What is Accounting Profit?
Accounting profit, also known as bookkeeping profit, is the net income for a company after subtracting expenses from revenues, all while considering the Generally Accepted Accounting Principles (GAAP).
The expenses include the direct and indirect costs of running the business, such as depreciation, interest, taxes, labor wages, inventory, raw materials, sales and marketing costs, overheads, and advertisements.
- Accounting profit is the profit of the business that stems from the financial statements.
- It includes all revenues and expenses, regardless of how frequent it affects company earnings.
- Accounting profit can be also used by management to determine the current performance of the business, as well as compare its current financial position relative to competitors across the industry.
How to Calculate Accounting Profit
The calculation of accounting profit is as follows:
Net Income = Revenue – COGS – Operating Costs – Non-Operating Costs – Corporate Taxes
For example, Gordon owns a candy shop, and he analyzes his monthly financial statements. His monthly revenue is $5,000, where 500 packs of candy were sold for $10 each. In order to run the candy store, Gordon pays:
- $500 in inventory
- $300 in sales and marketing
- $200 in advertisements
The interest that must be paid is $50, and his candy machines depreciated $10 during that month. The cost of each bag of candy is $3 each.
Subtracting $5,000 – $1,500 ($3 * 500) = $3,500 would be the candy shop’s gross profit. Then, we subtract the operating costs, which is $3,500 – $1,000 = $2,500, to calculate the company’s EBITDA.
Afterward, we subtract the non-operating expenses, which is $2,500 – $60 = $2,440, and multiply the amount by 35%, which is the corporate tax rate. Subtracting earnings before taxes by the taxed value ($2,440 – 854 = $1,586) becomes the accounting profit.
Another example would be the following:
Joseph owns Silky-Smooth Corporation, which manufactures pants. The company’s annual revenues are $2,000,000. The COGS are:
- Direct materials: $200,000
- Labor: $50,000
- Manufacturing overhead: $100,000
The operating expense is $200,000, and the interest expense is $15,000. The depreciation cost of Silky-Smooth’s property, plant, and equipment is $10,000. The corporate tax incurred is $25,000.
In total, the accounting profit is $2,000,000 – $350,000 – $200,000 – $15,000 – $10,000 – $25,000 = $1,400,000.
Accounting Profit vs. Economic Profit
Although the two types of profit both consider explicit costs when generating their bottom line, the consideration of opportunity costs – foregone alternative – are their primary differentiators.
For example, Gordon could’ve purchased a new candy machine for $1,000, which would’ve generated a forecasted value of $1,500 in revenues in the future. However, he did not take the deal due to the uncertainty of the current market conditions.
Aware of the fact, he would’ve subtracted $500 from his pre-tax income, as the opportunity cost of not purchasing the machine is foregoing $500 in future revenues.
To calculate economic profits, one must account for the alternative actions that could’ve taken place when making a decision. On the other hand, accounting profits do not consider opportunity costs but is instead calculated based on measurable book values. Thus, economic profits are often used to best assist management with decision-making.
Accounting Profit vs. Underlying Profit
Unlike accounting profit, underlying profit can be subjective and is based on one’s own opinion about what the true earnings should be for a company. Particularly, profits may be valued by negating and not considering one-time charges into the valuation, due to their infrequency.
Thus, underlying profit eliminates irregular or uncommon events that may affect earnings, such as natural disasters. Such a methodology generally focuses on every day, consistent costs that the business would incur when running operations. On the other hand, accounting profit considers all values recorded in the financial statements regardless of the number of times it affects earnings.
Accounting Profit vs. Taxable Profit
Taxable profit is the value used for tax declaration after adjusting accounting profit. To retrieve the value, the company needs to alter accounting profits that are allowed under accounting standards and tax law.
The composition of taxable profits varies by tax authorities, which is based on the location of the business. Therefore, when making adjustments, the company needs to identify which income items can and cannot be recognized under that area’s tax law. It also applies to expenses.
Taxable profit tends to be based on the following:
- Operating earnings
- Dividend income
- Capital gains on the sale of long-term assets
- Interest income
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