Net profit is the surplus for the period available for distribution after payment of return on the debt capital (interest) and government’s share in surplus (income tax). Conceptually, surplus is the amount that can be withdrawn from the business without impairing the capital at the beginning of the period. Ideally, surplus should be measured comparing the physical capital at the end and that at the beginning of the period. Practically, measuring capital in physical terms is very difficult, if not impossible. The next best method is to measure capital in monetary terms using a monetary unit adjusted for change in the purchasing power. But the contemporary accounting practice is to measure capital in monetary terms without adjusting the monetary unit for the change in the purchasing power.
Assets and liabilities in the balance sheet, and consequently, the equity capital are not adjusted for changes in the purchasing power. Therefore, in a situation of inflation, surplus is overstated in the profit and loss account. For example, assume the initial capital, without adjustment for inflation was Rs 1,000 and the closing capital is Rs 1,500. Assuming no fresh contribution or withdrawal (e.g. dividend) by shareholders, the increase in the capital by Rs 500 represents profit for the period. If inflation is assumed to be 10 per cent, profit should be measured by deducting the initial capital of Rs 1,100 from the closing capital. The profit should be reported at Rs 400. However, as per the contemporary accounting practice across the globe, companies report profit at Rs 500. At one time, effort was made to introduce inflation accounting, prescribing elaborate methods for adjusting assets, liabilities, income and expenses. But that failed.
Accounting practice is moving from purely transaction based accounting to event based accounting. Capital changes on account of transactions and other events related to operations of the company and also by events in the internal or external environment occurred during the period. IASB in has decided that certain gains should not be a part of the profit or loss for the period. It classified such gains as “other comprehensive income”. The total of the other comprehensive income and the profit or loss for the year is the ‘comprehensive income, which represents the change in capital during the period, after adjusting for the fresh contribution or withdrawal of capital by shareholders.
The components of other comprehensive income include: revaluation gain or loss arising from the revaluation of fixed assets; actuarial gains and losses on defined benefit plans recognised in accordance IAS 19 Employee Benefits; gains and losses arising from translating the financial statements of a foreign operation; gains and losses from investments in equity instruments measured at fair value through other comprehensive income; and the effective portion of gains and losses on hedging instruments in a cash flow hedge.
Usually financial analysts are interested in the profit or loss for the period. However, the use of the balance sheet approach and application of the principle of prudence result in understatement of profit or loss for the period. The matching principle, which requires matching of income and expenses for presentation of the operating results for the period, is no more the overriding principle. There are certain items of expenses which have no cause and effect relationship with revenue recognised in the profit and loss account. For example, research and development expenditure incurred during the period is recognised as expense for the period and is deducted in calculating the profit or loss for the period. Similarly, product promotion and other expenditures on advertising are recognised as expenses for the period even though those expenditures are expected to benefit the current and future periods. Another such example is expenditures on training. Analysts adjust the profit or loss for the period considering such expenditures as capital expenditures and notionally amortising it over an estimated period. Although, IFRS does not allow a company to present any item as ‘extraordinary item’ in the profit and loss account, analysts exclude non-recurring items (e.g. impairment loss) from revenue and expenses to determine the profit or loss for the period.
Use of profit or loss presented in the profit and loss account, without necessary adjustments, for the purpose of financial analysis, might lead to misleading results.
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