Tag Archives | GAAP

Accounting Income vs Economic Income

See Also:
Economic Income
Accounting Income Definition
Income Statement
Operating Income
Net Income
Future of the Accounting Workforce
Variance Analysis

Accounting Income vs. Economic Income Definition

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.

Gains and losses are realized only when the related transaction is settled or completed. 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 Conservatism

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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Accounting Income vs. Economic Income Example

Here is a simple example dealing with an individual. 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. 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.

Mark to Market Accounting 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 he company would value the silver on its balance sheet at $15 per troy ounce, and report the increase in inventory value as an element of its net income for the period being reported.

GAAP vs IFRS

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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Accounting Income vs. Economic Income

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Accounting Income vs. Economic Income

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Accounting Income Definition

See Also:
Accounting Income vs. Economic Income
Accrual Based Accounting
Financial Ratios
Comprehensive Income
Financial Accounting Standards Board (FASB)

Accounting Income Definition

Accounting income is defined as 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.

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.

Central to the accounting profits definition is whether a gain or loss is realized or unrealized. When a gain or loss is realized it becomes an income suitable for accounting. 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 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 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 Conservatism

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 it would have experienced an economic gain of $50. This is shown by the fact that 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. This means that the accounting income Investco received was incurred on the specific day that it sold the share of Google stock. With tax accounting, however, taxable income and expenses are matched 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. This means that an accounting income under Gaap may not be considered an accounting profit under I.R.S. tax rules.

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Compare IFRS vs U.S. GAAP for SME’s

Do you want to know what is going to change when the new international standards are adopted? The AICPA has now created a wiki comparing the streamlined and complete version of the international standards using IFRS vs. U.S.GAAP for SME’s (Small and Medium Sized Entities). All of the sections of the IFRS will be updated in a wiki format on a go forward basis.

You can now see how the new rules will apply to private companies. As the rules become evident and adoption more likely, this web site will be a great resource for navigating the change. To see the comparison go to the new site at wiki.ifrs.com.

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