Saddle River, NJ: Prentice Hall.
Wall Street Journal. (2009, July 31). Another $16 billion not available to other car makers.
Wsj.com. Retrieved from: http://www.wsj.com/articles/SB10001424052970203609204574314180298525294.
White, G.I., Sondhi, A.C., & Fried, D. (1998). The Analysis and Use of Financial Statements.
2nd ed. New York: John Wiley & Sons.
