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17/11/2020 03:16:50 PM

Income Concept

Income summarizes the financial effects of a business’s operating activities. The main purpose of the income statement is to explain how income is determined, with its important components reported as separate line items. 

To recap, there are two alternative concepts of income: economic income and per­manent income. Economic income measures the net change in shareholder’s wealth during a period and is typically equal to a period’s cash flows plus change in present value of expected future cash flows. Permanent income is an estimate of the stable average income that a business is expected to earn over its lifetime, given the current state of its business. Permanent income (also called sustainable income or recurring income) is conceptually similar to sustainable earning power, and its determination is a major quest in analysis. While economic income measures change in shareholder value, permanent income is proportional to value.

Accounting (reported) income is based on accrual accounting and is determined by recognizing revenues and matching costs to the recognized revenues. Accounting income purports to measure neither economic income nor permanent income. In addi­tion, accounting income has measurement error, arising because of accounting distor­tions introduced by arbitrary rules, earnings management, and estimation error. Because of these reasons, accounting income can be visualized as comprising of three compo­nents: (1) a permanent or recurring component, where each dollar is equal to 1/r dollars of company value (r is cost of capital); (2) a transitory component, where each dollar is merely equal to one dollar of company value; and (3) a value irrelevant component, which is irrelevant for valuation.

A major quest in analysis is identifying the permanent or recurring component of reported income. Standard setters are aware of the need to separate recurring and non­recurring components of income. Accordingly, the line items on the income statement are arranged in a manner that allows an analyst to identify nonrecurring components. As a first step toward determining permanent income, analysts determine core income, which is the current period’s reported income after removing all nonrecurring (or value irrelevant components). Accounting is gradually, but inexorably, adopting a model of fair value accounting. Under fair value accounting, reported income is conceptually similar to economic income and will include large, nonrecurring components in the form of unrealized gains/losses arising because of changes in assets’ and liabilities’ fair values. The impor­tance of analyzing income and isolating its permanent component will be an even more important task as fair value accounting becomes more pervasive.