What Are Accounting Earnings?
Accounting earnings, another name for a company’s stated earnings, or net income (NI), are calculated by subtracting business expenditures, including cost of goods sold (COGS), general and administrative expenses (G&As), depreciation, interest, and taxes, from revenue. In effect, it shows the amount of money a company has left over after deducting the explicit costs of running the business.
Accounting earnings should not be confused with economic earnings, which measure the actual profitability of a company.
- Accounting earnings, or net income (NI), are calculated by subtracting business expenses from a company’s revenues.
- The resulting number tells us what a company has left over after deducting the explicit costs of running the business.
- Accounting earnings is very influential as it is used as a basis to determine earnings per share (EPS), the most widely used metric for valuing stocks.
- It is open to manipulation, though, and, unlike economic earnings, doesn't factor in harder to quantify opportunity costs.
Understanding Accounting Earnings
The primary goal of any company is to earn money. That means that profit, the proceeds a business is left with after accounting for all expenses, is often the go-to metric for investors and analysts to gauge performance and evaluate the health of stocks listed on exchanges.
The problem is that companies often publish various versions of profit, or earnings, in their financial statements. Some of these figures conform to generally accepted accounting practices (GAAP). Others are creative interpretations put together by management and their accountants.
Accounting earnings, the bottom line of the income statement, fall into the former category. The income statement, one of three financial statements used for reporting financial performance, lists all revenues, expenses, gains, and losses over a specific accounting period. At the end it tallies all of this up, presenting investors with a snapshot of what income a company managed to keep hold of.
Accounting earnings is very influential as it is used as a basis to determine earnings per share (EPS), the most widely consulted metric for valuing stocks. EPS is calculated by taking NI minus preferred dividends, cash distributions paid to the owners of a company's preferred shares, and then dividing the number by average outstanding common shares. The resulting figure shows how much money a company makes for each share of its stock.
Accounting Earnings vs. Economic Earnings
Like accounting earnings, economic earnings deducts explicit costs from revenue. Where they differ is that economic profit also strips away implicit costs, the various opportunity costs, or benefits missed out on when choosing one alternative over another, a company incurs when allocating resources elsewhere.
Because economic earnings focus on all financial information available, many believe that they are a better gauge of profitability and provide a more accurate representation of the true underlying cash flows of a business than accounting earnings.
Economic earnings are not recorded on a company’s financial statements, though, nor required to be disclosed to regulators, investors, or financial institutions (FIs), so determining them can be a time consuming and complicated task. Deriving economic earnings from accounting earnings, and closing loopholes within GAAP accounting, requires extracting items from the footnotes to the financial statements and the management discussion and analysis (MD&A).
Other popular methods to measure a company’s underlying profitability include discounted cash flow (DCF) analysis, the internal rate of return (IRR) — sometimes referred to as the "economic rate of return" — economic value added (EVA) and return on invested capital (ROIC).
Accounting earnings, like other accounting measures, are susceptible to manipulation. For instance, companies may engage in aggressive revenue recognition tactics, recording sales prematurely, or hide expenses. They might also seek to minimize their accounting earnings to reduce their tax liabilities.
Earnings have become a shortcut to determining share prices, so some companies manipulate accounts to flatter them through aggressive accounting or other tricks that comply with the letter of GAAP.
These common practices mean that investors who base decisions on accounting earnings should not always take all the numbers presented in financial statements at face value. Companies are required by law to follow certain accounting standards. However, some leeway is provided too, making it sometimes possible to deflate or inflate earnings to meet certain objectives.
It's also worth bearing in mind that accounting earnings can be skewed by unusual and irregular one-time, nonrecurring events, such as the sale of a business division, restructuring costs or legal fees, that have nothing to do with everyday business operations.