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THE ACCOUNTING REVIEW
Vol. LIV, No. I
January 1979

The Nature of Income Measurement

William H. Beaver and Joel S. Demski

ABSTRACT: Theory and practice of financial reporting are typically centered on the
notion of income measurement. In this article, the authors adopt a fundamental measure-
ment perspective. Income measurement is then argued to exist in a world of complete
and perfect markets, but not necessarily otherwise. Hence, at a fundamental level the
central feature of financial reporting cannot be income measurement. The writers then
offer a reinterpretation of income reporting and accrual notions in terms of a "cost-
effective" communication procedure.

F reporting is heavily con-

INANCIAL
cerned with income "measure-
ment." Theorists have, for decades,
argued the nature of income and how best
to measure it. Practitioners define their
task in terms of income measurement. In
turn, the FASB's reaffirmation of the
importance of income [FASB, 1976]
raises renewed interest in the measure-
ment issue and provides a motivation for
our paper.
In particular, the purpose of this paper
is to explore the nature of income mea-
surement. We offer initially a strict
fundamental measurement perspective
in which income measurement is viewed
as the representation of a preference
ordering on a firm's production plans.
Such a measure exists and is open to a
straightforward present-value interpre-
tation in the usual economic setting of
perfect and complete markets. Unfortu-
nately, these market assumptions render
the measure superfluous. Movement to a
setting of imperfect or incomplete mar-
kets is necessary for economic returns to
such measurement to exist, but the de-
sired measurement does not necessarily
exist in such a setting.
Abandoning the fundamental mea-
surement perspective, we then offer a
reinterpretation of income measurement
as a noisy communication process that
may be more useful than a strictly cash
flow measure and more cost effective than
a more ambitious disclosure policy. In
this communication setting, however, we
do not view the reported datum as a
measure in the fundamental sense.
The paper consists of four sections.
In the first we review the traditional
notion of income measurement in a con-
ventional neoclassical setting under sub-
jective certainty. In the second section we
extend the discussion to an uncertain
setting where complete and perfect mar-
kets are retained. Incomplete markets
and the possibility of fundamental in-
The authors acknowledge the helpful comments of the
participants in the Stanford Summer Research Seminar
(August, 1977) on an earlier draft of this paper.
This research was sponsored by the Stanford Program
in Professional Accounting, major contributors to which
are: Arthur Andersen & Co.; Arthur Young & Com-
pany; Coopers & Lybrand; Ernst & Ernst; Peat, Mar-
wick, Mitchell & Co.; and Price Waterhouse & Co.
WilliamH. Beaver is ThomasD. Dee II
Professor of Accounting and Joel S.
Demski is Professor of Information and
Accounting Systems, both in Stanford
University.
Manuscript received November, 1977.
Revision received March, 1978.
Accepted April, 1978.

38
Beaverand Demski
come measurement in such a setting are
discussed in the third section. Finally,
our reinterpretation of financial reporting
as a noisy communication process in the
light of potentially impossible funda-
mental measurement is presented in the
fourth section.
INCOME MEASUREMENTIN A CERTAIN
WORLD WITH PERFECTAND
COMPLETEMARKETS
Consider a conventional economic
setting in which non-satiating households
supply various factors of production and
consume various commodities that are
produced by various firms employing the
supplied factors. The market structure is
complete in the sense that all consump-
tion goods as well as all factors of pro-
duction are traded in organized markets.
And each such market is perfect in the
sense that prices are known by all agents,
no transactions costs of any form are
present, all agents behave as strict price
takers, and the transaction technology is
convex.' Moreover, we presume the
economy is at an equilibrium, in which
supply and demand offers are equated at
the prevailing price.
Initially, we focus on an instantaneous
setting in which some firm acquires re-
sources and instantaneously transforms
these factors into salable consumption
goods. Let the m dimensional vector
q = (q 1, q.) denote the list of factor
quantities acquired by our firm in ques-
tion. Also let the n dimensional vector
r = (r1, * *, rn) denote the quantities of
consumption goods produced. Finally,
let P denote the m + n dimensional price
vector. We call the receipts less the ex-
penditures of this firm its income:
m+n m is rank-ordered in a complete and transitive manner.
l= E Pjrj - (1)
E Pjqj
j=m+ 1 j=1
At a fundamental level we would term
39
this an income measure. One of the fea-
tures of the neoclassical setting is that the
heterogeneous individual shareholders
are unanimous in their rankings of
alternative production plans for the
various firms in the economy [Radner,
1974b].
This ranking is represented by the
income measure in Equation (1). In
particular, one production plan is as good
as another if and only if it leads to an
income measure that is not lower.2 Each
individual is assumed to be nonsatiating,
(i.e., each prefers more consumption
to less). With perfect and complete
markets, an increase in the individual's
wealth is commensurate with more con-
sumption. And with the firm's income
increased, each shareholder's wealth is
increased. Thus, the income measure
is well-defined here-receipts less ex-
penditures-and the firms are described
as behaving as if they maximized the
income measure.
Extension to a multiperiod setting
retains the income measure description,
but in a more familiar present-value for-
mat. We merely recognize production
factors and consumption goods in each
period and decompose the initial period
measure in the obvious manner: that is,
a period's income is now defined as the
change in the present-value of the future
receipts during that period. This provides
a series of income measures, one for each
period, such that their sum equals the
firm's net receipts over the horizon and
such that vector maximization of the
1 Fractional quantities of all factors and commodities
are available.
2 In more precise terms, we have (with a given set of
endowments and prices) a set of production plans that
This is then represented by an income measure mapping
the production plans into the real numbers and using
the >relation defined on the real numbers. See Ijrii
[1967], Coombs et al. [1970], Krantz et al. [1971], and
Mock [1976].
40
measures is equivalent to present-value
maximization.3
We conclude this brief summary of in-
come measurement in a conventional
neoclassical setting with several addi-
tional points. First, the emphasis is on
fundamental measurement. We have
existence of a mapping from alternative
production plans into the real line that
(using the > relation) represents a
complete and transitive ranking of pro-
duction plans.4 The measure is by no
means unique, but it surely exists and is
open to straightforward, conventional
interpretation. Second, since plans, possi-
bilities, and market prices are all known,
no one would pay an agent to report this
measure. Income is already known or is
costlessly constructable by each agent.
This, of course, follows from the assump-
tions of certainty and perfect and com-
plete markets.
Third, the distinction between ex post
and ex ante measurement is unimportant.
At each intermediate point in time, the
market value of the firm's assets (and
claims against those assets) is known
because complete and perfect markets
exist. Moreover, an outcome which re-
sults in higher market value and higher
net income is preferred. Hence, the net
income measure easily and unambigu-
ously performs the role of ranking out-
comes as well. Indeed, with subjective
certainty assumed, the ex ante and ex
post measures will be identical.
INCOME MEASUREMENTIN AN UNCERTAIN
WORLD WITH PERFECTAND
COMPLETEMARKETS
Movement to an uncertain world
leaves the above argument intact, pro-
vided we endow the economy with an
appropriately rich set of perfect markets.
In such a setting, the precise productive
outcome is unknown at the time of
production. We model this uncertainty
The AccountingReview,January1979
in the usual way, by introducing a state
variable, denoted s e S, such that any
productive outcome is precisely deter-
mined by the productive act chosen and
which state of nature obtains [Debreu,
1959, especially Chapter 7].
This provides a basis for trading in
factors and consumption goods con-
tingent on which state actually obtains.
That is, complete insurance arrange-
ments are possible, through the mecha-
nism of event contingent trading. (Note
that we assume all agents eventually
learn which state does obtain, otherwise
their trade arrangements would be con-
strained to be equal across state occur-
rences they are unable to distinguish.)
Return now to our instantaneous pro-
duction setting in (1). With state indexing,
qs = (q-.. qs ) now denotes the quanti-
ties of factors acquired if and only if state
s obtains. Similarly, r8=(rj rs) de-
notes the quantities of consumption
goods produced if and only if state s ob-
tains; and Ps denotes the corresponding
price vector. Suppose there are { possible
states. Then the firm's production plan is
an { dimensional list of input-output
combinations:
3 An interesting feature of this income measure is that
none of the usual income measurement conundrums,
such as depreciation in the sense of cost allocation, arise
in this setting. To be sure, we may interpret the periodic
income measure as consisting of periodic cash flow less
depreciation. But it is unnecessary to view the deprecia-
tion datum as an allocation of some cost. To see this,
consider a situation in which factors acquired in one
period produce receipts in several future periods. In a
completely rich market setting, any factors carried over
from one period to the next are marketable with a known
price. In that sense no conventional accrual concepts are
involved; nor, for that matter, is any conventional de-
preciation in the sense of interperiod allocation of a pur-
chase price involved. Moreover, the perfect markets
assumption ensures the equivalence among present
value, replacement cost, and exit value measures.
4 Somewhat casually, we say a ranking of elements in
a set is complete if all elements in the set are ranked.
Similarly, the ranking is transitive when one element is
ranked ahead of a second and the second is ranked
ahead of a third necessarily implies the first is ranked
ahead of the third.
Beaver and Demski
((q', r') (qt, r))
and the income of such a firm with such a
plan is defined as
m+n m set of markets is incongruent with the
IPsrsE
s=1 j=m+
1 j=1Pjq ) (2)
Note in particular that-with the com-
plete and perfect markets assumption-
there is a market valuation of each possi-
ble production plan. That is, even ack-
nowledging uncertain returns, the pre-
sumed rich set of perfect markets allows
for an unambiguous (market) valuation
of the firm's production plan. And now
repeating the prior argument, we again
view this valuation as representing the
unanimous preference ordering on the set
of possible production plans.
Of course, we have merely expanded
the notions of factor and commodity in
the original setting. Thus, with such a
rich set of markets, all that was said before
extends with equal force. In particular,
the income measure exists in a funda-
mental sense, and we would not pay any-
one to provide it because the component
items are already assumed known. In
short, existence of uncertainty in and of
itself creates no problems with, or interest
in, income measurement.
Further note that the ex ante and
ex post measures are now influenced by
the state variable. Before the event, the
firm's production plan called for pro-
duction of r' if state 1 obtains, r2 if state 2
obtains, and so on, using some appro-
priate state contingent factor schedule
and resulting in the contemporaneous
income measure in Equation (2). After
the fact, state 3 has obtained, r( was ac-
tually produced, and qswas actually used.
However, under either perspective, the
income measure represents a unanimous
ranking (of production plans in the ex
ante perspective and outcomes in the ex
post perspective). Hence, as in the cer-
41
tainty case, the distinction is a trivial one,
because both perspectives can be easily
reconciled.
It is clear, however, that such a rich
existent economic structure. We, there-
fore, turn to the incomplete markets
setting, in which all conceivable state
contingent trades are not available;
rather, only a proper subset are.
INCOME MEASUREMENTIN AN UNCERTAIN
WORLD WITH INCOMPLETEMARKETS
A setting of imperfect and incomplete
markets is important because it is more
realistic than the setting discussed above.
Concentration on the incomplete setting
is, however, sufficient for our purpose. In
this setting, the firm is still envisioned as
specifying a production plan consisting
of state-contingent inputs and outputs.
The only difference is that some of the
inputs and outputs cannot be traded in
organized markets. At one level, the
firm may not have markets for certain
assets and liabilities, such as outcomes
from research and development expendi-
tures, petroleum reserves, rights to ac-
celerated depreciation for tax purposes
on its assets, used equipment and the like
[Arthur Andersen, 1977]. At another
level, the non-existence of futures and
insurance markets (except in a limited
number of cases) provides prima facie
evidence of the lack of such completeness.
Without marketability of all of the
factors and commodities, it is possible to
lose the unanimous ranking of alterna-
tive production plans. Some shareholders
may prefer one plan over another based
on nonmarketable commodities. And
without trading opportunities, there is no
way to resolve, via the implicit compen-
sation mechanism of trade, the differ-
ences in taste. That is, in a regime of
complete and perfect markets, income
maximization is unanimously preferred
42
because it is commensurate with in-
creased consumption. But without access
to some markets, irreconcilable conflicts
may arise. Shareholders may, for exam-
ple, display heterogeneous tastes in rank-
ing production plans because of non-
marketable assets which each possesses.5
It is, of course, possible to construct
settings in which unanimous agreement
on production plans does exist in an
incomplete market setting. For example,
if a proposed production plan is spanned
by existing plans (from an existing
equilibrium) unanimity will exist and
prices can be used to evaluate the
proposed plan. Similarly, unanimity ex-
ists in the mean-varianceworld of modem
finance. [Ekern and Wilson, 1974; Rad-
ner, 1974b.]
But even when unanimity does occur
in this setting, it is not necessarily repre-
sented by an income measure in any
traditional sense. Under monopolistic
conditions, the firm's owners, for exam-
ple, may be unanimous in not seeking to
maximize the firm's market value. And
in such a setting representation of the
unanimous tastes amounts to representa-
tion of subjective tastes. The measure, in
other words, becomes entirely subjective;
and in this sense it does not enjoy the
supposed objectivity of the traditional
income measure of resting on observed
prices.
The important point, though, is that
unanimity in the rankings of production
plans is not necessarily present here. In
such a case, the firm may simply be
unable to select between two alternative
production plans. (Game theory solu-
tion concepts, for example, often result in
exasperatingly rich sets of possible solu-
tions and no basis for distinguishing
among them.) Thus, some plans are
non-comparable. Indeed the ranking may
even be intransitive.
Income measurement, on the other
The Accounting Review, January 1979
hand, is viewed as a mapping from a set
of production plans into the real line
(with plans ranked by the magnitude of
this income). If such a measure represents
a ranking of the alternative production
plans, then that ranking must be com-
plete and transitive. The income measure,
that is, maps from the entire set of plans
and it is surely transitive. Hence, what-
ever it represents must be complete and
transitive. But the ranking of production
plans is not necessarily complete and
transitive in this setting. Thus, funda-
mental income measurement, in the sense
of representing a unanimous ranking of
alternative production plans for the firm,
is not necessarily possible here.
Financial reporting cannot, therefore,
be described in terms of income measure-
ment in this setting of incomplete mar-
kets.
A POSSIBLEREINTERPRETATION
What, then, is the nature of income?
One possible answer is available if we
more closely examine the nature of the
economy with incomplete markets. A
particular firm offers a complex set of
5 To illustrate, consider a three-commodity world (a,
/3,and y) and a firm that must select one of the three pro-
duction plans listed below (For example, the three com-
modities could be consumption in three states of the
world.):
Net Production Plan I Plan 2 Plan 3
a 45 40 35
20 30 34
Y 8 5 10
Three owners equally share in the returns and no market
for either commodity exists. Their respective utility
functions and evaluations are:
Indi- Ui Ui Ui Ui
vidual (a,f3,y) (45, 20, 8) (40, 30, 5) (35, 34, 10)
I 118 115 114
2a+#+?
2 a+?B 65 70 69
3 y 8 5 10
Observe that all three disagree on the best plan and that,
under majority voting, they will be intransitive.
Beaverand Demski
state-contingent production plans, but
many individuals (e.g., investors) do not
distinguish among the various states to
the extent that the firm's management
does. This is a major reason for market
incompleteness. Hence, the firm now
possesses information that is potentially
useful to individuals external to its direct
operations.
Such information may be useful in the
sense of revising beliefs before decisions
(e.g., investment decisions) are made
(termed pre-decision information). It
may also be useful in terms of providing
a basis for contracting, as exemplified by
cost-plus payment arrangements, divi-
dend restrictions stated in terms of in-
come, managerial incentive arrangements
based on income, and so on (termed post-
decision information). Of course, these
two roles may occur simultaneously in a
multiperiod world [Radner, 1974a].
In transmitting this information, for
either or both purposes, a number of
options become interesting once we
recognize costliness of the communica-
tion process. The firm might list its speci-
fic (re, qu) realizations, which would be
potentially useful because not everyone
(or anyone) is presumed to observe S.
But this is a vast undertaking. Alterna-
tively, it might list its ending cash
balance, say q1. An intermediate role is
to aggregate the (re, qS) realizations with
the introduction of various groupings
and allocations (which can be interpreted
as use of pseudo prices for non-market-
able factors and commodities). Presum-
ably, this notion of accrual accounting is
a cost-effective alternative.
However, the crux of the argument on
behalf of accrual accounting rests on the
premise that (1) reported income under
accrual accounting rules conveys more
information than a less ambitious cash-
flow-oriented accounting system would,6
(2) accrual accounting is the most effi-
43
cient means to convey this additional
information, and, as a corollary, (3) the
"value" of such additional information
system exceeds its "cost."
Income reporting under accrual rules,
then, is neither "good" nor "bad" as
such. Rather, it may be a desirable middle
ground between more and less reporting.
But interpreted in this light, it derives its
support from the information it conveys
(at whatever cost) and not from such
criteria as "more income is better than
less." Indeed, there is no reason to label
the bottom line as "income." (Of course,
there is no reason not to label it as
"income" either.)7
This is further discussed below, where
we focus more explicitly on the pre- and
post-decision settings.
PRE-DECISION INFORMATION
Consider the pre-decision perspective
in the AICPA Objectives Study [1973]
and the Tentative Conclusions of the
FASB's Conceptual Framework Project
[1976]. Both studies adopt the view that
the primary purpose of financial state-
ments is to provide information to some
defined class of users (e.g., investors and
creditors in the case of the FASB).8 At
the same time, they also support the use-
fulness of income reporting as a vehicle
6 Note that with cash also reported we can meaning-
fully speak of "more" information in this context.
7 Though the terminology differs, this is the spirit of
Sorter's [1969] "events" approach in which the proper
combination of "aggregation" and "valuation" are
sought so as to balance information demands and cost.
And by extending the argument we may find accrual
procedures to be that happy medium.
8 Although portions of the conceptual framework
create ambiguity regarding the extent to which the FASB
intends to adopt an informational perspective, recent
statements by Sprouse [1977] at an Annual Meeting of
the American Accounting Association confirm this in-
formational perspective. In answer to advocates of the
"full disclosure" approach to financial reporting,
Sprouse responded with a view of income as a cost-
effective alternative to a comprehensive disclosure
policy.
44
for providing the desired information.
By implication, they have reached a
a judgment regarding the three issues
noted above.
However, the basis for this judgment
is less than clear. As indicated earlier,
accounting income rules can be viewed
as resulting in aggregations over quanti-
ties and prices. If the aggregated number
which results is a sufficient statistic,
there is no loss of information. In this
situation, there is a potential savings in
cost of processing, and the income-rule
question is resolved on pure efficiency
grounds [Feltham, 1977].
In general, of course, there will be a loss
of information. In this case, heterogeneity
of preferences for income rules may arise
because the "value" and "cost" of the
information may fall differently across
users. A lack of unanimity regarding
preferences for income rules obviously
characterizes many of our popular con-
troversies. This occurs for the same rea-
sons that we lack unanimity with regard
to production plans; indeed, it is a by-
product of the basic argument because
information is, strictly speaking, a factor
of production.
In a world where markets (for infor-
mation) were perfect and complete, this
heterogeneity could be accommodated
by some market-based or elaborate con-
tracting mechanism. Gonedes and Do-
puch [1974], among others, have alluded
to the possibility that accounting infor-
mation may induce externalities (and in
the limit, a type of public good). In such
a situation, some form of collective ac-
tion may appear, either in the form of
private sector self-regulation (e.g., FASB)
or a public-sector-mandated system (e.g.,
Securities and Exchange Commission).
Contextually, however, there is one
important distinction between the mea-
surement and information viewpoints
that is worth noting. For certain classes
The Accounting Review, January 1979
of controversies over "most-preferred"
income rules, the major alternatives can
be reported via an essentially costless
disclosure policy. The measurement ap-
proach would still attempt to resolve the
issue as to which rule results in the "best"
measure of income (within limits imposed
by nonuniqueness of the measures). How-
ever, from an informational perspective,
the issue is not a substantive one. While
this constitutes a special case from an
analytical point of view, empirically
many popular accounting controversies
fall into this category. Examples include
interperiod tax allocation, accounting
for the investment credit, and certain
aspects of accounting for business combi-
nations.9 From an informational per-
spective, substantive issues occur where
disclosure or cost is at least implicitly
involved. Examples would be replace-
ment cost accounting, foreign currency
translation, segment reporting, and "fair
value" aspects of business combinations.
In any event, the jump from a desire to
supply information to income reporting
as a desirable vehicle for such reporting
remains unclear. Appeal to fundamental
measurement arguments is inadequate.
On the other hand, the income orienta-
tion may be rationalized with a costly
communication perspective. But the stud-
ies in question have not professed such a
perspective.
POST-DECISIONINFORMATION
Essentially the same observations
emerge in the post-decision setting of
traditional stewardship reporting in
which the ex post reported income datum
is used for contingent contracting pur-
poses. An employment contract based
on a target income goal requires ex post
9 This implicitly assumes that the format of disclosure
does not convey information or otherwise affect the
firm's production and financing opportunity set.
 Beaverand Demski 45

income reporting, a cost-plus contract income measurementin a fundamental

requiresex post reporting,a currentratio
constraint on a lender requires ex post
balance sheet reporting,and so on. And
in each instance, the motivation for re-
portingrestson the improvedallocations
which such reportingprovides, and not
on such criteria as "more income is
betterthan less." From an informational
perspectivewe analyzethis settingjust as
the pre-decision setting was analyzed.
Accrual-incomemeasures may again
be interpretedas a middle ground be-
tween extensive reportingof production
plansand resultsandcash basis reporting
that can be rationalized-oncost-of-infor-
mation grounds. In special cases resolu-
tion of the "proper" aggregation is
straight-forward(e.g., when an aggregate
datum is a less costly sufficientstatistic
for the more useful datum). But in gen-
eral, we expect heterogeneity of pref-
erences for information systems, which
are resolved via non-marketdetermina-
tion mechanisms. And our basic point
remains:choice of an income rulecannot
be resolved by applying fundamental
measurementarguments.'0
SUMMARY
In a regime of incomplete markets,
sensedoes not describewhat accountants
do. A condition for fundamentalmea-
surementmay be missingin cases where
we would commit scarce resources to
production of accountingnumbers.An
informationalperspectivedoes, however,
describethe accountant'sactivity.But it
raises deep concernsover the role of the
income concept. Matching of costs and
revenues,for example, is not an under-
lying notion here. Rather, the case for
income restson the assumptionof aggre-
gating more informativebut also more
costly data such that a cost-effective
communicationmechanismis obtained.
However, this assumption is problem-
atical, and in our view, one challengeto
accounting theorists is to address the
primitivequestionof the proprietyof the
accrualconceptof income.
10 Recent articles have expressed reservations about
various deficiencies in income as a fundamental measure
and about present value as a valuation mechanism
(Ashton [1977], Bromwich [1977], McIntyre [1977],
Peasnell [1977], and Scapens [1978]). The expressed
concerns arise because of some assumed incompleteness
(or imperfection) in the markets. Hopefully, the frame-
work provided here will serve to synthesize these con-
cerns and to provide some "convergence" on this long-
standing debate.

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COUNTING REVIEW (July 1977), pp. 567-575.
Bromwich, M., "The Use of Present Value Valuation Models in Published Accounting Reports," THE
ACCOUNTING REVIEW (July 1977), pp. 587-596.
Coombs, C., R. Dawes, and A. Tversky, Mathematical Psychology: An ElementaryIntroduction(Prentice-
Hall, 1970).
Debreu, G., Theory of Value (Yale University Press, 1959).
Demski, J., "Choice Among Financial Reporting Alternatives," THEACCOUNTING REVIEW (April 1974),
pp. 221-232.
Demski, J. and G. Feltham, Cost Determination: A Conceptual Approach (Iowa State University Press,
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