How do Accounting Reserve, Inventory Valuation & Capitalization of Disbursement affect Profitability

As the survival, growth and development of an undertaking is contingent upon its profits, it is the prime task of the manager to ensure that profits are not estimated in an unwarranted manner. If the profits are overstated, dividends will be paid to stockholders out of the capital.

Though the management has significant discretion in the estimation of profits, it should, while doing so, bear in mind that there must be:

  1. Accounting reserves;
  2. Capitalization of disbursements; and
  3. Inventory valuation.

Accounting Reserves

The accounting reserves set up by the company considerably affect its profitability. The basic issues in this context are concerned with the estimation of expenses on accounting reserves as well as an assessment of the decline in the asset value of such reserves. The expenses, which involve an immediate outlay of cash- outstanding payments or bills payable — can be easily recognized.

Contrary to this, for expenses that do not require an immediate outlay of cash but must be met well in time, their estimation is quite an uphill task; they are subjected Io a higher degree of error. The depreciation on equipment and buildings, unassessed taxes, provision of uncontrollable expenses and contingent losses are examples of such expenses.

One of the effective ways of handling such expenses is to make a reasonable estimate of the amount to be charged against operations each year and then to add up this figure along with other expenses as a deduction from the gross income in the estimation of net profit. It should be borne in mind that reserves should not be treated as a separate fund to be put aside to meet an anticipated cash payment. However, they help companies to prevent over-statements of profits.

Capitalization of Disbursements

One of the important questions — the estimation of profit — is related to the capitalization of disbursements. For example, in case of product development or improvements in fixed assets, the question arises whether to treat disbursements as expenditure in the current year and thus reduce profits, or to capitalize them. The example of patents states this problem specifically.

If a company buys a patent, it has an asset the cost of which should be charged as an expense throughout the life of the patent. But when the patent is the company’s own creation, the situation is not very clear.

Here, the management has to decide as to how much of the cost should be attached to the asset — should it be treated like an asset or partially written off every year? If a larger part of the cost is capitalized as an asset, the profit will be higher in the current year.

Inventory Valuation

One major problematic area in the computation of profit is inventory valuation. For this purpose, the management has to decide about the inventories which are in demand and those which are to be treated as scrap. The value of inventory depends upon its physical conditions — the future need of companies of spare parts, the ability to procure new inventories.

While valuing inventories, the management has to decide whether a specific item is still a good asset or should be written off. If a higher value is attached to the inventory as an asset, the profit will be higher. Therefore, while valuing inventories, the management must ensure that this is done in such a manner that it yields the best possible results.

Policy Issues in Profit Estimation

While computing profits, adequate attention must be paid to a number of issues — the size of the surplus, the valuation of inventories, and the capitalisation of costs. Though it is not necessary for the management to concentrate on the numerous entries involved in profit estimation, it is desirable that it should frame policies indicating the degree of general conservation to be followed in this context.

One of the important considerations of profit assessment relates to policy changes in estimation. If a given method is followed over a period of time, it will tend to balance out the profit postponed from the previous year and show it in the current year; and this largely affects the profit in the present year which is shown as delayed profit next year.

However, if a conservative policy is followed in one year and a liberal one in another one, the effects on the results that are reported during a particular year will be more satisfactory. Some companies stress consistency in the policy of profit estimation, whereas others follow one which minimizes the payment of income tax.

Like many other policy issues, profit estimation, too, is inter-related with various aspects of management functioning. The protection of capital calls for a conservative estimation of profit. At the same time, attention must be paid to such factors as income tax, interest, ease in raising new capital, etc.

In designing policies of protection of capital, adequate attention must be paid to the various financial aspects of the company.