A Study of Economic Income and Accounting Income
The debate surrounding the notions of income in accounting is ongoing. Despite the argument mainly stemming from the 1960s, this study highlights that these arguments are still relative to today's markets, particularly as the income figure is an important figure for the uses of tax, profitability analysis and company growth.
There are many forms of the economic income model, and some of these models are discussed and evaluated. There are various theories regarding economic income, all of which can be adopted by its managers and the main users of economic income. Thus, economic income is seen as a more relevant income model.
Accounting income has the primary objective of reporting to its shareholders. The theories surrounding the calculation of the income figure, therefore concerns itself with verifiability and reliability. We introduce the major forms of accounting income, such as FASBs comprehensive income, and using previous research on event studies as an appropriate indicator of the usefulness of the income figure, a conclusion is formed on the effectiveness of the income figure in the financial markets.
Using theories and well known literature we conclude that the usefulness of the income is dependent upon the user and their purpose, and that the two models cannot be fully critiqued against the other as whilst economic income looks at future expectations, accounting income looks at past events.
Chapter 1
Introduction
The debate surrounding income has been ongoing since the 1930's (Evans 2003, p195), where many theorists have argued about the nature of income [1] , what it is, how it should be defined, and its importance in financial reporting. Economic income and accounting income are both derived differently, and are generally different in nature. These two forms of income have caused confusion over the years amongst users of financial statements regarding which is more reliable, which is more useful and which shows a true indicator of a firm's performance. In order to distinguish between the two forms of income, we can provide a detailed description of its nature and the issues surrounding it. In order to achieve a sound conclusion regarding which form of income is useful for decision making, both needs to be critically analysed together.
This topic has been argued and discussed in great depth by many writers and theorists. The nature of income has been a major focus point for many writers over previous years. With many methods of arriving at an income figure, and many views on what income should be, an increase dependence on such a figure has lead to a demand on providing a clearer standard on how to calculate income.
1.1 Why is income important?
What is perceived to be an accountant's main role is to calculate income (Alexander 1973). Income is the focal point for all its users as it helps identify an increase in capital for the user. This can be used by the users, the owners, the shareholders, or retained within the business in order to grow. As previously mentioned, the importance of income in accounting didn't arise until the 1930s. As the investor market began to grow, shareholders began to notice the importance of income statements in financial reporting. Thus, companies began to take a serious interest in profit maximising, in order to appeal to investors and shareholders. Investors have realised that income can help assess business performance, which can be compared with previous years, future years or similar firms (Lee 1996, p 21). However, this is seen as the accountant's view of the importance of income. Accounting, by definition is to provide information for users that will aid decision making (Alexander et al, 2004, p5), and so the accountants reason for the importance of income is to help shareholders and other users make decisions.
However, Kaldor (1955), has an economists view on why income is important. He states that income is an important figure for the purpose of taxation. Taxation, as argued by Kaldor (1955), and Simons (1938), as an important economic tool to redistribute wealth and income in the economy. They state that income is important for the application of income tax, which are an 'instrument of economic control and a means of mitigating economic inequality'.
Solomons (1967) adds to this providing a number of other reasons for why income is important in accounting and economics. Income acts as a guide to how much dividends firms are allowed to pay to their shareholders. Managers are therefore able to assess how much wealth they are able to redistribute to shareholders and how much they wish to retain for financing activities. This protects the rights of shareholders as it prevents firms from giving out dividends from their already allotted share capital, ensuring their capital remains intact.
Income is therefore highly subjective amongst society. The various methods of calculating income have meant that an accurate figure is hard to achieve. Also, as the fact that income isn't actually real, and is simply a book keeping exercise (Evans 2003, p 195), income isn't construed as something that is tangible. Bedford (1951) notes that income is a measure of an increase in the value of assets or economic resources. Thus, users need to be careful that this doesn't necessarily mean an increase in cash or cash equivalent, but in most cases, it's a measure of the increase in the rights of property.
However, by looking further at the two main types of income, we may be able to understand the main concepts of income, and the thinking behind them. The following section takes a look at economic income in detail.
Chapter 2
Economic Income
Economic income has been subjected to many theories and viewpoints, and has a number of concepts surrounding it. In economics there are as many definitions of economic income as there are economists (Schwayder, 1967). There is, therefore, no clear definition for economic income. Economic income has been viewed in many forms; income as consumption, income as interest, ex ante and ex post, etc. In this chapter we look at economic income in greater detail, exploring the works of Fisher and other economists, and introducing the concept of real income, and the general underlying assumptions of economic income.
2.1 Hicks and Capital Maintenance
The meaning of income cannot be defined without mentioning the definition provided by Hicks (1946) stating that:
'…. Income should be defined as the maximum value which the individual can consume during the week, and still expect to enjoy as much welfare at the end of the week as he did at the beginning…'
Hicks created three definitions of income in order to obtain an accurate definition for income.
Income No.1 is simply the maximum an individual can consume in a period and still maintain their capital intact. However, a one off occasion is deemed unrealistic and Hicks proposed an Income No.2, which counters for a stream of cash flows. Here, income needs to be constant for the ensuing periods, and is therefore defined as 'the maximum an individual can consume in one week and still be able to spend the same amount in the ensuing weeks'.
Finally, Income No.3 attempts to incorporate the notion of changing interest rates and cash flows. This is defined as 'the maximum an individual can consume this week and still be able to spend the same amount in real terms in the ensuing weeks'.
The development of economic income has mainly stemmed from Hicks definition of income and his idea of 'well off-ness'. His concept, regarding retaining the same amount of capital from this period to the next, highlights the importance of capital maintenance when dealing with income. It has been argued that this view is only true for individuals, and cannot be applied appropriately to corporate bodies.
Economists have developed an acceptance to the idea of economic income being a measure of personal income.
Although Hicks' definition has been widely used in literature, there have been many criticisms of his work.
The main argument is that interest rates are difficult to determine (Kaldor 1955). Not only this, but that the scenario that Hicks has created is still too simplified to be applicable in a realistic situation. If this theory is applied to a business setting for example, it will be difficult to include the activity of managers as it focuses on the future rather than what is currently happening. However, this claim seems to be unjustified, as many economists also refer to the works of Alexander (1973), who adopted Hicks main idea to apply to a business environment.
He states that income for a firm is
'…the amount the corporation can redistribute to the owners of equity and be as well off at the end of the year as at the beginning'.
Solomons (1967) also comments on the simplicity of this theory by stating that the term 'well off' is not clearly defined, and in the business sense, it is particularly difficult, as there are various costs and revenues involved.
Paish (1978) further argues that Hicks' theory assumes that individuals want to keep their capital intact. He claims that it is the up to the individual whether they wish to invest for capital growth or to receive regular income.
Fisher and Economic Income
Fisher's most popular definition of 'income' is his concept of 'psychic income'. That is, people buy things not because of the item itself, but of what they could do with it, and what satisfaction they can receive from it. The notion of 'psychic income' itself comes under a lot of scrutiny amongst economics, mainly due the inability to accurately measure the value an individual places upon an object. Fisher (1930) himself points out this flaw, and so proposed a much detailed definition of income that can be measured.
His definition consists of three stages of income;
Income as Consumption
Real Income
Money Income
2.2.1 Income as Consumption
Fisher developed the idea of income being a measure of an individual's consumption. His definition of income and capital was 'a stock of wealth existing at a given instant of time is called capital, a flow of benefits from wealth through a period of time is called income'. The main factor of this theory is whether or not the income is consumed by the individual.
An example to illustrate this point would be the following;
X purchases shares for £10,000
His annual cash flows for the three years would be:
Year 1- 1,000
Year 2- 2,500
Year 3- 3,700
At Year 4 he sells his shares for 7,000. If X had spent his dividends and the proceeds from the sale of the shares, his economic income would be £14,200
2.2.2 Real Income
Real incomes are the physical objects and items that contribute to an individual's psychic income. For example, real income could be in the form of shelter, clothing or food, basically, what is construed as 'living costs'. However, this did not make sense to Fisher, as effectively, money is being spent to generate this form of income. So, rather than placing a value on how ones individual enjoyment, you can value what that enjoyment costs you. For instance, you cannot assess what it is worth to eat a meal, but you can find out how much that meal cost.
2.3.3 Money Income
Money income, as defined by Fisher, is simply money received and available for spending. For example, X has a salary of £10,000, and puts £4,000 away in savings. The remaining is available to spend and so this £6,000 will be X's money income.
However, his definition has come under some criticism, mainly from the works of Lindahl (1933) and Kaldor (1955). They both argue that this form of income does not take into account savings, or reinvestment of capital. This form of consumption is useful for calculating 'enjoyment' as it highlights the cost individuals are willing to forego to experience it. However, it is not useful when calculating the wellbeing of the individual, as it does not take into account the need to maintain capital, in order to preserve the stream of income. In the previous example regarding consumption, X's capital is not maintained, and the change in the economic value of the investment is not taken into account. Supposing the value of the investment decreased, this method does not highlight its effect on the amount of income X is able to consume.
The other obvious drawback to Fishers theory is what it attempts to measure. It is impossible to measure ones enjoyment level whilst consuming an item. For example, X may receive more enjoyment from consuming a sandwich than Y because he hasn't had one as frequently as Y. There are many external factors that affect ones enjoyment of a product and Fisher fails to take this into account.
2.3 General assumptions of economic income
The main issues and theories regarding economic income have been discussed in this chapter. The basis for economic income is to calculate income that is available to spend whilst keeping capital intact. The idea of this form of income appears to be quite an adequate one. It takes into account individuals' consumption, expenditure and well being.
Economic income is a measure of future cash flows and receipts. As these flows have yet to be realised, there is undoubtedly and element of uncertainty. As many have argued, if there is one hundred per cent certainty in the market, there is a constant interest rate, for a constant period of time, where it is applicable to everyone. However, this is rarely the case. Interest rates are now so complex, that is it difficult to assign one rate of interest to one form of income over a period of time. As Kaldor (1955) explains, different assets will all have different rates of interest applied to them, reflecting their market values. Even where a reliable interest figure is obtained, the value of the income deriving from that figure is a 'future' expectation. The 'expectations and realisation' concept forms the basis of Kaldor's (1955) argument, supported by other economists, where the timing of the realization of cash flows affects the economic income model (Lee 1996, p 43). The problem surrounding economic income is not only the prediction of cash flows, but the timing of those cash flows. Simons (1938) supports this by claiming that the not only is the valuation of the cash flow is important, but the ways these objects are valued are effective upon the amount of capital an individual has. Economists tend to refer to the 'perfect market' where all rates are easily identifiable and market values for assets can be easily valued. Simons (1938) stresses that this is not the case, and that it needs to be remembered that income is based wholly upon estimation.
Chapter 3
Accounting Income
Unlike economic income, accounting income uses past events and transactions to determine income.
During the 1920s and 1930s the financial market began to develop considerably. As a result, investors called for a much more sophisticated form of analysis and a change from the importance of the balance sheet, to the income statement, lead to a much heavier emphasis on the income figure. In addition to this, the development of tax systems also meant that income was a suitable way to redistribute wealth in the economy (Lindahl 1933). It is no wonder, then, that there have been a large number of attempts to create a single accounting theory in which accounting income can be derived.
Accounting, from an accountant's point of view is to provide information to help users in decision making. This view was strengthened once FASB chose to shift from the stewardship function to decision usefulness [2] . Most of this information, therefore, will need to be based upon past and future events. Although this form of thinking usually applies to an economist, what distinguishes accounting income from economic income is that it is valued based upon historical cost. This forms the basis surrounding accounting income.
3.1 Matching
Matching is on of the core accounting conventions. It concerns itself with the idea of 'duality', the fundamental basis of an accounting system. In this context, the matching concept is;
'…a process of matching against revenue the expenses incurred in earning that revenue…' (Alexander et al, p 14)
This therefore means that all the revenues generated from that period are matched with the expenses accrued. This is a simple form of income where the revenues from the period, minus the expenses accrued, gives income, an approach that has stemmed from the increasing use of the income statement when analysing a company's profitability [3] .
The main concepts are to define an accounting period; collect the revenues relating to the period, and then match those revenues to the costs occurred to generate them. Lee (1993) proposes a fourth concept, where the costs to subsequent revenues are carried forward to those periods. So, the account model is based upon transactions already occurred in that period, with the costs allocated to that period, and any costs relevant to future periods treated as assets. This appears to make sense. However most have criticised this model on the basis of revenue recognition and when income may or may not be accurately recognised.
3.2 The Realisation Principle
The realisation principle is the accounting concept that states income can only be recognised once it has been earned. So, for example, an asset being recorded at historical cost as £5000 is sold for three years later at £6000. This is recognised as revenue, with complete disregard for its market value, and any unrealised gains or losses on the asset during the period being ignored. The only revenue is that of £6000 which the actual sale taken place is.
Revenue recognition has been an important topic regarding accounting standards.
The IASB define revenue recognition in IAS 18 as
'…arising from the following transactions and event;
the sale of goods
the rendering of services
The use by others of entity assets yielding interest, royalties and dividends....'
They also use the economic definition of income as 'a flow of future economic benefits into the entity,' [4]
Revenue recognition is also discussed in FASB's Statements of Financial Accounting Concepts, as part of their conceptual framework project. SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue should be recognised once it has been earned, that is, once it has been exchanged for cash or its equivalents (SFAC 5, para 83). This statement, therefore, focuses on the transactions of the business, and shows very little guidance on how to account for gains and losses arising from the revaluation of assets.
The realisation principle is heavily related to the concept of prudence, or how Matthews and Grant (1962) refer to it as 'conservatism'. The main criticism here is that adopting the principle of prudence, unrealised gains are not recorded whilst unrealised losses are. This is an accountants attempt in order to ensure costs are not understated, and revenues are not overstated. The problem with conservatism is that it distorts the value of profit. Matthews and Grant (1962) uses the example of depreciation being a tool for keeping profits understated. Excessive depreciation charges would affect profit, and deem the accounts to be misleading , and makes the balance sheet 'useless' as a measure of a firms financial position as assets are not valued at an accurate and reliable method. However, Lee (1993) argues that the whole purpose of the concept of prudence is to account for an uncertain future. This is in contrast to economic income where their valuations on income are based on future expectations.
Another issue regarding revenue recognition is when revenue should be recognised. Bedford (1951) claims that from his research, he found that income can be recognised at several different stages. It could be, for example, recognized at the following stages;
At the same time of production
The legal date of sale
The distribution of goods and services
The time cash is received
As there is no particular time or standard relating to when these should be exactly, there is undoubtedly confusion regarding this topic.
However, FASB's concept No5 is a detailed explanation of revenue recognition and explains in detail the requirements for when and how revenue should be recognised. With these statements clearly explained, there should be very little difficulty in calculating income using an accounting model.
3.3 Current and Corrected Income
In an attempt to reflect the financial statements to current prices, accountants formed the idea of 'current income'. Baxter (1955) explains the 'time lag' when the sale is made and when the cash is received. This is significant as the value of the money at the time the sale is made is not always the same at the time when the cash is received. This is due to changing values of interest and inflation rates. So he proposes adjusting the recorded sales figure using a general index, to bring it in line with current values to create 'corrected profit'.
This idea had then been developed for current value income where it is applied to all relevant transactions and events. All values would therefore be adjusted to reflect the monetary value at a uniform point in time.
The main purpose of this is to be more useful for users, as prices are recorded at the current prices. These prices can then be used by them to assess whether they have the available resources when making decisions. However, it has been criticised that this is no more than a form of economic income (Lee1993 p68). It relies on adjusting prices using a price index, which is difficult to verify. Not only that, but it goes against the accountants role to record transactions on a factual basis.
3.4 Comprehensive Income
Comprehensive income is defined by FASB as;
'…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 investment by owners and distributions to owners' [5]
It is the sum of net income plus other items that are not included in the income statement as they have yet to be realised. This form of income therefore provides a more detailed view of the organisation as a whole as it includes holding gains and losses of items such as available for sale securities or foreign currency items, i.e., 'dirty surplus' items. The introduction of FASBs Statement 130 in June 1997 was to address user concerns of the treatment of holding gains and losses in the financial statements.
However, there has been very little empirical research supporting the usefulness of comprehensive income. Dhaliwal et al (1999) found no evidence that comprehensive income had a stronger link to returns that net income. In fact, they claim that the content of comprehensive income just 'added noise' to the financial statements, and on the exception of marketable securities, stated that FASB needed to revise the requirements of comprehensive income in order for it to have an effect in the market.
3.5 General Assumptions of Accounting Income
Despite there being many criticisms, it must be remembered that these accounting methods have been used extensively for over 80 years. This has obviously meant that users have found this method adequate to meet their needs. There is a generally accepted understanding regarding the strengths and weaknesses of accounting profit, all of which users have developed knowledge on.
There have been countless discussions on what an accountant's role is, or should be, but Crandell (1930) uses his notion of an accountant's role [6] to explain that the accounting model complies to the accountant's aim of being practical with reporting business operations. As prices of inflation are continuously changing, it will be difficult for accountants to be constantly compiling financial statements. Therefore, the only logical course of action would be to record items at historical cost, which can be verified as the prices the company paid for (or received).
The notion regarding accounting income being based upon past events is actually a plus factor for the accounting model. Yes, it focuses on past results, but using ratio analysis, regression models and growth tools, users can use the past results to predict future behaviour. With increasing availability of information, data regarding economic growth, interest rates and inflation can be obtained easily, and by taking these into consideration, users, particularly analysts are able to generate reliable forecasts.
When a scholar introduces the accounting model for income, it is usually done in a manor similar to its fellow scholars. Accounting income has been criticised heavily amongst economists, as well as fellow accountants. FASB issued a statement noting the weaknesses they have experienced in income recognition regarding IAS 18, where they claim no emphasis on the change in the value of assets is made, which is the main issue surrounding accounting income. FASB have joined with the IASB on this project in order to help create a standard that will replace the existing IAS 18. This project aims to improve financial reporting by creating a standard that clearly sets out the requirements of income recognition, whilst being applicable to all business entities [7] . This proposal in itself shows that accountants are not fully confident on their measures of income.
The argument, as mentioned previously, regarding accounting income is that it fails to take into account the changing market prices and values. Even adjusting figures in the balance sheet to reflect current price changes is still not seen as satisfactory, as the underlying figure used is still historical cost. Theses methods attempt to reflect the current values, but in essence, they are not revaluing assets, but are simply reflecting historical cost prices as they should be today. Matthews and Grant (1962) state here that changing the values is not a satisfactory measure of valuing current income. Accounting income simply measures 'business surplus' in historical terms, and this is not enough to assess how effective a firm's resource allocation is. It also must be noted that changing these figures to reflect current prices has caused much confusion amongst users as the unit of measurement is unclear. Supporting this claim further, Boussard's (1984) empirical study regarding the use of inflation accounting found that the different approaches on how to deal with deprecation and realised and unrealised holding gains meant the purpose of inflation accounting is 'ineffective' and does not provide interpretable data.
It must be remembered that the accounting model is still not fully evolved. The concepts of current values, replacement costs and deprival value accounting are all attempts to improve the apparent weaknesses in the model. These as such have their own drawbacks and so in order for accountants themselves to have confidence in this model, there would still need to be a method that satisfies the demand of its users.
Chapter 4
A Comparison
The economics and accounting model have been subjected to many criticisms regarding their calculation of the income figure. The growing importance of the income figure has meant that users are demanding a relevant and reliable income figure. Having discussed the opinions of various economists and accountants we can now provide a comparative analysis on the two models.
Alexander (1973 p 1) states that the choice of the concept of business income, depends upon the purpose to which the measure is to be used. Economic income can be used by managers to assess how much dividends they could pay out to its owners, whilst keeping capital intact, as defined by income number one. This is important as it is used to protect the rights of shareholders by preventing capital being distributed as dividends and as equity is seen as the appropriate measure of valuing the wellbeing of a company (Alexander 1973 p15).
Peasnell (1995) also goes on to say that economic income is useful for managers in order to effectively allocate resources within a firm. Not only this, but it can be used by external users to assess the financial performance of managers as it helps identify how effective they are at meeting targets and budgeting.
Managers use economic income in order to make decisions effectively. Edwards and Bell (1973 p5) highlight manager's increasing reliance on national income figures, and income and outcome data in order to make decisions that will be relevant to the future.
An accountant's view of income relates to measuring capital and its movements in value. Keeping with the definition provided by Hicks, accountants view income as a measure of capital. The economists view is the opposite to that of the accountants. It is also known as 'ex ante' as it values income based on future cash receipts. Economists, particularly Fisher (1930), have argued that income cannot be from the perspective of an entity, but from an individual. It does not involve the idea of capital maintenance therefore, but involves the idea of consumption. This consumption is what individuals choose to do rather than spend. From this, Fisher used the term 'enjoyment' to describe individual's level of consumption. Watts and Zimmerman (1990) explains that the main purpose of economic income is to predict and explain individual behaviour. Referring back to works of Kaldor (1955), income is also used as a redistributing tool, particularly forming the basis for income tax.
The debate surrounding the accountant's role is highly topical. However, here, we will assume that the accountant's main role is to report to the shareholders, and provide information that is useful for them in decision making. An accountant therefore calculates income from a business point of view. Rather than concentrate on an individuals income, they focus on calculating income of a business, to report to the owners. Although Edwards and Bell (1973, p5) claim that the accountants aim is to serve internal users first, then external users, they have also identified the increasing trend in 'social responsibility'. This has meant that accountants and businesses have become more 'concerned' about the external users of accounting income, and so have adapted their methods in order to meet their needs, for example, by providing different sets of information needed for tax authorities, stockholders, analysts, and labour union officials.
It is for this reason that income using the accounting model needs to be calculated accurately. It needs to be verified in order than shareholders and investors can rely upon it. One way of assessing how effective an income figure is to investors is to look at event studies. These studies measure the impacts of disclosures of such information on the value of t he firm, particularly its share price, and provides an ideal tool for examining the information content of financial statements (MacKinley 1997). The concept of useful information stems from the idea of capital market efficiency, if information is useful in forming capital asset prices, markets will adjust asset prices to that information quickly.
Beaver's (1968) study concentrated on assessing the effect of an earnings announcement in the market place. He initially explains the relevance of studying event studies by claiming that accounting information needs to be sufficient enough to 'induce a change in ones behaviour', and that the best way to identify such a change is through a change in the holdings of the company, and the most common form of that 'information' is that of the financial statements. His study found that information content does effect the investor's perception of the firm. Ball and Brown (1968) studied the information content of disclosures and found that of all the information that is disclosed in the statements, half of it is captured in the income figure. This is a considerable amount, and so it is vital that this information is as accurate as possible.
The users of economic income, however, are not so constricting. Economic income is calculated for the purpose of the managers. This form of income is used for internal purposes and so there are no constraints when adopting the model. An accountant will therefore find this form of income difficult to verify, an auditor, for example, would prefer to deal with more verifiable data rather than current values as they are easier to establish, whilst an economist would fail to see the relevance of an accounting figure, as it fails to reflect accurate market prices.
Accounting income and economic income have different views on the timing of calculating capital. Accountants adopt a historical approach calculating revenues and costs at the end of the period where they have already occurred, when they have been realised. However, economic income is the opposite, where capital is calculated at the beginning of the period, before the cash flows have been recognised. The main flaw to the economist's model is that is can be near impossible to predict what is going to happen in the future. The methods at which economists arrive at such a figure are not verifiable, they cannot be relied upon, and are not practical. They are constantly changing. An economist might argue that this is so that it reflects the prices in the market, but if this is so, wouldn't the economist need to keep altering the profit figure in order for it to remain relevant? Solomons (1967) also highlights the weakness in using future cash receipts, by claiming that the economist's views can affect human expectations about a firm. If cash flows for one year were predicted to be significantly higher than what they actually were, automatically, it will appear that the firm has done worse than expected. In actual case, it was due to a change in expectations regarding the future. An accountant therefore will be able to argue that their method doesn't need to rely on estimates. Instead, they record what has already occurred, and at the prices that they have occurred. Recording them at these prices means that shareholders are auditors are able to verify the transactions. Adjusting the prices to reflect current prices will be seen as impractical and useless for shareholders who might not fully understand the unit of measurement. In a perfect market full of certainty, therefore, accounting income will also be the same as if it was in a world full of uncertainty. However, economic income takes expectations, inflation, and interest rates into account, and so in a situation where there is certainty, economic income will always be different to an uncertain market.
Economic income has been argued that it is far too simplistic to be applied effectively in a business environment. Forecasting for a company can be difficult and costly to implement, with only large firms able to create budget reports. However, a large firm may find that appropriate discount factors will be difficult to obtain, particularly if they have a mass number of assets and transactions. The focus on capital maintenance can also be too restricting for the firm's activities.
Further to the previous point, accountants and managers may fail to see the relevance of economic income purely on the basis that the maintenance of capital isn't the firm's long term goal. A firm's main objective is usually to maximise profit in order to appeal to investors and shareholders. The adoption of the accounting model allows such flexibility that this can be obtained as it focuses on 'income' rather than 'capital'. Edwards and Bell (1973 p264) also think that managers are able to make decisions without the use of real data as it prevents them from over allocating resources. Economists, will feel, however that the importance should rely on capital as the size of the capital will determine the value of the income stream. Rather than isolate income and capital, economists recognise that the two are heavily related.
Economic income is also measured on the basis of valuation. Holding gains, whether realised or unrealised are always considered in the calculation as the basis for economic income. The main focus for economists is the balance sheet as it helps to identify the increase in value of capital for the company.
Accounting, in comparison relies on the concept of realisation. That is, applying the matching principle, costs are only accounted for once they have been received or paid. An increase in value for an asset, for example, would not be mentioned until the asset is sold. The proceeds will therefore be reflected in the income statement, hence the accountants preference for this when calculating income. However, that is not to say that gains and losses are not recognised in accounting income. Holding gains and losses for available for sale securities, for example, are treated in stockholders equity, and forms part of comprehensive income until it is sold, where it is reflected in the income statement.
These two differences have their drawbacks. A view solely on the balance sheet fails to take into account all the costs incurred to obtain it at that position. The income statement view has the difficulty in knowing when revenue can be realised. However, as Chang (1962) states, this does not mean the value of accounting income cannot be derived from the balance sheet, and economic income cannot be derived from the income statement. Despite the two models being seemingly poles apart, there is a link between the two.
Chapter 5
Summary and Conclusion
The debate surrounding these issues has been a long running one; however, having explored these issues in order to gain a better understanding of the differing views of income and how they are interpreted, we were able to provide a comparative analysis regarding the usefulness of both methods.
By evaluating the two forms of income, it is clear to see that there is support for the two, despite them being almost opposite in terms of content.
To determine whether an income figure is effective or not depends entirely upon the user and its purpose. It will be naïve to assume one income method would be adequate enough to cater for a wide range of users and purposes. Accounting income reports to shareholders, tax authorities and other stockholders the past performance of the firm. These users need to know what income has been generated in order to assess how well they have performed compared to previous years, similar companies, or changes in the market. Users of economic income are those who wish to assess the future performance of a firm. These could be its managers, analysts, or again, investors. Decision making that uses future values has the advantage of being more relevant for managers as they are regularly making decisions in the face of uncertainty (Edwards and Bell, 1973 p 5). For example, they have identified that managers use economic income to calculate a greater present value of equity, to provide a more accurate view on dividends they are able to issue.
By incorporating the strengths of both models, users may be able to create a model that is suitable to their needs, and provides a greater depth of information. It has been said that investors rely upon past performance when making decisions on a firm's profitability. By incorporating economic model into this, investors will be able to use future expectations to assess whether the company did perform as expected. Stockbroker analysts provide information on future expectations, such as expected sales, profits etc... Investors rely upon these figures when deciding to purchase or sell shares in that company. However, using these to look back and assess whether the company did meet the expectations of the analysts, will provide an alternative form of analysis. . Users should therefore see that both forms of income are useful for decision making as ex post and ex ante values provide a greater depth of information in which to create an analysis upon.
Event studies play an important part in determining the usefulness of accounting information. Various studies have been conducted to identify how disclosures of net income, comprehensive income and current cost accounting have effective investor behaviour. If investors see information as useful, they would react upon it, which thus in change affects the value of holdings in the firm. However, event studies are primarily related to accounting income. Firstly, if accounting income wasn't deemed to be useful for investors, prepares of financial statements would not disclose it.
Nevertheless, the accountant's notion on what income should be is ever changing. The introduction of comprehensive income has lead to many disagreements on its effectiveness amongst users. Its focus on dirty surplus items, for example, has lead to concerns that this might be misused as a measure of a firm's performance (O'Hanlan and Pope, 1999). However, the reporting of holding gains and losses of such items is the FASBs attempt to create a more accurate reflection of a firm's activity as it discloses the wealth of an organisation.
In conclusion, there is simply no right or wrong method of calculating income. As Alexander (1973, p1) states, there is no method that can claim to be the true method of calculating income. Each method has its own strengths and weaknesses, but even these cannot be clearly identified as what is good for one purpose, may not be good for another. One may feel that the others method has its significant drawbacks, but the income figure should be evaluated on its ability to influence decision making. If they do that, both methods should be good enough in their own rights.
