The nature of income

A difficulty facing students learning accounting is that it uses common language in specific and uncommon ways.

This is not unique to accounting. You might think that you know what metal is until you have a conversation with a metallurgist. Or more likely listen to metallurgists argue — it turns out they can’t settle on an agreeable definition. [1]

Scientists have the good sense to create their own specialised terms, such as electrons, quarks, neutrinos and the like. Accountants use terms like ‘fair value’, ‘assets’, ‘goodwill’, ‘equity’, ‘depreciation’, and apply them specifically, technically and unexpectedly.

Although these words may not be used in every student’s daily language, most come to class with some sense of their meanings. It would be easier if they didn’t because these rarely match the accountant’s definitions. Effective accounting education addresses this important ‘unlearning and re-learning’ phase so that your students are able to build robust conceptual foundations.

Just to be clear, this article is about income as revenue, not ‘net income’ as profit. Either way, the claim that income is not valuable holds. If income is not valuable, then profit (income less expenses) can’t be either.

A word of warning: however you teach income, don’t start with the IFRS Conceptual Framework defintion [2] which has been known to set off nose-bleeds in classrooms — it’s best avoided, at least to begin with. It’s also inadequate as it explains income only in terms of effects (increase assets/decrease liabilities) rather than its inherent nature.

A better place to start, as usual, is with semantics. Although, from an accounting perspective, dictionaries invariably provide incorrect and/or conflated definitions along the lines of ‘money received’ [3], a student’s initial understanding is likely to be closely aligned to this.

I start by sounding out the word: “in—come”, which sounds like something is coming in. It’s therefore reasonable to think that it is something good and so surely it must be valuable. This is an acceptable explanation outside the realm of accounting, but not within it. In accounting terms, the nature of income is not a ‘coming in’ of anything.

In the article about expenses, the recommended definition came from The Joy of Accounting and it was that expenses are activities that sacrifice or use up value. Income is similarly explained:

Income is activity that generates value.

Income is activity — it is action — it has effect.

It might seem like nit-picking to say that an activity that generates value is not itself valuable, but this is an important distinction which rests on the essence of double entry bookkeeping. Every transaction has two simultaneous but separate effects which we tend to collapse when talking.

For example, the term ‘car loan’ is used to describe a loan provided by a bank (liabilities increase) and the proceeds of the loan are used for the purchase of a motor vehicle (assets increase). In accounting terms, there’s no such thing as a ‘car loan’: there’s a car and there’s a loan—there’s an asset and there’s a liability.

It’s the same with income. You may have heard and understood the term ‘cash sale’, but this is another collapse of duality: there is more cash (assets increase) as a result of sales activity (income/revenue). ‘Cash sale’ describes two things that arise from a singular event: sales activity that generates cash.

Cash is valuable and, as we know, valuable things are assets. Income is a source of funds, not an asset, so it cannot be valuable. It is expressed as a monetary amount but it isn’t ‘money received’.

Watch out for phrases that are double conflations (there should be a word for that). For a gardening business, ‘mowing the lawn’ is value generating activity—gardening (income/revenue) will increase cash (assets)—and it’s a value sacrificing activity—use of the mower, petrol, labour hours (expenses) reduce the value of assets (paying out cash, recognising depreciation of the equipment etc.).

Income represents the part of the activity that creates value. Expenses represent the part that destroys value. If more value is created than destroyed, the activity generates profits (equity increases).

Mowing the lawn is an example of ‘active income’ which is relatively easy to identify within accounting ledgers because the account name usually describes the general activity: ‘gardening’, ‘consulting’, ‘cup-cake sales’, ‘conveyancing fees’ (these examples are probably not from a single enterprise).

‘Passive income’ represents returns on financial assets, such as dividends received or bank deposit interest received. ‘Return’ in this context is value generating activity, although the underlying actions that create value occur in another entity (the bank or the investment entity). The principle remains the same: passive income generated by financial assets is not valuable.

Transactions giving rise to active and passive income require a counterparty, that is another entity to buy gardening services or to provide financial returns. Income, however, may sometimes be recognised even when there’s no counterparty.

For example, an entity buys land and records it at cost. The entity opts for the ‘valuation model’ [4] for this class of asset so the land must periodically be restated to its ‘fair value’. The increase in value is unrealised—no activity has yet happened—but it is recognised—it shows up in the financial statements.

The justification for allowing entities to report unrealised income is that fair values provide useful information. There’s opportunity here for critical reflection of fair value accounting.

So far we have looked at income as activities that increase the value of assets, but (as we saw with expenses) income may result in decreases in liabilities. This happens when value is received from the customer in advance of goods or services being provided.

Try a story along these lines with your students. Let’s say a firm of solicitors requires a client to pay up front before providing any legal services. The firm receives the cash (assets increase), but there’s been no activity, no legal advice has been given, hence no income. There has to be a double entry — we can’t just leave the cash hanging there — so what’s the other entry?

The answer is that the firm has an obligation to provide legal services to its client — liabilities increase, and we call this obligation ‘deferred income’ (another term that tends to cause confusion [5]). This is a performance liability as it represents the obligation to do something rather than to pay somebody. It is discharged through action rather than settled with money.

When the activity takes place, the provision of legal services in this case, income is recognised and the obligation is discharged (increase income / decrease liabilities).

A couple of points to summarise.

(a) The nature of income is activity that increases the value of assets (or decreases liabilities). Income must therefore increase the value of equity (the residual of assets less liabilities). We’re now getting dangerously close to the IFRS definition, which students might now be in a position to confront.

(b) Whatever we call it, the statement of comprehensive income, the statement of profits or losses, the P&L, the income statement, it is a statement of financial activities. It is the story that explains how value was generated and sacrificed over the accounting period. It says nothing about the resources held by the entity, or money received and paid—we have other statements for those.

© AccountingCafe.org

Suggested further reading

The nature of expenses

I’ve lost count of the times a student has told me that an expense is cash paid, or that depreciation results in a cash payment. (“To whom?”, I always ask). It’s not their fault. Expenses are a perfect illustration of how accounting uses common language in specific and uncommon ways. Read more…

Notes and references

[1] This example is given in Paul Elbourne’s Meaning, a slim guide to semantics. Oxford Linguistics, 2011.

[2] “Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.” IFRS Conceptual Framework 2018, Para 4.68.

[3] Dictionaries invariably provide confusing, conflated and incorrect definitions that do not apply to the domain of accounting. The Oxford English Dictionary is typical: “income /ˈɪnkʌm / money received, especially on a regular basis, for work or through investments”. In 2023, Investopedia was similarly erroneously referring to income as “money…received”. Income is not ‘money received’.

[4] IAS 16 Property, Plant and Equipment.

[5] In my learning materials I call the unit that covers this topic “Deferred income is a liability” and its cousin “Accrued income is an asset”.