What is accounting profit? (Explained in 3 steps)

The dictionary definition of accounting profit is that it’s the amount remaining after you take away your expenses from your income/revenue (the money you generally bring it). But there’s more to this… that is, what qualifies as revenue item and what qualifies as expense.

If you want to understand the meaning accounting profit quickly, just watch this quick video:

Let’s think about what accounting profit is in 3 steps.

STEP 1: Earnings is greater than how much you spend to get that earning.

Let’s say you go to work and you earn $50,000 a year gardening.

To do your job, you rent out a mower each week and in a year, that costs $10,000. So… the money you really made (after taking away the cost of the mower) was $40,000.

That’s your profit.

The difference between the money you earned less, the money you paid out in order to earn your income.

STEP 2: When earnings is less than what you’re spending, it’s a loss.

If your earnings are less than what you spend, then you’ve made an accounting loss (this is generally considered a bad thing).

For example, say you go to work and earn the same amount $50,000 gardening.

You rent out the mower and that costs $10,000 again, but this time, you decide to hire 2 people to help you out because your back is really hurting.

You pay each of these people $25,000 a year (so two people would be $50,000 a year).

You’ll see now that you will make a loss.

50,000 – 10,000 – 25,000 – 25,000 = - 10,000 (Negative 10,000).

You aren’t making money, but rather you’re losing money because you have to find $10,000 to pay the rental of the mower and/or wages.

STEP 3: Apply to a business

The final step in understanding accounting profit is that you then apply it from an individual to a business.

So…

Instead of $50,000 a year from gardening, assume this is a business selling gardening tools making $50,000 a year.

This person is buying their tools and reselling, so we need to factor in the cost of his tools (say that's $20,000), this person doesn’t have a store but instead sells online through the web.

And the costs per year to do this is $2,000.

This business is making $28,000 in accounting profit. Not bad!

Accounting profit is the amount that shows how well a company is performing. A profit is a positive amount saying that it is performing well.

A figure of zero means it’s just breaking even.

A negative figure means that it is making a loss?

It’s different to the accounting equation, which is how much you own less how much you owe.

Say, for example, your business owns a building worth $100,000, a car worth $10,000 and $5,000 in cash and no debt.

The business’ basic net worth would be $115,000.

But the thing is that accounting profit seeps in to how much cash you own.

So for example, say you earned that $40,000 in accounting profit and that cash remains, then it would increase your cash holdings by $40,000 and therefore, increase your net worth by $40,000 to become $155,000.

Likewise, if the business made a loss of $40,000, it would mean that the base net worth would then go from $115,000 to $75,000.

Accounting profit shows you how your business is performing and it affects a business net worth.

Next: What is accounting? (A simple explanation)

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