Dumb economics question

andyfromotley

Hi, im sure this economics 101, but perhaps someone could explain this to me.

So a company (lets say a supermarket) trades for the year and makes £1m profit.

However it decides that its property portfolio has fallen by £2m from £10m to £8m.

It seems that they report this as an overall loss of £1m on the year.

Why? Their assets have fallen but unless they were bound to cash in these assets there is no loss? There is surely only a loss when they actually realise the assets? Confused.

princeofpounds

It's not a stupid question.


You need to understand the difference between cashflow accounting and accruals accounting.


That is why you have a profit & loss statement, and a cashflow statement in the complete set of accounts.


You book a profit or a loss whenever one is incurred, even if the actual cashflow is in the past or the future. It is a more true reflection of the assets and liabilities of the firm when 'all is said and done'.


So yes, in your example the loss is not crystallised in cash terms, but the company still has assets worth less than they did previously.


(note things are complicated a bit by the fact that sometimes companies do record gains and losses on assets like properties, and other don't. but these policies are all disclosed in the notes of the financial statements).

antrobus

andyfromotley wrote: »

Hi, im sure this economics 101, but perhaps someone could explain this to me.

So a company (lets say a supermarket) trades for the year and makes £1m profit.

However it decides that its property portfolio has fallen by £2m from £10m to £8m.

It seems that they report this as an overall loss of £1m on the year.

Why? Their assets have fallen but unless they were bound to cash in these assets there is no loss? There is surely only a loss when they actually realise the assets? Confused.

It's not an economics question, it's an accounting question.

And the answer to the question would be; because that's what it says you have to do in the Financial Reporting Standards. I'd guess FRS 11, Impairement of Fixed Assets and Goodwill.

Anyone who read (say) a supermarket's accounts and saw that they had made a £1m operating profit, but suffered a £2m impairement write down, would be free to ignore the latter, and focus on the former should they chose to do so.

I would regard that as being preferable to allowing the supermarket in question not to tell anyone about the fact that it's property portfolio was now worth £2m less than it had paid for it.

Generali

andyfromotley wrote: »

Hi, im sure this economics 101, but perhaps someone could explain this to me.

So a company (lets say a supermarket) trades for the year and makes £1m profit.

However it decides that its property portfolio has fallen by £2m from £10m to £8m.

It seems that they report this as an overall loss of £1m on the year.

Why? Their assets have fallen but unless they were bound to cash in these assets there is no loss? There is surely only a loss when they actually realise the assets? Confused.

It's an accountancy question rather than an economics one and it's certainly not a stupid question.

There are different sorts of profit or loss.

In this case the company has made a trading profit of £1,000,000.

However, it has made a gross loss of £1,000,000 (£1,000,000 operating profit minus £2,000,000 revaluation of assets).

Profit for the purposes of Corporation in this example is a loss of £1,000,000 so no Corporation Tax would be payable and that loss could also be offset against future profits for a few years.

Generali

LOL, I think we x-posted. Thankfully we came up with much the same answer!!!

CLAPTON

the other side of the coin is that, in times when property prices are rising, it is easy to show increase in profits even if the 'underlying' is doing badly

as already said look at the cash flow

Generali

CLAPTON wrote: »

the other side of the coin is that, in times when property prices are rising, it is easy to show increase in profits even if the 'underlying' is doing badly

as already said look at the cash flow

At work when we look at company valuations for equity investments, free cash flow, current and predicted, are probably the two most important metrics we use, especially for resources companies (obviously very important for Aussie investors).

somethingcorporate

As per the above its an accounting question.

The balance sheet is a reflection at a point in time of all the assets, liabilities and equity (the balance between the two, owed to the owners or shareholders).

The profit and loss tells the story of the movements in the intervening period between snapshots of a balance sheet so all the ins and outs that describe what a company has done to increase its assets/liabilities/equity.

As an asset value has been remeasured and decreased as per the above rules it needs to be reconised as a non-cash movement (hence why a cashflow or operating profit will give you a better story on trading performance) but it needs to be recognised as it impacts the value of a company.

It's a very good question

andyfromotley

Thank you for your replies everyone, you are a clever bunch!!

I suspected that it may be something along those lines. I was interested learn that they could use a downgrading in asset value to avoid corporation tax on essentially a profitable year, conversely if they uplift their assets (perhaps to cover a poor trading year) do they equally have to pay tax on that uplift?

Generali, when you say 'free cashflow' does that mean the actual business itself without asset appreciation/depreciation?

Generali

andyfromotley wrote: »

Generali, when you say 'free cashflow' does that mean the actual business itself without asset appreciation/depreciation?

I'd like to start by saying I'm not an accountant but I've learned a little about it due to my various jobs down the years.

Free cash flow is hard to fake. Profits and losses can be swizzled around by things like asset revaluation, goodwill changes and all sorts.

AIUI free cash flow is:

Revenue - actual costs - depreciation and amortisation (that is the reduction in value of capital goods over time) + change in cash in the bank - money spent on investing in future production.

Now it's not good enough to say that high free cash flow is good and low is bad. As a company I could simply increase my free cash flow by reducing investment in future output thus probably reducing future revenues.

It's a good starting point though, especially when you break it down to its component parts and think about how they could change.

chewmylegoff

Generali wrote: »

It's an accountancy question rather than an economics one and it's certainly not a stupid question.

There are different sorts of profit or loss.

In this case the company has made a trading profit of £1,000,000.

However, it has made a gross loss of £1,000,000 (£1,000,000 operating profit minus £2,000,000 revaluation of assets).

Profit for the purposes of Corporation in this example is a loss of £1,000,000 so no Corporation Tax would be payable and that loss could also be offset against future profits for a few years.

Actually there is a third sort of profit - taxable profit. The write off of land and buildings is not a tax deductible expense (loss on disposal would be). So CT would still be charged on the operating profit (with some adjustments for other differences between net profit and taxable profit).