Posts Tagged ‘financial reporting’

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