Profits hold an exalted place in the business world and in economic theory. The necessity of producing profits imposes order and discipline on business organizations. It fosters cost-reducing innovations, which in turn promote the efficient use of scarce resources. The profit motive also encourages savings and risk-taking, two indispensable elements of economic development. Finally, profitability is a yardstick by which businesspeople can measure their achievements and justify their claims to compensation.
In view of all these essential economic functions, one might suppose that users of financial statements would have long since devised a universally agreed-on definition of profit. This is the case, however, only at the following, extremely rudimentary level:
Profit = Revenue − Costs
Defining profit in such a manner merely stirs up questions, however: What is revenue? Which costs count? Or, more precisely, which costs count now and which count later? Because these questions can be answered in many different ways, countless definitions of profit are in common use. For analysts of financial statements, the most important distinction to understand is between bona fide profits and accounting profits.
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BONA FIDE PROFITS VERSUS ACCOUNTING PROFITS[/U][/B]
In defining bona fide profits, the simple formula, revenue minus costs, represents a useful starting point. When calculating this kind of profit, the analyst must take care to consider only genuine revenues and deduct all relevant costs. A non exhaustive list of costs includes labor, materials, occupancy,
services purchased, depreciation of equipment, and taxes. No matter how meticulously the analyst carries out these computations, however, no calculation of profit can be satisfactory unless it passes a litmus test:
[I]After a company earns a bona fide profit, its owners are wealthier than they were beforehand.[/I]
To underscore the point, there can be no bona fide profit without an increase in wealth. Bona fide profits are the only kind of profits that truly matter in financial analysis.
As for accounting profits, Generally Accepted Accounting Principles define voluminous rules for calculating them with extraordinary precision. For financial analysts, however, the practical definition of an accounting profit is simple:
[I]An accounting profit is whatever the accounting rules say it is.[/I]
If, during a stated interval, a business adds nothing to its owners’ wealth, but the accounting rules state that it has earned a profit, that is good enough. An accounting profit that reflects no genuine increase in
wealth is certainly sufficient for many stock market investors. They cheerfully assign a price-earnings multiple to any number that a reputable accounting firm waves its magic wand over and declares to be a profit.
Regards,
Ayush Prem