Question

10. Discuss the differences between economic earnings and accounting earnings. Which is preferred in financial analysis? Which is most widely used, and why?

Answer 1

Accounting Earnings are those earnings of entity which is calculated as per Generally Accepted Accounting Principles applicable to entity and are therefore different from economic earnings.

Accounting earnings are basically bottom line item of income statement calculated as per GAAP. Economic earnings are those earnings which are calculated by making adjustments to accounting earnings. These adjustments provides the basis to make adjustment in accounting data, so that correct value of company can be ascertained.

Adjustments to be made are like: Implicit cost, Non Operating Income, Non Operating Expenses, Off Balance Sheet Items, Non Cash Expenses etc.

Economic Earnings = Net Operating Proft after Taxes - (Weightage Average Cost of Capital * Capital Employed)

The use of Net Operating Profit after tax i.e. NOPAT in calculation of economic earnings signifies that non operating items along with other requisite adjustments does not form part of calculation of economic earnings as these items does not provides help in determining the true value of business.

It is the economic earnings which is prefered by financial analyst while making equity investment, because of following advantages of it:

1.It represent the true worth of business (i.e. measure the actual viability of an entity).

2.It seeks to analyse all the financial data and then even out data which do not form basis of valuation.

3. It provides a more reliable basis of inter firm and intra firm comparison.

Mostly debt investors make use of accounting earnings, because they mainly see the asset cover available for the security of their investment while equity investors prefer economic earnings to make their investment decisions. Therefore even if entity has positive accounting profit but has negative economic earnings, equity investors will generally not make investment in such entity.