Strategic Management: Formulation and Implementation

Accounting Earnings Vs. Economic Earnings

A balance sheet and an income statement are prepared in accordance with accounting principles, with the result that the accountant's estimate of past and current earnings often differs significantly from that of financial analyst or economist.

There are important conceptual differences between accounting profits and economic profits. These differences reflect a basis disagreement regarding the definitions of income and cost, but they also reflect the very different objectives of the accountant and the economist. Some of the more important are these:

Cash Flow and accural basis
Economic analysis is based on the concept of cash flow, while a firm's accounts typically are kept in accrual basis. This exemplifies the accountant's concern with allocating revenues and costs to specific years. The economist can match cost and revenues without one year incomes statements, and can replace it with a two- or more years. A major advantage of the cash flow approach is that it focuses in the timing of recept and expenditures.
What costs, which revenues
The economist and the account not only disagree with respect to the timing of revenues and costs; they often do not agree on exactly what costs should be deducted, and from which revenues, when calculating net income. For example, the economist assigns a cost of capital to the equity employed by the firm, the accountant recognizes only interest costs on debt capital.
Estimating depreciation
Depreciation is estimated differently. The accountant is concerned primarily with allocating the historical cost of the asset to the particular years of its expected lifetime. Economic depreciation is the difference between the assets's market value at the beginning of the period, and its market value at the end . For the economist, the original cost of the asset is irrelevant.
Sunk costs
For economists past costs (or sunk costs as they are often called) are irrelevant to all current evaluations and future decisions. This view is responsible for much of the divergence between the accounting and economic concepts of income.
Inflation can have a distorting effect on the historical valuations made by the accountant. Many corporate assets are worth more today than what was originally paid for them.