Why Two Honest Companies Report Very Different Profits

Two businesses can trade identically, collect identical cash and report different profits. Reported profit is a measurement, and a measurement needs choices. Anjani Stationers and Bharati Notebooks, two invented notebook printers, reported Rs 38,00,000 and Rs 42,00,000 on the same Rs 2,40,00,000 of sales. Two judgements account for the whole difference: how long a printing machine lasts, and whether an overdue school will pay. Neither business broke a rule and neither figure is wrong.

Two honest figures that disagree cost a reader something. Setting two businesses beside each other is not setting two facts beside each other but two measurements, and a measurement carries whoever made it. Notebooks either left the unit or they did not, so the Rs 2,40,00,000 of billing is close to a fact. The Rs 38,00,000 of profit is a different kind of object. A profit figure has passed through a set of views about the future, and two careful people looking at the same machine and the same unpaid school bill can land in different places without either of them being lazy, careless or dishonest.

The two businesses are the same in every respect a reader could check and differ on exactly two judgements, so the Rs 4,00,000 that appears out of nowhere can be followed all the way back to its two sources.

How can two businesses doing identical trade report different profits?

Start with the pair. Anjani Stationers prints school notebooks in one city out of one small unit with one van. Bharati Notebooks does the same trade, in the same city, at the same size. Both billed schools Rs 2,40,00,000 in the year. Both collected Rs 1,92,00,000 of it in cash. Both bought paper on the same terms and both hold the same machine, bought for Rs 30,00,000, with Rs 6,00,000 of wear already charged before this year opened, so both machines stand in the books at Rs 24,00,000 when the year begins. Both are owed Rs 78,00,000 by schools at the close, and in both of those totals sits the same Rs 6,00,000 that the Sunrise Public School group has left overdue.

Every figure a reader could check by looking at the two businesses is the same, and the two figures that come from looking forward instead are not. Anjani Stationers put the printing machine's working life at ten years. Bharati Notebooks put it at fifteen. Anjani Stationers set aside half of the overdue Rs 6,00,000 as unlikely to arrive. Bharati Notebooks set aside nothing, judging that the school will pay in the end. Two questions, and neither has an answer in the books. Both answers live in a future that has not happened yet. Each business answered them, wrote the answer down, and carried on.

An accounting estimateA figure that depends on a view about something not yet settled, such as how long a machine will run or how much of an unpaid bill will arrive. is not a soft version of a fact. An estimate is a different sort of number entirely. Both reported profits sit on the same subtraction, so once two estimates differ the two profits must differ too. The gross profitWhat is left of the amount billed once the direct cost of the goods that were sold has been taken off it. is Rs 1,14,00,000 in both businesses. Salaries, rent and insurance take Rs 68,00,000 out of it in both. The Rs 46,00,000 that is left is identical, and only then do the two businesses part company.

What does one view about a printing machine do to a whole year?

Take the machine on its own first. The machine cost Rs 30,00,000, sits in a shed, prints notebooks, and will keep printing them until it stops being worth running. Nobody in either business knows the date. Anjani Kulkarni looked at the run rate, the season, and what the supplier said about servicing, and settled on ten years. The people at Bharati Notebooks looked at the same class of machine and settled on fifteen.

Both are spreading the same Rs 30,00,000 straight lineSpreading the cost of an asset in equal amounts across each year of the life put on it, so every year carries the same charge., so the arithmetic is a single division. Ten years gives Rs 3,00,000 a year. Fifteen years gives Rs 2,00,000 a year. The gap of Rs 1,00,000 in the year's charge appears without anything at all happening to the machine. The machine runs at the same speed in both sheds, eats the same paper, and will wear out on whatever date it was always going to wear out on. Only a sentence in a note moved, and a sentence in a note moves a profit figure.

Watch what this does to the carrying amountWhat an asset is still shown at in the accounts after the wear charged so far has been taken off what it originally cost. as well. A reader who only looks at profit will miss half of it. Both machines opened the year at Rs 24,00,000. Anjani Stationers closes at Rs 21,00,000 and Bharati Notebooks at Rs 22,00,000. So the Rs 1,00,000 does not vanish. The Rs 1,00,000 sits on the other statement, waiting, and will be charged to some later year instead. Stretched far enough, the life can push the charge almost anywhere, one year at a time, and that reach is exactly why the length of the estimate is written down where a reader can find it.

What does the second view, about one overdue school, do?

Now the school. The Sunrise Public School group has left Rs 6,00,000 unpaid past its terms. Both businesses are owed it. Both know it is late. Neither knows whether it will arrive, and here the two answers are not a division but a straight difference of opinion about a customer.

Anjani Kulkarni has been chasing the group for four months and has decided that half of it is unlikely to come, so she charged Rs 3,00,000 against the year as a provisionAn amount charged against profit in advance for money owed to the business that is now judged unlikely to arrive, before anyone gives up on collecting it. and still shows the school owing the full Rs 6,00,000 underneath it. Bharati Notebooks has been chasing the same group, has a signed letter from its purchase head promising payment after the new session begins, and has charged nothing.

One school moves Rs 3,00,000 of profit between the two businesses, and the whole of it rests on nothing more than which of two people sounds the more convincing. Notice how little separates them in reasoning. Neither has written the money off. Neither claims to know. One has decided the risk is real enough to carry now, and the other has decided it is not. There is no arithmetic in this at all, and the absence of arithmetic is why the school produces three times as much of the gap as the machine did.

An everyday version sits in most households. Two brothers each lend Rs 20,000 to the same cousin, who has not paid either of them back in six months. One brother mentally treats half of it as gone and plans the month without it. The other keeps the full Rs 20,000 in his head as money he still has. Neither has done anything wrong, neither has given up on the cousin, and their two budgets for next month are Rs 10,000 apart. The gap between the brothers is the whole mechanism, at household scale, and Rs 3,00,000 of the Rs 4,00,000 is made of nothing else.

A reading that lives only inside a control is invisible to anyone who cannot run it, so four positions on the control are worth writing down. At ten years and one half the second business reports Rs 38,00,000, Anjani Stationers to the rupee, and the gap is zero. At fifteen years and nothing set aside it reports Rs 42,00,000, Bharati Notebooks to the rupee, and the gap is Rs 4,00,000 made of Rs 1,00,000 of depreciation and Rs 3,00,000 of the amount set aside. Push it to twenty years and nothing set aside and the report is Rs 42,50,000. Pull it back to five years and the whole Rs 6,00,000 set aside and the report is Rs 32,00,000. Between those two ends lies a spread of Rs 10,50,000 of reported profit across one business trading one way, and at no point on that range has anything been broken.

Does the Rs 4,00,000 gap account for itself completely?

An account that says two judgements explain a gap and then leaves a stray Rs 40,000 unaccounted for has taught nothing. The decomposition is the part to be strict about. The two reported figures are these. Anjani Stationers Rs 38,00,000. Bharati Notebooks Rs 42,00,000. The difference is Rs 4,00,000.

Now take the two judgements separately. The machine charge differs by Rs 3,00,000 less Rs 2,00,000, a gap of Rs 1,00,000. The amount set aside differs by Rs 3,00,000 less nothing, a gap of Rs 3,00,000. Rs 1,00,000 plus Rs 3,00,000 is Rs 4,00,000. There is no third difference anywhere in either business for a residual to come from, so the decomposition closes exactly, with no residual. An exact close is not a tidy coincidence but the test of the claim. If anything had been left over, something else would have to differ between the two businesses, and the wrong two judgements would have been described.

The same Rs 4,00,000 shows up a second time, on the other statement, and it is worth checking there too. Anjani Stationers closes with total assets of Rs 1,33,00,000. Bharati Notebooks closes with Rs 1,37,00,000. Both owe the same Rs 21,00,000. The gap of Rs 4,00,000 in what they hold is Rs 1,00,000 of machine carried higher plus Rs 3,00,000 of school bills carried higher, and it lands in the owner's stake as Rs 1,12,00,000 against Rs 1,16,00,000. Two statements, one gap, the same two parts in both.

Is either of the two businesses wrong?

No, and the discomfort that answer causes is the useful part. There is a strong instinct that if two numbers disagree one of them must be false, and the two honest figures dismantle that instinct. Both businesses applied a permitted method. Both applied it to the facts in front of them. Both wrote down what they had done. Both would survive an examination of their reasoning.

Anjani Stationers and Bharati Notebooks have both produced an honest measurement, and neither of the two figures is a ranking. Rs 38,00,000 is a true statement about a year measured one way. Rs 42,00,000 is a true statement about the same year measured another way. Neither set of accounts contains a statement that one business did better than the other, and that statement is exactly what a reader takes away if the two headline figures are set side by side and nothing else is read.

There is a second thing worth saying plainly. Being within the rules is a statement about compliance and says nothing at all about whether two figures can be compared. A room where everybody is telling the truth in a different unit is still a room where nobody can add anything up. The rules were never designed to force one answer out of a judgement about the future; they were designed to force the judgement into the open.

How far can a judgement stretch before something is actually improper?

Two positions are now on the table and both are defensible, so the obvious next question is where the edge lies. The edge is not where most people expect. The edge is not drawn by the size of the number, and this catches out readers who assume that a large adjustment is suspicious and a small one is fine.

The line between a judgement and something improper is the direction the reasoning ran, not the distance the number moved. A judgement is defensible when evidence produced the number: the machine's servicing record, the age of the school's unpaid bills, what the last three years actually did. When the wanted number produced the judgement, the same act has run backwards, and the judgement stops being defensible. A business that decides on the profit it wants to show and then reaches for the machine life that delivers it has done something categorically different from a business that looked at the machine.

Three practical signs come with that. Consistency comes first. A life that stretches in a hard year and shrinks in an easy one is being steered rather than estimated. Evidence comes second. A judgement that no document supports is not a judgement but a preference. Disclosure comes third. A choice that is not written where a reader can find it has already been half hidden, whatever the reason for it. All three are about direction of travel. None of them is about size.

Where does a reader find the choices that produced a reported profit?

At the back. Every choice the two businesses made is written down in the notes to the accountsThe part of the accounts, behind the statements, that sets out the methods, choices and judgements sitting behind each figure at the front., in the part that sets out the accounting policies and the significant judgements. The profit figure sits at the front of a set of accounts. The two sentences that produced it sit near the back, in smaller type, and most readers never reach them.

The accounting policy note is where the whole of this comparison is settled, and it is the least read part of any set of accounts. In Bharati Notebooks' note it reads as one line about plant, saying the printing machine is written off in equal amounts over fifteen years, and one line about amounts owed by customers, saying nothing has been set aside because the balance is considered recoverable. Two sentences. Rs 4,00,000. A reader who has both notes open can put the two businesses on the same footing in ten minutes, and a reader who has only the two profit figures cannot do it at all.

Putting two businesses on the same footing is the practical reason the note exists, and the note's limit is worth being blunt about. The note does not say which judgement is better. The note says what was chosen, and leaves the deciding to the reader. A note that ruled on the future would just be a second guess wearing an official jacket. Saying only what was chosen is a smaller promise than most readers expect and a much more useful one.

What does all of this mean for comparing any two businesses at all?

Not that comparison is hopeless. Comparison starts in a different place than most people start it. The notes say whether the figures are even measured the same way, so the two policy notes come before the two profit figures. The judgements go alongside each other first, one set adjusted to the other wherever that is possible, and only then do the two results sit side by side. Adjusting one set to the other puts two measurements on a shared footing, and a shared footing is the whole of what comparabilityThe quality that lets two sets of accounts be set beside each other so that a difference between them says something about the businesses rather than about their methods. means in practice.

Consider two runners with two stopwatches, one of which is running four seconds slow. The race can still be held. Nobody can read the two times off the two watches and call one runner faster. The watches are checked first. The policy note is that check, and skipping the note is not a shortcut. Skipping the note is running the race without knowing which watch is in hand.

Three questions do most of the work on any pair of accounts, and none of them is difficult. Are the lives put on the big assets similar, and if not, by how much? Has either business set anything aside against what it is owed, and on what basis? And has either changed one of these answers since last year? The note has to say so. The whole Rs 4,00,000 came out of the first two questions asked of one machine and one school.

How does a lender or an analyst put two sets of accounts on the same footing?

By rebuilding one of them onto the other's judgements, on paper, in about fifteen minutes. Rebuilding is ordinary desk work, and the shape of it separates a reader who quotes a profit figure from one who has actually used it.

The working method is to pick one set of judgements as the reference and restate the other business onto it, then look at what is left. Take Bharati Notebooks and restate it onto Anjani Stationers' two judgements. Charge the machine at ten years instead of fifteen, and Rs 1,00,000 comes off. Set aside half of the overdue Rs 6,00,000, and another Rs 3,00,000 comes off. Rs 42,00,000 becomes Rs 38,00,000 and the two businesses are identical, the correct conclusion and the one the raw figures hid. Run it the other way, restating Anjani Stationers onto fifteen years and nothing set aside, and it becomes Rs 42,00,000. Either direction works; using neither is the mistake.

A household does a smaller version of this without calling it anything. Two households compare what they saved last year. One counted the car's servicing and the school fees due next month; the other did not count either. Before the two savings figures mean anything, one household has to be redrawn on the other's rules, and everybody knows this instinctively about their own money and then forgets it the moment the numbers get printed and bound.

Two things about that table are worth holding on to. The first is that the restated figure is not more true than the reported one; it is the same year measured on a chosen set of rules so that a second business can be laid against it. The second is that the notes named the two judgements, so the whole exercise took two lines. Where a note is vague, the restatement cannot be done at all, and a reader who cannot restate is a reader who has to widen their margin instead.

Anjani Stationers Private Limited, Bharati Notebooks Private Limited, Anjani Kulkarni, the Sunrise Public School group and the lender are invented.
Educational material. Not advice on any investment, tax, budget or market position.