An organization needs to take into consideration two questions when measuring profit, which are as follows:
a. Which concept (accounting profit or economic profit) should be used for measuring profit?
b. What costs should be or should not be included in implicit and explicit costs?
These two questions complicate the whole process of measuring profit. The answer of first question is that selecting the concept depends upon the purpose of measuring profit. Accounting concept of profit is used when an exact figure of profit is required.
An organization needs to determine exact profit figures for the following purposes:
a. Informing shareholders about the progress of the organization
b. Proving the creditworthiness of the organisation for investors and other creditors
c. Assessing the performance of the organization
d. Calculating the tax due on the organization
On the other hand, if the purpose is to measure true profit, economic profit should be used. The true profitability of any investment or organization cannot be measured until the investment or organization is fully terminated. However, the life of an organization is endless. Thus, true profit can only be measured in terms of maximum dividends given to shareholders.
In this way, the concept of measuring true profit is of little practical use. Therefore, accounting concept of profit should be used for measuring the profit for practical purposes. However, measuring the profit with accounting concept is not an easy task. The problem arises in case of what to be included and what not to be included in implicit and explicit costs.
There are three items that pose problems for the inclusion in costs, which are as follows:
Refers to the loss in the value of an asset because of its continuous use. There are four methods of measuring depreciation providing different profit figures. Therefore, measuring depreciation becomes complicated.
2. Capital Gains and Losses:
Affect the profit to a large extent. The profit of an organization is affected by capital gains and losses, which are the results of fluctuations in stock markets. According to a sound accounting policy, both capital gains and losses should not be recorded until they are turned into cash.
However, some organizations do not record capital gains until they are realized in monetary terms, but deduct capital losses from current profits. In such a case, there would be different figures for profit of organizations following the accounting policy and organizations that are using their own methods.
3. Current vs. Historical Costs:
Helps in preparing the income statements of organizations. Most of the organizations use historical costs instead of current costs because they produce more accurate measurement of income. In addition, historical costs are less debatable and more objective.
However, they ignore inflation and deflation, whereas current costs always take into account current economic conditions. Therefore, the values of assets or inventories recorded by taking into consideration historical costs are understated. Consequently, the whole task of calculating profit gets affected and true value of the profit may not be reflected.