What are Accounting Earnings
Accounting earnings is another name for a company’s stated earnings, or net income, which is calculated by taking total revenue and subtracting the costs of doing business such as cost of goods sold, general administrative expenses, depreciation, interest, taxes, etc. Accounting earnings should not be confused with economic earnings, which measure the actual profitability of a company.
BREAKING DOWN Accounting Earnings
Accounting earnings are the bottom line of the income statement, and are used to calculate earnings per share (EPS). But because earnings have become a shortcut to determining share prices, some companies manipulate accounts to flatter earnings, whether through aggressive accounting or other tricks that comply with the letter of Generally Accepted Accounting Principles, if not the spirit.
Investors should focus on economic profit, as this provides a more accurate representation of the true underlying cash flows of the business and opportunity costs. But deriving economic earnings from accounting earnings is time-consuming and difficult, because it requires extracting items from the footnotes to the financial statements and the management discussion and analysis, in order to close loopholes within GAAP accounting.
However, more sophisticated investors do use valuation techniques like discounted cash flow analysis, and the internal rate of return — sometimes referred to as the "economic rate of return" — to gauge profitability.
Other economic measures of a company’s underlying profitability include economic value added (EVA) and return on invested capital. EVA focuses on managerial effectiveness, and is calculated by subtracting the after-tax cost of capital from net operating profit after tax. Another proxy for economic return is the cash flow return on investment.