Every for-profit business entity has the primary purpose of earning Profit through different business operations. The company’s Profit or loss, net income, is reported in the financial statements at the end of a financial year. Besides the net income, some different financial metrics and measures help assess a business entity’s financial health and profitability.
The income statement is the statement that reflects the current financial health and growth of the company. Similarly, the balance sheet of a business entity shows how well the assets and liabilities are doing. It also represents the information about share capital, dividends, etc. The third statement, the cash flow statement, tells how much cash in hand a company has. It also gives information about the business entity’s total cash inflows and outflows during a financial period.
Similar to the financial statements, there are many types of profits reported by a business entity. Profit is indeed the most significant measure of the financial health and growth of any company. Accounting profit, economic Profit, operating Profit, etc., are some of the business profits that a company reports.
This article will talk about the accounting profit and economic Profit of a company. We will also talk about the key differences between the two that everyone should know. So let’s get into it.
What Is Accounting Profit?
Profit can be defined as the access of revenues over expenses. There is not a single definite explanation of what Profit is. Accounting profit is reported in the income statement of the company. The net Profit calculated by subtracting the current year’s expenses from revenues is called accounting profit. Accounting profit is also often referred to as bookkeeping profit or financial Profit.
The accounting profit can be defined as,
The company’s net income calculated after subtracting all the expenses, tax, and interest expenses from total revenue is expressed as accounting profit.
Another definition of accounting profit is:
Gross revenues minus explicit costs of the company, deductible costs, is called the accounting profit.
The accounting profit is further segregated as gross Profit, operating Profit, and net Profit.
The gross Profit is calculated by subtracting the direct costs or cost of goods sold from the revenues. The operating Profit is the difference between the gross Profit and operating expenses incurred by a company during a financial period. The net Profit is the final Profit of the company. It is calculated by subtracting other expenses, interest expenses, and taxes from the company’s operating Profit.
Accounting profit is generally calculated for a specific financial period. Most commonly, companies prepare their financial statements at the end of a financial year. However, the accounting profit can be calculated bi-annually, quarterly or monthly.
Rules And Regulations
Two standards for rules and regulations regarding financial statement reporting are followed: GAAP and IFRS. The companies incorporated in the USA follow the GAAP(Generally Accepted Accounting Principles. Whereas the other part of the world usually follows IFRS(International Financial Reporting Standards.
Generally Accepted Accounting Principles are guidelines that dictate financial reporting and have been developed by FASB(Financial Accounting Standards Board).
Under the Corporations Law, all the companies, business entities that are registered and incorporated are required to maintain the financial records, prepare financial statements and report the findings of every financial year. Therefore, there is a legal requirement of calculating the accounting profit by any business entity.
Accounting profit, as earlier discussed, is one of the most-watched financial measures of any company. The accounting profit does not have implications for the managers of the company only. Instead, it is a sought-out measure by many prospective investors and stakeholders.
The managers and business owners keep track of their financial performance by preparing monthly, quarterly, and annual income statements. Every time, the final result of an income statement is the most significant figure for them. The managers evaluate their growth trends, financial performance, and future prospects by looking at the accounting profit. The future course of action is decided by assessing the profits of the company.
From the stakeholders’ point of view, the company’s accounting profit shows the growth trends, financial performance, future profitability, and return on investment. The accounting profit is further used for financial ratio analysis, earning per share, and other financial metrics.
The accounting profit can be calculated by subtracting expenses from the revenues. We discussed earlier what is included in the accounting profit: gross Profit, operating Profit, net Profit. Let’s look at the formula for each one of these.
Gross Profit = Gross Revenues – Cost of Goods Sold
Operating Profit = Gross Profit – Operating Expenses(day to day business expenses)
Net Profit = Operating Profit – Interest Expenses – Income Taxes
A company ABC has earned a total revenue of USD 1,500,000 during a financial period. The cost of goods sold is USD 700,000. The operating expenses are as follow:
Salaries = USD 100,000
Administrative & Selling Expenses = USD 50,000
Deductions = USD 25,000
Depreciation = USD 56,000
Rent = USD 21,000
Insurance Expense = USD 13,000
Other Expenses = USD 20,000
The interest expense of the company is USD 15,000.
Let’s calculate the accounting profit.
|(-) Cost of Goods Sold||(700,000)|
|(-) Operating Expenses|
|Administrative and Selling||50,000|
|(-) Interest Expense||(15,000)|
What Is Economic Profit?
The economic Profit is significantly different from the accounting profit. As the name suggests, the economic Profit reflects the impact of different economic decisions of a company’s management. We can comprehend the economic Profit when all the input costs are excluded from the output costs, giving the economic Profit. However, the costs included are implicit as well as explicit costs. In a moment, we will dissect this concept for a better understanding.
The economic Profit can be defined as,
When all the implicit and explicit costs are deducted from the sales proceed, it is called the firm’s economic Profit during a specific financial period.
It is important to understand the concept of implicit and explicit costs here. We talked about implicit costs in the accounting profit. Explicit costs are the deductible costs that can be appropriated as current costs of the company.
Or, more appropriately, the costs in which cash is an exchange with a good or service. At the same time, implicit costs can be explained as costs that do not involve cash exchange and are not recorded in financial accounting. The best example of implicit cost is opportunity cost.
The implicit costs do not impact the Profit but tell how much more revenues a company would’ve earned by availing an opportunity.
When we talk about the time frame of the economic Profit, it is not a legal requirement to report a company’s economic Profit. It depends on the management decisions when the company considers it necessary; they calculate the economic Profit. Economic Profit is also called Economic Value Added. It shows how an investment or cost will generate income for the company in the future. Economic Profit is generally calculated as an estimation before a new project or after its completion to assess the costs and benefits.
Rules And Regulations
There are no certain rules like GAAP or IFRS for calculating the economic Profit. However, the economic Profit is calculated by making adjustments in the accounting profit. Therefore, it can be said that the IFRS and GAAP provide the guidelines for the calculation of the economic Profit of any business entity for a given period.
Mostly the uses of economic Profit are managerial ones as there is no legal requirement to calculate the economic Profit. The variable economic Profit is used for making different decisions about the investments of the company. Economic Profit is a way of measuring the business efficiency of any business entity. In other words, it tells how effectively a business entity allocates its resources to the right places.
We can calculate the economic Profit of any business entity by the following simple formula:
Economic Profit = Gross Revenue –(Explicit costs + Implicit Costs)
Another illustration of economic Profit’s formula can be as follow:
Economic Profits = Net Operating Profit After Tax – (WACC x Net Assets)
WACC = the weighted average cost of capital
Net Assets = Net assets are the assets or funds that are available for a certain project.
Let’s recall the example discussed in the accounting profit explanation. All the explicit costs in the example were USD 987,000, and the net revenue was USD 1,500,000. Let’s say the implicit cost of USD 200,000 will be the income loss if the investment made in a specific project was invested somewhere else. Let’s say if the amount was fixed in the bank or invested in debt securities with a fixed interest. Similarly, the implicit revenue is estimated to be USD 100,000
In this case, the economic Profit will be calculated as follow:
Economic Profit = Gross Revenues –(Implicit Costs + Explicit Costs)
Economic profit = 1,600,000 – (987,000 + 200,000)
Economic Profit = 1,600,000 – 1,187,000
Economic Profit = USD 413,000
Difference Between Accounting And Economic Profit
Let’s conclude the differences between the accounting and economic Profit
|Accounting Profit||Economic Profit|
|The accounting profit is revenues minus all the explicit costs of the company.||The economic profit is revenues minus all the explicit and implicit costs of a company|
|It is one of the most significant measures that tells about its financial health and growth trends.||Economic profit is generally used when management wants to make decisions about capital budgeting and choose the best option.|
|What does it tell?|
|The accounting profit shows the financial profitability of a business.||Economic profit is a measure of business efficiency in resource allocation.|
|Accounting Profit = Revenues – Explicit Costs||Economic Profit = Revenues – (Explicit + Implicit Costs)|
|The accounting profit is a more realistic and practical measure as it is based on actual numbers.||Economic profit is based on the estimations of opportunity costs. Therefore, it does not picture a realistic story.|
|The accounting profit is generally prepared for one financial period. It can be monthly, bi-annually, quarterly, or annually.||The economic profit is calculated when management considers it necessary|
|The accounting profit is calculated for short-term profitability measurement.||Economic profit is generally calculated for long-term projects.|