Concept and Relevance of Income
University of Tokyo, Graduate Schoool of Economics, CIRJE Discussion Paper 2002-CF-171
Recently, many people criticize the traditionally accepted principles of realization, matching, and allocation. In addition, the reporting performance project in the International Accounting Standards Board (IASB) is willing to substitute the extant concept of net income for the unexperienced concept of comprehensive income with prohibition of recycling of other comprehensive income. On the other hand, the usefulness or relevance of net income has been repeatedly ascertained in empirical studies. It seems that accountants do not necessarily understand the common knowledge in academic circles correctly. This awareness is one of the motives of this paper to review the empirical evidence on relevance of net income.
This paper investigates again to confirm the concept of net income by comparing it with similar concepts, which is closely related to net income. This investigation consists of two parts. The first part in Section 2 compares cash flows with net income by focusing on accounting allocation. This comparison emphasizes the rationale for income measurement with allocation of cash flows. The second part in Section 3 compares comprehensive income with net income. By focusing on the difference between the two (i.e. other comprehensive income), this paper examines, though indirectly, the essential meaning of net income excluding other comprehensive income.
The review in this paper deduces the following conclusion. First, although accruals are criticized for being affected by managerial discretion, they are in fact valuable sources of information for investors. This is a commonly accepted academic theory that has been confirmed repeatedly through comparison of the value relevance between earnings and cash flows. Second, we cannot find the evidence that other comprehensive income is value-relevant, though it is expected to respond to the information needs of accountants and analysts. In sum, net income characterized by realization, matching, and allocation is most useful in comparison with cash flows and comprehensive income.
Number of Pages in PDF File: 36
Keywords: net income, accruals, earnings, cash flows, comprehensive income, value relevance
JEL Classification: K20, M41, M43, M44, G12working papers series
Date posted: October 29, 2002
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