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The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting Theory (07 $conomic %ncome !7"#

Introduction

These notes begin with definitions of economic income, the concept of wealth that, according to the deductive approach to accounting theory, financial accounting should be attempting to measure. The definitions are followed by a number of illustrations of how these economic income numbers may be calculated and the notes conclude with an assessment of the usefulness of economic income numbers in practical accounting.

The definitions of economic income

In these definitions, economic income is more or less synonymous with accounting profit and the difference between these two terms (income and profit), in these notes at least, is merely a matter of terminology although this may not always be the case. A deductive approach to financial accounting may stipulate that the purpose of the income statement is to report the true economic income earned by the business in the period covered by the statement. aving adopted this ob!ective, it now remains to

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0 provide a definition of economic income. owever, depending upon the

circumstances, different definitions of this central concept are available.

The definitions usually used in this conte't have been provided by (.). (&*+,$&*-,. &/01&&/), winner of the &*20 3obel 4ri5e for %conomics. that (&*+,$&*-,. &/6).

ic#s

ic#s stated

The purpose of income calculations in practical affairs is to give people an indication of the amount which they can consume without impoverishing themselves. 3ote that the stated purpose is an e'tremely modest one, deliberately so, and a purpose which does not sit too comfortably with more ambitious modern uses of the profit and loss account as the measure of a company7s operating and financial performance.

ic#s (&*+,$&*-,. &/+) defined Income 3o. & as.

8.the ma'imum amount which can be spent during a period if there is to be an e'pectation of maintaining intact the capital value of prospective receipts (in money terms). The phrase capital value of prospective receipts needs some e'planation. 9or

e'ample, consider a person whose only income is a wee#ly salary. in what sense can income in this case be lin#ed to a capital value, given that the person may own no capital: The procedure here is to consider the wee#ly salary as e;uivalent to the income yielded by investing an amount of capital in interest yielding securities. In

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6 this simple way, a stream of income can be converted into its capital e;uivalent and vice versa, a techni;ue commonly used in finance.

The definition of Income 3o. & is in fact a very accurate description of the general way in which profit is calculated under the historical cost accounting convention. Assume an opening capital value of <&// and a capital value at the end of the period of <&&/. Assuming no fresh capital has been introduced by the owners, the income (or profit) is <&/, because this is the ma'imum amount which may be spent to leave intact at the end of the period the opening capital value of <&//. The phrase in money terms is important here because ic#s, !ust as in the historical cost

accounting convention, is assuming that the monetary unit is stable and that there is no inflation.

This definition of income is probably the one that most people use (albeit implicitly) in their private affairs. A savings account containing <&// is increased by the

addition of <&/ of interest to create a new balance of <&&/. "ost people would consider the <&/ income and in spending it (to leave <&// remaining in the savings account) would not consider themselves worse off than before the interest was added to the account. owever, this definition of income is not always a good indicator of

the amount of income which may be spent, especially when interest rates change.

9or e'ample, assume an interest rate of &/ per cent per annum which is e'pected to remain constant for the foreseeable future. A capital sum of <&// will yield an income stream of <&/ each year in perpetuity. owever, assume that the interest rate

increased to 0/ per cent per annum from the beginning of the second period and that

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+ this changed interest rate was e'pected to continue indefinitely. A capital sum of <&// now yields <0/ per annum in income and this income stream is preferable to one which has a value of <&/ per annum.

The complication of a changing interest rate led ic#s to focus on income as a stream of wealth as opposed to a stoc# of wealth and hence leads to the definition of Income 3o. 0 as ( ic#s, &*+,$&*-,. &/=).

8.the ma'imum amount the individual can spend this wee#, and still e'pect to be able to spend the same amount in each ensuing wee#. If the rate of interest remains unchanged, this definition comes to the same thing as Income 3o. & but if the rate of interest is e'pected to change, the two income definitions cease to be identical and that of Income 3o. 0 is to be preferred as will be illustrated later.

A further complication arises when the assumption of stable prices is rela'ed. Income 3o. 6 now becomes ( ic#s, &*+,$&*-,. &/=).

8the ma'imum amount of money which the individual can spend this wee#, and still e'pect to be able to spend the same amount in real terms in each ensuing wee#. If a person7s money income is <&/, then the amount of goods and services which may be purchased with this sum of money will be greater or less by the e'tent to which prices have fallen or risen during the period. 3ote that the definition of Income 3o. &

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= could be modified in the same way to produce a definition of Income 3o. + ad!usted for the real value of money, but ic#s chooses not to do this.

owever,

ic#s does introduce a further complication to the income measurement

problem. All of the three definitions of income provided so far have been defined in terms of e'pectations, i.e., they are e' ante definitions, similar in nature to a budget in management accounting. >ut, e'pectations may not be realised e'actly and values may turn out to be greater or less than e'pected, resulting in windfall gains and losses (or variances from budget, to use the management accounting analogy). ence, for

each of the three e' ante definitions of economic income, there e'ists a corresponding e' post definition which deals with income including windfall gains or losses.

The calculation of economic income

The different definitions of economic income provided by

ic#s will now be

illustrated using a simple numerical e'ample. The e'ample will distinguish between e' ante and e' post definitions of economic income as well as illustrating the effects of both changing cash flows and changing interest rates upon the calculation of the income number.

Income 3o. & e' ante (constant cash flows? constant interest rate)

An investment is e'pected to yield an annual cash flow of <&/,/// in perpetuity. The rate of interest is e'pected to remain constant at &0.= per cent per annum in perpetuity. @hat is the income:

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%' ante variables

A/t/ F&t/ A&t/

B B B

CDpening capitalE CGash flowE CGlosing capitalE

Income 3o. & e' ante. A&t/ H F&t/ I A/t/ B <JJJJJJJJ

Income 3o. & e' ante and e' post (changing cash flows? constant interest rate)

%'pectations regarding both cash flows and the interest rate remain unchanged. owever, actual cash flows turn out to be different from e'pectations, resulting in the opportunity to construct an e' post measure of economic income. The cash received at the end of the first period is actually <&/,==/. At that time (t B &), e'pectations of future receipts are also revised upwards to <&&,/// per annum from time t B 0 in perpetuity. The e'pected rate of interest remains &0.=K per annum. >ecause actual and e'pected future cash flows differ from the original e'pectations, the calculation of economic income will re;uire e' post as well as e' ante variables.

%' ante variables

%' post variables

A/t/ A&t/ F&t/

B B B

A/t& A&t& F&t&

B B B

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2 3ote that each of the e' ante variables (t B /) has an e' post counterpart (t B &) which calculates the same figures (opening capital, cash flow, closing capital) but with the benefit of hindsight based on actual as opposed to e'pected figures and based upon revised e'pectations.

Income 3o. & e' ante remains unchanged. Income 3o. & e' post has two versions, A and >, depending upon whether the changing cash flows are incorporated into the calculation of opening capital. %' post version A calculates economic income with unrevised opening e'pectations.

Income 3o. & e' post version A.1 A&t& H F&t& I A/t/ B <JJJJJJJJJ

%' post version > calculates economic income by incorporating the revised e'pectations regarding cash flows into opening capital.

Income 3o. & e' post version >.1 A&t& H F&t& I A/t& B <JJJJJJJJ

The difference between the two versions of e' post Income 3o. & may perhaps best be illustrated by considering the pattern of economic income calculations over several years as seen below.

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%conomic income & < 3o. & e' post version A 3o. & e' post version > The two versions differ in their treatment of the windfall gains arising as a result of the changing cash flows. Aersion A considers all of these gains as income which may be spent. This results in a stream of income numbers that are consistent with Income 3o. & but which are inconsistent with the definition of Income 3o. 0 because the year & income materially e'ceeds the incomes calculated for the ensuing periods. In order to achieve a measure of Income 3o. & that is consistent with Income 3o. 0, version > needs to be adopted, i.e., revised e'pectations of opening capital need to be used in order to calculate an economic income number which e'hibits a consistent magnitude in each period, which is the underlying re;uirement of the definition of Income 3o. 0 as a constant stream of wealth. 0 < Lear 6 <

Income 3o. & and 3o. 0 (constant cash flows? changing interest rate)

ic#s preferred the definition of Income 3o. 0 when e'pectations regarding the future rate of interest changed. This e'ample illustrates why this is the case. Initial

e'pectations remain unchanged and actual cash flows correspond to initial e'pectations in that <&/,/// is actually received at the end of period & and they are e'pected to remain unchanged in perpetuity. owever, at the end of period &, the

future rate of interest is e'pected to be &/ per cent per annum and not &0.= per cent as in period &. >ecause e'pectations regarding the rate of interest have not been

fulfilled, both e' post and e' ante variables need to be calculated.

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* %' ante variables A/t/ A&t/ F&t/ B B B %' post variables A/t& A&t& F&t& B B B

The calculation of e' ante Income 3o. & remains unchanged. As in the previous e'ample, versions A and > of e' post Income 3o. & may be calculated, depending on whether revised e'pectations are incorporated into the calculation of opening capital (version >) or not (version A). Income 3o. & e' post version A.1 A&t& H F&t& I A/t/ B <JJJJJJJ

Income 3o. & e' post version >.1 A&t& H F&t& I A/t& B <JJJJJJJ

@ill either of these economic income numbers satisfy the definition of Income 3o. 0 as a constant stream of wealth:

%conomic income & < 3o. & e' post version A 3o. & e' post version > 0 <

Lear 6 <

Glearly, neither version of Income 3o. & satisfies the definition of Income 3o. 0 during a period in which interest rates as opposed to cash flows fail to fulfil e'pectations. Income 3o. 0 is in fact <JJJJJJJ. Ghanges in the capital value of an income stream arising as a result of changes in the rate of interest cannot be

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&/ considered as income if income is defined as a constant stream of wealth as in Income 3o. 0.

Income 3o. & and 3o. 0 (changing cash flows? changing interest rate)

9or completeness, an e'ample is given combining changing cash flows with a changing rate of interest in order to illustrate the calculation of two e' post versions of Income 3o. 0 which correspond to the e' post versions of Income 3o. &.

Initial e'pectations remain unchanged. Actual cash received is <&/,==/ and at the end of period & future cash flows are now e'pected to be <&&,/// per annum in perpetuity. The period & rate of interest is &0.= per cent per annum but at the end of period & e'pectations change and the future rate of interest is e'pected to be &/ per cent per annum. As in previous e'amples, unfulfilled e'pectations lead to the calculation of e' post and e' ante variables.

%' ante variables A/t/ A&t/ F&t/ B B B

%' post variables A/t& A&t& F&t& B B B

The calculation of e' ante economic income remains unchanged. Two versions of e' post Income 3o. & are available.

Income 3o. & e' post version A.1

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&& A&t& H F&t& I A/t/ B <JJJJJJJ

Income 3o. & e' post version >.1 A&t& H F&t& I A/t& B <JJJJJJJ

It now remains to calculate Income 3o. 0 in two corresponding versions with and without incorporating revised e'pectations into the calculation of opening capital. If e'pectations regarding the amount of the future cash flow stream are unrevised, then the e'pected stream of wealth will be a cash receipt of <JJJJJJJ per annum. At a rate of interest of &/ per cent per annum, the amount of capital re;uired to produce this stream of wealth is <JJJJJJJ.

Income 3o. 0 e' post version A.1 A&t& H F&t& 1 <JJJJJJJB <JJJJJJJ

Foes this version of Income 3o. 0 result in a constant stream of economic income as re;uired by ic#s7 definition:

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&0

%conomic income & < 3o. & e' post version A 3o. & e' post version > 3o. 0 e' post version A 0 <

Lear 6 <

Glearly, version A of Income 3o. 0 is deficient in producing the re;uired economic income number, hence, revised e'pectations need to be incorporated into the calculations such that the following e;uation is solved.1

Income 3o. 0 e' post version >(L).1 )& (A&t& H F&t& I L) B L

The revised value of opening capital may be used to calculate a constant economic income number as follows.1 A/t& B L H CL ' &E & H r/ r& & H r /

The solution to the e;uation is <JJJJJJJ, and.

Income 3o. 0 e' post version >.1 r& (A&t& H F&t& I L) B <JJJJJJJ

A summary of the e' post economic income numbers calculated in this e'ample is given below together with the income they will yield in subse;uent periods 0 and 6.

4eriod

Income 3o. & Aersion A Aersion > < <

Income 3o. 0 Aersion A Aersion > < <

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&6 & 0 6 9rom the above table it is clear that only version > of Income 3o. 0 produces an economic income number which fully satisfies the definition of Income 3o. 0 in a period in which both cash flows and the rate of interest change.

The usefulness of economic income

These notes now turn to a consideration of the usefulness of the definitions of economic income provided by ic#s for financial reporting by corporate entities. The focus is e'clusively on Incomes 3o. & and 3o. 0 because a consideration of Income 3o. 6 (ta#ing into account changing prices) is the focus of subse;uent lectures on the module.

In financial accounting, income numbers may serve a variety of purposes but generally these purposes fall into one or other of two categories. legal purposes or economic purposes. In certain circumstances, the legal purposes of accounting

income numbers are paramount. Dbvious e'amples are the determination of ta'ation liabilities and the determination of the amount of dividend payable to shareholders which does not threaten the rights of providers of long1term loan finance (whose cash is intended to fund new investment not the payment of dividends). The legal purposes of accounting income become paramount when the rights of third parties other than those of the e;uity shareholders are involved. Glearly, the definitions of economic income provided by ic#s do not provide any obvious guidance for these legal

purposes e'cept in so far as they point out the need to distinguish income

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&+ measurement in money terms from income measurement in real terms because the distinction may have important implications for calculating ta'able income.

owever, the economic purposes of accounting income numbers are more commonly in mind when such numbers are calculated. The purposes here include the

measurement of company performance and for income to act as a guide to the investment$consumption decision. In these circumstances, the usefulness of ic#sian

income numbers may be ;uestioned. The definitions of economic income provided by ic#s are couched in terms of cash flows and interest rates but given these data an income figure is not needed and finance models (based on dividend streams) may be more useful. This would appear to be a central parado' of ic#sian income theory.

Mnder certain conditions, an income number is not re;uired where a simple guide to wealth will suffice (>eaver and Fems#i, &*2*).

It is also the case that the definitions of income provided by

ic#s apply to

individuals but not necessarily to corporate bodies made up of a diverse array of shareholders. This point has been admirably illustrated by 4aish (&*2-). 4aish points out that ic#s7 definitions of income are true only in the limiting case. In other

words, Income 3o. & defines income in terms of capital value only, whereas Income 3o. 0 defines income in terms of an annual income stream only when in fact both of these definitions are e'treme cases and most individuals prefer a mi' of capital value and income. 9or e'ample, a very large capital sum will finance a substantial annual e'penditure for a long time and will be preferred to a small perpetual income. A capital sum of <=,/// receivable now will probably be preferred to a perpetual annual income of <=/ per annum. The decision may change if the amount of the capital sum

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&= fell to <=// from <=,///, and would definitely change if it fell as low as <=/. Mnder certain circumstances an individual will prefer to receive the capital value and in other circumstances will prefer the perpetual income stream. There will be capital values and income streams between which an individual is indifferent, i.e., one will do as well as the other. Dn this basis, an economist may plot an individual7s indifference curve as between capital value and annual income. The graph provided by 4aish (&*2-) illustrates the procedure. The analysis provided leads to the important

conclusion found in the last paragraph of the article (4aish, &*2-. &-&).

Therefore, it would appear that a definition of capital maintenance is essential for the determination of income. A definition of capital determines the welloffness to be maintained while a concept of capital maintenance determines income as opposed to defining the opening capital base. A concept of capital maintenance acts as an economic benchmar# against which to determine whether the shareholders are better off or not.

Two definitions of capital maintenance may be distinguished. maintenance and physical capital maintenance.

financial capital

9inancial capital maintenance

embodies a definition of the capital to be maintained as an amount representing the owners7 interest in the entity and hence ta#es a proprietary view of a company which is seen as an e'tension of the body of shareholders. The concept ta#es two forms. the maintenance of money capital (as in historical cost accounting) or the maintenance of money capital in real terms, i.e., ad!usted for inflation. 4hysical capital maintenance views a business as a separate entity e'isting independently of the claims of its shareholders because in most cases, long1term funds have been raised by a mi'ture of

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&, debt and e;uity. The concept aims to maintain the physical or operating capability of the entity in terms of the supply of the same amount of goods and services.

Fo the definitions of income provided by

ic#s have any practical uses: It may be

argued that their utility is undermined by the sub!ectivity of the numbers involved (especially in terms of e'pectations which may differ) and the problem of choosing an appropriate rate of interest. The definitions also assume that a re1investment

possibility e'ists but this is not always feasible.

To what e'tent are accounting income numbers an effective surrogate for economic income: To what e'tent are reported profits calculated on the basis of the historical cost convention a good appro'imation to economic income numbers: Accounting and economic income numbers coincide in the limiting case of a single pro!ect company with a finite life. The two numbers would also coincide in a perfect and complete mar#et where mar#et values reflected all future cash flows, but this is an e'treme and unli#ely case. Accounting income comes closest to economic income in the property sector and in the case of life assurance companies. owever, in the

manufacturing sector characterised by highly specific assets not traded in active mar#ets, the discrepancies are larger. Nervice companies generate income from

human assets that are not measured in financial statements.

owever, the selection of a good surrogate may act as a guide to income determination. The use of deprival values may appro'imate accounting income to economic income given that economic value (%A) is one of its valuation bases. The problem here is that in most cases the use of deprival value gives replacement cost

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&2 ()G) as a valuation basis which will only appro'imate %A if it is close to the net present value (34A) of the asset. If )G is used as a basis for valuation, which capital maintenance concept is closest to the definitions of ic#s: In fact, the relationship

between )G and 34A determines the choice between financial and physical capital maintenance. If )Gs change as a result of changes in cash flow e'pectations, then Income 3o. 0 can be measured by using financial capital maintenance. >ut, if

changes in )Gs are determined by changes in interest rates, then holding gains may not be distributed as income and physical capital maintenance is to be preferred. This is clearly illustrated by 4aish (&*2-).

owever, changes in )Gs may be caused, in an imperfect mar#et, by other factors such as an increase in demand leading to an increase in price. Is it possible to determine what causes changes in )Gs: There are at least two views here. Dne view is that these causes cannot be identified and that a search for such causes is irrelevant. Another view holds that interest rates move about a norm so that, in the long term, changes in )Gs are caused by changes in cash flow e'pectations. Acceptance of the latter view provides support for the use of financial capital maintenance as changes in interest rates even out over time. A more radical view is that a focus on economic income went out of fashion in the &*,/s and is now viewed as being rather old hat.

owever, there may be other reasons for preferring financial capital maintenance as a basis for determining income. 4hysical capital maintenance insists on the physical e'pansion of the company as a measure of welloffness rather than concentrating on economic value. Increasingly, sources of value are becoming more intangible. It may be argued that financial capital maintenance is an ob!ective that may be shared by all

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&companies regardless of industry sector. 9or e'ample, the MO inflation accounting standard, NNA4 &,, was based on physical capital maintenance and e'cluded ban#s from its scope. @hy should an income measure be based on a concept that does not apply to all companies: 9urthermore, research has shown that for a lot of companies, speculation in the form of one1off pro!ects is common. In these conditions, the preservation of physical operating capacity may be seen as irrelevant as the pro!ects are not continuing.

To the e'tent that the income figure is viewed as a measure of welloffness, then it may be that financial capital maintenance is to be preferred. The dividend distribution decision may be seen as a financial management problem rather than as a primary purpose of the income number. 9inancial capital maintenance has the advantage of lin#ing the wealth of the company to the wealth of the shareholders. It is more difficult to see the entity as important in this conte't. The ;uestion of defining the entity is a large one involving a decision as to whether the entity should be defined in terms of output or in terms of the labour force. maintenance is problematic, as the 4aish criti;ue illustrates. owever, financial capital

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