The main indicator of the performance of a business is its profits. Generally, the calculation of profits consists of deducting the expenses of the business from its revenues. There are many types of profits that businesses use to assess various aspects of their performance.
To calculate these profits, businesses deduct different types of expenses from their revenues. For example, to calculate its gross profit, a business will only deduct its production expenses from its revenues. One type of profit that business can calculate is the accounting profit.
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 are those expenses which 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, labour, production overhead, sales, marketing, administrative expenses, among many others. Explicit expenses are the opposite of implicit expenses, which consists 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 by using the accounting profit formula given below.
Accounting profit = Revenues – Explicit Expenses
For this formula, revenues consist of all income that a business generates 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 the 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 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. Cash profits, on the other hand, 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.
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 judgements 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 efficient 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 is something very different as compared to 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 jurisdiction the business is operating in 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.
Advantages of Accounting profit
Accounting profit can have certain advantages for businesses to calculate. The first advantage is that it is the main indicator of the performance of a business. Investors and stakeholders look for the accounting profit of a business to determine how it has performed over the last accounting period. Similarly, investors and stakeholders can use the accounting profit of a business to compare it with other businesses in the same industry.
Similarly, accounting profit is one of the many figures that the management of business based on which they make decisions. Thus, accounting profit can be useful in the decision-making process of the business. It can also help the management when deciding on issues such as expanding in new markets, new investments, resource allocation, etc.
The accounting profit of a business can also be helpful when the business applies for loans. Financial institutions, such as banks, require the business to calculate its accounting profits for several years to determine whether it can repay the loan in the future. Therefore, financial institutions consider the accounting profit of a business an essential element when determining its creditworthiness.
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 make it disadvantageous for investors or stakeholders that make decisions based on it. Its susceptibility to manipulation is mainly because it depends on the revenues and expenses of the business 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.
A company, ABC Co., has the following revenues and expenses for a single accounting period.
To calculate its accounting profit, ABC Co. must first calculate its total explicit expenses. The explicit expenses of ABC Co. will consist of all the expenses listed above, as all of them 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 formula provided above. 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.
|Less: Explicit expenses|
|– Production expenses||(13,000,000)|
|– Administrative expenses||(5,000,000)|
|– Marketing expenses||(3,000,000)|
|– Financial expenses||(2,000,000)|
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 is different from other types of profits such as cash profit, economic profit and taxable profit.