Adjusted current profit

What Is Adjusted Current Profit?

Adjusted current profit is a measure of a company's profitability that accounts for the effects of changing prices on its assets and expenses. It falls under the broader umbrella of inflation accounting, aiming to present a more realistic picture of economic performance during periods of inflation. Unlike traditional financial statements prepared under the historical cost principle, which records assets at their original purchase price, adjusted current profit seeks to reflect the current cost of replacing resources consumed in generating revenue. This adjustment provides insights into a company's ability to maintain its operating capability.

History and Origin

The concept of adjusting profit for changing prices gained significant attention during periods of high inflation, particularly in the mid-20th century. Traditional accounting methods, which relied on historical costs, were seen as inadequate in accurately portraying a company's financial health when the purchasing power of money was eroding rapidly. In the United States, concerns over this issue led to efforts by standard-setting bodies. For instance, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 33, Financial Reporting and Changing Prices, in 1979. This standard required certain large companies to disclose supplementary information on the effects of changing prices, including current cost data⁴. Similarly, the Securities and Exchange Commission (SEC) had previously issued Accounting Series Release (ASR) 190, requiring specific companies to provide replacement cost information. These initiatives reflected a broad recognition that reported profits could be significantly distorted by inflation if not properly adjusted.

Key Takeaways

• Adjusted current profit aims to measure a company's earnings by reflecting the current cost of replacing assets and goods sold, rather than their original historical cost.
• It is a concept rooted in inflation accounting, designed to provide a more accurate view of economic profit during periods of price instability.
• The calculation typically involves adjusting the cost of goods sold and depreciation expense to their current replacement costs.
• This measure helps stakeholders understand a company's ability to maintain its operating capacity and real capital.
• While offering valuable insights, its complexity and the subjectivity in determining current costs led to its limited adoption in general-purpose financial reporting.

Formula and Calculation

The calculation of adjusted current profit primarily involves two key adjustments to traditional profit metrics: the cost of goods sold (COGS) and depreciation.

The basic formula can be expressed as:

Where:

• Revenue: The total revenue generated from sales during the period.
• Adjusted COGS: The cost of goods sold calculated using the current replacement cost of the inventory at the time of sale, rather than its historical purchase cost. This adjustment prevents "inventory profits" (gains arising purely from rising inventory values).
• Adjusted Depreciation: The depreciation expense calculated based on the current replacement cost of the relevant assets, rather than their historical cost. This reflects the true cost of using up productive capacity.
• Other Operating Expenses: Generally, other expenses that are monetary in nature are considered to already be at current values or are not significantly impacted by specific price changes in the same way as inventory and fixed assets.

Interpreting the Adjusted Current Profit

Interpreting adjusted current profit provides a more insightful perspective on a company's true economic performance, especially in inflationary environments. A positive adjusted current profit suggests that a company is not only covering its current operating expenses but also has sufficient earnings to replace its consumed assets at current market prices, thereby maintaining its productive capacity. This is crucial for assessing the sustainability of operations. Conversely, if a company reports a positive net income under historical cost accounting but a negative or significantly lower adjusted current profit, it indicates that reported profits are not sufficient to fund the replacement of assets and inventory, implying that the company is eroding its real capital. Users of this information, such as investors and creditors, can use adjusted current profit to gauge the quality of earnings and the resilience of a business.

Hypothetical Example

Consider "Horizon Manufacturing Inc.," a company that started the year with 1,000 units of raw material inventory purchased at $10 per unit. During the year, it produced and sold 5,000 units of product. The raw material cost increased significantly during the year.

• Sales Revenue: $150,000 (5,000 units sold at $30 each)
• Historical Cost of Goods Sold: Assuming FIFO and initial inventory, 5,000 units would consume the initial 1,000 units at $10 and 4,000 new units purchased at an average historical cost of $12. So, ( (1,000 \times $10) + (4,000 \times $12) = $10,000 + $48,000 = $58,000 ).
• Current Cost of Goods Sold: At the time of sale, the current replacement cost for the raw materials used was $15 per unit. So, ( 5,000 \times $15 = $75,000 ).
• Historical Depreciation: The company has machinery with a historical cost of $200,000 and a 10-year useful life, resulting in $20,000 in annual depreciation.
• Current Cost Depreciation: Due to inflation, the current replacement cost of similar machinery is $250,000. The adjusted depreciation expense would be ( $250,000 / 10 = $25,000 ).
• Other Operating Expenses: $30,000 (unchanged by specific price inflation).

Traditional Net Income (Historical Cost):
Sales Revenue ($150,000) - Historical COGS ($58,000) - Historical Depreciation ($20,000) - Other Operating Expenses ($30,000) = $42,000

Adjusted Current Profit:
Sales Revenue ($150,000) - Current Cost COGS ($75,000) - Current Cost Depreciation ($25,000) - Other Operating Expenses ($30,000) = $20,000

In this scenario, Horizon Manufacturing Inc. reports a significantly lower adjusted current profit compared to its traditional net income, illustrating how historical cost accounting can overstate profitability during inflationary periods. The adjusted figure better reflects the real resources consumed to generate that revenue, providing a more conservative and sustainable measure of profit.

Practical Applications

Adjusted current profit, while not universally mandated in current accounting standards, serves several practical applications for specific analyses and contexts. Primarily, it is valuable in:

• Internal Management Decision-Making: Companies can use adjusted current profit for internal budgeting, pricing decisions, and performance evaluation. It helps management understand the true cost of production and ensure that pricing strategies allow for the replacement of inventory and assets at current market values, thereby maintaining profitability and operating capacity.
• Investment Analysis in High Inflation Economies: In economies experiencing significant inflation, analysts and investors may independently adjust publicly available financial data to derive a more realistic picture of a company's earnings. This helps in making more informed investment decisions by mitigating the distortions of historical cost accounting. International Accounting Standard 29 (IAS 29) specifically addresses financial reporting in hyperinflationary economies, requiring financial statements to be restated to the measuring unit current at the end of the reporting period³.
• Economic Research and Policy: Economists and policymakers often consider adjusted profit measures when analyzing national economic performance or industry trends. Data adjusted for inflation provides a clearer understanding of real economic growth and productivity, free from monetary distortions. For example, research on the measurement of corporate profits often delves into the impact of inflation on reported earnings².

Limitations and Criticisms

Despite its theoretical benefits in providing a more economically relevant measure of profit, adjusted current profit faces several limitations and criticisms that have hindered its widespread adoption in general-purpose financial reporting.

• Complexity and Subjectivity: Determining the current cost of all assets and inventory can be highly complex and subjective. Unlike readily available market prices for actively traded goods, specialized machinery or unique assets may not have easily ascertainable current replacement costs. This subjectivity can lead to inconsistencies and make financial statements less comparable across companies.
• Reliability vs. Relevance Trade-off: While adjusted current profit aims for greater relevance by reflecting current economic conditions, the subjectivity involved can reduce the reliability and verifiability of the reported figures. Traditional historical cost accounting, while less relevant in inflationary times, offers greater objectivity and verifiability due to its reliance on actual transaction costs.
• Limited Acceptance in Accounting Standards: Due to the complexities and debates surrounding its implementation, comprehensive inflation accounting, including adjusted current profit, has not been widely adopted as a primary reporting method under major accounting frameworks like Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) for non-hyperinflationary economies. The FASB, after experimenting with mandatory supplementary disclosures in the late 1970s and early 1980s (such as SFAS 33), eventually made such disclosures voluntary with SFAS 89 in 1986, citing a lack of widespread utility and the costs of preparation¹. This shift reflects the practical challenges and the perceived limited benefit in an environment of moderate inflation.

Adjusted Current Profit vs. Historical Cost Profit

Adjusted current profit and historical cost profit represent two fundamentally different approaches to measuring a company's financial performance. The key distinction lies in how they account for the value of assets and expenses consumed during operations.

The main point of confusion often arises because historical cost profit, as reported in the income statement, can appear robust during inflationary periods even if the company is not generating enough cash to replace its productive capacity. Adjusted current profit attempts to bridge this gap by providing a more conservative and economically realistic view of earnings that ensures the maintenance of real capital.

FAQs

What is the primary purpose of calculating Adjusted Current Profit?

The primary purpose is to provide a more accurate measure of a company's profitability by accounting for the impact of inflation on its assets and expenses. It aims to show whether a company's earnings are sufficient to replace the resources it consumes at current market prices, thus maintaining its productive capacity.

Is Adjusted Current Profit required by current accounting standards?

In most stable economies, major accounting standards like U.S. GAAP and IFRS do not require companies to report adjusted current profit for general-purpose financial statements. However, IAS 29, Financial Reporting in Hyperinflationary Economies, does require adjustments for inflation in countries experiencing hyperinflation.

How does Adjusted Current Profit differ from traditional profit?

Traditional profit (e.g., net income) is calculated using the historical cost of assets and expenses. Adjusted current profit, on the other hand, adjusts these costs to their current replacement values. This means adjusted current profit provides a measure of "real" economic profit, while historical cost profit reflects "nominal" profit which can be inflated during periods of rising prices.

What are the main adjustments made to calculate Adjusted Current Profit?

The main adjustments typically involve the cost of goods sold (COGS) and depreciation. For COGS, the current cost of replacing the inventory sold is used instead of its historical purchase price. For depreciation, the expense is calculated based on the current replacement cost of the underlying fixed assets, rather than their original cost.

Why did many accounting bodies move away from requiring inflation adjustments like Adjusted Current Profit?

Many accounting bodies, including the FASB in the U.S., moved away from requiring comprehensive inflation accounting due to its complexity, the subjectivity involved in determining current costs, and the perceived high cost of implementation versus the benefits, especially during periods of lower inflation.