Limitations of Accounting Income

Although financial statement readers find reported accounting income very useful, it does have several limitations. Conceptually, we often think of income as an increase in wealth. If our bank account grows by $100 because of interest, we feel as though our income is $100. For many assets, however, accounting does not recognize an increase in value when it occurs. Instead, the value increase and the associated income are recognized at the time of the asset’s disposal.

Sometimes the difference between historical cost and current value can be quite large. Consider Hiroshi Fujishige, who owns a 58-acre farm across the street from Disneyland. The farm was purchased in 1953 for $2,500. Southern California real estate experts estimate its value to be $55,000,000. In spite of this estimate, the Fujishige Farm balance sheet reflects the land at $2,500, and the increase in value has not appeared on any of Fujishige’s income statements. In general, to recognize a value increase, accounting rules require the occurrence of a transaction for verification purposes.

Financial statements do not reflect still other accomplishments of a firm. For example, the Wall Street Journal reported that the Food and Drug Administration planned to approve an anticlotting drug developed by CORTherapeutics, Inc. This was extremely good news for COR; in fact, its stock soared 79% on the news. However, this event was not included in its accounting records when the announcement was made. At that time, COR had not engaged in any transaction; no sales had been made. The financial statement effects of the drug sales will be recognized in the accounting records as they occur.

Accounting’s conservatism principle can also limit the extent to which accounting income reflects changes in wealth. This principle states that when doubt exists about the accounting treatment for a given transaction, a conservative alternative should be selected. In other words, select the alternative that reports lower asset values and lower net income. For example, expenditures for research and development are immediately expensed, even when they result in valuable products or patents. Spending on employee training is expensed immediately, even though its objective is to create a more highly skilled workforce. These examples suggest that the balance sheets of some companies may have undervalued or unrecorded assets; this, of course, implies that the net income figure on the income statement does not necessarily reflect changes in wealth. On the other hand, most accountants support the conservatism principle because it helps avoid overly optimistic financial statements.

In summary, to ensure that reliable and verifiable financial statements emerge from the accounting process, GAAP precludes the recognition of certain potential value changes. Because of this, accounting income does not strictly measure changes in wealth. However, it is a very useful performance measure on which the business community relies heavily.

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