In this article we will discuss about the advantages and limitations of accounting income.
Advantages of Accounting Income:
(1) Accounting concept of income has the benefit of a sound, factual and objective transaction base. Accounting income has stood the test of time and therefore is used by the universal accounting community.
(2) Another argument in favour of historical cost-based income is that it is based on actual and factual transactions which may be verified. Advocates of accounting income contend that the function of accounting is to report fact rather than value. Therefore, accounting income is measured and reported objectively and that it is consequently verifiable.
(3) Accounting income is very useful in judging the past performance and decisions of management. Also it is useful for control purposes and for making management accountable to shareholders for the use of resources entrusted to it.
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(4) Income based on historical cost is the least costly because it minimizes potential doubts about information reliability, and time and effort in preparing the information.
(5) In times of inflation, which is now a usual feature, alternative income measurement approaches as compared to accounting income could give lower operating income, lower rates of return which could lower share prices of a business firm.
Limitations of Accounting Income:
Despite of accounting income being useful in many respects, it has certain limitations:
Firstly, the historical cost concept and realisation principle conceal essential information about unrealized income since it is not reported under historical accounting. Unrealized income results from holding assets, which should be reported to provide useful information about a business and its profitability and financial position.
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It also leads to reports of heterogeneous mixtures of realised income items. This implies that the criteria of relevance and usefulness with regard to unreported information are sacrificed.
Accounting income may have little utility in many decision-making functions as it does not report all income accumulated to date; it does not report current values; balance sheet is merely a statement of unallocated cost balances and is not a value statement.
Secondly, validity of business income depends on measurement-process and the measurement process depends on the soundness of the judgements involved in revenue recognition and cost allocation and related matching between the two. There is a great deal of flexibility and subjectivity involved in assigning cost and revenue items to specific time periods and using matching concept.
According to Sprouse, “In most cases matching of costs and revenues is a practical impossibility.” Sprouse describes the process as one similar to judging a beauty contest where the judges cast their votes according to their personal preferences to decide the winner, because no established concepts exist to ascertain beauty, just as there are none to determine proper matching.
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Kam argues:
“One of the consequences of the conventional matching principle is that it relegates the balance sheet to a secondary position. It is merely a summary of balances that results after applying the rules to determine income. It serves mainly as a repository of unamortized costs. But the balance sheet has an importance of its own; it is the primary source of information on the financial position of the firm. The conventional matching principle is responsible for deferred charges that are not assets and deferred credits that are not liabilities. Traditional accounting principles complicate the evaluation of the financial position of a company when the balance sheet is considered mainly as a dumping ground for balances that someone has decided should not be included in the income statement.”
Thirdly, the traditional accounting income is based upon historical cost principle and conventions which may be severally criticised, e.g., lack of useful contemporary valuations in times of price level changes, inconsistencies in the measurement of periodic income of different firms and even between different years for the same firm due to generally accepted accounting principles. Thus, accounting income could be misleading, misunderstood and irrelevant to users for making investment decisions.