Dumb economics question

antrobus

chewmylegoff wrote: »

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).

Absolutely. You do not get tax relief on a FRS 11 impairement loss.

Capital assets are subject to a separate set of rules, you either get capital allowances or you don't.

princeofpounds

Hi again.

If the company books a gain in a revalued property, then all else equal it should have to pay tax on the profit. The fact that you don't receive cash does not in itself mean you don't have to pay tax.

However, things are rarely all else equal. The rules on accounting for financial reporting are different to the rules for tax reporting, to the extent that businesses typically run different sets of accounts for each purpose.

So some transactions that cause a profit or a loss might be recognised in one set but not the other. So you might book a profit, but not pay tax on it because the government decides to regard it differently.

There are actually many sets of accounts, which calculate information. The way you want to look at it. A company will run management accounts, which work to help record information and present it in a way to help run the business.

Their accountants will prepare financial reports for all the external stakeholders, which are designed to give a consistent and clear record for various audiences.

They will also prepare tax accounts, typically optimised to reduce tax - within the rules.

Then external analysts might also run adjusted accounts, based on the financial reports but 'corrected' to display information they want, such as removing the 'noise' of one-off factors to display the underlying profitability.

Etc.

As for free cashflow... It is basically the cash available that is free to be spent by the company as it wishes. Sometimes that is more than the profit of a company, sometimes it is less.

For an investor it is often a much more useful measure than accounting profit measures. Because ultimately what matters is whether an investment can pay you enough cash and how quickly. There are variations of the measure for equity investors (FCFE) and for people looking at all the investors in the firm, including things like debt (FCFF). You won't see it in financial reports but you will normally see it in accounting models developed by financial analysts.

Imagine a factory which generates 1000 net profit. It sounds great, but if equipment needs replacing every year for 1000, or you need to finance your customers 1000 to achieve the sales, it's no good as an investment. those aren't expenses you will immediately see in accounts - the equipment gets depreciated over many years, and the customers should one day pay you back - but they still required you to outlay the cash right away.

FCF metrics try to incorporate all that kind of information. In some senses it is trying to bridge that gap you initially mentioned between net profit, and the kind of profit that delivers cold hard cash in your hand.

The formulas are all over the web, but it's the concept that is most important.

Thrugelmir

andyfromotley wrote: »

There is surely only a loss when they actually realise the assets?

In the current market who wants to buy a Tesco Superstore? Even Tesco's are having trouble to finding profitable activities with which to fill the space. Subletting and acquiring ad-hoc businesses isn't the cure to their problems.

Nor are Tesco's problems over having done a considerable number of sale and leaseback deals which has tied them into many units for some years yet.

chewmylegoff

The reason tax and accounting rules diverge is that the taxman doesn't like the scope for judgement and choice in accounting standards (at least historically it was the case that you could choose to revalue land and buildings or to leave at cost and you could also revalue to a directors' valuation rather than bother to pay a surveyor - I am not sure to what extent IFRS has removed this ability). Clearly if revaluations were taxable and impairments tax deductible pretty much everyone would adopt the most aggressive impairments they could possible justify (listed companies where mgmt are remunerated by reference to profit aside...).

If a factory required £1,000 of equipment to be replaced every year then whatever depreciation policy you applied there would be a depreciation charge of £1,000 as the old equipment would be scrapped and the full cost would hit the p&l.

If your customers don't pay then your trade debtors will increase which can be easily observed by looking at the balance sheet/debtors note. It is most definitely obvious from the accounts when this is happening.

princeofpounds

If a factory required £1,000 of equipment to be replaced every year then whatever depreciation policy you applied there would be a depreciation charge of £1,000 as the old equipment would be scrapped and the full cost would hit the p&l.

I just had to address this because I wouldn't want you to think I had an incorrect understanding. But I was trying hard to simplify the concept, and took it too far by reducing it to the limiting case of a single year.


Yes, if the equipment required replacing every year and had an expected life of one year then you would depreciate it (or expense it in fact) over one year and it would come into the accounting P&L right away.


More realistically what you see is a situation where the depreciation charge is 1000 per year, with equipment that might last 20 years. But if for some reason the equipment is more knackered then it 'should' be, the expenditure of capital required to keep the business just running at its current capacity it actually higher than that.


Let's assume that management have been a bit naughty, or perhaps just underestimated, and in order to boost accounting profit have assumed that machines that last 10 years have a lifespan of 20 years (so the depreciation charge is halved).


After 10 years, you end up paying 20,000 in cashflow to replace the machines. That is not something accounting profit captures - you'll just see the depreciation charge go from 1000 per year to 2000 per year, but it is a very real bill for any investor in a company to consider.


Give it long enough and the two ways of viewing the economics of the company will equalise, but that can be so far in the future it's not useful.


Yes, if you want to be pedantic, you might suggest that the auditors would require a change in the depreciation period to make it more realistic, impair the capital representing the old machines etc. But reality is so much messier than accounting rules and it's quite rare for cashflow to match accounting profits, especially in growing or changing companies.

If your customers don't pay then your trade debtors will increase which can be easily observed by looking at the balance sheet/debtors note. It is most definitely obvious from the accounts when this is happening.

Yes, it is obvious from the accounts, if you know what you are looking for. All FCF measures are 'obvious', given they are mathematically derived from the accounts.


But accounts don't actually give you a number. That's not surprising as it is not a metric defined and required by accounting standards. But it's a useful number and someone needs to work it out.


Just looking at movements on a balance sheet can tell you what is going on, but it can't help you perform a discounted cashflow valuation of a company.