Monday, September 5, 2011

What is profit?

The layperson has no doubt about the way in which the question ‘What is profit?’ should be answered. Profit is the difference between the cost of providing goods or services and the revenue derived from their sale. If a greengrocer can sell for 10p an apple which cost him 6p, his profit must be 4p. Accountants also used to inhabit this seemingly comfortable world of simplicity, but they are now aware that such a world is not only uncomfortable but possibly dangerous. We can perhaps agree that profit is the difference between cost and revenue, but there is more than one way of measuring cost. Historical cost – the cost of acquisition – is only one alternative, which may indeed be one of the least helpful for many purposes. Furthermore, it is not even obvious that we should measure the difference between costs and revenue in monetary terms – actual pounds – for another unit of measurement has been suggested: the purchasing power of pounds.
In order to answer the question ‘what is profit?’ it is perhaps best to start by considering the most useful of hypothetical examples in accounting theory – the barrow boy who trades for cash and rents his barrow. Consider such a barrow boy whose only asset at the start of a day’s trading is cash of £2000.
Let us suppose that he rents a barrow and a pitch for the day which together cost him £20. Let us further assume that he spends £150 in the wholesale market for a barrow-load of vegetables, all of which are sold for £240. The trader therefore ends the day with cash of £2070 and we can all agree that the profit for that day’s trading is £70. In other words we have taken the barrow boy’s profit to be the increase in monetary wealth resulting from his trading activities.
Let us extend the illustration by supposing that the barrow boy has changed the style of his operation. He now owns his barrow and trades in household sundries of which he can maintain a stock. If we wish to continue to apply the same principle as before in calculating his profit, we would need to measure his assets at the beginning and the end of each day. Thus we would need to place a value on his stock and his barrow at these two points of time as well as counting his cash.
All this may appear to be very simple, but it is by no means trivial, for the above argument contains one important implication, that profit represents an increase in wealth or ‘welloffness’, and one vital consequence, that in order to measure the increase in wealth it is necessary to attach values to the assets owned by the trader at the beginning and end of the period.
Let us now consider the implied definition of profit in a little more detail. The argument is that a trader makes a profit for a period if either he is better off at the end of the period than he was at the beginning (in that he owns assets with a greater monetary value) or would have been better off had he not consumed the profits. This essentially simple view was elegantly
expressed by the eminent economist Sir John Hicks, who wrote that income – the term which economists use to describe the equivalent, in personal terms, of the profit of a business enterprise – could be defined as:

the maximum value which [a man] can consume during a week and still expect to be as well off at the end of the week as he was at the beginning.

This definition cannot be applied exactly to a business enterprise since such an entity does not consume. The definition can, however, be modified to meet this point, as was done by the Sandilands Committee, which defined a company’s profit for a year by the following adaptation of Hicks’s dictum:

A company’s profit for the year is the maximum value which the company can distribute during the year and still expect to be as well off at the end of the year as it was at the beginning.

The key questions that have to be answered in arriving at such a profit are, ‘How do we measure “well-offness” at the beginning and end of a period?’ and ‘How do we measure the change in “well-offness” from one date to another?’
This is not the end of the matter for we may wish to make a distinction between that part of the increase in ‘well-offness’ which was available for consumption and that which should not be so regarded. In traditional accounting practice a distinction has been made between realised and unrealised profits such that only the former is normally available for distribution.
Subsequently company legislation introduced into statute law the concept of distributable profits and the legal aspects of the assessment of this element of profit will be discussed in the final section of this chapter.
Turning to our two questions, we will first examine the question of how we may measure ‘well-offness’ or ‘wealth’ of a business at a point in time. There are two approaches. First, the wealth of a business can be measured by reference to the expectation of future benefits; in other words, the value of a business at a point of time is the present value of the expected future net cash flow to the firm. The second approach is to measure the wealth of a business by reference to the values of the individual assets and liabilities of the business. Actually these two approaches can be linked by the recognition of an intangible asset, often called goodwill, which can be defined as the difference between the value of the business as a whole and the sum of the values of the individual assets less liabilities.

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