Business is profit-motivated. No doubt. Profit stimulates innovation; it’s the reward for taking risks; it’s the return on capital invested in business; it’s compensation for hard work and long hours; it motivates efficiency; it weeds out products and services no longer in demand; it keeps pressure on companies to maintain their quality of customer service and products. In short, the profit system delivers the highest standard of living in the world. Despite all this, it’s no secret that many in society have a deep-seated distrust toward our profit motivated, free-enterprise, and open-market system — and not entirely without reason.
The job of accountants is to measure profit performance, not to pass judgment on its morality. Yet, accountants shouldn’t behave like the three monkeys who see no evil, speak no evil, and hear no evil. If a business is acting illegally, the last thing it wants to do is record a liability because of the likelihood of losing a major lawsuit or having to pay a huge fine because of its illegal activities. The chief accountant has to decide whether to be part of the conspiracy to conceal the illegal activities or to leave the business.
This post explains the effects of profit or loss on financial condition and how profit and loss performance is reported outside the business in the income statement. The term “income statement” generally means the external income statement reported by a business to its shareowners and lenders.
Externally reported income statements are bound by authoritative financial reporting standards for measuring and reporting profit. These rules are called generally accepted accounting principles, or GAAP for short. Business profit measurement and reporting shouldn’t deviate from these standards in any significant respect. Otherwise, the income statement could be judged as misleading and possibly fraudulent.
The Nature of Profit
Profit doesn’t have just one universal meaning or definition. One concept of profit is to buy low and sell high. This definition applies to investing in stocks and real estate, but it’s not a good definition for business profit. Another concept of profit is an increase in the market value of an asset. Accounting for business profit ignores market value increases of operating assets. Except for investment companies, hedge funds, and mutual funds, businesses don’t earn profit by holding assets that appreciate in value.
Most businesses earn profit through an ongoing process of selling products and services for prices that provide revenue higher than the expense of providing the products and services.
Business profit is the residual, or the amount remaining after deducting expenses from revenue. To make profit, a business needs to raise capital (generally money) to invest in operating assets that are used in its profit-making activities. These assets aren’t held for sale or for market value appreciation. The business’s sources of capital expect a return on their capital, and interest is paid on money loaned to the business. The profit remaining after paying interest to lenders and income tax to the government accrues to the benefit of the shareowners of the business.
Of course, a business may pursue profit in many other directions — from trading in pork belly futures to real estate speculation. But this post focuses on making profit the old fashioned way — making sales and controlling expenses.
Profit is a calculated number equal to the difference between sales revenue and expenses. Sales revenue is on one side of the scale, expenses are on the other side, and profit is the measure of how much the revenue side outweighs the expense side. To locate profit, you must trace the effects of revenue and expenses.
Suppose a business collects cash for all its sales and pays cash for all its expenses during the year. You need look to only one place — its cash account — to find the business’s profit. However, a business may make credit sales and not collect cash from all its sales during the year. Furthermore, the typical business doesn’t pay all its expenses during the year and pays some expenses before the start of the year. In summary, sales and expenses affect several assets, including cash and liabilities.
To follow the trail of profit, keep the following in mind:
- Sales Revenue = Asset Increase or Liability Decrease
- An Expense = Asset Decrease or Liability Increase
Case Example: Comparison Of Profit Making And Its Effect
- During the year, Royal Bali’s assets increase $3,000,000, and its liabilities increase $400,000 as the result of its profit making activities.
- While, during the same year, Royal Jewelry’s assets increase $2,700,000, and its liabilities increase $100,000 as the result of its profit-making activities.
- During the year, Royal Apparel’s assets increase $2,000,000, and its liabilities decrease $600,000 as the result of its profit-making activities.
None of these three businesses distributed any part of their annual profit to their shareowners during the year. What is the annual profit of each above business? All three businesses earn the same profit for the year: $2,600,000.
As I have explained in my other post explain that the accounting equation can be stated as follows:
Assets – Liabilities = Owners’ equity
Profit increases the owners’ equity of a business, which means that the changes in assets and liabilities have the effect of increasing owners’ equity. For each business in this scenario, owners’ equity improves $2,600,000, which is the amount of profit for the year.