Accounting Profit versus Economic Profit

by Paul J. Updike

INTRODUCTION

The objective of this article is to help the reader distinguish between economic profit and accounting profit. However, sometimes it is difficult to make a clear distinction, especially if the person measuring the profit is trained in both economics and accounting.

In this writing I will attempt to define profit. Then I will discuss some of the issues associated with the accounting definition of profit. I will point out some of the questions that must have definitive answers first, before a valid attempt can be made to measure profit. May I indicate here that accounting is a methodology that attempts to measure the economic notion of profit?

One of the biggest differences between an accounting definition of profit and various economic definitions of profit is that economics simply defines what profit is or what it should be and leaves the whole issue of calculating or measuring profit in the real-world up to the accounting profession. Then the economist, looking over what the accountants have accomplished, akin to a ‘Monday-morning quarterback’, says “no, that is not quite right, because you are not considering this or that accurately.” Sometimes, the economists are correct in their observations, too. However, this type of criticism is not especially helpful.

Finally, I will explore some of the consequences that our society has suffered by using the accounting methodology to measure profit among public companies whose stock is traded in the stock market. In conclusion, I will suggest one important substantive change that ought to accompany any accounting reform that politicians are wont to proffer. 

VARIOUS DEFINITIONS OF PROFIT

● “Profit is what’s left over after all the appropriate costs have been subtracted.” (Colander, Microeconomics, p57.)

● “Profit [is] the total amount of money that an individual receives for a product or service, minus all the costs of production.” (Invitation to Economics, p34)

● Profit-maximizing behavior in perfect competition is producing (and selling) the quantity indicated at the intersection of the marginal cost and marginal revenue curves, as long as the average total cost is less than the marginal revenue. (Colander, Microeconomics, p249)

● “Profit is what remains after the firm’s other income [costs] (employee compensation, rent and interest) is paid out.” (Colander, Macroeconomics, p170)

● “Investments on which the marginal return exceeds the cost of capital” (Alfred Kahn, Economics of Regulation, p114)

● Profit = Total revenue – Total cost. (Various sources)

For economists, “total costs” is explicit payments to the factors of production plus the opportunity cost of provided by the owners of the firm.

For economists, “total revenue” is the amount a firm receives for selling its product or service plus any increase in the value of the assets owned by the firm.

[Therefore], Economic profit = Explicit plus implicit revenue – Explicit plus implicit costs.

(Colander, Microeconomics, p202-203)

ISSUES THAT MUST BE CONSIDERED

Perhaps it is not obvious by looking at these definitions and explanations of profit, but understanding exactly what constitutes revenue and exactly what constitutes costs and how total revenue and total costs are calculated is not simple. In fact, literally thousands of textbooks have been written in an attempt to explain exactly what these terms mean and how they are best calculated.

In the accounting world, at least in America, there is a term applied to this body of methodology and theory. The term is Generally Accepted Accounting Principles, or GAAP. When economists refer to accounting definitions of this or that term, they are usually referring to GAAP. The terminology, theories, and concepts within GAAP, may or may not be economically reasonable, but the GAAP meanings applied are usually quite similar to the meanings one would find in an economic textbook. In fact, the biggest difference between economics and GAAP is that in accounting, one tries to measure and calculate each specific term, whereas in economics, one just applies a simple, but elegant definition and moves on.

For instance, both accounting and economics recognize that there is a time dimension problem encountered when measuring profit. In economics, they simply say short-run or long-run and leave the issue indefinite. Accounting methodology, on the other hand, specifically defines periods of time, and accountants look to the heavens to do so. The typical short-run period of time that profit in a firm is measured is one month or approximately the time it takes for the moon to orbit the earth.

The typical mid-range period of time that profit is measured in a firm is one year, or the time it takes for the earth to orbit the sun. There is not general agreement on exactly what constitutes long-term, but I have seen time periods offered as short as five years and as long as thirty years. Most people agree that “long-term” is somewhere between 10 and 20 years.

The typical economist defines terminology then moves on to explaining this or that relationship based on an elegant model. The accountant asks questions like the following. How exactly does one measure the cost of capital? How does one measure the value of an asset? How does one calculate asset depreciation over time correctly? How does one accurately measure capital recovery? How does one measure the value of unsold inventory in a production firm? The body of information and collected wisdom, called GAAP, takes on these larger issues. It is impossible to attempt to measure profit in a replicate-able form unless each accounting practitioner follows the same rules. Thus, GAAP was developed.

BENEFITS OF USING THE ECONOMIC DEFINITION OF PROFIT

Peter Drucker has long argued that firms need to measure, not count when we calculate costs. He recognized the importance of Activity-based costing as a more accurate measure of costs than what GAAP typically used. By the 1980s, Activity-based costing (ABC) was developed and became accepted.

In the last 15 or 20 years, some accounting experts who also grasp economic principles have tried to make ABC congruent with economics. One successful practitioner is Doug Hicks, who has installed over 100 Activity-based costing systems in production firms. Though not the first to do so, in his book, Activity Based Costing, Making It Work for Small and Mid-Sized Firms, Hicks answers most of the questions that I asked in the previous section. The first thing Hicks points out in his book is that accurately measuring costs is an economic issue, which is exactly the reason that ABC works well. (Hicks)

In the late 1980s, the consulting firm, Stern Stewart, developed an analytic tool called Economic Value Added, or EVA. The concept behind EVA is interesting. Instead of relying upon GAAP to measure on-going profit, Stern Stewart figured out that the most important issue for on-going firms was to have a methodology for measuring the cost of capital. By subtracting an opportunity cost for using capital from the reported profit, the remainder would be the economic value added, or EVA. The firms that consistently added value over and above the cost of capital were true profit-maximizers.

PROBLEMS WITH USING THE ACCOUNTING (GAAP) DEFINITION

The problem with allowing GAAP to define profit can be easily illustrated by looking at the corporate accounting scandals during 2000 to 2002. Enron, Tyco, WorldCom, Lucent, Qwest, HEALTHSOUTH, Global Crossing, etc., are all public firms, and they all tried to stretch reality by reporting to the shareholders that their firm generated more profit than it actually did. Many of these scandal-plagued firms ultimately filed for bankruptcy and their shareholders lost tens or even hundreds of billions of dollars that will never be recovered.

Three ways that public firms fraudulently try to appear more profitable than reality are through 1) misstating their actual expenses, 2) misstating their actual debt, and/or 3) misstating their actual revenue. We investors are more than simply curious to know for sure whether the business transactions of a specific enterprise are profitable. We must know in order to make rational decisions about where we invest our capital. We investors have a history of relying on auditing firms that are world-class masters at applying GAAP to every possible business circumstance. Whether the business is involved in mining or manufacturing or printing or flying airplanes, we investors understood that these firm's financial reporting would help translate all the business transactions into a familiar language with which we were fluent. That is why GAAP exists. Or so we thought. 

But in fraudulent situations, the accounting rules are stretched to the limit and beyond by utilizing some variation of these three practices: 1) amortizing expenses, that is, pretending the outlay is for an asset that legitimately contributes value over more than one year, when the cash outlay is actually for immediate consumption, 2) hiding debt by taking real debt off of the balance sheet (or never putting it on the balance sheet) and/or by 3) creating revenue out of thin air (by stealing income from future quarters, illegally reporting certain business transactions as revenue, etc., etc.)

GAAP allows for actual expenses to be immediately deducted from income, reducing profit. By amortizing expenses, we only recognize a portion of the transaction as affecting current profit. By hiding debt, the firm presents a rosier scenario than reality. Also, by taking on debt, a firm might be tacitly admitting that the cash flowing from current operations is not actually enough to support current operations, which reality managers are typically loathe to admit, which is why managers may be tempted to hide debt in the first place.

Operating cash flow is definitely information an investor wants, but a firm might want to deny investors access to that information. By creating revenue out of thin air, and recognizing that revenue in a current period, an enterprise can show more profit currently than reality, because the definition of profit is total revenue minus total costs, with many costs period-oriented.

GAAP then, can be gamed, especially when the incentive for the managers of the enterprise is to maximize their own income, even at the expense of the shareholders. Dishonest managers can accomplish their goal by using common GAAP terms, like revenue, expense, debt, assets, value and profit in uncommon ways. 

SUMMARY

Whether or not a firm is really making profit is a question that is not simply an economic (academic) or accounting (measuring) question -- investors want to know too. Most of the fraudulent accounting activities in the corporate world the last few years have been of the short-run variety. In the long-run, a firm cannot keep hiding reality via fraud, because the size of the fraud tends to grow geometrically over time, causing the whole company's operations to explode or implode, sooner, rather than later.

On the other hand, a firm with profitable short-run operations will be able to support and sustain long-run business operations. In fact, one hallmark of long-term, sustainable operations is the willingness of the firm to accept profit-reducing claims in the short-run in order to continue making profit for the long-term.

For instance, I once returned to Home Depot a faulty 3½ year-old window air conditioning unit, carrying a $280 list price and exchanged it for a new model, straight across. Did this transaction reduce Home Depot’s short-run profit? You bet it did. Did that behavior by Home Depot solidify me as a loyal customer in the future? Of course it did. I return to that store to make new purchases again and again.

The measurement of profit is most often a reporting issue, that is, how much and what kind of information is reported when; for what period; and is the information accurate? The reason profit matters, is that the issue of the firm’s long-term viability is directly related to profit. In this culture, with large public companies dominating the capital of our country, whether or not a business is making a profit is often a multi-billion dollar question.

Then do we need more laws? We must be careful suggesting that the government pass new laws. More government regulations may make an investor feel safer about this or that equity investment, but part of what got us into trouble in the first place is that the laws and regulations have gotten so complex that only GAAP experts and insiders can interpret them. Besides, more laws and regulations tend to provide greater incentive for dishonest people to commit fraud. However, I am in favor of better enforcement of the multitude of laws already in place.   

The best solution to the problems inherent in GAAP is probably the approach favored by Warren Buffett, the CEO of Berkshire Hathaway and the most successful investor in the world. Warren Buffet believes that public firms have an obligation to disclose to the investor as much of the actual operating information that an investor needs to have to make a rational decision whether to continue to invest their capital in a specific company or to withdraw. In a word, Buffett is talking about complete transparency of all business transactions. I agree. Complete transparency tends to emphasize having timely access to complete information, but probably does not require a specific law.

If investors in a firm have access to all the business transactions of that firm that they want to have access to, quarterly estimates of profit for public companies will lose its importance in determining market capitalization, which today is often used to determine the price (value) of an individual share of stock. Instead, each investor will be able to define profit in his or her own way, drawing their own conclusions and make the best decision possible for themselves, based on their self-interest. With the advent and universal nature of the Internet, that rosy scenario may happen.

May I make three important additions to the content discussed above given me by an internationally trained CPA, licensed to practice in several countries, after he read this article. *1

Note 1 - Recently, the U.S. and many other countries have agreed to have a standard GAAP, also known as International Accounting Standards. This is expected to eliminate any anomaly that the different countries' regimes may have caused so far.

Note 2 - One significant point worth paying attention to is that of the concept of income and expense matching. Accounting principles requires that there should be a matching of income and expense within the same financial statement period. This means, if you account for income in one year, you must account for all related expenses in the same year.

Note 3 - There is also "tax profit" that could be totally different from the “book” or GAAP profit and/or economic profit, depending on tax law.

References:

Alfred Kahn, Economics of Regulation: Principles and Institutions, Volume I, John Wiley & Sons, Inc., New York, NY, 1970.

Colander, D.C. (2001). Microeconomics (4^th ed.). [University of Phoenix Special Cover Edition]. Burr Ridge, IL: Irwin/McGraw-Hill.

Colander, D.C. (2001). Macroeconomics (4^th ed.). [University of Phoenix Special Cover Edition]. Burr Ridge, IL: Irwin/McGraw-Hill.

Douglas T. Hicks, Activity Based Costing, Making It Work for Small and Mid-Sized Firms, John Wiley & Sons, Inc., New York, NY, 1999.

Lawrence Wolken, Janet Glocker, Invitation to Economics, Teacher’s Annotated Edition, Scott Foresman and Company, Glenview, IL, 1988.

Peter F. Drucker, We Need To Measure, Not Count, Wall Street Journal, April 13, 1993.

*1 Private Correspondence between Paul Updike and Pallav Acharya, 2004.