Accounting and Economic Concepts of Income and Value

Accounting and Economic Concepts of Income and Value

Accounting concepts

Accounting concepts of income and value have been influenced mainly by two conventions-the cost and the realization convention. These conventions have received much criticism in recent years because they restrict the usefulness of financial accounting reports for decision-making purposes.

The effects of the cost convention

The basis of valuation in financial accounting is historical cost. This convention clearly conflicts with the going-concern convention of valuation when the value of money itself is changing. In effect, historical cost income is based on a venture rather than a going-concern view of the firm.

Under the venture concept, each asset purchased is regarded as a separate venture, so that income is determined for each venture. Thus, net income is measured by setting off against revenues the cost of the assets ventured in earning those revenues. The replacement of those assets is treated as a distinct second venture, for which funds should be raised independently.

By contrast, the going-concern concept which is supported by most businessmen and economists holds that the business enterprise should be considered as a unified continuing concern rather than a series of separate individual ventures.

The historical cost method of valuation seriously distorts the measurement of income, when the value of money is changing. This distortion results from the difference between the historical cost and the current cost which, as we shall see later, is a function of the time gap between the acquisition and the utilization of assets committed to earning periodic revenues. For items such as wages and other current expenses, this difference may be very small, but for such assets as inventories and fixed assets, there may be a substantial difference between the acquisition cost and the current cost when those assets are charged against revenue under the matching rule. Under conditions of rising prices, the historical cost may bear no resemblance to the current cost of assets, with the result that income is overstated. Conservative asset values on the balance sheet are contrasted by over-optimistic income measurements in the income statement.

The historical cost method of valuation creates a particular problem in periods of inflation when money units of different values are brought together in the accounting process as though they were money units of the same value. Such arithmetic is quite incorrect, for it involves adding together amounts expressed in different measurement scales. Accordingly historical cost values are not additive during periods of changing money values.

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The purpose of this website is to examine the implications for financial reporting of three concepts-capital, value and income. Two meanings may be attached to the concept of capital. First, capital may be seen as the totality of enterprise assets which give rise to income. Second, capital may be seen as the investment made by shareholders in the equity of the enterprise and from which they expect to derive income in the form of dividends. Investors are concerned not only with the interdependence of the value of their shareholdings and the value of enterprise assets, but also with maintaining the... see: Financial Reporting Summary