Transaction Approach (Net Income)

The transaction approach is a method of determining net income by identifying, recording and adding up the effects of the individual transactions and events that change a business's net assets during a period, other than investments by and distributions to owners. Each sale, purchase, wage payment, depreciation charge or asset disposal is recorded as a revenue, expense, gain or loss, and net income is the difference between the totals. It is the approach used in everyday accounting and is the basis of the income statement.

Accounting theory describes two ways of measuring income. The transaction approach builds income from the bottom up, one transaction at a time. The capital maintenance approach measures it from the top down, by comparing the owners' equity, or net assets, at the start and end of the period. When applied consistently, the two methods produce the same figure; they differ in how much information they provide.

Under the accrual basis of accounting, each transaction is analyzed for its effect on income:

• Revenues are recorded when earned, under revenue recognition rules, whether or not cash has been received.
• Expenses are recorded when incurred to generate those revenues, in line with the matching principle.
• Gains and losses from peripheral events, such as selling equipment or settling a lawsuit, are recorded when they occur.
• Adjusting entries at the period end capture events that happen gradually, such as depreciation, accrued interest and the use of prepaid items.

The core relationship is:

Here each term is the period total from the related accounts in the ledger.

A small printing company records these items during the year: printing revenue of $640,000, interest revenue of $3,000, a $5,000 gain on selling an old press, cost of paper and ink of $210,000, wages of $250,000, rent of $48,000, depreciation of $30,000, a $4,000 loss from a flood not covered by insurance and income tax of $22,000. Using the transaction approach, net income is $648,000 of revenues and gains minus $564,000 of expenses and losses, or $84,000.

Using the capital maintenance approach on the same business, suppose equity was $400,000 at the start of the year and $449,000 at the end, the owners invested an additional $15,000 and dividends of $50,000 were paid. Net income is $449,000 minus $400,000, minus $15,000 of new investment, plus $50,000 of distributions, which also gives $84,000. But only the transaction approach shows where the income came from.

The main advantage of the transaction approach is detail. It shows the sources of revenue and the types of expense, so users can analyze margins, compare periods and predict future results. It is also objective, because each figure is tied to a documented transaction, usually at historical cost. These features explain why accounting standards and the conceptual frameworks of the FASB and IASB rely on it.

Its main limitation is that it generally records only completed transactions. Changes in the value of assets that are still held, such as a rise in the market value of land, are usually not recorded as income until the asset is sold. Modern standards have moved partly toward a balance sheet view by measuring some items at fair value, with changes reported in net income or in other comprehensive income. As a result, today's income statement reflects mainly the transaction approach, but with value changes on some assets and liabilities blended in.