The following points highlight the top three concepts of income. The concepts are: 1. Accounting Income 2. Economic Income 3. Capital Maintenance Income.
Concept # 1. Accounting Income:
Accounting income, often referred to as business income or conventional income is measured in accordance with generally accepted accounting principles. The profit and loss account or income statement determines the net income or operating performance of a business enterprise for some particular period of time.
Income is determined by following income statement approach, i.e., by comparing sales revenue and costs related to the sales revenue.
Net income is determined as follows:
Revenue – Expenses = Net Income
The net income defined as the difference between revenue and expenses determine the business income of an enterprise. Under the income statement approach, expenses are matched with the revenues and the income statement is the most significant financial statement to measure income of a business enterprise. Thus, business income of an entity represents the difference between the realised revenues arising from the transactions of the period and the corresponding historical costs.
Accounting income is the increase in the resources of a business (or other) entity which results from the operations of the enterprise. In other words, accounting income is the net increase in owner’s equity resulting from the operations of a company.
It should be distinguished from the capital contributed to the entity. Income is a net concept; it consists of the revenue generated by the business, less losses and less expired costs that contribute to the production of revenue.
Accounting income is measured in terms of transactions which the business enterprise enters into with third parties in its operational activities. The transactions relate mainly to revenues received from the sale of goods and/or services, and the various costs incurred in achieving these sales.
All these transactions will, in some way, involve the eventual receipt or payment of cash, and, if the eventual cash exchanges with third parties is not complete at the moment of measuring income, this incompleteness is allowed and adjustments are made for amounts due by debtors for sales on credit, amounts due to creditors for purchase on credit.
Once these adjustments are made, the revenue and costs which have been recognised as having arisen during the defined period are then linked or matched in order to derive accounting income. Accounting income, thus, is computed in terms of a matching or related operational revenue and cost.
These revenues and costs are derived mainly from recorded business transactions, although they are also subject to the specific application of accounting principles such as those involved in depreciation and inventory accounting. In traditional accounting concept of income, a typical balance sheet describes and depicts unallocated or unmatched past costs as assets of the business.
Components of Accounting Income:
A profit and loss account or income statement, as stated earlier, determine the net income or business income of a business enterprise and displays revenues and expenses of the enterprises for a specified period.
Therefore, business income has the following two major components or elements:
Besides the revenues and expenses, gains and losses are also considered while determining business income or net profit of an enterprise.
Concept # 2. Economic Income:
The economic concept of income is based on Hick’s concept (1946) of income defined as follows:
“… The maximum value which he can consume during a week, and still expect to be as well-off at the end of the week as he was at the beginning.”
Hicks presented his concept of “well offness” as the basis for a rough approximation of personal income. According to Hicks, income is the maximum which can be consumed by a person in a defined period without impairing his “well offness” as it existed at the beginning of the period.
“Well offness” is equivalent to wealth or capital. Hick’s concept of personal income was subsequently adopted by Alexander and subsequently revised by Solomon’s to an equivalent concept of corporate profit. Alexander defined income of an enterprise as the maximum amount which a firm can distribute to shareholders during a period and still be as well off at the end of the period as at the beginning.”
Economic income may be defined as the operating earnings plus the change in asset values during a time period. Economic income is measured in real terms and results from changes in the value of assets rather than from the matching of revenue and expenses.
Like accounting income, it is not based on money values. The “Well offness” is measured by comparing the value of company at two points in terms of the present value of expected future net receipts at each of these two points.
In other words, economic income is the consumption plus saving expected to take place during a certain period, the saving being equal to the change in economic capital.
Economic income may be expressed as follows:
EI = C + (K1 – K2)
where El = Economic Income
C = Consumption
K1 = Capital as at period 1
K2 = Capital as at period 2
Economic income and Hicksian approach follow balance sheet approach of income measurement. The balance sheet approach determines the income as the difference between the value of capital at the opening and closing balance sheets adjusted for the dividend or the additional capital contributed during the year.
Under the balance sheet approach, income is determined as follows:
Income = Capital at the end minus capital at the beginning of the year plus Dividend or saving during the year minus capital contributed during the year. It is significant to observe that under economic income and balance sheet approach, different items of assets and liabilities possessed by firm at the beginning as well as at the end of the year are to be valued to determine income for the year. Therefore, income measurement in this approach depends upon the valuation of assets and liabilities.
Thus, economic income of the business is the amount by which its net worth has increased during the period, adjustments are made for any new capital contributed by its owners or for any distributions made by the business to its owners.
This form of words would also serve to define accounting income, in so far as net accounting income is the figure which links the net worth of the business as shown by its balance sheet at the beginning of the accounting period with its net-worth as shown by its balance sheet at the end of the period.
The correspondence between the two ideas of increased worth is, however, a purely verbal one; for Hicksian income demands that in evaluating net worth we capitalize expected future net receipts, while accounting income only requires that we evaluate net assets on the bases of their unexpired costs. The relationship between these two different concepts of increase in net worth, economic income and accounting income may be summed up in the following manner, by starting with accounting income and arriving at economic income:
+ Unrealized tangible asset changes during the period
– Realised tangible asset changes that occurred in prior periods
+ Changes in the value of intangible assets
= Economic Income
The changes in the value of intangible assets do not refer to the conventional intangible assets found in the balance but to a concept called subjective goodwill arising from the use of expectations in the computation of economic income. The following example illustrates economic income and accounting income.
Assume the following expected net cash flows from the total assets of a firm whose useful remaining life is four years:
Assume an annual depreciation of Rs. 7000 and a discount rate of 5 per cent.
Using the discount rate, the present value at the beginning of year I would be Rs. 32887 computed (using present value tables) as follows:
The income for the subsequent years can be computed in similar manner. The present value income, or economic income (for year 1) is Rs. 1644 which represents the real increase in the value of the firm in the first year. It is equivalent to 5 per cent of the starting capital of Rs. 32,887.
Because most authors define discount rate as the subjective rate of return, Edwards and Bell call the economic income Rs. 1644 the ‘subjective profit’. It is significant to note that the variable (e.g., cash flows) included in the capitalized value formula are merely expectations that are subject to change.
We can analyse the difference between the present value or economic income and the accounting income using the previous example.
While economic income is an exante income based on future cash flow expectations, the accounting income is an ex-post or periodic income based on historical value. Table 4.1 presents economic income and accounting income and reconciliation between the two is displayed in Table 4.2.
As Table 4.1 reveals, the economic income for the four-year period is equal to Rs. 4613 and the accounting income is equal to Rs. 9500. The difference between the economic income and the accounting income is Rs. 4887 which is the subjective goodwill.
The capitalized value method is deemed useful for such long-term operating decisions as capital budgeting and product development. The options yielding the highest positive capitalized values are deemed to be the best methods. Capitalized values of long-term receivables and long- term payables are also used in financial statements.
The capitalized value is generally considered an ideal attribute of assets and liabilities, although it presents some conceptual and practical limitations. From a practical point of view, capitalized value suffers from the subjective nature of the expectations used for its computation.
From a conceptual point of view, capitalized value suffers from:
(1) The lack of an adequate adjustment for risk preference of all users,
(2) The ignorance of the contributions of other factors than physical assets to the cash flows,
(3) The difficulty of allocating total cash flows to the separate factors that made the contribution, and
(4) The fact that the marginal present values of physical assets used jointly in operations cannot be added together to obtain the value of the firm.
Concept # 3. Capital Maintenance Income:
(or Capital Maintenance Concept of Income):
In traditional accounting, the concept of accounting income has been recognised widely. Adequate attention has not been given to the capital maintenance concept associated with income measurement. In fact, ‘income measurement’ and ‘capital maintenance’ are interrelated or twin concepts.
The term capital represented by assets refers to ‘stock’ or a ‘tree’ while the term ‘income’ refers to the fruit. As such, by using the concept of capital maintenance, income for a business enterprise can be defined as the amount which can be drawn from the business maintaining intact the capital that existed at the beginning of the period.
Capital maintenance concept of income requires that capital of a business enterprise needs to be maintained intact before income can be distributed. Return on capital (income) is distinguished from return of capital (cost recovery). Capital at the end of a year should be measured in order to determine the amount that can be distributed without impairing the capital that the firm had at the beginning of the year.
Capital maintenance may refer to maintaining capital intact in financial or in physical terms. According to Forker, the capital maintenance concept is viewed merely as a neutral benchmark to be used in determining the surplus which accrues to shareholders as income and implies nothing which ought to be interpreted as suggesting normative behaviour for the management of the enterprise.
Choice of maintenance concepts may however be dictated by the preferences of managers and/or owners.
The following are the concepts of capital maintenance:
(1) Financial Capital Maintenance.
(2) General Purchasing Power Financial Capital Maintenance
(3) Physical or Operating Capital Maintenance.