What is Accounting Profit?
Accounting profit is the net income available after reducing all the explicit cost and expenses from the total revenue calculated in accordance with the generally accepted accounting principles (GAAP).
Explicit costExplicit CostExplicit cost refers to the business expenses that impact the organization's profitability and are recorded in the general ledger. Such costs are the expenses that appear in the income statement.read more is clearly identifiable and measurable and include Material cost, Labour cost, Production & overhead cost, transportation cost, sales and marketing cost, etc. Implicit costsImplicit CostsImplicit cost is the opportunity cost of the organization's resources where the organization calculates what the business would have earned if the resource had been employed for some other purpose instead of the business activity.read more are not considered as the same is not incurred, and it is notional. These are the reported profits of the business (i.e.) as per the financial statements. It is also called as book profits.
Accounting Profit Formula
Below is the formula-
Example of Accounting Profit
Example #1
OZ Corp manufactures shirts. Its annual turnover is $1,000,000. Its direct Expenses are Raw Materials – $700,000, Labour cost – $100,000, Production Expenses – $50,000 and Depreciation – $50,000.
Accounting Profit Formula = Total Revenue – Explicit Cost
- = $1,000,000 – ($700,000+$100,000+$50,000+$50,000)
- = $1,000,000 – $900,000
- = $100,000
Example #2
X Corp has prepared its financial statements for the yearFinancial Statements For The YearFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more 2018-19. The details of revenue and profit are given below.
In the above-presented case, the calculated accounting profit for the year has improved in FY 18-19 over FY 17-18 by $500 (i.e.) 33.3% increase over PY. The revenue has increased by $10,000 (i.e.) a 25% increase over PY. It shows the book profitsBook ProfitsBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. read more generated by the business for a particular period. It acts as a check to evaluate the performance and efficiency of the business. Business calls relating to further investment, profitability, market position, etc. can be analyzed with the help of such profits.
Accounting Profit Vs. Cash Profit
Cash profits indicate the profits in terms of real cash inflows and outflow. Accounting profit is the theoretical one, whereas cash profit is the real profit of the business. It is considered to be a better measure of economic viability.
Example
ABC Inc. prepares its financial statements for the year 2018-19, both as per the accounting approach and cash flow approach to analyze its performance.
In the cash flow approach, the profit is more as it does not consider non-cash expenditureNon-cash ExpenditureNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more, and it reflects the real profits of the business.
Advantages
- It has the advantage over cash profits as it can be made favorable for the business as it can be legally manipulated.
- It reflects the financial position and performance of the business.
- It can be used as an indicator to compare across business and industry.
- It helps in decision making in terms of expansion of business, investments, business performance, etc.
- If the business is profitable, investors and other stakeholders will be interested in the business.
- It is considered as an essential element in measuring the repayment capacity of the business.
Disadvantages
- It is a book profit, and it varies from cash profits (i.e.). It is not the real profit as profit does not indicate the real cash inflow.
- Accounting Profit includes transactions of extraordinary and exceptional itemsExtraordinary And Exceptional ItemsExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more.
- It cannot be used as a proper comparison across the business as various methodologies are used in the areas of depreciation & amortization; Impairment; provisions; accruals and valuation.
- Different laws for taxation in various countries and different ways of presenting the financial statements (i.e.) as per IFRS, US GAAP, etc.;
- It can be easily manipulated as window dressing can be done in the presentation of the books of accounts.
- Profit cannot be considered as the proper benchmark for comparison as there are other indicators like Revenue, gross margin, financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more, cash flow position, etc. needs to be taken into consideration.
Limitation
- It measures the performance for a single period, so it is possible to manipulate the results favorable to the business/ management based on the yearend targets, huge discounts are provided to improve the top lineThe Top LineThe top line is the revenue earned by the business by selling goods or services, reported in the income statement for a defined period. read more.
- Non-cash expenditure like depreciation, amortization, etc. reduces the accounting profit but does not have any impact on the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more.
- ROI (i.e.) opportunity cost of capital employed is not considered in the calculation of accounting profits.
Conclusion
Accounting profit represents the profit for the business, and it includes all the revenue and expenses allowable. This profit can be derived from the financial statements of the business. It is useful for management to assess the performance of the business. It acts as a major indicator to compare business performance across the industry.
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