Understanding Where Profit Goes in a Corporation
In order to understand where the profit goes in a corporation, it helps to look at specific examples. The partners or shareowners of a business are entitled to a share of the business’s profit — but they may not get as big a piece of the sales revenue pie as you’d expect.
Following are some business examples to help put this into perspective:
Suppose that a private business earned $1.32 million net income for the year just ended and has issued 400,000 capital stock shares. Divide net income by the number of shares, and you come up with earnings per share of $3.30.
Assume that the business paid $400,000 cash dividends during the year, or $1.00 per share. The retained earnings account thus increased $2.30 per share (earnings per share minus dividends per share).
Although stockholders don’t have the cash to show for it, their investment is better off by $2.30 per share, which shows up in the balance sheet as an increase in the retained earnings account. Shareholders can hope that the business will use the cash provided from profit to increase future profit, which should lead to higher cash dividends.
Now, suppose the business is a public company that is 1,000 times larger. It earned $1.32 billion on its 400 million capital stock shares and distributed $400 million in cash dividends.
You may think that the market value should increase $2.30 per share, because the business earned this much per share that it retained in the business and did not distribute to its shareholders.
Profit is an increase in the net assets of a business (assets less liabilities, which is also called net worth). The business is $2.30 per share “richer” at the end of the year than it was at the start of the year, due to the profit it earned and retained. Yet it’s entirely possible that the market price of stock shares actually decreased during the year.
Market prices are governed by psychological, political, and economic factors that go beyond the information in the financial reports of a business. Financial statements are only one of the information sources that stock investors use in making their buy-and-sell decisions.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
