A New Approach to “What is Profit”

In a simplified accounting picture, we would have the equation that a business profit is equal to sales minus expenses. This generalized pattern of thought sounds — and is — right, but in our complex era a number of causes make this accounting thought more complex. Transfer pricing, reserves, asset sales, equity-related costs, changes in the pension structure, and so much more can impact profit levels, while creating a very different picture of business profitability.

A Blog Article by Dimitrios Koumparoulis.

This also applies to existing processes that change from time to time. The complexity of reasoning becomes even more complex if one estimates that the procedures applied vary according to the legal frameworks of a country, as well as over time. For example, in the United States, foreign exchange gains or losses on a business branch other than the parent company were formerly charged to profits and losses and are now charged to shareholders’ accounts.

Since the profitability of a business is one of the most critical variables of good corporate governance, one must always have the means to attribute a transparent and accurate calculation of the company’s profit and shareholders. It is not possible to expect that the directors of a company or the shareholders will be experts in the accounting so that they can perceive all the details of the accounting depictions. Therefore, the existence of objective profitability criteria is necessary.

Organizations, such as Standard & Poor’s (S&P), are proposing approaches that bring about significant changes in a company’s profitability. For example, General Electric (GE) had $ 1.42 earnings per share (EPS) in 2001. S& , however, suggests to make the following deductions from this profit rate:

• $ 0.06 which reflects adjustments from sales of assets;

• $ 0.04 of exercise of share options;

• $ 0.19 showing employees’ retirement earnings;

• $ 0.02 of other costs of various adjustments.

If one calculates the effect of all of these, GE’s actual profitability, as measured by EPS, is not $ 1.42 but only $ 1.11. That is, one sees one of the objectively best managed companies in the world showing a profit drop of more than 25% when one applies another “logic” in calculating its profitability, but adapted to the requirements of the time. The subject is not theoretical. Thousands of retired shareholders whose income is based on return on their shares are virtually affected by an income drop of 25%.

From the above, it becomes clear that when even experts find it difficult to accept and are forced to change the acceptable definition of an accounting figure, the daily shareholder or not very well-trained entrepreneur becomes much more vulnerable to ignorant or non-ethical business practices.

Written by Dimitrios Koumparoulis

Edited by Pablo Markin

Featured Image Credits: Too much money…, Site-specific installation, Artistic Bokeh in collaboration with Georgios Papadopoulos and Société Réaliste, Vienna, Austria, February 27, 2014 | © Courtesy of Artistic Bokeh/Flickr.