Accounting for profit figures

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Accounting profit can be differentiated into two main calculations. The gross profit is calculated as revenue less cost of goods sold, while net profit is known as the revenue less all cost incurred by the business including tax.

Profit measures the amount earned by the firm throughout the financial year, reflecting the growth of the firm, its future prospect, performance, as well as its efficiency in managing its expenses. It is an important source of information for investors, not only in calculating the profitability ratios, but also as a comparative figure to compare the firm with firms in similar field. Most stakeholders, however, often over-emphasise the importance of profit, pressuring directors to achieve the targeted figures and punishing them if they failed to do so.

All that being said, profit in itself can be quite subjective as it is bombarded by many estimates such as depreciations and doubtful debt. An example of creative accounting is that in order to achieve their targets, firms can, within limits, manipulate the figures by varying the estimates. Moreover, profit doesn't reflect the cash-book of the firm. The firm may look quite profitable up-front, but it may be struggling with liquidity issues caused by high trade receivables, inventories, etc.

In contrary to my initial belief, nothing in accounting is set-in-stone. "Profit" is simply a name given an agreed meaning. Combined with accounting procedures, it forms a generally accepted reference point(Wagner,1965) describing an increase in equity aside from contributions from shareholders. The fact that the measurement of profit is made up of many different components alongside the principle-based accounting standards championed by IASB signifies that, regardless of how complete the accounting standards are in guiding professional judgements(Wagner,1965), there are bound to be some forms of subjectivity caused by different interpretations of the accounting standards. Further emphasizing my point, sometimes, clashes between the key qualitative characteristics of IFRS's conceptual framework occurs, a key example being the method of measuring value. Fair value shows the current market price of the asset/liability, making it more relevant. However, compared to historical value, it is less verifiable as it is simply an estimate of an asset/liability's value and can thus be manipulated. As said by Deegan and Unerman(2011), for the same series of transactions, a change in rules and conventions will lead to different measures of profit.

This leads into my second point involving the possibility of earnings management. Through the module, I learnt to not underestimate the power of accountants. The truth is, even within the boundaries set by the IASs and IFRSs, accountants have the power to shape the picture of the organisation presented through interpreting assets, liabilities and revenue recognition differently. This is further supported by Positive Accounting Theory, which predicts manager's accounting policies choices when faced with different situations, displaying managerial flexibility in choosing accounting policies which subsequently affects the firm's earnings. For example, the bonus plan hypothesis formulated by Watts and Zimmerman(1986) predicts that managers are likely to choose less conservative accounting policies which shifts reported earnings to the current period. Voulgaris et al.(2014) showed that CEOs with an accounting-derived remuneration are incentivised to strategically adapt UK GAAP to IFRS reconciliations to boost their pay. All in all, this shows that accounting profit is subjective to the estimates, adjustments and policies made to its individual components. An organisation may choose policies which are beneficial to them, but may not actually present a fairer view of the organisation's operations (it's "true profit") to its users.

This links into my third point regarding the meaning of "true profit" which, before the module, I thought of as simply an alternative term for "profit". If it means providing a true and fair view of the organisation's profitability, taking into account every aspect which affects it. Can accounting profit be said to be truly neutral and that it captures everything that matters (Anderson-Gough,2014) when in fact, it only takes into account explicit costs, compared to economic profit, which takes into account both explicit and implicit cost. Although IAS 37 does provide some provisions for environment damages that arises as a present obligation, there still exists many social and environmental factors which may have some impact on the organisation, yet are not factored in. According to Hines(1988), it is mainly due to it being almost impossible to reach a consensus on ways to measure it objectively. Although the differences between accounting and economic profit may converge in the long run(Solomons,1961),for example, a fall in sales from ethical consumers may occur in the long run due to the firm's present irresponsible environmental behaviour, it still defeats the purpose of providing a present picture of the firm's efficiency and profitability.

Before the module, my opinion of standard-setters are simply those who sets rules and monitors compliance. However, I soon learnt about the dodgy on-goings behind the standard-setting process. Thus, the fourth point that I'm putting forward concerns the independence of standard-setting bodies. "Capture theory" describes how the regulated will ultimately control the regulator(Deegan&Unerman,2011). On regard to this, I will use the recent introduction of IFRS 6 to regulate the extraction industry as an example. The truth is, IFRS 6 did little to regularise the varied accounting practices which it initially set out to accomplish. Instead, it simply codified existing industry practices, enabling firms to continue reporting in their own preferred method (Corrine et al.,2010). This reflects the possibility that IASB have been captured by the very constituents it sought to regulate. The fact that IASB is a private entity which relies partly on private sector funding may have played a part in it. Brown(2006) noted that the close dependency relationship between IASB and its benefactors through its funding scheme may have marginalised critical issues, such as environmental and social accounting. This ties closely into the issue regarding the meaning of "true profit" discussed earlier. This claim is further supported by evidence showing that companies lobbied the IASB through their external auditor(Georgious,2004), who, no surprise, are major contributors of IASB. This is reflected in the case above, whereby PWC, the auditor of Exxon Mobile, lobbied heavily in the steering committee against using 'established terms' such as full cost(Corinne et al.,2010). On a positive note, IASB have taken steps to ensure its independence, among them being a change in its funding model, shifting its revenue stream from direct company contributions to government contributions(Bruce,2011). However, it is possible that firms may simply shift to influencing their national accounting-standards board in terms of degree of IFRS adoption instead. Relating back to the question, due to the possibility of regulatory capture, the reliability and neutrality of accounting standards in the measurement of "true profit" is thus questionable. So does accounting profit truly capture everything that matters, or has it, in some ways, been manipulated to show what the firm wants to be shown?

The bottom line is, although profit may seem straight-forward, it is actually one of the most inconsistent financial measures which incorporates so many assumptions and adjustments to the point of being confusing(Spitzer,2007). However, re-emphasizing my statement in the previous assignment, only when accounting profit is paired with other key accounting figures, such as cash flows and balance sheet, can it show a more complete picture of the organisations operations to its users.

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