Accounting For Profits And Decisions

Marketers, and business people more broadly, often use accounting profit to measure success. This isn’t too surprising; often firms claim to be profit maximizing so anything labelled as profit sounds like something that should be maximized.

The problem is that decisions taken to maximize accounting profit don’t necessarily maximize economic profit.

It seems like accounting and economic profit should be the same but they aren’t. Indeed these two “profits” are especially likely to diverge in the short-term. This isn’t because accountants are silly or for any sinister reason. Financial accounting standards are set to assist decisions but it isn’t managerial decisions being assisted. Financial accounting rules are there for investors and creditors. Anything that helps investors’ decisions is adopted by financial accounting standards and anything that doesn’t is ignored.

As the International Accounting Standards Board (IASB) concepts state:
“The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity” (IASB, 2012, page 1).

The logic is that the managers don’t need external reporting as they should already know what their economic profit is. They should be able to take sensible risks based upon the information they have. The accounting profit only aims to help investors make good investment decisions. The external financial statements therefore deliberately ignore economic profit by, for instance, taking an excessively risk averse posture. Financial accounting rules are set to limit the risk of overstating the external financial accounts. They try and avoid the investor buying something at too high a price. The same rules therefore accept the risk (actually the near certainty) of understating the accounts. Thus rules helping external decision makers usually understate and are thus inappropriate for internal decision makers attempting to make (economic) profit maximizing decisions.

The key idea is that when making an internal decision use information designed to facilitate that decision. This is perfectly acceptable, internal accounts don’t need to follow external accounting rules.

My summary: Accounting profit is not economic profit. It isn’t meant to be. If you are trying to maximize economic profit then don’t use information uncritically based upon the external financial statements.

Read: International Accounting Standards Board, (2012) The Conceptual Framework for Financial Reporting 2011 as issued at 1 January 2012