Accounting Principles – Profit Motive of Business

The media of organization through which such transfers are effected are those involved in the industries of extraction (fishing, farming, mining, etc.), transformation (manufacturing), and transportation, trading, real estate, banking, insurance, ana agency.

The economic function performed by the organization does not affect the nature of the income produced. An organization engaged in the real estate business, for example, may derive its income entirely from rent, while a banking concern may derive its income entirely from interest. In both instances, notwithstanding the fact that for purposes of classification and identification the income is given the special name of rent or of interest, it arises through the use of capital invested in the organization and remains unalterably the profit of same.

Capital successfully loaned returns interest. Capital successfully invested returns profit. Capital may be either loaned or invested, but not both at the same time. Hence the fallacy, in the opinion of the writer, of crediting to the proprietor’s or investor’s account interest on owned or invested capital. To follow out such theory requires that there shall be set up in the mind a business entity separate and distinct from the investors therein. Interest, say at 5%, is then charged to operations and credited to the individual investors. The charge to operations has the effect of increasing cost and decreasing the profit so that the amount ultimately received by the investor is only that profit which is in excess of 5% on the investment. The advantage claimed for this procedure is that it enables the proprietor or investor to compare the return on his investment with that in other lines of business and thus determine whether to continue with the present line or transfer the investment to other fields.

That this is true must be conceded. That the same result might be obtained by a simple computation quite outside the books and without the annoyance of unnecessary bookkeeping must, however, be maintained. Further, while the procedure may seem offhand to be harmless even though unnecessary, it may in reality be dangerous. Costs which have been loaded with interest on owned capital will be fictitiously high and may in the case of close competition operate to the detriment of an organization which follows this practice.
To sum up, it must be said that the procedure is unsound theoretically; it does not have advantages which cannot be obtained in a simpler manner and with less work; and the results obtained thereby may be dangerous.

The same position is sometimes taken with regard to rent where buildings are owned by the organization which occupies them for business purposes. It is contended that if the buildings were not owned rent would have to be paid. In order to put the organization under discussion on the same basis with other business concerns occupying rented buildings, an amount, sometimes calculated scientifically and sometimes selected arbitrarily, is charged to operations and credited to “rent-income.” Thus there is shown, it is said, “the amount of rent earned by the land on which the buildings stand.”

Again the statement is admittedly true, provided the amount of rent is determined scientifically. The amount of profit earned by the organization, however, and not the amount of rent earned by the land is the matter of importance. If the amount of the rent earned is needed for administrative purposes it may be readily computed without making it the subject of unnecessary bookkeeping. Like interest, the inclusion in the costs of rent on owned land or buildings produces a fictitiously high result which may prove detrimental in competition.

To attempt to analyze profit and attribute certain shares to the various forms of capital which assist in its production, as has been suggested above, seems not only wholly uncalled for, but wrong in principle. The income derived from capital invested in a business organization is profit and not subject to analysis or division.