At the end of every financial year, companies race to announce their “net profit” in bold headlines. A single number that shakes the stock exchange, decides the fate of loans and shifts investors’ confidence.
But have you ever asked yourself: who actually sets this number? The startling answer: not management alone, and not the accountant. Rather, it is a silent battle among 3 international standards… one standard that determines when you sell, one that measures what it cost you, and one that shapes how the result appears. These are the real makers of profit.
When a listed company announces that it made a profit of KD 50 million at the end of the year, many people believe that this figure represents the money that flowed into the company’s coffers. But the truth is different: net profit is not a cash balance, nor is it a figure that management sets as it wishes; it is the result of applying International Financial Reporting Standards (IFRS), which determine precisely when revenue is recognised, how costs are measured, and which expenses and losses must be charged to the financial period.
So who actually determines net profit?
The answer: the international accounting standards.
First: IAS 1… the constitution of profit presentation
International Accounting Standard IAS 1 “Presentation of Financial Statements” is the primary reference for the preparation and presentation of financial statements. It sets out the general framework for presenting financial statements and specifies the minimum information that must be disclosed, thereby ensuring transparency and comparability between companies.
It also stresses the application of the accrual basis, so that revenue and expenses are recognised when they arise in economic terms, not when cash is received or paid. Thanks to this principle, no company can inflate its profits merely by collecting amounts in advance or deferring the payment of some expenses.
Second: IFRS 15… the gatekeeper of revenue
If IAS 1 is the constitution, then International Financial Reporting Standard IFRS 15 “Revenue from Contracts with Customers” is the true guardian of revenue. This standard answers the most important question: when does a sale become revenue? The answer is not when the contract is signed, nor when the invoice is issued, but when control of the good or service transfers to the customer and the company becomes entitled to recognise the revenue.
For example, if a contracting company signs a contract worth KD 1 million in December and has not begun carrying out the project, it may not recognise the full value of the contract as revenue; rather, revenue is recognised in line with the stages of performance and the fulfilment of the standard’s requirements. This standard has helped to curb the practices that used to inflate profits by recording revenue before it was earned.
Third: IAS 2… the scales for the cost of goods
Revenue alone does not make profit; the cost of goods sold must also be measured correctly. This is where International Accounting Standard IAS 2 “Inventories” comes in, governing how inventory is measured and how cost of sales is determined. The standard requires companies to measure inventory at the lower of cost and net realisable value, to prevent the value of inventory being overstated and profits that are not real being reported. The higher the cost of sales, the lower the net profit, and vice versa.
Other standards that directly affect net profit
Although the three standards above are the ones most closely tied to net profit, there are other standards whose effect on financial results may be significant, the most important of which are:
1. IFRS 9 – Expected credit losses
If the company has receivables, loans or financial investments, the standard requires it to estimate expected credit losses and recognise them even before an actual default occurs, which may lead to a material reduction in profits.
2. IAS 16 – Depreciation
The cost of fixed assets is not charged all at once; it is spread over their years of use through depreciation, which reduces profits in a regular manner and reflects the actual benefit obtained from the asset.
3. IAS 36 – Impairment of assets
If the recoverable amount of a particular asset, such as a factory, a property or an investment, falls, an impairment loss must be recognised, which may lead to a sharp decline in profits.
4. IAS 37 – Provisions
This standard requires companies to make provisions for probable obligations once the recognition criteria are met, such as lawsuits, warranties and environmental obligations, which results in the expected costs being charged to the financial period.
5. IAS 12 – Income tax
After revenue and expenses have been computed, income tax comes along to take a portion of the profits in accordance with the provisions of the standard.
Does net profit mean there is liquidity?
The answer: not necessarily. A company may achieve high accounting profits and yet, at the same time, suffer from a shortage of liquidity as a result of slow collection from customers, a rise in the value of inventory, or the injection of large investments. That is why analysts always distinguish between profitability and cash flows, for each has its own significance when a company’s performance is assessed.
Simply put… how is net profit calculated?
Net profit = Revenue − Cost of sales − Operating expenses − Expected credit losses − Depreciation − Provisions − Taxes ± Other income and expenses
That is why any error in one of these elements will be reflected directly in the final figure that investors see in the financial statements.
When does net profit become misleading? Net profit may look high, yet it does not necessarily reflect true operating performance if it results from non-recurring profits, such as the sale of a fixed asset, exceptional gains, or the revaluation of some investments. That is why financial analysts are not content to look at net profit alone; they also study the sources of profits, their sustainability and their quality.
Summary
In short, net profit is not a certificate of success; it is a technical report. It is the outcome of a process that begins with the moment revenue is recognised under IFRS 15, passes through the measurement of cost under IAS 2, and ends with the presentation of the result under IAS 1.
So do not be taken in by the big number at the bottom of the statement. Always ask: is it sustainable profit from operations? Or merely “numbers on paper” from the sale of an asset or a revaluation?
Because in the world of finance, whoever understands the standards… understands the truth. And anything short of that may be nothing more than ink on paper.