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Income: It’s Definition, Measurement and Importance

July 11, 2010 1 comment

As per the American Institute of Certified Public Accountants (AICPA), accounting is the “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof” (Wikipedia). Thus an accountant must be able to capture a company’s financial interactions and present it in such a manner that will aid management in their decision making activities. The sensitivity of an accountant’s role comes in the form of deciding which financial data to capture, and the means of presenting them. This of course is dependant on management’s ever changing requirements, stemming directly from the owner’s objectives.

As the art of accounting has been around for thousands of years, it intricacies have been ever evolving, catering to the needs of its users. Brinberg (1980) has classified the accounting’s evolution into four periods, naming them the: Pure Custodial Period, Traditional Custodial Period, Asset Utilization Period, and Strategic Stewardship Period. With each period, the requirements of the business owners, or financiers, progressively became more thorough. The thoroughness were a result of complexities in the financial domain, brought upon by advancements in technology. These requirements manifested themselves in the financial reporting practices of the accountants.

In understanding our current financial reporting practices, one must focus on the current accounting period, along with the one that have lead up to it; the strategic stewardship and asset utilization periods. During those times, given the evolution of the investment markets, the external capital finance was released from the exclusivity grip of “bankers, other lenders and trade creditors” (Elliotte & Elliotte, p. 40, 2009). Reporting priorities shifted from liquidity to profitability, and as such, “the balance sheet data on its own was no longer sufficient; hence, the income statement emerged” (O’Connell, 2007). Central to this shift is the concept of income.

Income may be defined in many different ways, though the different conceptional notions are “reconciled in the long term” (Elliotte & Elliotte, 2007). The two dominant income views is that of the accountant and the economist. From an accountant’s perspective, income is defined as the residual portion of revenue which is the result of subtracting total revenues generated from the total expenses incurred by a company during the revenue generation phase. An economist though, would beg to differ, by defining income in terms of residual expected cash flows available from consumption, after dividends and equity appreciation has been taken into account.

Although the accountant’s and economist’s view of the income concept differ, in that one deals with historical values and the other in future expected cashflows, its importance is of vital use. Effectively, management has been entrusted with funds from various sources [shareholders, financiers, etc.] to appreciate its value, and as such, income is an effective indicator of measuring that. Management’s stewardship on its operating effectiveness of working capital may be best monitored by charting a company’s income patterns. From a managerial point of view, income will aid in highlighting the disparities between actual and predicted performance targets. As for governments, income is a benchmark of a company’s asset appreciation for a given period, that they may apply taxes on. Investors on the other hand, may use income in assessing a company’s commitment to seeing through theirs stated dividend and retention policies. As for financiers, income history may be used in predicting future performances.

With the vast benefits of income, extending beyond the aforementioned examples, its users must be aware of some drawbacks in its measurement process. The accountant’s view of income suffers from the following:

  • Revenue/loss is recorded for only certain assets [such as land and building] as they appreciate/depreciate in value (whereas the remainder of the assets are recorded according to their cost value)
  • Capital profits go unrecorded until they are realized
  • Unrealized profits are not recorded until their date of realization, whereas unrealized losses are recorded immediately
  • The allotted depreciation depreciation expense, is an accountant’s estimate.

As for the economist’s view of income, it suffers from the future unpredictability element and differing investor expectations:

  • The predicted cash flows are not concrete (thus the expected income to be generated is at best a guesstimate)
  • As investors have differing risk thresholds and time preferences, so does the variables used in finding the present value of the future cash flows; resulting in varying income figures. Therefore, the value of the economic income is user dependant; making it difficult to produce financial statements under the economist’s view of income.

Given the various definitions and drawbacks of measuring income, it uses is still of vital role in the ever evolving “sophisticated capital market[s]” (Elliotte & Elliotte, p. 55, 2009). With “‘the need for both retrospective and prospective data” (O’Connell, 2007) from the various users of the financial statements, income may provide just that.

Youssef Aboul-Naja

Measuring Financial Performance: Is the Cash flow Method Superior to that of the Accrual Basis?

Around two thousand five hundred years ago, the Greek philosopher Heraclitus noted that “nothing endures but change” (Wikiquote, 2010). This simple axiom, if I may, is the main underlying factor that influences our behavior when it comes to interacting with the outside sphere at any point of time. Given man’s inquisitive behavior, sciences were devised to explain the outside world. However, since these sciences are nothing but a mere reflection of what we know, it is by no coincidence that they are in a continual state of work-in-progress.  From an accounting perspective, whether the art of bookkeeping is maintained according to the rules devised by “stone counters [as was the practice some 10,000 years ago]” (Atkinson, 2002), or the more complex accrual basis, accounting will continually change to better serve the needs of the stakeholders. Accountants, essentially, are communicators.

But, one must humbly observe, that words have the power of changing the world; thus the duties of an accountant are ever so important. Within this ever-changing, sensitive, backdrop does the latest accounting contention arise: is the cash-flow method superior to that of the accrual?

In a nutshell, the cash-flow methods calls for recognizing transactions as cash is physically exchanged between two parties. Proponents of this method claim that the figures provided by the accountants are more factual, since they are backed by already executed transactions. As for the accrual basis of accounting method, transactions are recognized as their execution is earned [regardless of whether or not cash has been exchanged]. The proponents on this side of the camp claim that “accrual accounting information more fully reflects the overall effects of periodic managerial decisions” (Kwon, 1989).

To that respect, according to the two dominant, non-governmental, accounting bodies, the FASB [Financial Accounting Standards Board] and IASB [International Financial Reporting Standards], companies that claim adherence to either standard must provide statements that have an accrual and cash-flow outlooks. It is to be noted that adhering to one of the standards signifies that the financial statements have been prepared in accordance to accepted bookkeeping practices; facilitating comparability. This is of utmost importance to a lot of companies, as they seek capital from various sources.

Given the high-profile, “cooking the books” (Datar, 2002), scandals of companies in recent years, it has been proposed, by the cash-flow method advocates, that if accountants drop the accrual method as they prepare the financial statements, confidence would once again be restored in the financial reporting profession. They also claim that the difficulties, and controversies, of devising a unified set of global accounting standards would be a thing of the past.

To test this claim, it is best to start by clarifying the term confidence in a financial reporting context. “The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements” (Dechow,1994). The beneficiaries of these excess cash receipts are essentially the stakeholders of the company; most probably the shareholders, but could include employees, other parties, etc. [this is a company/country/culture specific]. These stakeholders are the financiers of companies. The commitment of backing a company is highly influenced, along with other factors, by the stake-holders’ confidence that the financial statements have been prepared in manner reflective of the actual financial reality of the company.

To that accord, if the cash-flow method was the only prevalent way of transmitting financial information to the stakeholders, that would not necessarily restore confidence in financial reporting. “If people [managers] are dishonest, any system [or method] is vulnerable” (Quinn, 2003). Managers may time cash disbursement to their benefit; especially that management compensation is closely tied to performance. Also, since projects could extend beyond one-year, inaccuracies creep into the cash-flow method. For example, this method will falsely portray a loss for a company in the first year on a given project and a profit on the second; provided that revenue will come only on the second year. This scenario shows the superiority and flexibility of the accrual basis method since it more accurately reflects the reality of the financial situation.

However, many successful companies that are profitable on paper declare bankruptcy, as they mismanaged their handling of cash, the bloodline of any organization. Each method complements the other. If we liken the cash-flow method to short-term war skirmishes and the accrual method to the overall war result, a war general should be concerned with winning both; as each is dependant upon the other. The way to restore confidence in the financial reporting sector, should lay along the lines of needing “good ethics and a good system of governance“ (Quinn, 2003).

Coming back to the claim, dropping the accrual method will remove the controversies surrounding a unified set of global accounting standards, it could be argued either way. The cash-flow method is more clear cut when it comes to what constitutes a completed transaction. Thus any issues related to cultural views, status of national accounting profession, taxation (to name a few) automatically become more or less irrelevant. Though if bookkeeping is handled in such a clinical fashion, other sets of issues will arise. For example, profit seeking investors will have a problem with financial statements that deal only with liquidity. Therefore, it may seem that controversies surrounding a unified set of global accounting standards might be lessened if the cash-flow method  is solely used; this claim is not entirely true. Needless to say, given the improvements in technology, a unified set of global accounting standards is required  regardless of which method is put in use; as various economies are linked via global transactions. “No man [or in that regards a country/economy] is an island” (Donne, 1839). “The rapid spread of the financial crisis” (Anon, 2009) in 2008 is a testament of that.

Youssef Aboul-Naja