Concepts of Income

A Critical Analysis of Accounting Concepts of Income Author(s): Norton M. Bedford Source: The Accounting Review, Vol. 26, No. 4 (Oct., 1951), pp. 526-537 Published by: American Accounting Association Stable URL: https://www.jstor.org/stable/242215 Accessed: 13-06-2020 15:40 UTC

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A CRITICAL ANALYSIS OF ACCOUNTING CONCEPTS OF INCOME

NORTON M. BEDFORD

Assistant Professor, Washington University

IN THE last two decades accountants have made remarkable progress toward a synthesis of accounting procedures.

Both the American Accounting Associa- tion and the American Institute of Ac- countants have contributed to this, gather- ing together diverse practices into a some- what cohesive body of acceptable account- ing principles. While it will be contended by some that the statements and bulletins by the accounting groups are not at- tempts to synthesize accounting pro- cedures, a detailed examination reveals that more than anything else such is their nature. More often than not the formula- tions may be viewed as a framework into which prevailing accounting practices are fitted. Of course, it is true that procedures other than those used in practice have at times been suggested, but such suggestions appear to be attempts to reconcile different views.

There has not been universal acceptance of the principles and procedures set forth by the two accounting groups but it ap- pears that enough progress in this direc- tion has been made to warrant an assump- tion that their statements are representa- tive of the views held by accountants. Especially is this so if it is assumed that the formulations are in the nature of syn- theses of extant accounting practice. In addition, the current interest in the con- cept of income used by accountants makes it appropriate to go along with the as- sumptions and examine the concept of income within the various formulations of accounting principles and procedures.

It is proposed here to examine the con- cept of income as expounded within cer- tain of the Research Bulletins of the

American Institute of Accountants and the 1948 Revision of Concepts and Standards Underlying Corporate Financial State- ments by the American Accounting As- sociation. The purpose of this examination is to point out variations in the account- ants' concept of income to the end that future reporting may be improved.

Broadly considered, the accountants' task of measuring income is similar to that of a boy counting the logs which float down a river. Just as a definition of a log is neces- sary for the boy, a definition of the nature of income is needed by accountants. Like the boy selecting a position from which the logs may be counted, accountants must decide from what position or from whose view income should be measured. Finally, just as the boy must choose to count the logs as they come into view, as they pass a certain point, or as they disappear from sight, accountants must decide when in- come is to be recognized.

The foregoing analogy suggests that the solution to the accounting problem of in- come is to be found in answers to the fol- lowing questions:

1. What is income? 2. Whose income should be reported? 3. When should income be recognized? Let us note some of the possibilities

which accountants might adopt as answers to the stated questions and then examine the answers presented in the formulations by the accounting groups.

As to the nature of income, it seems that three concepts of income exist in custom- ary and popular usage:

1. Psychic income which may be viewed as a flow of satisfaction.

2. Real income which may be considered

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A Critical Analysis of Accounting Concepts of Income 527

as a flow of goods or services. However, a definition of a good or a service suggests that more accurately this concept may be thought of as a flow of abilities in goods and service to satisfy wants.

3. Money income which must refer to the flow of money or its equivalent without consideration of the value of money.

As to whose income or from whose view income should be reported, there are several groups interested in each business enterprise and the income accruing to any group might be reported. Thus the re- ported income might reflect the gain of the economic entity, without considering the investors to whom the income accrues, or it might reflect the gain accruing to one or more groups of investors in the entity.

Regarding the time when income should be recognized, there are two phases of the problem, as follows:

1. When shall revenue be recognized? 2. When shall expense and loss be

recognized?

It has been asserted that in reality the problem has but one phase, as the amount of expense or loss to be recognized is simply the cost of obtaining the revenue. This view, however, is avoided here for such is not what the statements advocate in all cases. Therefore, the two phases require separate answers.

It is possible conceptually to recognize revenue in at least the following times:

1. Simultaneous with production and distribution efforts.

2. At the legal sale date. 3. At the disposition date of goods and

services.

4. At the time cash is collected. Expense and loss may likewise be recog-

nized among others in at least the follow- ing times:

1. At the acquisition date of goods and services.

2. At the time cash is spent. 3. At the disposition date of services or

rights in property. 4. At the disposition date of property.

ACCOUNTING CONCEPTS AND STANDARDS

UNDERLYING CORPORATE FINANCIAL

STATEMENTS

In the light of our examination, the Statement by the Executive Committee of the American Accounting Association in- dicates that the accountants' concept of income varies in the following respects.

1. As to the nature of income: a. Accounts imply at times that all gains in

ability to satisfy human wants are reported but attempt to report only a portion of the gains.

b. Accountants sometimes endeavor to meas- ure in terms of money the gain in ability to satisfy human wants. At other times ac- countants report a gain of money as income when there is little evidence that a gain of money measures a gain in ability to satisfy human wants.

2. As to whose income should be reported: a. Accountants tend to report the income ac-

cruing to the'total stock equity group, but do not consider gifts accruing to the total stock equity group as a part of income.

b. Accountants imply that the income of the business entity is to be reported but tend to report the income accruing to the total stock equity group.

3. As to when income should be recognized: a. Accountants state that revenue is to be

recognized at the disposition date of property but revert to the cash receipts date under certain circumstances.

b. Accountants advocate at times that ex- pense and loss should be recognized at the time revenue is recognized, but are forced to recognize certain losses at other times.

c. Accountants recognize some expense and loss at the disposition date of rights in property and other expense and loss at the acquisition date of the rights in property.

d. Accountants insist on objective evidence before either revenue or expense or loss are to be recognized but, nevertheless, they do use considerable subjective evidence.

e. Accountants recognize some expense and loss at the disposition date of property and other expense and loss at the disposition date of the rights in property.

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5928 The Accounting Review

The following discussion sets forth in more detail the variations in the account-

ants' concept of income as it is presented in the American Accounting Association's Statement.

The Nature of Income

The Statement apparently is based on the assumption that the nature of income is obvious or that no acceptable view of it exists, for a specific definition of the nature of income is not presented. Only a

generalization that "The income of an enterprise is the increase in its net assets (assets less liabilities)"' is offered. The following definition of assets is submitted: "The assets or economic resources of an enterprise are its rights in property, both tangible and intangible."2 Thus it appears that income is an increase of net rights in property. Presumably an increase of rights in property refers to an increase in the ability of property to satisfy wants. In any event, income is not construed as a mere increase of physical forms. Also, it would appear that income is not thought of as an increase in money or its equiva- lent.

However, the next sentence reads, "The most commonly useful financial state- ments report the origin and disposition of the assets of an enterprise in terms of costs established and recorded at the time the assets are acquired."3 Presumably this sentence applies to cash and receivables as well as items of merchandise and equip- ment. It seems that the formulation should mean this, for the basic nature of cost is something given up or sacrificed. Thus, the cost of cash is merchandise and other services given up to acquire the cash. This does not mean, however, that

I Unless indicated otherwise, all quotations in this section are from Accounting Concepts and Standards Underlying Corporate Financial Statements, 1948 Revi- sion by the Executive Committee of the American Ac- counting Association. For this quotation see Page 3.

2Ibid., p. 2. 3 Ibid., p. 2.

the cost of cash is the cost of merchandise given up to acquire the cash, for cost may be established by either a purchase or a revenue transaction as is recognized in the American Accounting Association's State- ment. It appears then that accountants believe that all assets on hand or assets sold should be measured at original cost expressed in terms of money. This tenta- tive interpretation of the formulation is strengthened by a later statement to the effect that evidence of cost of an asset purchased

. . . is found in the cash outlay, in the fair market value of any noncash consideration, or, in the absence of these measures of cost, in the fair market value of the asset acquired. The measure of cost for an asset received through a revenue transaction is fair market value, ordinarily indi- cated by the established selling price of the goods or services sold.4

It is not clear whether the Statement refers to income as legal rights in property or economic rights in property, but under either definition we are now in a position to observe that it is possible for rights in property to arise and disappear and yet not influence the reported income of the enterprise. Typical of such unmeasured economic rights in property would be goodwill created and destroyed. Also, definitely an unmeasured legal right in property and possibly an economic right as well would be a contract to buy some- thing in the future.

Therefore, it appears that the account- ants' concept of income is the increase in some rights in property. The rights ex- cluded are those to which no cost is attached. This suggests that there may be a better conception of the nature of in- come inherent in the procedure of measur- ing assets in terms of a money cost. If assets are measured at money cost, income is an increase in the net costs (costs- including cash and receivables-less li-

4Ibid., p.2.

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A Critical Analys is of Accountiny Concepts of Incomte 5 29

abilities) measured in terms of money at the time the cost is incurred. A concept of income as an increase in net costs implies that income is a gain of money or its equivalent rather than a gain of rights in property, for the increased net costs in terms of money was necessarily first recog- nized as a gain of money and not neces- sarily as a gain of rights in property.5 This view of the accountants' concept of the nature of income is strengthened by the realization that under the Statement's implied procedure for determining cost, a mere increase in the price level would yield an income if property were sold and a new cost established by the "revenue transaction." While the formulation does not define "rights in property," it seems that a change in the value of money would not reflect an increase in the rights in property. Therefore, no income should be recognized from a price level change if the formulation's defined view on the nature of income is used. The conclusion is that accountants must think of income as a gain of money or its equivalent. However, this suggestion that income is considered a gain of money or its equivalent is weak- ened by the following footnote:

A marked permanent change in price levels might impair the usefulness of statements report- ing asset costs; however, price changes during recent years do no afford sufficient justification for a departure from cost.6

Clearly this implies that the nature of income is rights in property gained but measured in terms of money. However, it is asserted later in the Statement that "The usual criteria for the recognition of revenue are subject to modification where there is an extended period of collection."7

a This assumes that these increases in assets excluded by the Statement in determining income are not to be -considered a part of the increased costs. For example, an increase in net costs arising from stockholders con- tributions would be excluded.

0lbid., p.3. 7 Ibid., p. 3.

Therefore, in spite of the footnote, a gain of money or its equivalent rather than an increase of rights in property must be considered to be the nature of income, as rights in property must have increased, at least in part, with the acquisition of the right to collect. The deferment of the time for recognizing the increase until cash is received indicates that income must be something other than a mere increase of rights in property.

Before leaving the problem of the nature of income, it seems appropriate to note that conceptually income may be an in- crease in rights in property, but that measurement of such is almost impos- sible. Because of the measurement diffi- culty, it may be intended that only a rough approximation of income of rights in property is possible. However, ifs this was the intent, it seems especially im- portant that this be stated for the pro- cedures advocated definitely determine a money or its equivalent type of income.

The Location of Income Recognition

It is not stated whose income it is that is to be reported or when the income is to be recognized. However, the statement that "The income of an enterprise is the increase in its net assets (assets less li- abilities)"8 and the further observation that "The income of a corporation is not affected by the issuance, acquisition, or retirement of the corporation's own capital shares, adjustments of stockholders' in- terests, or dividend distributions by the corporation,"9 suggests that it is the in- come accruing to the total original stock equity group (the group that contributed to the entity whether or not such are the present owners) that is to be measured. But the sentence that "Revenue does not arise from a gift"10 indicates that some

8 Ibid., p.3.

9 Ibid., p. 3. '? Ibid., p. 3.

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530 The Accounting Review

gain accruing to the total original stock equity group is not income. One might then conclude that it is the income of the economic unit that is to be recognized, for a gift to an economic entity is similar to a stockholder's contribution to the entity, which is not income. But this conclusion is refuted by the statement that "Revenue is a generic term for . . . (c) the gain from advantageous settlement of liabilities."' If the losses of creditors should be treated as income, the reported income must be the gain accruing to the stockholders, for to the entity such is just a change in the nature of the equities in the firm.

However, it is possible to reconcile this seeming variation in the concept of income by assuming that the reported income is the gain earned by the entity for the stock- holders. This requires an assumption that advantageous settlements with creditors are earned gains-in many cases an un- warranted assumption. Also, if retirement of bonds below book value is an earned gain, retirement of senior stocks below book value must be an earned gain for the remaining stockholders. It is even a gain to the original junior stock equity group, for to the junior stock equity group, senior stock carries an economic status similar to bonds.

The Timing of Income Recognition

The wide disagreement in practice as to when income should be recognized is re- flected in the Statement at many points. The Statement starts with the view that

Revenue is recognized upon the transfer of an asset, the performance of a service, or the use of a resource of the enterprise by another party, ac- companied by a concurrent acquisition of an asset or a reduction of a liability.'2

The implication that revenue is to be recognized at the disposition date of assets

11 Ibid., p. 3. 12 ib., p. 3.

or services is definite. Yet it is stated later, "The usual criteria for the recogni- tion of revenue are subject to modification where there is an extended period of col- lection.... "13 This implies that revenue is to be recognized upon the receipt of cash. The formulation makes no attempt to synthesize the two variations in the times of realization. It is believed that such a synthesis would be accomplished by stating that revenue is to be recognized when the asset acquired will be collected or used in the business within a certain period of time.'4

The statement that "Expense is the cost of assets or portions thereof deducted from revenue in the measurement of in- come"''5 implies that expense and loss could be recognized at a time other than when revenue is recognized-as complete matching of costs and revenues on a product basis would do. This implication is revealed when the term "deducted from revenue" is used. Had it been intended to match costs and revenues on a product basis, it should have been stated that expense would be the cost associated with the obtaining of the revenue. From this implication, one must conclude that the statement is based on the assumption that revenue and expense and loss should be recognized in part as separate items.'6

As to when expense and loss is to be recognized, it is indicated that it may be recognized at different times, as follows:

Expense is given recognition in the period in which there is (a) a direct identification or as- sociation with the revenue of the period, as in the case of merchandise delivered to customers; (b) an indirect association with the revenue of the period, as in the case of office salaries or rent; or (c) a measurable expiration of asset costs even though not associated with the production of

13 Ibid., p. 3. 14 Such a synthesis would greatly improve present-

day procedures of installment sales accounting. 15 Ibid., p. 3. 16 Conclusions from implications are not sound

enough for our purposes. However, further reading of the Statement suggests that the conclusion is justified.

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A Critical Analysis of Accounting Concepts of Income 531

revenue for the current period, as in the case of losses from flood or fire. The revenue deductions of a period include all costs not previously de- ducted from revenue and not applicable to future periods.'7

While the Statement presents a three- way classification of the times for recog- nizing expense and loss, the basic feature of all three phases of the classification is the assumption that the disposition date of rights in property is the time to be used. This is revealed by the sentence to the effect that all costs "not applicable to future periods" revenues should be recog- nized as expense and loss of the current period. This must mean that the loss of rights in property as well as the disappear- ance of property may be considered as a loss, for all costs must be expenses or losses unless assignable to the production of revenue in future periods. Since some portions of the rights in property, which are not assignable to revenue in future periods may be associated with the bring- ing in of current revenue and other por- tions not so associated, it appears that losses of rights in property are considered to be a deduction prior to the disposition of the property containing the rights.

At one point it is implied that certain items should be recognized as expense or loss even prior to the disposition date of the rights in property. This is revealed by the suggestion that certain selling and administrative costs should be charged off as expense in the period in which acquired, for it is generally recognized that many selling and administrative costs are ac- quired in one period of time and used to produce revenue in another period of time. Therefore, the rights in property should be thought of as not being disposed of until the revenue is recognized.

In the main accountants desire objective evidence of the disposal of rights in property. But subjective evidence is indi-

17 Ibid., P.4.

cated as suitable in certain instances. This is revealed by the following sentence:

Expense not subject to precise measurement should be based on estimates of a definite and con- sistent character and should be in reasonable con- formity with policies generally established within the industry or trade.'8

As a result of the conflict between ac- curacy and objective evidence, it seems that accountants at times recognize losses at the disposition date of property and at other times recognize losses at the dis- position date of rights in property. The second procedure is used when obsolete merchandise is written down. The dis- position of property date is necessarily used when it is discovered that the buyer of property will not buy all of the apparent rights in the property, but does buy the property for some of the rights in it. As a result, the rights lost by not being sold are recognized as a loss, although considered as an expense, on the date the property is sold.

Summary

If the American Accounting Associa- tion's Statement is representative of the accountants' concept of income, one must conclude that considerable development in accounting must take place before complete consistency will exist in the accountants' concept of income.

ACCOUNTING RESEARCH BULLETINS

It is necessary to note the nature of these bulletins. In the first place, they represent guides to practicing accountants in handling special situations. The Com- mittee on Accounting Procedure indicated that the bulletins are directed toward the problems of accounting for profit enter- prises. Several of them are applicable to the war years alone and do not bear on practice at the present time. Also, some bulletins imply accounting treatment dif-

18 Ibid., p. 4.

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The Accounting Review

ferent from that advocated in other bulle- tins. Therefore, it seems that the bulletins must represent pronouncements of a na- ture which can hardly be called standards or principles of accounting.

Although the bulletins are not a formal statement of accounting standards, it is evident that underlying them are certain basic concepts which do not change with every slight change in economic conditions. It appears that the questions considered here on the nature of income, the entity or persons whose income should be re- ported, and the time for recognizing in- come are somewhat basic in nature and should be somewhat consistent. There- fore, the bulletins may be examined as though they reflected the accountants' concept of income.

In the light of this examination, the bulletins by the American Institute of Accountants indicate that the account- ants' concept of income varies in at least the following respects.

1. As to the nature of income: a. Accountants generally report a money or its

equivalent type of income but at times at- tempt to report a gain of rights in property as income.

b. Accountants generally report money or its equivalent as income but do not report all of it as income.

2. As to whose income should be reported: a. Accountants imply that the income re-

ported should be that accruing to present stockholders, but do not recognize gains and losses on retirement of stock as income.

b. Accountants state that the income of the legal entity should be reported but prepare consolidation returns and at times report the income accruing to more than one group.

c. Accountants report the income accruing to the total original stock equity group yet refer to bond interest as a claim against in- come. If bond interest is a claim against in. come, accountants must consider net in- come to be that accruing to the economic entity or to all investors.

3. As to when income should be recognized: a. Accountants recognize revenue at the sales

date, collection date, and construction date but are not consistent as to when each should be used.

b. Accountants recognize expense and loss at the disposition date of rights in property, at the acquisition date of right in property, and at decision of accountants or manage- ments.

The Nature of Income

These bulletins, like the American Accounting Association's Statement, fail to set forth the exact nature of income or what it is considered to be. However, the insistence on cost valuation throughout the bulletins suggests that money or its equivalent is the nature of income. George 0. May implies that the cost basis of accounting assumes an accounting for money or its equivalent. He states this in the following terms:

Accountants who are most insistent on cost as the basis of charges against revenue would prob- ably say that over the life of the enterprise the income is the money or other property withdrawn (measured in terms of money at the time of with- drawal) over the amounts of money or property paid in (measured in terms of money at the time of contribution).19

If we can now establish satisfactorily that the bulletins do insist on cost, it would appear correct to conclude that accountants consider income to be money or its equivalent. A desire for the cost basis of valuation is expressed in several bulletins, as follows:

Accounting for fixed assets should normally be based on cost, and any attempt to make prop- erty accounts in general reflect current values is both impractical and inexpedient. Appreciation normally should not be reflected on the books of account of corporations."

Generally book or balance-sheet values (using the word "value" in this sense) represent cost to the accounting unit or some modification there- of.21

19 George 0. May, Business Income and Price Levels- An Accounting Study (New York, 1949), p. 25.

20 Committee on Accounting Procedure, Accounting Research Bulletins, No. 5, p.37.

21 Ibid., No. 9, p. 85.

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A Critical Analysis of Accounting Concepts of Income 533

The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location

In spite of their constant reference to cost as the basis of valuation, the bulletins also sanction procedures wherein amounts other than costs should be charged off as expenses. The following statement is sufficient to indicate that the bulletins are not unanimous in their implication that income is money or its equivalent.

The committee is of the opinion that when such appreciation has been entered in the books, income should be charged with depreciation com- puted on the new and higher values. The propo- sition is the most important part of the present statement and for it there seems to be general support'

However, there is a far more extreme departure from the concept of income as a gain of money or its equivalent. This has to do with the part of the money or its equivalent which will be recognized as income, for all money or its equivalent earned or lost is not a factor in income determination. This is revealed when direct charges to surplus are suggested as follows:

The committee recognizes the great impor- tance of distinguishing between charges against income and charges against earned surplus. It does not here undertake to define proper charges against earned surplus. For purposes of this state- ment it simply takes cognizance of the fact that such charges are from time to time found to be necessary though perhaps a debatable feature of accounts.24

The foregoing statement provides evi- dence to the effect that all money or its equivalent earned or lost is not to be con- sidered as income. Since the bulletins

22 [bid., No. 29, p. 237. 23 Ibid., No. 5, p. 38. 4 Ibid., No. 8, p. 64.

have not set out in clear terms which losses or gains should not be included, it would appear that the items excluded would vary from. one company to another. Therefore, by implication, one might con- clude that the accountants' concept of income varies in what is considered income and what is excluded therefrom. Such a conclusion is supported by a survey of published annual reports.

The Location of Income Recognition

The views expressed in the bulletins on whose income should be reported indicate that some variations prevail in this phase of the problem.

The bulletins start with the statement that "accounting problems have come to be considered more from the standpoint of the current buyer or seller in the market of an interest in the enterprise than from the standpoint of a continuing owner."21 This dearly implies that the income accru- ing to present stockholders or creditors and stockholders, or some type of an approximation to it, should be reported. This implication is supported by the statement that "Earned surplus of a sub- sidiary company created prior to acquisi- tion does not form a part of the con- solidated earned surplus of the parent company and subsidiaries.26 If only earn- ings since the parent company acquired the subsidiary company stock is to be considered as income, it appears that it is the income of present stockholders which the accountant should report.

In spite of these two statements, the Committee is somewhat at variance to this view when it supports the concept that the retirement of stock at above or below book value should not be considered in determining net income.27 This means that the Committee must consider the

2, Jbid.,No.1,p.1. `6 Ibid., No. 1, p. 6. 27 Ibm., No. l, p. 7.

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534 The Accounting Review

reported income to be that accruing to some total original equity group's invest- ment. Such a group is not the same as the present equity group which was indicated in an earlier bulletin as a desirable objec- tive.

More than one view of whose income should be reported may be reflected in the following statement:

The income of an enterprise may be divisible among many interests in a certain order of pri- ority. The portion which remains after deducting prior charges is the net income from the stand- point of the interest or interests then remaining. As used in corporation accounting, therefore, net income means the portion of gross income remain- ing after deducting all claims (such as bond in- terest) ranking ahead of that of the corporation as a legal person.28

One can only guess as to the meaning of "all claims ranking ahead of that of the corporation as a legal person." However, the example "such as bond interest" may indicate that the committee felt that the income to be reported should be that accruing to the total original stock equity group. If this is the conclusion to be reached, the bulletin is inconsistent in the following paragraph which reads as fol- lows:

"Net income" is used to indicate the balance remaining after deducting from gross income all negative elements not heretofore deducted and also claims against income ranking ahead of that of the person, natural or legal, with respect to whom the term is used. From this standpoint a statement of income might properly take the following form:

Sales xxxxxX Less cost of sales xxxxxx

Gross income xxxxxx Deduct expenses xxxxXX

Net income from sales xxxxxx Deduct bond interest xxxxxx

Net income of corporation xxxxxx Pref erred dividends mpXX

Net income for common stock xxxxxx29

28 Ibid., No. 9, p. 72. 29 Ibid., No. 9, p. 73.

The derivation of a net income for com- mon stock indicates that the final income to be reported is not that accruing to a total stock equity group but that accruing to a junior stock equity group.

The reference in the bulletins to "posi- tive and negative elements" in the de- termination of income and further ref- erence to "claims against income" suggests that the net income to be reported should be that of the economic entity. From such a reported income various claims would be deducted. The following definition of the income statement supports this view:

Income Account (or Income Statement): An account or statement which shows the principal elements, positive and negative, in the derivation of income or loss, the claims against income, and the resulting net income or loss of the accounting unit.30

It is well recognized that a claim is a distribution of income whereas a negative element in determining income is taken into consideration before income is re- ported. Therefore, since the stockholders must consider bond interest a negative element in determining their income rather than a claim against their income, one must conclude that income is not that accruing to stockholders, if bond interest is a claim against income.3'

A little reflection suggests that only to the economic entity or to the combined creditor and equity group could bond interest be considered a claim against income rather than a negative element in determining income.

One might be inclined to approve the variation in the foregoing statements on the grounds that the conclusion reached-to to the effect that the income to be reported is that accruing to the "accounting unit" is desirable. However, since the accounting unit might be several possible groups of equity holders, it becomes evident that

30 Ibid., No. 9, p. 84. 31 Ibid., No. 9, p. 72.

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A Critical Analysis of Accounting Concepts of Income 535

that accountants' concept of income is not clear cut. Unless the "accounting unit" is well defined, practice may vary in the application of the concept.

From an economic point of view, the statement that "The income of the cor- poration is determined as that of a sep- arate entity without regard to the equity of the respective stockholders in such income,"32 suggests that the decision as to whose income should be reported is an uncrystallized concept. This is apparent when one realizes that a corporation could be defined as the economic entity or any group interested in the economic entity. That is, a corporation is not just a group of owners but is a being separate from the owners. In one sense, the corporation must view both stockholders and creditors as sources of funds. While it is possible to define a corporation as a group of stock- holders, such is not the basic nature of the corporation. Because of the indefinite nature of the concept of a corporation, it may be defined in various ways.

There is an indication that the bulletins are not concerned with the income accru- ing to any group below the total original stock equity group. This is suggested by the statement that "adjustments resulting from transactions in the company's own capital stock . .. should be excluded from the determination of net income under all circumstances."33 All groups of rank less than the total original senior stock equity group would necessarily consider some or all gains or losses resulting from stock re-acquisition in computing income.

In summary, the bulletins indicate that no little confusion exists on the question of whose income should be reported. While the bulletins may be partly consistent if considered from the legal approach, the economic approach indicates that several

variations exist. It hardly seems necessary

32 Ibid., No. 11, p. 103. 3 Ibid., No. 32, pp. 264-65.

to point out that the economic approach is more fundamental.

The Timing of Income Recognition

The time for recognizing revenue is indicated by the following statement:

This committee has heretofore stated that in- come is a realized gain and in accounting it is recognized, recorded, and stated in accordance with certain principles as to time and amount; that profit is deemed to be realized when a sale in the ordinary course of business is effected un- less the circumstances are such that the collection of the sales price is not reasonably assured; that delivery of goods sold under contract is normally regarded as the test of realization of profit or loss.

In the case of manufacturing, construction, or service contracts, profits are not ordinarily recog- nized until the right to full payment has become unconditional, i.e., when the product has been delivered and accepted, when the facilities are completed and accepted, or when the services have been fully and satisfactorily rendered. This accounting procedure has stood the test of ex- perience and should not be departed from except for cogent reasons.

It is, however, a generally accepted accounting procedure to accrue revenues under certain types of contracts, and thereby recognize profits, on the basis of partial performance, where the circum- stances are such that aggregate profits can be estimated with reasonable accuracy and ultimate realization is reasonably assured.3

The variations are even stated. Such

variations might not be undesirable if one knew exactly when and under what conditions each time should be used. The failure to do this leaves the time for recog- nizing income indeterminate, and the amount of income reported can vary considerably depending upon which time is selected. For example, two accountants might present different income results for the same firm in the same period of time if one elected to use the installment basis for recognizing income and the other chose the sales date as the recognition point.

Because of the different times now used for recognizing income in general purpose

84 Ibid., p. 157.

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536 The Accounting Review

accounting statements, more satisfactory reports will be rendered if only one time is used for recognizing income. Until that one time can be selected, it would seem advisable to indicate clearly when dif- ferent times may be used.

Having noted some of the variations in the time for recognizing revenue, let us now examine the time for recognizing expense and loss. The statement "Profit is deemed to be realized when a sale in the ordinary course of business is af- fected"3 has interesting implications. It suggests that expense and loss could in some instances be recognized at the dis- position of property date.

However, the following statement sug- gests that a different time and different evidence should be used for recognizing expense and loss.

From the strictly accounting point of view the depreciation charge against income is the element of primary importance. It should fairly reflect the consumption or expiration of property usefulness that has taken place.3

The different time implied is the disposi- tion date of the rights in property rather than the disposition of property date noted previously. The distinction between the two dates is that losses may be recog- nized well before any disposition of property date if accountants recognize the loss of rights in property prior to the disposition of the property.

The Committee later states:

... that it is plainly desirable to provide .. for all foreseeable costs and losses applicable against current revenues, to the extent that they can be measured and allocated to fiscal periods with reasonable approximation.37

The words "approximation" and "allo- cated" suggest some type of a decision by managements or accountants as the basis for recognizing losses. Still later, the Com-

35 Ibid., No. 1, p.6. 36 Ibid., No. 5, p. 38. 31 Ibid., No. 13, p. 111.

mittee states "that in accounting for tangible fixed assets, depreciation is used in a specialized sense and not to describe downward changes of value regardless of their causes."38 This statement supports the view that depreciation should be based on a subjective decision. It also suggests that a time other than the disposition date of rights in property may be used for recognizing some expense and loss. This suggestion is confirmed by the following statement:

The various methods of computing deprecia- tion in use obviously rest on materially different assumptions. The fact that methods are em- ployed which produce as widely different alloca- tions as (a) the diminishing balance method; (b) the sinking-fund method; and (c) a unit-cost method, emphasizes the truth that the allocation bears no close relation to change in value and does not attempt to measure the exhaustion which actually takes place within a given period-an important truth that is not always fully under- stood. All that the various methods have in com- mon (which is all that could be embodied in a definition) is that they are designed to distribute the estimated total depreciation incurred or to be incurred during the useful life of a unit or group of units over that life in a systematic and equitable manner.39

Under this conception, depreciation ex- pense is recognized at the time indicated by some systematic method of allocating costs. Further support for this conclusion is given by the following statement.

Depreciation accounting is a system of account- ing which aims to distribute the cost or other basic value of tangible capital assets over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. Depreciation for the year is the portion of the total charge under such a system that is al- located to the year. Although the allocation may properly take into account occurrences during the year, it is not intended to be a measurement of the effect of all such occurrences,40

It has been indicated that the bulletins

38 Ibid., No. 16, p. 137. 39 Ibid., No. 16, pp. 141-42. 10 Ibid., No. 20, p. 167.

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A Critical Analys-is of Accounting Concepts of Income 537

differ in that expense and loss may be recognized upon two types of evidence; namely, upon the disposition of the prop- erty and upon a subjective decision that rights in property have disappeared. In addition, there is evidence that loss may be recognized upon a third type of evi- dence. This third type is a decline in mar- ket price. It is discussed in the bulletins under the valuation of inventories, in the following terms:

A departure from the cost basis of pricing the inventory is required when the usefulness of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their dis- posal in the ordinary course of business, will be less than cost, whether due to physical deteriora- tion, obsolescence, change in price levels, or other causes, the difference should be recognized as a

loss of the current period. This is generally ac- complished by stating such goods at a lower level commonly designated as "market."'"

In summary, it has been pointed out that income is recognized at several dif- ferent times and upon different evidences, and that no specific standard has been set as to when the different times or different evidences should be used. While the prac- titioner is undoubtedly more concerned with the circumstances under which each time and evidence should be used, the theoretical problem is to have all income recognized at one time for such would permit more accurate interpretation to be made of accounting reports.

4' Ibid., No. 29, p. 238.

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