Estimation of Ex-post Income

In the foregoing example, the income for the year 19X0 has been calculated on the basis that the expected future net receipts at the end of the year 19X0 remained the same as those at the beginning of the year. Under such conditions, ex-ante and ex-post income would be the same.

If, however, the present value of expected future net receipts at the end of the year 19X0 are different from the present value of those expected receipts at the beginning of the year, we may say that the ex-post income is different from the ex-ante income. The ex-ante income refers, therefore, to the estimated income derived from the time perspective of the beginning of the year, and the ex-post income refers to the estimated income derived from the time perspective at the end of the year.

The subjective nature of economic income

The net present value method of valuation presents measurement problems in a number of ways. Accuracy of measurement depends upon the degree of certainty under which the forecasts of expected future cash flows are made. Ideally, the size of the net future cash flows should be estimated with reasonable accuracy as should the time-profile of these future cash flows. This is because a sum of money in two years' time is worth more than the same sum of money in three years'. We shall discuss the problems further when we examine capital budgeting decisions.

The net present value concept also requires that the discount rate selected for reducing the future cash flows to their present value should reflect accurately the time-value of money. If interest rates are going to fluctuate during the time period considered for using the asset, it follows that the correct present value of the asset will be distorted simply because the correct discount rate has not been applied.

Because the future cash flows and discount rate cannot be determined with certainty, Edwards and Bell ( 2015) call economic income 'subjective income', and dismiss the concept on the grounds that it cannot be satisfactorily applied on an operational basis. They echo, therefore, Hicks's own dissatisfaction with the concept.

We mentioned in Part 2 that because of uncertainty surrounding the valuation of a firm, it is not the accountant's function to value the firm for the shareholder or investor. On the contrary, it is for the investor to establish the firm's value as an investment and to bear the risk implied in such a valuation. The role of the accountant is to furnish information which is useful for this purpose. The usefulness and relevance of the information provided in financial reports lies in the effectiveness with which it allows the investor to formulate valuations with some degree of accuracy. In the face of uncertainty, accuracy can never be guaranteed, but information about past and current performance may be used as a basis of developing projection and estimates of likely future trends. The adequacy of the accountant's presentation of information for this purpose, the clarity and sufficiency of disclosure are the central problem, therefore, facing the accounting profession in this area. The investor should use the information provided to make his own estimates of future net receipts, and taking into account his assessment of the degree of uncertainty involved in those estimates, he should discount those estimated net receipts by an appropriate discount rate to arrive at his valuation of the firm. This valuation will retain a high degree of subjectivity, for the discount rate will vary from individual to individual depending upon their respective risk preferences. Therefore, the concept of well-offness is really a matter of an individual's personal preferences. For all these reasons, the concept of economic income has little applicability to the problem of financial reporting.

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Read on: Economic Concepts

The process of valuation is central to all aspects of decision making. As we shall see in Part 5, capital budgeting decisions require forecasts to be made about the present value of streams of future net cash receipts associated with investment projects. Similarly, investors may also be regarded as exchanging current assets, namely cash or cash equivalents, for a stream of future dividends in the form of cash dividends or increments in the value of their shares.

In this analysis, capital is valued on the basis of discounted future net receipts. Therefore, it is directly relevant to the... see: Economic Concepts