The following points highlight the six main economic problems of measuring business income. The Problems are: 1. Treatment of Cost 2. The Problem of Depreciation 3. The Treatment of Capital Gains and Losses 4. Accounting for Inflation 5. Profitability Measures 6. Predictability of the Future.
Problem # 1. Treatment of Cost:
The first problem centres around the concept of cost. Of course, outlays for materials, labour and interest on borrowed money are to be included in total cost. But there is controversy regarding top executives’ salaries. Some economists think that managerial wage, even when paid as salaries (rather than as dividends), should be included in costs. Others believe that they are profits.
“But the central issues”, opines Dean, “concern non-cash items such as income that owners could earn if working elsewhere, and interest that their funds could command if lent to other firms. These opportunity costs do not appear on the books and hence are excluded from conventional profits.”
Problem # 2. The Problem of Depreciation:
To an economist depreciation is capital consumption. It also includes the opportunity cost of capital equipment (i.e., the most profitable alternative forgone by putting it to its present use). To the accountant, depreciation is an allocation of capital expenditure over time.
Problem # 3. The Treatment of Capital Gains and Losses:
The ways in which such gains or losses (i.e., windfalls like the bankruptcy of a major credit not allowed in bad debt reserves, or the unanticipated rise in the share price of a firm) are handled, also affect a company’s reported profits. In accounting practice a capital gain is not made until the property is sold. But management should be aware of the magnitude of such windfalls.
Problem # 4. Accounting for Inflation:
The economist’s version of profit requires an estimate of the present value of all future cash flows. This cannot be accurately estimated in an uncertain world. Replacement cost (RC) accounting can tackle this problem. It is a term which covers a range of alternative methods of accounting for inflation.
(a) Book Profits:
Accounting profits are those that are reflected in the book of accounts. These are also known as book profits. These are figures reported by individual corporations to their stockholders. These represent “management’s official evaluation of the firm’s performance, and are a major factor in determining dividend policies and investment programmes.”
(b) Tax-Return Profits:
These are net income reported by corporations to the Income Tax Department (Ministry of Finance). These data differ from profits reported to shareholders in several important respects, chiefly in the rate at which plant and equipment are depreciated, in treatment of investment allowance, and in the way in which earnings of overseas subsidiaries are consolidated into the total.
(c) National Income Profits:
These profits measure what corporations would earn if they kept their books in a manner consistent with the national income accounts, as published by the Central Statistical Organisation (Government of India). These national income figures are probably the most widely quoted and used in assessing the financial well-being of corporations and the economy.
(d) Real Profits:
These are earnings after making allowance for the impact of price changes. Efforts in this direction have ranged from “a simple adjustment of book profits for changes in purchasing power to a detailed restatement of corporation balance sheets and earnings statements in constant prices.”
Problem # 5. Profitability Measures:
These measures attempt to relate the rupee level of profits to sales or capital in order to measure the efficiency or investment potential of a corporation or an industry. Profits margins are the number of paise of after-tax profits realized per rupee. Rates of return usually relate after-tax profits to net worth or shareholders’ equity.
Problem # 6. Predictability of the Future:
Economists look at expected future profits of a concern as a basis for decision-making. In the purchasing decision of a durable asset like a printing machine, future earnings and economic conditions play an important role. To a businessman the past is irrelevant, except as a forecaster of the future. However, accountants want to report historical facts and eschew speculation about the future.
In the words of Dean, “to an accountant, net income is essentially a speculation about the future.”
Profits do fluctuate from year to year. Since most business decisions are taken under uncertain conditions the prediction of the future becomes vital. In other words, there is need to forecast “all future changes in demand, changes in production processes, cash outlays to operate the business, cash revenues, and price changes (to state cash flows in terms of constant purchasing power).”
The accountant uses past transactions and measures net income (or profit) by finding the difference between net assets at the beginning of the year and net assets at the end of the year. But an economic balance sheet is an attempt to aggregate the future earnings of the firm’s assets now on hand. It derives entirely from income expectations.
In general, “the kind of profit measurement needed for most business decisions comes closer to the ideal of the economist than to the practice of the accountant.”