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Profits or cash flow – Part 2

Sarah Ardiles and Tom Clendon continue their discussion of profit versus cash flow. Last month they explored the usefulness of cash flow reporting. Now they turn their attention to profit.

Sarah sets the scene 

I enjoyed our discussion on cash flow last week Tom. We certainly came up with lots of reasons why reporting on cash is so important to investors. You may remember that what got me thinking about cash versus profit was one of my students asking the astute question, ‘if a statement of cash flows is so useful, what’s the point of publishing a profit and loss account too?’ In the interest of fairness, I think we should turn our attention to profit now.

Tom defines profit

I think a good place to start would be to understand the word ‘profit’.  Interestingly, the term is not defined in the IASB’s Conceptual framework. Back in the days when I taught the equivalent of F3 (Financial Accounting), I would always ask my students what they thought profit meant. A great many would say something like ‘is it income received minus costs paid?’ And that would lead me to talk about accruals accounting. Actually, profit has nothing to do with cash received or paid – profit is basically the surplus of income earned over expenditure incurred. It’s all about those verbs: earned and incurred. Income is recognised as it is earned and costs when they are incurred. Accordingly, IFRS dictates when income such as revenue, government grants, interest on financial assets and so on must be recognised in profit. Likewise, IFRS determines when costs, such as the purchase of non-current assets, leases, wages, pensions and even tax must be expensed. 

Sarah introduces the matching concept

I remember when I used to teach F3 and I would explain the meaning of cost of sales. I used to make the point that cost of sales isn’t the cost of everything you’ve bought this year but rather the cost of the goods you have actually sold this year. Hence the need to deduct closing inventory (as you didn’t sell it). I would tell my students that in accruals accounting we apply matching, a concept they would see over and over in their financial reporting studies. Another concept that has never been properly defined, matching assigns revenue earned and expenses incurred to the accounting period in which these events occur.

Tom talks about matching in accounting for pensions

What I love about IFRS is that it is principles-based, and I would say that matching is one of the key principles that runs through it. There are many examples of matching, but I am going to pick one: accounting for pension costs. At first glance, you may think that a company should report its cost of paying its pensioners when it pays them; after all that’s when the cash goes out. But really, if we are going to account for employment costs in a faithful way, we should be looking to recognise the cost of employing staff over the period they provide economic benefit to the company – in other words over their service. Accounting for pensions is a complex area, best left for another article; it relies on all sorts of estimates about the future. But fundamentally, the reason we account for pensions in the way that we do is simple: matching!

Sarah reveals how profit has been criticized

Another principle of IFRS is the idea that financial statements should be comparable. For example, investors should be able to make meaningful comparisons between different entity’s statements of profit or loss.  However, the way companies present their profit in the statement of profit or loss has come under some criticism of late. Rather unhelpfully, IAS 1 Presentation of Financial Statements only requires entities to report revenue and profit or loss for the year. There is no requirement to provide subtotals in between. Many entities choose to report an operating profit subtotal but there is inconsistency in how it is calculated. This has caused frustration for investors who rely on operating profit to analyse the performance and make judgements about the value of a company. Given different entities are calculating operating profit in different ways, a meaningful comparison is nigh on impossible.

Tom sheds light on the new proposed rules

Fortunately, the International Accounting Standards Board (IASB) has proposed that listed companies standardise their definitions of operating profit in financial statements in order to help investors when making comparisons. The new rule would require companies to disclose three new subtotals: operating profit, profit before financing and income tax, and one that includes operating profit, income and expenses from associates and joint ventures.

Sarah sums up

We have seen how useful profit is in reporting on the performance of a business, and how the application of the matching concept in accruals accounting ensures that costs are paired against the related income in the statement of profit or loss. But we also learnt that as helpful a concept as profit it, its presentation in the financial statements currently is less than helpful. Fortunately, IAS 1 will soon be amended to ensure a more comparable presentation of operating profit. Watch this space!

Tom Clendon FCCA is an online ACCA SBR lecturer

Sarah Ardiles is an online ACCA FR and SBR lecturer – See courses here

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