UK Custom Essay Sample on «Economic and Accounting Theories of Income and the Concept of Prudence»

Economic and Accounting Theories of Income and the Concept of Prudence

Introduction

Prudence concept introduced by the IASB in its accounting framework is the accounting principle directed at ensuring non-distribution of unrealized profits as dividends of the shareholders. This principle has been an object of discussion and conflicts in the area of accounting. Inclusion and exclusion of the principle of prudence in the Exposure Draft in 2015 affected the identification of accounting and economic income.

Clarification of Accounting and Economic Theories of Income

From the position of economic and accounting areas, the income and its distribution are considered differently in accounting. When economists and accountants distinguish the costs, the methods of income calculating are also not identical. The financial statements of a company contain accounting income. The information about it is important for the owners of a business, its shareholders, investors, managers, and tax authorities to make decisions (Schroeder, Clark & Cathey 2011). Accounting income is defined as the difference between gross income and the explicit costs of a company. The amount of economic income is the benchmark in management decisions on the appropriateness of a company's activity in the industry (Collier 2015). Economic income is the difference between gross income of the company and all alternative costs (internal and external) of the production and supplied goods and services.

The distinction between accounting and economic approach is important for the determination of income. Economic decisions are related to the alternative use of available resources. Economic decision-making processes should be based on the economic costs only that include implicit costs. However, it is accounting value that is used for the calculation of a number of economic indicators. For example, calculation of the taxes is based only on the accounting value. Therefore, economic income is less than accounting by the value of the implicit financial costs (Chambers 2006).

Economic income differs from its accounting value by the fact that its calculation does not take into account only the cost of paying interest on borrowed funds but also the use of long-term and other interest-bearing liabilities (Whittington 2008). Thus, accounting income exceeds its economic alternative by the value of opportunity cost or the cost of forgone opportunities.

It is economic profit that is considered to the criterion of efficiency of business resources use as its positive value represents the excess of the earned money over the cost of the resources used. On the other hand, quantitative assessment of economic income is rather conditional as there is the likelihood of a subjective approach to the selection of reference for the calculation. In addition, the calculation of economic income is carried out primarily for the companies traded their stocks on the stock exchange in order to provide information to the owners about the changes in equity.

Despite the differences between accounting and economic income, they should be used as complementary indicators. Economic income is useful for understanding the income essence while accounting income helps understand the logic and order of its practical calculation.

Introduction of the Context of Prudence

The context of prudence refers to a range of international principles of accounting used for calculation of financial outcomes of the businesses. The way of income calculation will affect the direction of future managerial decisions. Therefore, the choice of tools for the measuring of income and costs is essential for the relevant reflection of factual financial outcome of a business at the decisions of its stakeholders and shareholders (Devalle, Onali & Magarini 2010). This concept of prudence immediately follows the chosen method of income determination. According to the prudence concept, unrealized gains are not taken into account until realized. However, the expected losses are recognized immediately at the first threat of their occurrence. According to some experts in accounting, the principle of prudence is difficult to combine with the "truthful and honest assessment", which is required in publishing of financial statements (Wolk, Dodd & Rozycki 2007). Compliance of the concept of prudence provides an assessment with pessimistic scenario. However, most of the accounting experts believe that the preparation of reports based on "truthful and honest assessment" is just the action on the concept of prudence.

Prudence attested the quality of financial reports (Bushman & Piotroski 2006). This international principle of accounting was used by the international organisation dealing with the standards of financial reporting. A deirability of prudence was changed due to its conflicting with neutrality in accounting. The positions of prudence in the Framework were conditioned by its presence in the conceptual basis of income distribution and evaluation. Its renewal was supplemented with alignment to neutrality in accounting (Wagenhofer 2015). The Exposure Draft of the conceptual framework dedicated to the financial reporting distinguished the concept of cautious prudence (Elliott & Elliott 2007). Discussion of the draft particularly highlighted the ability of this prudence to still counteract optimistic managerial bias. The developer assumed that their return to prudence was explained by an attempt to make accounting more neutral. Thus, such peculiarities do not recognize all liabilities and assets including a company’s goodwill, and do not prohibit the weakening of assets (Wagenhofer 2015). It can affect the ultimate calculation of economic profit taking into account internal costs in the form of low-valued assets. The demonstrations of the concept of prudence are originated from the theories of accounting and economic income. On the other hand, they lead to comprehensive application of prudence towards different accounting objects (Evans 2010).

 Widespread methodology and conceptual approach of the accounting theory of income demonstrate accounting of explicit costs while introduced prudence was directed at evaluation of all applied costs and their optimal value, without overstating or understating of any of assets and liabilities. Accounting theory of income lacks consideration of implicit internal costs of an entrepreneur or investor that understate his costs applied during the business contribution (McKernan 2007). Instead, economic theory stimulated the reintroduction of the concept of prudence as it took into consideration all production costs and normal profit (income).

Economic theory of income contributed to the renewal of cautious prudence that has appeared under the uncertain conditions and necessity to reflect all costs and benefits in financial statements (Penman 2007). Prudence was endowed with new approach to evaluate implicit entrepreneurial liabilities and costs. In order to support neutrality, prudence demands fair judgement basing on relevant information about all business expenses (Power 2010). The contribution of accounting theory of income to the prudence reintroduction was caused by the changed requirements to all liabilities and assets. It addresses the ability of an expert to apply as easy accounting approach as for economic theory of income (Getting a Better Framework 2013). Overall, reintroduction allowed applying both theories of income in the practice of any entity, namely with stock capital.

The concept of prudence became flexible and allowed analysing the assets of a company under the conditions of uncertainty (Feleagă, Dragomir & Feleagă 2010). Along with this influence on prudence, its appearance is based on an honest assessment of the external explicit costs of resources and the internal liabilities of entrepreneurs. Global economic processes amplified the demand for the qualitative accounting data. These circumstances caused the abandoning of accounting concept that based on prudence and measurement of costs. New approach to accounting theory of income facilitated the income concept that was defined by the provisions of economic theory (Procházka 2011).

Due to the following to theoretical peculiarities of accounting and economic income, the improved concept of prudence allowed making accounting processes more secure for investors and other stakeholders. As liabilities and assets are measured by their fair value and managed by the concepts of fair management, investors have an opportunity to make decisions based on accurate information about the fair value of the assets of a company (Procházka 2011). The peculiarities of an income, its structural assessment by the principles of accounting, and economic theories of income substantiate the practical sufficiency of prudence's application in regard to the investment objects.

These suggestions are provided by the provisions of new prudence approach attesting that income and assets should not be estimated by high value and price while liabilities should not be estimated at low cost. Implementation of prudence concept ensures that profits or income are reported if they are able to provide high level of benefits until realized. Along with this fact, losses should be identified earlier, just after the moment of their identification (Ristea & Dumitru 2008). Calculation of economic income contributes to this function of the concept of prudence and eases the access of investors to the real and actual information about the current value of assets and accompanied costs.

However, application of prudence in accounting may influence the accountting policy guided the timely identification of emerged financial phenomena and transactions, proper measurement of liabilities and assets, and provision of stakeholders with information on losses and gains (Radu & Isai 2014). The same functions are carried out by accounting and economic income. Their informational support of investment decision is the strong argument of financial analysis. Proper implementation of cautious prudence that was promoted by 2015 draft may play a significant role in practical preparation of financial reports and improvement of accounting standards (Getting a Better Framework 2013).

It is interesting that provision of useful and accurate information is the goal of reintroduced prudence concept. Among the qualitative characteristics of new approach, there is information relevance. Such information distinguishes various decisions of its users (Getting a Better Framework 2013). In addition, the reintroduction was remarkable for other specific goal of clear principle of prudence such as faithful representation (Getting a Better Framework 2013). This goal means the accurate demonstration of financial conditions or phenomena and its faithful, complete, and neutral representation. Therefore, the investment decisions are supported by the developed economic toolset for preceding investment consideration (Elliott & Elliott 2006).

Among the benefits of the reintroduced concept of prudence, experts eliminated the ability of an investor to delay recognition of assets or income transactions until he/she is certain of their validity and sustainability (Bartelmus 2009; Schaltegger & Burritt 2010). The investors may also review assets, record and verify liabilities and expenses during the period of their availability. The same concerns their value decline or the growth. Providing a less positive view of the valuation of assets and other valuable investment objects, the user provides him/her with useful information as well as certain winning from the time taking for the control over a company's assets. Herein, if short-stoke may not show the income growth in contrast to the cost, the investor will be able to determine the fair real value of assets and liabilities (Arewa 2006).

The concept of prudence may be implemented due to reserve concerning obsolete inventory, or allowance for dubious accounts, or other issues of assets’ application. A particular item will lead to the costs that have not yet determined although a prudent individual may mark this reserve as the investment object, with certain long term in expectation of growing expenses in the nearest future. Thus, the ability of the investors to delay recognition belongs to the advantages of the concept of prudence based on the basis of accounting and economic theories of income.

Reintroduced prudence may be incorporated in numerous standards. For example, they may force to record fixed assets while their fair value declined (Asher 2006). Although the assets could have long-term perspectives, an investor would not be able to record them in the case of occurred reverse. An international organisation engaged in development of reporting standards enables the performers to commit upward re-estimation of fixed assets.

The theoretical background of the concept of prudence is provided by the economic idea of fair managing of the investments and receiving quality information on the dynamics of prices for a company's assets (Perry, Serven & Suescun 2008). Evaluation with the concept of prudence argues that its economic basis is associated with the conceptual framework of the theory of income. If all investors are interested in costs' minimizing and return' maximizing, these solutions demonstrate the economic component of the concept of prudence. Through it is the echo to the economic theory of the mechanism of prudence actions, this concept came back into the area of accounting with an updated target quality destination.

Conclusion

Consideration of the emergent concept of prudence in the financial business sector is supported by theoretical background of the theory of accounting and economic profit. Prudence principle was introduced with respect to the conceptual basis of the new policy and evaluation of assets in order to make high-quality investment solutions. Excellent methodological development for the implementation and support of the concept of prudence were designed to ensure the identity of the investor and appropriate qualitative information about the real and fair value of assets (Asher, 2006). It should be noted that prudence harmoniously continues the tradition of evaluation including the theory of income. Economy and the peculiarities of calculation are the qualities imitated by this concept. They will serve as guidelines for implementing of the qualitative accounting and economic proposals.

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