CHAPTER 5 INCOME CONCEPTS

The Purpose of Income Reporting 1Income is used as the basis of one of the principal forms of taxation. 2Income is used in public reports as a measure of the success of a corporation’s operations. 3Income is used as a criterion for the determination of the availability of dividends. 4Income is used by rate-regulating authorities for investigating whether those rates are fair and reasonable. 5Income is used as a guide to trustees charged with distributing income to a life tenant while preserving the principal for a remainderman. 6Income 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 1Financial 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

Current purchasing power 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: 1Entry price or replacement cost 2Exit value or selling price or fair value 3Discounted 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