MEASUREMENT OF BUSINESS INCOME-ALL YOU NEED TO KNOW

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.”

Measurement of business income (or profit) is very important due to the following reasons:

(a)   An important objective of most business enterprises is to earn profit.

(b)   Income-tax is levied on the basis of income earned by the individuals and others from various sources including profits and gains from business and profession.

(c)   Management takes various types of decisions such as dividend and transfer to reserves on the basis of income earned during the accounting period.

(d)   Income is used as a basis for evaluating the performance of the enterprise.

Therefore, it is necessary to ascertain the correct amount of income (or profit) earned during the period. According to Accounting Standard-5, “all items of income and expense which are recognised in a period should be included in the determination of net profit or loss for the period unless an Accounting Standard requires or permits otherwise.” The word income is also used for aggregate of revenues and gains.

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

Income refers to the money that a person or entity receives in exchange for their labor or products. Income may have different definitions depending on the context—for example, taxation, financial accounting, or economic analysis.

For most people, income means their total earnings in the form of wages and salaries, the return on their investments, pension distributions, and other receipts. For businesses, income means the revenues from selling services, products, and any interest and dividends received with respect to their cash accounts and reserves related to the business.

Economists have different definitions and ways of measuring income.  Whether their studies involve earnings, savings, consumption, production, public finance, capital investment, or other related topics and subtopics, their concept of income will correspond to the purpose of their research. While the measure of income on a macro level is critical to societal and policy studies, individuals are more focused on their personal and business income.

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.