Wattie’s new profit approach welcome

Press, 21 October 1983, Page 12

Wattie’s new profit approach welcome

By

CHARLES CARSLAW

The open discussion by Wattie Industries, Ltd, of the accounting difficulty in respect of its mutual crossholding in the Goodman Group is a pleasant change from the attitude adopted by some companies in their reporting practices to shareholders. Wattie’s has taken some unusual steps to try to resolve the problem by consulting the Accounting Research and Standards Board, the standard-setting body of the New Zealand Society of Accountants, to seek its advice and recommendation in respect of this issue.

The nature of the problem is that Wattie’s owns 33 per cent of the Goodman Group and Goodman’s owns 35 per cent of Wattie’s. Under normal accounting practice, Wattie’s would add to its trading profit its share of Goodman’s profit. However, Goodman’s profit on the same basis includes Goodman’s share of Wattie’s profit. The danger is, therefore, that Wattie’s might include some of its own profit twice. Taking an example, assume that company A and company B both earn $lOO profit on their normal trading activities during the year. If A and B are entirely independent then that is the profit that Tvill be reported to shareholders. If, however, Company A owns 40 per cent of Company B, under the application of normal equity accounting rules, Company A will report a profit of $l4O being its own profit plus its share of Company B’s profit because it owns 40 per cent of Company B. Company B will still report its own $lOO in its accounts.

In the case of Wattie’s and Goodman’s, the situation is more complicated because each owns a share of the other. Extending the above example, assume now that company B also owns 40 per cent of company A. In this case, A says that it

will initially report its own $lOO of profit plus the $4O share of B. This is equivalent to what Wattie’s has. been doing in the past. However, company B’s profit is not just the $lOO trading profit that it has earned but should include the share of company A’s profit. Company A’s profit has now become $l4O, therefore, company B should be reporting profits of its own trading profit of $lOO plus its 40 per cent share of company A, i.e. $lOO plus 40 per cent of $l4O, or $156. Company A now says that what it should be reporting is its own profit of $lOO plus its true share of company B’s profit of $156, i.e. $162.40, and company B now says that its true profit is its 100 plus the share of A’s profit of $162.4, etcetera, etcetera. In accordance with normal accounting practice this is acceptable and this is what Wattie’s has done with the blessing of the Accounting Research and Standards Board.

Certainly this treatment is superior to the previous treatment used by Wattie’s in previous years and the earnings attributable to ordinary shareholders and the net assets per share are more correctly stated under this method.

The only problem with this method is that the figures for profit and assets can be inflated by this method.

Going back to companies A and B, one can see that they have trading or economic income of $lOO each. By virtue of the inter-company investments the sum total of the incomes reported to shareholders will always be more than this $2OO economic income because of the principles of equity accounting. In the case of Wattie’s and Goodman’s the effect of this inflation is substantial. Wattie’s, therefore, has three choices.

@ First, to do as it has done in previous years and ignore the existence of Goodman’s holding in it and thereby mis-state the mutual effect but keep the accounts simple. • Second, to do as it and the Accounting Research and Standards Board recommends to include the full effect of the equity income, including the effect of the cross-holding.

© Third, to identify the shareholders of Wattie’s that the report is directed towards, namely the independent shareholders, and report to them the economic profit that is due only to them, which would avert the possible inflation of the figures. I have a preference for the latter method but general favour is for the method that Wattie’s has now adopted. The effect of the method that is adopted is substantial.

However, the effect of the second and third methods while causing a change in the balance sheet and profit and loss figures does result in the same figures being reported for earnings per share and net assets per share.

Investors should, therefore, take due note of these and other ratios in making their decision. In any event, the disclosure by the company of this awkward problem is to be commended.

Footnote.—Explaining its policy on the crossholdings, Wattie’s said in a statement reported by the Press Association:

“The new policy is that where an associated company holds an equity interest in a group company the group’s share of the associate’s earnings is calculated by taking into account the progressive additions to the associate’s income arising from their interest in the group

company. Previously we excluded from our share of the associate’s retained earnings all income which they derived from us. “Under the former policy it was possible to report negative retained earnings from a profitable associate (where dividends exceed equity income) and even report an equity loss from a profitable associate (where the associate’s holding costs of the investment in the group company exceed the associate’s other earnings). The old method does not show the full post-acquisi-tion increase in the associate’s net assets. “The new method overcomes the deficiencies mentioned above and yields the same earnings per share as would have been obtained by consolidating the associate and treating its outside shareholders as a minority interest.”