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In the conceptual framework has defines income as 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. (AASB framework, para.70a)
Furthermore, income encompasses both revenue and gains. Revenue is income that arises during the course of the ordinary activities of an entity, and is referred to by a variety of different names, including sales, fees, interest, dividends, royalties and rent. Gains are income that arises from the disposal of non-current assets or from the revaluation of current and non-current assets, such as marketable securities and long-term investments, respectively.
In this report we will look at the Income, how it measuring use revenue or expense approach also look at the alternative approaches to price variation problems.
Revenue is the gross inflows of economic benefits during the period arising in the course of ordinary activities of an entity when those inflows result in increases in equity, other than those relating to contributions from equity participants. (AASB 118, para.7)
It can be said that profit over the life of an enterprise is easy to determine. At the end of the enterprise's life, all expenses have resulted in cash outflows, and all the revenue earned has resulted in cash inflows. There is no need for estimates, the results are known with certainty. Profit for the life of the firm is simply the difference between the total cash contributed to the business by the owners and the total cash withdrawn by the owners plus and cash remaining at the end.
The difficulty in reporting profit periodically, which is how economic decision makers require information about the operations of a firm, is that of finding way to put the essentially continuous operations of a firm into discrete time periods. The result is that profit determined earlier, so that it is relevant for evaluating the enterprise performance over shorter decision periods, is unavoidably subject to estimates and judgements, because the whole story is never known until the end, but no one wants to wait for the end.
If revenues and expenses are recognized earlier, so that they are more relevant for decision-making and they will not be as reliable as they would be if recognition were delayed until later, when outcomes of the various economic activities are better known.
Time when recognized in accounts
FIGURE 1. Trade off between relevance and reliability
However, this discussion has not been broad enough to encompass ever type of income, such as gain arising from the sale of non-current asset or an appropriation to a government department from the Commonwealth Government. For example, when the Commonwealth Government takes over the superannuation liabilities of a department, this would result in income for the department totaling the amount by which the liability was reduced.
Back to the framework definition, Income only arises when the entity controls the future economic benefits arising from the transaction or other event. Consequently, revenues will not normally arise before the provision of goods or services by an entity. For example, when a company rents out a property, revenues will not arise until the company has a claim against the tenant for rent in respect of the property. This claim arises progressively as the tenant uses the rental property.
According to the Framework for the preparation of Financial statements, income should be recognized when and only when:
It is probable that any future economic benefits associated with the item will flow to or from the entity; and
the item has a cost or value that can be measured with reliability.
For a above, 'probable' means more likely rather than less likely. For many entities, the majority income will result from the provision of goods and services, and these provisions will involve little or no uncertainty that an inflow of future economic benefits has occurred and since the entity will either have received cash or have an explicit claim against an external party. However, an absence of an exchange transaction will often raise doubts about whether the requisite degree of certainty has been attained.
For b, in most cases the income will be able to be reliably measured. However, in some cases there is a need for estimates. For example, in using percentage of completion method in accounting for construction contracts, the stage of contract completion or the amount of revenues that will ultimately be recognized can be uncertain, and would need to be estimated.
For example, the Framework suggests that if all the criteria were met, the definition and recognition criteria for income would be satisfied. This is because it would be probable that an increase in future economic benefits related to an increase in an asset or the decrease of a liability would have occurred (with respect to the entity acts of performance) and because the economic benefits that had been, or would be received, could be measured reliably.
The Framework states that 'expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants' (AASB 29, para.10). However, this definition of expenses encompasses losses as well as expenses arising in the course of the ordinary activities of the entity.
Expenses arising during the course of the ordinary activities of the business represent economic benefits that are consumed during the current accounting period, such as when stationery supplies are used. Some other expenses are wages and salaries, depreciation, amortization, cost of goods sold, rent and interest. Examples of losses include losses from disasters such as fire and flood, as well as those arising from the disposal of non-current assets. The definition of expenses also include unrealized losses, for example, those arising from the effects of increases in the rate of exchange for a foreign currency in respect of the borrowings of an entity in that currency. When losses are recognized in the income statement, they are usually displayed separately because knowledge of them is useful for making economic decisions.
According to the Framework, an expense should be recognised when, only when:
it is probable that the consumption or loss of future economic benefits resulting in a reduction in assets and/or an increase in liabilities has occurred; and
the consumption or loss of future economic benefits can be measured reliably.
Most expenses result from the production or delivery of goods and services during the accounting period, and the large majority of these involve little or no uncertainty that economic benefits have been consumed, for example, cost of goods sold, cost of employee services, and supplies and equipment used. However, in some cases there will be uncertainty. For example, it may be difficult to determine impairment (in addition to physical wear and tear) during the reporting period.
In addition, generally the consumption or loss of economic benefits will be capable of being measured with a high degree of reliability. However, in some cases this measurement will be subject to estimates (such as future warranty claims). In such cases, whether an item would qualify as an expense depends on whether the estimates can be made reliably. In general, estimates such as warranties, long service leave, doubtful debts and so on can be made reliably based on past experience, and are therefore recognised as expenses. In the framework, it is stated that, for profit-seeking entities who are determining profitability, the matching of revenues and expenses is typical. However, while application of the concepts in the Framework typically results in the matching of expenses should be recognised in a particular accounting period.
Wealth, Income and Capital Maintenance
A change in the purchasing power possessed by an individual represents a change in his or her capacity to engage in transactions. This is true also of business entities. The stock of purchasing power possessed by an entity is commonly referred to as wealth. The wealth of an entity in this sense is depends on two factors, namely the general level of prices and the amount of money or money equivalent at its command. Firms usually do not keep their financial resources in cash, rather they invest them in other assets. If the market prices such assets change, the capacity to command other goods and services will also change. Furthermore, if the value of money as expressed by the general level of prices decreases over a period, the amount of money or its equivalent at the end of period will have less purchasing power than at the beginning. Therefore, it is important that, in financial reporting, any change in these two factors should be identified and accounted for.
In general, in addition to being useful to managers, accounting income is also important for stewardship purposes as well as others such as wage and price fixing and dealing with governments (tax authorities). The conventional accounting model based on historical costs was designed for use in a situation where prices are stable or where prices change slowly. Although it may appear that a reasonable informed reader of conventional accounting reports can make his or her own judgements and allow for the effects of price movements, such effects are likely to be different in different cases, depending upon the composition of assets, method of financing and sources of income.
Therefore, accounting reports themselves should contain such information and also under the framework, whether income is revenue or a gain is a matter of professional judgement that depends upon whether the income arises in the course of ordinary activities of the entity.
Alternative approaches to price variation problems
Two fundamentally different approaches have been taken in different countries at different times, to reflect the effect of inflation in financial statements. One can be characterized as comprehensive, the other is as piecemeal. Under the comprehensive approach, all or at least the main elements of financial statements affected by inflationary price movements are modified from their original amounts. There are the example: Current Purchasing Power Accounting (CPPa), Current Cost Accounting (CCA) and Continuously Contemporary Accounting (CoCoA). For under a piecemeal approach, only selected elements will be modified. Examples are the procedure of provision for the increased cost of asset replacement, revaluation of assets, and etc.
Current Purchasing Power (CPP) accounting
Under CPP accounting, non-monetary assets are adjusted by an index of changes in the general level of prices; all items in the income statement are adjusted by using the same index; gains and losses in monetary items, i.e. cash, receivables and payables, which result from changes in purchasing power of money are recorded additionally to the other conventional items in the income statement. However, the degree of objectivity under CPP accounting is virtually the same as for Historical Cost Accounting (HCA), apart from the selection of the index. The effect of this method is to maintain purchasing power capital instead of financial or nominal capital.
Current Cost Accounting (CCA)
The more widely used and version of current value accounting is known as Current Cost Accounting (CCA). The CCA model is aimed at:
eliminating from operating profit those gains arising on stock appreciation, and
charging by way of depreciation an amount based on the value of the business of the asset consumed during the accounting period.
Edwards and Bell (1961) provide the rationale for RPA and CCA. It is based on the premise that current cost is measure of the cost of the services embodied in the actual asset owned by the company. They assume that the present production process will not change but continue. The unrealized holding gains represent actual economic phenomena occurring in the current period, and therefore something which should be recognised. There is sufficient objective evidence to support the price changes. They also argue that operating profit based on current cost is an indication that the firm is making a positive long run contribution to the economy, and that the production process in use by the firm is effective (Edwards & Bell 1961, pp.98-99).
Continuously Contemporary Accounting (CoCoA)
The CoCoA model is based on the adaptive behavior of business entities, which implies a continual attempt by them to adjust to the changing environmental circumstances. The rationale for CoCoA is fully explained in Chambers (1966). The rationale for CoCoA can be summarized as follows. Adaptive behavior is essential for the attainment and maintenance of given levels of satisfaction of the expectations of the interested parties associated with the entity.
According to the Chambers (1966), the single financial property which is uniformly relevant at a point of time for all possible future actions in markets is the market selling price or realizable price of any or all goods held (p.92).
The CoCoA model requires the revision of asset values to their current cash equivalents (defined as their market resale price if disposed of in the ordinary course of business) at the end of each period.
The statement of Changes in Equity
All reporting entities must also present a statement of changes in equity (SOCE). The content and elements of the SOCE, as set out in AASB 101 Presentation of Financial Statement.
The statement of comprehensive income reports all non-owner changes in equity and the SOCE reports all owner changes to equity that are taken directly to the equity section of the balance sheet. Owner changes in equity consist of selling or buying shares from the owners or shareholders and the payment of dividends. It enables user to observe the overall change in equity during a period as a result of the transactions with the owners.
The income statement is based on the historical cost model of revenue recognition and expense matching. That does not mean, however, that it will not change. Some of the changes in the income statement that have occurred in the past fifteen years provide a hint as to what might be expected in the future. And the process involves deciding when the recognition criteria for expenses are satisified.