Difficulties of Defining, Measuring, and of Disclosing Profit as an Accounting Concept - Essay Example

Profit: Difficulties of defining, measuring and of disclosing it as an accounting concept Introduction There are several accounting concepts which are subject to different interpretations. Accountants are only concerned about the abstract sense of the concepts and not in economic sense as interpreted by the economists. Profit is one of the concepts which this paper deals with. Difficulties arise in defining profit especially in the absence of conceptual frame work (CF) prescribed by the IASB. The CF only defines income and expense. Measure of profit by an economist also differs from how an accountant measures it. Business profit Profit is income as is known in the U.S.A. Business profit is the excess of price for goods and services realised by business firms over the cost of their procurement. The purpose of business is only to make profits. (Godfrey et al, p514) The return on investment is considered profit if it will justify capital maintenance on review at the end of each accounting period. Terminal case and certainty of future case In what the author calls a terminal case, on termination of business, what ever amount the owner takes home minus value of investment he has made, is called profit. This is easy to measure when the business is for a limited period.(Godfrey et al, p 515) In a case where future is certain which the author chooses to call it a ‘crtainty-of-future’case, the business owner knows all the future receivable and payables and he calculates his profit using the present value method.(Godfrey et al 516,517) In this scenario, non-current assets and their depreciation need not be entered at all in the books of accounts, though at the time of their acquisition, they may be entered and treated appropriately. Accrual basis of accounting is strictly by measuring increase in value of assets and liabilities to arrive at the profit earned during the relevant period. This is subject to the assumption that there has been no fresh investments and no writing off of liabilities in the said period.(Godfrey et al, p518) Holmes says that there is no certainty in life but there is only certainty of uncertainty. Hence in businesses, it can not be predicted that newly acquired equipment will become obsolete in a matter of weeks. He cites even more examples such as the partner suddenly becoming dishonest after years of fruitful business relationship etc. He impresses upon the fact that in a world of uncertainty, the information measured and disclosed is subject to assumptions. (Godfrey et al p519) Ideal measurement of profit Hence profit is ideally measured by following a middle course approach between accrual and cash basis of accounting. As already said the conceptual frame work of the IASB says the profit is just the difference between income and expense. This broad frame work facilitates determining profits without limitations. Even the Australian CH monograph has no definition of profit to offer. The residual nature of profit is what makes it difficult to define in a precise sense. The FASB uses the word comprehensive income so as to cover change in equity or net assets which can include not only earnings of the given period but also due to inherent changes in valuations of the net assets. (Godfrey et al, p520) Comprehensive income Consistent with the FASB’s concept of comprehensive income, the author defines profit changes in the value of capital from one point of time to another without the changes in the value of investments. This requires explaining the meaning of value, capital, scale and measurement of change. Since value is subjective, it should be measured in terms of money. (Godfrey et al, p521) This makes historical costing practicable for valuation of property, plant and equipment but not for valuation of forest and biological products for which the IAS 41/ AASB 141 Agriculture, prescribes fair value assessment. So depending on the nature of items, the IAS/AASB prescribes either historical cost base or fair market value to ascertain profit. Thus in cases of impairment of assets, though the loss due to impairment is reduced from profits, the recoverable value of the impaired asset is measured by the higher of the fair value and value in use. And value-in-use is calculated using present value method. (Godfery et al, p522) Capital maintenance Profit helps capital maintenance in that there can be no profit unless the originally invested capital is maintained. Any erosion means there has been no profit. Capital is perceived in two forms, financial and physical. While financial capital reflects actual money invested by the owners and profit earned is over and above that investment, physical capital reflects goods and services produced in cycles as a result without being stagnant. Here well-being of the firms lies in its ability to produce the same level of goods and services at any point of time as it was at the beginning. The capital maintenance capacity of a firm is the index of its productive capacity which implies its profitability. Productive capacity is viewed in three perspectives. First, it is the assumption that assets of the firm being replaced as they were at the beginning only after which the surplus can be called profit though this policy will not permit innovation at the cost of depletion of some assets. Second refers to the volume of output being maintained at the same level as it was at the beginning and hence any profit is considered earned only after the said level of out put is achieved with possible technological advancement though it is not very practicable. (Godfrey et al, p525) Third perspective is achievement of the original level of sales in terms of quantity. If only value of original level is sought to be achieved, capital maintenance and profitability will be distorted. This physical concept of capital to ensure against erosion of capital is universally accepted. UK’s Sandilands report, Exposure Draft 18 and SSAP 16, U.S.A.’s FASB and Australia’s SAP 1 share the same view of physical capital. Capital maintenance is achieved by changes in prices and hence any extra profitability can not be taken as actual profit as a result. (Godfrey et al p526) For example, due to variation in prices upward, if the firms sell at a higher price without additional cost, then the resultant increase can not be withdrawn by owner as profit. It should be adjusted to capital as an act of capital maintenance. Otherwise, the capital left over will not be sufficient to purchase in the next year. But there are criticisms against both the concepts because it is not the accountant’s outlook but management’s and the latter may even choose to go in borrowed capital without resorting to capital maintenance. Still other say that in such an event it would be to the share holders’ benefit if the assets are sold or unit is wound up and cash distributed to them.( Godfrey et al , p527) The surplus resulting out of price changes is called ‘holding-gains’ under financial capital concept and ‘capital-maintenance-adjustment’ under the physical capital concept. However the price changes always are bound to happen and hence the profit does not measure what it is deemed to measure. (Godfrey et al p528) Purchasing power Profit simply shown in terms of dollars has no meaning unless shown with its purchasing power. Only then can be it be known whether firm is earning profit in tune with the inflationary trend and lapse of time. (Godfrey et al, p529) Purchasing power measurement of profit is necessary because money by which it is measured is subject to fluctuations according to demand and supply as a commodity. (Godfrey et al, p530) There are several explanations to justify the increase in value due to inflationary trend as historical cost and that therefore it should not be part of the profit. An analogy given is the measurement of a grown up man’s height by a scale at two different points of time. At earlier point, it is 75 inches and at the later point, it is 70 inches. The explanation given for the reduction in height is not the shrinkage in the man’s height but the shrinkage in the scale due to weather. The shrinkage is fictional and not real. Hence measurement of profit through dollar which is subject to shrinkage due to inflation can not be real and hence any change in the profit thus measured in terms of dollars is not real profit and should be adjusted to capital. Another example is measurement by inches and centimetre in which figures will differ for the same length. (Godfrey et al, p 531) Current value method Since inflation can only be measured through indirect sources of general price index, current accounting has been advocated by the Australian accounting in SAP 1 for price adjustment to arrive at profit to adjust for capital maintenance. There are three alternatives of Gross Domestic Product (GDP) Implicit Deflator, Consumer Price Index, and Investment Prices Index but they are of little use to accountants. Monograph 10 states that although purchasing power of dollar is essential to adjust capital maintenance, accountants ignore it for several reasons. Some of them are: absence of accurate measure of money value, multinational presence which makes it difficult for the firms to choose a particular monetary measure, impact on taxation, contracts in case of changes to capital and profit and futility of such exercise since users do not find them useful as evidenced by empirical studies. (Godfrey et al, p531, 532) Though the monograph reflects these difficulties, it has not resolved them apparently for the very same reasons. Besides, even though in 1974 UK accounting body had recommended to companies to publish accounts adjusted to price level changes and some companies also followed, the practice was discontinued primarily because it was not mandatory and it created lot of misunderstanding among the users. Implementation of such a change also proved very costly for the firms. Transactions backed approach Although accountant require any adjustments to be backed by transactions, there are already practices in place to record some items like foreign exchange gains, fair value accounting of assets of superannuation plans etc pursuant to IAS 16/AASB 116 without the basis of transactions.. Profit has been defined by FASB as resulting out of transactions, events and circumstances.( Godfrey et al, p533) Especially accountants detest recording of anticipatory gains. Besides, such a measure of accounting as per market value will result in massive taxation and depletion of funds. There have been wide spread protests against such a measure for capital maintenance from various business sectors. Besides there is a view point that profit volatility will reduce confidence in the investors.(Godfrey et al, p534) Though IASB for the time being has not made it mandatory, these issues are still under it active consideration should the need arise any time. The debate in this regards has been there since 1960s and 1970s In order to know the reaction on such current value accounting; Dyckman prepared three set of reports; one in conventional unadjusted form, second in conventional along with adjusted reports and third only in adjusted reports. He found the third one could impact on the evaluation though not strongly. Further studies however did not result in any difference in evaluations. Backer’s survey among 72 financial analysts (FA), 74 bankers and 109 financial executives (FEs), 71 FAs, all of the bankers, and 105 of the FEs did not favour constant dollar information through price level adjustments. (Godfery et al, p537) Buzby’s and Chandra’s surveys resulted in the respondents numbering about 800 and in some cases 39 unanimously ranking the price level adjusted reports as the last of the several items in order of importance. Even the insurance companies did not want such purchasing power adjusted reports from the companies they had invested in. (Godfrey et al, p538) Conclusion In view of the forgoing discussion, the difficulties in explaining profit as a concept of accounting are quite understandable. Critics point out the cases such as Enron which had embarked on such forward looking concepts only to meet with financial disasters coupled with personal disasters to several dignitaries of the corporate and accounting world. Consequences of unbridled forward looking valuation will be worse than that of the limited valuation. Hence the accounting world should settle for the lesser evil. In the maze of discussion of discussion, one point is missed. The very purpose of viewing profit partly of capital is only to retain the value of capital intact in tune with inflationary tendencies so that that part of the capital is not taken away by the owners or shareholders. But in the same breadth, valuation of all assets is sought to be increased by passage of time which will likely result in extra profits and risk of the same (mostly fictional) being distributed. This will render the company bankrupt. Hence concept of profit must be handled with care. There must be definite conceptual frame work for profit determination instead of the present vague definition. . Works Cited Godfrey, J., Hodgson, A., Holmes, S., Tarca A., 2006 Accounting Theory, 6th ed, John Wiley & Sons Australia Ltd Read More