Difference Between Accounting and Economic Profit
The difference between accounting and economic profit lies in the fact that the accounting profit is the result of the subtraction of income and expenses, while the economic profit is the variation in own funds between one financial year and the previous one.
The basic objective of a company is the creation of value for its shareholders, maximizing the value of the company's equity in the market in the long term. Therefore, the creation of wealth as a potential generator of income is an irrevocable objective.
This definition is supported by the concept of economic benefit against accounting. Said accounting profit is defined as the difference between income and expenses for a period, while the economic profit is established by means of the difference between the economic value of equity between two periods.
We can then define both benefits:
- Economic profit = Own Funds (period X) – Own Funds (period X-1)
- Accounting profit = Income – expenses
It is normal that conflicts of objectives arise in companies. In fact, to maximize shareholders' wealth in the long term, the first conflict occurs with the objectives of the managers of the company itself. The biggest problem, which we quote below, is the most common when it comes to aligning economic (shareholders) and accounting (managers) objectives.
The interest groups – made up of suppliers, society, government, creditors, clients, owners, managers, employees, unions…- have different objectives in relation to the shareholders. At this point, it is worth highlighting the directors, who have great decision-making power vis-à-vis shareholders due to their greater contact with business reality.
In many companies, the phenomenon of separation between management (accounting profit -Directors-) and ownership (economic profit -Shareholders-) occurs. This translates into a diversity of opinions and pursuit of different interests.
Agency theory addresses these problems. From this theory we can understand how the interests of managers have monetary and non-monetary components. If their primary objective is the growth of the company, then this fact will lead to greater remuneration or possibilities of power. The conflict here is that growth can either create or destroy shareholder value.
In short, the solution to this problem comes from the hand of greater control of management by shareholders through internal control measures (greater direct supervision and salary incentives) and external ones. Of the external measures, we could say that if the directors do not create value, they could force external investors to buy the company ( takeover bid ) and replace the management. As for the other external measure, it is for the capital market to converge the benefits of both.