Nature of business income
The
matching of costs and revenues to determine periodic net income is a principle
purpose of accounting practice. This is a difficult task since it requires
allocating the various activities of continuing business into arbitrary time
period which rarely coincide with the period which of the various activities
comprising the total business is stated and completed.
matching of costs and revenues to determine periodic net income is a principle
purpose of accounting practice. This is a difficult task since it requires
allocating the various activities of continuing business into arbitrary time
period which rarely coincide with the period which of the various activities
comprising the total business is stated and completed.
Nevertheless,
managers try to accomplish this matching by associating as best they can their
companies ‘accomplishment of the period (revenue) with the efforts expanded to
achieve these accomplishment (expenses). The result of this matching process is
net income or profit.
managers try to accomplish this matching by associating as best they can their
companies ‘accomplishment of the period (revenue) with the efforts expanded to
achieve these accomplishment (expenses). The result of this matching process is
net income or profit.
Net
income (net loss) can be defined as the excess of revenue over expenses for an
accounting period, which is the increase (net decrease) in owners’ equity
(assets minus liabilities) of an enterprise for an accounting period from
profit directed activities that is recognized and measured in conformity with
generally accepted accounting principles.
income (net loss) can be defined as the excess of revenue over expenses for an
accounting period, which is the increase (net decrease) in owners’ equity
(assets minus liabilities) of an enterprise for an accounting period from
profit directed activities that is recognized and measured in conformity with
generally accepted accounting principles.
Revenue
is conventionally recognized at a specific point in the earning process of a
business enterprise, usually when assets are sold or services are rendered.
is conventionally recognized at a specific point in the earning process of a
business enterprise, usually when assets are sold or services are rendered.
This
convention recognition is the basis of the pervasive measurement principle
knows as realization. The realization principle state that revenue is generally
recognized when both the following conditions are met;
convention recognition is the basis of the pervasive measurement principle
knows as realization. The realization principle state that revenue is generally
recognized when both the following conditions are met;
1. The earning process is complete or
virtually complete and
virtually complete and
2. An exchange has taken place.
However,
Accounting and Economists have long debated what constitutes income and how
income should be measured. The possible cause for the long debate on concept of
income by the two professionals stems from the different professional objective
of income measurement.
Accounting and Economists have long debated what constitutes income and how
income should be measured. The possible cause for the long debate on concept of
income by the two professionals stems from the different professional objective
of income measurement.
The
accountants’ primary objective in measuring income is to satisfy the needs of
various user groups such as the equity investors, government, loan-creditors;
employees and labour unions, analysts and advisers and the generally public.
accountants’ primary objective in measuring income is to satisfy the needs of
various user groups such as the equity investors, government, loan-creditors;
employees and labour unions, analysts and advisers and the generally public.
But the
economists’ objectives of income measurement are to evaluate resources
allocations and to control and regulate businesses.
economists’ objectives of income measurement are to evaluate resources
allocations and to control and regulate businesses.
Economists view points on income
Adam
Smith in his Wealth of nations published in 1776 defined income as that amount
that can be consumed without encroaching upon capital, including both fixed and
circulating.
Smith in his Wealth of nations published in 1776 defined income as that amount
that can be consumed without encroaching upon capital, including both fixed and
circulating.
J.R Hicks
in his value and capital published in 1946 maintained that income is the amount
that a person can consume during a period of time and be as well off at the end
of that time as he was at the beginning.
in his value and capital published in 1946 maintained that income is the amount
that a person can consume during a period of time and be as well off at the end
of that time as he was at the beginning.
According
to Irving Fisher, income is a flow of services through time while capital is a
stock of wealth at an instant of time. Thus while capital is the embodiment of
future services, income is the enjoyment of these services over a specified
period of time.
to Irving Fisher, income is a flow of services through time while capital is a
stock of wealth at an instant of time. Thus while capital is the embodiment of
future services, income is the enjoyment of these services over a specified
period of time.
Here
capital relates to amount in the reservoir at any one time, and the other
refers to the amount flowing out of the reservoir during a period of time.
However, to define income as the enjoyment derived from the use of capital is
vague because a business enterprise does not exist for the purpose of
enjoyment.
capital relates to amount in the reservoir at any one time, and the other
refers to the amount flowing out of the reservoir during a period of time.
However, to define income as the enjoyment derived from the use of capital is
vague because a business enterprise does not exist for the purpose of
enjoyment.
Its
purpose is to provide a flow of wealth for the benefit of its owners or
beneficiaries- the equity holders.
purpose is to provide a flow of wealth for the benefit of its owners or
beneficiaries- the equity holders.
It is
evident from the foregoing that economist incomes represent an increase in
capital over a time period excluding any injection and withdrawal of funds into
and from the business by the proprietor.
evident from the foregoing that economist incomes represent an increase in
capital over a time period excluding any injection and withdrawal of funds into
and from the business by the proprietor.
Accountants view points on income
Accountants
regard income as the excess of revenues from sales (investments) over the
operating costs of goods sold and services rendered.
regard income as the excess of revenues from sales (investments) over the
operating costs of goods sold and services rendered.
The
accounting equation for the measure net of net income is as shown below:
accounting equation for the measure net of net income is as shown below:
Net
Income = Revenues – Expenses + Gains – losses
Income = Revenues – Expenses + Gains – losses
Equation
one
one
Where
Gains
increase in net assets from all transactions during a period except those that
result from revenues or investments by owners.
increase in net assets from all transactions during a period except those that
result from revenues or investments by owners.
Losses
are decreases in net assets from all transactions during a given period other
than those resting from expenses or distribution to owners.
are decreases in net assets from all transactions during a given period other
than those resting from expenses or distribution to owners.
Accountants
equally regard income as an increase in the net worth of a business enterprise
calculated from two balance sheet dates on the basis of historical cost. The
accounting equation depicting this definition is:
equally regard income as an increase in the net worth of a business enterprise
calculated from two balance sheet dates on the basis of historical cost. The
accounting equation depicting this definition is:
Net worth = Total Assets –
Liabilities.
Liabilities.
In all
while accountants and economists differ in terms of the concept of net worth,
they agree that income represents an increase in the net worth of business
enterprise
while accountants and economists differ in terms of the concept of net worth,
they agree that income represents an increase in the net worth of business
enterprise
Measurement of business income
While
income recognition seems to turn on the timing of revenue recognition, the
final measurement of income must also include a consideration of the past,
current and estimated future costs related to the revenue recognized.
income recognition seems to turn on the timing of revenue recognition, the
final measurement of income must also include a consideration of the past,
current and estimated future costs related to the revenue recognized.
Norton
Bedford (1971) contends that readers of income reports should realize that the
meaning of accounting income can be understood only by knowing how the income
was measured. That is, the readers should understand the operation used by the
accountant to produce the income amount but first let us look at the ways
through which economists argue enterprise could use to measure income.
Bedford (1971) contends that readers of income reports should realize that the
meaning of accounting income can be understood only by knowing how the income
was measured. That is, the readers should understand the operation used by the
accountant to produce the income amount but first let us look at the ways
through which economists argue enterprise could use to measure income.
1. The capitalization of all accepted
future cash distributions to shareholders at the beginning and end of the
period.
future cash distributions to shareholders at the beginning and end of the
period.
2. The ascertainment of the market value
or net realizable value of the whole enterprise at the beginning and end of the
relevant period.
or net realizable value of the whole enterprise at the beginning and end of the
relevant period.
3. The determination of the net present
value of the business at the beginning and end of the relevant period. This
involves determining the expected streams of receipts and payments as far into
the future as possible and subsequently discounting them to determine the net
present value at the beginning and end of the period.
value of the business at the beginning and end of the relevant period. This
involves determining the expected streams of receipts and payments as far into
the future as possible and subsequently discounting them to determine the net
present value at the beginning and end of the period.
We shall
now study three essential approaches to business income measurement namely: –
Transactions approach, Activity approach and the Capital Maintenance approach.
now study three essential approaches to business income measurement namely: –
Transactions approach, Activity approach and the Capital Maintenance approach.
The transactions approach
The
transactions approach to income measurement is the more conventional approach
used by accountants. It involves the recording of changes in asset and
liability valuations only as these are the result of transactions. The term
“transactions” is used in the broads’ sense to include both internal and
external transactions.
transactions approach to income measurement is the more conventional approach
used by accountants. It involves the recording of changes in asset and
liability valuations only as these are the result of transactions. The term
“transactions” is used in the broads’ sense to include both internal and
external transactions.
External
transactions could lead to valuation changes, only those that result from the
use or conversion of assets are usually recorded. To the extent that new market
valuations replace input (cost) valuations when an external transactions
occurs.
transactions could lead to valuation changes, only those that result from the
use or conversion of assets are usually recorded. To the extent that new market
valuations replace input (cost) valuations when an external transactions
occurs.
When
conversions take place, the value of old assets is usually transferred to the
new asset. Therefore, the transactions approach lends itself readily to the
concept of realization at the time of sale or exchange and to the cost
convention in accounting.
conversions take place, the value of old assets is usually transferred to the
new asset. Therefore, the transactions approach lends itself readily to the
concept of realization at the time of sale or exchange and to the cost
convention in accounting.
The activity approach
The
activities approach to business income differs from the transactions approach
in that it focuses on a description of the activities of a firm rather than on
the reporting of transactions. That is, income is assumed to arise when certain
activities or events take place rather than only as a result of specific
transactions.
activities approach to business income differs from the transactions approach
in that it focuses on a description of the activities of a firm rather than on
the reporting of transactions. That is, income is assumed to arise when certain
activities or events take place rather than only as a result of specific
transactions.
For
example, activity income would be recorded during the planning, purchasing,
production, and sale processes as well as possibly during the collection
process.
example, activity income would be recorded during the planning, purchasing,
production, and sale processes as well as possibly during the collection
process.
In its
application, it is merely an expansion of the transactions approach since it
starts with the transaction as a basis of measurement. The main difference is
that the transactions approach is based on the reporting process which measures
an external event – the transaction, the activities approach is based on the
real-world concept of activity.
application, it is merely an expansion of the transactions approach since it
starts with the transaction as a basis of measurement. The main difference is
that the transactions approach is based on the reporting process which measures
an external event – the transaction, the activities approach is based on the
real-world concept of activity.
Capital maintenance approach
The capital
maintenance approach to income measurement ensures that capital must be
maintained before a business entity earns income on that capital.
maintenance approach to income measurement ensures that capital must be
maintained before a business entity earns income on that capital.
An
application of this approach requires a comparison of the beginning and ending
capital of an enterprise during a given period.
application of this approach requires a comparison of the beginning and ending
capital of an enterprise during a given period.
The
beginning and ending capitals are net assets after adjusting for any additional
investments into the enterprise during the period.
beginning and ending capitals are net assets after adjusting for any additional
investments into the enterprise during the period.
Under the
Capital Maintenance Approach net of an enterprise is measured using the
accounting equation expressed below:
Capital Maintenance Approach net of an enterprise is measured using the
accounting equation expressed below:
Net Income = Capital at the end – Capital at the
beginning
beginning
Where,
Capital
at the beginning = Total Assets at the end – liabilities at the end…
at the beginning = Total Assets at the end – liabilities at the end…
Equation two
Capital
at the beginning = Total Assets at the beginning …
at the beginning = Total Assets at the beginning …
Equation three
Liabilities
at the beginning … Equation 2 and 3 are consistent with the equation 1, present
earlier.
at the beginning … Equation 2 and 3 are consistent with the equation 1, present
earlier.
It is
important to emphasize here that net income is a function of the asset
valuation technique. Assets valuation techniques are synonymous with depreciation
methods.
important to emphasize here that net income is a function of the asset
valuation technique. Assets valuation techniques are synonymous with depreciation
methods.
Methods of measuring business income
We have
noted the three essential approaches to income measurement as the transactions
approach, the activities approach and capital maintenance.
noted the three essential approaches to income measurement as the transactions
approach, the activities approach and capital maintenance.
However,
the determination of income by an annual valuation of the business as suggested
by the capital maintenance approach can provide the most meaningful measurement
of a firm’s net income. Since the method of assets valuations and calculation
of annual depreciation charges adopted by a firm has a great influence on the
firms reported net income. This income measurement depends on the valuation
method adopted by the firm.
the determination of income by an annual valuation of the business as suggested
by the capital maintenance approach can provide the most meaningful measurement
of a firm’s net income. Since the method of assets valuations and calculation
of annual depreciation charges adopted by a firm has a great influence on the
firms reported net income. This income measurement depends on the valuation
method adopted by the firm.
Several
methods proposed by many writers on the field include the following:-
methods proposed by many writers on the field include the following:-
Historical cost method
Income
measurement under this method is based on the matching concept of accounting.
Here, income is determined by deducting from revenues the actual operating
costs of the period.
measurement under this method is based on the matching concept of accounting.
Here, income is determined by deducting from revenues the actual operating
costs of the period.
Revenue
and cost recognized as they are earned or incurred, not as money is received or
paid. The proponents of this method argue that accounts should be in real
money, not in hypothetical money as proposed by critics.
and cost recognized as they are earned or incurred, not as money is received or
paid. The proponents of this method argue that accounts should be in real
money, not in hypothetical money as proposed by critics.
Historical
cost basis of measurement is better, if there is a realistic assets valuation
by the directors on a regular basis, but with occasional endorsement by
professionals.
cost basis of measurement is better, if there is a realistic assets valuation
by the directors on a regular basis, but with occasional endorsement by
professionals.
If this
properly done and a breakdown of value added, one can look at inflation and
analyze the future to one’s own purposes.
properly done and a breakdown of value added, one can look at inflation and
analyze the future to one’s own purposes.
Replacement cost method
Here the argument by those who favor this method is
that the firm’s assets (including inventories) should be valued at their
replacement cost prices. This implies that the cost of goods sold deducted from
revenue during income measurement should be valued at their replacement cost.
that the firm’s assets (including inventories) should be valued at their
replacement cost prices. This implies that the cost of goods sold deducted from
revenue during income measurement should be valued at their replacement cost.
This
method is based on adjustment of historical costs using either general consumer
price index, general purchasing price index, or specific price index.
method is based on adjustment of historical costs using either general consumer
price index, general purchasing price index, or specific price index.
One
obvious disadvantage of these methods is that a firm will need to hire teams of
cost accountants and engineers in order to estimate the current replacement
costs of the firm’s assets. There is also the problem of which price index to
select and use, that is, one that is general or specific for accurate estimate.
obvious disadvantage of these methods is that a firm will need to hire teams of
cost accountants and engineers in order to estimate the current replacement
costs of the firm’s assets. There is also the problem of which price index to
select and use, that is, one that is general or specific for accurate estimate.
Resale price/net realizable value method
Here, we
mean that income should represent proceeds from sale less expenses of sale. By
implication, revenue is recognized at an early date before sales that is at the
date the net realizable values were placed on the assets concerned.
mean that income should represent proceeds from sale less expenses of sale. By
implication, revenue is recognized at an early date before sales that is at the
date the net realizable values were placed on the assets concerned.
Sympathizers
of this method argue that it provides on a regular basis the current cash
equivalent of assets and presumably of the company itself for the purpose of
decisions regarding possible adaptations.
of this method argue that it provides on a regular basis the current cash
equivalent of assets and presumably of the company itself for the purpose of
decisions regarding possible adaptations.
However,
critics of this method argue that problems do arise where the assets have no
market value due to obsolescence.
critics of this method argue that problems do arise where the assets have no
market value due to obsolescence.
Opportunity value method
Opportunity
value represents the value assets would have in their best alternative use. The
alternative use could be a different pattern of employment of the assets within
the firm.
value represents the value assets would have in their best alternative use. The
alternative use could be a different pattern of employment of the assets within
the firm.
This
value is determined by discounting the quasi-rent expected to be earned in that
use, this method thus appears subjective.
value is determined by discounting the quasi-rent expected to be earned in that
use, this method thus appears subjective.
The
opportunity value can be objective if the alternative is to dispose of the
assets. There is a problem of whether to use the entry or exit value of the
assets. The exit value approach has been criticized because it leads to the
anticipation of operating profit before sale by valuing stocks in excess of the
current cost incurred in their production.
opportunity value can be objective if the alternative is to dispose of the
assets. There is a problem of whether to use the entry or exit value of the
assets. The exit value approach has been criticized because it leads to the
anticipation of operating profit before sale by valuing stocks in excess of the
current cost incurred in their production.
The critical or crucial event
We wish
to emphasis that the recognition of business income is an industrial norm and
is generally considered to be determined in large part by the timing of revenue
recognition, since the sale of goods and services is typically a necessary
prerequisite to earning income.
to emphasis that the recognition of business income is an industrial norm and
is generally considered to be determined in large part by the timing of revenue
recognition, since the sale of goods and services is typically a necessary
prerequisite to earning income.
Starting
from this position, management must still determine what the critical event is
in the chain of business events from production through receiving an order to
be receipt of the payment of an account receivable.
from this position, management must still determine what the critical event is
in the chain of business events from production through receiving an order to
be receipt of the payment of an account receivable.
For
banking and allied institutions in Nigeria, the CBN through the prudential
guidelines of November 7, 1990 issued minimum and general guidelines on the
recognition of income by banks and other financial institution in Nigeria.
Banks were required to cease charging interest and recognizing same on non-performing
credit facilities after a period of time. The statement of Accounting standard
(SAS 10) issued
banking and allied institutions in Nigeria, the CBN through the prudential
guidelines of November 7, 1990 issued minimum and general guidelines on the
recognition of income by banks and other financial institution in Nigeria.
Banks were required to cease charging interest and recognizing same on non-performing
credit facilities after a period of time. The statement of Accounting standard
(SAS 10) issued
By the
Nigeria Accounting Standard Board (NASB) spelt out the professional standards
on recognizing income on performing facilities by banks and other financial
institutions in Nigeria.
Nigeria Accounting Standard Board (NASB) spelt out the professional standards
on recognizing income on performing facilities by banks and other financial
institutions in Nigeria.
But the
critical or crucial event concept suggest that the most appropriate moment of
tome is when the most critical decision is made or when the most difficult task
is performed. This could be at the point when the correct is signed, the time
the services are performed, when cash is collected, or at same other time.
critical or crucial event concept suggest that the most appropriate moment of
tome is when the most critical decision is made or when the most difficult task
is performed. This could be at the point when the correct is signed, the time
the services are performed, when cash is collected, or at same other time.
Thus,
revenue is typically recognized when the event which reduces the task of
ultimately receiving the revenue is reduced to a minimum level which is
considered prudent by those issuing financial statements.
revenue is typically recognized when the event which reduces the task of
ultimately receiving the revenue is reduced to a minimum level which is
considered prudent by those issuing financial statements.
However,
in a number of cases, there can be disagreement as to the nature of the
critical event and what is prudent.
in a number of cases, there can be disagreement as to the nature of the
critical event and what is prudent.
In
practice, management appears to tolerate slightly more uncertainty in the
recognition of cost than it does it in the case of revenues. If the eventual
costs of obtaining the revenue are fairly uncertain, the revenue should be
deferred and held back from the income statement until the costs are more
certain.
practice, management appears to tolerate slightly more uncertainty in the
recognition of cost than it does it in the case of revenues. If the eventual
costs of obtaining the revenue are fairly uncertain, the revenue should be
deferred and held back from the income statement until the costs are more
certain.
To do
otherwise might be misleading and imprudent.
otherwise might be misleading and imprudent.
Economists criticisms of accounting income
The
following points reflect areas of criticism of the accounting income by the
economist.
following points reflect areas of criticism of the accounting income by the
economist.
1. The concept of accounting income has not
yet been clearly formulated.
yet been clearly formulated.
2. There is no long-run theoretical basis for
the computation and presentation of accounting income.
the computation and presentation of accounting income.
3. The generally accepted accounting
practice permit inconsistencies in the measurement of periodic income of
different firms and even between different years for the same firm.
practice permit inconsistencies in the measurement of periodic income of
different firms and even between different years for the same firm.
4. Prices-Level changes have modified the
meaning of income measured in terms of historical naira and;
meaning of income measured in terms of historical naira and;
5. Other information may prove more useful
to investors and shareholders for the making of investment decisions.
to investors and shareholders for the making of investment decisions.
6. While some of these criticisms may not be
considered valid presently, some are still valid today. Their validity arises
from the fact that accounting incomes poses considerable conceptual and
practical problems. Several suggestions have been proffered to provide solution
to some of these problems. They include: –
considered valid presently, some are still valid today. Their validity arises
from the fact that accounting incomes poses considerable conceptual and
practical problems. Several suggestions have been proffered to provide solution
to some of these problems. They include: –
(a) Accounting income should focus more on
transaction data and accrual process:
transaction data and accrual process:
(b) There should be agreement on a single
concept of income which will conform more closely to what is referred to as
“economic” income.
concept of income which will conform more closely to what is referred to as
“economic” income.
(c) All measurements of income are deficient in
one way or the other, therefore they should be superseded by other measure of
economic activity. Concept such as realization, matching, accrual basis, and
cost allocation must be defined in terms of precise rules because they do not
have real – world counterparts.
one way or the other, therefore they should be superseded by other measure of
economic activity. Concept such as realization, matching, accrual basis, and
cost allocation must be defined in terms of precise rules because they do not
have real – world counterparts.
Conclusion
Business
income has different meanings to accounts and economist. Economist income
represents an amount a person can consume without encroaching upon capital of
firm.
income has different meanings to accounts and economist. Economist income
represents an amount a person can consume without encroaching upon capital of
firm.
Accounting
incomes refers to the excess of revenues from sales over the operating costs
goods sold and services rendered.
incomes refers to the excess of revenues from sales over the operating costs
goods sold and services rendered.
However,
accountants and economists agree that income represents an increase in the net
worth of a business enterprise but differ but in terms of the concept of net
work.
accountants and economists agree that income represents an increase in the net
worth of a business enterprise but differ but in terms of the concept of net
work.
The
principle approach to income measurement used by accountants is the
transactions approach, the activities approach and the capital maintenance
approach.
principle approach to income measurement used by accountants is the
transactions approach, the activities approach and the capital maintenance
approach.
The
critical or crucial event factor concept in income recognition suggests that
the most appropriate moment of time recognizing income is when the most
critical decision is made or when the most difficult task is performed.
critical or crucial event factor concept in income recognition suggests that
the most appropriate moment of time recognizing income is when the most
critical decision is made or when the most difficult task is performed.
Economists
have leveled some criticisms against accounting income. While some of these
criticisms may still be valid today, other ceased to be valid.
have leveled some criticisms against accounting income. While some of these
criticisms may still be valid today, other ceased to be valid.
