Elements of Natural Tax Planning in Nigeria - A Case Study

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1 HE CLASSIFICAION OF CAPIAL AND REVENUE IN ACCOUNING AND HE DEFINIION OF INCOME IN HE MARKE-PLACE WORKING PAPER SERIES Working Paper No. 73 July 200 Correspondence o: Kevin J. Holmes, Professor Ph Cenre for Accouning, Governance and axaion Research School of Accouning and Commercial Law Vicoria Universiy of Wellingon PO Box 600, Wellingon, NEW ZEALAND el: Fax: Websie: hp://

2 HE CLASSIFICAION OF CAPIAL AND REVENUE IN ACCOUNING and he DEFINIION OF INCOME IN HE MARKE-PLACE Ewen McCann 2 and Kevin J Holmes 3 Address for correspondence: Kevin J. Holmes School of Accouning & Commercial law Vicoria Universiy of Wellingon PO Box 600 Wellingon New Zealand kevin.holmes@vuw.ac.nz Ph Ewen McCann he auhors are obliged o he referees for improvemens in he srucure of he paper. 2 axaion Research Group, School of Accouning and Commercial Law, Vicoria Universiy of Wellingon. Laerly Principal Economis, Policy Advice Division, Inland Revenue Deparmen, New Zealand. 3 Professor, School of Accouning and Commercial Law, Vicoria Universiy of Wellingon, Wellingon, New Zealand.

3 2 Ph ABSRAC Over many years various accouning auhoriies have grappled wih he problem of appropriae recogniion and classificaion of income and expendiure iems in he preparaion of financial saemens. One obvious case in poin is he disincion beween he ordinary revenue and capial gain naure of ransacions; anoher is he iner-period allocaion of expendiure. o a large exen, accouning aemps o resolve hese issues by relying upon he saemen preparer s subjecive judgmens. ha approach has implicaions for oher disciplines, such as axaion. Perpeuaion of accouning s imprecision is aribuable o he inadequacy of he crieria used by prevailing accouning saemens and convenions. his paper demonsraes ha he marke place iself can resolve hese concerns. In doing so, i renders he accouning docrine of accrual superfluous. he paper also develops and proves he direc relaionship beween he radiional Schanz-Haig-Simons definiion of income and he presen value formula, which is he foundaion of he marke approach o classifying ransacions correcly.

4 3 Inroducion he disincion beween he capial and revenue naure of ransacions is a basic concep in he preparaion of financial accouns and here is an exensive lieraure on he locaion of he capial-revenue boundary. Various auhoriies have issued guidelines o assis accounans in grappling wih his problem. 4 he classificaion of a ransacion or a financial even as on capial accoun or as on revenue accoun can have legal implicaions ha accounans and cours have long sruggled wih. he legal issues impac upon an eniy s ax liabiliy and is dividend policy. he disincion also affecs he ineres of an income beneficiary of a rus and he remainderman s ineres agains he rus s corpus. here can be an economic impac of he classificaion upon he value of a corporaion s sock. hese effecs are all examples of he broad problem of esablishing adequae crieria o classify financial iems and applying hose crieria in he preparaion of financial saemens. he burden of his paper is ha he marke-place iself resolves he locaion of he capial-revenue boundary in a way ha has gone unrecognized 5. We show how his marke placemen of he boundary occurs and how i can be applied. o be concepually robus, accouning pracice and law (especially ax law) should embody he marke mehod. In he grea majoriy of cases he marke deermined crieria provide he same classificaions of ransacions as do presen accouning convenions. However, in addiion he proposed mehod provides a clear-cu resoluion o he problem of classifying financial iems ha have ambiguous classificaions on exising accouning or legal crieria. 4 ypically naional professional accouning associaions have adoped a concepual framework as he basis upon which financial saemens are o be prepared and presened, e.g. Financial Accouning Sandards Board, (985) (Unied Saes); Accouning Sandards Board, (999) (Unied Kingdom); and Ausralian Accouning Sandards Board, (2004) (Ausralia). Since hese pronouncemens draw upon, or largely correspond wih, Inernaional Accouning Sandards Board, (200), hereafer his paper refers only o he IASB Framework. 5 Excep in McCann and Bucher (2006, 2008).

5 4 One paricular aspec of our approach, which has no been recognized in he lieraure, is of special ineres. his is he very close relaion ha we develop beween he Schanz-Haig-Simons (SHS) definiion of income and he presen value formula, which is he foundaion of he marke approach o classifying ransacions. We will explore he significan consequence of he direc connecion beween he SHS concep of income and he presen value formula, viz. ha asse markes equilibrae on a concep of income. However, we will show ha he SHS definiion, qua definiion, is no required o answer quesions abou which iems consiue income and which are capial. his is a fundamenal conclusion for accounans, which adds o he veraciy of financial saemens ha are prepared on a curren price basis. he paper will also plumb he relaion beween he marke s noion of income and he accouning docrine of accrual expendiure. ha docrine will be shown o be superfluous. A he formal level, he paper requires ha asses, in paricular businesses, may be priced by presen value echniques. he saring poin of he paper in his and in oher respecs is Samuelson s 964 classic. Secion 2 discusses he heoreical concep of income and is relevance o accouning. Exising accouning convenions concerning he disincion beween capial and revenue receips and expendiure are addressed in Secion 3. Secion 4 furnishes examples of our proposed procedure for classifying a financial iem as capial or revenue. Secion 5 is he core formal maerial. he close connecion beween SHS income and he presen value formula is esablished here and he formal classificaion crieria ha res on ha connecion are presened. In addiion, Secion 5 derives he concep of income ha is adoped in he marke place. he redundancies of each of he SHS definiion and of he docrine of accrual expendiure are examined in Secion 6. Our conclusions are presened in Secion 7 of he paper. An Appendix conains he mahemaical formalism incorporaing axaion.

6 5 2 Concep of Income 2. SHS Definiion of Income 6 he firs auhoriaive conribuion o he concepualisaion of income was provided in 896 by he German economis, Georg von Schanz. Wih respec o an individual, von Schanz (896) conended ha: []he concep of income is relaed o he economic abiliy of persons. When we wish o deermine an individual s income, we mus ask wha economic power has accrued o a given person over a given period of ime. In oher words, we wish o know wha means came wihin he disposing power of he given person, who, during he period in quesion, neiher impaired his capial nor incurred personal debs. 7 weny-five years laer, in he Unied Saes, and osensibly independenly of von Schanz s work, Rober Murray Haig proceeded o define income as (Haig (92: 7)): he increase or accreion o one s power o saisfy his wans in a given period so far as ha power consiss of (a) money iself, or, (b) anyhing suscepible of valuaion in erms of money. he elemens suscepible o moneary valuaion ha enhance one s power o saisfy wans necessarily include any good or service obained in kind (wheher consideraion was given or i was obained by way of gif), which can be valued in money erms, any unrealised increase in he value of asses held during he period, and he value of benefis obained from non-marke ransacions. Algebraically, his noion of income during a period can be expressed as: MONEY RECEIVED AS REURNS FROM FACORS OF PRODUCION + IN-KIND BENEFIS + NE MONEARY INCREASE IN ASSE VALUES + IMPUED INCOME FROM NON-MARKE RANSACIONS 6 Generally, he wealh approach o income analysis has been coined, in jurisprudenial and public policy lieraure, he Schanz-Haig-Simons (or, more commonly, in Unied Saes publicaions, simply he Haig-Simons ) concep of income: see, for example, Andrews (972). Like oher wriers who recognise Schanz s conribuion, we adop he erm Schanz-Haig-Simons or SHS income. 7 ranslaed in Wueller (938:02).

7 6 Haig (92: 7) wen on o refine his inerpreaion: [m]ore simply saed, he definiion of income which he economis offers is his: Income is he money value of he ne accreion o one's economic power beween wo poins of ime. (emphasis in original) he increase in an individual's economic power, which saisfies desires over a period is cenral o Haig's definiion of income. In 938, Henry Simons developed a similar concep of income o ha of Haig, which is based upon changing values of righs over a relevan period. In Simons s view (Simons (938: 49-50)): [p]ersonal income connoes, broadly, he exercise of conrol over he use of sociey's scarce resources. I has... o do wih... righs which command prices (or o which prices may be impued). Is calculaion implies esimae (a) of he amoun by which he value of a person's sore of propery righs would have increased, as beween he beginning and he end of he period, if he had consumed (desroyed) nohing, or (b) of he value of righs which he migh have exercised in consumpion wihou alering he value of his sore of righs. In oher words i implies esimae of consumpion and accumulaion... Personal income may be defined as he algebraic sum of (I) he marke value of righs exercised in consumpion and (2) he change in he value of he sore of propery righs beween he beginning and end of he period in quesion. In oher words, i is merely he resul obained by adding consumpion during he period o "wealh" a he end of he period and hen subracing wealh" a he beginning. Simons framed his formulaion in erms of he value of propery righs held by a person (ha is, he abiliy o conrol resources and, herefore, o exercise economic power). Simons (938: 49) iniially adops Haig s noion of income as an increase in he value of a person s propery righs over a period on he assumpion ha he person had consumed... nohing. He saes he same hing in an alernaive way in

8 7 his poin (b); ha is, he value of propery righs obained during a period ha a person migh have exercised by way of consumpion expendiure so ha he is lef no worse off han a he beginning of he period. In oher words, income is he increase in he value of propery righs available for consumpion expendiure. Simons mainained, correcly, ha a lieral inerpreaion of Haig s definiion excludes consumpion, alhough, according o Simons, i was obviously inended o be included wihin he concep. 8 Simons (938: 49) hen akes Haig s analysis furher by saing ha income implies esimae of consumpion and accumulaion and formulaes income algebraically in erms of hose wo variables: Y = ΔW + C where: Y income in period ; ΔW change in wealh over he measuremen period, ; and C consumpion expendiure in period. Simons breaks down Haig s accrual of economic power ino he wo ways ha i can be applied: (i) consumpion expendiure and (ii) saving. hus, Simons measures income a a laer sage han Haig does. Under Simons s model, one mus wai o see how Haig s a priori economic power is acually applied before income can be deermined. 9 8 Samuelson was also concerned (somewha emoionally) wih he shocking looseness of he Haig definiion of income as he accreion o wealh beween wo periods [which] is of course o be modified... o ake ino accoun consumpion of he period in quesion : Samuelson (96) in Luz and Hague (96:56). However, Haig s definiion does no need o deal explicily wih consumpion. Consumpion arises afer economic power has been obained. For Haig, income is he accrual of economic power over a period. Income is deermined when ha power is accrued. Once ha poin is reached, nohing furher is required o be done o idenify income. Haig did no need o specify how ha economic power is subsequenly applied. For furher analysis of his poin, see Holmes (200: 68-74). 9 Only consumpion gives rise o his iming difference. Increase in economic power always occurs simulaneously wih wealh accumulaion.

9 8 2.2 Hicks s definiion of income Hisorically, accouning heoriss have repeaedly paid lip service o Hicks s definiion o measure income on he basis of source preservaion. 0 Hicks s analysis of income ress on an individual s expecaions and plans (Hicks (946: 72)): he purpose of income calculaions in pracical affairs is o give people an indicaion of he amoun hey can consume wihou impoverishing hemselves. Following ou his idea, i would seem ha we ough o define a man s income as he maximum value he can consume during a week, and sill expec o be as well off a he end of he week as he was a he beginning. Hicks s approach is o deermine, in he mind of a consumer, how much he consumer can plan o spend during a period on he basis of he income sream yielded a he end of ha period. he principle is similar o ha expounded by Simons s (938: 49) alernaive view of income, viz. he amoun by which he value of a person s sore of propery righs would have increased, as beween he beginning and he end of he period, if he has consumed... nohing (emphasis added). Hicks illusraes his definiion of income under varying circumsances: consan and changing ineres raes and prices. In he simples, bu mos common, case, an individual may inves in a securiy for one week, a he end of which she expecs o receive $x. Subjec o he individual's preference for being beer or worse off a he end of he period han she was a he beginning, her consumpion expendiure during ha week will be based on he expeced receip. Consequenly, here is an amoun of expendiure ha will reduce he expeced value of he individual s securiy o he amoun invesed a he beginning of he week. ha amoun is he individual s income. hus, Hicks (946: 77) posulaes ha income is a subjecive concep, dependen on he paricular expecaions of he individual in quesion. 0 Zeff (962) has observed ha his definiion recurs wih remarkable frequency in economic and (especially) accouning wriings. Surprisingly, reference is seldom made in he accouning lieraure o he Schanz-Haig-Simons definiion of income. An excepion is Fellows (989) who does allude o he SHS concep of income.

10 9 Hicks (946: 78) noes ha [n]ohing is said abou he realisaion of his expecaion, and goes on o argue ha, if he expecaion is no realised exacly, a windfall profi or loss is derived. If ha gain (or loss) is added o (or subraced from) ex ane income, corresponding ex pos income can be calculaed; ha is, income including windfall gains or losses. herefore, in he simple and common case, income ex pos equals he value of an individual s consumpion plus he incremen in he value of her invesmen during he week. Hicks s noion of ex pos income can be expressed arihmeically as: INCOME ex pos = CONSUMPION + CAPIAL ACCUMULAION he aracion of ex pos income is ha i is capable of reasonably objecive measuremen (provided ha changes in he value of human capial are ignored). However, for Hicks (946: 79), ex pos income calculaions have heir place in economic and saisical hisory. (emphasis in original). Hicks was a heoreical behavioural economis. Ex pos calculaions were no useful his predicions of conduc. Ex pos income can only be calculaed a he end of Hicks s week. He was concerned wih an individual's economic behaviour during he week. herefore, he concluded ha (Hicks (946: 79)): he income which is relevan o conduc mus always exclude windfall gains; if hey occur, hey have o be hough of as raising income for fuure weeks (by he ineres on hem) raher han enering ino any effecive sor of income for he curren week, heoreical confusion beween ex pos and ex ane corresponds o pracical confusion beween income and capial. 2.3 Corporae income measuremen Accounans generally examine he noion of income in he conex of a business eniy, which is owned by oher eniies, including individual people. Hicks s income definiion was cas in erms of an individual. Accouning heoriss have applied he definiion o business underakings. Alexander (962) made he firs significan reference o Hicks s definiion of income in a corporae conex: income is he amoun [a] company can disribue o

11 0 shareholders and be as well off a he end of he year as i was a he beginning. Subsequenly, income definiions for accouning purposes included specific reference o capial mainenance. Fellows (989: 5) observed ha: []he ne income of an eniy for any period is he maximum amoun ha can be disribued o is owners during he period and sill allow he eniy o have he same ne worh a he end of he period as a he beginning, afer adjusing for he owner's conribuions. In oher words, capial mus be mainained before an eniy can earn income. he Hicksian and Simons conceps of income specifically refer o an individual s consumpion expendiure. Simons s and Hicks s ex pos inerpreaions of an individual s income are he sum of consumpion and changes in wealh (afer consumpion has aken place). Applying hose inerpreaions o a company, income could be regarded as he sum of dividend disribuions o shareholders plus ne changes in equiy (afer he dividend disribuions). Hence, dividend disribuions o shareholders of a company correspond o consumpion expendiure of an individual. Hence, Fellows s reference o he maximum amoun ha can be disribued o is owners (Fellows (989: 5)) in place of Hicks s reference o he maximum value he [an individual person] can consume (Hicks (946: 72)). Similarly, Haig s formulaion of he concep of income could also be inerpreed in a corporae conex. For an individual, Haig analysed income in erms of wealh accumulaion before consumpion expendiure occurred. ransposing his noion o a corporae conex, a company s income is he increase in is oal equiy over is reporing period before disribuions o shareholders are aken ino accoun. hus, Haig s inerpreaion of income simply means ha one can avoid he need o adjus aggregae changes in equiy for dividend disribuions. However, we will reconsider he difficulies of his approach in Secion 6.. Alexander s and Fellows s inerpreaions of accouning income clearly conemplae Hicks s ex pos noion of income. Accouning heoriss generally ignore he expecaions aspec of Hicks s definiion of income. Definiions of income in accouning lieraure occasionally cie Hicks s reference o one s expecaion of well-

12 offness a he end of a measuremen period, bu invariably he premise of he definiion is Hicks s ex pos income; ha is, an hisoric measure of income, which encompasses acual gain and loss deviaions from expecaions. Performance measuremen for accouning purposes is no subjec o he consrains of expecaions. I is, perhaps, of lile consequence ha accouning lieraure ignores he ex ane basis of Hicks s definiion. he fundamenal issue is ha accouning scholars have decided ha he capial mainenance noion underlying Hicks s definiion is he heoreically appropriae basis for inerpreing he meaning of accouning income. For example, he Financial Accouning Sandards Board in he Unied Saes formally embodied his capial mainenance, or ne accreion, noion in is Saemens of Financial Accouning Conceps (Financial Accouning Sandards Board (99: 775)): [a]n enerprise receives a reurn only afer is capial has been mainained or recovered. he concep of capial mainenance, herefore, is criical in disinguishing an enerprise's reurn on invesmen from reurn of is invesmen. Boh invesors and he enerprises in which hey acquire an ineres inves financial resources wih he expecaion ha he invesmen will generae more financial resources han hey invesed. (emphasis in original) Hicks s ex pos income is closer o he SHS concep han his ex ane noion. A more rigorous analysis of Hicks s work by accouning commenaors may have led hem formally o place greaer emphasis on his ex pos income noion, or i even may have led hem o ake greaer cognisance of he SHS heory of income. 3 Accouning Convenions on Capial and Revenue 3. Income Ne income is he generally acceped measure of financial performance of a commercial eniy. Because modern accouning heory predicaes ha income over he life of an eniy is broadly he excess of he cashed-up value of he eniy a is

13 2 erminaion over he owners iniial cash invesmen, i is necessary o divide he life of he eniy ino pre-deermined ime periods, which are shor enough o render useful informaion o decision makers, bu long enough o ouweigh he adminisraive coss of compiling informaion repors oo ofen. Accouning segmens he eniy s life-long income ino each of hose periods. his means ha income is measured in an arificial way, which requires a subjecive iner-period allocaion of he eniy s cash flows. 2 he fundamenal problem wih he accouning reamen of income and gains herefore arises from he naure of accouning iself. As he Unied Saes Whea Commiee (a special commiee of he American Insiue of Cerified Public Accounans charged wih sudying how accouning principles should be deermined) repored as long ago as 972 (Whea Commiee (972: 9): Financial accouning and reporing are no grounded in naural laws as are he physical sciences, bu mus res on a se of convenions or sandards designed o achieve wha are perceived o be he desired objecives of financial accouning and reporing. Accouning income measuremen hen somewha incoherenly adops a combinaion of he conceps of hisoric cos based realisaion, and maching expendiure wih he benefis ha i is inended o produce over ime, and, in accordance wih seleced crieria, he conflicing concep of fair value accouning (i.e. embracing unrealised gains and losses). In fac, he real focus of accouning income measuremen is no on SHS or Hicksian wealh accrual a all. he saring poin is realisaion of revenue or expendiure based on exchange ransacions wih hird paries. Year-end iner-period allocaions of revenue and expendiure (i.e. cash flows) are made when he benefis or coss of a ransacion cross more han one accouning period. hus, objecively ascerainable income over he life of an eniy mus be apporioned on an ex ane basis o se ime Adjused for paymens o owners (being addiions in calculaing income of he eniy) and addiional conribuions from owners (being subracions in calculaing he eniy s income). 2 As Obinaa (200) pus i: earnings is regarded as core informaion in he disclosure sysem, hough i is derived from he arificial allocaion of cash flows.

14 3 periods. Dissecing life-long income in his way involves esimaion and assumpions abou specific periods. Periodic income measuremen hus becomes parly a subjecive exercise. herefore, he accouning approach o measuring ne income for he period under review is in erms of he difference beween revenue and expendiure, afer aking accoun of he income and expendiure accrual adjusmens. 3 A furher adjusmen o ha ne income figure is made o reflec unrealised changes in values of he seleced asses held a he end of he measuremen period. hus, alhough accounans have claimed o adop he Hicksian concep of income, hey have radiionally measured income primarily on a realisaion basis: he concepual approach and he measuremen approach are incoheren. Furhermore, accouning convenions ha address capial and revenue differ depending upon wheher he focus is on income or expendiure. o a large exen he disincion beween capial and revenue on he income side of accouning profi deerminaion comes down o a quesion of presenaion, raher han any maer of a concepual naure. If we ake he Framework for he Presenaion and Preparaion of Financial Saemens (he Framework), published by he Inernaional Accouning Sandards Board (IASB), as an auhoriaive saemen on he meaning and recogniion of income and expendiure, and heir presenaion for accouning purposes, we learn ha income is (IASB (200: 70(a))): increases in economic benefis during he accouning period in he form of inflows or enhancemens of asses or decreases of liabiliies ha resul in increases in equiy, oher han hose relaing o conribuions from equiy paricipans. 4 3 he lieraure well esablishes ha he ne income figure can be manipulaed hrough discreionary accruals : see, for example, Subramanyam (996). 4 An asse is defined in 49(a) of he Framework as a resource conrolled by he eniy as a resul of pas evens and from which fuure economic benefis are expeced o flow o he eniy in subsequen accouning periods. Asses are recognised in he balance shee when i is probable ha he fuure economic benefis will flow o he eniy and he asse has a cos or value ha can be measured reliably. ( 89). A liabiliy is defined in 49(b) of he Framework as a presen obligaion of he eniy arising from pas evens, he selemen of which is expeced o resul in an ouflow from he eniy of resources embodying economic benefis. Liabiliies are recognised in he balance shee when i is probable ha an ouflow of resources embodying economic benefis will resul from he selemen of a presen obligaion and he amoun a which he selemen will ake place can be measured reliably.

15 4 he Framework hen goes on o break down is definiion of income ino wo pars: revenue and gains. he disincion beween hese wo elemens urns on ordinary (and, by defaul in layman s parlance exraordinary) aciviies of he reporing eniy. IASB (200: 74, 75) pus i his way: Revenue arises in he course of he ordinary aciviies of an eniy. Gains represen oher iems ha mee he definiion of income and may, or may no, arise in he course of he ordinary aciviies of an eniy. Gains represen increases in economic benefis and as such are no differen in naure from revenue. IASB (200: 75) gives sales, fees, and passive income flows as examples of revenue. Gains on he disposal of non-curren asses and unrealised gains from he revaluaion of markeable securiies and long-erm asses are offered as examples of he ypes of gains ha are conemplaed by he Framework (IASB (200: 76)). In erms of presenaion in he financial saemens, IASB (200: 76) observes ha [w]hen gains are recognised in he income saemen, hey are usually displayed separaely. In summary, hen, he accouning approach is o embrace all revenue and gains wihin he concep of income, and, based on a judgmen of wha consiues he eniy s ordinary aciviies, o disclose revenue and gains separaely in he financial saemens. he criical facor from an accouning perspecive is ha separae disclosure of gains is made o he users of he financial saemens. Separae disclosure of he gains provides useful knowledge o he users for he purpose of heir economic decision making concerning he reporing eniy. However, he idenificaion of an eniy s ordinary aciviies o make he separae disclosure is necessarily a subjecive one. ha subjeciviy has wider implicaions; for example, i is a facor ha influences wheher or no a gain is axable in jurisdicions where axes ( 9). Equiy is defined in 49(c) of he Framework as he residual ineres in he asses of he eniy afer deducing all of is liabiliies. his definiion produces he familiar accouning equaion, Equiy = Asses Liabiliies.

16 5 on capial gains do no exis or, where hey do exis, wheher a paricular gain is o be reaed as a capial gain or as ordinary income (each of which may be axed a differen raes). 5 In oher words, in such cases he accounan s judgmen influences wheher he gain is axable, and ha discreion undermines he equiy and cerainy enes of a good income ax sysem. here is also a furher, more fundamenal, issue relaed o he recogniion of income in accouning. IASB (200: 92) prescribes ha [i]ncome is recognised in he income saemen when an increase in fuure economic benefis relaed o an increase in an asse or a decrease of a liabiliy has arisen ha can be measured reliably. herefore, recogniion of income is resriced o hose iems ha can be measured reliably and have a sufficien degree of cerainy (IASB (200: 93)). hus, even before addressing he quesion of wheher income is on revenue or capial accoun, he accounan mus form an opinion abou wheher he income is o be repored in he accouning period in he firs place. his means ha he accounan is required o ascerain wheher economic benefis relaed o an increase in an asse (or a decrease of a liabiliy) have arisen in he reporing period and, if so, wheher hose benefis can be measured reliably. he subjeciviy inheren in hese accouning rules means ha accouning iself canno resolve he uncerainy ha surrounds he numbers ha i produces. 3.2 Expendiure While he capial-revenue disincion can be problemaic on he income side of he profi calculaion, he issue is more acue on he expendiure side of he equaion. IASB (200: 70(b)) defines expenses as: decreases in economic benefis during he accouning period in he form of ouflows or depleions of asses or incurrences of liabiliies ha resul in decreases in equiy, oher han hose relaing o disribuions o equiy paricipans. 5 See, for example, Commissioner of Inland Revenue v. homas Borhwick & Sons (Ausralasia) Ld (992) 4 NZC 9,0 and Federal Commissioner of axaion v. Myer Emporium Ld (987) 8 AR 693.

17 6 Under he concep of accrual accouning, which is prescribed in he Framework as an assumpion ha underlies he preparaion of financial saemens IASB (200: 95-97): [e]xpenses are recognised in he income saemen on he basis of a direc associaion beween he coss incurred and he earning of specific iems of income. his process [is] commonly referred o as he maching of coss wih revenues. When economic benefis are expeced o arise over several accouning periods and he associaion wih income can be only broadly or indirecly deermined, expenses are recognised in he income saemen on he basis of sysemaic and raional allocaion procedures. hese allocaion procedures are inended o recognise expenses in he accouning periods in which he economic benefis associaed wih hese iems are consumed or expire. An expense is recognised immediaely in he income saemen when an expendiure produces no fuure economic benefis or when, and o he exen ha, fuure economic benefis do no qualify, or cease o qualify, for recogniion in he balance shee as an asse. [6] Wheher expendiure is wholly or parly allocaed o he curren accouning period and reaed as revenue expendiure or capialised ino he cos of an asse and allocaed agains income derived in fuure accouning periods again falls o he accounan s discreion. When he accounan decides on capialisaion of an iem of expendiure, furher judgmen mus hen be exercised o deermine he lengh of he expense amorisaion period, and he amoun of expendiure o be amorised in each reporing period so long as (a leas some of) he expendiure remains capialised as an asse in he balance shee. o make hose decisions, he accounan mus make some esimae of he life of he benefi ha is expeced o arise from he expendiure, he amoun of any residual value a he end of he useful life of he asse, and he mehod by which he amoun o be allocaed o each reporing period will be 6 An expense is recognised in he income saemen when a liabiliy is incurred wihou he recogniion of an asse (IASB (200: 98)).

18 7 calculaed. In accouning, subjeciviy pervades he disincion beween capial expendiure and revenue expendiure. hus, uncerainy of accouning numbers persiss. Again, he uncerainy embodied in he accouning approach o expense classificaion infecs oher disciplines, which rely o a greaer or lesser exen on accouning resuls o achieve heir ends. For example, o he exen allowed by law, reliance on he accouning reamen of expenses for income ax purposes leaves deerminaion of axable income vulnerable o he vagaries of he expense allocaion process adoped by he accounan. he quirks of accouning hen impac upon he surdiness of he income ax sysem. 4 Marke Mehodology he auhoriies on capial and revenue reviewed in Secion 3 covered a wide variey of cases and circumsances. Generaliy of reamen forced hem ino absracions a a philosophical level of discourse. We are o offer an alernaive o such discourse: our approach is rooed in he marke-place raher han in absracions. he commercial inuiion ha underpins our approach o he capial-revenue boundary is se down by way of examples in he presen secion. he normal haggling in he marke place is he foundaion of he whole approach and is used hroughou Secion 4. Formal crieria for separaing capial from revenue ransacions will be developed from he commercial inuiion in a slighly more general form in Secion Commercial Inuiion Readers will be familiar wih he presen value mehod of pricing an asse. Recall ha by his mehod he price of an asse is se by he discouned value of is fuure income sream. Since he use of he word income may prejudge issues we will use he neural erm ne renals insead. Under he presen value mehod buyer and seller necessarily agree on he sream of fuure ne renals when hey agree on he price of an asse. I will be shown in he nex secion of he paper ha under ideal circumsances he presen value formula does in fac provide he marke price of an asse.

19 8 Ideally, a business can be valued or priced by a discouned ne renal sream ha is o be muually agreed upon by he buyers and sellers of he business. A paricular ransacion eiher appears in ha agreed ne renal sream or i does no. We can hus classify one group of ransacions as hose ha are included in he muually agreed ne renal sream. A second group consiss of ransacions ha are excluded from he muually agreed fuure ne renal sream. Every ransacion belongs eiher o he firs group or he second. he classificaion is exhausive. We propose o classify iems ha are included in he muually agreed ne renal sream as revenue accoun iems. ransacions ha are excluded from he muually agreed ne renal sream are o be classified as on capial accoun. 7 Observe ha on hese definiions he marke marks ou he disincion beween capial and revenue iems. he capial-revenue boundary hen ceases o be a maer of legal decisions, of accouning convenions or of ax pracice. he locaion of he boundary is fixed in he marke place. he nex few subsecions provide simple examples of he applicaion of he proposed mehod. hey mosly conform o he classificaions obained by convenional crieria. his should buress confidence in he mehod. 4.2 Revenue expendiure Consider wheher expendiure on elecriciy by a manufacuring concern is o be classified as a revenue iem or as capial expendiure. I will no surprise ha he mehod deermines he elecriciy oulay o be a revenue expense, which is consisen wih he accouning convenion discussed in Secion 3. he procedure involves he seing up of a noional sale of he business which incurs he expendiure. Poenial buyers and a poenial seller mus agree on he price of he business. In doing so, poenial buyers and sellers discoun heir evaluaions of he fuure ne renal sreams from he business. 7 here will be one excepion o he exclusion from ne renals rule ha will be discussed in Secion 5.

20 9 Price agreemen requires he poenial buyer and seller arrive a he same presen value for he discouned fuure ne renal sream. hey boh mus use he marke rae of ineres as he discoun facor because i represens he opporuniy cos of capial. 8 o arrive a a common valuaion he paries mus agree on he ne renal sream ha is o be discouned. ha is, hey mus agree on wheher he elecriciy oulay is o be subraced in he compuaion of he ne renal sream or wheher i is o be omied from ha flow alogeher. Le us suppose ha he poenial seller is of he view ha he elecriciy oulay should no be deduced when compuing he ne renal sream. his would increase he seller s presen value compared wih subracing he elecriciy oulay. Poenial buyers would no concur wih his reamen of he elecriciy oulay. his is because he price of he business would rise by he presen value of he omied elecriciy oulays. hen, having aken he business over, a buyer would be faced wih elecriciy bills in he fuure he presen value of which has already been paid o he seller. ha would resul in a double paymen for elecriciy. Consequenly, here would be no agreemen on presen value beween a poenial buyer and a poenial seller of he business if elecriciy oulays were omied from he ne renals. o his sage here is no classificaion of elecriciy paymens as a revenue or as a capial iem. he alernaive reamen is for he poenial seller o deduc he elecriciy expenses in he ne renal calculaion. his reduces he seller s presen value compared wih exclusion and he buyer would hen no be surprised by fuure elecriciy bills. 8 Conrary o common pracice, a comprehensive income ax sysem does no resul in a discoun rae ha is equal o he afer-ax rae of ineres. he appropriae discoun rae is obained by he mehod shown in he Appendix.

21 20 hus poenial buyers and sellers agree on he presen value of he business when elecriciy oulays are included in he calculaion of he ne renal sream. wo hings have happened: (A) poenial buyer and seller have agreed on he presen value of he business, and (B) elecriciy oulays are aken ino accoun in calculaing he agreed ne renal sream. When hese wo crieria are me we define he expendiure (or receip) under es o be on revenue accoun. his is a roundabou confirmaion of he convenional accouning reamen of revenue expendiure (such as elecriciy oulays), described in Secion 3. Under he accouning ess here, he benefi of he elecriciy purchased is used up in he curren accouning period and is herefore fully expensed (as revenue expendiure) in ha period. 4.3 Capial expendiure Some oher ougoing may, by muual agreemen, be omied from he calculaion of he ne renal sream. he paries would hen agree on presen value. We would have (a) agreemen on presen value, and (b) he iem being omied from he agreed ne renal. In his circumsance we define he iem o be on capial accoun. ake a commimen o purchase a delivery ruck by a manufacuring concern. Again, he mehod is o se up a noional sale of he business. We suppose ha whoever owns he business acceps a commimen o buy a ruck a he presen or a fuure ime. Possible buyer and possible seller calculae he presen value of he business. Since i is he classificaion of he purchase price of he ruck ha concerns us, boh paries, we suppose, agree ha he ruck conribues o fuure oupu and boh include ha conribuion in he ne renal sream. Preend ha one pary, say he buyer, subracs he purchase price of he ruck in calculaing he ne renal sream. his would depress a buyer s presen value of he business compared wih no subracing he purchase price of he ruck. he seller would no agree o such a buyer s presen value calculaion. his is because buying he ruck is a conversion of one asse ino anoher, cash is convered ino a ruck. he wealh of he business has no changed excep o he exen ha he

22 2 ruck may make a greaer conribuion o fuure oupu han holding cash 9 which, by assumpion, boh paries agree o. he seller would no accep ha buying a ruck reduces he presen value of he business when wha he sees is simply a useful change in he composiion of he business s asses. Poenial buyer and seller do no agree on presen value. here is no classificaion of he ruck purchase o his sage since here is no a muual agreemen on he conen of he ne renal sream. here would be agreemen on he ne renal sream and so he presen value if he buyer excluded he cos of he ruck from he ne renal. Since he ruck is excluded from he agreed ne renal is purchase is a capial accoun ransacion. his conclusion on he purchase of he ruck is again compaible wih he accouning approach, which also reas he even as one on capial accoun. When he accounan comes o record he ransacion a he ime ha i akes place, no income is recognised in erms of he definiions of income and expendiure in he IASB Framework. here is simply he subsiuion of one asse (cash) for anoher asse (a ruck) of equal value. 20 he rules and convenions of presenaion of financial saemens ell us ha such a ransacion is o be disclosed direcly in he asse accouns in he balance shee, raher han as gains and expendiure in he profi and loss accoun. 2 9 he argumen is similar were he ruck o be financed wih deb. he seller of he business would argue ha ne worh is unalered and he presen value of he business is largely unaffeced, excep for he oupu effec of he ruck, which boh paries have agreed upon. he classificaion of ineres on he deb is separae from he classificaion of he purchase of he ruck so we may assume ha boh paries subrac he ineres in he ne renal calculaion. 20 Sricly, applicaion of he Framework s income definiion reas he receip of he ruck as income in he form of a gain. he ruck represens an increase in economic benefis in he form of an enhancemen of asses, which, in erms of he accouning equaion, resuls in an increase in equiy. Bu he acquisiion of he ruck is only half of he ransacion. I was acquired by paring wih cash, and ha ouflow of cash is expendiure in erms of he Framework s definiion of ha erm, i.e. he paymen of cash reflecs a decrease in economic benefis in he form of an ouflow or depleion of asses, which, in iself, resuls in a decrease in equiy. One cancels ou he oher so here is no profi, or ne income, from he ransacion. 2 See, for example IASB (2003: 8), which specifies ha, in his respec, he income saemen need include only he pos-ax gain or loss recognised on he disposal of asses.

23 Revenue receip As our nex example consider he classificaion of he sale of some iem of invenory. Again invoke he poenial sale of he business. Assume ha he business has an agreemen o sell currenly held invenory immediaely he buyer akes possession of he business. Cash balances or debors will increase when he invenory is sold. ha is o say a shif occurs in he composiion of he firm s asses a he dae of sale. Suppose ha he poenial buyer omis he sale of ha invenory from fuure sales proceeds. his depresses he buyer s ne renals and he presen value of he business compared wih including he invenory proceeds in he ne renal sream. ha receip from sales increases cash or debors by an amoun equal o he sale. However, he buyer would no be paying for he increase in hose asses because he equal amoun of receips from sales have been omied from ne renals and from he presen value calculaion. Were he poenial seller of he business o acquiesce in he reduced sales figure a sum of cash or debors would be received by he business ha he buyer of i does no pay for. he poenial seller would no give hose asses away in his manner. he seller would include he sale of he invenory in he ne renal and would no agree wih he buyer s presen value. As ye here is no classificaion of he sale of invenory because he paries do no consen o an agreed ne renal sream. Were boh paries o include he sale of invenory in heir ne renals here would be agreemen on he presen value of he business. Since invenory sales are included in he agreed ne renal hey are classified as revenue ransacions. he accouning reamen will produce he same resul when he ime comes o record he sale of he invenory. Income in he form of revenue arises because he receip of cash or acquisiion of a debor o he value of he sale price of he invenory represens an increase in economic benefis in he form of an inflow or enhancemen of asses ha resuls in an increase in equiy (IASB (200: 70(a))) Of course, he deparure of he invenory iself falls wihin he definiion of expendiure (see foonoe 3) bu, assuming ha he sale price of he invenory is higher han is cos price, and ha he

24 Capial receip he nex applicaion of he marke based mehod of classificaion separaes he sale of a long-erm asse from he foregoing sale of invenory. Imagine ha a manufacuring concern sells of a piece of used equipmen, say, a lahe. Again, we apply he crieria o a noional sale of he business. o fix ideas, we suppose ha he proposed ransfer of ownership is o be on one dae and includes a prior agreemen ha whoever hen owns he firm will sell he lahe say six monhs laer. We wish o deermine wheher he lump sum from he sale of he lahe is o be a capial or a revenue ransacion. Holding wealh idle is sub-opimal so he lump sum from he sale of he lahe will be invesed when i is received, le us say in a replacemen lahe. Oupu from he exising lahe and is replacemen conribue o he fuure ne renal sream of he business. Since our concern is jus wih he lump sum, we may assume ha he poenial buyer and seller of he business have agreed ha he conribuions o oupu from he lahe and is successor are o be pars of he fuure discouned ne renal sream. hey agree ha he presen value of he business is o include he conribuion o ne renals of he lahe for he six monhs remaining and he oupu conribuions of is succeeding asse. o classify he proceeds of he sale of a second hand asse le us suppose ha he poenial seller of he business reas he lump sum (he lahe proceeds) as if i were a receip from sale of oupu, hereby increasing he ne renal sream. ha is o say, no only has he seller included he oupu sreams from boh lahes bu he incorporaes he lump sum from he sale of he old lahe in he sream of proceeds from he sale of normal oupu. his would increase he seller s esimae of presen value compared wih omiing he lump sum from he ne renals. invenory was, since is purchase, recorded in he eniy s books a is cos price, he amoun of he expendiure will be less han he amoun of income, yielding a profi on he ransacion. I is his profi ha is he focus of he buyer s and seller s ne presen value calculaions.

25 24 he poenial buyer of he business would no accede o he seller s reamen of he lump sum. his is because he oupu conribuion of he lahe and is succeeding asse is included in he fuure ne renals and so in he presen value of he business. here are wo pars o his conribuion. he firs is he six monhs oupu conribuion from he old lahe. he second par is he fuure oupu conribuion of he replacemen asse. his second par has a presen value equal o he lump sum because he lump sum is he price of he replacemen asse. he poenial buyer hus pays for he lump sum in he presen value of he business because he discouned fuure oupu conribuion, included in he agreed ne renals, of he succeeding asse is equal o he lump sum. reaing he lump sum as an ordinary sales receip would hus be double couning he value of he lahe iself and he value of he replacemen lahe. In oher words, incorporaing he lump sum ino he agreed ne renal calculaions would be asking he poenial buyer of he business o pay wice for he lump sum. here is no agreemen on he presen value of he business if he seller includes he lump sum in he ne renal calculaion. he lump sum proceeds are no ye classified. he alernaive is for boh paries o exclude he lump sum from he ne renals. hey hen arrive a a common presen value for he business so here is price agreemen. Exclusion means ha he proceeds from he sale of a used asse are a capial ransacion on he proposed marke crieria. he sandard accouning reamens of hem are confirmed. In erms of he IASB Framework, here is no income in his case because one asse (he old lahe) has simply been replaced by anoher asse firs cash, hen (par of he cos price of) a new lahe. 23 Again, he rules and convenions of presenaion of financial saemens ell us ha such a ransacion is o be disclosed direcly in he 23 Following he same analysis as in secion 4.3, upon he sale of he old lahe, applicaion of he Framework s income definiion reas he receip of cash as income in he form of a gain. he cash represens an increase in economic benefis in he form of an enhancemen of asses, which resuls in an increase in equiy. However, he receip of he cash required giving up he old lahe. he deparure of ha asse is expendiure in erms of he Framework s definiion of ha erm, i.e. i represens a decrease in economic benefis in he form of an ouflow or depleion of asses, which resuls in a decrease in equiy. he receip of cash is negaed by he loss of he old lahe of equal value, so ha here is no profi, or ne income, from he ransacion.

26 25 asse accouns in he balance shee, raher han as gains and expendiure in he profi and loss accoun. 4.6 Lease inducemen paymen Our las illusraion applies he marke based mehod o classify lease inducemen paymens. he difficuly wih lease inducemen paymens is ha in some sense or anoher i is undeniable ha hey are a parial offse o he amouns of he regular paymens due under he lease by he enan. While applicaion of he accouning convenions discussed in Secion 3 would rea such gains as income derived from ouside an eniy s ordinary aciviies, he classificaion of lease inducemen paymens has differed beween counries for income ax purposes. For example, New Zealand cours have found hem o be nonaxable, capial amouns, 24 whereas Ausralian cours have viewed hem as axable, revenue iems. 25 he firm is o make agreed regular lease paymens. By doing so i acquires he righ o receive a lease inducemen paymen. ha is o say, regardless of who owns he business, he landlord will pay i a lump sum a a fuure dae. he problem is o decide on he accouning reamen of he lump sum. he marke based procedure makes a deerminaion by envisaging a hypoheical sale of a business. When he lump sum is received i will be invesed by he owner of he business because i is sub-opimal o do oherwise. he lump sum may be invesed in a new asse wihin he business or ouside i. Eiher way, he lump sum makes a conribuion o he fuure ne renal sream of he business. We are concerned jus wih he classificaion of he lump sum so we may assume ha boh paries agree on he conribuion of he new asse o fuure ne renals. 24 See, for example, Waie and Lawrence v. Commissioner of Inland Revenue (998) 9 NZC 3,99 (PC). 25 See, for example, Federal Commissioner of axaion v. Cooling (990) 2 AR 3 and Roherwood v. Federal Commissioner of axaion (996) 96 AC 4,203.

27 26 Poenial buyer and seller of he business realize ha he exra oupu increases he presen value of he business. he price of he new asse is equal o he presen value of is fuure ne conribuions and he new asse s price equals he lump sum from he lease inducemen. hus he presen value of he fuure oupu conribuions from he new asse are equal o is price and in urn equal he lump sum of he lease inducemen. Now suppose, having agreed ha he oupu conribuions from he invesmen of he lump sum expand he ne renal sream, one pary decides furher o include he lump sum iself as a receip in he ne renal sream. Inclusion of he lump sum in his second way would increase he ne renal sream compared wih exclusion. We have seen how he lump sum equals he presen value of he oupu conribuions from he new asse. hose oupu conribuions are already in he ne renals, i.e. he value of he lump sum is here oo. Including he lump sum again would hus be o include i a second ime. A buyer of he business would be paying wice for he lump sum were his reamen of he lease inducemen o be acceped. So here would be no agreemen on he presen value of he business. ha is o say a poenial buyer would no agree o he inclusion of he lease inducemen in he ne renal sream. here is no classificaion of he lease inducemen o his poin. Omiing he lease inducemen from he ne renals would leave a muually agreed ne renal sream ha includes he oupu conribuion from he invesed lump sum. Poenial buyer and seller would hen agree on he presen value or price of he business. Since he lease inducemen is omied from he agreed ne renal sream he inducemen is a capial ransacion under he marke crieria 26. he lump sum from he lease inducemen is invesed which provides a reurn. he economic effec is a reducion in he agreed regular lease paymens once he ime value of money is incorporaed. he reurns from he invesmen of he lump sum are 26 A lease inducemen paymen could be made on he expiry of he lease. If he firm coninues beyond ha dae he foregoing analysis applies as he lump sum will sill be invesed.