Table of Contents:
"Measurement Triggering" Transactions and Events
Economists often refer to income as a measure of "better-offenses." In other words, economic income represents an increase in the command over goods and services. Such notions of income capture a business's operating successes, as well as good fortune from holding assets that may increase in value.
The Meaning of "Accounting" Income
Accounting does not attempt to measure all value changes (e.g., land is recorded at its purchase price and that historical cost amount is maintained in the balance sheet, even though market value may increase over time - this is called the "historical cost" principle). Whether and when accounting should measure changes in value has long been a source of debate among accountants. Many justify historical cost measurements because they are objective and verifiable. Others submit that market values, however imprecise, may be more relevant for decision-making purposes. Suffice it to say that this is a long-running debate, and specific accounting rules are mixed. For example, although land is measured at historical cost, investment securities are apt to be reported at market value. There are literally hundreds of specific accounting rules that establish measurement principles; the more you study accounting, the more you will learn about these rules and their underlying rationale.
For introductory purposes, it is necessary to simplify and generalize: thus, accounting (a) measurements tend to be based on historical cost determined by reference to an exchange transaction with another party (such as a purchase or sale) and (b) income represents "revenues" minus "expenses" as determined by reference to those "transactions or events."
More Income Terminology
At the risk of introducing too much too soon, the following definitions may prove helpful:
• Revenues - Inflows and enhancements from delivery of goods and services that
• constitute central ongoing operations
• Expenses - Outflows and obligations arising from the production of goods and
• services that constitute central ongoing operations
• Gains - Like revenues, but arising from peripheral transactions and events
• Losses - Like expenses, but arising from peripheral transactions and events
Thus, it may be more precisely said that income is equal to Revenues + Gains - Expenses - Losses. You should not worry too much about these details for now, but do take note that revenue is not synonymous with income. And, there is a subtle distinction between revenues and gains (and expenses and losses).
An Emphasis on Transactions and Events
Although accounting income will typically focus on recording transactions and events that are exchange based, you should note that some items must be recorded even though there is not an identifiable exchange between the company and some external party. Can you think of any nonexchange events that logically should be recorded to prepare correct financial statements? How about the loss of an uninsured building from fire or storm? Clearly, the asset is gone, so it logically should be removed from the accounting records. This would be recorded as an immediate loss. Even more challenging for you may be to consider the journal entry: debit a loss (losses are increased with debits since they are like expenses), and credit the asset account (the asset is gone and is reduced with a credit).
The Periodicity Assumption
Business activity is fluid. Revenue and expense generating activities are in constant motion. Just because it is time to turn a page on a calendar does not mean that all business activity ceases. But, for purposes of measuring performance, it is necessary to "draw a line in the sand of time." A periodicity assumption is made that business activity can be divided into measurement intervals, such as months, quarters, and years.
Accounting must divide the continuous business process, and produce periodic reports. An annual reporting period may follow the calendar year by running from January 1 through December 31. Annual periods are usually further divided into quarterly periods containing activity for three months.
In the alternative, a fiscal year may be adopted, running from any point of beginning to one year later. Fiscal years often attempt to follow natural business year cycles, such as in the retail business where a fiscal year may end on January 31 (allowing all of the Christmas rush, and corresponding returns, to cycle through). Note in the following illustration that the "2008 Fiscal Year" is so named because it ends in 2008:
You should also consider that internal reports may be prepared on even more frequent monthly intervals. As a general rule, the more narrowly defined a reporting period, the more challenging it becomes to capture and measure business activity. This results because continuous business activity must be divided and apportioned among periods; the more periods, the more likely that "ongoing" transactions must be allocated to more than one reporting period. Once a measurement period is adopted, the accountant's task is to apply the various rules and procedures of generally accepted accounting principles (GAAP) to assign revenues and expenses to the reporting period. This process is called "accrual basis" accounting -accrue means to come about as a natural growth or increase - thus, accrual basis accounting is reflective of measuring revenues as earned and expenses as incurred.
The importance of correctly assigning revenues and expenses to time periods is pivotal in the determination of income. It probably goes without saying that reported income is of great concern to investors and creditors, and its proper determination is crucial. These measurement issues can become highly complex. For example, if a software company sells a product for $25,000 (in year 20x1), and agrees to provide updates at no cost to the customer for 20x2 and 20x3, then how much revenue is "earned" in 20x1, 20x2, and 20x3? Such questions are vexing, and they make accounting far more challenging than most realize. At this point, suffice it to say that we would need more information about the software company to answer their specific question. But, there are several basic rules about revenue and expense recognition that you should understand, and they will be introduced in the following sections.
Before moving away from the periodicity assumption, and its accounting implications, there is one important factor for you to note. If accounting did not require periodic measurement, and instead, took the view that we could report only at the end of a process, measurement would be easy. For example, if the software company were to report income for the three-year period 20x1 through 20x3, then revenue of $25,000 would be easy to measure. It is the periodicity assumption that muddies the water. Why not just wait? Two reasons: first, you might wait a long time for activities to close and become measurable with certainty, and second, investors cannot wait long periods of time before learning how a business is doing. Timeliness of data is critical to its relevance for decision making. Therefore, procedures and assumptions are needed to produce timely data, and that is why the periodicity assumption is put in play.