Appendix C: Measurement of Income

• Author: Vern Krishna
• Profession: Professor of Common Law, University of Ottawa Barrister at Law
• Pages: 627-677

627

APPEN DIX C

meaSuremenT

ofIncome

A. GENER A L COMMENT

Every tax system need s a method of measuring t he base upon which it

imposes taxe s. Sales taxes, for example, must identify taxable sales of

goods and services. Usage taxes, such as highway tolls, must identi fy

the consumer’s use of the part icular facility. Thus, the key to a good

income tax system is the accurate measurement of the taxable ba se. In

the Income Tax Act the taxable base is “income.”

We saw in Chapter 4 that “income” is a measure of gain over time.

Thus, measuring income requires that we identify the amount of the

gain and relate it to the appropriate period when we should recognize

the gain for tax purposes. As we will see in this chapter, both of these

aspects of measurement can be uncertain processes inf‌luenced by law,

economics and accounting. The measurement of income is more art

than science.

Accounting is the art of meas uring and presenting f‌inancial i nforma-

tion. As such, accounting is the la nguage of f‌inancial transact ions. Users

of f‌inancial inform ation need to understand this l anguage, regardless of

whether they act for business or represent interests that are adverse to

business. Law yers, for example, must deal with accounting problems

in the same way they address other issues, with judgment and analysis.

This means that lawyers need to understand accounting to draft f‌inan-

cial clauses i n contracts, to structure negotiated sett lements, for advo-

cacy in litigation, for tax pur poses and to negotiate damage award s.

Income Tax L aw628

As with all languages, accounting has cer tain fundamental rules of

structure and composition. We refer to these rules a s the principles of

accounting. Contrary to popular conceptions and, perhaps, most fortun-

ately, accountants did not devise the fundamental st ructural rules of re-

cording f‌inancial d ata. A Renaissance monk named Pacioli devised the

basic process of recording f‌in ancial data. This process allows us to record

information in a methodical manner for analysis and deci sion making.

It is important to note, however, that the principles of accounting

are neither rigid nor uniform. Variations i n accounting principles make

comparisons of f‌inancial information diff‌icult. For present purposes,

however, we conf‌ine our attention to the basic principles of Canadian

accounting.

B. ACCOUNTING PRINCIPLES

A taxpayer’s income for a taxation year f rom a business or property is

his or her prof‌it therefrom for the year.1 The term “prof‌it” means net

prof‌it, that is, the amount of revenue remaining after t he deduction of

expenses i ncurred for the purpose of earning the revenue.2 Thus, we

need a system of principled accounting for measuri ng prof‌it.

We speak of generally accepted accounting principles (GAAP) as

the principles that underlie the prepar ation of f‌inancial statements for

commercial use. We say “generally accepted” because various profes-

sional accounting bodies, regul atory agencies, securities comm issions

and f‌inanc ial institutions gene rally accept the principle s as appropriate

for f‌inancial statements. In Canada, the Canadian Institute of Chartered

Accountants (CICA) Handbook is an authoritative source of GAAP. The

Canada Business Corporations Act and regulatory statutes recogni ze it

as the benchmark of accounting pr inciples. GAAP, however, encom-

passes not only the specif‌ic recommendations and procedures set out

in the Handbook, but also broad principles and conventions. Thus, if

the Hand book does not cover a matter, we use other accounting princi-

ples that practitioners accept and that are con sistent with the Handbook.

These accounting principles develop over time and through usage.

When the Hand book does not cover a matter, accountants refer to

other sources of information. For example, the CICA’s Emerging Issues

1 Income Tax Act, RSC 1985, c 1 (5th Supp) [ITA], subs 9(1); subs 9(2) def‌ines “loss.”

2 Montreal Light, Heat & Power Consolidate d v MNR; Montreal Coke & Manufac-

turing Co v MNR, [1940– 41] CTC 217 (Ex Ct), aff’d [1942] CTC 1 (SCC), aff’d

[1944] CTC 94 (PC).

Measurement of Inc ome 629

Committee (EIC) Abstracts, International Accounting St andards, stan-

dards promulgated by the Financia l Accounting Standards B oard

(FASB) in the US and accounting literature are u seful sources. Unfortu-

nately, these sources do not always agree on what constitutes GAAP.

The Handbook addresses such potential di fferences by saying, “the

relative importance of these various sources is a matter of professional

judgment in the circumst ances.” In practice, the order of importance of

these sources is as follows:

• CICA Handbook and EIC Abstracts;

• CICA accounting guidelines;

• Establi shed Canad ian pract ices;

• Recommendations of the FASB in the US;

• International accounting standards; and

• Literature.

Since GAAP represent authoritative guidelines for the preparation

and presentation of f‌inancia l statements for commercial purpose s, we

need to clearly understand their f undamental premise s. These assump-

tions are the bedrock upon which we inter pret f‌inancial inform ation.

Net income essentially comprises two components, namely, rev-

enue and expenses dur ing a period of time. We calculate net prof‌it or

net income according to the formula:

NI = R – E

where:

NI = Net Income

R = Revenues

E = Expense s

All measurement of income for commercial purpos es begins w ith this

basic formula. The essence of the income statement is matching rev-

enues and expense s over a period of time, usually one year.

The f‌irst step in the calculation of net prof‌it is to look to accounting

and commercial principles. In Daley v MNR, for example:

. . . the f‌irst enquir y whether a partic ular disburs ement or expense

is deductible should not be whether it is excluded f rom deduction

by [paragraph 18(1)(a) or (b)] but rather whether its deduction is

permis sible by the ordinar y principles of commerci al trading or ac-

cepted business a nd accounting practice. . . .3

3 Daley v MNR (1950), 50 DTC 877 at 880 (Ex Ct) (fee for call to Ba r not deduct-

ible expense a s preceding commencement of the pr actice of law). See also