Capital and Income
• Capital in accounting is essentially the amount of money or resources
that business owners invest in their company. It's the funds used to
start and operate the business, covering expenses like buying
equipment and inventory and paying for daily operations.
• Capital is the stock of wealth that can provide future services, income
is thought of as the flow of wealth or services in excess of that
necessary to maintain a constant capital.
• To preserve capital is primarily the responsibility of the management
Understanding Capital
• From the economists' perspective, capital is key to the functioning of
any unit, whether that unit is a family, a small business, a large
corporation, or an entire economy.
• Capital assets can be found on either the current or long-term portion
of the balance sheet. These assets may include cash, cash
equivalents, and marketable securities as well as manufacturing
equipment, production facilities, and storage facilities.
• By investing capital, a business or individual seeks to earn a higher
return than the capital's costs.
Income
Income is a useful information to those who are most interested in
financial reports
• Measurement of managerial efficiency
• Income is regarded as a guide to a firm’s dividend and retention policy
• Basis for taxation
• Economists use income figures in evaluating the allocation of resources
• EPS is considered to be an important factor in investment decision
Two concepts of income
• The accounting concept of income
• The economic concept of income
Accounting concept of income
Ia=R-E
Ia=Accounting Income
R=Realized Revenues of the period
E=Expenses
Accounting income is the difference between the realized revenues arising
from the transactions of the period and the corresponding historical costs
Favorable arguments
• Accounting income is very useful in judging the past performance and
decisions of management. Also, it is useful for control purposes and
for making management accountable to shareholders for the use of
resources entrusted to it.
Favorable Arguments
• Accounting concept of income has the benefit of a sound, factual and
objective transaction base.
• In times of inflation, which is now a usual feature, alternative income
measurement approaches as compared to accounting income could
give lower operating income, lower rates of return which could lower
share prices of a business firm
• Income based on historical cost is the least costly because it
minimizes potential doubts about information reliability, and effort in
preparing the information. [For example, a company purchases a machine
for $10,000, and that value is recorded as its cost. If the machine's market value
later rises to $15,000, the company doesn't report a $5,000 gain in income;
instead, it continues to report the machine at its historical cost of $10,000 until
it is sold or depreciated]
Limitations of Accounting Income
• Firstly, the traditional accounting income is based upon historical cost
principle and conventions which may be criticized, e.g., lack of useful
contemporary valuations in times of price level changes, inconsistencies in
the measurement of periodic income of different firms and even between
different years for the same firm due to generally accepted accounting
principles.
• Secondly, validity of business income depends on measurement process and
the measurement process depends on the soundness of the judgments
involved in revenue recognition and cost allocation and related matching
between the two. There is a great deal of flexibility and subjectivity involved
in assigning cost and revenue items to specific time periods and using
matching concept.
Limitations of Accounting Income
• Thirdly, the historical cost concept and realization principle conceal
essential information about unrealized income since it is not reported
under historical accounting. Unrealized income results from holding
assets, which should be reported to provide useful information about
business and its profitability and financial position. [such as unrealized
gains on certain investments]
Present value (PV)
• The current value of a future sum of money or cash flow, discounted by a
specific rate of return.
• Basis: It is a financial calculation used to make decisions, not a measure of
income itself. It relies on making assumptions about future rates of return.
• Purpose: It helps determine what a future amount of money is worth today,
or whether an investment is profitable. The Net Present Value (NPV)
compares the present value of future cash inflows to the present value of
outflows.
• Example: If an investment is expected to pay you $1,000 in one year, the
present value of that $1,000 would be less than $1,000 because of the time
value of money and the potential for other investments
Revenue Recognition
• The revenue recognition principle is a cornerstone of accrual accounting together
with the matching principle. They both determine the accounting period in which
revenues and expenses are recognized. According to the principle, revenues are
recognized when they are realized or realizable, and are earned (usually when
goods are transferred or services rendered), no matter when cash is received. In
cash accounting—in contrast—revenues are recognized when cash is received no
matter when goods or services are sold.
• Accrued Revenue refers to revenue that has been earned but not yet invoiced or
received. It occurs when goods or services have been delivered, but payment will
occur in the future.
Accounting Entry for Accrual Revenue:
When you recognize accrual revenue, the following journal entry is
made:
Debit (increase) Accounts Receivable (or Accrued Revenue) – This
represents the amount the customer owes.
Credit (increase) Revenue – This represents the revenue earned from
the service or sale.
Example:
In December, a company earns $5,000 for services provided but hasn't
invoiced the customer yet.
• Debit Accounts Receivable $5,000
• Credit Service Revenue $5,000
• Presentation in the Financial Statements:
• Balance Sheet (Statement of Financial Position):
• Accounts Receivable (or Accrued Revenue) will appear under current assets.
This reflects the amount the company expects to collect from customers in
the future.
• Income Statement (Statement of Profit and Loss):
• The revenue will be reported as part of total revenue earned during the
period, even though the cash hasn't been received yet. The key principle is
that revenue is recognized when earned, not when payment is received.
Deferred revenue:
Deferred revenue is money received in advance for
products or services that are going to be performed in
the future. Rent payments received in advance or annual
subscription payments received at the beginning of the
year are common examples of deferred revenue.
How deferred income is treated in financial statements:
1. Balance Sheet (Statement of Financial Position)
• Deferred income is recognized as a liability because it represents an
obligation to deliver goods or services in the future. This liability can be
classified as either:
• Current Liability: If the company expects to earn the revenue (i.e., deliver
the goods/services) within the next 12 months.
• Non-Current Liability: If the company expects to earn the revenue beyond
12 months.
Example:
• If a customer pays for a subscription that will last for 2 years, the portion of
the payment covering the first year would be classified as a current liability,
and the portion covering the second year would be a non-current liability.
Income Statement (Profit & Loss Statement)
Once the company performs the service or delivers the goods, it recognizes the
revenue by moving the deferred income (liability) to earned revenue (revenue on
the income statement).
Example:
If the company has a contract to provide services over the course of 12 months,
each month a portion of the deferred income will be recognized as earned revenue.
Journal Entries
When deferred income is received:
Debit: Cash or Accounts Receivable (to record the payment received).
Credit: Deferred Income (liability account).
When the revenue is earned (as the service is performed or goods are delivered):
Debit: Deferred Income (to reduce the liability).
Credit: Revenue (to recognize the earned income).
Example Scenario
Let's assume a company receives $12,000 for a 12-month service contract,
which starts in January.
At the time of receiving payment (January 1):
Debit: Cash $12,000
Credit: Deferred Income $12,000
Each month, the company recognizes $1,000 in revenue (assuming the
service is performed evenly over the year):
Debit: Deferred Income $1,000
Credit: Revenue $1,000
By the end of the year (after 12 months), the company would have
recognized the entire $12,000 as revenue, and the balance of the Deferred
Income account would be zero.
International Financial Reporting Standards criteria
The IFRS provides five criteria for identifying the critical event for
recognizing revenue on the sale of goods:
[Link] and rewards have been transferred from the seller to the buyer.
[Link] seller has no control over the goods sold.
[Link] of payment is reasonably assured.
[Link] amount of revenue can be reasonably measured.
[Link] of earning the revenue can be reasonably measured.
Recognition of revenue from four types of
transactions
• Revenues from selling inventory are recognized at the date of sale often
interpreted as the date of delivery.
• Revenues from rendering services are recognized when services are
completed and billed.
• Revenue from permission to use company's assets (e.g. interest for using
money, rent for using fixed assets, and royalties for using intangible assets)
is recognized as time passes or as assets are used.
• Revenue from selling an asset other than inventory is recognized at the point
of sale, when it takes place
Accounting Income vs Economic Income Definition
• Accounting income or loss recognizes realized gains and losses, and
does not recognize unrealized gains and losses. Economic income or
loss recognizes all gains and losses, whether realized or unrealized.
• When the related transaction is settled or completed, gains and
losses are realized. Until a transaction is completed, any gains or
losses related to that transaction are considered unrealized.
Unrealized gains and losses are also called paper gains or paper
losses, because the nominal value of the asset or liability has
changed, but the cash has not actually changed hands.
Accounting Income vs Economic Income
Example
• Imagine Ralph earns $50,000 dollars per year salary, after tax, and has $10,000 dollars
invested in the stock market. At the end of the year, his stock market investment is worth
$15,000.
• Because Ralph has not yet sold his stock and collected the profits, the increase in value
of the investment is considered unrealized. Consequently, it is a paper profit. At the end
of the year Ralph has a realized income of $50,000 from his salary. His total realized
income is $50,000. He has unrealized profits of $5,000 dollars. His combined realized and
unrealized incomes equal $55,000.
• In this example, Ralph’s accounting income would be $50,000 and his economic income
would be $55,000. According to accounting income, the increased value of the stock
investments do not count as actual income because the investor has not actually sold the
stock, completed the transaction, and collected the profits.
• According to economic income, the increased value of the stock investments to count as
actual income because the real value of the assets has gone up. The assets are worth
more now then they were at the beginning of the year. In this sense, Ralph has earned
the full $55,000 income.
Capital Maintenance
• The capital maintenance concept states that the business net worth is
said to have been maintained if net assets at the end of the period are
equal to or more than net assets at the beginning of the accounting
period keeping aside any withdrawal during the said period.
Cost Expiration
• Cost expiration is the process of recognizing a cost as an expense in a
specific accounting period because its economic benefit has been fully
used or consumed.
• An expired cost is recorded on the income statement, while an unexpired
cost remains on the balance sheet as an asset because it will provide
future economic benefits.
• For example, when a business uses up office supplies, the cost of those
supplies is an expired cost. However, if it pays for a year of insurance in
advance, that cost is initially unexpired (a prepaid expense) and becomes
an expired cost each month as the insurance coverage is used.
Step1: Identify Revenue
• Determine the revenue earned within an accounting period.
• Example: A consulting firm provides services worth $20,000 in June 2024.
Step 2: Link expenses to revenue
• Identify all costs incurred to generate the revenue.
• Example: The consulting firm paid $8,000 in employee salaries, $1,000 in
software subscriptions, and $500 in office supplies during June 2024.
Step 3: Record expenses in the same period
• Record the expenses in the same accounting period as the related revenue.
• Example: The $9,500 in expenses ($8,000 salaries + $1,000 subscriptions +
$500 supplies) is recorded in June 2024, alongside the $20,000 revenue.
Step 4: Apply depreciation to long-term assets
• For long-term assets, allocate the cost over their useful life.
• Example: A company buys a $10,000 machine with a 5-year lifespan.
Using the matching principle, it records $2,000 as depreciation
expense annually over five years, matching the machine’s cost to the
revenue it helps generate each year.
Step 5: Ensure the reporting is GAAP-compliant
Follow Generally Accepted Accounting Principles to maintain accuracy.
Example: By applying the matching principle, the consulting firm’s
financial statements reflect $8,500 in net income ($20,000 revenue –
$9,500 expenses- $2000 depreciation expense) for June 2024,
providing an accurate snapshot of financial performance.
Concepts of Capital Maintenance
• Financial concept
• Physical concept
Financial Concept
• Income is equal to the change in the money amount of net assets. If
there is no change in the amount of net assets, there is no income.
That means capital can be said to be maintained only if capital at
the end of a period has the same general purchasing power as
capital at the start of the period.
Physical Concept
The physical concept of capital maintenance is an accounting
principle that focuses on ensuring a business maintains its physical
capacity to produce goods or services over time. Under this concept,
capital is considered maintained if the entity can continue to operate
at the same physical level of activity without diminishing its ability to
generate future profits. Essentially, capital maintenance is about
ensuring the business's physical assets (like machinery, buildings, and
equipment) remain intact and are not depleted or consumed in the
process of earning profits.
Key Points:
[Link] on physical capacity: It’s not just about maintaining monetary
or financial capital but maintaining the actual physical assets that
allow the business to generate income.
[Link] of productive capacity: To maintain capital, businesses
must reinvest in replacing worn-out assets or repairing damaged
equipment to keep production levels stable.
[Link] measurement: Profits are only considered "real" if the
business has preserved its physical capital. If capital is consumed (i.e.,
assets are reduced in value), part of the profit must be used to
restore or replace these assets.
Example:
Let’s consider a manufacturing company that produces widgets using a machine.
The company initially purchases a machine for $100,000, and over time, this
machine undergoes wear and tear from regular use.
After one year, the machine is worth $90,000 due to depreciation, but it is still
functional and able to produce widgets.
If the company generates $30,000 in profit during the year, under the physical
capital maintenance concept, the company needs to reinvest at least $10,000 (the
depreciation amount) to restore the machine to its original productive capacity.
This ensures that the company’s capital (the machine) remains intact and it can
continue to produce widgets in the future without reducing its production capacity.
If the company instead takes the entire $30,000 profit as dividends without
replacing the depreciated value of the machine, it would have consumed part of its
capital and could not maintain its productive capacity in the future.
In this scenario, physical capital maintenance means measuring profits in a way
that ensures any depreciation or depletion of physical assets is accounted for, and
the business's ability to produce in the future remains unaffected.