What is Accounting Profit? | Definition, Calculation, Pros and Cons

Accounting profit is defined as a business’s net profit which is derived by deducting all the expenses and explicit costs from the revenue. In order to calculate Accounting profit, the standards set by Generally Accepted Accounting Principles (GAAP) are followed. It is also called the Net Income of a firm. Businesses are required to include the Accounting Profit information in their financial statements. The matching principle says that every expense that occurred during a period of time in order to earn an income has to be recognized. There are some costs that might not happen during that specified period, but before showing the net income they are deducted beforehand.

Explicit costs are those costs that are clearly measurable and identifiable. An example is Labor cost, it is included in explicit cost because labour cost can be clearly calculated depending on the amount paid as wages for a specific accounting period.

Implicit costs are not considered while calculating accounting profit because these costs are theoretical and have not incurred. These costs are used to calculate the economic profit of a business.

How to calculate Accounting Profit?

For calculating Accounting Profit a period you have to deduct all the expenses from the total earned revenue of that accounting period.

Profit = Income – Expense

Profits are shown at the end of the Income Statement. It can happen that the expenses exceed the revenue amount of that accounting period. But it doesn’t mean that the company has a negative profit, it means that the company will show a net loss in their Income Statement. This will show that the company doesn’t have enough revenue to cover the expense of that accounting period.

Advantages, Disadvantages, Limitations of Accounting Profit

Advantages

  1. Accounting profit shows the financial position and performance of a business.
  2. For comparing two businesses, accounting profit can be useful.
  3. Accounting Profit amount is useful while making business decisions.
  4. A good accounting profit will encourage more investors to invest in the business.

Disadvantages

  1. Cash inflows cannot be indicated with Accounting profits.
  2. Accounting profit cannot be used to compare businesses if they use different methods for calculating depreciation, amortization, provisions, accruals, impairments, valuation, etc.
  3. There are different methods and laws in various countries for calculating tax amounts and they also differ in ways for presenting financial statements.
  4. To show a better picture of a company, accounting profit can be manipulated.

Limitations

  1. Only a single period’s performance is measured.
  2. While calculating accounting profit, Return on Investment (ROI) is neglected.
  3. Some non-cash expenditures do not impact the Accounting Profit but they surely affect the cashflow like amortization and depreciation.
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References

  1. https://www.tandfonline.com/doi/pdf/10.1080/00014788.1985.9729252
  2. https://heinonline.org/hol-cgi-bin/get_pdf.cgi?handle=hein.journals/austraxrum13&section=27
  3. https://www.econstor.eu/handle/10419/109932