Accounting profit

Accounting profit is the sum of income less expenses according to generally accepted accounting principles (GAAP). In an accounting financial statement, implicit costs as for example opportunity cost are not allowed to be considered because it is against the accepted principles of accounting. Therefore, it discloses the past performance of the company’s performance during a financial time interval (monthly, quarterly or annually) and does not reflect an economic performance of an entity that includes in a several periods.

The calculation of the accounting profit

The measurement process of company’s performance contains the analyzation of the financial status and results of the businesses. Also, it results from the difference between capital of business unit from the beginning of a fiscal period to the end. There are many different methods as accrual accounting, cash accounting, semi-accrual accounting, modified accrual, and modified cash to identify profits which is based on the present a report on the performance of the company.

The calculation of the accounting profit reveals the past economic performance of the company throughout a specific time interval.

It is calculated in an income statement that includes at least the following:

• Sales revenue
• Gains and losses on derecognition of financial assets measured at amortized cost
• financing costs
• the share of profit or loss of associates and joint ventures accounted for using the equity method
• certain gains or losses in connection with the reclassification of financial assets
• tax expense
• a single amount for the total of discontinued operations

Financial result shows the comparison of revenue and expenses and, depending which case appears, it can develop profit or loss:

• revenue < expenses = gross loss
• revenue > expenses = gross profit

Income statement accounts are considered "temporary" accounts, as they report amounts accumulated over a specific period of time (month, quarter, or usually a year). Expenses must be calculated either by their nature (raw materials, personnel costs, depreciation, etc.) or by their purpose (cost of sales, selling, general and administrative expenses, etc.). Some IFRS (International Financial Reporting Standards) require or allow some components that are not expenses to be included in the income statement as other comprehensive income.

Why is accounting profit important?

The purpose of the income statement is to show not only whether a company earned a profit (or not), but also how it made the profit (or loss). When the company announces its financial reports, there is good news and bad news. If the reported accounting profit is above the prediction, then it is good news, because then investors will update the company's profit prediction upwards. Conversely, there may be bad news if the reported profit is less than investors forecast. Accounting profit can be used as a KPI to assess the financial performance of a company, but not as a performance concept. As a result, accounting profit does not reflect the initial need for cash input and output flows in future years and cannot be used as a complete criterion for decision making.

Key figures from accounting profit

There are three main types of profitability ratios, of which profit divided by amount invested as noted above is just one:

• Return of Sales (ROS) essentially measures the return, or profit, on a currency of sales revenue. ROS = profit / Total Sales

• Return on Assets (ROA) focus at the profit given the total resources available, independent of how the resources were financed. The indicator is the net profit adjusted for the cost of financing net of any tax effects. The key figure is the total resources available. ROA = (Net Income + Interest Expense (1 − the tax rate)) / Total Assets.

• Return on Equity (ROE) measures the return to a specific investor group: the owners. No adjustment is made to the numerator because borrowing well (or poorly) is part of the net return to the owners. ROE = Net Income / Owner’s Equity

Accounting KPIs illustrate a trade-off between providing the best valuation of the assets versus providing the best basis for estimating future cash flows. The manager decides based on the picture of the firm how should be presented to outsiders. As the business venture becomes more complex, so does the impact of these trade-offs.

References

• International Accounting Standards Board (Board) (accessed on 28.11.2022). IAS 1 Presentation of Financial Statements, IFRS.org
• Krstanovic, N., & Barbaca, D. B. (2016). Accounting Profit as a Determinant of Development of Entrepreneurship. Economy transdisciplinarity cognition journal, 19(2), 14
• Paramita, R. W. D. (2017). The the window information for investor on accounting profit forecasting. Jurnal Terapan Manajemen dan Bisnis, 3(2), 193-204
• Tulvinschi, M. (2013). The accounting profit–a measure of the performance of the business entity. The USV Annals of Economics and Public Administration, 13(1 (17)), 140-148
• Vahid, N., Reza Dehghanpour, M., & Nasirizadeh, H. (2013). Comparison between accounting profit and economic profit and its effect on optimal point of production. European Online Journal of Natural and Social Sciences, 2(3 (s)), pp. 493-499
• Weiss, L. A. (2017). Accounting for fun and profit: a guide to understanding advanced topics in accounting (First ed.). Business Expert Press

Author: Roberto Nguyen