It is impossible in a small compass to deal exhaustively with the rules for arriving at true profits, but some of the main principles may be sum marised as under : I. The sales and purchases shall be included at the total of the period's transactions, and that all expenses incurred during the period! under review shall be brought into account ; the fact that some of any such transactions have not been settled in cash is immaterial ; reserves must be made for expenses incurred if their exact amount be unknown.
2. Stock shall be valued at cost price or market price at time of closing, whichever be lower; proper reserves must be made for bad and doubtful debts, and for discounts to be allowed to, or received from, debtors and creditors.
3. Depreciation must be written off plant, premises, buildings, &c., on the proper basis of the estimated life of each such asset.
4. No profit should be taken credit for in respect of any assets of which the value has risen until such assets are sold.
5. Downward fluctuations in the value of floating assets (see article ASSETS) must be provided for; extraneous fluctuations in value of fixed assets may be disregarded, but depreciation through use or effluxion of time must be included in every case.
6. Generally, profits must be estimated cautiously, and the integrity of the capital embarked is to be considered of first importance.
Although the above principles are vital in order that profits shall be stated at their correct figure, it is to be remembered that true profits and legal profits, or profits legally divisible, do not necessarily coincide, and that the one may be greater or less than the other. Where, however, the legal profit is greater than the true profit, as frequently occurs in com panies, it is open to the proprietors to follow the course financially sounder if they so please. One noteworthy example of this divergence may be men tioned, viz., that under the decisions in Lee v. Neuchatel Aspluilte Co. Ltd., and Verner v. General and Commercial Investment Trust, Ltd., depreciation or loss of fixed assets, e.g., a mining company's mine or an investment company's permanent investments, need not be charged against profits available for dividend unless (as is rarely the case) the articles of association require it.
It is sometimes thought that the making of profits must of itself increase the cash balance of a business by a corresponding amount ; this, however, is a fallacy, and, in the case of a going concern, the amount of any profit made may be accompanied by reduction in total due to creditors, increase of debtors, stock, and other assets as easily as by an enhanced cash balance. It is admitted that profits cannot be divided unless sufficient cash be in hand or be borrowed, but it may be stated as a rule that the state of the cash balance of a business is not a satisfactory index to profits fiJade, except where trading has been suspended and liquidation is complete.
The most simple and convenient method, short of a detailed investiga tion, by which statements of profit can be criticised is on a basis of percentages. The sales for the year (or whatever other figure replaces them in a given business) are regarded as a basis figure and as the equivalent of 100; and every other item appearing in the trading (or manufacturing) account and profit and loss account is resolved into its proportionate percentage of the sales, as has been done in the specimen accounts previously given. It will be found that the relation of gross profit, expenses, stocks and purchases to the sales, as well as their bearing to each other, are far more clearly grasped -11 are reduced to a single common denomi nator ; and while, as a rule, the comparison of one year's sales with another will show whether the business is progressive, stationary, or diminishing, a comparison of the percentages will reveal whether expenses and the inter nal working are keeping pace with the gross turnover. Any appreciable deviation in the course of these percentages, taking one year with another, should form ground for inquiry, and such defects as excessive purchases, excessive stock, and lack of discrimination in regard to customers' stability will usually be accompanied by admonitory increases in their respective percentage figures. And see CAPITAL AND REVENUE.