The main objective of all businesses is generating profit as a result of their effort. The success of any business endeavor is measured with this metric. Accounting profit is the net earnings of a business, which is calculated by deducting explicit costs from the revenue.
The revenue is any type of income that a company gets from its business activity, while the explicit cost is the business expenses a company does for operation. The business needs to utilize Generally Accepted Accounting Principles or GAAP for this calculation. Let’s learn how accounting profit works and what are the advantages associated with it.
How does it work?
In the financial world, the term accounting profit refers to the financial profit or bookkeeping profit. It is a simple deduction between the earned revenue of a company and its explicit cost. The explicit cost does include wages, inventory, raw materials, transportation, advertisement cost, and other overhead expenses. The accountant is required to follow GAAP guidelines for this calculation.
For example, in a financial quarter a company X sells 10,000 pens at $3 rate. So its earned revenue of this quarter will be (10,000 X 3) = $30,000. For these 10,000 pens the company spend $5,000 on employee wages, $8,000 on raw materials, $1,000 on transportation cost, $3,000 on advertisement cost, and $2,000 on inventory, and overhead cost. So the explicit cost of this business operation will be ($5,000 + $8,000 + $1,000 + $3,000 + $2,000) = $19,000. Hence, in this financial quarter the accounting profit of company X will be ($30,000 – $19,000) = $11,000.
Accounting profit shows the financial health of a company. Every company publishes this information to its investor and shareholder at the end of every financial quarter. This information shows where the company is generating its revue from and its expenditure. It brings transparency to the company’s financial operation.
Advantages of Accounting Profit
A company’s financial health and its operational feasibility reflect in the account profit report. This report also summarises all the explicit costs and the expenditure record. Every company uses GAAP standards to make this report. For this reason, it is widely accepted in the financial world and everybody can understand it’s summery with a glance. The information on the accounting profit also helps the company file taxes. Many lenders also check account profit before lending any capital to any company. In short, it is a financial statement of a company.
Disadvantages of Accounting Profit
The numbers of accounting profit can be deceiving sometimes, especially when a company grows at a fast pace. Here the capital expenditure at the beginning may reflect negative results on the accounting profit report. Accounting Profit also doesn’t reflect the long term goal or the vision of the company. This report doesn’t show other matrices like the economic profit of the company. Many accountants also use estimated data for generating the report. These data points can be inaccurate and give an incorrect report in the end. Many companies also defraud their investors by manipulating biased accounting reports.
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