Income Measurement - Analysis of Operating Decisions, Financial Analysis and Reporting | Financial Analysis and Reporting - B Com PDF Download

Income Measurement Approach # 1. The Transaction or the Operation Approach to Income Measurement:

This is the more conventional approach used by accountants and most of the business enterprises adopt this method.

This approach indicates that the changes between asset and liability valuations arise as a result of transactions.

These transactions relate mainly to revenues for the sale of goods and/or services and the various costs incurred in achieving these sales. These transactions include the receipt or payment of cash in some way or other. Moreover, if the eventual cash exchange with third parties is not complete at the point of time while measuring income the same incompleteness is allowed with the help of a process of adjustment. Once the process of adjustment starts, the revenues and costs are then matched for deriving accounting income. Therefore, matching is nothing but the association of effort and accomplishment.

Of course, here the term ‘transaction’ is used in a broader sense which includes both internal and external transactions. An internal transaction is one which arises from the use or conversion of assets within the firm. But an external transaction is one which arises from dealing with outsiders and the transfer of assets or liabilities to or from the firm. The measurement of cost and revenue which are generated from external transactions is easier since they are settled through agreement.

On the contrary the values of internal transactions are determined by the application of some conventional procedures. As such, there remains a change in measuring the transactions in an arbitrary way as a result of which different authorities differ as to the valuation of assets viz., inventories, fixed assets etc.

Needless to mention that if such changes arise from changes in market valuation or from changes in expectations alone, the said changes in value are to be excluded. By the amount that asset valuations are adjusted at the end of the period in order to incorporate these changes, there is a deviation from the pure transaction approach which represents an application of the annual inventory method implicit in the capital maintenance approach.

Income is recognised by the amount that new market valuations replace the input valuations when an external transaction occurs. Internal transactions also may lead to valuation changes, but the same are the product of the use or conversion of the recorded assets. Naturally, when conversions take place, the value of the old asset is transferred to the value of the new asset. So it may be regarded as to the concept of realisation at the time of sale or exchange.

Revenues and expenses are recorded as soon as they arise from the external transactions. The problems arise of timing and valuation for recording each transaction. But the fundamental principal problem is to make a proper matching against the related revenues during a particular period.

The different concepts of incomes can be incorporated into the transactions approach by making proper adjustments to revenues and expenses at the time of recording each transaction and by making adjustments to asset valuations. Therefore, the current accounting practice is a combination of maintenance of capital concepts; operational concept and transaction approach.

Advantages:

The primary advantages of the transaction approach are:

(i) Under this method, profit earned from each product can be determined separately. As such, it provides more useful information to the management.

(ii) The incomes from operations and from external causes can be reported separately.

(iii) It supplies a basis for the determination of the types and quantities of assets and liabilities which exist at the end of the period and, consequently, other valuation methods can easily be applied.

(iv) Recording and analysing the external transactions are essential for efficient managerial work.

(v) Different statements can be prepared to articulate with each other for which a comparative analysis of different data becomes possible.

Income Measurement Approach # 2. The Activities Approach to Income Measurement:

This approach differs from the previous approach, viz. the transaction approach, in the sense that it expresses a description of the activities of a firm rather than on the reporting of transactions alone. In other words, income is believed to arise when certain events or activities take place and not as a result of certain transactions.

For example, activity incomes are recorded at the time of planning, purchasing, production and sales including collection process (i.e., it is an expansion of the transaction approach). Therefore, the fundamental difference between the two approaches is that the former is based on the reporting process which measures an external event, i.e., transaction, whereas the latter is based on the real-world concept of event or activity.

Of course, both of them fail to reflect the measurement of income in reality since they are to depend on the same structural relationships and concepts which have no real world application. Although, this method has an advantage — it allows the measurement of several different concepts of income.

Income Measurement Approach # 3. The Balance Sheet Approach:

This approach is also known as capital maintenance approach. Increase in assets is the result of income. As such, measurement of income requires the measurement of net increase in assets (of a specific accounting period) which are made for the period after maintaining the capital intact.

We know that net wealth/net worth can be measured from the data available in a Balance Sheet. In short, if closing assets exceed opening assets, there is a profit and, in the opposite case, there is a loss. That is, in other words, each item of income is supported by earnings of additional assets and the total assets so earned — minus the portions left for expenses — gives the measure of the net profit or income.

Thus, the measure of net income or profit is the excess of the amount of net assets (assets minus liabilities) or net worth at the end of the period over that at the beginning of the period. It is to be noted in this respect that while finding out income, proper allowances will have to be made as regards introduction and withdrawal of capital within the period and the amount of drawings made within the same for the purpose of measuring income. Since, under this approach, income is measured with the help of opening and closing Balance Sheets, it is called Balance Sheet Approach to income measurement.

Under this approach, the opening assets of a business constantly bring a change. As soon as a transaction occurs, there is a change in assets, either in their shape or in their nature. It is also known to us that a flow comes out of stock and, similarly, an income comes out of capital. Therefore, the income— after mixing up with capital— is circulated again and again for generating further income which usually increases the volume of total assets although a major portion of fixed assets do not bring any change.

Since all transactions bring change in assets, the net increase in assets is recognised by measuring the total income in assets which is the sum total of all individual transactions for the period, i.e. individual effects are not recognised. As all the increase in net assets remain within the business, net income/net increase in assets are measured by taking the difference between closing net worth and opening net worth.

It is to be noted that measurement of net asset needs valuation of both fixed and current assets. There is difference of opinion among accountants as to the valuation of assets. In case of current assets, of course the difference is not so important. But, in case of fixed assets, there is a wide difference of opinion among accountants as to their valuation.

The decrease in value of fixed asset, as a result of use, deterioration in the form of depreciation or any other factor should also be considered, i.e., market value should be taken into consideration in order to maintain the capital intact .

Income Measurement Approach # 4. Value Added Approach:

Under this approach, the income is measured with the help of the value added by the firm during a particular period and the same is determined by the differences between the value of the product/output over the cost of raw materials including stores and necessary components which are purchased from outside and are used in this production process of the concern. In this respect, it must be remembered that the prices so paid for the purchase of materials, stores etc. are to be deducted from that value of the product.

For example, the selling prices of a product of a firm is Rs. 50 per unit with the help of two components —A and B. Suppose component A’ is purchased from outside at a cost of Rs. 10 per unit and component ‘B’ actually is produced by this firm itself at a cost of Rs. 20 per unit which use raw materials purchased at Rs. 16 per unit.

Now the value added per unit will be computed as:

Needless to mention here that the prices of the product must be equal to the marginal utility of the same and same in case of raw materials, stores and components. Naturally, the value added will be the amount of difference between the price of output and the price so paid for material stores etc. from outside and the price of materials to be purchased for the production process. Ultimately it is converted into a finished product for the firm.

The value added is to be a distributed among:

(i) The worker to whom wages are paid

(ii) The supplier of non-manual services to whom expenses are paid

(iii) Supplies of capital to whom interest is paid

(iv) Maintenance of capital by way of depreciation etc.

(v) To the owner to whom profits are to be paid.

To sum up, value added of the firm amounts to:

Wages + Expenses + Interest on Capital + Depreciation + Profit.

In order to measure income accurately, proper determination of expenses and revenues are required since income of an entity is the surplus and revenues over the expenses and costs. Therefore, both the terms, viz., expenses/costs and revenues, need detailed clarification.