Accounting Concepts Related to Income Measurement

One important objective of accounting is to ascertain the results of operations of an organisation for a period of time. In case of profit oriented organisation, the income statement summarises the results of its operations for a given period of time, generally a year. The going concern concept of accounting assumes that the life of a business is perpetual. Such being the case, owners, management and other interested parties cannot wait indefinitely to know how much income has been earned by the business. They would like to know at least on a periodical basis the results of operations of the business. This brings into play certain concepts, which are related to income measurement. These are discussed below:

Time Period Concept (Periodicity Concept)

This Time Period Concept indicates that the profitability of a business is to be measured periodically. The period for which income is measured is called the accounting period. For the purpose of external reporting, the accounting period is generally one year. Thus, accounting profit is the result of completed transactions during the accounting period. For income tax purposes, a business has compulsorily to adopt financial year beginning on 1st April in any calendar year and ending on 31st March in the next calendar year as its accounting year. However, for internal reporting the profitability report can be prepared monthly, quarterly or half yearly depending on the nature of project to facilitate better control and evaluation of performance.

Revenue Recognition (Realisation) Concept

According to Revenue Recognition concept, revenue is considered as being earned on the date on which it is realised. Revenue is thus recognised in the Profit and Loss Account of an enterprise when a sale is made or service is rendered to customers. According to Accounting Standard-9 (AS-9) in case of sale of goods, revenue will be recognised when the seller of goods has transferred to the buyer the property in goods and no significant uncertainty exists regarding the sales price. In a transaction involving the rendering of services, revenue should be recognised when services have been rendered to the satisfaction of the customer and when no significant uncertainty exists regarding the amount of consideration. According to Anthony and Reece, "The conservatism concept suggests the period when revenue should be recognised. Another concept, the realisation concept indicates the amount of revenue that should be recognised from a given sale".

Matching Concept

Deducting expenses from revenues arrives at accounting profit. However, accountants carry forward expenses until they can be identified with the revenue of particular accounting year and carry forward receipts until they can be regarded as revenue of the particular year. Thus, this principle is very important for correct determination of profit, which is also a measure of performance. All expenses that generate revenue in the current accounting period are recognised as expenses of the current period. Cost of goods sold and operating expenses incurred during the current period are recognised as expenses of the current period and will be matched with the revenue of the current period. Incomes received in advance or relating to earlier periods must not be taken into account. Similarly, expenses paid in advance are also to be ignored while computing the income of current accounting period.

Materiality Concept

According to this Materiality Concept, financial statements should disclose all material items, i.e., items the knowledge of which might influence the decisions of the user of the financial statements. What is material may, however, differ from concern to concern and year to year. Kohler has defined materiality as 'the characteristic attaching to a statement, fact or item whereby its disclosure or the method of giving it expression would be likely to influence the judgement of a reasonable person.' Thus when the event is material, it should be disclosed. But if the item or event is immaterial, it may not be disclosed. It is on the basis of materiality concept that items of stationery are considered to have been used up either at the time of purchase or at the time of their issue from stores.

Consistency Concept

The Generally Accepted Accounting Principles (GAAP) permit more than one method of describing identical operating situations. For example, a firm may have different methods of providing depreciation on fixed assets or inventory valuation or making provision for likely bad debts, which are permissible under the GAAP. As a result, the firm will report different amounts of income in different years for the same accounting transactions. Inconsistency will make the two financial statements incomparable. It is for this reason that the consistency principle requires that the basis of income measurement and preparation of financial statements should remain consistent for intra-firm and inter-firm comparison. Accounting Standard-I (AS-I) also states that it is assumed that accounting policies are consistent from one period to another. Thus, a firm should follow same accounting methods and procedures from year to year. However, it is permitted to change them if it has a sound reason to do so. But the effect of such a change must be disclosed in the financial statements of the year in which change took place to enable the users to be aware of the lack of consistency.

Conservatism (Prudence) Concept

The Conservatism Concept suggests its traditional approach of playing safe or being cautious in recognising all the possible losses but ignoring all probable profits. This is also known as prudence concept implying the common and accepted behaviour of accounting or providing for future losses. Though this approach leads to creation of secret reserves and understatement of income; it also of safeguards the interest of outsiders by preventing the management from recognising unrealised, profits and providing for all future losses. There are few instances, which illustrate the acceptance and adherence of this concept.

1. Inventories are valued at lower of cost or market price.
2. Providing for doubtful debts and discount allowed to debtors but ignoring the probable discount received from creditor till the time final payments are made.
3. All the fixed assets are valued on historical costs irrespective of their market price except in the case of revaluation of business.
4. Preference of written down value method over straight-line method of depreciation, since the earlier one, provides for more depreciation in the initial years of use.
5. Valuing Joint Life Insurance Policy at its surrender value irrespective of amount of instalments paid.