Book profit is a kind of profit that has not been realized on investment. Book profit happens when the current price of an asset is higher than the purchase price, but the owner of an asset still owns(holds) the security. As a result, there is the likelihood that the book profit may decrease in case of a price drop. In order to calculate the book profit for an asset the following formula is used :
In most countries, book profit is not taxable; the tax amount is collected when gains and losses are realized. Also known as unrealized profit or unrealized loss or paper profit or paper loss.
Importance of Book profit
The finding of the study conducted by Alhadab and Tahat highlight the importance of unrealized gain to investors. The outcomes show that investors undervalue the business that reports unrealized losses and gains in their comprehensive income statements in the pre and post-crisis periods. The way that the unrealized gains and losses that published in the are considered to be a major root cause of the recent financial credit crisis in 2008 .
The variances between book profit and tax base are powerful and this may be observed in medium and large enterprises. Nonetheless, it is rather complicated to highlight any trends since the direction and the scale of the variations differ remarkably across companies .
Difference between net porfit and book profit
Net income, also called net profit or net earnings, is a concrete concept. The figure that most comprehensively reflects a business' profitability while book profit only represent the unrealized profit or loss due to market fluctuation.
The net income of a business is the outcome of a number of computations, starting with revenue and including all expenses and revenue streams for a given point. All the cash that flows in and out of a company is accounted for as a sum. This covers costs for the manufacture of products; debt payments; operating expenses; interest paid on credits; further income streams from subsidiary holdings or the sellout of assets; depreciation and amortization of assets; taxes.
On the other hand, book profit only represents the potential profit due to price movements on the market for a given set of assets.
Examples of Book profit
- Capital Gains: When an asset is sold for a higher price than what it was bought for, the difference between the two prices is known as capital gain and it is considered as book profit. For example, if a person buys a house for $200,000 and sells it for $250,000, then the capital gain would be $50,000, which is the book profit.
- Dividend: When a company pays out dividends to its shareholders, the amount paid out is considered as book profit. For example, if a company pays its shareholders a dividend of $1 per share, then the total book profit for the company would be $1 multiplied by the total number of shares owned by the shareholders.
- Interest Income: When an investor earns interest from their investments, the amount earned is considered as book profit. For example, if an investor earns 5% interest on a $100,000 investment, then the book profit would be $5,000.
- Non-Operating Income: When a company earns income from sources other than its normal business activities, the amount earned is considered as book profit. For example, if a company earns $10,000 from the sale of an investment property, then the book profit would be $10,000.
- Unrealized Appreciation: When an asset appreciates in value but is not sold, the increase in value is considered as book profit. For example, if a company owns a piece of land that is worth $500,000 and its value appreciates to $600,000, then the book profit will be $100,000.
Advantages of Book profit
Book profit is a term used to describe the amount of profit that has been earned by an investment but has not yet been realized. Some of the advantages of book profit include:
- It provides an accurate record of how profitable an investment has been. This can be useful for measuring the performance of an investment over time.
- It allows investors to plan future investments by providing an estimate of the potential returns that could be earned.
- Book profit can also be used to assess the potential risks associated with an investment, as it provides an indication of the amount of money that an investor could lose if the investment does not perform as expected.
- Book profits can also be used to calculate taxes that are due on an investment, as they provide an accurate picture of the profit that has been made. This can help investors to minimize their tax liability.
Limitations of Book profit
Book profits can be a useful tool for investors, but there are certain limitations to consider. The following are some of the main limitations of book profit:
- Book profits are based on estimated values and do not always accurately reflect actual market value. This can lead to investors overestimating the value of their investments and making decisions based on inaccurate information.
- Book profits are not always reflective of a company's financial performance since they are based on estimated values rather than actual market values.
- Book profits can be affected by changes in accounting principles and practices, which can lead to overstated or understated profits.
- Book profits are not always indicative of a company's performance because they do not take into account other factors such as cash flow, economic conditions, and other market factors.
- Book profits can be misleading if the investor does not understand the accounting principles used in calculating them.
Book profit is a kind of profit that has not been realized on investment. Other approaches related to book profit include:
- Accounting Profit: This is the amount of money that a company makes on its financial statements. It is calculated by subtracting all expenses from total revenue.
- Economic Profit: This is the amount of money that a company makes after accounting for the opportunity cost of its resources. It takes into account the cost of capital, labor, and other resources that have been used in the production process.
- Taxable Profit: This is the amount of money that a company has to pay in taxes. It is calculated by subtracting all allowable deductions from total revenue.
In summary, book profit is a kind of profit that has not been realized on investment. Other approaches related to book profit include accounting profit, economic profit, and taxable profit.
- Webster, T. (2015).
- (Alhadab and Tahat, 2016)
- Leszczylowska, 2014
- Alhadab, Mohammad and Tahat, Yasean. (2016). The value relevance of unrealized gains and losses around the financial credit crisis: Evidence from the UK. Corporate Ownership and Control. 14. 10.22495/cocv14i1c2p7.
- Boulland, R., Lobo, G. and Paugam, L. (2019). Investors Pay Sufficient Attention to Banks’ Unrealized Gains and Losses on Available-for-sale Securities? European Accounting Review, pp.1-30.
- Kolev, K. (2010), Investors Perceive Marking-To-Model As Marking-To-Myth? Working Paper. New York University
- Leszczylowska, Anna. (2014). The Relationship Between Book Profit And Taxable Income From A Research Perspective - Evidence Based On Corporations in Poland. International Journal of Economics and Management.
- Webster, T. (2015). Managerial economics.
Author: Mariia Gordiyenko