Financial managers can do certain things to increase or decrease net income that’s recorded in the year. This is called profit smoothing, income smoothing or just plain old window dressing. This isn’t the same as fraud, or cooking the books.
Most profit smoothing involves pushing some amount of revenue and/or expenses into other years than they would normally be recorded. A common technique for profit smoothing is to delay normal maintenance and repairs. This is referred to as deferred maintenance. Many routine and recurring maintenance costs required for autos, trucks, machines, equipment and buildings can be delayed, or deferred until later.
A business that spends a significant amount of money for employee training and development may delay these programs until the next year so the expense in the current year is lower.
A company can cut back on its current year’s outlays for market research and product development.
A business can ease up on its rules regarding when slow-paying customers are written off to expense as bad debts or uncollectible accounts receivable. The business can put off recording some of its bad debts expense until the next reporting year.
A fixed asset that is not being actively used may have very little current or future value to a business. Instead of writing off the un-depreciated cost of the impaired asset as a loss in the current year, the business might delay the write-off until the next year.
You can see how manipulating the timing of certain expenses can make an impact on net income. This isn’t illegal although companies can go too far in massaging the numbers so that its financial statements are misleading. For the most part though, profit smoothing isn’t much more than robbing Peter to pay Paul. Accountants refer to these as compensatory effects. The effects next year offset and cancel out the effects in the current year. Less expense this year is balanced by more expense the next year.
It might seem like a no-brainer to define just exactly what profit and loss are. But of course these have definitions like everything else. Profit can be called different things, for a start. It’s sometimes called net income or net earnings. Businesses that sell products and services generate profit from the sales of those products or services and from controlling the attendant costs of running the business. Profit can also be referred to as Return on Investment, or ROI. While some definitions limit ROI to profit on investments in such securities as stocks or bonds, many companies use this term to refer to short-term and long-term business results. Profit is also sometimes called taxable income.
It’s the job of the accounting and finance professionals to assess the profits and losses of a company. They have to know what created both and what the results of both sides of the business equation are. They determine what the net worth of a company is. Net worth is the resulting dollar amount from deducting a company’s liabilities from its assets. In a privately held company, this is also called owner’s equity, since anything that’s left over after all the bills are paid, to put it simply, belongs to the owners. In a publicly held company, this profit is returned to the shareholders in the form of dividends. In other words, all liabilities have the first claim on any money the company makes. Anything that’s left over is profit. It’s not derived from one element or another. Net worth is determined after all the liabilities are deducted from all the assets, including cash and property.
Showing a profit, or a positive figure on the balance sheet, is of course the aim of every business. It’s what our economy and society are built on. It doesn’t always work out that way. Economic trends and consumer behaviors change and it’s not always possible to predict these and what income they’ll have on a company’s performance.
A sole proprietorship is the business or an individual who has decided not to carry his business as a separate legal entity, such as a corporation, partnership or limited liability company. This kind of business is not a separate entity. Any time a person regularly provides services for a fee, sells things at a flea market or engage in any business activity whose primary purpose is to make a profit, that person is a sole proprietor. If they carry on business activity to make profit or income, the IRS requires that you file a separate Schedule C “Profit or Loss From a Business” with your annual individual income tax return. Schedule C summarizes your income and expenses from your sole proprietorship business.
As the sold proprietor of a business, you have unlimited liability, meaning that if your business can’t pay all it liabilities, the creditors to whom your business owes money can come after your personal assets. Many part-time entrepreneurs may not know this, but it’s an enormous financial risk. If they are sued or can’t pay their bills, they are personally liable for the business’s liabilities.
A sole proprietorship has no other owners to prepare financial statements for, but the proprietor should still prepare these statements to know how his business is doing. Banks usually require financial statements from sole proprietors who apply for loans. A partnership needs to maintain a separate capital or ownership account for each partners. The total profit of the firm is allocated into these capital accounts, as spelled out in the partnership agreement. Although sole proprietors don’t have separate invested capital from retained earnings like corporations do, they still need to keep these two separate accounts for owners’ equity – not only to track the business, but for the benefit of any future buyers of the business.