Question

Which statement is true? (LO2) a) Accounting profits are greater than economic profits. b) Economic profits are greater than accounting profits. c) Accounting profits are equal to economic profits.

Short answer

The correct statement is (a) Accounting profits are greater than economic profits because accounting profits only consider explicit costs, while economic profits account for both explicit and implicit costs, resulting in a lower value for economic profits compared to accounting profits.

Step-by-step solution

Understand Accounting Profits

Accounting profits are the profits a business calculates by taking the difference between total revenues and explicit costs. Explicit costs are the easily identifiable costs, such as wages, rent, and materials. Essentially, it is the net income recorded in the financial statements.

Understand Economic Profits

Economic profits are the profits a business calculates considering both explicit and implicit costs. Implicit costs are the opportunity costs of using resources in one way instead of another. These costs are not recorded in the financial statements but need to be considered to make meaningful business decisions.

Compare Accounting and Economic Profits

While accounting profits consider only explicit costs, economic profits take into account both explicit and implicit costs. As a result, economic profits will be lower than accounting profits because they account for the costs that accounting profits ignore. Now, we can determine which of the given statements is true. a) Accounting profits are greater than economic profits. b) Economic profits are greater than accounting profits. c) Accounting profits are equal to economic profits.

Find the Correct Statement

Based on the analysis, the correct statement is (a) Accounting profits are greater than economic profits. This is because accounting profits only consider explicit costs, while economic profits take into account both explicit and implicit costs, which results in a lower value for economic profits compared to accounting profits.

Key concepts

Accounting Profits

When businesses analyze their financial performance, a common measure that pops up is accounting profits. This figure is obtained by subtracting explicit costs from total revenue. In more practical terms, it's the net income that you'll find on a company's financial statements.

Explicit costs, which we'll delve into later, include all the clear-cut expenses a business faces—like utility bills, payroll, and materials. These costs are the nuts and bolts of running a business, and because they are paid out in cash or in kind, they are easily traceable in the books. So when you hear about a company making a profit, unless otherwise specified, it’s usually the accounting profit being referred to.

Economic Profits

Fortunately or unfortunately, the true profitability of a venture isn't always as straightforward as accounting profits suggest. This is where economic profits come into play. They revolve around the broader concept of costs by considering both explicit and implicit costs. Think of implicit costs as the potential income lost when the company's resources are not put to their next best use. For example, if an entrepreneur who could be earning \(100,000 as a consultant decides to run their own business instead, their business’s economic profits would be reduced by this \)100,000—regardless of whether this cost appears on any financial statement.

Comparing economic and accounting profits is crucial for understanding the true profitability and efficiency of a business by taking into account all costs, including the ‘what might have been’ costs, which are often overlooked.

Explicit Costs

Picture the direct, out-of-pocket payments a business makes and you've got yourself explicit costs. These are the expenses with price tags, the ones you can trace directly to the business’s operations. Examples are everywhere: the lease payment for the storefront, the salary paid to employees, the money spent on advertising, and purchasing raw materials are all explicit costs.

One of the key characteristics of explicit costs is their easy identification and documentation, making them a very straightforward input when determining accounting profits. They are clear and can be found in the company's transaction records, manifesting as invoices, receipts, and financial statements.

Implicit Costs

Implicit costs are the sneaky cousins of explicit costs. They represent the opportunity cost associated with a business’s use of resources that could have been put to some other use—generating income in the process. To elucidate, these are costs that do not result in a cash payment but still carry value because the resources could have generated revenue had they been employed differently.

Examples include the loss of interest or potential rental income from property owned and used by the business instead of being rented out. Implicit costs are inherently more difficult to calculate because they involve hypothetical scenarios. However, they play a pivotal role in determining economic profits and can drastically affect business decisions and strategy when taken into account.