ECONOMIC VS ACCOUNTING PROFIT

Income is a key component of our lives and economic system, may it be at personal or an organizational level we all bank upon income to fulfill our needs, wants and carry out operational activities. Income can be divided in to three different categories including active, passive and portfolio income. Active income is described as earnings received in form of wages and salary, or by running a business via active participation. Passive income on the other hand can be regarded as more of an indirect income collected from a rental property, a limited partnership or a business in which one is not directly involved. While the portfolio income consists of income derived from investments in form of interest, dividends and royalties. Regardless what kind of income is it there are two schools of thought which define and measure it, the very first relates to Accounting and the second to Economics. Since the beginning both accountants and economist have held a different opinion of income and how it is measured. In this paper we will discuss both schools of thought in detail, and identify which of the two holds more weight age over the other and what other means can we use to derive the most exact and accurate amount of income in todays society. Accounting as we know defines income in a very straight forward fashion and limits the calculation of income to revenues and expenses. The accounting profit or income is derived by subtracting total costs from total revenues. What we are left behind with is termed as net income or net profit. Among US corporations the accounting income is calculated using (GAAP) Generally Accepted Accounting Principles and which includes all explicit cost involved in conducting a business. These explicit costs can comprise of but are not limited to interest, depreciation, amortization and taxes. The three versions used for income in terms of accounting consist of gross income, net income or (NPAT) net profit after tax and operating income. The gross income or profit is defined as total sales minus direct costs of goods and services sold. The operating income consists of a companys earning capacity from current operations, operating income equals to operating revenue minus operating expense and does not include income taxes and interest payments. While the last and the final form of income is net income which is deduced after paying corporate and personal income taxes, depending upon what form of business it is. It can be a corporation, a limited liability company or a sole proprietorship. Economics on the other hand holds a different view of income and like accounting not only is limited to subtracting total costs from total revenue but takes it a step further and throws another element in the equation called the opportunity cost. From an economic perspective opportunity cost is defined as the cost which one must be willing to pay or incur while letting go of an alternative option or in simple words the cost of benefits you will or are willing to loose if you choose to go another route. For example consider that you are willing to invest $5000 in to the stock market by buying 39 shares of Apple incorporation for $128.24 on S&P500 index, promising al return of 3% over the next year and your other option is to invest the same amount in a low risk government bond promising an annual return of 6%. Your opportunity cost in this case will be 6% minus 3% and which equals to 3%. Accounting profits are always higher as compared to economic profits as they are based on explicit rather implicit costs like the opportunity cost. All in all you do need to make a decision and the risk that you may take realizing greater benefit by following option 2 will be your opportunity cost. Under economics the income is obtained once it exceeds the total opportunity cost of all the inputs including cost of equity and capital obtained from normal profit. While in accounting the net income is deduced once revenues exceed the accounting costs. Though it may sound complicated but economics treat normal profit as cost, which once deducted from total cost leaves us behind with economic profit or income. Today the best of both the systems can be achieved by an implementation of the (EVA) the Economic Value Added system developed by Stern Stewart & Co. EVA is accounting based and is not a metric but is considered more of a way of thinking with technical language and an operational effectiveness. Its functionality is based upon the expected required rate of return in which a corporations cash flow is subtracted from required profits, providing us with an economic income or a profit for a certain division. Divisions with higher EVA are favored for more capital investment, those meeting the targets still receive capital allocations but those which fall under are re-evaluated and considered ready to harvest which

means selling. The EVA is determined by calculating the (NOPAT) Net Operating Profit After Tax, (TC) Total Invested Capital and the (WACC) Weighted Average Cost of Capital, EVA= (NOPAT) - (TC * WACC). The other benefit of using EVA is the incentive system it provides to management and the employees. It is suggested that a higher EVA generated should be rewarded but if the opposite occurs managers should be punished and held responsible for their doings which leading to a lower EVA. (Measuring EVA, 2008) Where economists are interested in multi dimensional forces of production accountants are more interested in proprietorship, relationship between business and its owners, and deduction of cost from income. Economic income has lately drawn criticism because of its dependency on future cash flows, lack of precision and different individuals having different approach towards risk resulting in discounting cash flows at dissimilar rates. Some believe that economic income is equivalent to current value of un-observable future cash flows while accounting income is a difference between todays observable revenues and expenses.

Reference: Accounting vs. Economic Costs (2008) The University of North Carolina [Online] Available from: http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/Actg_V_Econ.htm (Accessed: 26 September, 2008) Barry Elliot, Jamie Elliot (2008) Financial Accounting and Reporting 12th Edition Prentice Hall Financial Times, England, UK David Solomons (1961) Economic and Accounting Concept of Income The Accounting Review, 36(3), pp.374-383 [Online] Available from: http://www.jstor.org/pss/242868 (Accessed: 26 September, 2008) Economic and Accounting Profit (2008) Invesotpedia [Online] Available from: http://www.investopedia.com/terms/e/economicprofit.asp (Accessed: 26 September, 2008) Edward J. Ketz (2003) The objectives of financial reporting Accounting today, 17(12), pp.8-8 [Online] Available from: http://search.ebscohost.com (Accessed: 27 September, 2008) Measuring Economic Value Added (EVA): How Corporate Governance Works for Shareholders (2008) Singapore Management University [Online] Available from: http://knowledge.smu.edu.sg/article.cfm? articleid=1128 (Accessed: 27 September, 2008) Robert L. Bartley (2003) Thinking Things Over Debating Sarbanes-Oxley: Economic Profit vs. Accounting Profit The Wall Street Journal, 2 June [Online] Available from: http://www.factiva.com/ (Accessed: 26 September, 2008)