David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

6.2 A firm's accounts
Earnings
When a firm makes profits after tax, it can pay them out to shareholders as
dividends, or keep them in the firm as retained earnings. Retained earnings affect
the balance sheet. If kept as cash or used to purchase new equipment, they increase
assets. Alternatively, they may reduce the firm's liabilities, by repaying the bank
loan. Either way, the firm's net worth increases.
Retained earnings are the
part of after-tax profits ploughed
back into the business.
Opportunity cost and accounting costs
The income statement and the balance sheet of a company provide two useful guides to how a firm is
doing. But economists and accountants take different views of cost and profit. An accountant is interested
in tracking the actual receipts and payments of a company. An economist is interested in how revenue and
cost affect the firm's supply decision, the allocation of resources to particular activities. Accounting methods
can mislead in two ways.
Economists identify the cost of using a resource not as the payment actually made
but as its opportunity cost. To show that this is the right measure of costs, given
the questions economists study, we provide two examples.
Opportunity cost is the
amount lost by not using a
resource (labour, capital) in its
best alternative use.
If you run your own firm you should take into account the cost of your labour time
in the firm. You might draw up an income statement such as Table 6.1, find that
profits are £20 000 a year and conclude that the firm is a good thing. This conclusion neglects the
opportunity cost of your time. If you could have earned £25 000 a year working for someone else, being
self-employed is losing you £5000 a year despite an accounting profit of £20 000. To understand the
incentives that the market provides to guide people towards particular jobs, we must use the economic
concept of opportunity cost, not the accounting concept of actual payments.
The second place where opportunity cost must be counted is with respect to capital. You put up the money
to start the business. Accounting profits ignore the use of owned (as opposed to borrowed) financial capital.
But this money could have been deposited in an interest-bearing bank account or used to buy shares in
other firms. The opportunity cost of that money is part of the economic costs of the business but not its
accounting costs. If it could earn 5 per cent elsewhere, the opportunity cost of your
funds is 5 per cent times the money you put in. If, after deducting this cost and the
true cost of your time, the business still makes a profit, economists call this
supernormal profit.
Supernormal profit is pure
economic profit and measures
all economic costs properly.
Supernormal profits are the true indicator of how well you are doing by tying up your time and funds in
the business. Supernormal profits (or losses), not accounting profits (or losses), are the incentive to shift
resources into (or out of) a business.
Economic vs accounting profits
II
The inclusion of opportunity costs in economic profits creates an important distinction from
the concept of accounting profits. To stress this distinction further, suppose you start your own
firm. Suppose that your total revenues are £60 000 and you have explicit costs of £40 000 (for example, wage
payments to your workers, the cost of raw materials, etc.). According to those numbers, you should obtain an
accounting profit of £20 000.
However, suppose that your best alternative was to work for someone else and receive a wage of £25 000.
Then your firm, according to an economist, is running at a loss of £5000. 0
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