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
ofIncome
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
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