In this article we will discuss about the differences and similarities between accounting income and economic income.
Difference between Accounting Income and Economic Income:
The following are the differences between accounting income and economic income:
1. Accounting income is an income resulting from business transactions arising from the cash-to-cash cycle of business operations. It is derived from a periodic matching of revenue (sales) with associated costs. Accounting income is an expost measure—that is, measured ‘after the event.’
In contrast to accounting income, economic income is a concept of income useful to analyse the economic behaviour of the individual. It focuses on maximizing present consumption without impairing future consumption by decreasing economic capital. Economic income is used as a theoretical model to rationalise economic behaviour.
In this respect, it is similar to accounting income which measures, in aggregate terms, the results of human behaviour and activity, and which, through use, modifies and influences human behaviour. In other words, economic income aims to rationalise human behaviour while accounting income measures the results of it.
2. The accounting income recognises income only when they have been realised. On the other hand, the economic income, because it is based on valuations of all anticipated future benefits, recognises these flows well before they are realised. This means that, at the point of original investment, economic capital will exceed accounting capital by an amount equivalent to the difference between the present value of all the anticipated benefit flows and the value of those resources transacted and accounted for at that time.
The difference represents an unrealized gain which will, over time, be recognised and accounted for in computing income as the previously anticipated benefit flows are realised.
3. Accounting income and economic income basically differ in terms of the measurement used.
As Boulding observes:
“accountants measure capital in terms of actualities, as the primary by-product of the accounting income measurement process; and that economist in terms of potentialities, in order to measure economic income.”
The accountant uses market prices (either past or current) in measuring income based upon recorded transactions which may be verified. Current values, if used in accounting income, utilise the historic cost transactions base before updating the data concerned into contemporary value terms.
The economist, on the other hand, uses predictions of future flows stemming from the resources which have the subject of past transactions. The accountant basically adopts a totally backward-looking or expost approach, and consequently ignores potential capital value changes.
The economist, on the other hand, is forward looking in his model and bases his capital value on future events. Under accounting income, the accountant aims to achieve objectivity maximization while measuring income for reporting purposes. The economist is free of such a constraint and is quite content in his model which may have large-scale subjectivity.
As a result, the two income concepts appear to be poles apart in concept and measurement—certainly the accountant would find the economic model almost impossible to put into practice in financial reporting, despite its great theoretical qualities. On the other hand, the economist would not find the accounting model relevant as a guide to prudent personal conduct.
4. Conventional accounting income possess a limited utility for decision-making purposes because of the historical cost and realisation principle which govern the measurement of accounting income. Changes in value are not reported as they occur. Economic concept of income places emphasis on value and value changes rather than historical costs. Economic income stresses the limitations of accounting income for financial reporting and decision-making purposes.
Similarities between Accounting Income and Economic Income:
In spite of the above differences in concept and measurement between accounting income and economic income, there are some similarities between the two:
(1) Both use the transactions for income measurement.
(2) Both involve measurement and valuation procedures.
(3) Capital is an essential ingredient in income determination.
(4) In a world of certainty and with perfect knowledge, accounting income and economic income as measures of better-offness would be readily determinable and would be identical. With such knowledge, earnings for a period would be the change in the present value of the future cash flows, discounted at an appropriate rate for the cost of money.
(5) Under current cost accounting, the reported income equals economic income in a perfectly competitive market system. During periods of temporary disequilibrium and imperfect market conditions, current cost income may or may not approximate economic income.
When asset market prices move in directions opposite to expected cash flows, there tends to be a difference between current cost income and economic income, i.e., the assets are overvalued. On the other hand, when asset values move together with expected cash flows, current cost income tends to approximate economic income quite well.
The True-blood Committee Report comments on accounting income as follows:
“Accounting income or earnings should measure operations and represent the period-by-period progress of an enterprise towards its overall goals Accounting measurements of earning should recognise the notion of economic better-offness, but should be directed specifically to the enterprise’s success in using cash to generate maximum cash.”
According to True-blood Committee Report, accounting income, although having some limitations, is preferable:
“…the real world does not afford decision-makers the luxury of certainty. Earnings, therefore, are based on conventions and rules that should be logical and internally consistent, even though they may not mesh with economists’ notions of income. Enterprises have attempted to provide users with measures of periodic earnings….Since these measures are made without benefit of certainty, they are of necessity imprecise, because they are based on allocations and similar estimates.”