Accounting Income vs. Economic Income
Accrual Based Accounting
Financial Accounting Standards Board (FASB)
Accounting Income Definition
The accounting income definition is an estimate of performance in the operations of a company. It is influenced by financing and investing decisions. Accounting income or loss generally recognizes realized gains and losses, and does not recognize unrealized gains and losses.
Realized Accounting Income
For income to be realized, it must be related to actual business transactions; in effect, the cash you have must increase or decrease. A change in market value rather than cash received is not an accounting income; it is an economic income. Economic income or loss recognizes all gains and losses whether realized or unrealized.
Whether accounting realizes a gain/loss or not, it is central to the accounting profits definition. It becomes an income suitable for accounting when a gain or loss is realized. The accounting value for this asset is generally listed at the historical value of the transaction selling it. When a gain or loss is unrealized, you may or may not be account for it in general. This depends on the placement of the gaining or losing asset in the balance sheet. Despite that this gain or loss may be accounted for, the fact that it is unrealized makes it an economic income or loss. The accrual accounting income statement will look very different from the fair value accounting statement.
Essentially, accounting income defined the ways companies evaluate their cash standing after the sale of an asset. This, once again, differs from economic income in that economic income is the way for companies to account for changes in the value of a given asset in the market. The deciding factor is whether or not a transaction takes place.
Accounting income is a critical part of knowing your economics. If you’re struggling to identify your company’s economics, download the free Know Your Economics Worksheet.
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Accounting income or loss does not incorporate unrealized gains and losses because of the convention of accounting 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 from an accounting perspective to exclude increases or decreases in value that have not yet been actualized.
Accounting Profit Example
A perfect example of accounting profit occurs every day in the stock market. Investco is a company which invests in market securities. Investco currently owns a share of Google stock worth $600. The following week Investco notices the share of Google stock has increased in value from $600 to $650. Investco sells this share of Google stock and receives $650 from the sale of one share of Google stock. What is Investco’s accounting income? Accounting profit and economic profit demonstrate two different principles.
Investco experienced an accounting income: their share of Google stock was sold for $50 more than it was initially worth. Thus, Investco has a realized accounting gain of $50. The accounting income calculation is $650 – $600 = $50.
If Investco never sold the share of Google stock, then it would have experienced an economic gain of $50. Investco did not have a transaction in which cash increased by $50.
Accounting Income vs Taxable Income
The treatment of accounting income and taxable income is different. The inclusion of tax accounting confuses the matter. Under GAAP, income and expenses are matched to the period in which they are incurred. As a result, the accounting income received incurred on the specific day it sold the share of Google stock. With tax accounting, however, match taxable income and expenses to the period upon which the I.R.S. decides. Investco may or may not incur an increase in taxable income based on I.R.S. regulations. It has incurred this potential increase in the accounting period the I.R.S. chooses. Do not consider accounting income under GAAP an accounting profit under I.R.S. tax rules. Want to check if your unit economics are sound? Download your free guide here.
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