CHAPTER ( 5 )

1 Income Concepts
&
Capital Maintenance Concepts
 The primary objective of financial accounting is to provide information useful to investor in making
predictions about enterprise performance.
 The emergence of income reporting as the primary source for investor decision making has been
well documented, and income reporting aids economic society in a variety of ways, and the following
uses of income as Alexander discussed it:
1. Income is used as the basis of one of the principal forms of taxation.

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2. Income is used in public reports as measure of
the success of corporation`s operations.
3. Income is used as a criterion for determining of
the availability of dividends.
4. Income is used by rate-regulating authorities for
investigating whether those rates are fair and
reasonable.
5. Income is used as a guide to trustees charged
with distributing income to a life tenant while
preserving the principal for a remainderman.
6. Income is used as a guide to management of an
enterprise in the conduct of its affairs.

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 Conclusion: Income determination is important
because a company`s value is related to its
current and future earnings.
 The FASB has indicated that the purpose of
financial accounting is to provide information to
financial statement users that will assist them
in assessing the amount, timing, and
uncertainty of future cash flows.
 During the past three decades. The relationship
of accounting information to the value of the
firm has been of interest to accounting
researchers, then the Efficient Market
Hypothesis (EMH) was introduced.
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 So The (EMH) Holds that a company`s
stock price reflects market consensus
expectations about the company`s future
earnings and cash flows while
simultaneously incorporating information
about the economy and competitor actions.
 The stock price changes in response to new
information that is received periodically
such as quarterly earnings information.
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 The performance of many large companies is
closely followed by financial analysts who provide
quarterly earnings estimates.
When:

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 But this issue may be further complicated by
the existence of a whisper number for closely
followed companies A whisper number
occurs when some financial analyst`s
estimates of a company`s quarterly earnings
differ from their original estimates as the
reporting date approaches.
 The existence of a whisper number can
cause additional positive or negative
earnings announcement surprises and also
can effect the company`s stock price.
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 Example: on January 18,2000, Microsoft Share price
rose to $116.5 in anticipation of the company`s
expected positive earnings surprise announcement the
next day ( its” whisper number” ) however when the
earnings announcement was made on January 19, the
value of Microsoft Shares dropped 8 percent to $107 .
Microsoft actual earnings per share for the quarter was
$0.44 as opposed to an estimate of $0.42, but
analyst`s attributed much of the drop price to
Microsoft inability to meet the whisper number of
$0.49. However, other factors that might have
contributed to this decline were the company`s
ongoing problems with U.S.Justice Department and
management expressed concern about the company`s
ability to meet future revenue expectations.

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 The Nature of Income:
Income may take Various Forms :
1. Psychic income, which refers to the satisfaction
of human wants.
2. Real income, which refers to increase in economic
wealth.
3. Money income, which refers to increase in the
monetary valuation of resources.
 These three concepts are all important, yet each
has both advantages and disadvantages.
The measurement of psychic income is difficult
because the human want are not quantifiable and
are satisfied on various level as an individual gains
real income, Money income is easily measured but
does not take into consideration changes in the
value of monetary unit 9
CAPITAL MAINTENANCE CONCEPTS:
 The Occurrence of Income Implies a return
on invested capital. A return on invested
Capital occurs only after the amount
invested has been maintained or
recovered. Consequently, a concept of
capital maintenance is critical to
distinguish between a return of and return
on invested capital, and thus to the
determination of income.
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 There are two primary concepts of capital
maintenance :

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 The primary difference between Physical Capital
Maintenance and Financial Capital Maintenance lies
in the treatment of holding gains and losses.
* and here a holding gains or losses occurs when
the value of a balance sheet item changes during an
accounting period. For example, when land held by
a company increases in value, a holding gain has
occurred.
 Proponents of physical Capital Maintenance
consider holding gain and losses as returns of
capital and would do not include them in income.
Instead, holding gains and losses are treated as
direct adjustment to equity. Conversely, under the
Financial Capital Maintenance Concept, holding
gains and losses are considered as returns on capital
and are include in income. 12
 The concept of Capital Maintenance used,
And is found in the following way:
1. Find the difference between the value
of the assets less liabilities at the
beginning and end of the period after
adjusting for capital introduced or
withdrawn.
2. Decide how much of the difference ( if
any ) needs to be retained in the business
to maintain capital.
3. The residual is then the profit for the
period. 13
 The Financial Capital Maintenance:
- Not adjusted for inflation ( Money
Financial Capital Maintenance ).
- Adjusted for inflation ( Real Financial
Capital Maintenance ).
 The Physical ( Operating ) Capital
Maintenance :
- From the stand point of the entity.
- From the stand point of the Equity
Shareholder`s interest.
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MONEY FINANCIAL CAPITAL
MAINTENANCE:
 With Money Financial Capital Maintenance the
benchmark used to decide whether a profit has
been earned is the book value of the
shareholder`s interest at the start of the period.
* if money capital is to be maintained then the
profit for the period is the difference between the
values of assets less liabilities at the start and end
of the period with no further adjustment.
* Money Financial Capital Maintenance is used in
traditional historical cost accounting which is not
to say that, we will show it in the Example.

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REAL FINANCIAL CAPITAL MAINTENANCE:
 With Real Financial Capital Maintenance ( which is
often referred to simply as real capital
maintenance ) the benchmark used to determine
whether a profit has been made is the purchasing
power of the equity shareholder`s interest in the
company at the start of the period.
*Thus, if the equity Shareholder`s interest in the
company is $1000 at the start and the general
price level increase by 5 percent in the period
under review, a profit will only arise if, on the
selected basis, the value of the assets less
liabilities, and hence the equity shareholder`s
interest at the time, amount at least $1050. 16
REAL FINANCIAL CAPITAL
MAINTENANCE(CONT`D):

* The amount $1050 (1000 +

(1000*5%)).
 Both the money Financial Capital and the
real Financial Capital Maintenance
approaches Concentrate on the equity
shareholder`s interest in the company and
are hence sometimes referred to as
measures of profit based on proprietary
capital maintenance.
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PHYSICAL ( OPERATING ) CAPITAL
MAINTENANCE:
 The Operating Capital Maintenance
concerned with the physical assets of the
enterprise and suggests that capital is
maintained if at the end of the period the
company has the same level of assets as it
had at the start. We will explain this type
with simple Example.

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* Example:
Suppose a business starts the period with $100 in cash, $20 Widgets
and $32 Flanges.
Then the profit for the period, using the operating capital
maintenance approach, could be regarded as being:
( Profit = $30 in Cash + $5 widgets + $2 flanges ).
 for certain purposes one could stop here. For the list of assets given
above shows the increase in wealth achieved by that business over the
period. To state profit in this way does provide a very clear picture of
what has happened and shows in an extremely objective fashion the
extent to which the business has grown in physical terms. Accountancy,
however is concerned with providing information stated in monetary
terms.

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* In order to take this additional step it is
necessary to select a basis of valuation, for
this would then enable the accountant to
place a single monetary value on the profit.
If we assume that it is decided that
replacement cost is the selected valuation
basis and that the replacement cost at the
end of the year are widgets $100 each and
flanges $150 each.
How we will calculate the profit for the
period?
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 The profit for the period would then be
stated as follows:

Increase in cash 30
Increase in widgets,( 5*$100) 500
Increase in flanges,(2*$150) 300
Profit 830

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EXAMPLE ( DIFFERENT PROFIT
CONCEPTS)
 In this example the three valuation bases used
are: historical cost ( HC ), replacement cost ( RC )
and net realizable value ( NRV ), and the three
measures of capital maintenance are ( money
financial capital, real financial capital and physical
(operating) capital.
Suppose that a trader has an inventory
consisting of 100 units at the start of the year (all
of which were sold during the year) and 120 units
at the end of the year, but has no other assets or
liabilities.
Assume that the trader has neither withdrawn
nor introduced capital during the period. 22
 * Suppose that the following prices prevailed:
Opening position ( 100 units)
Unit price Total Capital
Basis of valuation $ $
Historical Cost 10.00 1000
Replacement Cost 11.00 1100
Net Realizable Value 11.50 1150

Closing position ( 120 units )

Unit price Total Capital
Basis of valuation $ $
Historical Cost 15.00 1800
Replacement Cost 17.00 2040
Net Realizable Value 18.00 2160

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* In order to use the real financial capital approach
it is necessary to know how a suitable general
price index moved over the year, For illustrative
purposes, we shall assume a high rate of inflation.
We will assume that an index moved as follows:

index
Beginning of the year and dates on which the
opening inventory was purchased
100
Date on which the closing inventory was
purchased
118
End of year
120
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 Solution:
(a) Money Financial capital:
The opening money financial capital depends on the selected
basis of assets valuation and profit is the difference between the
value of the assets at the end of the period and the
corresponding figure for opening money capital.

Closing value Opening money

of assets capital Profit
Basic of valuation $ $ $
Historical Cost 1800 1000 800
Replacement Cost 2040 1100 940
Net Realizable Value 2160 1150 1010

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(b) Real financial capital:
1. Historical cost: The Closing Inventory of $1800 ( as
measured by historical cost ) was acquired when the general
price index was 118. The index has risen to 120 by the year
end and thus the historical cost of inventory expressed in
terms of pounds of year-end purchasing power is:
( $1800*(120/118))= $1831.
Opening money Capital based on historical cost was
$1000. the index stood at 100 at beginning of the year and
rose to 120 by the year end. Thus the real financial capital
which has to be maintained is : ( $1000*(120/100))= $1200.
The profit derived from combination of historical cost
valuation and real financial capital is hence $1831-$1200=
$631. ( expressed in year-end ).

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2. Replacement Cost: As the replacement cost is a
current value it is automatically expressed in year-
end pounds and hence the closing value of
inventory is $2040.
Opening money capital using replacement cost
was $1100 which, expressed in year-end dollars, is
equivalent to:
( $1100*(120/100))= $1320.
The profit for this particular combination is
thus:
( $2040-$1320 )= $720
3. Net Realizable value: The argument is similar to
that which was used above and the profit derived
from a net realizable value/real financial capital
concept combination , but how we calculate it ?? 27
 Solution:
$
Closing inventory at net realizable value
( automatically expressed in dollars of
year-end purchasing power ) 2160
Opening money capital
( based on net realizable ) restated
in year-end dollars, ($1150*(120/100)) 1380
Profit 780

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(c) Physical (Operating ) Capital:
In this example it can seen that the wealth of the
business has increased by 20 units , but how we
will value this 20 unit ?

Profit
Basic of valuation $
Historical Cost ( using first in, first out ) 20*$15.00 300
Replacement Cost 20*$17.00
340
Net Realizable Value 20*$18.00 360

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 The various profit figures are summarised in the following
table:
capital maintenance concept
Money Real Operating
Financial Financial Capital
Basic of valuation $ $ $
Historical Cost 800 631 300

Replacement Cost 940 720 340

Net Realizable Value 1010 780 360

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REFERENCES :

 Financial Accounting Theory And Analysis :

( Schroeder , Clark , Cathey ) .

 Advanced Financial Accounting :

( Lewis , Pendrill ) .

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Thank you for your attention

Made by: Rawan Gharbieh

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