Having concluded in earlier articles that money is an illusion and that inflation is a silent cancer for wealth, this particular part in the series on profit is in a manner of speaking, superfluous. Nonetheless it is necessary to cover all aspects prior to arriving at any conclusions, and a profit being real is surely exigent. But what exactly does real profit mean?
A friend in the real estate business once pointed out that the reason why real estate is called thusly is because compared to other forms of investments such as equities, it really physically exists. Perhaps the reason why property prices are sticky even in a recession; at a subconscious level investors derive comfort from the physical existence of an asset and are unwilling to book a loss even when it is reasonable to sell. This simplistic notion may even have universal application beyond enunciating the characteristics of a particular investment; however explaining real profit requires further deliberation and at any level is a nightmare.
An internet search will reveal that after centuries of economic and accounting thought, definition of profit is not straightforward. Wikipedia alone talks about normal profit, economic profit, monopoly profit, super profit, excess profit and accounting profit to mention a few. Even an accountant might have a tough time explaining all these terms to a layman especially when accounting profit alone has sub classes like budgeted profit, gross profit, operating profit and net profit, to mention a few. Admittedly, the world really did not need another classification of profit except that the title phrase was coined simply to put across an important distinction between real profit and bookish profit!
The artful attempt at humour aside, modern corporate scandals across the globe have created doubts about the word profit, almost relegating it as a synonym for corruption. Investors wonder with awe and of course misery at how a darling of the corporate world can suddenly disappear into oblivion. While some might categorise the following statement as a tacit betrayal of the accounting profession, but considering the quantum of complicated accounting regulations only a gifted few can understand how profit is computed in the corporate world. A friend once commented that in the plethora of information in company's accounting reports it is well neigh impossible to differentiate between noise and music. More importantly the question is whether even that is real profit.
It might come as a revelation to many that accounting profit is determined on the basis of something referred to in the profession's parlance as the historical cost convention. The prerequisite for attempting to explain this terminology in lucid terms is an informed audience; suffice it to say that the end result has no relationship with current prices, which perhaps is also Greek for most. In essence however the fault lies elsewhere.
Courtesy a hyper active financial sector, the world is continuously bombarded with innovative investment vehicles which, short of psychic abilities, remain ambiguous even to their creators. As if creating the greatest illusion ever, money, was not enough, the pundits proceeded to complicate life further with derivatives and the likes the outcome of which is always uncertain, to say the least. Tongue in cheek, if the inventors' of Collateralized Debt Obligations (CDO) had any idea of the havoc they were wrecking by conceiving these Weapons of Mass Destruction, subprime would not have happened. Irrespective, can the profit that was determined and disclosed during the decade leading up to the eventual collapse of the financial sector, be categorised as real profit?
"Derivatives are financial weapons of mass destruction," Warren Buffett Perhaps the most appropriate definition of profit, from personal experience, was forwarded by a profit-maker; profit is the increase in capital stock in real terms at the end of any period. This methodology of determining gains on current valuation of capital is indeed pragmatic. A singular focus on periodic results invariably clouds the complete picture, synonymous with the inability to differentiate the trees from the forest. If inflation surpasses interest in any given period, banking profit is not real profit. If a business is plagued by the possibility of diminishing results, net profit is not real profit since it may not be sufficient to compensate for losses arising from a current business valuation.
Ironically, one solution to apprise investors might be to include an additional disclosure in the annual report relating to previous and current business valuation. For the proponents of Efficient Market Hypothesis which primarily postulates that financial markets are informationally efficient, seriously!!
The quest to define profit might be near to fruition; however the word "real" continues to be incredibly deceptive. In the information age where valuation of commodities and currencies continue to be a moving target, storage of wealth is another related unsurmountable objective. Wealth represents a sacrifice of current wants for future wants but if both are not comparable, the suffering gets magnified. If making profit is complicated at the individual and corporate level, imagine its impact on the wealth of nations.
As pointed out in previous articles a country's GDP is not its profit and as yet economics is devoid of any mechanism to value the wealth of a nation. Reverting to the definition which recognises profit as the real increase in capital stock, the mercantilist approach, wherein trade surplus is identified as the primary directive, seems to be on the right track, which might even explain the recent hike in value of gold bullion. Serendipitously, national reserves denominated in currencies only augment the money illusion especially when recoverability and valuation are both uncertain.
The abstraction that interest rates and money supply are the panacea for nation's financial perils, notwithstanding that monetarism is not an exact science, is rather optimistic. For example the strategy of devaluing currency to facilitate exports is at best questionable. Nonetheless, this tangent requires detailed deliberation which may be articulated in a future article, suffice it to say that if inflation and interest both are functions of money supply, how do they factor into real profit?
To paraphrase the Godfather, some day and that day may never come, future generations might eventually solve the riddle of a nation's real profit, for the moment let's just stick with the increase in capital stock definition. Accordingly, at the national level the earlier, almost forgotten, strategy of export based manufacture and import substitution coupled with proactive management of foreign reserves or debt is nearest to turning a real profit.
Realistically speaking trading surplus is a revenue enhancing strategy while managing currency exposure is a cost control strategy. Of the two, the strategy of increasing revenue is forward looking since there are obvious limits to any cost control initiative with associated negative outcomes. Implementing both strategies in tandem is the rational approach. From Pakistan's perspective a focus on a positive trade balance coupled with an austerity drive, even to the extent of rationing, to reduce foreign debt is the recommended course of action. At the end it is all about real profit.
(The writer is a chartered accountant based in Islamabad)