Appendix C: Measurement of Income

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

627

APPENDIX C

meaSuremenT

ofIncome

A. GENERAL COMMENT

Every tax system needs a method of measuring the base upon which it

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

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

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

income tax system is the accurate measurement of the taxable base. 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 information need to understand this language, regardless of

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

business. Lawyers, 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 in contracts, to structure negotiated settlements, for advo-

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

Income Tax L aw628

As with all languages, accounting has certain fundamental rules of

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

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

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

cording f‌inancial data. 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 decision 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 from 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 the deduction of

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

need a system of principled accounting for measuring prof‌it.

We speak of generally accepted accounting principles (GAAP) as

the principles that underlie the preparation of f‌inancial statements for

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

sional accounting bodies, regulatory agencies, securities commissions

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 recognize it

as the benchmark of accounting principles. 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 Handbook 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 Handbook 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 ome629

Committee (EIC) Abstracts, International Accounting Standards, stan-

dards promulgated by the Financial Accounting Standards Board

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

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

The Handbook addresses such potential differences 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;

• Established Canadian practices;

• Recommendations of the FASB in the US;

• International accounting standards; and

• Literature.

Since GAAP represent authoritative guidelines for the preparation

and presentation of f‌inancial statements for commercial purposes, we

need to clearly understand their fundamental premises. These assump-

tions are the bedrock upon which we interpret f‌inancial information.

Net income essentially comprises two components, namely, rev-

enue and expenses during 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 purposes begins with this

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

enues and expenses 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 enquiry whether a particular disbursement or expense

is deductible should not be whether it is excluded from deduction

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

permissible by the ordinary principles of commercial trading or ac-

cepted business and 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