A change in market value rather than cash received is the perfect example of an economic income. Economic income or loss recognizes all gains and losses whether realized or unrealized. This differs from accounting income which only recognizes realized gains: gains resulting from an actual business transaction. This defines the difference of accounting earnings vs economic earnings.
For income to be realized it must result from actual business transactions. A change in market value rather than cash received is economic income and not accounting income. When a gain or loss is unrealized it may or may not be accounted for 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 term economic income was born out of the need for financial accounting income vs economic income comparisons.
Economic income assists companies in knowing the value of an asset if it was sold at a given time. Key to the economic income discussion is the current value of the asset. By then selecting a time period, research can estimate what price will be paid for the asset. This, as compared to estimations of market performance for the time period, can allow for projections of the market value of the asset in the future.
“If the current price of the land is $100,000 and we expect the market to increase by 10% next year, then the value of the land will be somewhere around $110,000 by the end of next year ($100k + $10k = $110k)”.
These measurements allow projections which influence decisions of financing, cash flow, insurance, timing of the asset sale, and other important decisions. Including costs in the decision can expand further to allow for net accounting income vs net economic income comparisons.
A perfect example of economic income occurs every day. Realco is a company which sells land. Realco purchased, last year, a piece of land for $100,000. The following year Realco notices the land is selling for $110,000. What is Realco’s economic income?
Realco has not sold the land. As a result it experienced an economic income of $10,000. This is proven by the fact that Realco did not have a transaction in which cash increased by $10,000. The economic income concept revolves around the recognition of income in spite of the fact that no sale has taken place.
If Realco sold the property, then it would have experienced an accounting income. Their land was sold for $10,000 more than initially worth. Thus, Realco has a realized gain of $10,000. The accounting earnings vs economic earnings calculation is the same: The difference is whether Realco gains $10,000 from the sale or not.
$110,000 (revenue from sale) – $100,000 (cost of land) = $10,000 (profit from sale)
economic income accounting income $10,000 $10,000
In addition to monitoring market value changes, economic income provides a place holder for an asset in company financials. This allows for managerial accounting income vs economic income decisions. Without economic income, you would only account for an asset when sold or purchased. Economic income allows the monitoring of an asset between the transaction. At the time of accrual accounting income vs economic income evaluations are not the most important matter. They do form an important issue, however, with the natural business cycle changes that result from time.