ICBC_2006RR
Exhibit C15-11
Fourth Edition
ACCOUNTING
THEORY
Eldon S. Hendriksen
Professor of Business Administration
University of Santa Clara
1982
L~1.
-D
RICHARD D. IRWIN, INC.
Homewood, Illinois 60430
Chapter 7
142
Capital
versus
income
In the terms of the economist Irving Fisher, capital is a stock of wealth at
an instant of time, lU Income is a flow of services through time. Capital is
the embodiment of future services, and income is the enjoyment of these
services over a specific period of time. With these definitions, it does not
seem possible to confuse the two terms. The one relates to the amount in
the reservoir at anyone time, and the other refers to the amount flowing
out of the reservoir during a period of time.
When these terms are related to a business enterprise, however, they
take on slightly different meanings. In the above definition, income is the
enjoyment from the use of capital; however, 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.
Whereas, capital is still the stock of wealth that can provide future services, income is thought of as the flow of wealth or services in excess of
that necessary to maintain a constant capital. Although a firm may be
thought of as relatively permanent in nature, it is not the responsibility of
the accountant to see that the invested capital is preserved. This is the
responsibility of management,
or possibly the decision of the owners or
equity holders, The accountant's responsibility is to report the amounts
that have been made available to the beneficiaries for their enjoyment or
reinvestment and the change in the capital of the enterprise. Thus, there
is an important distinction between the flows to beneficiaries that represent amounts that can be enjoyed without impairing the future cash flows
and those flows that represent reductions in wealth. In accounting terms,
this is the distinction between ipcome and a return of capital.
Why is it important to distinguish between enterprise income and a
return of capital? The answer is twofold. First, changes in the capital of
the enterprise may affect the amount of future flows to residual equity
holders (the holders of common stock) and thus the value of their equity at
any point in time. Second, changes in enterprise capital may affect the
relationships among the various equity holders, including the holders of
debt and preferred stock.
The residual equity holders are interested not only in how much they
can expect to receive from the enterprise during the following period, but
also in the net changes in the ability of the enterprise to provide future
flows. Current investor interest is focused not only on the ability of the
firm to maintain dividends, but in many cases on its growth potential. The
knowledge of these changes is even more important when the ownership
rights to these future flows are transferred frequently during the life of
the enterprise. During the early period of the railroad industry in the
United States, it was not uncommon for promoters to pay huge dividends
to
Irving Fisher, The Nature of Capital and Income (New York: Macmillan,
1906), p. 52.
143
cOllceptJl for financial reporting
out of capital during the early life of the firm. Investors, believing this to
be the true income of the firm, paid high prices for the stock, only to find
later that the ability to pay dividends in the future was being eroded
because of these huge early dividends. Equity requires that both buyers
and sellers of common stock have adequate information to make expectations regarding the current and future dividends of the firm.
With the separation of ownership and control in most large corporations, accounting also has the responsibility to report on the stewardship
of the management group entrusted with the proper use of the invested
capital. A proper distinction between income and changes in capital is one
of the means of determining the extent to which management has carried
out the function of operating the enterprise for the benefit of the owners.
The concept of wealth maintenance is also important to bondholders,
preferred stockholders, and the providers of short- term credit. All of these
equity holders are interested in the probability of repayment at some
future date. The prospect of repayment is greater if the total invested
capital of the enterprise is maintained at a constant level or permitted to
increase. The prospect of repayment is less if the capital is diminished
either through losses or by the p'ayment of dividends in excess of earnings.
The creditors cannot always be protected against losses, but if they are
properly notified, they may be able to protect their position before it is too
late. To a certain extent, creditors are protected legally and often contractually from the impairment of invested capital by the payment of dividends in excess of earnings.
The various classes of equity holders are also interested in the return
on their investment, whether it be contractual (as interest on debt) or
dependent on earnings (as dividends on preferred and common stock).
Since invested capital reflects, in part, the ability of the firm to continue
the-payment of a return to equity holders in the future, changes in the
amount of invested capital are vital in decisions regarding the future flow
of this return to any class of equity holders.
The concepts of capital and income, however, are not clearly formulated. Capital can be defined in terms ofthe current monetary unit or a
monetary unit of constant value; in physical terms; in terms of capacity to
produce goods and services; or in terms of the future expectations regarding future flows to stockholders. The measurement difficulties in separating capital and income are even greater. These conceptual and measurement difficulties are discussed in the following section.
The wealth
maintenance
concepts
of income
Among economists, Adam Smith was the first to define income as that
amount that can be consumed without encroaching upon capital, including both fixed and circulating 'capital. Hicks elaborated upon this by
saying that income is the amount that a person can consume during a