Accounting Profit

What is Accounting Profit?

Definition: Accounting profit, also called bookkeeping profit, is the net income that remains after subtracting the explicit costs from a firm’s total revenues in accordance with generally accepted accounting principles (GAAP). These costs include labor costs, raw material costs, distribution costs, and other production expenses.

Accounting profit is the difference between total monetary revenue and total monetary costs, and is computed by using generally accepted accounting principles (GAAP). Put another way, accounting profit is the same as bookkeeping costs and consists of credits and debits on a firm’s balance sheet. These consist of the explicit costs a firm has to maintain production (for example, wages, rent, and material costs). The monetary revenue is what a firm receives after selling its product in the market.

Accounting profit is also limited in its time scope; generally, accounting profit only considers the costs and revenue of a single period of time, such as a fiscal quarter or year.

Accounting Profit Formula

Below is the formula to calculate Accounting Profit:

Accounting Profit = Total Revenue – Explicit Cost

What Does Accounting Profit Mean?

What is the definition of accounting profit? This is the net income reported on the all GAAP basis financial statements. Accountants subtract a firm’s explicit costs from the total revenues to calculate the accounting profit. Explicit costs are costs that can be clearly identified and measured. For example, labor costs are explicit costs because they represent a specific amount paid for wages during a given period.

All of the costs included in the calculation are amounts actually paid except depreciation expense. This represents the year’s ratable portion of the past outlay of cash required to purchase production equipment. Thus, this also is included.

Accountants do not consider implicit costs in this calculation because they haven’t been incurred and are merely theoretical. Implicit costs are used for the calculation of a firm’s economic profit.

Accounting profit is also known as the net income for a company or the bottom line. It’s the profit after various costs and expenses are subtracted from total revenue or total sales as stipulated by generally accepted accounting principles (GAAP). Those costs include:

  • Labor costs, such as wages.
  • Inventory needed for production.
  • Raw materials.
  • Transportation costs.
  • Sales and marketing costs.
  • Production costs and overhead.

Accounting profit is the amount of money left over after deducting the explicit costs of running the business. Explicit costs are merely the specific amounts that a company pays for those costs in that period – for example, wages. Typically, accounting profit or net income is reported on a quarterly and annual basis and is used to measure the financial performance of a company.

Example

Let’s look at an example of how accounting profit is calculated. Company A operates in the manufacturing industry and sells widgets for $5. In January, it sold 2,000 widgets for a total monthly revenue of $10,000. This is the first number entered into its income statement.

The cost of goods sold (COGS) is then subtracted from revenue to arrive at gross revenue. If it costs $1 to produce a widget, the company’s COGS would be $2,000, and its gross revenue would be $8,000, or ($10,000 – $2,000).

After calculating the company’s gross revenue, all operating costs are subtracted to arrive at the company’s operating profit, or earnings before interest, taxes, depreciation, and amortization (EBITDA). If the company’s only overhead was a monthly employee expense of $5,000, its operating profit would be $3,000, or ($8,000 – $5,000).

Once a company derives its operating profit, it then assesses all non-operating expenses, such as interest, depreciation, amortization, and taxes. In this example, the company has no debt but has depreciating assets at a straight line depreciation of $1,000 a month. It also has a corporate tax rate of 35%.

The depreciation amount is first subtracted to arrive at the company’s earnings before taxes (EBT) of $1,000, or ($2,000 – $1,000). Corporate taxes are then assessed at $350, to give the company an accounting profit of $650, calculated as ($1,000 – ($1,000 * 0.35).

Advantages of Accounting Profit

  • It has the advantage over cash profits as it can be made favorable for the business as it can be legally manipulated.
  • It reflects the financial position and performance of the business.
  • It can be used as an indicator to compare across business and industry.
  • It helps in decision making in terms of expansion of business, investments, business performance, etc.
  • If the business is profitable investors and other stakeholders will be interested in the business.
  • It is considered as an important element in measuring the repayment capacity of the business.

Disadvantages of Accounting Profit

  • It is book profit and it varies from cash profits (i.e.) it is not the real profits as profit does not indicate the real cash inflow.
  • It includes transactions of extraordinary and exceptional items.
  • It cannot be used as a proper comparison across the business as various methodologies are used in the areas of depreciation & amortization; Impairment; provisions; accruals and valuation.
  • Different laws for taxation in various countries and different ways of presenting the financial statements (i.e.) as per IFRS, US GAAP, etc.
  • This can be easily manipulated as window dressing can be done in the presentation of the books of accounts.
  • Profit cannot be considered as the proper benchmark for comparison as there are other indicators like Revenue, gross margin, financial ratios, cash flow position, etc needs to be taken into consideration.

Limitation

  • It measures the performance for a single period so it is possible to manipulate the results favorable to the business/ management based on the yearend targets, huge discounts are provided to improve the top line.
  • Non-cash expenditure like depreciation, amortization, etc. reduces the accounting profit but does not have any impact on the cash flows.
  • Return on investment (i.e.) opportunity cost of capital employed is not considered in the calculation of accounting profits.

Accounting Profit vs Economic Profit

Like accounting profit, economic profit deducts explicit costs from revenue. Where they differ is that economic profit also uses implicit costs, the various opportunity costs a company incurs when allocating resources elsewhere.

Examples of implicit costs include:

  • Company-owned buildings
  • Plant and equipment
  • Self-employment resources

For example, if a person invested $100,000 to start a business and earned $120,000 in profit, his accounting profit would be $20,000. Economic profit, however, would add implicit costs, such as the opportunity cost of $50,000, which represents the salary he would have earned if he kept his day job. As such, the business owner would have an economic loss of $30,000 ($120,000 – $100,000 – $50,000).

Economic profit is more of a theoretical calculation based on alternative actions that could have been taken, while accounting profit calculates what actually occurred and the measurable results for the period. Accounting profit has many uses, including for tax declarations. Economic profit, on the other hand, is mainly just calculated to help management to make a decision.

Accounting Profit vs Underlying Profit

Companies often choose to supplement accounting profit with their own subjective take on their profit position. One such example is underlying profit. This popular, widely-used metric often excludes one-time charges or infrequent occurrences and is regularly flagged by management as a key number for investors to pay attention to.

The goal of underlying profit is to eliminate the impact that random events, such as a natural disaster, have on earnings. Losses or gains that do not regularly crop up, such as restructuring charges or the buying or selling of land or property, are usually not taken into account because they do not occur often and, as a result, are not deemed to reflect the everyday costs of running the business.