Income measurement: some comments
Lecturer at the Estonian Business School
Abstract: The author emphasizes the fact that the current Estonian Accounting Act, which entered into force 01.01.2005, is moving towards fair value accounting. The more perfect the market the more useful market values will be in measuring income based on changes in the value of assets and liabilities. Under the real world conditions in which accounting operates, market values need not exist for all assets and liabilities, a condition known as incomplete markets. Concepts should be remembered for a lifetime. This is especially important in a world where details are constantly changing. On the other hand, students need an appreciation of the dynamics of accounting because most students will forget procedural details within a short period of time. This paper emphasizes the dynamics of accounting along with the comprehension of income measurement. Introduction
In 1991, Robert Elliott and Peter Jacobson drew attention to the fact that the new wealth-creation method of information era (see Figure 1) requires more sophisticated information. Figure 1. Methods of wealth creation (Source: Elliot, R. K. and Jacobson, P. D. 1991. p.57) Through the ages, mankind has developed three fundamentally different methods of wealth creation: agriculture, industry and information technology. As each new wealth- creation method supersedes the previous one, more sophisticated accounting information is required. Information technology permits leading companies to become more competitive … (Elliot, R. K. and Jacobson, P. D. 1991. p.54). Prior to the development of large-scale enterprises, if a measure of performance was needed, it was not uncommon for it to be arrived at by valuing assets and liabilities directly, computing the net asset position at two different dates and comparing one with the other to arrive at income. The emergence of large-scale enterprises in the nineteenth century, and the consequent separation of ownership and management control, created a need for financial statements for the purpose of accountability in order to ensure that managers rendered a reliable report of their activities to owners. If a measure of performance was needed, accounting focused on tracking the cost of resources obtained and used by the enterprise and on matching cost with the revenue realized by the enterprise through time to arrive at income. A balance sheet did not purport to show the realizable value of assets. The results were not a measure of the increase or decrease in net assets in terms of purchasing power. These historical cost basis financial statements served the bygone industrial era well, but were becoming obsolete. Reliance on financial statements is insufficient for evaluating the ability of information-era enterprises to create future economic value. The balance sheet versus the income statement approach
An accounting for income is not merely a question of reporting in a different format but involves issues of recognition and measurement. The recognition, measurement and reporting of income depends on the construction of an accounting theory and is important for the use of accounting information.
Two approaches in calculating income using the articulated accounting model (Belkaoui, A. R. 1994. p. 189 - 190) are identified in Figure 2. There has generally been little discussion in accounting literature about the criteria needed in choosing the best approach which would serve the needs of the users of financial statements and guide standard-setters in formulating an accounting theory.
Figure 2. Articulated accounting model
According to the articulated accounting model, important aspects of traditional financial statements are basic elements to be included in the accounting concepts. Identifying and defining basic elements of the balance sheet and the income statement may be provided by both the balance sheet approach and the income statement approach. Balance sheet elements describe amounts of resources and claims to resources at a moment in time. Income statement elements describe amounts from value creation process throughout a given period. Objectives of financial statements
Over decades professional bodies have studied the concept of decision usefulness. To understand this concept, professional bodies need to consider other theories from economics and finance. Accountants cannot make financial statements more useful until professional bodies know what usefulness means. Decision usefulness is contrasted with another view of the role of financial reporting, which is to report on management’s success in managing the enterprise’s resources. Aware of the importance of objectives,
the professional bodies have made various attempts to formulate the objectives of financial statements. The Study Group on the Objectives of Financial Statements (the Trueblood Commission in April 1971) of the American Institute of Certified Public Accountants (AICPA) published it findings in 1973: The basic objective of financial statements is to provide information on which to base economic decisions (AICPA. 1973). First enunciated in 1966, and reinforced by the influential 1973 report of the Trueblood Commission, this simple observation has had major implication for accounting theory and practice. In particular, we must now pay much closer attention to users of financial statements and their decision needs since, under non-ideal conditions, it is not possible to read the value of the firm directly from the financial statements (Scott, W. R. 2003. p.52). Two years later, a discussion paper issued by the UK Accounting Standards Steering Committee began with the words: Our basic approach has been that corporate reports should seek to satisfy, as far as possible, the information needs of users: they should be useful (Accounting Standards Steering Committee. 1975). The Financial Accounting Standards Board (FASB)1 began its efforts to develop a conceptual framework for financial accounting and reporting in November 1978 when it issued authoritative, broadly based guidelines spelling out the objectives of financial reporting in Statement of Financial Accounting Concepts No.1 (SFAC 1). The statement was not limited to the contents of financial statements: Financial reporting includes not only financial statements but also other means of communicating information that relates, directly or indirectly, to the information provided by the accounting system, that is, information about an enterprise’s resources, obligations, earnings, etc. … (SFAC 1, paragraph 7).
1The Financial Accounting Standards Board (FASB) was formed in 1973 as a private-sector body for leadership in establishing accounting standards in the US.
The International Accounting Standards Board (IASB)2 conceptual framework, which was approved by the IASC Board in 1989, and adopted by the IASB in 2001, takes the view: The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. Financial statements prepared for this purpose meet the common needs of most users. However, financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non-financial information. Financial statements also show the results of the stewardship of management, or the accountability of management for the resources entrusted to it. Those users who wish to assess the stewardship or accountability of management do so in order that they may make economic decisions; these decisions may include, for example, whether to hold or sell their investment in the entity or whether to reappoint or replace the management. (Framework for the Preparation and Presentation of Financial Statements, paragraph 12-14). The IASB recognizes that business enterprises have a responsibility to the society and not just to their owners. The ordering of financial statements may reflect the outcome of a political battle. IASB’s framework has been developed so that it is applicable to a range of accounting models and concepts of capital maintenance. IASB’s framework applies to the financial statements of all the public and private sector business enterprises, where private investors play a much less important part in the economy than they do in the United States. The financial reporting needs of the public sector are more important and the objective of financial reporting in those countries should reflect those needs. The purpose in setting accounting theories in countries other than the United States varies widely.
2 The International Accounting Standards Board (IASB) was established in 2001 as part of the International Accounting Standards Committee (IASC) Foundation. The IASC came into existence in 1973, in the same year with the FASB.
The current Estonian Accounting Act (EAA)was established by legislation and is accompanied by guidelines from the Estonian Accounting Standards Board (Estonian GAAP). The purpose of this Act is to create the legal basis and establish general requirements for organizing accounting and reporting in the Republic of Estonia pursuant to internationally recognized accounting and reporting principles (EAA, paragraph 1). The balance sheet approach
The question is not which of these two statements is more important, rather which statement should form the basis from which the others are derived. Historical cost basis accounting is an income statement approach. Under this approach unrealized increases in asset and liability values are not recognized and the balance sheet is derived from the income statement. When real world conditions are constantly changing, then the question is whether historical cost basis accounting provides sufficient information on which to base economic decisions for evaluating the enterprise’s abilities to create future economic value. Present value accounting is a balance sheet approach. Under this approach increases or decreases in asset and liability values are recognized by discounting future cash flows and the income statement is derived from the balance sheet. Both the FASB’s and IASB’s conceptual frameworks are based on the balance sheet approach. David Solomons summed up several reasons for preferring a balance sheet approach (Solomons, D. 1995; p. 45-46): Assets and changes in them are central to the existence and operations of business enterprises. Proponents of the matching view are forced to define revenues and expenses in terms of changes in assets and liabilities. Anthony defines revenues as “those additions to entity equity resulting from operating activities of the period that can be reliably measured” (Anthony, R.N. 1983; p. 160) and he later says that “equities are thought of as claims against the assets (p. 269). The FASB’s definition of revenues is unambiguous: “Revenues are inflows or other enhancements of assets of any entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations (SFAC No.6, paragraph 78). This is the fundamental reason for taking the balance sheet approach. If there is not a strict relationship between the process of income determination and changes in owner’s equity, debits and credits are apt to creep into the income statement that do not represent real transactions or the effects on the enterprise of real events and conditions – items like charges for future maintenance, for example. This opens the way for income smoothing, which is probably why preparers tend to prefer the matching approach. Economic versus accounting income
To understand the concepts of economic income and accounting income, professional bodies need to consider the concept of income. Figure 3 implies that income is a generic INCOME concepts
Hicks’ approach (1946) FASB’s approach (1985) IASB’s approach (1989) INCOME = INCOME = INCOME = Figure 3. Comprehension of income concepts
According to Hicks’ approach, income is the change in wealth. In the approach used by the FASB, income refers to the excess of revenues and gains over expenses and losses for a period. However, in the IASB’s approach, income refers to both revenues and gains. Hicks’ approach
Income is the change in wealth adjusted for withdrawals by owners (Hicks, J. R. 1946. p.172).
The following Equation 1 and Equation 2 illustrate the measurement of change in wealth:
change in wealth = income - withdrawals by owners Equation 1. Change in wealth depends on measuring income and withdrawals by owners during the period change in wealth = wealtht - wealtht-1 Equation 2. Change in wealth depends on measuring wealth at the beginning and end of the period
Both mathematical sentences have something in common on the left side. Simplifying wealth Equation 1 and Equation 2:
income = withdrawals by owners + wealtht - wealtht-1 (3) Equation 3. Economic income
Economists have adopted a wealth maintenance concept. They measure income by the difference between wealth at two points in time. They subtract beginning wealth from ending wealth and adjust for any withdrawals by owners during the period. Economic income consists of withdrawals by owners, which is consumption, and change in owners’ wealth, which is saving. Under the wealth maintenance concept, income is the maximum amount that can be consumed during a period and still leave the owners with the same amount of wealth at the end of the period as at the beginning. Hicks’ classical definition states that enterprise can measure economicincome, which is based on some valuation (e.g. historical cost, fair market value, or discounted future cash flows) as a measure of increase or decrease in net wealth. The author draws attention to the accounting of the off - balance - sheet assets which are vital to the information-era enterprise. Human resources, information systems, R&D play key roles in the net wealth of owners. For example, if the manager leaves the enterprise, the difficulty lies in the recognition and measurement of the gain or loss. The investor’s ability to evaluate the qualitative factors (e.g. decision-making ability of managers) is as important as the investment decision itself.
Hicks’ wealth is determined with reference to the current market values of equity at the beginning and end of the period. Therefore, the economic income would fully incorporate market value changes in the determination of periodic return on an investment:
Periodic return = dividend + [(market value)t - (market value)t-1] Equation 4: Financial return on an investment consists of dividend and change in market value
The periodic return shareholders get on an investment comes in two forms. First, shareholders may receive some cash from the enterprise during the year, called a dividend, which is a realized component of periodic return. In addition, market value changes of equity represents an unrealized component of periodic return. If shareholders sold the investment at the end of the period, both dividend and market value changes of equity are realized components of periodic return. FASB’s approach
The continuous process of earnings is conceptually straightforward, but application of the wealth maintenance concept to short periods is difficult. The opposite of the continuous process approach is the complete process approach, which is the accountants’ approach for income measurement. The key reason for the disparity between the economic and accounting measures of income relates to the need for periodic reporting. Investors believe that information can be useful in investment decision-making only if it is relevant and reliable. Since fluctuations in market values are often a matter of conjecture, accountants preclude the recognition of market value changes until these are realized by a transaction. Accountants have concluded that there must be guidelines for revenue and expense recognition. Accountants have defined income by reference to specific events that give rise to recognizable elements of revenue and expense during a reporting period. The events that produce reportable items of revenue and expense comprise a subset of economic events that determine economic income. Changes in the market value of wealth
components are often deliberately excluded from the measurement of accounting income but are included in the measurement of economic income. Both accountants and economists understand that the earnings process occurs throughout the various stages of production, sales, and final delivery of the product. However, the difficulty in measuring the precise rate at which this earnings process is taking place has led accountants to conclude that income should normally be recognized only when it is fully realized. Realization generally implies that the enterprise producing the item has completed all of its obligations relating to the product and that collection of the resulting receivable is assured beyond reasonable doubt. For very sound reasons, accountants have developed a reliable system of income recognition that is based on generally accepted accounting principles applied consistently from period to period. The interplay between recognition and realization generally means that values on the balance sheet are recognized only when realized through an income statement transaction (Epstein, B.J. and Mirza, A.A. 2000. p.65). The FASB’s definition of comprehensive income of business enterprises is discussed in Statement of Financial Accounting Concept No. 6 (SFAC6), Elements of Financial Statements:
Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (SFAC6 paragraph 70).Comprehensive income results from (a) exchange transaction and other transfers between the enterprise and other entities that are not its owners, (b) the enterprise’s productive efforts, and (c) price changes, casualties, and other effects of interactions between the enterprise and the economic, legal, social, political, and physical environment of which it is a part (SFAC6 paragraph 74).Comprehensive income result fromrevenues and gains, expenses and losses, which are classified according to business activities: operating income, nonoperating income, price level changes. Revenues and expenses are gross concepts, whereas gains and losses are net concepts. The income statement reports gains and losses at net instead of
gross amounts because owners do not need information on the components of either peripheral or nonrecurring income items. Currently, Hicksian income is probably the understanding of the FASB’s comprehensive income from the viewpoint of the preferred and common shareholders. The appropriate measurement of income is partially dependent on the vantage point of the party doing the measuring. From the perspective of outside investors taken as a whole, income might be defined as earnings before any payments to those investors, including bondholders and preferred shareholders, as well as common shareholders. On the other hand, from the viewpoint of the common shareholders, income might better be defined as earnings after payments to other investors, including creditors and preferred shareholders. Companies have issued various capital share classes that differ in their priority ranking in bankruptcy proceedings. Also, accounting standard-setting bodies have issued pronouncements that create new shareholders’ equity accounts. An effective analysis of the profitability and risk of an enterprise requires an understanding of the accounting for shareholders’ equity. IASB’s approach
According to the IASB’s Framework income of business enterprises is defined as follows: Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (IASB’s Framework paragraph 70 (a)).
The IASB’s Framework owes much of its development and direction to the prior work of the FASB. The IASB emphasizes this definition of income encompasses both revenue and gains. The IASB’s Framework states that profit is used as a measure of business enterprise’s economic performance. The basic elements directly related to the measurement of profit are income and expenses. The IASB’s Framework has an Anglo-Saxon influence. In the U.S., it is usual to use the term income for a net amount after the deduction of expenses. In Britain this restriction is not so observed. In this sense, the term income is more general and can be applied to a person or to an enterprise.
Surveys of shareholders show that the average investor understands the term earnings or profit more clearly than income (Dyckman, T.R., Dukes, R.E., Davis, C.J., Welsch, G.A. 1992. p.134). According to economic substance over form, income reporting should be the same regardless of legal form. Revenues-gains and expenses-losses of a corporation are separated from the revenues-gains and expenses-losses of the shareholders. In both the sole proprietors and partnership form of business enterprise, the revenues-gains and expenses-losses identification process is more difficult. Items such as salaries paid to owners or partners may by thought of as distributions of profit rather than expenses. So, the income of owners depends on legal form of entity. The IASB approach does not focus only on the income of owners but also focuses on the income of the business enterprise. Conclusion
Instead of dwelling on income, accountants turned their efforts to making historical cost based financial statements more useful. As a practical matter, it seems impossible to prepare financial statements that are both completely relevant as well as reliable. Historical cost accounting is relatively reliable because the cost of an asset or liability to an enterprise is usually an objective number that is less subject to errors of estimation and bias than are present value calculations. However, historical cost may lack relevance. While historical cost, market value and present value may be similar in regard to the date of acquisition, market values and present values will change over time as real world conditions change. Nevertheless, accountants continue to use historical cost bases accounting for major asset types because they are willing to trade off a considerable amount of relevance to obtain reasonable reliability. References
American Institute of Certified Public Accountants. 1973. Objectives of Financial Statements. New York: American Institute of Certified Public Accountants.
Accounting Standards Steering Committee. 1975. The Corporate Report. London: Accounting Standards Steering Committee. Anthony, R.N. 1983. Tell it Like it Was. Homewood, IL: Richard D. Irwin Inc. Belkaoui, A.R. 1994. Accounting Theory. 3rd Edition. London: The Dryden Press. Dyckman, T.R., Dukes, R.E., Davis, C.J., Welsch, G.A. (1992). Intermediate Accounting. Rev. Edition. Homewood, IL: Richard D. Irwin Inc. Elliott, R.K. and Jacobson, P.D. 1991. US accounting: a national emergency. Journal of Accountancy. November 1991, p. 54 – 58. FASB. 1978. Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises. FASB. 1985. Concepts Statement No. 6, Elements of Financial Statements. IASC. 1989. Framework for the Preparation and Presentation of Financial Statements. Scott, W.R. 2003. Financial Accounting Theory. 3rd Edition. Toronto: Pearson Education Canada Inc. Solomons, D. 1995. Criteria for Choosing an Accounting Model. Accounting Horizons. March 1995, p. 42 – 51.
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