2.04 – Disassembling Profit
Understanding profit is crucial to comprehending a business’s financial health. While it’s common to think of profit as simply revenue minus expenses, this definition doesn’t capture the full picture. This section breaks down the components of profit to give a deeper understanding of its substance.
The Anatomy of Profit
Consider the income statement of a technology company that earned net income for the year. Profit results from the interplay between revenue and expenses, akin to the two blades of a pair of scissors: one blade represents revenue (positive) and the other expenses (negative). The interaction of these two elements determines the profit.
Revenue and Expense Effects
Revenue increases assets or decreases liabilities. For example, cash sales increase the cash account, while advance payments from customers increase a liability account called deferred revenue. When the product or service is delivered, this deferred revenue is converted to actual revenue, decreasing the liability.
Expenses, on the other hand, decrease assets or increase liabilities. For instance, recording the cost of goods sold reduces the inventory asset account. Similarly, recording a bill increases the accounts payable liability.
Understanding Profit
Profit itself doesn’t appear directly in the equation; it’s the net result of recorded revenues and expenses. To see how this works in practice, let’s look at three profit scenarios where the business makes the same profit amount of $10:
- Case 1: Revenue consists entirely of asset increases.
- Case 2: Revenue is derived from decreases in liabilities.
- Case 3: Revenue involves both asset increases and liability decreases.
In all cases, total expenses amount to $90. The revenue and expense transactions ultimately determine the profit.
Cash Flow vs. Profit
Revenue and expenses don’t always equate to cash inflows and outflows. For example, a business might buy products on credit and sell them later, or make sales on credit and receive payment later. Therefore, the net cash flow from profit (revenue inflow minus expense outflow) usually differs from the accounting-based measure of profit. The income statement reports profit, but not cash flow.
Folding Profit into Retained Earnings
After determining profit for the period, it’s added to retained earnings, ensuring the accounting equation stays balanced. For example, if assets increase by $40, liabilities by $30, and retained earnings by $10, the equation balances. Retained earnings, despite its name, is not an asset but a source-of-assets account, reflecting owners’ equity.
Understanding how profit activities affect assets and liabilities is essential for business managers. Managing these changes is crucial, as making a profit can have both positive and negative impacts on a company’s financial position. The statement of cash flows, discussed later, provides a summary of the financial changes caused by profit activities.
