Accounting Profit

What Is Accounting Profit?

Accounting profit is defined as profit before taxes, interest, and adjustments for non-cash items (like write-offs). It is the profit that is calculated based on the difference between costs of production and revenue.

How Accounting Profit Works?

Accounting profit is an essential part of financial statements. It provides the basis for investors and lenders to evaluate whether the company has effectively generated, or is on track to generate, profits. Accounting profit is calculated before taxes, interest, and adjustments for non-cash items (like write-offs).

The purpose of the rules is to determine how much profit a company must report in the financial statements is to ensure that the company is adequately reporting its earnings and incurring minimal losses. In addition, a company must show an audit and other independent examiners that it has adhered to accounting principles.

Accounting profit is the net income earned after subtracting all dollar costs from total revenue. This amount is also called financial profit or bookkeeping profit. Accounting profit is an important measure of how much money a firm has left over after deducting the business’s explicit costs.

When calculating a company’s accounting profit, one must consider the expenses incorporated into the process. This includes-

  • labor, 
  • inventory,
  • raw materials, 
  • transportation costs, and 
  • marketing and sales costs.

Accounting Profit vs. Economic Profit

Accounting profit and economic profit are closely related. Accounting profit is the money left over after all costs are paid, while economic profit is the sum of accounting profit plus any implicit opportunity costs.

Implicit costs include land, non-depreciated capital goods, and other factors such as time and opportunity.

For example, if a company invested $120,000 to start a new sector and earned $140,000 in profit, their accounting profit would be $20,000. However, the economic profit would add implicit costs, such as the opportunity cost of $40,000. As such, the company would have an economic loss of $60,000 ($120,000 – $140,000 – $40,000).

To help business owners and creditors reach more informed decisions, it is best to use the accounting profit. Profit reports provide detailed information about financial transactions, activity trends, the effects caused by positive or negative items, and other relevant factors that make them very useful for decision-making.

Application

Accountants commonly use accounting profit as a measurement of a company’s operating income. Because accounting profit is based on the firm’s accounting, it is often considered a more accurate representation than economic profit. However, economic profit is used to represent how well a firm makes use of its resources. Economic profit is often used in sales and merger negotiations and production analysis.

Accounting Profit vs. Underlying Profit

Underlying profit is a key metric for businesses. Unlike accounting profit, it excludes one-time items but can incorporate management’s take on sectors and key markets.

It considers all expenses, including those that do not occur regularly or are not expected to reoccur. It overlooks positive or negative gains and losses that are not representative of the typical costs associated with running a business. By calculating underlying profit, investors can get a clearer picture of how well a company performs.

Accounting Profit vs. Taxable Profit

Taxable profits are generally calculated by deducting the appropriate expenses from accounting profits. To calculate your company’s taxable profit, you need to use a standard accounting method that the country’s tax laws allow.

For a multinational company, the composition of taxable profits varies by regional tax authorities. As a result, adjustments to the financial statements must be made to ensure that only income recognized according to the rules of each applicable local tax authority is reported. This issue also applies to expenses.

Taxable profit is the accounting profit after deduction of all expenses, including operating costs, dividend income, and interest income.

Accounting Profit Calculation and Formula

Accounting Profit can be calculated by using the below formula:

Net income = Revenue – COGS – Operating Costs – Non-Operating Costs – Corporate Taxes

Where,

  • Net Income or Income consists of all income coming in after all expenses are paid. This is usually referred to as profits. 
  • Revenue is the money brought in; this could be from sales or a loan or grants etc. 
  • Cost of goods sold or COGS are the profit of the business 
  • Operating Costs are materials, equipment, electricity, maintenance, etc. 
  • Non-operating costs are fancy words used to describe the costs of non-core operations such as research and development 
  • Corporate taxes are taxes paid to governments

Example of Accounting Profit

Let’s assume ABC company is into manufacturing shoes. The company’s annual revenues are $8,000,000. The COGS are:

Direct materials: $700,000

Labor: $50,000

Manufacturing overhead: $80,000

Assuming the operating expense is $400,000, and the interest expense is $10,000. The depreciation cost of ABC’s property, plant, and equipment are $12,000. The corporate tax incurred is $25,000.

In total, the accounting profit is $8,000,000 – $830,000 – $400,000 – $10,000 – $12,000 – $25,000 = $6,723,000.