A reminder of the format of the income statement (click to enlarge).
An account which is recognized as being a bad debt should be written off immediately. The debt becomes an expense of the business. However, we may know, based on our trading history, that it is likely a proportion of our debts will go unpaid, we just cannot identify at this stage who the non-payers will be. Since it would be misleading not to recognize the likelihood of non-payment – it would make our profit look better than it is – we create a Doubtful Debtors account. More softening of the numbers and scope for interpretation!
The entries that we have discussed above should all relate to the company’s normal trading. In other words, if the company is a retailer, the income statement should indicate how the company has performed as a retailer. There will be some activities which don’t fit squarely within the normal operational scope of the business and these should be shown separately. The meaning of most of these entries will be self-evident. Common examples are:
You may occasionally see the phrase such as ‘one-time charge’, ‘extraordinary items’, ‘write-offs’, ‘restructuring charges’ or ‘write downs’. Much can be hidden under such a heading! A new CEO may wish to change the way the business operates and so embarks on a radical program that results in closing premises, laying off staff and de-commissioning equipment. It is now up to the accountants to decide which costs fall under this restructuring program. Under accounting regulations, accountants should record expenses as soon as it is known that they will be incurred.
The restructuring expenses must now be estimated and recorded. Alarm bells should be ringing in your head now. Can you imagine, firstly, how difficult this task is, and secondly, how much scope there is to ‘massage’ the figures. A new CEO would like the previous regime to look worse. So, a high restructuring charge reduces current profits. This is known as taking a ‘big bath’. In comes the knight in shining armour and he not only restructures, he also does it for less than the accountants estimated (although he may have had a say in those estimates).
There must now be a reverse entry – the amount that was overestimated needs to be added back to the profits for the new period – which are now higher than forecast. Turn it round the other way – a charge which is too small, and profits in the future will be hit when the actual charges are known. Maybe the current CEO will have moved on by then, his perfect profit record in place.
Analysts tend to be highly sceptical about restructuring charges. Managers have considerable leeway in deciding when to record restructuring charges and what to include. A particular concern is that the so-called ‘non-recurring charges’ are really operating expenses that are being misclassified to make trading performance look better than it is.
As you will have seen above, there are several profit figures at the bottom of the Income Statement:
Most businesses operate on credit, meaning that purchases are not paid for nor money received from sales at the time of the transaction. The purchases and sales are still recorded in the accounts. A sale made on credit is still a sale even though payment may not be received for several weeks. Likewise, with purchases. Thus a company may show a large profit and yet be short of cash; in fact, many profitable businesses have failed for lack of cash. (We will examine the critical importance of cash in the section on working capital.)
Dividends are cash returns to shareholders. The payment of dividends is largely determined by past performance, particularly recent past performance. Legally a company is allowed to pay dividends until retained earnings (ie the profits that have not previously been returned to shareholders as dividends) are exhausted – after that the company would be paying back capital and that would be against the basic principles of limited liability and so illegal.
If a dividend is paid, the shareholder receives the benefit of the cash but the company, of course, cannot use that money in the business. The money is not available for promotion, employing new staff, investing in R&D, skills development and so on. Thus a possible impact of paying a dividend this year is to reduce the company’s potential to generate dividends in the future which, as we shall see, may affect the share price. If a company is in an expanding market, then it would make sense for the company to retain profits and reinvest them in the business. Withdrawing cash at this stage may seriously dent the company’s ability to compete and it is noticeable that IT companies, where there is constant pressure to remain abreast of technological developments, tend not to pay dividends. Microsoft did not pay a dividend until 2003, by which point it had a bank balance of $43 billion. A lot of cash but only half of what Apple accumulated before it decided to pay dividends.
One of the reasons why companies hold on to their cash is that investors expect organisations to have a consistent dividend policy and tend to get upset if this is not followed. As a pension fund manager, I rely on the companies in my portfolio to meet their dividend forecasts in order to pay my pensioners. If a company fails to deliver, then I may be forced to sell shares from my portfolio, reducing the potential for dividends in the future. I would not be happy! As a fund manager my disapproval can have severe consequences for the company’s share price.