JOBKEY UNIVERSITY

Ch 5 Income Concept
CH 6 : Positive Accounting theory
Ch Financial report
Lecturer : Yusuf H. Mohamed

The Purpose of Income

Reporting
Income is used

1 as the basis of one of the principal forms of taxation.

2 in public reports as a measure of the success of a corporations
operations.
3 as a criterion for the determination of the availability of
dividends.
4 by rate-regulating authorities for investigating whether those
rates are fair and reasonable.
5 as a guide to trustees charged with distributing income to a life
tenant while preserving the principal for a remainderman.
6 as a guide to management of an enterprise in the conduct of its
affairs.

JOBKey UNIERSITY
CH 5 Income Concept
CH6: POSTIVE Accounting theory
Ch 7 Financial reporting
Lecturer Yusuf Hussein Mohamed

Importance of Income
Reporting
The EMH and stock prices
Economic Vs. Accounting Income
Related sciences
concerned with the activities of business firms
use similar variables
differences over the timing and measurement of
income

Relative importance of income statement

(accounting) and balance sheet (economics)
e
m
o
Inc eme
t
a
t
S
nt

Ba
l an
ce
Sh
ee
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In an Attempt to
Reconcile
What is the
nature of
income?
When should
income be
reported?

What is the Nature of Income?

Three possibilities
Psychic
Satisfaction of human wants

Real
Increase in economic wealth

Money

Increases in monetary value

The concept of well-offness or capital maintenance

Problems

Because of the difficulties in measuring real income Accountants have adopted a transactions approach to
income recognition

CHAPTER-5: INCOME CONCEPTS

The measurement of income occupies a central position in accounting.
Income measurement is the probably the most important objective and
function of accounting, accounting concepts, principles, and procedures
used by business enterprise.
Income represents wealth increase and business success. This means that
the higher the income , the greater will be the success of a business
enterprises.

The importance of income concepts

Income as a guide to dividend and retention policy:
income information determines how entitys periodic income can be
distributed to the owners and how much shall be retained to maintain or
expand its activities.
Based on the difference in accrual accounting and cash accounting income,
the firm may distribute the total recognised income as dividend.
Liquidity and investment prospects are necessary variables for the
determination of dividend policy.

The importance of income concepts

Income as a measure of managerial efficiency:
Income is regarded as an indicator of managements effectiveness in
utilizing the resources belonging to the external users.
Income also tends to provide the basic standard by which success is
measured.
Income is a measure to evaluate the quality of managements policy
making, decision making and, controlling activities.

The importance of income concepts

Income as guide to future prediction:
Income helps in predicting future income and future economic
events of business entity as current income acts to influence future
expectations.
Income also helps in evaluating the worth of future investments
while masking investment decisions.
For example: the higher in income of the firm, the higher level of
share-price or value in intangible assets.

The importance of income concepts

Income as a Means of Determining Tax:
Income figure determines the tax liability of a business enterprise.
Managements and investors are highly appreciate how tax is determined.
The taxation authorities generally accepted accounting income as a basis
of assessing the tax.
Income as a guide to creditworthiness and other economic decisions:
Credit grantors, individuals and institutional require evidence of sound
financial status before advancing loans to business enterprises.

The importance of income concepts

Income-current and future both is a relevant data to determine concern's
ability to repay loans and other liabilities at maturity.
The term of income is also useful in other decision areas such as: pricing,
collective bargaining, governmental, social, and economic regulation and
policies.
Income Statement and Balance Sheet
The relationship between income statement, which reports net income and
balance sheet, which reports financial position of the firm has been a
matter of debate and research in accounting.

Income Statement and Balance Sheet

The differences in emphasise over the years has led to two schools of
thought about measuring earnings.

One view is usually called the Balance sheet: Asset and liability or capital
maintenance view.

The other view is called the income or earnings statement: revenue and
expenses or matching view.

The view of balance sheet is simply a list of what is left over after expenses
have been matched with revenue.

Ch 6 : Positive Accounting
Theory

14

PAT Concept
Agency Theory

Normative
Theory

Bonus
Plan
Hypothesis

Efficient Market Hypothesis

(EMH)

Positive Accounting
Theory (PAT)

Debt
Covenant
Hypothesis

Political
Cost
Hypothesis

Accounting Standards and Practices

15

Positive Accounting Theory

Watts and Zimmerman in 1978 and 1986
Apply to Positive Theory of Economic

16

Agency Theory

The agent (like the principal) will

be driven by self-interest, and
therefore the principals will
anticipate that the manager,
unless restricted from doing
otherwise, will undertake selfserving activities that could be
detrimental to economic welfare of
the principals.

17

Efficient Market Hypothesis

(EMH)

The capital markets react in an

efficient and unbiased manner to
publicly available information.

18

Positive Accounting Theory

Assumptions:
The accountants (and, in fact, all
individuals) are primarily motivated by
self-interest (tied to wealth
maximisation), and that the particular
accounting method selected (where
alternative are available).

19

The Three Hypotheses

1. The Bonus Plan Hypothesis
2. The Debt Covenant Hypothesis
3. The Political Cost Hypothesis

20

The Bonus Plan Hypothesis

Bonus based on net income
To get more bonus, choosing accounting
methods that increase current reported
earnings

21

The Bonus Plan Hypothesis

All other things being equal,
managers of firms with bonus plans
are more likely to choose accounting
procedures that shift reported
earnings from future periods to the
current period

22

The Bonus Plan Hypothesis

Because of the nature of of the accrual
process, this will tend to lower future
reported earnings and bonuses, other
things equal.
PV of managers utility from future bonus
stream will be increased by shifting
earnings toward the present

23

The Debt Covenant Hypothesis

All other things being equal, the
closer a firm is to violation of
accounting-based debt covenants,
the more likely the firm manager is
to select accounting procedures that
shift reported earnings from future
periods to the current period

24

The Debt Covenant Hypothesis

Violation of debt covenant is costly
Restriction on dividends
Limit additional borrowing
Issuance of stock,

Increase current earnings

Assets increase
To avoid violation

25

The Political Cost

Hypothesis
All other things equal, the greater
the political costs (taxes, regulations)
faced by a firm, the more likely the
manager is to choose accounting
procedures that defer reported
earnings from current to future
periods

26

The Political Cost

Hypothesis
Large firm with high profit attracts
media, consumers, and politicians
attention
Large firm trend to reduce profit reports

27

Theory Perspectives
Opportunistic Perspectives

Efficiency Perspectives

28

2 Versions of PAT
Opportunistic Version
Managers choose accounting
policies for their own benefit

Efficient Contracting Version

Managers choose accounting
policies to attain corporate
governance objectives of the firm

8-29

Criticisms

Not improving accounting pratices

Not value free
Not positive thinking for humankind

30

Ch7: Financial Reporting

Financial reporting may be defined as communication of published
financial statement and related information from the business enterprise to
third parts.
The objectives of financial reporting are:
Investment decision making and
Management accountability.
Development of financial reporting objectives
the subject of financial reporting objectives has been generally
recognised as very important in accounting area sine long time.

Many accounting bodies and professionals in all over the world have
attempted to define objectives of financial statement and financial
reporting which are vital point to the development of accounting theory
and practice.
The Trueblood Report
Who need financial statement?
what information do they need?
how much information can be provided by accountants to cover the
needs?
what framework is required to provide the needed information?

Objectives of Financial Reporting

1) For NGOs to provide information useful for evaluating the effectiveness
for management of recourses in achieving the organisation's goal.
2) To provide statement of financial activities useful for predicting,
comparing, and evaluating enterprises earning power.
3) To provide factual and interpretive information about transaction and other
events which is useful for predicting future enhancement.
4) To provide the activities of the entity affecting the society (like social and
accounting environmental accounting concepts)

Benefits Of Financial Reporting

Financial reporting, if adequate and reliable, would be useful in many aspects
Benefits of financial reporting may be listed as follows:
Managers decisions
Economic decision making
Customer decisions
Employee discussions
Cost of capital
Fluctuation of share price

General Purpose For Financial Reporting

USER GROUPS

DECISIONS

Shareholders:
share price or sale decision and mgt performances.
Investment analysis: analysis for advising clients etc.
Creditors:
Competitors:

Credit granting , bankruptcy and terms of credit

financial performance for competitiveness

Employees:
Customer:

wages, salary, security of employees and so on

continuity of supply, economic

Government:
Public:

taxes, regulatory policy, environmental impact

Social responsibility

Qualities of Financial Reporting

The quality of financial reporting is characterised to include the following:
Relevance: the report should be relevant to entities' activities
Reliability: the report should be true and fair
Understandability:
the quality of Financial reporting relates to
understanding
Timeliness: information should be available as needed not earlier.
Neutrality: the report should be freedom from bias
Comparability: comparability implies to have like things reported in similar
fashion.

Qualities of Financial Reporting

Consistency: consistency of method over period of time.

Materiality: materiality implies not all financial activities reported

Verifiability: financial reporting should be traced back if needed

Conservatism: Conservatism is generally referred to convention system
Evaluation qualitative characteristics
Conflict of objectives
Environmental influences and
Lack of complete understanding of the objectives

END