Non-business items
A private business is a useful vehicle in which non-business expenses can be charged to provide benefit to its owners. Such matters as private motor vehicle, travel and telephone expenses are often included in business expenses and should be eliminated to arrive at real profit.
Non-recurring items
Where a business has any income or expense that is not likely to recur in future this should be removed from the published accounts to arrive at real profit.
Owners’ salaries
In calculating real profit it is sometimes necessary to deduct owners’ stated salaries from published profits and to replace them with salaries Ibased on market rates) which would be payable to managers undertaking equivalent work to the owners. Simply, you could ask what the business would need to pay on the open market for managers to undertake the owners’ current management tasks. This is also a useful guideline for an investor/purchaser who does not intend working in the business, as real profit can be calculated for the circumstances where an employed manager will be running the business.
Premises
Where the business owns the premises in which it operates, ownership can reside in different legal entities controlled by the business owner. In these circumstances rental is sometimes completely excluded from published business accounts, or charged at excessive amounts to move profits from one business entity to another.
In calculating real profit it is important that a true market rental figure is included in the business’s accounts. The true market rent should be easy to establish. Advice can be sought from your local estate agent if you have any doubts.
Cost of goods sold and gross margins
It is easy to manipulate the profit of any entity that purchases goods by adjusting the value of the closing stock in the accounts at period end. A business can achieve continuously increasing published profits merely by increasing the value of its closing stock. Conversely, a business can often eliminate its profit by writing down the value of its closing stock.
In calculating real profits, an amount needs to be added to or subtracted from the accounting profit to allow for any unrealistic valuation of stock.