Challenges and Relevance of the Application of the Hicksian Income Theory - Essay Example

Advance accounting Contents Contents 2 Introduction 3 Discussion 3 Conclusion 10 References 12 Introduction Profit and income are the basic economic concepts which have attracted numerous discussion and research among the economists and researchers. The researchers have been deeply involved in developing the concepts of income comprising of personal income, national income, taxable income etc. Income is a measure used as a concept in accounting in a business for measuring various policies like taxes, dividend etc. Hicks has developed three theories relevant to income. According to Hicks, income is a kind of well-off. Hicks has tried to evaluate the relation between the wealth of an individual before and after the event of receiving income. Hicks describes that the function and nature of income can be segregated under two organizations in the economy which are dynamic economy and static economy. Though the theories of income developed by Hicks have acted as a base for future researches in the area, it has been identified that there are many discrepancies in the application of these theories in the conceptual framework of accounting. The emergence of various policies and the involvement of the governments have made it difficult to implement the theories of Hicks in the income accounting perspective. Both explicitly as well as implicitly, these theories are usually considered as theoretical concepts of income. This paper aims at critically evaluating the challenges and relevance of the application of the Hicksian income theory in the conceptual accounting framework and its implication in the asset versus liability approach to measure income as compared to the comparison of revenues and expenses. Discussion The theories of income devised by Hicks are aimed at understanding income from different levels and perspectives. The first theory of Hicks deal with pure in come calculated in two periods, the second theory deals with interest and the third theory is base in windfall gains or losses and inflation. According to the Hicks theories, the income in the non-growing or static economy is the amount of income received by an individual in a week if the individual does not anticipate any changes in the prevailing economic conditions and if the individual expects a constant inflow of money in the further weeks. The concept of income is largely based on the definition of liabilities and assets. The traditional income theories face challenges like defining the concept of income directly based on subjective terminologies and not with reference to liabilities or assets. The FASB defines liabilities to be derived from assets with the conceptual implication of the assets becoming a constraint in the application of the income theories in the accounting framework (Whittington, 2008, pp.139-168). The board has proposed that the conventional accounting systems need to be replaced by the conceptual principles developed in the theoretical framework of accounting. The major challenges in this respect are that the conventional concepts and the conceptual concepts of accounting should be complementary to each other rather that substituting or challenging one another. According to the board, the main objective of accounting and financial reporting is to make them usable in the economic decision making processes through the prediction of the future revenues and expense i.e. the cash flows (Walton, 2007, p.114). The board focuses in the enterprise resources to make them consistent with the defining concepts in the financial statements relevant to resources. These defining concepts categorize assets as the economic benefits that may be obtained and controlled in future developed or created through past transactions. The assets have major primacy because all other elements relevant to income are derived from the resources or assets. This is in accordance with the view of the superiority of liabilities and asset based concept of income as compared to the revenue versus income based approach to income. Income is conspired as the increase in the level of net resources measured in terms of increase of assets and decrease of liabilities (Penman, 2007, pp.33-44). Income can be derived from the change in the wealth of the individual and the consumption of an individual from one period to another period. The definition of the assets is not inclusive of the deferred debits that are derived from the revenue versus expense approach used for measuring income. In this respect, the deferred revenue expenditures are carried forward so as to sum up the economic benefits ion the future years. The theory of Hicks has been used in the conceptual framework with respect to the primacy of the assets in measuring income. There are major differences between the theories proposed by Hicks and the implementation of the rules by the board in the accounting policies. These are discussed in the following segments. Firms or Net assets The preliminary income theories of Hicks are developed for individual income and not national income. Later, Hicks also proposed certain income theories related to the income of a firm and the concepts of income of a firm being different from the assets and liabilities held by the firm. The FASB or IASB has not provided any justification that is relevant to the capital value being utilized and captured in the assets and liabilities of a firm as indicated by the income theories developed by Hicks (VanCauwenberge and DeBeelde, 2007, pp.1-26). It is difficult to apply the capital value as derived by Hicks in the incomplete and imperfect market conditions existing in the practical world. Hicks proposed the derivation of the capital value of firms from the assets and liabilities as used in accounting. The initial works of Hicks do not make any reference to the income of firms. However, at a later stage, Hicks improvised his work to estimate the income levels and profitability of a form to establish profitability as the maximum amount that can be taken from a business without altering the future prospects of the business. The advents of joint stock corporations, income taxes and new regulatory policies have made the judgemental approach towards income to become redundant. Instead, transparency and providing information to the shareholders have become critical to sustain the profit and income levels in a business. The accounting approach in this respect should be aimed to minimize disagreements and not to measure profit in absolute terms (Penno, 2008, pp.339-351). Objective versus subjective The income theories of Hicks identified profit or income as the measurement and representation of the amount that can be taken out from the business without disturbing the balance of the business or affecting the daily operations of a business. This kind of estimation of profitability can be developed only on the basis of judgement. But the use of judgement as the sole discretion to the topic may lead to disparity and discrepancy in the opinions of the parties involved in the business for example, the owners of a business against the tax authorities. Therefore, it is difficult to measure profit and income by considering the judgemental approach in the practical accounting purposes (Rayman, 2007, pp.221-225). The need for overhead allocation and depreciation of fixed assets emphasize on the economic and accounting judgments which shadow the maximum profit that can be derived from the firm without hampering the business. Hicks has identified Income number one ex post as objective and not subjective. This indicates that the confinement of the focus on the income from properties and excluding the consideration of increase or decrease in the prospect values caused by the change in the earning power of the people. But the income can be considered as objective and not subjective only on a perfect or complete market which is not possible in the practical scenario. In practice, the markets are not perfect or complete and have large values of future cash flows that are not taken into consideration in the values of the net current assets or property (Barth, 2008, pp.1159-1179). Markets being mostly incomplete and imperfect on nature, the value of most of the business enterprises are comprised of relevant cash flows and cash flow prospects that cannot be sufficiently captured in the market prices of the asserts even if the individual markets are highly liquid in nature. The internal goodwill is the value of the super profits that are calculated after the general rate of return from the assets is surpassed. The internal goodwill forms a major part of the value which depends on the skills of the management in exploiting the people resources and physical resources available in a business and the macro environmental opportunities including the opportunities from the social, political and economic aspects (Potter, 2005, pp.265-289). Hicks coined the term ‘Human Capital’ which indicates the value derived from the management of the assets within a business. This is majorly dependant on the quality of management of the resources. Therefore, according to the theory of Hicks, the only objective measure of income in a business would be the fluctuations of the capital values related to the business in the stock market. The changes in the dividend and market capitalization values are not taken into account which is a major drawback of these theories of income in the modern financial world (Lennard, 2007, pp.51-66). This also makes the financial statements and reporting to the shareholders of the business about the net assets and activities of the firm much redundant. On the other hand, from the real accounting perspective, it is critically important to report the activities and resources of a business to the shareholders in order to maintain appropriate transparency and communication between the firm and the stakeholders (Laughlin, 2008, pp.247-254). Ex post income or ex ante income The ex-ante income is reflective of the expectations from the future cash flows in a business. This is subjective in nature. The ex post income on the other hand, represents the actual cash flows that have occurred during the period along with the relevant revisions of the future expectations at the end of the period. This is objective in nature. According to the income theory devised by Hicks, the calculations of ex post income do not have any particular relevance in the process of decision making and significance related to conduct (Ohlson, 2006, pp.271-279) .But the ex post income is of particular relevance to statistical and economic history of the business. According to FASB or IASB, the asset primacy approach to income should be able to display its usefulness if it has to act as the bedrock for the income theories (Sunder, 2009, pp.101-111). This is because the usefulness in decision making processes is the main objective of financial statements and accounting principles. But the ex post concept of income by Hicks is not applicable in this respect because the theory indicates that the measure of ex post income is irrelevant to the process of decision making and conduct setting by the management (Watts, 2003, pp.207-221). Income number 1 or Income number 2 The income number 1 as indicate by Hicks is the maximum amount that can be taken from the business and that can be distributed among the shareholders of the business without affecting the initial capital value of the firm. But, with a change in the rate of interest, this amount also changes and is different from the maximum distributable amount that can maintain the firm’s abilities to distribute similar amounts in the future. This is represented by the Income number 2 of Hicks theory of income. The disclosures of these standard or permanent levels of incomes are likely to help the business in the decision making processes in future. The market value of a business can be calculated when the proper rate of discount and the income streams are provided. In the modern business scenario, companies are known to show high levels of maintainable or permanent income in their financial reporting so as to maintain the credibility and future prospects of the business (Kothari, Ramanna and Skinner, 2009, p.115). The income number 2 as devised by Hicks is often non applicable in the present accounting environment as the management of modern day businesses believe that the communication of the performance of the companies to the shareholders help to improve the interest and understanding of the shareholder regarding the feasibility of their investments (Wells, 2003, p.273). The disclosure of the Earnings per share (EPS) helps the investors to understand the underlying ability of the business to generate returns for their investments in the stocks of the business (Weetman, 2007, pp.233-242). Therefore, for companies listed in stock exchanges, the income number 2 would reflect the maximum level of dividends that can be maintained in the current and the future period of operation of the business (Landsman, Peasnell, Pope and Yeh, 2006, pp.203-245). Assets and liabilities can be derived from such income and the related practice dependant disclosures under restrictive assumptions but income cannot be derived from the assets under similar conditions (Landsman, 2006, p.44). The maintenance of such levels of earning to help the investors in the investment decision making would call for the derivation of assets and liabilities form income in place of deriving income from assets and liabilities. This is a major hindrance in the practical application of the Hicks theory of income in accounting because the superiority of the assets in deciding the income becomes irrelevant in this case. The conceptual clashes between the Income number 1 and income number 2 as proposed by Hicks creates the scope for the income concepts used by firms in their decision making processes would vary with the prevailing conditions and circumstances for the business (Jameson, 2005, pp.44-48). Any measure for income which has relevance to the decision making processes of businesses are subjective in nature and therefore are generally the ex ante incomes. The ex post income can be used to predict the future incomes and to refer to the underlying statistics as documented in the accounting records. But this should ensure that the accounting records contain sufficient information for facilitating the decision making processes. The main challenges faced in ex post income measure is that it is not sufficient for forecasting the future income levels and therefore is often lacking in its usefulness in decision making (Jones and Slack, 2008, p.102). These challenges indicate that the income theories of Hicks do not find a practical way of implementation for defining the income of a form which can be used in accounting for decision making and other relevant purposes. Conclusion Thus, it can be seen that the Hicksian theories of income are not entirely suitable for implementation in the modern day accounting framework. The reasons can be summarized as follows. Firstly, the firms in the current business environment have many activities and they do not operate only on the basis of generating return from the identifiable assets. These assets do not always have a readily accessible market value. The element of human capital remains important in creating internal goodwill when the markets are not complete and the asset markets exist in equilibrium. The theory of Hicks is not sufficient to arrive at a practical measure for income from the business perspective that can be reflected in accounting. This is because the income considered in the Hicksian income theory considers the income of the proprietors more than the overall income of the firm. This measures the ex post income driven by the shifts in the expectations related to the future cash floes of the business rather than by the realized cash flows considered for the completed period for the accounting purposes. Another main challenge is that the assessment of Hicks for income is subjective and irrelevant in a decision making process which is in sharp contrast to the main aim of financial reporting and accounting. References Barth, M. 2008. Global Financial Reporting: Implications. The Accounting Review. Vol.83 (5), pp.1159-1179. Jameson, J. 2005. FASB and the IASB versus J. R. Hicks. Research in Accounting Regulation. Vol. 18(1), pp.44-48. Jones, M. J. & Slack, R. 2008. The Future of Financial Reporting 2008: Measurement and Stakeholders. London: ACCA. Kothari, S. P., Ramanna, K. & Skinner, D. 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