A. Lowes Dickinson[58] says: “In the widest possible view, profits may be stated as the realized increment in value of the whole amount invested in an undertaking; and, conversely, loss is the realized decrement. Inasmuch, however, as the ultimate realization of the original investment is from the nature of things deferred for a long period of years, during which partial realizations are continually taking place, it becomes necessary to fall back on estimates of value at certain definite periods, and to consider as profit and loss the estimated increase or decrease between any two such periods.” It is in the making of these estimates that the most difficult problems of profits determination are met.
Mr. Montgomery in his dictum, “The net profit of a business is the surplus remaining from the earnings after providing for all costs, expenses, and reserves for accrued or probable losses,” offers the best available working definition, although a caution is needed against the danger of relying exclusively upon any one definition.
Methods of Determining Profits
Systems of bookkeeping, in the main, provide two distinct methods for the determination of profits, namely, by means of single entry and double entry. The student is referred to the author’s first volume for the detailed working out of profits by single entry. Here it is sufficient to say that the determination of profits rests upon a comparison of assets and liabilities as at the beginning of a fiscal period, with those as at the end of the period. Then the increase or decrease in net worth as so determined, after making due allowances for any withdrawals or investments of capital during the period, constitutes the figure of net profit or loss for the period. The disadvantages and inaccuracies inherent in this method have already been pointed out.
The method of determining profits by means of double entry provides an entirely distinct set of accounts known as temporary proprietorship or profit and loss accounts. These record the daily changes in net worth and must be summarized through the Profit and Loss account at the close of the fiscal period, at which time they must prove against the profits as determined by the balance sheet, the method of which is essentially the single-entry method. In addition to this control secured by checking the results obtained by one group of accounts against those of another group, is the important advantage of presenting in the record a mass of statistical information for guidance in the conduct of a business, without which the present-day enterprise with its many complexities of organization and working could not hope for any certain measure of success.
The Problem a Question of Valuation
Inasmuch as every profit made must be reflected in a corresponding increase of some asset or the decrease of a liability, and, conversely, every expense incurred is reflected as a decrease of assets or increase of liabilities, it is apparent that profits determination is largely a question of the valuation of assets and liabilities and therefore rests upon the principles already established. Thus the amount of gross profit is not determinable until the value of the stock of merchandise on hand is known. Gross profit rests on inventory valuation, whether that be accomplished by the perpetual inventory method or that of periodic stock-taking. While under the double-entry system the charges for expense are more or less fixed and certain and not so dependent on inventory, it has been seen in Chapters XIV and XIX that before accuracy can be secured, here too there must be an inventory or appraisal to determine the prepaid and accrued expense items. The basis for valuing these was indicated in the chapters referred to. Estimates of depreciation, bad debts, and other similar items must also be made to secure a proper appraisal of the corresponding asset items. Similarly, in the determination of other income, accruals and prepayments must be taken into account. In the making of the record of temporary proprietorship data, the fundamental distinction between capital and revenue charges is vital and must be kept constantly in view.
Thus the problem of profits is seen to be in its broader aspects the same problem of valuation to which attention has already been directed. It is purposed here to point out the application of the valuation problem to the periodic determination of profits and to re-examine some phases of the problem from the standpoint of profits as distinguished from that of assets.
Effect of Asset Losses on Future Profits
The first question for discussion may be stated as follows: In the determination of periodic profits must all the data which have affected proprietorship during that period be summarized in order to make a proper showing of profits for the period? An illustration will better present the issue. A manufacturing concern with plants in many places suffers a heavy loss from fire. Must this loss be considered (1) as an expense applicable to the current period and to be taken account of before the determination of profits for the period; or (2) may it be treated as a deferred expense to be shared by several succeeding periods; or (3) may it be charged directly against capital?