Measurement of Business Income – tryspring

By | October 7, 2019

Measurement of Business Income

One of the most significant accounting concepts is “Concept of
Income
”. Similarly, measurement of a business income is also
an important function of an accountant.

In General term, payment received in lieu of services or goods
are called income, for example, salary received by any employee
is his income. There may be different type of incomes like Gross
income, Net income, National Income, and Personal income, but we
are here more concerned for a business income. Surplus revenue
over expenses incurred is called as “Business Income.”

Objectives of Net Income

Following are the important objectives of a net income −

  • Historical income figure is the base for future projections.

  • Ascertainment of a net income is necessary to give portion of
    profit to employees.

  • To evaluate the activities, which give higher return on
    scarce resources are preferred. It helps to increase the
    wealth of a firm.

  • Ascertainment of a net income is helpful for paying dividends
    to the shareholders of any company.

  • Return of income on capital employed, gives an idea of
    overall efficiency of a business.

Definition of Income

The most authentic definition is given by the American Accounting
Association as −

“The realized net income of an enterprise measures its
effectiveness as an operative unit and is the change in its net
assets arising out of a (a) the excess or deficiency of revenue
compared with related expired cost, and (b) other gains or losses
to the enterprise from sales, exchange or other conversion of
assets:”.

According to the American Accounting Association, to be as
business income, income should be realized. For example, to be a
business income, only appreciation in value of assets of a
company is not enough, for this, asset has really been disposed
of.

Accounting Period

For the measurement of any income concerns, instead of a point of
time, a span of time is required. Creditors, investors, owners,
and government, all of them require systematic accounting reports
at regular and proper intervals. The maximum interval between
reports is one year, as it helps a businessman to take any
corrective action.

An accounting period concept is directly related to matching
concept and realization concept; in the absence of any of them,
we could not measure income of the concerns. On the basis of
matching concept, expenses should be determined in a particular
accounting period (usually a year) and matched with the revenue
(based on realization concept) and the result will be income or
loss of the accounting period.

Accounting Concept and Income Measurement

The measurement of accounting income is the subject to several
accounting concepts and conventions. Impact of accounting
concepts and convention on measurement of the accounting income
is given below −

Conservatism

Where an income of one period may be shifted to another period
for the measurement of income is called as ‘conservatism
approach.’

According to the convention of conservatism, the policy of
playing safe is followed while determining a business income and
an accountant seeks to ensure that the reported profit is not
over stated. Measurement of a stock at cost or market price,
whichever is less is one of the important examples as applied to
measurement of income. But it must be insured that providing
excessive depreciation or excessive provisions for a doubt full
debt or excessive reserve should not be there.

Consistency

According to this concept, the principle of consistency should be
followed in accounting practice. For example, in the treatment of
assets, liabilities, revenues, and expenses to insure the
comparison of accounting results of one period with another
period.

Therefore, the accounting profession and the corporate laws of
most of the counties require that financial statement must be
made out on the basis that the figures stated are consistent with
those of the preceding year.

Entity Concept

Proprietor and business are the two separate and different
entities according to the entity concept. For example, an
interest on capital is business expenditure, but for a
proprietor, it is an income. Thus, we cannot treat a business
income as personal income or vice-versa.

Going Concern Concept

According to this concept, it is assumed that business will
continue for a long time. Thus, charging depreciation on a Fixed
Asset is based on this concept.

Accrual Concept

According to this concept, an income must be recognized in the
period in which it was realized and costs must be matched with
the revenue of that period.

Accounting Period

It is desirable to adopt a calendar year or natural business year
to know the results of business.

Computation of Business Income

To compute business income, following are the two methods −

Balance Sheet Approach

Comparison of the closing values (Assets minus outsider’s
liabilities) of a firm with the values at the beginning of that
accounting period is called as Balance Sheet approach. In above
value, an addition to capital will be subtracted and addition of
drawings will be added while computing the business income of a
firm. Since, income is calculated with the help of Balance Sheet
hence called as Balance Sheet approach.

Transaction Approach

Transactions are mostly related to production or the purchase of
goods and the sale of goods and all these transactions directly
or indirectly related to the revenue or to the cost. Therefore,
surplus collection of the revenue by selling goods, spent over
for production or purchasing the goods is the measure of income.
This system is widely followed by the enterprises where double
entry system adopted.

Measurement of Business Income

There are following two factors which are helpful in the
estimation of an income −

  • Revenues − Sale of goods and rendering of services are
    the way to generate revenue. Therefore, it can be defined as
    consideration, recovered by the business for rendering
    services and goods to its customers.

  • Expenses − An expense is an expired cost. We can say
    the cost that have been consumed in a process of producing
    revenue are the expired cost. Expenses tell us – how assets
    are decreased as a result of the services performed by a
    business.

Measurement of Revenue

Measurement of the revenue is based on an accrual concept.
Accounting period, in which revenue earned, is the period of
revenue accrues. Therefore, a receipt of cash and revenue earned
are the two different things. We can say that revenue is earned
only when it is actually realized and not necessarily, when it is
received.

Measurement of Expenses

  • In case of delivery of goods to its customers is a direct
    identification with the revenue.

  • Rent and office salaries are an indirect association with the
    revenue.

There are four types of events (given below) that need proper
consideration about as an expense of a given period and
expenditure and cash payment made in connection with those items

  • Expenditure, which are expenses of the current year.

  • Some expenditure, which are made prior to this period and has
    become expense of the current year.

  • Expenditure, which is made this year, becomes expense in the
    next accounting periods. For example, purchase of fixed
    assets and depreciation in next up-coming years.

  • Expense of this year, which will be paid in next accounting
    years. For example, outstanding expenses.

Matching Concept

It is a problem of recognition of revenue during the year and
allocation of expired cost to the period.

Recognition of Revenue

Most frequent criteria, which are used in recognition of the
revenue are as follows −

  • Point of Sale − Transfer of ownership title to a buyer
    is point of sale, in case of sale of commodity.

  • Receipt of Payment − Criteria of cash basis is widely
    used by the attorneys, physicians, and other professionals in
    which revenue is considered to be earned at the time of
    collection of cash.

  • Instalment Method − Instalment method is widely used
    in retail trading specially in consumer durables. In this
    system, revenue earned is treated in the same manner as is
    used in any other credit sale.

  • Gold Mines − The accounting period in which gold is
    mined is the period of revenue earned.

  • Contracts − Degree of contract completion, especially
    in long term construction contracts is based on percentage of
    completion of a contract in a single accounting year. It is
    based on total estimated life of the contract.

Allocation of Costs

Matching of expired revenue and expired costs on a periodic time
basis is the satisfactory basis of allocation of cost as stated
earlier.

Measurement of Costs

Measurement of costs can be determined by −

  • Historical Costs − To determine periodic net income
    and financial status, historical cost is important.
    Historical cost actually means – outflow of cash or cash
    equivalents for goods and services acquired.

  • Replacement Costs − Replacing any asset at the current
    market price is called as replacement cost.

Basis of Measurement of Income

Following are the two significant basis of measurement of income

  • Accrual Basis − In an accrual basis accounting,
    incomes are recognized in a company’s books at the time when
    revenue is actually earned (however, not essentially
    received) and expenses is recorded when liabilities are
    incurred (however, not essentially paid for). Further,
    expenses are compared with revenues on the income statement
    when the expenses expire or title has been transferred to the
    buyer, and not at the time when the expenses are paid.

  • Cash Basis − In a cash basis accounting, revenues and
    expenses are recognized at the time of physical cash is
    actually received or paid out.

Change in the Basis of Accounting

We have to pass adjustment entries whenever accounting records
change from cash basis to accrual basis or vice versa specially
in respect of the prepaid expenses, outstanding expenses, accrued
income, income received in advance, bad debts & provisions,
depreciation, and stock in trade.

Features of Accounting Income

Followings are the main features of accounting income −

  • Matching revenue with related cost or expenses is a matter of
    accounting income.

  • Accounting income is based on an accounting period concept.

  • Expenses are measured in terms of a historical cost and
    determination of expenses is based on a cost concept.

  • It is based on a realization principal.

  • Revenue items are considered to ascertain a correct
    accounting income.

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