For a U.S. GAAP company, which of the following statements best describes the relationship between the amount of accounting profits and the amount of economic profits of a company? A. Accounting profits and economic profits are similar. B. Economic profits are greater than accounting profits. C. Accounting profits are greater than economic profits. D. No systematic relationship exists between accounting and economic profits. The answer is C. I don’t understand why accounting profs are larger than economic profs.
In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs. As a result, you can have a significant accounting profit with little to no economic profit. For example, say you invest $100,000 to start a business, and in that year you earn $120,000 in profits. Your accounting profit would be $20,000. However, say that same year you could have earned an income of $45,000 had you been employed. Therefore, you have an economic loss of $25,000 (120,000 - 100,000 - 45,000).
Economic profit includes both explicit and implicit costs, including normal profit (the opportunity cost to a firm of using its own capital and the opportunity cost of the time and financial resources of the firm’s owners). This is the amount of money that could be made elsewhere. For example, the owner of a firm is making $20,000 working for his business. If he took a job at a different place, he could be making $50,000. Thus, he is forgoing $30,000. That $30,000 would be accounted for in (subtracted from, since it’s an expense) economic profit, but not in accounting profit.