A Review of Income and Value Measurement Concepts in Conventional Accounting Theory And

A REVIEW OF INCOME AND VALUE MEASUREMENT CONCEPTS IN CONVENTIONAL ACCOUNTING THEORY AND THEIR RELEVANCE TO ISLAMIC ACCOUNTING

Shahul Hameed Bin Hj .Mohamed Ibrahim

Abstract

The purpose of this essay is to review the various proposals suggested in the accounting literature on the measurement of income and value and discuss their relevance to Islamic accounting. In Part I of the essay, the definitions of the concepts of income, capital, value and capital maintenance and their inter-relationships are discussed. Alternative income measurement models including traditional accounting, economic and current value models are then elaborated . Belkaoui's (1992) evluation of the different income measures is then discussed.

In Part II, The world view and nature and objectives of Islamic Accounting, as opposed to conventional accounting is discussed as a background to possible differences in income and valuation concepts in Islamic Accounting. Two main institutions of Islam, Zakat and the prohibition of interest and its consequences for income and valuation models are discussed. Finally, the relevance of conventional accounting's income measurement and valuation models are examined in the light of zakat determination and equitable profit distribution and avoidance of doubt and conflict among stakeholders. It is concluded that a form of current value based income models are more compatible with the Islamic accounting objectives of fairness and full disclosure.

Part I: A Review of Conventional Income and Valuation Models

1. Introduction

Measurement and valuation of assets, liabilities and the consequent determination of income have been the most intractable problems in accounting theory. In fact the true income school is one of the most important schools of accounting theory which concern is to find a measure of 'true income' (AAA 1977). Various income measurement models have been put forward in the literature. This issue is undeniably intertwined with the problem of asset valuation if one adopts a Hicksian economic concept of income as the difference in "well- offness". Even under a traditional accounting concept of income as the residue of revenue over expenditure. the recognition of revenue and costs and the amount of depreciation which depends on how assets are valued presents the same problems.

2. The Importance of Income Measurement

In conventional accounting, the determination of income or 'profit' is one of the main function of accounting as it determines wealth transfers between persons. For example, Employee bonuses are often made based on income numbers. Dividends of investors are dependent on income (although dividend policy may not lead to a direct relationship). Income is also a measure of the efforts and accomplishments of management of a business upon which they are rewarded (bonuses / share options) or otherwise. Their future employment prospects may depend on income numbers as their effectiveness is often evaluated by investors on the basis of company earnings. Income is also a guide to investment e.g. earnings per share , based on an income number is a major indicator on which share value depends on which investors make decisions on whether to buy , sell or hold their investments. In addition, accounting income is the basis of taxation although it is adjusted to comply with requirements of fiscal policy. In Islamic accounting, wealth and profits are both bases on which Zakat (Islamic tax) is assessed on individuals and organizations. It becomes especially important because interest is forbidden in Islam and thus a predetermined fixed return on capital is prohibited. Thus profit or income is especially important in Islam, more so than in conventional accounting for the income is the only basis on which financiers get a return on the renting/employment of their capital. Further income measurement has taken up a major portion of the subject of accounting theory and there have been entire books devoted to the subject e.g. Davidson et al (1964). Hence it can be seen that income is a very important concept , we shall therefore review the concept of income in the literature next.

3. Accounting and Economic Concepts of Income

We have seen above how the concept of income is important in accounting. However, as Lee (1985, p6) observes, despite this importance in both accounting theory and practice , there is little relevant literature in accounting devoted to the exposition of the fundamental nature of income. The more important works have been in the economics and or inter-disciplinary literature by authors with an economics background (e.g. Fisher (1906), Canning (1929), Lindahl (1933), Sweeney (1936), McNeal (1939), Hicks (1946) and Alexander (1950)). Income to the economist is different than what it means to the accountant. According to Parker and Harcourt (1969)

Economists , mindful of Jevon's remark that 'bygones are forever bygones', have tended to define income in term of expectations.

Hence, economists define income as an ex ante measure i.e. before the event in terms of future expectations whereas accountants measure income as the result of economic activities of an entity for a defined past period of time i.e. ex-post. We shall now discuss the differences in some detail.

Accounting concept of income

The traditional definition of income or profit by the accountant is the surplus resulting from business activity , resulting from the cash to cash cycle of business operation. It is arrived by matching the revenues against the associated expenses of an entity for a period of time (usually a year) known as the financial year. Thus income is determined ex-post i.e. after the event . The matching process causes an aggregation of unallocated costs to be carried forward (in the balance sheet) at the end of the defined accounting period. These unallocated costs (non-monetary assets) together with the monetary resources of the entity after deducting the liabilities gives rise to a residue called accounting capital or residual equity. Accounting income therefore results in a corresponding measure of capital and in fact analyzed as a temporal change in capital. The exact definition of accounting income has been elusive as it can mean many things. Pertinent questions include:

Does income include incidental gains which are not the main activity of the organization e.g. sale of fixed assets (extraordinary and exceptional items )?

Does income include gains which occur infrequently (non-maintainable earnings/quality of earnings). This has implications for share-price in the market.

Does income include unrealized holding gains arising from increases in the value of assets?

The FASB (1980) for example , has come out with the term "comprehensive income" which is taken to include all changes in equity except those that result from investment by and distribution to owners. According to Belkaoui (1992, p 204), this is more inclusive than the traditional concept of accounting income. Presumably, this would include loan receipts in income as well, as long-term creditors are not owners of business although this would not be correct.

Economic concept of income

On the other hand, the economist consider income as a series of personal psychic experiences i.e. enjoyments or perceived events of a more personal nature rather than arising to an entity (Fisher 1930). In fact, according to him, an artificial entity such as a business cannot have an income because it has no consciousness. The absolute necessity of consumption to Fisher's concept of income was so important that he did not recognize savings as income because he considered savings was only potential consumption from which no psychic enjoyment is derived. However, later economists have adapted his personal income concept to the business entity by including savings in addition to consumption as part of income.

Since personal enjoyments are subjective and is not measurable directly, Fisher approximated it by going two steps behind enjoyment income to the cost of living or the money measure of real income i.e. the monetary value of the final consumption of physical goods and services in the outer world.

Hicks (1946) extended the concept of economic income to include what is known today as the maintenance of capital intact, before any income is recognized. Following from the idea that "income calculations in practical affairs is to give people an indication of the amount they can consume without impoverishing themselves", he introduced the concept of well-offness as a basis in the approximation of personal income of Fisher. According to him, income is :

the maximum value which ..(a person) can consume during a week and still expect to be as well off at the end of the week as he was in the beginning.

This elegant definition which insists that the capital must be returned before income can be calculated, however, begs the question, how 'well-offness' is defined. This is answered in part by Hicks himself . He further elaborates & operationalises his well-offness concept in a series of approximations i.e.

1) under conditions of unchanging interest rate and absence of inflation

2) under changing interest rate but no inflation

3) under fixed interest rate with inflation

and defines income under each of these conditions.

Under condition 1, income is defined to be the maximum amount which can be spent during a period , if there is an expectation of maintaining intact the capital value of prospective receipts ( in money terms ).

Under condition 2) income is defined as the maximum amount a person can spend in a period and still expect to be able to spend the same amount in each ensuing period. This definition reduces to the one under condition 1) when interest rates are fixed.

Under condition 3) income is defined as the amount a person can spend in a period and still be able to spend the same amount in real terms in the ensuing weeks.

Economic income thus can be written in the following equation:

Ye= C+Kt-Kt-1 where

Ye = economic income

C = consumption

Kt and Kt-1 are the capital at the end and beginning period respectively as measured by the present value of expected future cash flows at times t and t-1 respectively.

This can be compared with the accounting income Ya,

Ya= Rt-Rt-1 +D where Rt and Rt-1 is the residual equity at the end and beginning of the period and D is dividend distributed to owners. Although the equation is similar, economic income is the result of capital valuation at the beginning and of the period as the capitalized value of the expected future receipts in contrast to accounting income which results from the matching process resulting in a residual capital. Hence in economics, income is the residue i.e. the economists computes capital to measure income whereas in traditional accounting, capital is the residual figure after income is calculated.

Economic under uncertainty is termed ideal income (Lee, 1985, p31). In a "dynamic economy" to borrow the term of Alexander (1977), where values are changing both because prices and expectations are changing, this income cannot be computed objectively and therefore is impractical for business. Predicting the amount and timing of cash flows and choice of an appropriate discount rate (which depends on the individual's preferences and the availability of alternative investments) approximating the entity's opportunity cost presents considerable problems. Further in economic income, it is assumed that returns of capital included in the realized cash flow is reinvested at the discount rate. This presumes that reinvestment can be made and the interest rate remains constant. However this is not the reality in a world of uncertainty and will lead to unexpected gains (referred to as windfalls by Lee 1985). The reiteration of the reinvestment in subsequent periods compounds this problem. Finally there is a problem of the assumption of constant well-offness which is not realistic because in reality, a person or a business would have as one of its objectives capital growth. Despite the fact that growth can be incorporated in the economic in the model (e.g. Gordon's Dividend growth model), the prediction of the growth rate confounds the problem.

However, economic income is considered to be the most perfect of all income models theoretically, because the value of capital is undeniably related to the cash flow deriving from it. It takes into account both the human and physical resources of an entity which underlies capital. It (ex ante economic income) also reflects 'guidance to prudent conduct' i.e. the maximum amount the owner of capital anticipates he can consume (or dividends a company can distribute) without impairing his capital and future consumption. Its valuation based on prediction of future cash flows is particularly relevant for decision making (this is the basis of discounted cash flow investment appraisal techniques in management accounting). Economic income is also takes into account the important factor of timing (potential economic benefits becoming more valuable as the relevant realization dates nears). Finally, return of capital are specified as guides to reinvestment and capital maintenance (Lee 1985 p43).

4. Capital and Capital Maintenance

In accounting, capital can be said to be the collection of tangible and intangible assets , both monetary and non-monetary , less any liabilities of the entity. It is "an expression of the property rights of the entity in net assets" and representing future service potential (Lee 1985). It is transactions based and depend on the process of deriving income from recorded transactions. To the economists , however, capital is the stock of service potential from which income flows i.e. economists look forward in time in terms of anticipated services and these expectations form the basis of determining capital (Lee 1985 p9).

Fisher (1930), for example, defined capital as the present value of future anticipated benefits which can be represented by the equation;

Ko=S Ct(1+i)-t

where Ko= capital at time t=0 and Ct represents anticipated future consumption in terms of predicted cash flows and i, the subjective rate of interest ( a personal opportunity cost rate). Fisher saw interest as the bridge between income and capital, while Hicks defined capital as well-offness and defined it as the capitalized money value of future receipts. His view was that capital and income was actually one and the same but isolated for measurement purposes.

It can be seen that the difference between accounting and economic capital is one of measurement. As Boulding (1962) points out; whereas accountants measure capital in terms of actualities as the by-product of the income measurement process , economists measure it in terms of potentialities in order to measure economic income.

The idea of capital and its maintenance depends on the definition and valuation system adopted. For example capital can be defined as money capital, physical capital (tangible assets/operating capacity), potential consumption (economist's discounted cash flow measurements) or purchasing power. Values could include historical cost, current replacement cost, net realizable value or present value. All these possibilities give various permutations of income and capital.

Capital Maintenance

Capital Maintenance is a very important concept in income measurement. Capital needs to be maintained before any income is recognized (thus the need for depreciation) , otherwise distributions (e.g. dividends) can be made out of capital. This is illegal under the Companies Act for corporations as it is feared that distributing dividends out of capital would reduce the amount of money available to creditors, whose only recourse to a limited liability company , in normal circumstances, is the capital and reserves.

The concept of maintenance of capital intact implies the necessity for depreciation. According to Pigou (1941), capital, at any moment consist of an unambiguous collection of physical things and if any object in this collection were to wear out or scrapped, then it must be replaced by equivalent objects.

However, changes in values of components of capital makes the notion of capital maintenance difficult (Hayek 1941). Since capital , in real life, consist of many heterogeneous things, a physical magnitude can only be arrived at by equating all these items in terms of an equivalent item in terms of what each component is worth in terms of the equivalent item. The difficulty lies, however in that the relative values of different things are not independent of the equilibrating process, hence capital would not be maintained if there was a change in the relative value of its components, even if the physical inventory remained the same. Another problem is whether obsolescence due to changes in technology should be regarded as depreciation, although the physical capital remain intact. Hayek suggested that forseeable obsolescence should be made good before considering income as 'net'. Hicks also regards forseeable obsolescence as "true depreciation" and thus should be provided for in order for capital to be maintained. Unforseeable obsolescence according to him is capital loss. In actual practice, however, it is difficult to distinguish between foreseen and unforeseen obsolescence and thus all cases of obsolescence would result in a capital loss (Goyle 1990)

The various concepts of capital also leads to difficulties. What capital is to be maintained? Is it the money (original cost) capital, real capital (purchasing power) or operating capacity (in order to maintain the income stream ). In order to maintain money capital intact, it is adequate for depreciation to based on acquisition (historic) cost of the asset. In periods of general inflation, however, although the money income would be the same in successive periods, the owner would not be able to consume the same amount of goods as he did in the previous period and this would thus rebel against the Hicksian concept of income. If real capital is to be maintained in periods of rising prices, then the cost of the asset would be multiplied by a relevant index number and the depreciation would be based on this new value. If however, the specific prices of assets move differently in relation to general price level, then even the adjustment for price level would not be sufficient to maintain capital as when the time comes to replace the asset, the amount of fund retained (not cash) would not be able to acquire the replacement of a similar or equivalent asset in order to produce at the same capacity. If we are to provide an amount adequate to maintain the physical capital then, we must provide depreciation based on the current value of assets at any accounting period and adjust for any back-log depreciation which was the line taken by SSAP 16. The problems becomes more complex if due to new technological improvements, the new replacement equipment has more capacity at a lower cost e.g. in the case of computers where the power/cost ratio doubles almost every six months. In that case, if we follow a current cost depreciation concept, we might be 'over maintaining' capital.

Grinyer and Symon (1980) argue that capital maintenance is an unnecessary abstraction for which they could not identify any logical reasons why the 'constraint' of capital maintenance should be imposed in the long term interests of the participants in business. Their arguments are based on the fact that economists have been unable to agree on a definition of income and of its relationship to capital. Since wealth cannot be defined unambiguously, therefore , they argue that it is not possible to maintain what one cannot define.