Income measurement analysis

Value Added Approach:

Under this approach, the income is measured with the help of the value added by the firm during a particular period and the same is determined by the differences between the value of the product/output over the cost of raw materials including stores and necessary components which are purchased from outside and are used in this production process of the concern. In this respect, it must be remembered that the prices so paid for the purchase of materials, stores etc. are to be deducted from that value of the product.

The value added is to be a distributed among:

(i) The worker to whom wages are paid

(ii) The supplier of non-manual services to whom expenses are paid

(iii) Supplies of capital to whom interest is paid

(iv) Maintenance of capital by way of depreciation etc.

(v) To the owner to whom profits are to be paid.

To sum up, value added of the firm amounts to:

Wages + Expenses + Interest on Capital + Depreciation + Profit.

The Balance Sheet Approach:

This approach is also known as capital maintenance approach. Increase in assets is the result of income. As such, measurement of income requires the measurement of net increase in assets (of a specific accounting period) which are made for the period after maintaining the capital intact.

Under this approach, the opening assets of a business constantly bring a change. As soon as a transaction occurs, there is a change in assets, either in their shape or in their nature. It is also known to us that a flow comes out of stock and, similarly, an income comes out of capital. Therefore, the income after mixing up with capital is circulated again and again for generating further income which usually increases the volume of total assets although a major portion of fixed assets do not bring any change.

It is to be noted that measurement of net asset needs valuation of both fixed and current assets. There is difference of opinion among accountants as to the valuation of assets. In case of current assets, of course the difference is not so important. But, in case of fixed assets, there is a wide difference of opinion among accountants as to their valuation.

The decrease in value of fixed asset, as a result of use, deterioration in the form of depreciation or any other factor should also be considered, i.e., market value should be taken into consideration in order to maintain the capital intact.

The Activities Approach to Income Measurement:

This approach differs from the previous approach, viz. the transaction approach, in the sense that it expresses a description of the activities of a firm rather than on the reporting of transactions alone. In other words, income is believed to arise when certain events or activities take place and not as a result of certain transactions.

For example, activity incomes are recorded at the time of planning, purchasing, production and sales including collection process (i.e., it is an expansion of the transaction approach). Therefore, the fundamental difference between the two approaches is that the former is based on the reporting process which measures an external event, i.e., transaction, whereas the latter is based on the real-world concept of event or activity.

The Transaction or the Operation Approach to Income Measurement:

This is the more conventional approach used by accountants and most of the business enterprises adopt this method.

This approach indicates that the changes between asset and liability valuations arise as a result of transactions.

Revenues and expenses are recorded as soon as they arise from the external transactions. The problems arise of timing and valuation for recording each transaction. But the fundamental principal problem is to make a proper matching against the related revenues during a particular period.

The different concepts of incomes can be incorporated into the transactions approach by making proper adjustments to revenues and expenses at the time of recording each transaction and by making adjustments to asset valuations. Therefore, the current accounting practice is a combination of maintenance of capital concepts; operational concept and transaction approach.

Advantages:

• The incomes from operations and from external causes can be reported separately.
• Under this method, profit earned from each product can be determined separately. As such, it provides more useful information to the management.
• Recording and analysing the external transactions are essential for efficient managerial work.
• It supplies a basis for the determination of the types and quantities of assets and liabilities which exist at the end of the period and, consequently, other valuation methods can easily be applied.