Accounting income (or reported income) is based on the concept of accrual accounting. While accounting income does reflect aspects of both economic income and permanent income, it does not purport to measure either income concept. Also, accounting income suffers from measurement problems that reduce its ability to reflect economic reality. Consequently, a major task in financial statement analysis is adjusting accounting income to better reflect alternative economic concepts of income. This section describes the process by which accountants determine income. It then discusses analysis implications, including conceptual approaches to adjusting income for analysis purposes.
Revenue Recognition and Matching
A main purpose of accrual accounting is income measurement. The two major processes in income measurement are revenue recognition and expense matching. Revenue recognition is the starting point of income measurement. The two necessary conditions for recognition are that revenues must be: Realized or realizable. For revenue to be recognized, a company should have received cash or a reliable commitment to remit cash, such as a valid receivable. Earned. The company must have completed all of its obligations to the buyer; that is, the earning process must be complete. Once revenues are recognized, related costs are matched with recognized revenues to yield income. Note that an expense is incurred when the related economic event occurs, not necessarily when the cash outflow occurs.
Revenue Recognition and Matching
A main purpose of accrual accounting is income measurement. The two major processes in income measurement are revenue recognition and expense matching. Revenue recognition is the starting point of income measurement. The two necessary conditions for recognition are that revenues must be: Realized or realizable. For revenue to be recognized, a company should have received cash or a reliable commitment to remit cash, such as a valid receivable. Earned. The company must have completed all of its obligations to the buyer; that is, the earning process must be complete. Once revenues are recognized, related costs are matched with recognized revenues to yield income. Note that an expense is incurred when the related economic event occurs, not necessarily when the cash outflow occurs.
Accounting versus Economic Income
Conceptually, accrual accounting converts cash flow to a measure of income. Recall that economic income differs from cash flow because it includes not only current cash flows but also changes in the present value of future cash flows. Similarly, recall that accrual accounting attempts to obtain an income measure that considers not only current cash flow but also future cash flow implications of current transactions. For example, accrual accounting recognizes future cash flows of credit sales by reporting revenue when the sale is consummated and before cash is received. In some respects, therefore, there is some similarity between accounting measures of income and economic income. However, accounting income does not purport to measure either economic or permanent income. Rather, it is based on a set of rules that have evolved over a long period of time to cater to several, often conflicting, objectives. It is a product of the financial reporting environment that involves accounting standards, enforcement mechanisms, and managers’ incentives. It is governed by accounting rules, many of which are economically appealing and some of which are not. These rules often require estimates, giving rise to differential treatment of similar economic transactions and allowing opportunities for managers to window-dress numbers for personal gain. For all these reasons, accounting income can diverge from economic income concepts. Some reasons accounting income differs from economic income include:
Conceptually, accrual accounting converts cash flow to a measure of income. Recall that economic income differs from cash flow because it includes not only current cash flows but also changes in the present value of future cash flows. Similarly, recall that accrual accounting attempts to obtain an income measure that considers not only current cash flow but also future cash flow implications of current transactions. For example, accrual accounting recognizes future cash flows of credit sales by reporting revenue when the sale is consummated and before cash is received. In some respects, therefore, there is some similarity between accounting measures of income and economic income. However, accounting income does not purport to measure either economic or permanent income. Rather, it is based on a set of rules that have evolved over a long period of time to cater to several, often conflicting, objectives. It is a product of the financial reporting environment that involves accounting standards, enforcement mechanisms, and managers’ incentives. It is governed by accounting rules, many of which are economically appealing and some of which are not. These rules often require estimates, giving rise to differential treatment of similar economic transactions and allowing opportunities for managers to window-dress numbers for personal gain. For all these reasons, accounting income can diverge from economic income concepts. Some reasons accounting income differs from economic income include:
- Alternative income concepts. The concept of economic income is very different from the concept of permanent income. Accounting standard setters are faced with a dilemma involving which concept to emphasize. While this problem ispartially resolved by reporting alternative measures of income , this dilemma sometimes results in inconsistent measurement of accounting income.
- Historical cost. The historical cost basis of income measurement introduces divergence between accounting and economic income. The use of historical cost affects income in two ways: (1) the current cost of sales is not reflected in the income statement, such as under the FIFO inventory method, and (2) unrealized gains and losses on are not recognized
- Transaction basis. Accounting income usually reflects effects of transactions. Economic effects unaccompanied by an arm’s-length transaction often are not considered. For example, purchase contracts are not recognized in the financial statements until the transactions occu
- Conservatism. Conservatism results in recognizing income-decreasing events immediately, even if there is no transaction to back it up—for example, inventory write-downs. However, the effect of an income-increasing event is delayed until realized. This creates a conservative (income decreasing) bias in accounting income
- Earnings management. Earnings management causes distortions in accounting income that has little to do with economic reality. However, one form of earnings management income smoothing may, under some conditions, improve the ability of accounting income to reflect permanent income.
As noted earlier, accounting standards are moving away from historical cost and transaction
basis toward a model of fair value accounting. This move is significant because it brings bottom-line income (called comprehensive income) closer to the concept of economic income.
Permanent, Transitory, and Value Irrelevant Components
We note that accounting income attempts to capture elements of both permanent income and economic income, but with measurement error. Accordingly, it is useful to view accounting income as consisting of three components:
basis toward a model of fair value accounting. This move is significant because it brings bottom-line income (called comprehensive income) closer to the concept of economic income.
Permanent, Transitory, and Value Irrelevant Components
We note that accounting income attempts to capture elements of both permanent income and economic income, but with measurement error. Accordingly, it is useful to view accounting income as consisting of three components:
- Permanent component. The permanent (or recurring) component of accounting income is expected to persist indefinitely. It has characteristics identical to the economic concept of permanent income. For a going concern, each dollar of the permanent component is equal to 1/r dollar of company value, where r is the cost of capital.
- Transitory component. The transitory (or nonrecurring) component of accounting income is not expected to recur it is a one-time event. It has a dollarfor- dollar effect on company value. The concept of economic income includesboth permanent and transitory components.
- Value irrelevant component. Value irrelevant components have no economic content they are accounting distortions. They arise from the imperfections in accounting. Value irrelevant components have zero effect on company value.
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