What constitutes a profit is oftentimes a perplexing question and at all times its determination is more an estimate than an absolute fact. This arises from the nature of accounting itself in that so many items of expense are known to exist and must accordingly be provided for but the amount of such expenses cannot be exactly determined. This is seen to be true in the case of the provision which must be made for bad and doubtful accounts and for depreciation of fixed assets and is, of course, inherent in all problems of valuation. As is proverbially true of the prescriptions of different physicians for the same malady, so no two accountants would arrive at the same figure of profit for any given concern.
Economic Definition
It may be of some advantage at this point to attempt a definition of profits although to compress the meaning of the word within defined limits is hardly possible and for this reason the formulation of a working definition is very difficult. Etymologically, “profit” comes from the Latin word proficere, meaning to make progress, and a better definition than this would be difficult to find. At the best the term is an elusive one, being used with slightly different connotations in different schools of thought. Thus, we find the word used and defined in economics, law, and accountancy, and some of the definitions are twisted almost to the point of absurdity. Alfred Marshall,[52] the English economist, says: “If a person is engaged in business, he is sure to have to incur certain outgoings for raw material, the hire of labour, etc. And, in that case, his true or net income is found by deducting from his gross income ‘the outgoings that belong to its production.’” Charles S. Devas[53] says: “The income from production combining both labor and capital is profits.” He defines gross income as “the total wealth added to the property of a given person in a given time from whatever source ... and net income as gross income minus the following items: (a) Destruction, damage, or loss by fire or other accident, by violence, by thieves, by bad debtors. (b) Using up of materials in production, and wear and tear of machinery and industrial buildings such as factories or shops. (c) All sums spent on purchases of goods that are to serve the purchaser not as subjects of enjoyment, but as means of getting an income. (d) All sums spent on hire of goods that in like manner are to serve as means of getting an income. (e) All payments for labor that in like manner are to serve as means of getting an income.” One wonders if Marshall’s idea of incomings and outgoings is limited to a cash basis or if he recognizes accruals. On the other hand, from the point of view of accounting, Devas includes too much, as will be pointed out later. E. R. A. Seligman[54] says: “Profits are the income from business enterprise.... Profits are always a surplus. They are the difference between the cost of production or acquisition and the selling price.” He summarizes expenses of production as including cost of raw materials, wages, rent, interest on capital borrowed or invested, taxes, and miscellaneous outlays such as insurance, advertisements, and transportation expense. Again, he says:[55] “Income is that which comes in to an individual above all necessary expenses of acquisition and which is available for his own consumption.” He recognizes depreciation as a necessary expense.
All of this attests the statement made above that the formulation of a satisfactory working rule for the determination of net profits, from the business standpoint, is extremely difficult. It should be said, of course, that in some respects the idea of net profit as used in economics differs from that used in business; the chief difference being that interest on invested capital is in economics looked upon as an expense deduction before the determination of profits.
Legal Definition
The efforts of the law, as evidenced by court decisions, to mark out definitely the meaning of net profits have resulted in many odd twists of terms and meaning. In an English case[56] decided as recently as 1902, this language is used: “If it is a mere question what were the profits made in a particular year, it seems to me that the duty is to ascertain what cash has been received and what cash has been expended, and, if that is fairly done, you know the profits of the year. If there is a large outstanding liability which cannot be settled, the partners will estimate that, and it will not be considered as part of the profits. If there is a large outstanding possible loss, and there is a large sum due to a client, then you would provide for that. But in ascertaining what is really actually divisible for the year fairly, you would take the cash account as it stands.” In the light of such mental obtuseness and obliquity, one cannot wonder at the occasional reluctance of business to entrust the determination of important matters to the courts.
In cheering contrast is a legal opinion quoted by R. H. Montgomery,[57] in the following: “I should think that no commercial man would doubt that this is the right course—that he must not calculate net profits until he has provided for all the ordinary repairs and wear and tear occasioned by his business. That being so, it appears to me you can have no net profits unless this sum has been set aside.... If you had done what you ought to have done, that is, set aside every year the sum necessary to make good the wear and tear in that year, then in the following years you would have a sum sufficient to meet the extra cost.” Even here confusion is apparent between a valuation reserve and a reserve which has been funded and the emphasis is rather on the point of providing funds necessary for the purpose—a financial problem as distinguished from an effort to define net profits.
Between these extremes of legal opinion and phraseology one finds all shades and degrees of understanding and misunderstanding. In recent years there is evident in the decisions of our higher courts and of our many excellent governmental commissions and bureaus a real appreciation of some of the technical points involved in profits determination. It is believed that a body of authoritative decisions will in time and perhaps soon reflect the best opinion of the business men of the country.
Accounting Definition
The purpose of this chapter is to discuss some of the points at issue in this vexed problem, but before entering upon this discussion it will be of advantage to quote from leading authorities on the attitude of accountants towards the determination of profits.