Accounting income or loss recognizes realized gains and losses, and does not recognize unrealized gains and losses. Economic income or loss recognizes all gains and losses, whether realized or unrealized.
When the related transaction is settled or completed, gains and losses are realized. Until a transaction is completed, any gains or losses related to that transaction are considered unrealized. Unrealized gains and losses are also called paper gains or paper losses, because the nominal value of the asset or liability has changed, but the cash has not actually changed hands.
Accounting income or loss does not incorporate unrealized gains and losses because of the convention of conservatism. When accountants confront uncertainty in regard to method or procedure, they conventionally choose the option that is least likely to overstate income or asset value. In the case of realized versus unrealized gains and losses, it is more conservative to exclude increases or decreases in value that have not yet been actualized.
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Here is a simple example dealing with an individual regarding accounting income vs economic income. Imagine Ralph earns $50,000 dollars per year salary, after tax, and has $10,000 dollars invested in the stock market. At the end of the year, his stock market investment is worth $15,000.
Because Ralph has not yet sold his stock and collected the profits, the increase in value of the investment is considered unrealized. Consequently, it is a paper profit. At the end of the year Ralph has a realized income of $50,000 from his salary. His total realized income is $50,000. He has unrealized profits of $5,000 dollars. His combined realized and unrealized incomes equal $55,000.
In this example, Ralph’s accounting income would be $50,000 and his economic income would be $55,000. According to accounting income, the increased value of the stock investments do not count as actual income because the investor has not actually sold the stock, completed the transaction, and collected the profits.
According to economic income, the increased value of the stock investments to count as actual income because the real value of the assets has gone up. The assets are worth more now then they were at the beginning of the year. In this sense, Ralph has earned the full $55,000 income.
There are exceptions to the methodology of reporting net income, based solely on the historical cost of acquired assets. US GAAP includes the principle of “Mark to Market Accounting.” Under this accounting principle, valuation of commodities, securities and other financial instruments on a company’s balance sheet are based on the market values of such assets.
For example, if the cost of a precious metal acquired by a company for use in its production process, such as using silver to produce a catalyst used by the petrochemical industries was $10 per troy ounce and the market value of silver increases to $ 15 per troy ounce, the company would value the silver on its balance sheet at $15 per troy ounce. It would also report the increase in inventory value as an element of its net income for the period being reported.
Another development in the financial arena is the move towards “IFRS” or International Financial Reporting Standards, which have been adopted by European companies, and which US companies will move to, in order to provide a common measuring stick when comparing earnings per share of publicly traded companies. IFRS mandates adjustment of many assets to a market value, which adjustments would be/ are included in the calculation of accounting income.
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