1. It must generate profit. 2. It must generate cash flow. It is very important not to mix these two key concepts and differ them from each other. Profit is calculated by identifying the sales in a period and deducting the costs incurred to produce that periods sales. Cash flow is calculated by identifying cash received in a period and deducting the cash paid out in the same period. Business exists for the primary purpose of generating wealth, or profit, and it is the profit generated during a period which is the primary concern of many users.
Also the amount of profit generated is of particular interest to the owners of a business, other groups such as managers, employees and suppliers will also have an interest in the profit-making ability of the business. The purpose of the profit and loss account is to measure and report how much profit (wealth) the business has generated over a period. (Atrill, 2008) Main Part There are a lot of different definitions of profit and according to Gowthorpe (2005) profit measures changes in wealth. When a company states it has made a profit, it is not saying it has more cash, it is saying its wealth has gone up.
In other words, it owns more. To analyse how to measure profit we should first understand some definitions such as revenue, expenses, profit, loss, a profit and loss account and a balance sheet. According to Gowthorpe (2005) revenue is the amount of goods and/or services sold, expressed in monetary terms; expenses are the amounts incurred by the business in purchasing or manufacturing the goods sold, and other expenditure on items such as rent and telephone charges; profit is the surplus remaining when evenue exceeds expenditure (a desirable state of affairs in a commercial organisation); loss is the deficit that occurs when expenditure exceeds revenue (a state of affairs that cannot persist for a long period in a commercial organisation).
As Dyson (2007) mentioned, a profit and loss account shows whether the business has made a profit or loss during the year, i. e. it measures how well the business has done; a balance sheet lists what the entity owns (its assets), and what it owes (its liabilities) as at the end of the year. There are two important facets of profit measurement. First, measurement is relative it is related to something else whose size is known. Second, measurement is numerical it involves putting numbers on things. (Dyson, 2007) Dyson (2007) stated measurement rules as following:
1. Money measurement. Data must be translated into monetary terms before they are included in an accounting system. 2. Historic cost. Financial data should be recorded in the books of account at their historic cost, that is, at their original purchase cost or at their original selling price. . Realisation. Transactions that reflect financial data should be entered in the books of account when the legal title to them has been transferred from one party to another party, irrespective of when a cash settlement takes place. 4. Matching. Cash received and cash paid during a particular accounting period should be adjusted in order to reflect the economic activity that has actually taken place during that period. 5. Dual aspect. All transactions should be recorded in such a way that they capture the giving and the receiving effect of each transaction. 6. Materiality. The basic accounting rules must not be rigidly applied to insignificant items.
According to Atrill (2008) the structure of profit measurement is following: Profit measurement and recognition of revenue: A key issue in the measurement of profit concerns the point at which revenue is recognised. It is possible to recognise revenue at different points in the production/selling cycle and the particular point chosen could have a significant effect on the total revenues reported for the period.
Profit measurement and the recognition of expenses: Having decided on the point at which revenue is recognised, we must now turn to the issue of the recognition of expenses. The matching convention in accounting is designed to provide guidance concerning the recognition of expenses. This convention states that expenses should be matched to the revenues which they helped to generate. In other words, expenses should be taken into account in the same profit and loss account in which the associated sale is recognised.
Profit measurement and the calculation of depreciation: The expense of depreciation which appeared in the profit and loss account above requires further explanation. Fixed assets (with the exception of freehold land) do not have a perpetual existence. They are eventually used up in the process of generating revenues for the business. In essence, depreciation is an attempt to measure that portion of the cost of a fixed asset which has been used up in generating the revenues recognised during a particular period.
The depreciation charge is considered to be an expense of the period to which it relates. Profit measurement and the valuation of stocks: The way in which we measure the value of stock is important, as the amount of stock sold during a period will affect the calculation of net profit, and the remaining stock held at the end of the period will affect the portrayal of financial position. The business must determine the cost of the stock sold during the period and the cost of the stock remaining at the end of the period. However, it may be difficult to match precisely particular purchases with sales.
When stocks are acquired, they may enter a common pool and become indistinguishable from earlier stocks purchased. Profit measurement and the problem of bad and doubtful debts: Most businesses sell goods on credits. When credit sales are made, the revenue is usually recognised as soon as the goods are passed to, and accepted by, the customer. Recording the dual aspect of a credit sale will involve: (1) increasing the sales and (2) increasing debtors by the amount of the credit sale. However, with this type of sale, there is always the risk that the customer will not pay the amount due.
Where it is reasonably certain that the customer will not eventually pay, the debt is considered to be bad and this must be taken into account when preparing the financial statements. Interpreting the profit and loss account When a profit and loss account is presented to users it is sometimes the case that the only item with which they will be concerned will be the final net profit figure, or bottom line as it is sometimes called. Although the net profit figure is a primary measure of performance, and its importance is difficult to overstate, the profit and loss account contains other information which should also be of interest.
In order to evaluate business performance effectively, it is important to find out how the final net profit figure derived. Thus, the level of sales, the nature and amount of expenses incurred and the profit in relation to sales are important factors in understanding the performance of the business over a period. Conclusion We have seen how the profit measured and now can conclude that profit is more important than cash, because the primary aim of any business is to make profit. When an organisation states that it made profit, it does not mean that it has cash.
According to Atrill (2008) the foregoing sections on revenues and expenses reveal that revenues do not usually represent cash received and expenses are not the same as cash paid. As a result, the net profit figure (i. e. total revenue minus total expenses) will not normally represent the net cash generated during a period. It is therefore important to distinguish between profit and liquidity. Profit is a measure of achievement, or productive effort, rather than a measure of cash generated. Although making a profit will increase wealth; cash is only one form in which that wealth may be held.