Accounting profit means the money that a business make by selling products or services after paying the costs involved, or simply the revenue gain less the costs of generating the revenue. Profit figures are included in business' financial statements to deliver information about the business' performance during a particular year to users of accounting statement. Regardless of the size of an organisation, the method for calculating profit is basically the same because Generally Accepted Accounting Standard (GAAP) already outlined the standard framework in preparing the Profit and Loss account of a business. GAAP introduced some very important accounting principles in the preparation of financial statement and in this case, calculating profit which include matching, prudent, accruals, and consistency concept. These principles help businesses provide a true and fair view of their statements for themselves and the users.
Types of profit usually include in the financial statements are gross profit (profit after cost of sales and other direct costs), operating profit (gross profit after overheads and other indirect costs, before interest and taxes), and net profit (operating profit after interest payments and taxes). Different types of profit show different aspects of business performance during the year. Until today, the accounting profit has been used for various purposes such as to evaluate a business, compare performance with competitors, improvements, development, and R&D. From investors' point of view, profit might help them decide for their investment although usually other factors are taken into account as well (e.g dividends, equity, economic condition). This shows that users and even the business itself rely heavily on the accounting profit figures to make decisions. So, the true profit of an organisation is likely to be the accounting profit shown in the financial statements as it also follows the GAAP standard of calculating profit.
Note that in the last sentence I used the word likely. Or is it not likely rather than likely? Why such word exists and why can't we just be certain and simply say that accounting profit is the true profit? That sure will make our life easier because no complication or conflict will disturb our perspective about profit. I would like to start by giving a simple example. If we were given a value, say, $1000, we won't have any expression on the number without knowing what the value is. If we know it is our weekly expenses, we might want to cut our expenditure in the future because it's too much, or maybe not for rich people. However, if the number represent profit figure for a particular year of a company we currently invested in, we might instantly sell our shares of the company to invest in other more profitable company. From this example, we can see that people react differently to numbers, provided we know what the numbers represent. Frandsen (2009) and Lowe (2001) provide good examples of how accounting information and figures 'blended' into people's daily life. Those articles gave us the idea of how powerful accounting became since it was developed because it helps position a company, shape the economy, and subsequently able to develop a country. So, I think people react on what they believe. If they believe the accounting profit figure is the true profit of an organization, they will react accordingly to have the full benefit of it, vice versa.
The collapsed of Enron sure was a tragedy for most active investors in the market. I think one of the most important effect of Enron's scandal was people's confidence on financial market was substantially distorted. People keep questioning about the auditors work and how come they can keep on providing false figures. As I mentioned before, people's reaction will change once their belief change. At this particular point in time, people might not believe that the accounting figures are the true presentation of a company. Sarbanes-Oxley Act (SOX) was introduced in July 2002 to restore confidence in financial market. Article by Burrowes and Hendricks (2005) explained further about SOX. The question is, does private interest should be on top of legitimacy? If no, shouldn't the persons responsible already see this coming and think of a solution beforehand? The least they can do is include clear disclosures (Cormier and Gordon 2001, Prencipe 2004) so that shareholders or intended users have the clear understanding of how the company is doing.
The above figure is the idea of corporate legitimacy from O'Donovan (2002). As Y and Z are stated, X represents the interception or the congruence between the corporation's actions and activities and society's expectation. The objective of an organization should be to obtain as large X as possible to ensure the organization's legitimacy remains high. I think we could say the legitimacy of an organization is somehow related to the profit to some extent because the more the organization actions 'integrate' with the society's expectation, the more it gains people's trust and the more it can exploit from those people to maximize its profit. The downturn of this is once it breach the 'social contract', an organization might lose more than they can imagine. I think we could say that their accounting profit figures (given in the report or financial statements) is likely to be their true profit (expectation from the society) provided the society know, understand and clear about every main activities and transactions of the organizations. I know the ideology of thinking that the true profit is the expectation from the society is not quite appropriate to some extent because it is much easier to say that the true profit is the profit that the organization should provided in the financial statements. I just do so to give the idea of legitimacy in terms of profit because we could say that the true profit is the society's expectation because that is the purpose of having 'social contract' with the society.
In conclusion, real life business is not as easy as it sounds. Even the source of legitimacy is not solely society's expectation but also government regulators (Deephouse 1996). So, to say that the accounting profit figure is simply the true profit is very subjective. Other factors such as financial reporting rules, economic conditions, organizations' capabilities and objectives, laws and regulations, and credibility should be considered as well. One of the important point is, public should at least have the accounting knowledge in order to have a good analysis of an organization (assumptions, estimates etc). However, the management and auditors also have to be legitimate in preparing their financial information and delivering them to the public.
- O'Donovan, G., 2002. Environmental disclosures in the annual report: Extending the applicability and predictive power of legitimacy theory. Accounting, Auditing & Accountability Journal, 15 (3), 344-371.
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- Lowe, A., 2001. Casemix accounting systems and medical coding: Organisational actors balanced on ``leaky black boxes''. Journal of Organizational Change Management, 14(1), 79-100.
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- Lowe, A., 2004. Postsocial relations: Toward a performative view of accounting knowledge. Accounting, Auditing & Accountability Journal, 17(4), 604-628.
- Prencipe, A., 2004. Proprietary Costs and Determinants of Voluntary Segment Disclosure: Evidence from Italian Listed Companies. European Accounting Review, 13(2), 319-340.
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- Burrowes, A., Hendricks, A., 2005. Independent financial experts: From wished for to wistful thinking. Manaagerial Finance, 31(9), 52-62.
- Frandsen, A.C., 2009. From psoriasis to a number and back. Information and Organization, 19, 103-128.
- Baker, C.R., Hayes, R., 2005. The Enron fallout: Was Enron an accounting failure? Managerial Finance, 31(9), 5-28.
- Deegan, C., Unerman, J., 2006. Financial Accounting Theory. European ed. New York: McGraw-Hill Education (UK).
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- McCrone, A., 2005. Triumph of the grey suit brigade [online]. Available from: http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article745437.ece