The following points highlight the four main steps involved in procedure of computing accounting income. The steps are: 1. Defining the Particular Accounting Period 2. Identifying Revenues of the Accounting Period Selected 3. Identifying Costs Corresponding to Revenues Earned 4. Matching Principle.
Step # 1. Defining the Particular Accounting Period:
Accounting income refers to the financial performance of the firm for a definite period. The commonly accepted accounting period is either the calendar or natural business year. It should be recognised, however, that income can be determined precisely only at the termination of the entity’s life.
The preparation of annual financial statements represents somewhat of a compromise between the greater accuracy achieved by lengthening the accounting period and the greater need for frequent operating reports.
Step # 2. Identifying Revenues of the Accounting Period Selected:
Accounting income requires the definition, measurement, and recognition of revenues. In general, realisation principle is used for recognition of revenues and consequently for the recognition of income. Revenue is the aggregate of value received in exchange for the goods and services of an enterprise.
Sale of goods is the commonest form of revenue. In accordance with realisation principle, the accountant does not consider changes in value until they have crystallized following a transaction.
The realisation principle is not applicable in case of unrealized losses which are recognised, measured, accounted for and subsequently reported prior to realisation. There are some other instances where realisation principle is ignored and unrealized income is recognised. Some such examples are valuation of properties, long-term contract business.
Step # 3. Identifying Costs Corresponding to Revenues Earned:
Accounting concept of Income is based on the historical cost concept. Income for an accounting period considers only those costs which have become expenses, i.e., those costs which have been applied against revenue.
Those costs which have not yet expired or been utilised in connection with the realisation of revenue are not the costs to be used in computing accounting income. Such costs are assets and appear on the balance sheet. Prepaid expenses, inventories, and plant thus represent examples of deferred unallocated costs.
Step # 4. Matching Principle:
Traditional accounting income is expressed as a matching of revenue and expenditure transactions, and results in a series of residues for balance sheet purposes. Matching principle requires that revenues which are recognised through the application of the realisation principle are then related to (or matched with) relevant and appropriate historical costs.
The cost elements regarded as having expired service potential are allocated or matched against relevant revenues. The remaining elements of costs which are regarded as continuing to have future service potential are carried forward in the traditional balance sheet and are termed as assets.
Such asset measurements, together with corresponding measurements of the entity’s monetary resources, and after deduction of its various liabilities, give rise to its residual equity in accounting.