The so called ‘balance sheet approach’ to income measurement


Definitions and recognition of Income.

According to paragraph 70 of the AASB Framework, income is defined as:

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in an increase in equity, other than those relating to contributions from equity participants. (Deegan, C, 2007, p.557)

The definition given above is a theoretical definition that is the so called 'balance sheet approach' to income measurement. It means that on a conceptual level, income is the difference between net assets at the beginning of the period and the end of the period. (Morton, A, 2010, p.19)

Income can be subdivided into revenues and gains, which in paragraph 74 states: Income encompasses both revenues and gains. Revenue arises in 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. In another hand, paragraph 75 and 76 of the AASB Framework state: Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Gains also represent increases in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as continuing a separate element in this Framework.

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Gains include those arising on the disposal of non-current assets. The definition of income also include unrealized gains (those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long term assets). When gains are recognized in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Gains are often reported net of related expenses. (Deegan, C, 2007, p.557)

The differentiation between revenues and gains is based on some degree of professional judgment and it is very possible that something that is considered to be a gain by an accountant might be considered to be revenue by another.

Deegan, C (2007, p558) states that "income can be earned from the provision of goods and services, from returns generated from investing in or lending to another entity, from holding and disposing of assets, by receiving non-reciprocal transfer such as grants, donations and bequest, or where liabilities are forgiven." "To qualify as income, the inflows or other enhancement or the savings in outflows of economic benefits must have the effect of increasing equity. Therefore, transactions such as the purchase of assets or the issuance of debt are not considered income because they do not result in equity."

Income can be recognized if:

It is probable (means more likely than less likely) that any future economic benefit associated with the item will flow to or from the entity.

The item has a cost or value that can be measured with reliability. (Deegan,C, 2007, p.562)

The former Australian Conceptual Framework (SAC 4) identified numbers of factors or issues to consider in determining if it is probable that an inflow of future economic benefits has occurred that is capable of reliable measurement. Such factors include when:

An agreement for the provision of goods or services exists between the entity and one or more parties external to the entity.

Cash had been received, or the entity has a claim against an external party or parties that:

Is for a specified consideration in the form of cash , other asset or a reduction in a liability; and

Cannot be avoided by the external party without incurring a penalty set sufficiently large as, in normal circumstances, to deter avoidance

All acts of performance necessary to establish a valid claim against the external party or parties have been completed

It is possible to estimate reliably the collectability of debts or the return of the goods sold. (Deegan, C, 2007, p.563)

Measures of Income.

Hicks, (1946 ,p.172) defines income is measured as 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.

This amount can be measured in two ways:

Traditional revenue or expenses approach.

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Basically relies on the concepts such as the matching principle. In accounting, matching principle used the notion that expenses should be recorded in the same period in which the expenses were used to earn revenues. This is idea that a business should match the maturity of its liabilities with the maturity of its assets. For example, long-term assets should not be financed with short-term liabilities. This principle recognizes expenses when they are incurred, and when they distinguishes between deferred and accrued revenue in order to determine its actual value for the business at a certain point in time. (Karimi, S , 2010, p.1)

Karimi, S (2010, p.1) also explains four different types of timing differences that must be factored into the final reporting of revenue and expenses. Accrued revenues are recognized before the cash from a sale is received; this is similar to a prepaid expense where the revenue is posted to the accounting records before the company has the cash in its accounts. An accrued expense is incurred as soon as the goods or services are received, but no cash has been paid to the vendor. Deferred expenses are considered to be an asset because the amounts of the services or goods are not paid out until the invoice. Deferred income or deferred revenue is considered to be a liability and not an asset until the cash is received. Making sure various accounts are posted with consideration to these timing differences insures that the GAAP matching principle is in effect. In brief, all expenses are matched with the corresponding revenue.

Asset or liability approach, this links profit to changes in asset and liabilities (equity).

This approach relies on the concept of well offness which depends on capital maintenance concepts. The concept of measurement arrived at by comparing the amount of total equity at the end of a period to the amount of total equity at the beginning of the period. If a company had $50 million of equity at the end of the year, however at the beginning of the year it had $19 million, the government could conclude that he earned $31 million during the year. This method is contrast to the transaction approach which calculates net income by subtracting the expense transactions from the revenue transactions. (Accounting Coach, 2010, p.1)

These capital maintenance perspectives could be separated into three divisions:

Financial Capital Maintenance

Financial capital maintenance measures that profit is depending on the amount of net assets. If the amount of net assets increases during a period (excluding equity transactions), there is a profit. If does not increase during the period, there is no profit. The Financial Capital Maintenance concept is used to calculate income under the income statement. This perspective are taken in historical cost accounting which assumes that money holds a constant purchasing power. (Deegan, C , 2006, p.131)

Elliot (1986, p.33) assumes an implicit assumption in the historical cost model is that the monetary unit (unit remains fixed in term of its monetary value) is fixed and constant over time. However, there are three components of the modern economy that make this assumption less valid, for instance, specific price-level changes as technological advances and shifts in consumer preferences; general price-level changes or inflation; and the fluctuation in exchange rates for currencies. Thus, the book value of a company only coincidentally reflects the current value of assets.

Deegan, C (2006,pp.131-133) states many assets can or must be measured at historical cost (inventory measured at net realisable value if cost is lower; plant and equipment can be valued at cost-model pursuant to AASB 116). But, because of changing prices AASB 141 provides the measurement rules for the fair value of biological asset from period to period be treated as part of the period's profit or loss. AASB 141 encourages disclosures which differentiate between changes in fair value based on price changes and physical changes.

There is also an argument historical cost accounting can tend to overstate profits in times of rising prices, and that distribution to shareholders of historical cost profits can actually lead to an erosion of operating capacity which could lead the financial capital or purchasing power remain intact. (Deegan, C, 2006, pp.132-133)