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. But in this chapter, the word income is used in the sense of net profit earned by the enterprise.
Table of Contents
Accounting Concept of Income
Net Profit = Revenues – Expenses
Procedure for Measurement of Business Income
Objectives of Business Income Measurement
Revenue Recognition : Salient Features of AS-9
Certain Special Situations Covered by AS-9
1. Accounting Concept of Income
Income in its natural and commonly accepted sense means the balance of revenues and gains over expenses and losses. The term “income” means, as applied to a business, the profits made in that business.
There are two approaches to the measurement of income, namely
(i) net worth approach and
(ii) matching approach.
In case of net worth approach, income is measured by comparing the net assets at the end of the accounting period with the net assets at the beginning of the period. Increase in net worth over the accounting period represents income or profit and decrease in the net assets indicates net loss. This approach is followed in case of small business where double entry system of accounting is not followed.
In case of matching approach net income or net profit is measured by matching cost with related revenues. In this approach, first the revenues are recognised and then related expenses are matched with them. The excess of revenues over the expenses is called net income or profit. While calculating income or profit the realised gains during the period and normal and abnormal losses suffered during the period are also taken into account. The ascertainment of accounting income or net profit can be shown by the following equation :
2. Net Profit = Revenues – Expenses
The measurement of net income or profit by matching approach is better because it gives more information to the users of accounting information for decision making. Moreover, it is also consistent with the net worth approach. Matching approach is usually followed while measuring net income or profit. Accounting Standard-5 requires the adoption of this approach. It says, as reproduced earlier, that “all items of income and expenses 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.” In other words, what is not income (or revenue) should not be included in profit and loss account.
The following are the limitations of accounting concept of income :
(a) It ignores changes in the level of prices as it is based on historical cost.
(b) It does not recognise unrealised gains in the value of assets.
(c) Generally Accepted Accounting Principles permit use of different accounting policies. For example, depreciation may be charged by straight line method or by written down value method. Moreover, the calculation of depreciation depends upon estimates as regards life of the asset and scrap value of the asset. Thus, determination of net income or profit depends on estimates.
3. Procedure for Measurement of Business Income
The following steps are needed for measurement of business income :
Step 1 : Determination of accounting period. As per the going concern concept or continuity doctrine an entity is assumed to continue its activities for a fairly long period in future unless there is evidence to the contrary. But the users of accounting information need the information periodically. Therefore, for providing timely information, the indefinite life of the business is divided into shorter intervals. These shorter intervals are called accounting periods. The accounting period normally has a time span of one year. It may be April 1 to March 31 or January 1 to December 31 or any other time interval. For measurement of income, the determination of accounting period is the first step. Now-a-days most of the business enterprises in India maintain accounts on financial year basis i.e. April 1 to March 31 as their accounting periods. Some companies particularly foreign multinational companies, maintain their accounts on calendar year basis.
Step 2 : Recognition of revenues. The second step in the measurement of business income is identification of revenues relating to the accounting period. Revenues are recognised on the basis of realisation concept. Accounting Standard-9 deals with recognition of revenues. Revenue is usually recognised as being earned on the date when goods or services are furnished to the customers in exchange for cash or for other valuable consideration. Salient features of AS-9 are given later in this chapter.
Step 3 : Recognition of expenses and matching principle. The third step in the measurement of income is identification of expenses and matching of costs with revenues. An expense is incurred when goods or services are consumed in the process of earning revenue. Expense is recognised in the period in which associated revenue is recognised. According to American Accounting Association.
In case of direct identification of expenses with revenues of the period, sales value of a certain product is reported as revenue in a particular year then cost of that product is reported as an expense in that year. But all expenses are not directly associated with specific revenues. Some items of expenses like rent, salaries etc. are associated with a certain accounting period. They are related in general way to the revenues of the period. Further where an item of cost is incurred but neither the direct association with revenue is possible nor it is associated with operations of the period, that item of cost is debited to the Profit and Loss Account if it cannot be associated with revenue of some future period. For example, loss by fire or loss by theft is debited to Profit and Loss Account in the period in which the loss occurs even though it has no connection with the revenue of that period or with the operations of the period.
Matching principle requires that the revenues and expenses are recognised for an accounting period on a certain basis. It may be (i) cash basis; (ii) accrual basis; or (iii) hybrid basis. Matching of cost with revenues on accrual basis is the most appropriate basis. Therefore, accrual is one of the fundamental assumptions of accounting as per AS-1. All these three basis of accounting have been explained in Chapter 1.
In case of business enterprises, Income Statement or Profit and Loss Account or Statement of Profit and Loss is prepared to find out net income or profit. In case of non-corporate entities Trading and Profit and Loss Account is prepared. The first part or trading account shows gross profit/gross loss and second part or profit and loss account shows net profit/net loss. Gross profit is the difference between sales and cost of goods sold where cost of goods sold is equal to opening stock plus purchases plus direct expenses and minus closing stock. The gross profit is transferred to second part, i.e., profit and loss account. All items of revenues (including gains) except sales are transferred to the credit side of the profit and loss account and all items of expenses (including losses) except items of cost of goods sold are transferred to the debit side of the profit and loss account. The excess of revenues over expenses is net profit. In simple terms net profit is equal to gross profit plus other items of revenue (except sales) minus indirect expenses. Thus, net profit includes profit from trading activities, non-trading activities, extraordinary items, prior period items and change in accounting estimates. This has been explained in detail in chapter on Financial Statements of Non-Corporate Business Entities.
4. Objectives of Business Income Measurement
The following are the objectives of business income measurement :
Assessment of performance: Net income or profit is calculated for assessing the overall performance of the business enterprise. Net income or profit of current year can be compared with the net profit of the past years and with the net profit of similar enterprises in the same industry. Non-operating income and loss should be separately reported to know the results of the operating activities of the enterprise.
Guide for future investment: Determination of business income facilitates the calculation of return on investment. If the return on investment is high for an enterprise, the investors would come forward to invest in that enterprise. Thus business income acts as a guide for future investment.
Base for determining tax liability: Income-tax is levied on individuals on the basis of their income. Similarly income-tax/corporate tax is levied on joint stock companies on the income earned by them as per the provisions of income-tax law. Therefore, net income or profit earned by a business enterprise acts as base for ascertaining the income-tax/corporate tax liability.
Fixing the rate of dividend: The Board of Directors recommend the rate of dividend to be given to the equity shareholders based on the net income earned by the company. Higher the amount of net profit, the higher may be the rate of dividend. Thus, rate of dividend depends to a large extent on the amount of net profit earned by the company.
Helps in meeting corporate social responsibility: The amount to be spent on corporate social responsibility depends in certain cases on the amount of net profit earned by the company. Even where it is not directly linked with the amount of net profit, the management may spend more amounts on corporate social responsibility if the company earns higher amount of profits.
Formulation of Government policy: Tax revenues are the main source of revenue for the government. The government formulates its fiscal policy taking into consideration the amount of net profit earned by the business enterprises.
Satisfaction of employee needs: The employees of a business enterprise are interested in the amount of net profit earned by the enterprise. If the enterprise is earned more than the normal rate of return on the capital employed then they can also legitimately demand higher remuneration in the form of salaries, wages, bonus, etc. particularly in information technology sector.
Net Income and Continuity Principle
The continuity doctrine or going concern concept states that business will continue for a forseeable future. In other words, there is no intention to close the business. Therefore, while preparation of income/position statement, assets are not shown at their liquidation values.
Net Income and the Accounting Period
The financial statements are prepared periodically. The normal accounting period is one year. Accounts of revenues and expenses are transferred to the income statement to ascertain the net income. The net result of the income statement is transferred to capital account in case of non-corporate entities and the position statement shows assets, liabilities and equity accounts.
Net Income and Matching Concept
Net income is calculated by matching the revenues earned and expenses incurred during the accounting period. The revenues and expenses are recognised usually on accrual basis. The recognition of the amount and timing of revenues and expenses affects the amount of net income of the enterprise.
Economic Concept of Income
Economic concept of income is based on current values and not on historical cost. Unrealised gains/losses are taken into consideration while valuing the fixed assets.
5. Revenue Recognition : Salient Features of AS-9
The following are the salient features of Accounting Standard-9 :
AS-9 is mandatory in nature and is applicable for all levels of enterprises w.e.f. 1-4-1993. AS-9 explains how revenue is to be recognised in the profit and loss account of an enterprise. It deals with only those revenue which arise in the ordinary course of business activities, such as :
(a) the sale of goods;
(b) the rendering of services;
(c) the use by others of enterprise resources yielding interest, royalties and dividends.
However, there are certain aspects to which special considerations apply. Therefore, this standard does not apply to :
(i) Revenue arising from construction contracts;
(ii) Revenue arising from hire-purchase and lease agreements;
(iii) Revenue arising from government grants and other similar subsidies;
(iv) Revenue of insurance companies arising from insurance contracts.
Definition and Measurement of Revenue
Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from rendering of services, and from the use by others of enterprise resources yielding interest; royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the rewards arising from the use of resources by them. In an agency relationship, the revenue is amount of commission and not the gross inflow of cash, receivables or other consideration.
The following items are not included within the definition of revenue for the purposes of AS-9 :
(i) Realised gains resulting from the disposal of and unrealised gains resulting from the holding of, non-current assets e.g., appreciation in the value of fixed assets;
(ii) Unrealised holding gains resulting from the change in value of current assets, and the natural increases in herds and agricultural and forest products;
(iii) Realised or unrealised gains resulting from changes in foreign exchange rates and adjustments arising on the translation of foreign currency financial statements;
(iv) Realised gains resulting from the discharge of an obligation at less than its carrying amount;
(v) Unrealised gains resulting from the restatement of the carrying amount of an obligation.
Amount of Revenue
The amount of revenue arising on a transaction is usually determined by agreement between the parties involved in the transaction. When uncertainties exist regarding the determination of the amount, or its associated costs, these uncertainties may influence the timing of revenue recognition.
The amount of revenue depends on:
(i) its measurability and
(ii) its ultimate collection.
When the amount is not reasonably measurable, the recognition of revenue should be postponed.
Timing of Revenue Recognition
Revenue recognition is mainly concerned with the timing of recognition of revenue in the statement of profit and loss of an enterprise.
(a) Sale of goods
Revenue from sale of goods is recognised when the following conditions are satisfied :
(i) The seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
(ii) No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of goods.
The transfer of property in the goods, in most cases, coincides with the transfer of significant risks and rewards of ownership to the buyer. However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership. Revenue in such situations is recognised at the time of transfer of significant risks and rewards of ownership to the buyer. Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the goods are at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes the parties may agree that the risk will pass at a time different from the time when ownership passes.
(b) Rendering of services
Following conditions should be satisfied for recognition of revenue from rendering of services :
(i) Revenue from service transactions is usually recognised as the service is performed, either by the proportionate completion method or by the completed service contract method, whichever relates the revenue to the work accomplished.
(ii) Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service.
Proportionate capital method. Proportionate completion method is a method of accounting which recognises revenue in the statement of profit and loss proportionately with the degree of collection of services under a contract. The revenue recognised under this method would be determined on the basis of contract value, associated costs, number of acts or other suitable basis. This is similar to percentage of completion method that is used for construction contracts.
Completed service contract method. Completed service contract method is a method of accounting which recognises revenue in the statement of profit and loss only when the rendering of services under a contract is completed or substantially completed. If the performance consists of the execution of a single act or consists of performance of more than a single act, and the services yet to be performed are very significant in relation to the transaction taken as a whole, revenue is recognised when the sole or final act taken place and the service becomes chargeable on the basis of completed service contract method. It may be noted that As-7 (Revised) has done away with the completed contract method and replaces it with another surrogate.
(c) Use of enterprise resources
Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognised when no significant uncertainty as to measurability or collectability exits. These revenues are recognised on the following bases :
(i) Interest. Interest is recognised on a time proportion basis taking into account the amount outstanding and the rate applicable.
(ii) Royalties. Royalties are recognised on an accrual basis in accordance with the terms of the relevant agreement.
(iii) Dividends from investment in shares. Dividends are recognised when the owner’s right to receive payment is established, i.e. when the dividend is declared. For recognising dividend in a particular year the right to receive dividend should be established during the year. If the right to receive dividend is established subsequent to the balance sheet date the dividend is recognised in the subsequent year.
Effect of Uncertainties on Revenue Recognition
Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of service it would not be unreasonable to expect ultimate collection. For example, it may be uncertain that a foreign government will grant permission to remit the consideration from a sale in that country. In such situations, revenue is not recognised until the permission is granted.
6. Certain Special Situations Covered by AS-9
Sale of Goods
(a) Delivery is delayed at buyer’s request and buyer takes title and accepts billing. In such a situation, revenue should be recognised notwithstanding that physical delivery has not been completed so long as there is every expectation that delivery will be made, provided that the goods must be on hand and ready for delivery to the buyer at the time sale is recognised.
(b) Delivery subject to condition. The following revenue recognition principles would apply when sales are subject to condition :
(i) Installation and inspection. When goods are sold subject to installation, inspection etc. revenue should not be recognised until the customer accepts delivery and installation and inspection are complete. However, in some cases, the installation process may be so simple in nature that it may be appropriate to recognise the sale notwithstanding that installation is not yet completed. For example, in installation of a factory-tested television, receiver normally only requires unpacking and connecting of power and antennae/cable/satellite dish, the revenue may be recognised even before the installation is complete.
(ii) Sale on approval. When the goods are sold on approval, revenue should not be recognised until the goods have been formally accepted by the buyer or the buyer has done an act adopting the transaction or the time period for rejecting has elapsed or where no time has been fixed, a reasonable time has elapsed.
(iii) Guaranteed sales. In case of guaranteed sales i.e., when delivery is made giving the buyer an unlimited right to return the goods, the recognition of revenue in such circumstances will depend on the substance of the agreement. In case of retail sales offering a guarantee of “money back if not completely satisfied” it may be appropriate to recognise the sale but to make a suitable provision for returns based on previous experience. In other cases, the substance of the agreement may amount to a sale on consignment, in which case it should be treated as indicated below.
(iv) Consignment sales. In case of consignment sales, i.e., when delivery is made whereby the recipient undertakes to sell the goods on behalf of the consignor, the revenue should not be recognised until the goods are sold to a third party.
(v) Cash on delivery sales. In this case revenue should not be recognised until the seller or his agent receives cash.
(vi) Warranty sales. Revenue should be recognised immediately but provision should be made to cover unexpired warranty.
(c) Instalment payment and delivery of goods on final payment. Revenue from such sales should not be recognised until goods are delivered. However, when experience indicates that most of such sales have been consumated, revenue may be recognised when a significant deposit is received.
(d) Special order and shipments. In case of special order shipments, i.e., where full payment or partial payment is received for goods not presently held in stock (for example stock is still to be manufactured or is to be delivered directly to the customer from a third party), revenue from such sales should not be recognised until goods are manufactured, identified and ready for delivery to the buyer by the third party.
(e) Sales/Repurchase Agreements. Where seller concurrently agrees to repurchase the same goods at a later date, the resulting cash inflow is not revenue as defined and should not be recognised as revenue where such transactions are in substance a financing agreement.
(f) Sales to intermediate parties. In case of sales to intermediate parties, i.e., where goods are sold to distributors, dealers or others for resale, revenue from such sales can generally be recognised if significant risks of ownership have been passed; however, in some situations the buyer may in substance be an agent and in such cases the sales should be treated a consignment sale.
(g) Subscriptions for publications. Revenue received or billed should be deferred and recognised either on a straight line basis over time or, where items delivered vary in value from period to period, revenue should be based on the sales value of the item delivered in relation to the total sales value of all items covered by the subscription.
(h) Instalment sales. When the consideration is receivable in instalments, revenue attributable to the sales price exclusive of interest should be recognised at the date of sale. The interest should also be recognised as revenue, proportionately to the unpaid balance due to the seller.
(i) Trade discounts and volume rebates. Trade discounts and volume rebates received are not encompassed within the definition of revenue since they represent a reduction of cost. Trade discounts and volume rebates given should be deducted in determining revenue.