Accounting Profit – Definition

Cite this article as:"Accounting Profit – Definition," in The Business Professor, updated September 19, 2019, last accessed June 6, 2020, https://thebusinessprofessor.com/lesson/accounting-profit-definition/.

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Accounting Profit Definition

Accounting Profit is a company’s gross revenue minus its explicit costs. It is the net earnings on its income statement calculated according to generally accepted accounting principles (GAAP). The explicit costs of a company include the labor costs, costs of the raw materials, transportation costs, distribution expenses, and all other production costs.

While calculating the accounting profit, the implicit costs of the company are not considered and thus the accounting profit of a company tends to be higher than its economic profit.

A Little More on What is Accounting Profit

Accounting profit only represents the monetary expenses and doesn’t consider the opportunity costs.

For example, Sandra is a full-time employee in a multinational company and earns $120,000 a year. Now she decides to leave her job and open a café in her locality. She expects sales of $300,000 a year and her explicit cost for running the café is estimated at $200,000. The explicit cost includes the labor wage, raw material costs, property rental, and others. According to this estimation, her accounting profit would be $100,000. So, it seems the business is profitable, but an economist will see things differently. They will argue that Sandra should consider what she would give up that includes the investment she is making (otherwise she could earn interest on this amount) and her salary. So, according to economists, she’ll be making a loss as her economic profit is negative.

The economic loss doesn’t imply that Sandra is losing money, but it indicates that Sandra would make more by using her time and resources in her current job.

Let’s look at the calculation of the accounting profit. X is a company that produces toys. For the sake of simplicity let’s assume that they sell each of their toy for $10. In the first month of an economic year, they sell 5,000 toys for total monthly revenue of $50,000. This is the first number to be entered into the income statement of the company.

Now, the gross revenue of the company is calculated as the total monthly revenue minus the cost of goods sold (COGS). Suppose the cost of making each toy is $3 then the company’s COGS would be $15,000 and the gross revenue would be $35,000.

Then, the operating costs are subtracted from the gross revenue to get the company’s operating profit. If the operating cost is $10,000, the operating profit would be ($35,000- $10,000) = $25,000.

After deriving the operating profit, the non-operating expenses are assessed. This includes interest, depreciation, taxes, and amortization. Let’s assume this company does not have any debt and has depreciating assets at a straight-line depreciation of $5,000 a month and has a corporate tax rate of 35%.

The company’s earnings before taxes (EBT) is $25,000-$5,000 = $20,000. The accounting profit of the company are then calculated as {$20,000-($20,000*0.35)} = $13,000.

The accounting profit is also called bookkeeping profit or financial profit. Monitoring the profit of a company is important to assess its financial health.

References for “Accounting Profit”

https://www.investopedia.com › Investing › Financial Analysis

https://www.investopedia.com › Investing › Financial Analysis

https://www.wallstreetmojo.com/accounting-profit-vs-economic-profit/

https://corporatefinanceinstitute.com › Resources › Knowledge › Accounting

https://www.myaccountingcourse.com › Accounting Dictionary

https://www.higherrockeducation.org/glossary-of-terms/accounting-profit

https://www.dummies.com/…/how-to-distinguish-between-accounting-profits-and-eco…

Academic research on “ Accounting profit”

Firm and industry effects in accounting versus economic profit data, Holian, M. J., & Reza, A. M. (2011). Firm and industry effects in accounting versus economic profit data. Applied Economics Letters, 18(6), 527-529. This article presents estimates of firm and industry fixed effects on profit rates for large US corporations, using Economic Value Added (EVA), the popular measure of profits produced by Stern Stewart & Co., and simple (unadjusted) accounting measures as the dependent variables. We find that the improvement in explanatory power of the fixed-effect model is substantially greater when using EVA than has been documented with alternative measures.

Cash flow accounting, profit and performance measurement: a response to a challenge, Lee, T. A. (1985). Cash flow accounting, profit and performance measurement: a response to a challenge. Accounting and Business Research, 15(58), 93-97.

Tax treatment of capital expenditure and the measurement of accounting profit, Edwards, J. R. (1976). Tax treatment of capital expenditure and the measurement of accounting profit. BTR, 300.

The gap between accounting profit and taxable income, Tran, A. V. (1997). The gap between accounting profit and taxable income. Austl. Tax F., 13, 507. This paper reports a statistical analysis of the effective tax rates (ETRs) of more than 500 listed Australian companies to mea-sure the gap between accounting profit and taxable income caused by permanent differences. The results show that companies in three industry groupings benefited substantially from concession-al tax treatments of gold-mining income, dividends and capital gains, and had accounting profit consistently higher than taxable income. After controlling for industry effect, the analyses also identify a size effect: large firms had a wider book-tax income gap than small firms.

Measuring the firm’s performance: Accounting profit versus market Value, Hax, H. (2003). Measuring the firm’s performance: Accounting profit versus market Value. Journal of Institutional and Theoretical Economics (JITE)/Zeitschrift für die gesamte Staatswissenschaft, 159(4), 675-682.

The relationship between accounting profit and economic income, Ryan, J. (2007). The relationship between accounting profit and economic income. Australian Accounting Review, 17(43), 33-46. The reliance on economic concepts, most notably economic income, for the measurement of profit in financial accounting is misplaced. This paper explores the concept of economic income, contrasting it with the concept of profit in the conventional accounting model. The concept of individual economic income cannot be used for measurement of profit for a past period as the concept is based on the capitalisation of expectations and excludes “separate but correlated” concepts of profit and capital needed for capital maintenance.

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