THE ability of a listed company to declare dividends either in cash or in stock depends on the amount of its retained earnings. In contrast, a losing company piles up deficits that, if worse comes to worst, it could end up with negative stockholders’ equity should it fail to cut its losses.
Both retained earnings and deficits are entries under a company’s stockholders’ equity together with, among others, capital stock and additional paid-in capital. This piece, however, would focus on retained earnings, or surplus, leaving deficit for a future topic.
Let us look at what could be a typical example of a listed company that was once on a deficit but has since recovered from wrong auditing.
In the early 1980s, Engineering Equipment Inc. (EEI) reported net profits in its financial filings. By 1986, a review of the company’s financial performance showed the opposite: EEI, one of the construction pioneers in the Middle East, had actually been losing heavily. In fact, it had piled up more than P2 billion in losses.
That was EEI, then a subsidiary of Benguet Corp. Today, as a unit of the Yuchengco group of companies and renamed EEI Corp., it has fully recovered and has even accumulated retained earnings of P5.206 billion as of Dec. 31, 2014, net of dividends that it has distributed over the years.
To the more vigilant investors, P5.206 billion is EEI’s retained earnings. However, by reading the footnotes of the company’s audited financial statements, they would learn that of EEI’s retained earnings of P5.206 billion as of Dec.31, 2014, only P2 billion was available for distribution as dividend.
Not that EEI reported P5.206 billion as its retained earnings to mislead the public. The amount also included “retained earnings of the subsidiaries,” which had yet to be declared as dividend by its units. As of Dec. 31, 2014, these units had yet to remit to EEI P3.2 billion of their retained earnings as dividend.
EEI’s financial posting is used here as an example to warn potential investors not to rely solely on a company’s profitability. It is also as important, if not more important, for them to scrutinize stockholders’ equity for retained earnings. By deciphering the meaning of unappropriated and appropriated retained earnings, they would learn how much would be declarable as dividend.
Not a few would be curious to know why listed companies maintain such huge amounts in their books over the years.
Ask the Securities and Exchange Commission. After all, the SEC is tasked to check every corporate abuse. Perhaps the SEC examiners could not match the strategy of corporate lawyers and CPAs in hiding the numbers. It is even presumed that accounting entries could have been intelligently and legally crafted beyond the coverage of securities laws.
On its own website, the agency proclaims that, “shareholders have the right to receive dividends,” which, sad to say, is conditional because the enjoyment of such right is “subject to the discretion of the board.”
While “board approval” may restrict the distribution of dividends, the SEC assures that as the regulator of the securities industry, it “may direct the corporation to declare dividends when its retained earnings are in excess of 100 percent of its paid-in capital stock . . .”
Said declaration of retained earnings “in excess of 100 percent of its paid-up capital stock,” according to the rule, is not compulsory in some instances, as follows:
“a) when justified by definite corporate expansion projects or programs approved by the Board,” which would be easy to do because what is definite is not defined;
“b) when the corporation is prohibited under any loan agreement with any financial institution or creditor, whether local or foreign, from declaring dividends without its consent, and such consent has not been secured.”
Why should a company engage in a borrowing spree to the detriment of stockholders? Borrowing beyond one’s capacity to pay would be at the expense of stockholders, particularly the public, and more importantly, dangerous to a company’s financial health.
“or, c) when it can be clearly shown that such retention is necessary under special circumstances obtaining in the corporation, such as when there is a need for special reserves for probable contingencies.”