ACT 4191 CHAPTER 16 : PROFIT

1. ACT 4191CHAPTER 16 : PROFIT GROUP MEMBERS: NGOH SOO HOW 124219 KHAW WOOI CHENG 130023 YAP MEI WVEN 129334 LEONG SIEW WAI 129758 OON SHIAU HUN 129546

2. What is Profit? • United States terms “income” • How much wealthier a person or entity has become in a given period • Economy theory assumes that individuals satisfy their “wants” via consumption of goods and services • Acquiringgoods and services to satisfy wants is thus the main reason people wish to earn a “profit”

3. Definition John Hicks: • the maximum value the person can consume during a week and still expect to be as well off at the end of the week as at the beginning. Barton: Adopted for accounting(business income) • The increased in net wealthis income of the period excluding additional capital contributions and withdrawals from initial capital investment.

4. Profit Defined • Profit is represented by a bundle of assets or rights to consume. • Changes in the value of these assets occur through use and through activities designed to increase their value of the assets. • A positive change between values of assets held at two points in time

5. Business Profit • the excess of the price ultimately paid by individuals and other entities for the firm’s output over the expenses incurred by the firm • represents the increase in net value created by the firm during a given period Bedford: • it is the reward paid by individuals to business entities for their productivity which represents business income and therefore it is reward… which acts as the motivating force in a free market economy.

6. Cont… • The objectivity is to ensure that the value of the initial bundle of assets is not eroded and that n appropriate return is achieved by management • relates to the capital maintenance concept

7. Two Limiting Cases Two extreme situations: • When a business is to be terminated • When a business is under complete certainty (Ideal Case) Terminal Case • When the life of the business is terminated, profit is determined as the total cash receipts less total cash outlays excluding investment by the owner or payments to the owner. Formula: • Profit = Cash Received- Cash Paid

8. Terminal Case • When the firm has no future, it is possible to equate revenues with the cash receipts and expenses with the cash payments • Adjustment for changes in purchasing power could be made. • Another way to determine the profit is to compare the ending balance of capital, adjusted for withdrawals by owners with the beginning balance. Formula: • Lifetime Profit = Ending balance of capital – Beginning balance of capital

9. Certainty- of- Future Case (Ideal Case) • In a world of certainty, everything is known for sure, when the amount of cash to be received and paid is certain: • All assets and liabilities reduce to expectations of future cash flows- in effect, receivables and payables.

10. Cont…. • The increase in value of total assets that concurrently increases capital during a given period constitutes revenue for the period. This is assuming that the owner does not invest additional assets in the firm. • The increase in value of the total liabilities that concurrently decreases capital during a given period constitutes expenses for the period, assuming that no liabilities are forgiven and no distributions are made to owners.

11. Cont…. • The profit for the period is equal to the increase in value of capital, as measured at the beginning and the end of the period. • All values increased at a predetermined rate, thus revenue is the interest earned on total assets, expense is the interest incurred on the total liabilities and profit is the interest on investment (capital). • A strict accrual accounting basis takes place. There is no revenue recognition or matching problem.

12. Cont….. • Assets and liabilities are economic objects that have real world existence separate from their valuation. • The meaningfulness of profit and its components, income and expenses is directly tied to the value characteristic of these objects. • The ideal case defines profit as the increase in the value of capital, the difference between values of assets and liabilities at the beginning and at the end of the reporting period.

13. Cont…… • Profit and its components- revenue, gain, expense and loss refer to the changes in their value. • The accounting equation A= L+ E means the value of the assets, liabilities and capital.

14. Cont….. • By nature, cost is not same as value. • In ideal circumstances their amounts are identical because the cost is incurred in expectation of future benefits. • When buyer and seller are certain of future benefits such that a reasonable rate of return can be derived, cost will equal the present value of cash related to the benefits.

15. Cont.... • In a world of certainty, cost is also equal to value on the date of transaction. • In the real world, value changes through time as people’s expectations change. • Thus, historical cost will not necessarily equal current value.

16. Profit Under Uncertainty Ideal case: • Profit should focus on the economic event of changes in value of the assets and liabilities, not on cash received and paid. Terminal case: • Profit is the difference between cash inflows and cash outflows.

17. Cont…. • If the of a business is short and its end is know, the terminal case indicates calculation of profit is uncomplicated. • Historical cost supporters favor the implication of the terminal case whereas advocates of current values tend to refer the inferences of the ideal case.

18. Cont….. Accruals and deferrals are important only when: • the life of firm is long or its terminal date is unknown • information about profit is desired before the firm’s expiration. This is why, in conventional accounting theory, the “going-concern’ assumption is made.

19. Professional’s Definition • Profit calculation is a necessity due to conventions and legal requirements. • The Malaysian conceptual framework does not provides formal definition of “profit”, instead provides definition of income. • Income includes bothrevenue and gains.

20. International Standards IAS 12- Accounting for Taxes on Income • accounting income is the aggregate income or loss for a period including unusual items as reported in the profit and loss account, before deducting related income tax expense or adding related income tax saving.

21. Value • Value generally means economic value. • Value has to do with preferences of people for one commodity over another because of their expectations of future benefits. • Value is personal.

22. Market Value • Market value serves as an objective guideline for the measure of value for a commodity. • Money is used as the “standard commodity” to measure goods and services. • At any given time, a structure of prices, expressed in terms of money reveals the relative values of commodities.

23. Cont….. The structure contains past, current and future prices: • Past price is the historical cost of an item. • Current prices include replacement or current costs, exit prices and calculated present values. • Future prices are future replacement or current costs, or future exit prices. • However, accountants agree that future amounts should not be used for reporting purposes because they are not objective.

24. Ideal Value • The ideal value is present value, and for monetary items that is used. • However, for short- term items the discount rate is not used. • The three viable alternatives for non-monetary items are historical cost, replacement cost or current cost (including calculate amounts), and exit price- or a combination of them.

25. Capital In accounting, capital is the net assets. It is the difference between the sum of total assets and total liabilities. Profit does not come until the beginning of the amount capital is maintained and that is until the costs are recovered.

26. Financial Capital • The financial capital emphasis on the monetary value of the assets less the monetary value of the liabilities. • It focuses on the owners’ contributions to the entity finance the assets. This mean capital represents that the cash invested by owners plus profit reinvested by retention in the business.

27. Cont….. Profit must be the amount of cash received by the firm over the cash (or cash equivalent) investment by owners into the firm.

28. Physical Capital • The physical capital view focus on the ability of the firm to generate goods or services. • The current value of the assets and liabilities to an entity are reported and the change in value between reporting periods is adjusted in the calculation of profit.

29. Three Possibilities Meaning of Productive Capacity • Refers to the same physical non monetary assets that the entity possessed at the beginning of the period. • Refers to the volume production • The last one is pertains to the volume of sales.

30. Physical capital view: RM Sales revenue 500 Current cost of sales 350 Profit 150 Capital Maintenance Adjustment 150 Holding Gain or Capital Maintenance Adjustment Financial capital view: RM Sales revenue 500 Current cost of sales 350 Operating Profit 150 Holding Gain 50 Profit 200

31. Criticisms of Financial Capital View and Physical Capital View • Critics of financial capital view subscribe to physical capital standpoint. • Criticism focuses in the inclusion in profit of amounts that they believe are necessary to maintain the physical capital of the firm. • the replacement price of a non-monetary asset increases, profit under the financial capital concept is overstated because the amount of the increase is needed to maintain the capital.

32. Cont… • profit under the financial capital is not reduced by the amount. Holding gains cannot be distributed as dividends without impairing the firm’s ability to generate the same level of goods or services. • Critics of the physical capital concept are support the financial capital position. • Criticisms consider that the capital maintenance adjustment is actually profit. Physical capital viewpoint is based on confusion between the function of the accountant to determine financial performance and that of management to ascertain the desired level of operations.

33. Cont… • Critics charge that the difference between what is considered a holding gain which under financial capital view and capital maintenance adjustment which under physical capital view is based on a decision as to what is essential or non-essential o the continuance of the business. • If an asset is deemed to be essential, then the increase in its replacement cost is a capital maintenance adjustment, otherwise it is included in profit.

34. Two Scales • Nominal dollars scale • Units of money or quantity of dollars • Purchasing power of the dollar scale • Constant dollars

35. Selection of Index • Inflation can only be measured indirectly through a general price index. • There are three alternatives: • (i) Gross Domestic Product (GDP) Implicit Deflator • (ii) Consumer Price Index (CPI) • (iii) Investment Price Index

36. Current Issue • Although economists and accountants agree on the concept of profit, they differ in their approaches to the measurement of profit. • This has fostered considerable debate about the appropriate basis for profit measurement. • This issue is extremely controversial, as the measurement techniques adopted by organizations can affect the perceived value of an organization.

37. Cont. • Recent financial scandals such as WorldCom, Enron and Transmile have shown us how creative is accountants to “cooked” or “roasted” the financial statement to show the investors and shareholders for the expected or “surprise” profit.

38. Cont. • In Transmile case, the company have been practice a few creative accounting such as recognizing fictitious revenue, misreported assets and liabilities, getting creative with Income Statement and problem with cash flow reporting. • All these practices have “blurred” the shareholder what is the real profit of the company.

39. Conclusion • Since it is necessary for firms to calculate their periodic profit under convention and legal requirements, a workable definition of profit is critical and must takes into account the real world of uncertainty that is between the two extremes.

40. Thank You