Accounting Income vs Economic Income

By Ike Onwubuya

The bigger the income, the larger the assumed success. This ambiguity puts income on a pedestal as one of the more important elements of the free market enterprise. This might not be as good a definition as it gets, but accounting has suffered from the lack of a clear cut, operational definition of income on the basis of a well-defined objective. However, despite the non-existence of a sustainable definition of income, the meaning can be interpreted in a variety of ways. First, as a value increment, Where it serves as a flow of gains or benefits from the use of capital. Secondly, it is used as an indication of the efficiency of management, when viewed in connection with the use of available economic resources. Thirdly it serves as an investment predictor.

These are common grounds where the accountants and economists have a subtle agreement. This essay will attempt to evaluate the accountants’ and economists’ concepts of income, and make comparisons on their similitude and identify what differences they might have.

Accountants are of the opinion that income is a surplus arising from business activity, resulting from the cash to cash cycle of business operations and derived from a periodic matching of revenues from sales of relevant costs.[1] This in effect shows that income is measured “ex-post” i.e. after the event has taken place (usually after the financial period). In accounting income, the total of unallocated costs is to be carried forward at the end of each accounting period. These non-monetary assets in association with the with the business’ cash (after liability deductions) are the accounting capital. Accounting (Ya) can be measured with the formula:

Ya = Rt –Rt-1; where Rt is the residual equity at the end of the period and Rt-1 is the residual equity at the beginning of the period. This formula is used if there is no new capital, dividends and if prices remain constant. However, if dividends are paid to shareholders, the formula will be adjusted to Ya = D +(Rt-Rt-1); where D represents dividends. R always represents the accounting capital.

The economist has a somewhat contrasting view to income. Sir John Hicks in his book – Value and Capital (1946) – defined income as what a person can consume during the week and still expect to be well-off at the end of the week as he was in the beginning.[2]   Sidney Alexander approximated this definition in terms of a corporation. He described it as being the amount the corporation can distribute to the owners of equity and be as well off at the end of the year as they were in the beginning. Yet another economist, Irving Fisher described income as a series of perceived events or psychic experiences called enjoyment.

From the views of these 3 eminent economists, we can deduce that economists view income as psychological wants with underlying satisfaction, with 2 basic components of consumption and savings. Economic income (Ye) is thus determined to be equal to consumption and savings (C + S). If savings (S) is interpreted as a periodic change in personal economic capital (K), then economic income (Ye) = C + (Kt – Kt-1); where Kt is the closing capital and Kt-1 is opening capital. This measurement takes into cognisance changes in economic wealth and the need to maintain closing capital at a pre-described opening level before income is recognised.

Economic income is usually measured under 2 conditions, certainty and uncertainty.   The condition of certainty is usually called ideal income. This assumes a world of perfect knowledge of the future, where constant interest rates operate. Ideal income is measured by the notation; Ye = C + (Kt – Kt –1).

On the other hand, there are 2 distinct models for the measurement of uncertainty. These are income “ex ante” and income “ex post”. The ex ante model measures in a world of imperfect knowledge, the expected income of the period as a proportion of the anticipated realisations for the same period. For ex ante, interest rates and values are by and large a matter of prediction. Income ex ante, which is before the event, can be identified as Ye = C’ + (K’t – Kt-1); where C’ is the anticipated maximum possible consumption for the period t-1; K’t is the closing capital at t, and Kt-1 is the opening capital at t-1.

The other model of measuring economic income in a world of uncertainty and imperfect knowledge is income ex post. This measurement is carried out at the end rather than at the beginning of each relevant period. It incorporates adjustments for realised and unrealised gains known as “windfall gains”. Ex post is computed by Ye = C + (Kt – K’t-1; where C is the actual realised consumption for the period; Kt is the closing capital measured at the end of the period and realised due to changes in expectations during the period.

These theoretical models highlighted above fail to satisfy many of the measurement and communication criteria as recognised by the accountant. The traditional accounting concept of income, which uses historic business transaction as its foundation, is measured and reported widely throughout the free enterprise economies. The traditional accounting concept of income has been developed for over a hundred years past as a consequence of the development in investment and a desire of management to minimise tax payment. (Lawfully)

One of the most fundamental purposes of reporting income is to make management accountable for its effort on behalf of its investors and stakeholders.

Accounting income is also useful as the basis for determining taxation; assessing financial strength and determining how credit worthy a business entity is. It is also used to assess lending risks, government fiscal policy, and to determine demand predictions and forecast the future. It is also used to recognise and match costs, which are relevant to the business entity.

Three accountants, Kohler, Ijiri, and Littlejohn over the years have made spirited defences of the accounting income model. First and foremost they infer that historic accounting income has stood the test of time. Secondly, traditional accounting income provides knowledge of historic business activity and hence, prediction of the future can be made using it as a foundation. Thirdly, it is based on verifiable and objective methods and also less open to dispute over information reliability. Last, it is useful for control purposes when reviewing the tenacity of past decisions. It is also used for making management accountable.

There are a few arguments against traditional accounting income. The one most pronounced is that the principles of historic cost and realisation preclude essential information about unrealised income. This means that traditional income may have little use in many decision making functions because it does not include all income reported to date. Secondly, it ignores contemporary valuation in the historic cost basis and makes assumptions for the indefinite existence of the business entity. Traditional accounting income also gives the impression that the balance sheet is a value statement than a statement of allocated resources.

The main differences between economic and accounting income are based chiefly on value increments. Economic income is based on valuation of anticipated future benefits, while accounting is historical and transaction based. It recognises benefit flows only when they are recognised while economic income recognises flows after they are received. This shows that at the point of initial investment, economic capital will exceed accounting capital by an amount equal to the difference between the present value of all the anticipated distributions and the transacted value of the resources at the given time.  Over time, as flows are realised, economic capital (Ye) less accounting capital (Ya) will be become recognised and be accounted for.

By and large economic income is generally defended as an ideal income concept which is impractical to implement because of difficulties in an uncertain world of measuring future cash flows.

I am of the opinion that until a fundamental change to the way income is defined, the accountant’s concept will be the traditional method of determining income.

BIBLIOGRAPHY

  1. a. LEE, Income and value measurement, VNR series, 3RD EDITION

HENDRICKSEN AND BUDGE, CONTEMPORARY ACCOUNTING THEORY,

DICKENSON PUBLISHING COMPANY, 1974.

  1. R. HICKS, VALUE AND CAPITAL, CLARENDON PRESS, 2ND EDITION, 1946.

EDWARDS AND BELL, THE THEORY AND MEASUREMENT OF BUSINESS

INCOME, UNIVERSITY OF CALIFORNIA PRESS, 1961

[1] Tom Lee, income and value measurement 3rd edition ,  page 6

[2] J. R. Hicks, Value and Capital  1946  , page 174

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