This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
In connection with the preceding paragraph, it must be admitted, however, that the conception of the word income as referring only to net cash receipts, has the advantage of being much simpler than the present significance of the word. Income as understood in modern business includes all the various kinds of realized gain from operations during a given period. This gain may be realized in the form of increased accounts receivable, enlarged facilities for production, reduced obligations, or in various other ways. Inasmuch as the extent of the gain is frequently difficult to measure, there is left considerable latitude for the exercise of discretion and good faith on the part of officials in estimating income. It is sometimes possible for them, if they are not governed by the strictest integrity, to stretch or reduce the statement of income which they give to their stockholders and to the public in order to serve their personal interests.
* Francis W. Pixley, "Auditors: Their Duties and Responsibilities," pp. 515-517.
In the first report of the United States Realty and Construction Company, earnings for the nine months' period ended June 30, 1903, were given as $1,417,000; but it later appeared that $487,000 of these earnings consisted of "profits from estimated increase in the value of investments still held" and $577,000 consisted of "profit on buildings in progress, estimated proportion accrued." The first item is typical of a practice that is frequently advocated by corporate officials who desire to make a showing of profits that have not been earned through operation. Real estate, securities, stocks of merchandise, and the like are constantly fluctuating in value. If any of these properties is actually sold and a profit is realized, it is entirely proper that this profit should be credited to surplus, but it should certainly not be credited to the surplus arising out of operations during a given period. So long as the profit is not realized, but exists simply on paper, it is almost universally agreed that it should not be credited at all. Officers who advocate marking up profits on account of fluctuations in value of permanent holdings are frequently the first ones to find some plausible reason for declining to mark down profits when these same holdings decline in value. If a company is engaged in the business of buying and selling real estate or securities, the case may be different and may be worthy of further consideration, but in other cases such profits should not be credited unless realized.
As to the second item, there is undoubtedly more room for debate. It would seem unfair that companies which customarily engage in long-time contracts, such as the construction of buildings and the like, should credit no profits to the period in which the construction work is going on. On the other hand, it was found in the case of the United States Shipbuilding Company that the anticipated profits on large contracts, which had been counted in the millions of dollars, were never realized, but actually turned into a loss at the completion of the contracts. Estimates of profits on uncompleted contracts are likely to be made by officers whose judgment may be warped by their own interests. Such items are to be considered, therefore, with some degree of skepticism.
A curious difficulty of accounting in arriving at gross profits is illustrated in the financial history of the American Malting Company. It appears that in the malting process each bushel of cleaned barley produces 112 to 115% of a bushel of malt. This increase is a normal incident in the process of manufacturing malt and it is claimed should be taken into consideration as a source of profits. It is, however, at least questionable whether anticipated profits from this source should be counted. It probably is time enough to count them when the profits have actually been realized.
Another fruitful source of error in stating gross earnings is overoptimism in the valuation of finished and partly finished products and raw materials on hand. Sometimes balance sheets are found in which inventories amount to several times the aggregate of gross sales. In such cases it is clear that even a slight excess valuation of the inventories may be the real source of a considerable proportion of the alleged profits. Where the item of inventories appears to be constantly growing, from year to year, more rapidly than sales and profits, the estimate of gross earnings should certainly be subjected to close examination.
At the formation of the American Bicycle Company in 1898, the constituent plants were taken in largely on the basis of their reported net earnings. From later developments and analysis it seems probable that these net earnings were in many cases overstated, by reason of the fact that inventories of dead stock which should have been charged off to profit and loss were carried at their full valuation.*
It should never be forgotten that, by reason of the discretion which is necessarily accorded to them in estimating gross earnings, corporate officials ought to be exceptionally conservative, and for their own protection should rely to a great extent upon the judgment of impartial accountants and other outside advisers. Misstatements of gross earnings are not made necessarily with dishonest intentions; the men who are most interested in the business are frequently the very ones who are most easily persuaded that an exaggerated estimate of unrealized earnings is sound and reliable.