© 2000 John Petroff
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© 2000 John Petroff |
1)- Mandated or recommended earnings appropriations
In countries where capital markets are not, or were not, as developed as in the United States, legislators recognized the importance and the difficulty of assuring company growth using retained earnings (as discussed already in Chapter 11). In these countries (e.g. many European and Latin American countries in particular), companies are required by law to set aside a portion of profits in special reserves, commonly called legal reserves. They are usually stated as a percentage of results of operation: a 5% legal reserve is typical. This legal requirement is sometimes incremented by the founders or directors of corporations with the same intent, in that case the requirement is stated in the charter of the corporation and the reserves are called statutory reserves.
In international accounting, reserves and provisions are optional (i.e. not required) appropriations of earnings. One will recall that, generally speaking, provisions are set aside for some potential obligation resulting from past operations, whereas reserves are created for some specific goal in the future. Should one of these reasons come to the attention of auditors, and the firm fails to make the recommended appropriations, the auditors may go as far as threatening the corporation with a negative opinion in the annual report.
Retained earnings are also (or used to be) the offset account for a number of accounting entries involving corrections of prior year results, adjustment of assets or liabilities, reevaluation of assets for inflation, absorption of net effect of discontinued operations, recognition of currency translation gain or loss, and the like. Since SFAS 130 was in issued at the end of last century, some of the entries that do not represent actual earnings (such as foreign currency translation, unrealized gain on investment or pension liability adjustment) are now shown separately from retained earnings as accumulated comprehensive income or loss, but it is far from evident that separating the two improves the meaning of what retained earnings represents because of the remaining hodgepodge of entries from the past is still there. All these entries were logical and necessary from an accounting stand point, but they later diminish any meaningful target anyone can formulate for a retained earnings number. Moreover, in light of the distortion that is known to be present in retained earnings (which was touched upon at the beginning of previous chapter), it is clear that retained earnings is not in itself a data as carefully looked at as earnings per share or working capital.
Although we have just argued that the earnings retained in any given year and accumulated retained earnings cannot be looked upon as targets of management strategy, it is still important for an analyst to look at the historical pattern of accumulated earnings. All changes in retained earnings must be reconciled to profits, dividend distributions and appropriations in the Statement of Shareholder's Equity. But appropriations of earnings or unusual gains are passed through other income. It is, therefore, other income that must be studied for unexplained changes can be especially revealing of some unusual event, mistake or strategy.
See review questions Q-12A1.1 through Q-12A1.3.
See research assignments R-12A1.1 and R-12A1.2.
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