The accounting profit figure

“The accounting profit figure is simply a measure of the true profit of an organisation.” Discuss.

In order to assess whether the accounting profit is a measure of the true profit it must first be shown that there is such a thing as true profit. If we decide there is, we then need to know what it is exactly, in order to assess the extent to which the accounting profit reflects this true profit figure. Before studying this module I believed that the true profit was essentially the accounting profit calculated correctly. I saw profit as being a simple calculation that would always return the same figure.

As I didn’t realise the extent to which professional judgement is involved in reaching the profit figure I couldn’t identify the real issues surrounding the idea of the true profit. Instead I pointed out flaws in the concept of profit itself, for example that profit doesn’t consider cash flow. However as these flaws apply to true profit as much as accounting profit (they apply to the notion of profit itself), they’re not really relevant to the question.

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I first learned that accounting profit and true profit could not be the same thing early in the module. Accounting profit draws directly on data from the accounts. The way these accounts are held is the outcome of applying various accounting rules and conventions, and at times relies on the professional judgement of individual accountants. Deegan and Unerman add that “As these rules change (as they frequently do), the same series of transactions will lead to different measures of ‘profits’ and net assets.”1 The accounting profit also varies from country to country.

Even amongst countries that have adopted IFRS there are systematic differences in how accounts (and therefore the profit figure) are calculated (Kvaal and Nobes, 2010)2. If accounting practices can vary so much over time and between countries then the accounting profit and true profit cannot be the same thing. For a number to be described as “true” it must surely be a solid, objective figure which doesn’t change – once you are at the truth you can’t change your mind or perceive it differently. Therefore whatever true profit is, it is not the accounting profit, as I believed before.

1

Deegan & Unerman, Financial Accounting Theory, McGraw-Hill Education, 2011 Kvaal & Nobes, International Differences in IFRS Policy Choice (September 2, 2009). Accounting and Business Research, Forthcoming 2010. Available at SSRN: http://ssrn.com/abstract=1466693 2

I soon began to doubt that there even is such a thing as true profit. In the Hines article from the first seminar Hines shows how accountants create reality when they describe it. In accounts objects only exist once they are realised by the accountant3. Hines uses the example of revenue: “We recognise revenue when it is realised. By naming it ‘revenue’, it becomes revenue.. Just like the black holes.” Concepts like revenue and profit are the creations of accountants. What they are depends on how you define them. With real life objects (e.g. a chair), definitions may vary, however they are all based on the existence of the same underlying object.

With a concept like profit there is no object until it’s fully defined. Once I fully considered this the idea of true profit seemed strange. Profit was created as an accounting concept and accountants decide what it is. Profit doesn’t exist in reality outside accounting - there is no such thing as true profit. This idea was soon challenged in later seminars. Wagner argues that there is objectivity in accounting4. He defines objectivity as “a relative absence of perceptual defects in the exercise of professional judgement is the general meaning of objectivity in accounting.”

If you perceive something objectively you are seeing it as it truly is. Therefore true profit could be defined as the profit figure obtained using perfect objectivity and neutrality. Although it only exists in theory it would be possible to observe when a profit figure is getting closer to true profit as practices improve, or farther away from true profit as bias is introduced. If true profit is lack of bias and perfect neutrality we can see how close accounting profit is to true profit by analysing how neutral and objective practices are in the accounting profession.

There are two ways bias could be introduced into accounts. Firstly through the standards that accountants follow. It is possible that these standards themselves aren’t neutral. Secondly when creating company accounts managers and accountants may not do so in a neutral and objective manner. It is likely that bias is introduced into the standards where it is deemed appropriate to consider economic and social consequences when setting standards.

If the negative implications of introducing a standard are significant, that standard could be dropped. Zeff states “What is abundantly clear is that we have entered an era in which economic and social consequences may no longer be ignored as a substantive issue in the setting of account standards.”

5 Although it is beneficial that standard setters consider these implications, it does weaken the neutrality of the standards. This serves to increase the distance between the accounting profit and true profit. There are several other clear examples of where neutrality is compromised in accounting. These factors contribute to the conclusion that there is a significant difference between accounting profit and true profit.

5

Zeff, S. (1978). The Rise of Economic Consequences, The Journal of Accountancy (December 1978)

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