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Limitations of accounting profit

Limitations of accounting profit

Measures of accounting profit suffer from a number of important to be aware of limitations. These include:

  • Single period measure – any single period measure is susceptible to manipulation especially when bonuses are contingent on achieving a particular year end target. Revenue make be brought forward by deep discounting towards year end even though this may prejudice performance in the following year.
  • Subjective non cash costs – depreciation and amortisation of goodwill are subjective non cash costs that reduce accounting profit, but have no impact on free cash flow and thus no impact on a company’s enterprise value.
  • Ignore the opportunity cost of capital employed – When investors entrust their money to a company, they expect to receive a minimum return by way of compensation. This minimum return is ignored in traditional measures of accounting profit.

In response to these concerns, a plethora of new value-based measures have emerged, which advocates claim provide a much more reliable basis for judging business performance and in particular value creation performance than the traditional accounting measures. These new measures vary from the comparatively simple to the highly technical & complex, and include such acronymic delights as total shareholder returns (TSR), total business returns (TBR), cash flow return on investment (CFROI), economic profit (EP), economic value added (EVA), market value added (MVA), cash value added (CVA), and so on. The most commonly used new measures are total shareholder returns (TSR), economic profit (EP) and EP’s close relative, economic value added (EVA). Learn more about some of these new measures in the article entitled Shareholder Value Illustrated.

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