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What Is Accounting Profit?
Accounting profit is defined as the firm’s net revenue obtained by subtracting all the expenses from the gross revenue. Accounting profit calculation follows the standards set in Generally Accepted Accounting Principles (GAAP).
Accounting profit is the net income that remains after subtracting all the explicit costs (such as labor costs, production costs, raw material costs, transportation/distribution costs, sales and marketing costs, and other expenses) from the total revenue of the business as per GAAP.
To ascertain accounting profit, accountants ascertain the total revenue of a firm and then deduct the direct costs and not the implicit ones. As such, businesses needed to be able to differentiate between what explicit and implicit costs are. In such scenarios, revenue refers to all the income earned by the business, and direct costs are all the expenses incurred by the business within the same period.
Accounting profit is also frequently confused with other types of profits, such as taxable profit, cash profit, and economic profit. Albeit not as widely used, these three types of profits remain crucial for business.
Expenses deducted from gross revenue typically include labor costs, raw material purchase expenditure, transportation costs, marketing and sales expenditure, production and overhead costs, etc.
Accounting Profit Formula
The calculation of accounting profit is as follows
Net Income = Revenue – COGS – Operating Costs – Non-Operating Costs – Corporate Taxes
Example of Accounting Profit
Let us understand the concept of accounting profit with an example- Assume ABC owns a Chocolate shop and performs analysis of monthly financial statements. The monthly revenue of ABC is $40,000,000.
Costs of other expenses are-
Production expenses – $13,000,000
Administrative expenses – $5,000,000
Marketing expenses – $3,000,000
Financial expenses – $2,000,000
Taxes – $2,000,000
Total Explicit Expenses= $25,000,000
Accounting profit = Revenues – Explicit Expenses = $40,000,000 – $25,000,000 = $15,000,000
Accounting Profit vs Economic Profit
The economic profit of a business can be derived from its accounting profit. To achieve this, a business needs to subtract its implicit costs from the accounting profits. The latter is derived by deducting the total expenses incurred from the total revenue incurred. Implicit expenses involve the opportunity costs of the business.
Economic profit, in other words, includes explicit and implicit costs. Opportunity costs may be defined as the foregone cost of choosing one business method over its alternative. As such, these costs are somewhat subjective. Economic profits can help a business determine its efficiency.
As such, economic profit is more of a theoretical calculation, one that ponders what could have been taken as a course of action. This type of profit also greatly aids the management in determining the best business decisions that can be made. Investors rely on economic profits to gauge the profitability of a business and then decide if they should invest in a firm or not.
Accounting Profit vs Cash Profit
A business’s cash profit indicates the profit it has made in monetary figures. While the accounting profit indicates the net revenue, the cash profit is merely the difference between the cash inflow and outflow of a firm. As a result, if the cash inflow exceeds the cash outflow, the business is said to have made a cash profit.
This type of profit is crucial for a business, as a business that fails to make profits in cash will not able to pay off its debts, which may worsen the company’s image in front of its suppliers, and make it hard it secure loans in the future. Cash profits are therefore a necessity to prevent a business from dissolving.
Accounting Profit vs Taxable Profit
The taxable profit is quite different from its economic, cash, and accounting counterparts. The profits earned before tax deductions are termed gross profits. All businesses are required to audit the books and calculate the taxable profits, and – depending on the local laws- only some expenses may be allowed to be deductible. The origin of the business and the jurisdiction it falls under will determine what laws it needs to follow when calculating taxable profits.
Businesses may also need to reassess some expenses, such as depreciation. Most tax laws forbid businesses from evaluating the relevant taxes via economic or accounting profits. Taxable profit is not necessary for disclosure in the books of accounts, which means that shareholders and investors will likely remain oblivious to this piece of information.
Taxable profit includes operating earnings, income in the form of interest, gains from the sale of long-term assets, and income in the form of dividends received.
Accounting Profit vs Underlying Profit
Underlying profit is inherently subjective and is based on opinions about the true earnings of the company. It is calculated by deducting any unusual or infrequent expenditures of the business.
This methodology only accounts for the fixed and consistent expenses that occur in the course of business and – unlike accounting profit – eliminates any irregular or rare expenses incurred by the business.
Merits Of Costs Accounting Profit
Accounting profit has several advantages that can be deemed useful for the business. The principal advantage is that it serves as an indicator of the performance of the business, which is useful for shareholders and investors looking to gauge the performance of the business against other companies and also against the previous accounting periods of the firm.
Accounting profit also serves as a barometer for the management team to make crucial business decisions. The management team analyzes the profit and sources of income to decide on issues like business expansion, new investments, staff requirements, and more.
A business showing adequate profits in its financial statements will have an easier time applying for and receiving loans. Banks and other financial institutes gauge a business on profit and cash outflow amongst other parameters to gauge their creditworthiness before they elect to sanction a loan. As such, accounting profits play a crucial role in the financial makeup of a company.
Demerits Of Accounting Profit
Accounting profits also have some downsides. Businesses follow the accrual concept of accounting when calculating profits, which includes income and expenditure transactions despite a lack of actual exchange of money. This, in turn, portrays an inaccurate and incomplete picture of the business.
Accounting profits can be easily changed and is not impervious to manipulation by skilled accountants, as it is based upon accounting principles and not strict and regulated rules. This can be a nightmare for investors and stockholders who use accounting profits to gauge the business for their decisions and plans.
It also makes a comparison between different companies an arduous task, as all companies will have different and subjective methods of accounting for various issues such as inventory, depreciation, etc. This is bound to deter many potential investors from investing in the future.
Wrap Up!
On the concluding note, it is clear that accounting profit is used in the financial statements of an organization for evaluating its performance.
Businesses calculate different types of profits, and accounting profit is one of the integral parts of profits that are preferably calculated by the businesses that follow Generally Accepted Account Principles.
Accountants subtract the total explicit costs of a firm from the total revenues for calculating the accounting profit of the firm. Different stakeholders might fuse the accounting profit of a business for comparing its performance with other businesses in the same industry.
What are your thoughts about the importance of accounting profit for evaluating the financial health of a business?
