In business accounting, the concept of income should exhibit, as ex post fact, realized income which is calculated based on actual cash flows of an enterprise as investment proceeds, because income is a measurement of to what extent the expected outcome of the investment has been achieved. In the case of financial investments, reporting income through measuring financial instruments at fair value is acceptable only to the extent that current fair value of assets is equivalent to future cash flows and that the result measured by the changes in fair value can be regarded as realized income. In other words, income is deemed realized income without actual sales as long as expected future cash flows can be converted into the equivalent present cash flows at any time. However, this argument does not apply to financial instruments which are fixed to particular business and thus are not available for sale, such as financial liabilities which finance physical assets. Even though current fair value is equivalent to expected future cash flows, expectations cannot be considered as realized fact if the instrument cannot be readily converted into cash. For example, when fair value of these liabilities depreciate as a result of an increase in market interest rate, the resulting increase in income should be recognized in the form of reductions of subsequent interest burden. In this example, even if liabilities were to be redeemed at fair value, they have to be replaced with liabilities of the same principal amount because the fund financed by the liabilities is fixed to particular business. Some financial assets may bear similar nature. Reporting gains and losses resulting from measurement of their fair value as net income is tantamount to calculating net income in a manner totally inconsistent with the concepts of business accounting. What is being recognized is not realized income which is evidenced with actual cash flows but income measured by the mere increase or decrease of assets' value under the appreciation concept of income. Needless to say, if we were to recognize net income in line with the appreciation concept, measurement of fair value should no longer be limited to financial instruments. Changes in value of physical assets must be recognized as components of net income as well. The confusion arises not from the dispute over the interpretation of the term "realization", but from the income concept itself where realization concept and appreciation concept coexist. Consistent implementation of the concept is far more important than the choice of concept.
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Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE J-Series with number
97-J-9.