Top 2 Approaches to Income Measurement

The following points highlight the top two approaches to income measurement. The approaches are: 1. Transactions Approach to Income Measurement 2. Activities Approach to Income Measurement.

Approach # 1. Transactions Approach to Income Measurement:

The transactions approach in income measurement records changes in asset and liability valuations only as these are the result of transactions. The term transactions is used in a wider sense and it includes both external transactions and internal transactions. As it can be inferred, external transactions relate to dealings with outside parties and internal transactions arise due to use or conversion of assets within the firm.

Changes in values are not recognised if such changes are based on market valuations or expectations and changes therein. Income is recognised when new market valuations are more than the input (cost) valuations and when the external transactions take place. Internal transactions may have valuation changes, but only those that result from the use or conversion of assets are usually recognised and recorded.

When conversion takes place, the value of the old asset is usually transferred to the new asset. Therefore, the transactions approach fulfils the concept of realisation at the time of sale or exchange and cost concept recognised in accounting.

In transactions approach, income is determined after recording revenues and expenses associated with external transactions. It should be understood that revenues and expenses have their own problems of timing and valuation. However, the vital issue is of proper matching of expenses with the associated revenues during a definite period.

Furthermore, the different concepts of net income based on different methods of determining capital maintenance can be considered in the transactions approach which will require adjustments to revenues and expenses at the time of recording each transaction and assets valuations at the end of each period.

In fact, current accounting practice is a combination of capital maintenance concept of income, operational concept and the transactions-based approach to income measurement.

The transactions-based income measurement has some advantages.

Firstly, it provides information about assets and liabilities existing at the end of a period.

The availability of this information facilitates application of different asset valuation methods.

Secondly, the net income of a business can be classified in terms of products, customers which certainly provide more useful information to the management.

Thirdly, income data can be collected for operations within the firm and external factors separately.

Fourthly, different statements prepared under the transactions approach can be made to have linkage with each other. This enhances the fuller understanding and utility of data developed in this approach.

Approach # 2. Activities Approach to Income Measurement:

The activities approach focuses on description of activities of a business enterprise rather than on transactions (as in transactions approach). In activities approach, income is recognised when certain activities or events occur; income recognition is not confined to the mere result of specific transactions.

A business firm does many activities such as planning, purchasing, producing, selling. Activity income is recognised at each of these activities. Practically speaking, activities approach are expansion of the transactions approach.

The main difference between transactions approach and activities approach is that the former is based on the reporting process that measures an external event—the transaction—and the latter is based on the real-world concept of activity or event in a wider sense.

Both approaches, however, fail to achieve realistic income measurement since both depend on same structural relationships and underlying concepts and both have no real-world counterpart.

Activities approach income facilitates the measurement of several concepts of income, which can be used for different purposes. It can be contended that income in case of production and sale of merchandise requires different valuations and predictions which may not be relevant while measuring income in case of purchase or sale of securities or holding assets for mere capital gains.

The availability of income components by different types of operations or activities is useful in measuring the efficiency of management and also in better predictions as different activities reflect different behavioural patterns.