Chapter 6

Distinguish between the accounting concept of income and the Chapter 7

economic concept of income. distinguish between recognition and measurement
Accounting income Economic income recognition measurement
It is the gap between total It is the gap between total Transactions that result in Accounting measurement is
revenue and accounting costs revenue and economic cost. the recognition of revenue the representation of data in
include sales assets, services terms of a specific method,
or explicit costs. Economic income includes
rendered, and revenue from the such as currency, hours, or
Accounting profit does not both explicit as well as implicit
use of company assets. units.
account for implicit or costs on its cost side. The The same data can be
opportunity costs in its cost Economic income cannot be revenue recognition principle measured in a variety of ways.
side. taken as a part of accounting is a cornerstone of accrual Maintaining a consistent
Accounting profit can be income. accounting together with the accounting measurement
taken as a part of economic It is a macro concept based on matching principle. allows firms and analysts to
profit. a comprehensive market view. Guidelines compare certain variables over Chapter 8
It is a micro concept based on It is calculated based on revenue recognition will a period of time.
the accounting period. assumptions and long run the affect how and when revenue The unit of measure concept DISTORTION IN ACCOUNTING RESULTS
It is a more practically phenomenon is reported on the income states that all reported currency the monetary postulate underlying historical cost accounting does not
determined and short-run statement. must be reported in the same hold good during the period of changing prices . Consequently, a host
phenomenon Explain how the currency, regardless if certain of problems begin to creep into the accounts with the movement -
revenue recognition principle transactions were done in a upwards or downwards - in prices . Such problems have the effect of
The Accounting Concept of Income
affects how a transaction is foreign currency. distorting the accounting results in various ways . These distortions are
“In general, income refers to increases in wealth. The accounting
recorded manifested in the form , among others of an overstatement of profits
concept of income is consistent with the everyday use of the term:
and an understatement of assets during inflation . Conversely , there is
Income equals increases in net assets if net assets are Rs 1 lakh at the
an understatement of profit and an overstatement of assets when there
start of a period, and Rs. 1.5 lakhs at the end, income is Rs 50,000
Elements of financial statement by IASC is deflation.
(assuming the effects of any new investments by owners and any
The IASC has given only five elements of financial statements against There are three primary factors which contribute to distortions in the
distributions to owners are ignored in computing net income).
the ten elements given by the FASB. They are: ' assets ' , ' liabilities ' , ' reported results. They are depreciation on fixed assets , cost of
Accounting income is defined by the following equation:
equity ' ( in the case of the balance sheet ) , and ' income ' and ' inventories consumed , and purchasing power gains ( losses ) on
I=R–E
expenses ' ( in case of the income statement ) . ' Investment by owners ' monetary assets / liabilities held by the firm during the period of
where
and ' distribution to owners ' (given by the FASB) have been taken care changing prices
I= Accounting income
of in the ' equity ' . Similarly ' income ' will include ' revenues ' and ' Depreciation on Fixed Assets
R = Realized revenues of the period E Expenses
gains ' , and ' expenses ' will include both ' expenses ' and ' losses ' . The The point at which rising prices are apt to have the greatest impact
E= (corresponding historical costs)
grouping made by the IASC is simple and easily understandable. The upon historical cost accounts is the depreciation on fixed assets . As per
Thus, we can say that accounting income is the difference between the
different elements have been defined by the IASC in the following the historical cost convention , fixed assets of an enterprise are taken ,
realized revenues arising from the transactions of the period and the
manner in its framework: for depreciation purposes , to have been purchased at uniform prices ,
corresponding historical costs.
Asset though in practice they are purchased at various prices in the past . The
Physical Concept
An asset is a resource controlled by the enterprise as a result of past total amount of depreciation provided over the working life of the asset
Under this concept, a profit is earned only if the physical productive
events, and from which future economic benefits are expected to flow is equal to the original money cost of the asset ( assuming that the scrap
capacity (or operating capability) of the enterprise (or the resources or
to the enterprise. value is nil ) . Obviously , there would be no difficulty in financing the
funds needed to achieve that capacity) at the end of the period exceeds
Liability replacement of the used - up asset if the prices have not changed . But
the physical productive capacity at the beginning of the period, after
A liability is a present obligation of the enterprise arising from past with the changes in prices , replacement of assets becomes difficult . It
excluding any distributions to, and contributions from, owners during
events, the settlement of which is expected to result in an outflow from is so because the depreciation provision , based as it is , on the original
the period. Financial capital maintenance can be measured in either
the enterprise of resources embodying economic benefits. money investment in fixed assets , represents an amalgam of costs
nominal monetary units or units of constant purchasing power.
Equity incurred at various points of time , and does not represent the same
Financial concept
An Equity is a residual interest in the assets of the enterprise after amount of purchasing power as was originally invested in the assets
Under this concept, a profit is earned only if the financial (or money)
deducting all its liabilities. exhausted during the operations . It will thus be seen that as the level of
amount of the net asset at the end of the period exceeds the financial (or
Income prices goes up , the historical cost basis of depreciation provision
money) amount of net assets at the beginning of the period, after
Income is an increase in the economic benefits during the accounting causes a gap between the annual depreciation provision and the cost of
excluding any distributions to, and contributions from, owners during
period in the form of inflows or enhancements of assets or a decrease in the used up portion of the asset , both measured in terms of purchasing
the period. Financial capital maintenance can be measured in either
those liabilities that result in an increase in equity. power . Over long period , such a difference , being cumulative in
nominal monetary units or units of constant purchasing power.
Expenses nature , tends to widen and leads the firm into a critical financial
Comprehensive income
expenses are a decrease in the economic benefits during the accounting position ; the firm faces difficulties in replacing its fixed assets.
was defined in the SFAC No. 6 as follows
period in the form of outflows or depletion of assets or incurrence of Cost of inventories consumed
Comprehensive income is the change in equity (net assets) of an entity
those liabilities that result in a decrease in equity. Another factor responsible for causing distortions to historical cost
during a period from transactions and other events and circumstances
Measurement of Revenue accounts the cost of inventories consumed. Under the existing
from nonowner sources It includes all changes in equity during a period
Measurement is an assignment of numerical values to represent specific accounting practices, the inventories consumed are valued at their
except those resulting from investments by owners and distributions to
attributes of selected objects or events. Revenue is measured by the money cost of acquisition (or market price, if lower ) but they are
owners.
exchange value of the product or service of the enterprise This value matched with sales revenue expressed at current prices .
Stated more explicitly, comprehensive income comprises
represents either the net cash equivalent or the present discounted value Purchasing Power Gains and Losses
1. All changes in assets or liabilities (or both) from delivering or
of the money claimed to be received eventually from the revenue Purchasing power gains (losses) occur simply because the firm is
producing goods, rendering services, or other activities that constitute
transaction. holding some monetary liabilities and assets which gain or lose
the enterprises’ ongoing major or central operations, and
A question arises as to whether the cash discounts and any reduction in purchasing power during inflation. These gains and losses are in the
2. All changes in owners ‘equity from peripheral, incidental or
the billed prices such as bad debt losses should be deducted from the nature of costs of holding monetary assets and liabilities and should be
occasional transactions of an enterprise and other events and
cash equivalent or present discounted value of the money claims, or taken into account while considering the effects of price changes on
circumstances.
should they be treated as expenses? The traditional view is that they are historical cost accounts.
Recognition Criteria
treated as an expense. Whichever way it is dealt with, net income will Features of the Current Cost Accounting Method
The SFAC No. 5 has defined recognition as the process of formally
remain the same. The salient features of the CCA method are:
recording or incorporating an item into the financial statements of an
Matching and the Measurement of Expenses Fixed assets are shown not at their depreciated original cost but at their
entity as an asset, liability, revenue, expense, or the like. A recognized
The term ' matching ' has a variety of meanings in the accounting net replacement value
item is depicted in both words and numbers, with the amount included
literature. In its broadest sense, matching refers to the entire process of Stocks are shown at their net replacement value
in statement totals.
income determination as identifying measuring, and relating revenue Depreciation is calculated at the current value of assets
An item and information about it should meet four fundamental
and expenses of an enterprise for an accounting period. " Matching may Gains/losses due to the changes in the price level are shown in a
recognition criteria to be recognized.
also be used in a more limited sense to refer only to the process of separate statement
Definition. The item meets the definition of an element of SFAC No. 6.
expense recognition or in an even more limited sense to refer only to Inventory consumed is valued at the price at the date of consumption
Measurability. It has a relevant attribute measurable with sufficient
the recognition of expenses by associating costs with revenue on a Under the CCA method, assets and expenses are shown in financial
reliability.
cause-and-effect basis. statements at the current cost to replace those specific resources.
Relevance. The information about it is capable of making a difference
Measurement of Expenses Thus, profit is measured by comparing revenues with the current
in user decisions.
There are many concepts of income depending upon the objectives of replacement cost of the assets consumed in the earning process.
Reliability. The information is representationally faithful, verifiable,
measurement. Consequently, the measurement of goods and services The current purchasing power (CPP) method is also known as
and neutral.
used in operations also depends upon the definition of objectives. " general price-level accounting.
Difference Between Earnings and Comprehensive Income
Those who define expenses as the net assets of the firm, a logical The current purchasing power method is a technique used to measure
Earnings focus on what the entity has received or reasonably expects to
measurement is the value (exchange price) of the goods and services at financial performance and assets over time by adjusting figures for the
receive for its output (revenues) and what it sacrifices to produce and
the time they are used in operations of the enterprise. effects of inflation. This allows users to understand the true value of
distribute that output (expenses). Earnings also include results of the
On the other hand, those who emphasize the reporting cash flows of the money in terms of what it can purchase at a specific point in time.
entity’s incidental or peripheral transactions and some effects of other
enterprise usually suggest that expenses should be measured in terms of CPP method is useful for finding out real financial position of the
events and circumstances stemming from the environment, while
transactions to which the firm is a party and measured by the past, organization. Following are the advantages/ features of CPP method.
comprehensive income is a broad measure of the effects of transactions
current or future cash expenditures. Generally, the measurement of 1. CPP method adopts the same unit of measurement by taking into
and other events (T & O E) on an entity, comprising all recognized
expenses is made on the basis of historical cost. But due to volatile account the price changes.
changes in equity (net assets) of the entity during a period from T &
changes in prices, replacement costs or current cash equivalents have 2. Under CPP method, historical accounts continue to be maintained.
OE and circumstances except those resulting from investments by
also been proposed. CPP statements are prepared on supplementary basis.
owners and distributions to owners.
Measurement and Valuation 3. CPP method facilitates the calculation of gain or loss in purchasing
Though earnings and comprehensive income have the same broad
the assignment of numerical values to represent specific attributes of power due to the holding of monetary items.
components – revenues, expenses, gains, and losses – they are not the
selected objects/events. Measurability has been explained in SFAC No. 4. CPP method uses common purchasing power as measuring unit. So,
same because certain classes of gains and losses are included in
5. It has been stated that " the asset, liability, or change in equity must the comparative study is easy.
comprehensive income but are excluded from earnings items that fall
have a relevant attribute that can be quantified in monetary units with 5. CPP method provides reliable financial information for taking
into two classes.
sufficient reliability. management decisions to formulate plans and policies.
The Value-Added Concept of Income
The valuation of assets is the process of measuring financial attributes Following are some major points for the limitation of CPP method:
Those countries and governments, which lay a social emphasis on their
(past , present or future ) of assets or aggregations of assets . Thus, 1.CPP method considers only the changes in general purchasing power.
policies, require companies to show in their annual reports how the net
measurement is a broader concept than valuation. The former can have It does not consider the changes in the value of individual items.
income has been distributed among owners and other investors,
many types of attributes. Modern authors favor the concept of 2. CPP method is based on statistical index number which cannot be
creditors, employees, and government. In fact, now there is a trend to
measurement which includes valuation. used in an individual firm.
disclose the social income statement and social balance sheet along
3. It is very difficult to choose a suitable price index.
with other annual financial statements and reports.
4. CPP method fails to remove all the defects of the historical cost
accounting system.
INFLATION ACCOUNTING INDIA
Not much empirical research on inflation accounting practices has been
done in India. A few attempts have of course , been made on
methodology and disclosure of current cost information in the annual
reports of some large companies based upon the requirements of SSAP
- 16 of UK .
An empirical study on inflation accounting practices was completed in
India . Based upon that study , we give below the highlights of its
findings and suggestions :
This is a study of 235 companies having a paid - up capital of more
than Rs . 5 crores in 1979-80 . This was the total number of companies
in the public and the private sectors coming under this category in that
year . Questionnaires were sent to the chief executives of each , and this
was followed , in most cases by personal interviews . The total number
of companies which responded totaled 80. The representative character
of these 80 companies was tested from many angles , and was found to
be satisfactory . Thus , this is a study of 34 per cent of all the
companies in the universe.

Measurement and Valuation

the assignment of numerical values to represent specific attributes of
selected objects/events. Measurability has been explained in SFAC No.
5. It has been stated that " the asset , liability , or change in equity must
have a relevant attribute that can be quantified in monetary units with
sufficient reliability .
The valuation of assets is the process of measuring financial attributes (
past , present or future ) of assets or aggregations of assets . Thus ,
measurement is a broader concept than valuation . The former can have
many types of attributes. Modern authors favor the concept of
measurement which includes valuation .