Is Net Profit an Actual Profit?
The concept of business and its activities started much earlier than the time when accounting concept was introduced. During the initial period, business was measured by cash transactions – managed on cash basis. Then, one fine day, someone started to argue that as long as the business had sold something to someone (even if it has yet to receive cash from the buyer), then the business would need to recognise the transaction as sales. Thus, the concept of accrual accounting was born. The whole idea behind the concept of “accrual” is that the business needs to capture the “attributable” income, expenses, and profit for that particular period even before it receives cash.
Before proceeding further, it would be useful for readers to understand the concept of double entry in accounting. Every transaction involves a pair of activities. When there is a seller, there is a buyer. When cash is paid, there is a receiver. That means when we are recording a transaction, we have to take into consideration both activities. This is the basic concept behind double entry.
For instance, when we pay cash as rental, we will deduct (or “credit” in accounting terms) the amount from the cash account. However, this is not complete. We must also record that the rental has been paid, and thus recognise rental expenses paid in the accounts (or “debit” expenses account).
The birth of “accrual” concept marks the shift from cash-based accounting to profit (or income statement) -centric accounting. The objective became to derive “actual” profit for the financial year. Any double entry adjustment will be recognised at the balance sheet level.
For example, a sales transaction occurs but the buyer has yet to pay for the goods (i.e. sales on credit terms). Under the cash accounting concept, sales will not be recognised as payment has yet to be received. However, under accrual accounting, the sales will be recorded as “Revenue” in the income statement. Coming back to double entry, “Trade Receivables” would need to be recognised in the Balance Sheet under the Current Asset section.
Similar treatment is used for other expenses as well. For example, assuming that a rental is due and yet to be paid; under the accrual concept, the rental still needs to be recognised as an expense in the income statement. The double entry in this case would be creating a Rental Accrued account in the balance sheet under the Current Liabilities section.
After the series of accounting scandals that surfaced early in the 21st century, mainly arising from companies either inflating its non-existent assets or making its liabilities non-existent, the accounting community shifted their focus from the income statement to the balance sheet.
Rather than focusing on determining the “actual” profit, there was a shift towards determining what is the “fair” value of the assets and the liabilities. One of the biggest implications was the birth of fair-value accounting. Under the fair-value accounting, the “fair” value of the assets has to be determined and reported in the balance sheet. As a result, any adjustments to the changes in the value would have to be adjusted at the income statement level or the reserve level, depending on the circumstances.
Thus, in layman terms, the income statement became a “dumping ground” (as double entry is needed) for any adjustments at the balance sheet level in the pursuit of deriving “fair” asset values.
So, the fundamental question is, is the net profit shown in the income statement a fair representation of the actual profit of the business? We will look into some of the adjustments investors can make to derive what we call “Core Earnings”, which is the actual core profit of the company.