The following points highlight the five important recipients of net income. The recipients are: 1. Value-Added Concept of Income 2. Enterprise Net Income 3. Net Income to Investors 4. Net Income to Shareholders 5. Net Income to Residual Equity Holders.
Recipient # 1. Value-Added Concept of Income:
Broadly speaking, it is possible to view the and other investors but also employees and landlords of rented property. This is the value-added approach. Value added is the market price of the output of an enterprise less the price of the goods and services acquired by transfer from other firms.
Thus, all employees, owners, creditors and governments (through taxation) are recipients of the enterprise income. This is the total/price that can be divided among the various contributors of factor inputs to the enterprise in the production of goods and services. The value-added income would include wages, rent, interest, taxes, dividends paid to shareholders, and undistributed earnings of the companies.
Recipient # 2. Enterprise Net Income:
This concept of net income has an advantage from the point of view of separating the financial aspects of an enterprise from its operating. The net income to the enterprise is an operating concept of net income. Net income resulting under ‘operating capability concept’ is known as enterprise net income.
Recipient # 3. Net Income to Investors:
In accordance with the entity concept of the business enterprise, both shareholders and creditors of long-term debt are considered equally as investors of permanent capital. With the separation of ownership and control in the business enterprises, the differences between shareholders and debt holders are no longer as important as they once were.
The main differences arise in the priorities of claims against income and against assets in liquidation. In the entity concept, income to investors includes the interest on debt, dividends to preferred and common shareholders, and undivided remainder.
This concept of income has considerable merit for several purposes:
(1) The decisions regarding the sources of long-term capital are financial rather than operating matters. Therefore, the net income to investors reflects more clearly the results of operations.
(2) Because of differing financial structure, comparisons among firms can be made more readily by using this concept of income.
(3) The rate of return on total investment computed from this concept of income portrays the relative efficiency of invested capital better than does the rate of return to shareholders.
In the computation of net income to investors, income taxes are treated as expenses. Corporate income after taxes is much more stable—by industries—than income before taxes; income taxes seem to be passed on much as other expenses. Also, both investors and managers seem to make most of their decisions on the basis of income after taxes.
Recipient # 4. Net Income to Shareholders:
The most traditional and accepted viewpoint of net income is that it represents the return to the owners of the business. Although this concept has its firm foundation in the proprietary approach, many authors apply it to the entity approach and consider the accounting profit of the entity to be a liability to the owners.
FASB Statement of Financial Accounting Concepts No. 1 emphasized the predictive nature of reported earnings. It states, for example, that in addition to being used to evaluate management’s performance, reported earnings may be used to predict future earnings, to predict the long-term earning ability of the enterprise, or to evaluate the risks of investing in or lending to the enterprise.
Recipient # 5. Net Income to Residual Equity Holders:
In financial statements presented primarily for shareholders and investors, the net income available for distribution to common shareholders is usually thought to be the most important single figure in the statements.
Net income per share of common share and dividends per share are the most commonly quoted figures in financial news, along with the market price per share. Therefore, there is pragmatic support for presenting statements from which the net income to residual equity holders can readily be obtained.
The holders of common stock and the prospective buyers of common shares are interested primarily in the future flow of dividends. Normally, only a part of the residual net income is distributed as dividends, but the knowledge of the net income available and the financial policy of the companies may provide useful information to common shareholders in their evaluation of the firm and in their prediction of the total amount of annual dividend distributions in the future. However, in order to predict the amount of dividends he may receive in the future, an investor must also predict the number of shares that will be outstanding in each period.
Although it is possible to view current net income as the return to current outstanding shareholders, potential residual equity holders must be taken into consideration in predictions regarding future earnings and dividends per share. Furthermore, if current net income is not distributed to current shareholders, the amount added to retained earnings may be shared by these potential holders of common shares.
Illustrative Problem 1:
The Tandy Company produces and sells a product at a price of Rs. 10 per unit. There were no inventories on January 1, 2008. During 2008, 2,00,000 units were produced at a cost of Rs. 12,00,000 or Rs. 6 per unit.
During 2008, 1,80,000 units were sold with delivery costs being 50 paise per unit under a contract with a trucking firm. During 2009 there was no additional production, but the remaining units were sold and the 50 paise delivery charge was paid on those units.
Calculate 2008 and 2009 income before income taxes under the production method and the sales method of revenue recognition and give the inventory figure for December 31, 2008, under each method.
As can be seen, the profit pattern are quite different. When revenue is based on production, there is no profit in the second period (2002) because there is no production. Obviously, the choice between the two methods depends on the nature of earning process and when it is judged to be reasonably complete.
Illustrative Problem 2:
Giant stores started operations in 2008, selling merchandise on the instalment plan. During the first years, sales were recorded at Rs. 68,40,000. During 2009, sales were recorded at Rs. 71,75,000.
The cost of goods sold and operating expenses for the two years are given below:
2008 – Rs. 41,04,000
2009 – Rs. 43,05,000
In 2008, cash collections from customers amounted to Rs. 34,00,000. Collections on sales during 1 997 are given below:
On 2008 Sales – Rs. 15,00,000
On 2009 Sales – Rs. 40,00,000
(i) Prepare summary income statements with revenue and expense recognized at the point of sale.
(ii) Prepare summary income statements with revenue and expense recognition as collections are made from the customers.
Illustrative Problem 3:
Based on the following information, prepare conventional income and value-added statement.