No other business term is so misunderstood, misstated, misleading or deceiving as the words ‘net profit’. Accounting defines net profit as the amount earned after all associated costs and expenses are subtracted from the associated sales. The larger or more public the company the more reliable the dollar value as stated on the bottom line. But in small business, the more likely the value is inaccurate as stated in the financial report.
To understand and appreciate this term, the reader must first grasp the technical definition. Next, the term is used in different contexts including taxable net profit, financial net profit, accrual or cash basis and is sometimes stated with market basis in mind. Therefore, the reader must understand that the term net profit must be interpreted from the perspective of the particular basis of accounting. Finally, there are outside factors that can greatly impact its meaning and therefore its application in business. This article is designed to introduce the reader to these various definitions of net profit so that in reading or in conversation the reader can ask the appropriate questions to gain the best understanding of the term ‘net profit’ as conveyed by the source.
Net Profit – Technical Definition
The American Institute of Certified Public Accountants (AICPA) created a set of rules known as Generally Accepted Accounting Principles (GAAP). Our federal government via the Securities and Exchange Commission (SEC) has made at least one wise decision by incorporating these rules into defining net profit for publicly traded companies. The standard definition of net profit is sales less all costs associated with those sales less taxes equals net profit. A standard model for the income statement (profit and loss statement) looks like this:
Cost of Sales (ZZZ,ZZZ)
Gross Profit ZZZ,ZZZ
– Management $ZZ,ZZZ
– Facilities ZZ,ZZZ
– Insurance ZZ,ZZZ
– Office Communications Z,ZZZ
– Taxes and Licenses Z,ZZZ
– Other ZZZ
Sub-Total Expenses (ZZ,ZZZ)
Operating Profit Before Capital/Taxes ZZ,ZZZ
Capital Costs (Interest, Deprec., Amort.) (Z,ZZZ)
Income Taxes (Z,ZZZ)
Net Profit $Z ZZZ
The net profit shows up in the equity section of the balance sheet as current earnings for the year.
GAAP defines each of the respective sections. Revenue includes sales and ancillary forms of income including gains or losses on the sale of assets. Cost of sales, a.k.a. cost of goods sold is also defined in the rules (principles). General overhead includes expenses and capital costs of operations. In this section are expenditures for the front and back office along with selling expenses. Naturally, the government gets its share via income taxes at both the federal and state level.
This is the standard presentation outline for most businesses. The net profit appears relatively simple to comprehend. This is where the term starts to get wonky in its meaning.
Accrual or Cash Basis of Accounting
Accountants decided that there should be two different fundamental methods of accounting. They are accrual and cash basis of accounting. The cash basis is essentially simpler and easier to understand. Economic transactions are only recorded for bookkeeping purposes when cash exchanges hands between any party involved (customers, vendors, landlord, suppliers, etc.). This method is very commonly used with micro businesses.
As a business grows and prospers, the documentation becomes more complicated and convoluted. Therefore, accountants advocate recording the transaction when it becomes legally binding. Now when sales are made and the customer owes the company money, it is recorded as an account receivable from that customer. Therefore, instead of recording the sale at the time of cash collection, it is recorded at the moment a legally binding exchange occurs.
This is also true with inventory. When the vendor delivers materials, the company is now legally bound to pay the amount due. This is referred to as the matching principle in accounting whereby costs for the sale are recorded to the income statement at the time of sale. Now net profit on the accrual basis does not mean how much cash actually transpired. It merely means that the net profit is the legally earned amount.
This accrual concept also takes into consideration a multitude of other expenses too. They include:
- Depreciation – Expensing of a fair ratio (utility) of the fixed assets used to the earn the sale(s).
- Amortization – Similar to depreciation but is used with intangible assets.
- Prepaid – Some expenses are prepaid as a requirement of the vendor; this financial outlay is allocated to the income statement based on the time period covered by the prepayment.
- Deposits – Customer deposits are not considered a sale but a liability owed back to the customer until acceptance is issued by the customer. Then the deposit is transferred to the income statement as a sale.
- Work in Process – This form of accrual accounting is used in construction to record costs and earnings associated with a project. Two distinctly different sub methods (construction accounting methods) are used: 1) Completed Contract and 2) Percentage of Completion.
The accrual method of accounting is more accurate but more complicated to implement and operate. The level of accounting knowledge is more advanced than that needed for the cash method. The interesting aspect of the accrual method relates to the various alternatives used with small business.
Invariably there is always a difference between GAAP based financial profit and the taxable profit. First off, there is the tax itself. The taxable profit often excludes the federal income tax but includes the state income tax. Another critical factor that plays into taxable income is timing differences. The Internal Revenue Code traditionally allows for accelerated expenses such as depreciation and Section 179 in excess of the more conservative GAAP allowed definitions. Furthermore, the tax code has a different set of revenue recognition rules than GAAP. This is explained in the bookkeeping series Lesson 58 – Tracking Income Taxes.
However, all the above tax differences pale against the pass-through tax entity codes allowing most small businesses limited or exemption from income tax. Since publicly traded companies are taxed as traditional corporations and file Form 1120, the net profit is the after-tax value. Whereas small businesses file tax returns assigning net income to the owners via Form K-1 (pretax income). This means net profits in small business are generally higher as a percentage of net sales when compared to a similar publicly traded business. Therefore the net profit term is misleading as to its real value when stated in the context of closely held entities.
To illustrate, look at the two columns below. The first is a publicly traded steak restaurant chain with 300 locations and the other is a Mom & Pop steakhouse. The publicly traded entity is comparable to the Mom & Pop by a factor of 300. The difference is in the taxes section. The Mom & Pop files as an 1120-S company (S-Corporation).
Franchise (300 Locations) Mom & Pop (1 Location)
Steak Restaurants % Steak House %
Sales $540,000,000 100 $1,800,000 100
Cost of Meals Served (385,020,000) (71.3) (1,283,400) (71.3)
Gross Profit 154,980,000 516,600
Overhead (127,980,000) (23.7) (426,600) (23.7)
Profit B/F Taxes 27,000,000 5.0 90,000 5.0
Income Taxes (11,340,000) (2.1) -0- –
Net Profit $15,660,000 2.9% $90,000 5.0%
The small business has a distinct advantage over the larger corporation. The key is that although the conditions are the same between them; the net profit as a percentage of sales is significantly different.
A third and rarely thought of value related to profit are market factors that either force profit immediately or defer profit into the future. As a reader, you are saying to yourself ‘What in the world is he talking about?’.
At the time of writing this article there is a company called TESLA that has yet to earn a single dollar in profit (6 years in business) and is losing cash at the rate of billions per quarter. Yet the stock price increased during the past week. Why? Well Elon Musk’s 3rd generation car had pre-orders in excess of 300,000 automobiles. The market is saying that he will earn a profit and therefore the current financial losses will easily be overcome in the future. These pre-orders are a sign of market profitability. It is difficult to quantify, but it does exist.
In some situations, the market profit is easily identifiable. Take for example an apartment complex operation. A typical middle class 200 unit complex has a fair market value of $10,000,000 for the underlying assets. In a year, the financial statements indicate a profit of $210,000 and a tax profit of a negative $37,000.
In reality the actual profit is much higher as the financial profit does not include the increase in the market value of the apartment complex. Suppose the market for real estate increased 1.9% during the same year. How much did the business really earn in profit?
Tax Basis Financial Basis
Net Income Reported ($37,000) $210,000
Value Increase in Real Estate -0- 190,000
Market Profit ($37,000) $400,000
Notice the significant change in profit? The market adjustment of $190,000 is what is often called unrealized profit. It is sometimes referred to as deferred profit. This type of unrealized value is very common in real estate based operations or investment organizations like private equity or venture capital firms.
There is still one more interesting profit adjustment when using this term.
Practically all businesses will experience some form of an unusual and/or infrequent transaction. These include:
* Natural Catastrophe/Disaster
* Closing of a Department or Segment of a Company
* Sale of a Fixed Asset
* Death of a Key Man
* Governmental Law/Regulation Change Impacting Operations
Publicly traded entities record these unusual occurrences as extraordinary activity after ordinary profit and before taxes and final net profit. Most extraordinary items are losses greatly reducing net profit. Although net profit may be stated correctly it doesn’t mean that the value reflects ongoing regular profit as a novice reader may believe.
There is another issue related to extraordinary items and it is the tax impact. Often these unusual transactions create big tax timing impacts and can actually generate refunds for the company. They are reported as credit values in an expense section of the income statement. It is not unheard of for the tax savings/refund to actually be the sole source of profit for that particular year. Sophisticated business entrepreneurs investigate the details to fully understand how the net profit is derived. To illustrate, here is an example of a metal fabrication company closing down its casting segment and the net profit associated with both the extraordinary item and its tax implication.
New England Metals
Income Statement (Summary Format)
For the Year Ending December 31, 2016
Net Sales $23,280,710
Cost of Sales (19,440,708)
Gross Profit 3,840,002
General and Administration (1,708,753)
Operational Profit 2,131,249
Extraordinary Items (2,480,000) * Note A
Profit (Loss) B/F Taxes (348,751)
Income Tax Benefit 576,605
Net Profit $227,854
Note A – New England Metals closed its castings division due to cost of upgrades compliance with state laws.
With this example, New England Metals used the tax code to acquire tax credits and utilize loss carry forwards associated with the closing of the castings segment to generate a net profit. Notice the net profit exists even though the extraordinary item’s cost exceeds the operating profit?
Summary – Net Profit
Novice entrepreneurs believe that the term ‘net profit’ is a straight forward traditional GAAP defined bottom line earnings. More experienced business owners and investors
understand that the term must be interpreted based on the context of how net profit is derived. There are several different accounting definitions:
* Traditional Accrual GAAP Based
* Cash Based
* Tax Profit in Accordance with the U.S. Internal Revenue Code
* Market Based Profit which takes into Consideration Unrealized Gains and Losses
* Net Profit after One Time Charges called Extraordinary Items or Events
As a business entrepreneur make sure to ask the proper questions as to how the profit is derived and what set of rules were used to determine the end result. ACT ON KNOWLEDGE.
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