Limitations of Economic Income

In this article we will discuss about the limitations of economic income.

Economic income has several difficulties. In fact there is no agreement as to the meaning of “better offness” that occurs in specific time periods. Also, this term is not well defined in case of business enterprises. The greatest problem lies in measuring the net assets at the beginning and end of the period, which are required to ascertain income.

Several methods of valuation of assets may be suggested:

(i) Capitalisation of the expected future net cash flows or services to be received over the life of the firm,

(ii) Aggregation of selling prices of the several assets of the firm less the total of the liabilities,

(iii) Valuation of the firm on the basis of current share market prices applied to the total equity outstanding, and

(iv) Valuation of the firm by using either historical or current cost for non-monetary assets and adding the present cash value of monetary assets and subtracting liabilities.

In certainty, the cash flows and benefits could be determined with accuracy. But certainty is a rare factor, and the expected future cash flows upon which income exante (income at the beginning) and ex-post (income at the end) depend, are subject to a great deal of uncertainty.

In practice, the economic income would be subject to extreme subjective-ness and inaccuracies of the predictions:

Secondly, there is a problem regarding the choice of the discount factor used in computing the present values of the future cash flows. Ideally, the discount factor should reflect accurately the time value of money.

If interest rates fluctuate during the time period considered for using the asset, the present values of the opening and closing capital will be distorted simply because the correct discount rate has not been used. The variations in the discount factors would lead inevitably to an increase in the subjective-ness of the resulting income figure; different discount factors produce entirely different measures of income.

Thirdly, accurate predictions about the timing of the receipt of future cash flows are difficult to make. Different times of cash flows produce different measures of capital, and thus different income figures. Inaccuracies in forecasting of realisation times will therefore produce corresponding inaccuracies in the income measure.

Fourthly, the economic income concept assumes a static situation, i.e., an individual or a business enterprise will attempt to maintain his “well offness” at a constant level. In fact, it seems reasonable to assume that individuals will, on the whole, attempt to maximise their “well offness” by investing capital in activities which will yield increasing benefits over time.

Therefore, in forecasting benefits and cash flows for discounting purposes, a significant problem would be to incorporate degree of growth in the cash flows. The choice of such a growth factor further increases the subjective-ness of the economic income.

Edwards and Bell call economic income ‘subjective income’ and observe that it cannot be satisfactorily applied in practice by business enterprises. The notion of “well offness” is indeed a matter of individuals’ personal preferences. Because of the aforesaid limitations, the concept of economic income has little application to the area of financial accounting and reporting.