The Paradox of Profit

Accountants define profit as the financial benefit realized when revenue generated from a business activity exceeds the expenses. For a business to be successful profit and a positive cash flow are required. A business which cannot pay its bills as and when they fall due will ultimately fail. Current financial statements provide this information and the notes to a set of financial statements declare the basis for the preparation of the financial statements.

Primarily, the financial statements are prepared on a going concern basis (i.e., the business continues to keep trading) and on a cost basis (transactions are recorded at the price paid). The notes however do not declare that the financial statements only summarise the short-term activity (the previous 12 months) of the organisation and the financial statements are silent on the reporting of long-term value.

The purpose of all for profit organizations is to maximizes sales and minimize costs. Maximising the sale price and the income occurs by highlighting the benefits and concealing the disadvantages of the product. Costs are minimised by operating as efficiently as possible and by pushing costs and risks to suppliers, employers, customers, and society. Current costs are minimised by pushing costs into the future which will inflate the current period profit.

For small to medium size organizations where management and ownership of the organisation are the same, the ability to push costs into the future exists. However, managers/owners realize the day of reckoning will occur. For most small to medium size businesses the owner has provided personal guarantees and the family home offered as security, so the incentive to push costs and risk into the future is diminished. The appetite for risk is less as at some time in the future the risk will return to the organisation and ultimately to the individual owners.

For small to medium size businesses the cost of acquiring the new customer is often greater than servicing the current customer. So, providing a quality good or service where the value provided matches the price paid ensures a long-term happy customer. As management of most small to medium size businesses engage directly with the customer, a personal long-term relationship exists with the customer. Maximising the price and profit is not the only determinant.

In large organizations, where management and ownership are separate, the managers and directors provide no personal guarantees and no family home as security.  Bonuses and salaries are determined by the short-term profit figure. Managers and directors are incentivised to generate short-term profit at the expense of long-term value. The customer is just a number where management has no personal and no long-term relationship.

The 2008 global financial crisis, Australian Royal Commissions into the banking sector and nursing homes, the Australian state government enquiries into Crown Casino shows how dangerous and incomplete current financial reporting is.

Not for profit organizations further highlight how incomplete current financial reporting is. By giving away their goods and services the current financial statements only disclose the organisations’ ability to pay its bills as and when the fall due, and it is ability to fund future activities.  The financial statements are completely silent on providing information on the value the organisation provides to the community and society. The financial statements provide no information on how effectively the organisation provides those goods and services to the community.

The paradox of profit is that a larger profit appears to be good for the owners of the organization as the result of a profit is that the Net Assets of the organization (Net Assets minus Net Liabilities) has increased by a greater amount. However, where the current year profit is the result of management pushing risk into the future and pushing extra risks and costs on to customers, suppliers and employees and society then the current year profit is illusory.

Accountants are mesmerised by profit and economists are mesmerised by output. By recording and reporting the quantity of the outcomes and placing a financial proxy value of those outcomes value reporting can easily occur.