On the Definitions of Income, Expenses and Profit in IFRS

Forthcoming in Accounting in Europe, 2010 (2)

Dr Richard Barker
Cambridge Judge Business School
University of Cambridge
Trumpington Street
Cambridge CB2 1AG
UK

+44 (0) 1223 339646

r.barker@jbs.cam.ac.uk

Acknowledgements
The author is grateful to Anne McGeachin and Geoff Whittington, for valuable
comments and discussion, and to the editor and reviewers for helpful suggestions.

Electronic copy available at: http://ssrn.com/abstract=1579401

On the Definitions of Income, Expenses and Profit in IFRS

Abstract
This paper makes two contributions. First, it demonstrates that income and expenses
are incorrectly defined in the Framework, and it proposes alternative definitions.
Second, the paper identifies that, in part as a consequence of these incorrect
definitions, and in part because there are two, conflicting concepts of profit in IFRS,
there is, first, no definition of profit in the Framework and, second, inconsistency and
needless complexity in the concept of profit in IAS 1. The issues raised in this paper
contribute to the current IASB projects on the conceptual framework and on financial
statement presentation.

This paper identifies and addresses weaknesses in the definitions of income,

expenses and profit in IFRS. The paper therefore contributes to two current projects
currently on the agenda of the IASB: those to revise the conceptual framework
(hereafter ‘Framework’, IASC, 1989) and to revise IAS 1 Presentation of Financial
Statements (IASB, 2007).
The first section of the paper notes the importance of the Framework, and in
particular its balance sheet approach. It is then argued that the definitions of income
and expenses are incorrect in the Framework, because they are inconsistent with the
double-entry logic on which the Framework is based. In response, the paper offers
alternative definitions. The second section of the paper identifies that the current,
incorrect definitions of income and expenses lead to a flawed conceptualisation of
profit in IFRS. It is first noted that a curious anomaly exists in the Framework,
whereby income and expenses are explicitly defined yet profit is not. Moreover,
while the definitions of income and expenses are based upon the notion of clean
surplus, IFRS explicitly allows dirty surplus items, namely capital maintenance
adjustments and reclassification adjustments, with the odd result that IFRS does not
allow income less expenses to be defined to equal profit. The paper examines capital
maintenance adjustments and reclassification adjustments in IFRS, and revised
definitions of income and expenses are proposed that take these adjustments into
account. Finally, it is shown that total comprehensive income, which was recently
introduced into IAS 1, is neither consistent with the Framework nor with the analysis
of income, expenses and profit in this paper. The paper concludes with a summary of

Electronic copy available at: http://ssrn.com/abstract=1579401

its two main contributions, which are, first, to identify flaws in the IFRS definitions of
income and expenses and to propose alternative definitions and, second, to identify
corresponding flaws in the concept of profit in IFRS and to suggest how these can be
resolved, in such a way that profit in IFRS can be defined to equal income less
expenses.

Income and Expenses

The starting point for analysing income and expenses in IFRS is the
Framework. Any IASB pronouncement relating to recognition or measurement, on
all issues ranging from stock compensation to financial instruments, to pension
obligations or to business combinations, rests first and foremost upon consideration of
the Framework.
At the heart of the Framework are the elements of financial statements (paras.
47-81), namely assets, liabilities, equity, income and expenses. The Framework
adopts a ‘balance sheet approach’ in that the definitions of liabilities, equity, income
and expenses all follow inexorably from the definition of assets: liabilities are defined
to be the opposite of assets, equity is the residual interest in assets having deducted
liabilities, and income and expenses are defined as, respectively, increases and
decreases in net assets (other than from transactions with equity holders). This
balance sheet approach can be viewed simply as an application of the logic of double-
entry accounting, which is that assets are sources of value that are necessarily equal to
the claims on those sources, namely equity and liabilities(Pacioli, 1494; Cayley,
1894).1
The adoption of a balance sheet approach has caused proponents and critics of
the Framework alike to focus debate over financial reporting on the determination of
balance sheet values. A corollary is that the definitions of income and expenses in the
Framework have remained in the background. The current, joint FASB-IASB project
on the Framework, which pays careful attention to the precise wording of the
definition of assets and liabilities, has not yet explicitly considered the definitions of
income or expenses, nor that of profit (FASB, 2010a). The FASB-IASB Financial
Statement Presentation project, meanwhile, which for the IASB concerns revising
IAS 1, takes the definitions in the Framework as given and fixed (FASB, 2010b).

1
The same logic is fundamental to the Modigliani-Miller theorem in financial economics.

3
 As the definition of assets precedes those of income and expenses under a
balance sheet approach, the following definition in the Framework is central.
An asset is a resource controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the
entity. (para 49a)
While it is possible to disagree with the precise wording of this definition, the
basic point that an asset is a controllable right to future economic benefits is not
particularly contentious. For similar reasons, it is also difficult to argue with the basic
point that a liability is a present obligation expected to result in an outflow of
economic benefits (para 49b). The IASB’s definition of equity then follows directly:
Equity is the residual interest in the assets of the entity after deducting
all its liabilities. (para 49c)
These definitions of assets, liabilities and equity follow the logic of double-
entry accounting. So, for example, the double entry at the inception of a finance lease
is a debit for the capitalised asset, which represents value from which the entity will
benefit, and an equal and opposite credit for the financing of the asset, corresponding
to the obligation to transfer economic benefits to the holder of a claim on the entity.
Similarly, cash raised by issuing new shares increases economic benefits (a debit to
assets) while also increasing the claims on those benefits (a credit to equity).
Consider, however, what happens when the credit entry is income or the debit
entry is expense. Income is defined in the Framework as an increase in net assets,
other than from equity holders, that gives rise to an increase in equity (and expenses
are defined as the opposite, para 70b).2
Income is increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to
contributions from equity participants. (para 70a)
In practice, taking for example a revenue transaction, the debit entry is
typically to accounts receivable, while the credit entry is to sales (i.e. to income).
Hence, the debit entry corresponds to an increase in assets, while the credit entry
corresponds to an increase in equity. The two entries are necessarily equal in amount,

2
Revenue and gains are subsets of income. Hence, for example, revenue could be defined, consistently
with the Framework, as ‘a particular type of increase in economic benefits that arises in the course of
ordinary activities in the form of inflows or enhancements of assets or decreases in liabilities and
results in an increase in equity.’ (DRSC, EFRAG and CNC, 2007)

4
but not in meaning. The former is a change in assets and the latter is a change in
claims on assets. Income is an increase in equity that results from an increase in net
assets, not an increase in net assets that results in an increase in equity. Looking back
at the definition above, it is clear that the Framework gets this wrong.3
A common misunderstanding among non-accountants is that if a company has
retained profits, then there must be cash available to spend. After all, if a company has
made a profit and has reserves, then surely it must have liquid resources. Yet, of
course, this interpretation fundamentally misunderstands the concept of profit, and of
its components, income and expenses. The composition of assets is independent of
that of liabilities or equity, and a company may have profit but not cash. Yet this
confusion between debits and credits is the same as that made in the Framework. Cash
flow is an increase in assets, while profit is an increase in claims on assets. Equity,
which is correctly defined in the Framework, is not an asset but a residual interest in
net assets. Income and expenses are changes in this residual interest; they are not
changes in net assets, even though they are of equal amount.
It is surprising, given that the Framework is so important yet also in essence
very simple, that it appears to have passed unnoticed that the definitions of income
and expenses are in conflict with the basic principles of double-entry accounting: it is
not simply that they are not worded as tightly as they might be, but rather that they
fail to recognise the distinction between a debit and a credit.
This discussion suggests that income should be re-defined as follows. (For
simplicity of exposition, definitions of income only are presented in this paper;
definitions of expenses follow directly and are without need of further explanation.)4
Definition 1
Income is an increase in equity that results from an increase in
assets or a decrease in liabilities, other than from contributions from
equity participants.
This redefinition can be taken further. If equity is defined to equal assets less
liabilities, and if income and expenses are changes in equity, then there is no need, in
the definition of income or expenses, to refer to either assets or liabilities. This would
be to over-define and to make the definitions unnecessarily wordy. Definition 1 can

3
The same is true for US GAAP (FASB, 1984, 1985).
4
For example, expenses under Definition 2 would be: Expenses are decreases in equity, excluding
distributions to equity participants.

5
therefore be simplified. Hence, and in summary of this section of the paper, the
following definition is both more accurate and more concise than that in the
Framework.
Definition 2
Income is an increase in equity, excluding contributions from equity
participants.
While Definition 2 is different from that in the Framework, the amount
recognised as income under either definition is nevertheless the same, and so a
reasonable challenge is whether these definitional issues have any practical effect.
Accordingly, this paper will now proceed by arguing that the conceptual difference
between the definitions above and that in the Framework does have practical
consequences, and that these shed light on the current, contentious debate over the
reporting of financial performance (Barker, 2004; FASB, 2010b). To see this, we
need first to consider a further problem of definition in the Framework, which
concerns profit. Specifically, the next section makes the second contribution of the
paper, which is to note that the incorrect definitions of income and expenses lead to a
flawed conceptualisation of profit in IFRS.

Profit
It might reasonably be expected that profit would be defined in the Framework
to equal income less expenses. After all, if income is not something that increases
profit, then what is it? Equally, an expense is surely something that reduces profit;
how else is the term meaningful in reporting financial performance? This paper
therefore adopts the premise that a basic property of accounting is that profit should
be defined to equal income less expenses.
A curious anomaly in the Framework, however, is that, while income and
expenses are explicitly defined, profit is not. Moreover, while the definitions of
income and expenses are based upon the notion of clean surplus, because they include
all changes in net assets (other than from transactions with equity holders), IFRS
explicitly allows dirty surplus items. The result is that profit as reported under IFRS
is not equal to income less expenses as defined in the Framework.
In order to explore this issue, we can start with the first of Hicks’ classic
definitions of profit, according to which profit is equal to the maximum distribution
that could be made to shareholders during a period while maintaining constant the

6
economic value of net assets (Hicks, 1946).5 Alternatively stated, profit is equal to
the change in the economic value of an entity’s net assets that would have taken place
in the absence of transactions with shareholders.
The economic value of net assets differs, of course, from book value.
Nevertheless, Hicks’ definition finds an obvious parallel in the Framework’s
definitions of income and expenses, because the total of income less expenses is
defined to be equal to the change in the book value of an entity’s net assets that would
have taken place in the absence of transactions with shareholders.6 Yet the
Framework does not take the obvious next step of equating profit with income less
expenses. Indeed, while acknowledging that (para. 69) ‘the elements directly related
to the measurement of profit are income and expenses,’ the Framework, remarkably,
does not define profit at all.
There are two reasons why the IASB is not able to define profit as income less
expenses. The first concerns capital maintenance adjustments and the second concerns
reclassification adjustments (recycling). While all changes in net assets (excluding
transactions with equity holders) are by definition either income or expenses, those
associated with capital maintenance or reclassification adjustments are excluded from
the calculation of profit in the income statement. Hence, income less expenses cannot
be defined to equal profit. An example of the consequence of this position is the
following, rather obtuse statement (Para. 71): ‘The definitions of income and expenses
identify their essential features but do not attempt to specify the criteria that would
need to be met before they are recognised in the income statement.’ In other words,
an item can be defined as income, because it has the ‘essential features’ of income,
yet this is not a sufficient condition for inclusion in the income statement.7
The underlying problem is that identified above, namely that income and
expenses are not defined consistently with the logic of double-entry accounting. It is
a feature of the double-entry system that there can be changes on one side of the

5
There is a potential confusion in terminology here, which is that Hicks actually uses the term
‘income’ to refer to net income. Hence income for Hicks corresponds, in the lexicon of accounting, to
profit and not to income.
6
The Framework’s division of income between revenue and gains also finds its counterpart in Hicks.
Specifically, Hicks’ second definition of profit addresses the sustainability of the profit stream, for
which revenue is directly relevant but gains are only indirectly relevant: ‘The income which is relevant
to conduct must always exclude windfall gains; if they occur, they have to be thought of as raising
income for future weeks (by the interest on them) rather as entering into any sort of effective income
for the present week.’
7
Instead, IAS 1 (para. 88) requires simply that ‘an entity shall recognise all items of income and
expense in a period in profit or loss unless an IFRS requires or permits otherwise’ (italics added).

7
balance sheet that are independent of changes on the other side. So, for example, an
investing cash flow changes the composition of assets, without any impact on the
other side of the balance sheet, while the creation of a provision changes equity and
liabilities, but not assets. Hence, there can be changes within equity that provide
information that is independent from changes within assets, even though the aggregate
change must be the same. The distinction between, on the one hand, income and
expenses and, on the other hand, capital maintenance adjustments, arises within
equity, and not within assets. Similarly, the reclassification of items of other
recognised income and expenses concerns the analysis of changes within equity, and
not within assets. The current definitions of income and expenses suppress these
analyses of changes within equity, however, because the definitions are tied to assets.
In other words, the Framework takes the wrong side of the balance sheet as its starting
point.
As the difficulties with the concept of profit in IFRS concern either capital
maintenance adjustments or reclassification adjustments, each of these will now be
now considered in turn.

Capital Maintenance Adjustments

According to the Framework (para. 105), ‘only inflows of assets in excess of
amounts needed to maintain capital may be regarded as profit and therefore as a
return on capital.’ In other words, profit is not equal to the change in net assets
(excluding equity-holder transactions), but is instead only the residual amount of that
change having first made an adjustment to equate the opening value of equity to its
value in real terms at the end of the reporting period.8 There exists a substantial and
divided literature on this subject, for example without consensus on central issues
such as whether the capital to be maintained is financial or physical (Edwards and
Bell, 1961; Whittington, 1983).9 There is consensus in this literature, however, on
profit and capital maintenance adjustments being distinct components of equity, with
the latter categorically not a subset of the former. This is not to deny the importance
of clean surplus (e.g. Ohlson, 1995), but rather to recognise that of the two

8
There is again a connection here with Hicks, whose third and final definition of profit is expressed in
real terms, thereby implicitly making the distinction between profit and capital maintenance.
9
The Framework does not express a preference for either financial or physical capital maintenance, and
in principle it allows either.

8
components that comprise clean surplus, it is profit and not capital maintenance
adjustments that measures the gain in equity in real terms.
The Framework requires some odd wording in order to accommodate capital
maintenance adjustments (para. 81): ‘While these increases or decreases meet the
definition of income and expenses, they are not included in the income statement
under certain concepts of capital maintenance.’ In fact, by their very nature, capital
maintenance adjustments are never included in the income statement, even though
they are constrained by definition to comprise income and expenses. It seems odd,
given that profit is in principle a separate component of equity from capital
maintenance adjustments, that both of these components should be defined to
comprise income and expenses. This is a consequence of viewing income and
expenses as changes in assets rather than as components of changes in equity. There
would be greater clarity from making a definitional distinction between profit and
capital maintenance adjustments, with income and expenses comprising the former
and not the latter. The existence of capital maintenance adjustments in the
Framework therefore suggests the following definition of income.
Definition 3
Income is an increase in equity, excluding contributions from equity
participants and capital maintenance adjustments.
A further issue, which is arguably more fundamental then the discussion so far
in this section, although it is also less readily demonstrable, is that the current
definitions in the Framework have served to suppress discussion of capital
maintenance by the IASB, because there is no apparent meaning in separating capital
maintenance adjustments from profit when both are defined to comprise the same
elements: the premise in the Framework is that because all changes in equity
(excluding equity-holder transactions) are equal by definition to income less
expenses, they ‘belong’ in the income statement. The contrary view, that capital must
first be adjusted in order for profit to be an economically-relevant metric is, in effect,
ruled out from the start. It is striking that capital maintenance adjustments have not
once been on the agenda of the IASB, even though they reside in the Framework.
This in spite of there being long-standing projects in related areas such as financial
statement presentation, measurement and the Framework itself, and in spite also of the
likelihood that capital maintenance adjustments would be economically significant if

9
reported and, finally, in spite of the conceptual and practical debate around capital
maintenance adjustments remaining unresolved.

Reclassification Adjustments (‘Recycling’)

IFRS allows reclassification adjustments, which have the effect of deferring
the recognition of profit or loss in the income statement to a date later than that of
initial balance sheet recognition. For example, gains or losses on available-for-sale
financial assets, as defined in IAS 39 (IASB, 2003), are initially recognised in the
statement of other recognised income and expenses, and so in an equity reserve
separate from retained earnings, and then on realisation (which is the triggering event)
they are reported in the income statement and reclassified from their separate reserve
into retained earnings.
The motivation for reclassification adjustments can be expressed in terms of
primacy for the income statement over the balance sheet, with an emphasis on
conservatism and realisation in the former, though not necessarily in the latter (e.g.
Schmalenbach, 1959). This income statement primacy is achieved by creating dirty
surplus items, in order that profit does not equal changes in net assets (excluding
equity-holder transactions). It can be viewed as an alternative to a strict balance sheet
approach.
Reclassification adjustments create two problems for the definition of income,
expenses and profit in IFRS. The first is that the reporting of these items of income
and expenses outside the income statement has no basis in the Framework. The
second is that profit includes items that are neither income nor expenses under the
Framework, because of the recycling into the income statement, in reporting periods
after initial recognition, of items originally recognised in equity but outside retained
earnings. Overall, therefore, profit excludes income or expenses of the period, while
also including items that are not income or expenses of the period. IAS 1 (BC69)
therefore identifies the need to disclose separately true income and expenses from
‘imposters’: ‘The Boards’ view was that separate presentation of reclassification
adjustments is essential to inform users of those amounts that are included as income
and expenses in different periods.’
There are two ways to deal with these problems. The first is to abandon the
practice of reclassification adjustments, thereby removing the inconsistency between
the Framework and accounting standards such as IAS 39. The second is to amend the

10
Framework to make it consistent with accounting standards. The first of these
solutions would be highly contentious in practice, and the evidence is that the IASB is
unable or unwilling to take this step.10 Given that reclassification adjustments are
likely to remain for at least the foreseeable future, not least because they have wide
IFRS constituent acceptance (FASB, 2010, b), a definition of income is therefore
provided here that would at least ensure consistency between the Framework and
IFRS standards. This is Definition 4. The aim is not to defend dirty surplus
accounting, but rather to provide a definition of income should the IASB decide to
continue with dirty surplus. If, in due course, the IASB decides to eliminate the
practice of reclassification adjustments, then the consequential amendment to the
Framework would be very simple, in effect replacing Definition 4 by Definition 3.
Definition 4
Income is an increase in equity, excluding contributions from equity
participants, capital maintenance adjustments and changes in other
reserves.11
Definition 4 defines income and expenses to be the collectively exhaustive
components of the income statement, such that profit or loss is defined to equal
income less expenses. This approach stands in contrast with current IFRS, which
takes as its starting point definitions of income and expenses that do not have a one-
to-one mapping with the components of the income statement, and so income less
expenses is not equal to profit. This difficult starting point has led the IASB, in its
latest revision of IAS 1, to introduce a term that does not exist in the Framework,
namely ‘total comprehensive income’, which is defined as follows.
Total comprehensive income is the change in equity during a period
resulting from transactions and other events, other than those changes
resulting from transactions with owners in their capacity as owners.12
(para 7)

10
IAS 1’s Basis for Conclusions suggest that the IASB is actually willing but unable.
11
The term ‘other reserves’ is used here to mean reserves relating to other comprehensive income, as
defined in IAS 1.
12
In this definition, ‘transactions with owners in their capacity as owners’ replaces ‘contributions from
equity participants,’ presumably because ‘transactions’ embraces both contributions and distributions,
and because equity participants could transact in alternative roles, such as that of employees. If profit
is defined simply as income less expenses, then both of these definitional complexities go away,
enabling a less wordy definition.

11
 In other words, total comprehensive income is equal, by definition, to income
less expenses (somewhat unhelpfully, the term ‘income’ is used here in two quite
different ways, with ‘total comprehensive income’ being a net concept, analogous to
profit, while ‘income’ is gross).13
The IASB’s answer to the problem of profit not being equal to income less
expenses is therefore not to redefine income or expenses (as, for example, in
Definition 4), but instead to reinvent profit; total comprehensive income is effectively
clean surplus profit by another name. As will now be shown, however, total
comprehensive income in IAS 1 is a confused concept that results from the internal
inconsistencies identified above in IFRS definitions of income, expenses and profit.

Total Comprehensive Income

Profit can be conceptualised from either of two perspectives. On the one
hand, it can be argued that there are not meaningful differences among different
elements of changes in equity (other than transactions with equity-holders), in which
case capital maintenance adjustments and reclassification adjustments should be
removed from IFRS. On the other hand, profit can be viewed as fundamentally
different from either or both of capital maintenance adjustments and reclassification
adjustments, in which case income less expenses should not be defined in IFRS to
equal changes in net assets (excluding equity-holder transactions). The problem with
total comprehensive income is that it imposes the appropriate response to the first of
these two perspectives, yet it does so for accounting standards that in practice adopt
the second perspective. It cannot, in principle, be the right answer. Its introduction to
IFRS creates unnecessary additional complexity in reporting profit, income and
expenses, without resolving any underlying difficulties.
To illustrate, consider the first perspective. It is straightforward in this case to
argue for a single, clean surplus income statement, because there is no conceptual
basis for reporting certain income and expenses in the income statement and others
elsewhere.14 It follows that there is no meaningful distinction between profit and total
comprehensive income, which are simply alternative descriptions of the same thing,

13
Interestingly, it is defined correctly as a change in equity rather than as a change in net assets.
14
This is the case made by those IASB members dissenting to IAS 1. This position is also, of course,
consistent with residual income valuation (Ohlson, 1995).

12
namely the bottom line of the income statement. In other words, total comprehensive
income is redundant as a measure.
If, in contrast, the second perspective is followed, and profit is perceived to
differ fundamentally from other components of changes in equity, then the need for a
summary metric that adds together apples and pears is questionable. For example, if
capital maintenance adjustments are viewed as remeasurements of capital, rather than
as components of financial performance, then there is no conceptual meaning in a
summary measure that adds capital maintenance adjustments to profit. It would also
seem to be inappropriate to use the term comprehensive income for the sum of profit
and other changes in equity (excluding equity-holder transactions), because the whole
point of the other changes is that they should not be viewed as forming part of the
financial performance of the reporting period. Moreover, the term ‘comprehensive’ is
also misleading in this context, because the recognition of changes in net assets in
financial reporting is far from comprehensive.15 This is not just a semantic point. In
the case of cash flow hedging, for example, the very rationale for reclassification
adjustments is that balance sheet recognition is not comprehensive. Again, the point
here is not to defend dirty surplus, but rather to argue that if dirty surplus is adopted in
IFRS, then total comprehensive income is conceptually flawed. And if dirty surplus
is not adopted, then total comprehensive income is redundant.

Conclusion
There are two primary conclusions in this paper. The first is that the
Framework, which is central to financial reporting under IFRS, incorrectly defines
two of the five elements in the financial statements: income and expenses. These are
defined as changes in assets, rather than as their counterpart, changes in equity. It is
unsatisfactory for a conceptual framework to be conceptually flawed in this way.
Profit is not a change in assets: that is not the way double-entry accounting works. If
the simple and accurate communication of financial information is valued, profit
should be described to be what it is, rather than what it is not. The solution is for the
proposed Definition 2 to be adopted in IFRS.
Second, profit should be defined to equal income less expenses, yet in practice
it is not. While neutral on whether IFRS should require, allow or eliminate capital

15
It might also be noted that the term total is redundant given that the term comprehensive is also in
use.

13
maintenance adjustments and/or reclassification adjustments, this paper identifies
inconsistency in IFRS on these issues which, together with the flawed extant
definitions of income and expenses, leads to profit being undefined in the Framework
and flawed in IAS 1. This has in turn led to the introduction of total comprehensive
income, which is a metric that is not defined in the Framework and that lacks
conceptual merit. The solution is either for IFRS to abandon capital maintenance
adjustments and reclassification adjustments, leading to Definition 2, or else for IFRS
to adopt, in part or in full, Definition 4.

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