#2942 - 5. Hicks' Income - Financial Accounting, Analysis and Valuation

Hicks - “the maximum value which he can consume during a week and still expect to be as well off at the end of the week as he was at the beginning”

To be made operational, must be clear on what is meant by “well off”

• This is where his approximations come in, each of which has a concept of ‘capital’ that needs to be maintained to maintain ‘well-offness’

Ex ante = calculations made at the beginning of the year in the light of knowledge and expectations at that time

• This is the one relevant for decision making

Ex post = calculations made at the end of the year in the light of knowledge and expectations at that time

• Normally still very subjective since it is still based upon expectations of the future from time 1 onwards

The concept of income is only fully determinable and objective where there are ‘complete and perfect markets’ (Beaver)

“Income No. 1 is the maximum amount which can be spent during a period if there is to be an expectation of maintaining intact, the capital value of prospective receipts (in money terms)”

The level of welloffness is the NPV of future cash flows

Y₀₁=D₁+V₁V₀=rV₀t₀

• The cash flow arising at time 1 + capital value at time 1 + capital value at time 0

• Capital value = PV of FCF from time x onwards

• i.e. the realised cash flow for the period plus the change in capital value over the period

Y₀₁=D₁t₀+V₁t₀V₀t₀=rV₀t₀

Will always equal interest on the capital value at the start of the period

The versions differ in their treatment of windfall gains and losses

• i.e. those that arise from differences between expected interest rates and actual interest rates, or changes in expected interest rates when we no longer assume interest rates are constant

Version A: Y₀₁=D₁t₁+V₁t₁V₀t₀

• The actual cash flow for the period, plus capital accumulation including windfalls

Version B: Y₀₁=D₁t₁+V₁t₁V₀t₁=rV₀t₁

• The actual cash flow for the period, plus capital accumulation excluding windfalls

Takes into account changes in interest rate, which changes the concept of “welloffness”

“The maximum amount the individual can spend this week and still expect to be able to spend the same amount in each ensuing week”

• Capital is ‘the maintainable or permanent income”

Closer to the central concept of income

Ex ante (solving for Y): Y=r₁t₀(D₁t₀+V₁t₀Y)

Income number 2 will be affected if there are differences between expected and actual current year cash flows or differences between originally expected future cash flows and revised expectations

Version A:

• “the maximum amount an individual can consume in a period and still expect to be able to consume the originally foreseen number 2 ex ante income in all future periods”

• $\mathbf{D}_{\mathbf{1}}\mathbf{t}_{\mathbf{1}}\mathbf{+}\mathbf{V}_{\mathbf{1}}\mathbf{t}_{\mathbf{1}}\mathbf{-}\frac{\mathbf{original\ no.2\ ex\ ant}\mathbf{e}}{\mathbf{r}_{\mathbf{1}}\mathbf{t}_{\mathbf{1}}}$

Version B:

• “the maximum amount an individual can consume in a period and still expect to be able to consume the same amount in all future periods”

• Y=r₁t₁(D₁t₁+V₁t₁Y)

“the maximum amount of money which the individual can spend this week and still expect to be able to spend the same amount in real terms in each ensuing week”

Accounting ‘grounded in theory prevalent in economics’ as sought by the Board’s framework, is good in principle, provided the full theory is understood, used and interpreted properly

Has objectivity if income is confined to income from fully exchangeable assets where everyone faces the same prices and discount rates (Beaver and Demski, 1979)

Use of income ex-post is objective, but ex-post “bygones are bygones” and have no relevance to decisions (Hicks, 1946)

Sandilands Report (1975) – “the maximum value which the company can distribute during the year and still expect to be as well off at the end of the year as it was at the beginning”

• Reporting such a value as opposed to historical cost accounting since a company may not necessarily be ensuing this goal, provides little value to users of financial statements

• Hicks was speaking in terms of social accounting and welfare economics

The balance sheet of the company is designed to show shareholders what has been done with their money, and thus original cost of the actual assets is the relevant magnitude (Brief, 1982)

The Central Concepts of Income were not expected by Hicks to be taken up by accountants and thus his meaning has been adapted incorrectly in many ways

• Hicks felt it was not the role of accountants to make price-level adjustments

Relies on perfect and complete markets (which in such a case accounts wouldn’t be needed anyway)

Reporting income based on expectations, but who’s expectations gives subjectivity to the principles

• Isn’t it the role of users to judge their own future expectations and adjust accordingly?

The framework emits the crucial qualifying condition that the income is not subject change due to accumulation or decumulation of human capital (i.e. management skill and workforce exploitation of internal goodwill)

Hicks (1946) – Main text – “Value and Capital”

Bromwich, Macve and Sunder (2010) – Critical analysis of the framework’s use of Hicks theory

Brief (1982)

Beaver and Demski (1979) – Use of Hicksian theory in accounting