Accounting Profit
Refers to the net profit or the income earned by the firm, calculated by subtracting the total expenses from the total revenue
What Is Accounting Profit?
Accounting Profit refers to the net profit or the income earned by the firm, calculated by subtracting the total expenses from the total revenue. It is also known as net income, financial profit, or bookkeeping profit.
It is measured under the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) rules and guidelines.
However, it determines how much the company has earned after deducting the expenses from its total revenue.
In simpler words, we can also say that are 3 types of accounting profits, namely
1. Net profit
The amount left with the firm after deducting all the expenses and tax for the year is referred to as net profit. However, it is commonly known as the bottom line, as it is represented in the firm's income statement's final line.
2. Gross profit
It is the amount measured by deducting all manufacturing or direct costs from the firm's total revenue and is represented in the Income statement.
3. Operating profit of the company
It refers to the amount measured as the income from the real operation of the business and its core functions. It excludes tax and interest expenses.
Key Takeaways
- Accounting Profit refers to the net income earned by a firm, calculated by subtracting total expenses from total revenue. It encompasses net income, financial profit, and bookkeeping profit.
- Accounting Profit is calculated by subtracting explicit expenses from total revenue. It offers a comprehensive view of a company's financial standing and is crucial for evaluating performance and making business decisions.
- Accounting Profit differs from economic profit, focusing solely on monetary expenses and revenue. Economic profit considers both explicit and implicit costs. These distinctions impact financial decision-making.
Understanding Accounting Profit
Accounting profit observes, analyzes, and evaluates the company’s performance and compares it with competitors of the business in the market. It also reflects on the business's financial position in the market among the competitors. It is calculated as a part of the Income statement by subtracting the total expenses from the firm's total revenue. It is also shown in the Balance sheet as an addition to the Retained Earnings of the Equity section.
What's important to know is that accounting profit is different from economic profit and underlying profit. It only considers the money expenses and revenue. Economic profit, on the other hand, takes into account more factors, and underlying profit tries to eliminate the impact of nonrecurring items.
Accounting profit helps us see the actual profits a company makes, not just the theoretical numbers that economic profit looks at. This profit is calculated for loan, interest, and growth, whereas economic profit determines a company's total production cost and total value.
Accounting profit shows us the difference between a company's expenses and the money it makes from its operations over time. It's important to note that accounting profit should never be higher than economic profit. Economic profit is calculated by subtracting something called "opportunity cost" from accounting profit, and it can be positive (making money) or negative (losing money).
In a perfectly competitive market, when a company's total revenue equals its total costs, we call it "normal profit." If it's negative, the company lost money during a certain period. Even if a company makes sales, if it spends a lot, it can still end up losing money.
How to Calculate Accounting Profit?
The formula for calculating Accounting Profit using the following formula:
Accounting Profit = Total Revenue - Explicit Expenses
Any payment made by the company to other companies or individuals which led to a cash outflow is referred to as explicit costs. Some examples include: wages, mortgages, rent, utilities, advertisements, raw materials and other general and administrative.
Let's understand this through an example, Company ABC generated a revenue of $120,000, and the explicit costs, including wages of $5,000 and rent of $15,000, calculate the accounting profit for the company.
Now, using the formula:
Accounting Profit = $120,000 - ($5,000 + $15,000) = $120,000 - $20,000 = $100,000
So, through this example, we can see and observe that the explicit costs (rent and wages) are deducted from the company's revenue to calculate the company's accounting income.
Accounting profit vs. Economic profit
Accounting profit is calculated as the difference between a company's revenue and its explicit expenses. It is distinct from economic profit, calculated as the difference between revenue and the sum of the firm's explicit and implicit costs.
Implicit costs are the money a company loses by using an asset it owns instead of selling or renting it to customers.
It can be used for various purposes, including tax declarations and evaluating a company's financial performance. Economic profit, on the other hand, is primarily used to assist management in making financial decisions.
Here is the tabular difference between accounting and economic profit, which confuses the people with its interpretation and definition, but these differences help to understand better and fairly.
| Basis | Accounting Profit | Economic Profit |
|---|---|---|
| Meaning | Total revenue less explicit costs. | Total revenue less implicit costs and explicit costs. |
| A fair and true picture | It provides a true and fair picture of the company's financial performance. | It does not provide a true and fair picture of the company's financial performance. |
| Uses | Used for financial performance and income tax. | Used for determining the market entry and expected profit and assisting management with financial decisions. |
| Reporting profits | Need to report the profits to the IRS. | Do not need to report the profit to the IRS. |
| Financial Principles | Follows the guidance of GAAP. | Guided by economic principles. |
| Special items | Do not include any special items. | Include special items like inflation. |
| Practical approach | Higher practical approach | Lower practical approach |
| Duration | Used for short term | Used for long-term |
| Formula | Total revenue - explicit costs | Total revenue - (explicit costs + implicit costs) |
This difference between accounting and economic profit is important to understand and interpret working with financial statements.
Accounting Profit FAQs
It is also known as pre-tax book income (PTBI), net operating income before taxes, or simply pre-tax income.
Yes, it includes the opportunity costs of the firm during the year.
The accounting profit is generally greater than the economic profit, but in cases where the opportunity cost is zero, it is equal to the economic profit.
When the accounting profit is zero, the company's total revenue is equal to the explicit costs.
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