CHAPTER 5
INCOME CONCEPTS
The Purpose of Income Reporting
1 Income is used as the basis of one of the principal forms of
taxation.
2 Income is used in public reports as a measure of the success
of a corporation’s operations.
3 Income is used as a criterion for the determination of the
availability of dividends.
4 Income is used by rate-regulating authorities for
investigating whether those rates are fair and reasonable.
5 Income is used as a guide to trustees charged with
distributing income to a life tenant while preserving the
principal for a remainderman.
6 Income is used as a guide to management of an enterprise in
the conduct of its affairs.
Importance of Income Reporting
• Economic Vs. Accounting Income
– Related sciences, concerned with the activities
of business firms and use similar variables differences over the timing and measurement of
income
– Relative importance of income statement
(accounting) and balance sheet (economics)
Definition of Income
• The maximum amount that can be consumed during the
period while still expecting to be as well off at the end of
the period as at the beginning of the period (Hicks 1946)
• Consideration of ‘well-offness’ relies on a notion of capital
maintenance
• Different notions of capital maintenance will provide
different perspectives of income
Capital Maintenance Concepts
1 Financial capital maintenance –
Historical cost effect
2 purchasing power capital maintenance
Adjusted historical cost
3 Physical capital maintenance
Inflation accounting
1-Historical cost accounting
• The income and financial capital
maintenance
Support for historical cost
accounting
• Predominant method used so tended to maintain support of profession
• If not found useful business entities would have abandoned it
• Nevertheless, recent accounting standards being released have
embraced ‘fair values’ as the basis of measurement. However, various
assets are still measured on an historical cost basis
– e.g. inventory, which is measured at the lower of cost and net
realisable value, and property, plant and equipment where the ‘cost
model’ and not the ‘fair-value model’ has been adopted
2-Adjusted historical cost or CPPA
• Instability of the accounting measuring unit
is due to the effects of inflation or deflation
• General purchasing power adjustments
Currentpurchasingpower
accounting(CPPA)
• Also called general purchasing power
accounting; general price level accounting;
constant dollar accounting
• Based on the view that in times of rising
prices, if an entity were to distribute
unadjusted profits based on historical costs,
in real terms the entity could be distributing
part of its capital
Calculating indices
• A price index is used when applying general
price level accounting
• A price index is a weighted average of the
current prices of goods and services related
to a weighted average of prices in a prior
period (base period)
Performing current purchase
power adjustments
• All adjustments are performed at the end of
the period
• Adjustments are applied to historical cost
accounts
• Monetary and non-monetary assets
considered separately
– values of monetary assets do not change as a
result of inflation
– liabilities generally considered monetary items
Performing current purchase
power adjustments (cont.)
• In times of inflation, holders of monetary
assets will lose in real terms
– the assets have less purchasing power at the end
of the period relative to the beginning of the
period
• Holders of monetary liabilities gain, given
the amount they have to repay at the end of
the period is worth less than at the
beginning
Performing current purchase
power adjustments (cont.)
• No change in purchasing power arises from
holding non-monetary assets
– non-monetary assets are restated to current
purchasing power so no gain or loss is
recognised
• Purchasing power gains or losses are
included in income for the period
Advantages of current purchasing
power adjustments
• Relies on data already available under
historical cost accounting
• No need to incur cost or effort to collect
data about current asset values
• CPI data also readily available
Disadvantages of current
purchasing power adjustments
• Movements in the prices of goods and
services included in a general price index
(CPI) may not reflect specific price
movements in different industries
• Information generated under CPPA may be
confusing to users
• Studies of share price reactions failed to
find much support for decision usefulness
of CPPA data
3-Current Value Accounting
• The concept of physical capital maintenance
requires assets and liabilities to be stated at
their current values
• Approaches:
1 Entry price or replacement cost
2 Exit value or selling price or fair value
3 Discounted present value
Current cost accounting (CCA)
• Based on actual valuations not adjusted
historical cost
• Differentiates between profits from trading
and holding gains
• Holding gains can be realised or unrealised
• Income perspective adopted will determine
whether holding gains or losses treated as
income
Treatment of holding gains or
losses
• Financial capital maintenance perspective
– holding gains or losses can be treated as income
• Physical capital maintenance perspective
– holding gains or losses can be treated as capital
adjustments
Adjustments using CCA
approach
• Adjustments usually made at year end
• Historical cost accounts used as basis of
adjustments
• Operating profit calculated by using
replacement costs
• Holding gains excluded in calculating
current cost operating profit
– not available for dividends
Advantages of current cost
accounting
• Differentiating operating profit from
holding gains and losses can enhance the
usefulness of information provided
– holding gains different to trading income as due
to market-wide movements that are often
beyond management’s control
• Better comparability of various entities’
performance
Criticisms of current cost
accounting
• Replacement cost of assets may not be the
same for all firms
– some firms may not choose to replace the asset
• If the entity requires replacement assets it
may be more efficient and less costly to
acquire different assets
• Replacement cost does not reflect what the
asset would be worth if sold
Criticisms of current cost
accounting (cont.)
• Often difficult to determine replacement
costs
• Allocating replacement cost via
depreciation is still arbitrary as with
historical cost accounting
• Chambers (1995) claimed products of CCA
were irrelevant and misleading