Accounting profit

Accounting profit is the net income that a business generates as calculated under generally accepted accounting principles by subtracting all explicit costs from total revenue ^[1]. This figure appears at the bottom line of an organization's income statement and represents the financial profit available to shareholders after all recorded expenses have been deducted. Accounting profit serves as the primary measure of financial performance for external reporting purposes and forms the basis for income tax calculations and dividend distributions.

Historical development

The concept of profit as the difference between revenues and expenses has existed since merchants first began keeping financial records. Early trading enterprises calculated profits by comparing the proceeds from sales with the costs incurred to acquire and transport goods ^[2]. However the formal definition of accounting profit evolved with the development of standardized accounting practices in the nineteenth and twentieth centuries.

The industrial revolution created need for more sophisticated profit calculations as manufacturing businesses required methods for allocating costs across multiple periods and products. The matching principle which requires that expenses be recognized in the same period as the revenues they help generate became fundamental to calculating accounting profit accurately. Depreciation of fixed assets, accrual of expenses and deferral of revenues all developed to ensure that profit figures reflected economic performance during specific periods.

The establishment of professional accounting standards further refined the calculation of accounting profit. In the United States the Financial Accounting Standards Board codified requirements for revenue recognition, expense measurement and income statement presentation that determine how accounting profit is calculated ^[3]. International Financial Reporting Standards provide similar guidance for companies in other jurisdictions. These standards ensure that accounting profit figures are calculated consistently and can be compared across different companies and time periods.

Definition and calculation

Accounting profit equals total revenues minus total explicit costs incurred during a specific period ^[4]. The calculation follows prescribed accounting rules that define when revenues and expenses are recognized and how they are measured.

Components of the calculation

Total revenue includes all amounts earned from the sale of goods and services during the period plus income from other sources such as interest, dividends and gains on asset disposals. Revenue recognition rules under accounting standards determine when revenue is considered earned and can be included in the calculation.

Explicit costs are the actual expenses paid or incurred by the business including cost of goods sold, operating expenses, depreciation, interest expense and income taxes. These costs appear in the accounting records and represent resources consumed or obligations incurred in generating revenue.

Basic formula

The fundamental formula for accounting profit is:

Accounting Profit = Total Revenue - Total Explicit Costs

A more detailed breakdown shows:

Accounting Profit = Total Revenue - Cost of Goods Sold - Operating Expenses - Depreciation - Interest Expense - Income Taxes

Income statement presentation

The income statement typically presents several profit measures that build toward accounting profit ^[5]:

• Gross profit equals revenue minus cost of goods sold showing the margin earned on products or services before operating expenses
• Operating profit equals gross profit minus operating expenses showing profit from core business activities before financing costs
• Profit before tax equals operating profit minus interest expense and plus or minus other gains and losses
• Net income or accounting profit equals profit before tax minus income tax expense

Accounting profit versus economic profit

Accounting profit differs fundamentally from economic profit in the costs that each measure includes ^[6].

Explicit versus implicit costs

Accounting profit considers only explicit costs which are actual monetary outlays recorded in the accounting system. Economic profit subtracts both explicit costs and implicit costs from revenue. Implicit costs represent opportunity costs or the value of resources used in the business that could have been employed elsewhere.

For example an owner who works in the business without taking a salary incurs no explicit cost but does incur an implicit cost equal to the salary they could have earned working elsewhere. Similarly capital invested in the business could have earned returns in alternative investments. These opportunity costs reduce economic profit even though they do not affect accounting profit.

Relationship between the measures

Economic profit always equals or is less than accounting profit because economic profit includes additional costs. The relationship can be expressed as:

Economic Profit = Accounting Profit - Implicit Costs

A business showing positive accounting profit may have zero or negative economic profit if implicit costs exceed the accounting profit. In this case resources would be more productively employed in alternative uses.

Normal profit

Normal profit occurs when economic profit equals zero meaning the business earns just enough to cover all costs including opportunity costs ^[7]. At normal profit the owners receive returns equal to what they could earn in their best alternative use of resources. Accounting profit at this point equals the total implicit costs.

In competitive markets economic theory suggests that businesses tend toward normal profit in the long run. Positive economic profits attract new competitors while negative economic profits cause firms to exit until returns equal opportunity costs.

Uses of accounting profit

Accounting profit serves several important purposes in business and finance ^[8].

Financial reporting

Accounting profit is the primary measure of performance reported in financial statements prepared under GAAP or IFRS. Stakeholders including investors, creditors, employees and regulators rely on reported profit figures to assess the organization's financial health and make decisions about their relationships with the business.

Taxation

Taxable income is based on accounting profit though tax rules may require adjustments for items treated differently for tax purposes. Corporate income taxes are calculated as a percentage of taxable income derived from the accounting profit figure. Individual business owners also pay taxes based on accounting measures of business profit.

Performance evaluation

Management uses accounting profit to evaluate business performance and make operational decisions. Comparison of actual profits to budgets and prior periods helps identify areas needing attention. Divisional accounting profits may be used to allocate resources and evaluate manager performance.

Dividend decisions

Accounting profit determines the amount legally available for distribution as dividends to shareholders. Most jurisdictions prohibit dividend payments that exceed accumulated profits to protect creditors from distributions that impair capital. Retained earnings which accumulate from profits not distributed as dividends provide resources for business growth.

Valuation

Investors and analysts use accounting profit in valuation models. Price-to-earnings ratios compare stock prices to earnings per share. Discounted cash flow models often start with accounting profit and adjust for non-cash items. Historical profit patterns help forecast future performance.

Factors affecting accounting profit

Multiple factors influence the level of accounting profit a business reports ^[9].

Revenue factors

Sales volume, pricing decisions, product mix and customer retention all affect total revenue. Economic conditions, competitive dynamics and strategic positioning influence a company's ability to generate revenue. Revenue recognition policies determine when revenue appears in the accounting records.

Cost management

Controlling costs directly impacts profit. Cost of goods sold depends on input prices, production efficiency and inventory management. Operating expenses can be managed through careful planning and monitoring. However excessive cost cutting may impair revenue generation or product quality.

Accounting policies

The choice of accounting methods affects reported profit even for the same underlying transactions. Inventory valuation methods, depreciation approaches and revenue recognition policies all influence how transactions are measured and when they affect profit. Consistent application of policies is required but changes in methods can cause profit variations.

Capital structure

Financing decisions affect interest expense which reduces accounting profit. Businesses using more debt financing have higher interest costs than equity-financed competitors. However the tax deductibility of interest may offset some of the profit reduction.

Limitations of accounting profit

While accounting profit is widely used it has important limitations ^[10]:

• Does not consider opportunity costs of resources employed in the business
• Can be affected by accounting policy choices that do not reflect economic differences
• Historical cost accounting may not reflect current economic values
• Accrual accounting may differ from actual cash generation
• Single period focus may not capture long-term value creation or destruction
• Earnings management can distort reported figures
• Comparison across companies may be difficult due to different accounting policies

Accounting profit — recommended articles

Financial management — Decision making — Efficiency — Cost of quality — Planning — Strategy — Management — Organization — Production

References

• Kieso D.E., Weygandt J.J., Warfield T.D. (2022), Intermediate Accounting, John Wiley & Sons, 18th edition.
• Mankiw N.G. (2021), Principles of Economics, Cengage Learning, 9th edition.
• FASB Accounting Standards Codification.
• Horngren C.T., Sundem G.L., Elliott J.A. (2021), Introduction to Financial Accounting, Pearson, 13th edition.
• Wild J.J., Shaw K.W. (2022), Fundamental Accounting Principles, McGraw-Hill Education, 25th edition.

Footnotes

1. Kieso D.E. et al. (2022), p. 142
2. Horngren C.T. et al. (2021), pp. 12-15
3. FASB ASC Topic 606 and Topic 842
4. Wild J.J., Shaw K.W. (2022), pp. 18-22
5. Kieso D.E. et al. (2022), pp. 145-150
6. Mankiw N.G. (2021), pp. 268-272
7. Mankiw N.G. (2021), p. 270
8. Horngren C.T. et al. (2021), pp. 25-30
9. Wild J.J., Shaw K.W. (2022), pp. 580-595
10. Kieso D.E. et al. (2022), pp. 155-160

Author: Sławomir Wawak