Definition:
Accounting profit is the net income of a business calculated after deducting all its explicit costs and expenses from its revenues. The calculation of accounting profit follows the standards set in the Generally Accepted Accounting Principles (GAAP). Businesses following GAAP are required by it to report their accounting profit in their financial statements. However, to calculate the accounting profit, businesses must first understand what explicit expenses are.
Explicit expenses
Explicit expenses are those expenses that a business can identify and measure. In other words, they are expenses that are a part of the accounting system of a business.
These may include material, labor, production overhead, sales, marketing, and administrative expenses, among many others.
Explicit expenses are the opposite of implicit expenses, which consist of costs that are not a part of the accounting system of a business and mainly refer to opportunity costs.
Accounting profit calculation
Businesses can calculate their accounting profit using the accounting profit formula below.
Accounting profit = Revenues – Explicit Expenses
For this formula, revenues consist of all a business’s income from its operations. It is also known as income or sales of the business.
On the other hand, explicit expenses consist of all the expenses of the business from its accounting system.
Accounting profit Vs other profits
The concept of accounting profit can be further simplified by comparing it with other types of profits. The three types of profits that are often confused with accounting profit are cash profit, economic profit, and taxable profit.
While these three types of profits are not as widely used, they are still important for businesses. Therefore, it is necessary to know the difference between these profits and accounting profits.
Cash profit
The cash profit of a business indicates the profits it has made in monetary terms. In accounting profit, expenses are deducted from revenues regardless of whether these expenses have been paid for or not.
In other words, the accounting profit also consists of accrued expenses.
On the other hand, cash profits only consist of calculating the difference between the cash inflows and outflows of a business.
The rule for cash profit is that if the cash inflows of a business exceed its inflows, it is said to have made a cash profit.
Cash profit is important for businesses for many reasons. First of all, if a business keeps making accounting profits but fails to generate a cash profit, it will not be able to meet its cash payment obligations on time.
Therefore, the business may strain its relationship with its suppliers.
Furthermore, cash problems can cause a business to obtain more debt to finance activities. Rising debts can also be harmful to a business.
Likewise, cash profits are also important because they can save a business from going into liquidation.
Economic Profit
The economic profit of a business depends on its accounting profits. This is because a business can calculate its economic profits by deducting its total explicit and implicit expenses from its revenues.
In other words, a business can calculate its economic profit by subtracting its implicit expenses from its accounting profit.
As mentioned above, implicit expenses consist of the opportunity costs of a business. Businesses can calculate their opportunity cost by considering alternative uses for their resources.
Implicit expenses are subjective because businesses make judgments to calculate them.
Economic profit is also an important type of profit that businesses can use to calculate their efficiency. By calculating the opportunity costs of their resources, businesses can understand how efficiently they are currently using those resources to generate profits.
The economic profit of a business can also assist its management in making decisions regarding the use of its resources.
Similarly, investors and other stakeholders can use it to make decisions regarding the profitability of the business and whether they are better off investing elsewhere.
Taxable Profit
Taxable profit differs greatly from cash, economic, and accounting profits. A business must calculate its taxable profits under the tax laws in specific jurisdictions rather than accounting standards.
While it can deduct most of its expenses from its revenues when calculating its taxable profits, some expenses may not be allowable deductions.
The tax law of the business’s jurisdiction will provide information regarding which expenses are deductible and which are not.
Businesses may also need to recalculate some expenses such as depreciation according to the tax laws and not accounting laws.
The taxable profit of a business is crucial in calculating its tax for a period. That is because tax laws don’t allow businesses to calculate their taxes based on accounting or economic profits.
There are various reasons why tax laws restrict businesses from deducting every type of expense when reaching their taxable profits.
Investors and other stakeholders may not receive information regarding the taxable profit of the business as the profit is not a part of the disclosures required from a business.
What is the purpose of Accounting Profit?
The purpose of accounting profit is to measure the financial performance of a business over a specific period. Accounting profit is calculated by subtracting a company’s expenses from its revenues and is an important metric for evaluating its profitability.
There are several reasons why accounting profit is important:
- Measure of Financial Performance: Accounting profit measures a company’s financial performance over a specific period, such as a quarter or a year. Stakeholders can evaluate a company’s financial progress and growth by comparing accounting profits over time.
- Basis for Taxation: In most countries, businesses are required to pay taxes on their profits. Accounting profit provides a basis for calculating the tax owed to the government.
- Basis for Decision Making: Accounting profit is often used to make business decisions, such as whether to invest in new equipment or expand operations. By evaluating the potential impact of these decisions on accounting profit, business owners and managers can make informed choices about allocating resources.
- Reporting to Stakeholders: Accounting profit is an important metric that is often reported to stakeholders, such as investors, lenders, and regulators. By providing an accurate picture of a company’s financial performance, accounting profit can help stakeholders make informed decisions about whether to invest in or lend money to the company.
Advantages of Accounting profit
Accounting profit provides several key advantages for businesses when calculating financial performance.
Firstly, it is a primary indicator of a business’s performance and is closely monitored by investors and stakeholders to assess its performance over a given accounting period.
In addition, accounting profit can be used to compare a business’s performance with other companies within the same industry, providing valuable insights into market competition.
Secondly, accounting profit is a crucial figure management uses when making strategic decisions.
By assessing accounting profit, managers can determine the business’s overall financial health, and make informed decisions about resource allocation, expansion into new markets, investment opportunities, and other key issues.
Thirdly, accounting profit is critical in securing loans from financial institutions. Banks and other lenders typically require businesses to provide several years’ worth of accounting profit data when applying for loans, as this figure serves as a key indicator of the company’s ability to repay the loan in the future.
In this way, accounting for profit is considered an essential element when determining a business’s creditworthiness.
Overall, accounting profit provides:
- A crucial tool for assessing financial performance.
- Informing strategic decision-making.
- Securing funding from financial institutions.
By carefully monitoring accounting profit, businesses can ensure long-term success and sustainability.
Disadvantages of Accounting profit
Accounting profit may also have some disadvantages. The first disadvantage is that accounting profits are not the real profits of a business. As mentioned above, accounting follows the accrual concept when accounting for expenses.
So, although a business does not pay cash in exchange for its expenses or receive cash for revenues, it will still include them when calculating its accounting profit.
Therefore, while accounting profit is important, it doesn’t give a true picture of the actual profitability of the business.
The accounting profit of a business is also easily susceptible to change. This can disadvantage investors or stakeholders that make decisions based on it.
Its susceptibility to manipulation is mainly because it depends on the business’s revenues and expenses that follow accounting principles and not strict rules.
The management can easily manipulate these principles to window dress the accounting profit.
While the stakeholders can use the accounting profit of a business to compare its performance with other businesses in the same industry, it cannot give a true comparison.
This is because accounting profit considers subjective calculations such as depreciation, amortization, provisions, etc., which means every business will have a different methodology to calculate them.
Similarly, due to different financial reporting frameworks, such as GAAP. IFRS, etc. the accounting profits of the same business may be different when using different financial reporting frameworks, thus, making the comparison even more difficult.
Example
A company, ABC Co., has the following revenues and expenses for a single accounting period.
| Description | Amount ($) |
| Revenue | 30,000,000 |
| Production expenses | 13,000,000 |
| Administrative expenses | 5,000,000 |
| Marketing expenses | 3,000,000 |
| Financial expenses | 2,000,000 |
| Taxes | 2,000,000 |
ABC Co. must first calculate its total explicit expenses to calculate its accounting profit. The explicit expenses of ABC Co. will consist of all the above expenses, as they are identifiable and measurable already.
Therefore, the explicit expenses of ABC Co. will be $25,000,000. Now, ABC Co. can also calculate its accounting profit using the above mentioned formula. The calculation is as below.
Accounting profit = Revenues – Explicit Expenses
Accounting profit = $30,000,000 – $25,000,000
Accounting profit = $5,000,000
ABC Co. can also represent its accounting profit in the form of a statement. The representation is as below.
| Particulars | Amount ($) |
| Revenue | 30,000,000 |
| Less: Explicit expenses | |
| – Production expenses | (13,000,000) |
| – Administrative expenses | (5,000,000) |
| – Marketing expenses | (3,000,000) |
| – Financial expenses | (2,000,000) |
| – Taxes | (2,000,000) |
| Accounting Profit | 5,000,000 |
Conclusion
There are different types of profits that businesses calculate. One important type of profit among those is accounting profit.
All businesses that follow Generally Accepted Account Principles must calculate accounting profit and include it in their financial statements.
Businesses can calculate accounting profit by deducting their explicit expenses from their revenues. Explicit expenses consist of all expenses that businesses can identify and measure.
Accounting profit differs from other types of profits such as cash profit, economic profit, and taxable profit.
