Accounting Earnings

What exactly does accounting earning mean?

Account earning typically represents the money gained (or lost) after deducting all costs, depreciation, interest, taxes, and expenses from a company's total revenue. After subtracting necessary business expenses, it reveals how much money a corporation has left. It is typically a company's stated earnings or net income (NI).

Accounting earnings are not the same as economic earnings, which represent a company's actual profitability. They must not be used interchangeably.

In-Depth Understanding of Accounting Earnings

Every business's primary goal is to make money. Investors and analysts commonly use profit, the earnings left over after deducting all expenses from revenue, as their go-to metric to assess performance and gauge the condition of stocks listed on exchanges.

Companies' financial statements may typically include conflicting interpretations of profit or earnings. Some of these figures are as per generally accepted accounting principles (GAAP), and some interpretations are theoretical and developed by management and its accountants. Accounting earning, listed as the bottom line of the statement, typically adheres to concepts set by GAAP.

The income statement, which is one of three financial statements used to report financial performance, includes all revenues, costs, profits, and losses for a specific accounting period. In essence, it adds up and tallies all of these, giving investors an idea of how much money the corporation managed to hold.

Accounting earnings are particularly significant since they help calculate earnings per share (EPS), the most commonly used indicator for evaluating stocks. EPS is calculated by deducting NI from preferred dividends (cash payments given to the company's preferred share owners) and dividing the result by the average number of outstanding common shares. The resultant number depicts how much money a firm makes for each share of stock issued.

How do Accounting Earnings work?

A very simple and straightforward formula is used to calculate accounting earnings. The formula is defined below:

Accounting Earnings = Revenue - Cost of Goods Sold (COGS) - General & Administrative Expenses - Depreciation - Interest Expense + Interest Income - Taxes - Preferred Dividends

Assume Company JTP reported the following financial report last year:

Using the formula and the example information above, we can calculate Company JTP's accounting earnings as follows:

$1,000,000 -$500,000-$300,000-$100,000-$5,000+$1,000-$10,000-$10,000 = $76,000 (accounting earnings)

It is to be noted that negative or low earnings indicate various issues, ranging from inadequate gross profit margins to customer or expenditure management deficiencies to unfavorable accounting practices.

Accounting methodology changes may significantly impact accounting earnings, although, in many situations, these changes may have nothing to do with a company's real operations. Some companies attempt to avoid taxes and, as a result, purposefully understate their accounting earnings.

Accounting Earnings vs. Economic Earnings

Economic earnings, like accounting earnings, are also calculated by deducting explicit expenses from revenue. The difference is that economic earning also excludes implicit expenses, such as the numerous opportunity costs or advantages lost when choosing one alternative over another that a corporation incurs when moving resources elsewhere.

Economic earnings are a better predictor of profitability and a more accurate depiction of a company's genuine underlying cash flows than accounting earnings since they take into account all financial information available.

Economic earnings, on the other hand, are not reflected in a company's financial statements. Additionally, they are not required to be reported to regulators, investors, or financial institutions (FIs). Calculating economic earnings can take a significant amount of time and effort. To extract economic earnings from accounting earnings and rectify gaps in GAAP accounting, items from the financial statements' footnotes and management discussion and analysis must be deleted.

Other popular methods for determining a company's underlying profitability include discounted cash flow (DCF) analysis, internal rate of return (IRR) - sometimes known as the "economic rate of return" - economic value added (EVA), and return on invested capital (ROIC).

Some Considerations

Accounting earnings, like other accounting measures, are vulnerable to manipulation. Businesses may utilize aggressive revenue recognition strategies, declare sales early, or conceal expenditures. They may also try to limit their accounting earnings to reduce their tax liabilities.

Due to these prevalent techniques, investors who base their judgments on accounting earnings should only occasionally take financial statements at face value. Some accounting standards are mandated by law for businesses. Nonetheless, some wiggle space allows profits to be deflated or inflated to match certain goals.

It's also worth noting that uncommon and nonrecurring events like the sale of a company division, restructuring expenses, or legal fees that have nothing to do with day-to-day business operations might skew accounting earnings.

Why do companies report false earnings?

A company's management may sometimes falsify its earnings. The management may under-report earnings to avoid paying income taxes or over-report earnings to increase the firm's stock price. Profits may be altered in several ways. One way is to postpone the recognition of supplier bills, which causes reported expenditures to be shifted into a later period. Another method is inflating depreciation data to delay or accelerate depreciation expense. Another option is to falsify the closing inventory balance, which calculates the cost of goods sold; the ending amount declared can move earnings either up or down.

The Bottom Line

Accounting earnings are among the most closely watched metrics that a company discloses for investors and shareholders. It must be remembered that many businesses and industries are cyclical or seasonal when comparing accounting results from period to period. As a result, comparisons across fiscal quarters in different years are frequently the most insightful.