What Is Income?

Income is money (or some equivalent value) that an individual or business receives, usually in exchange
for providing a good or service or through investing capital. Income is used to fund day-to-day
expenditures. Investments, pensions, and Social Security are primary sources of income for retirees. For
individuals, income is most often received in the form of wages or salary. Business income can refer to a
company's remaining revenues after paying all expenses and taxes. In this case, income is referred to as
"earnings.” Most forms of income are subject to taxation.

KEY TAKEAWAYS

Income is money what an individual or business receives in exchange for providing labor, producing a
good or service, or through investing capital.

Individuals most often earn income through wages or salary. Businesses earn income from selling goods
or services above their cost of production.

Tax authorities treat income earned through various means differently.

Income

Understanding Income

Individuals receive income through earning wages by working and making investments into financial
assets such as stocks, bonds, and real estate. For instance, an investor’s stock holding may pay income in
the form of an annual 5% dividend.

In most countries, earned income is taxed by the government before it is received. The revenue
generated by income taxes finances government actions and programs as determined by federal and
state budgets. The Internal Revenue Service (IRS) calls income from sources other than a job, such as
investment income, “unearned income.”1

Taxable Income

Income from wages, salaries, interest, dividends, business income, capital gains, and pensions received
during a given tax year are considered taxable income in the United States. Other taxable income
includes annuity payments, rental income, farming, and fishing income, unemployment compensation,
retirement plan distributions, and stock options. Lesser-known taxable income includes gambling
income, bartering income, and jury duty pay.2

The types of income listed above would be classified as ordinary income, which is composed mainly of
wages, salaries, commissions, and interest income from bonds, and it is taxable using ordinary income
rates. This type of income differs from capital gains or dividend income in that it can only be offset with
standard tax deductions, while capital gains can only be offset with capital losses.3

Tax-Exempt and Tax-Reduced Income

Types of income that may be tax-exempt include interest income from U.S. Treasury securities (which is
exempt at the state and local levels)4 , interest from municipal bonds (which is potentially exempt at the
federal, state and local levels)5 and capital gains that are offset by capital losses.3

Types of income taxed at lower rates include qualified dividends and long-term capital gains. 3 6 Social
Security income is sometimes taxable, depending on how much other income the taxpayer receives
during the year.7

Disposable and Discretionary Income

Disposable income is money that’s remaining after paying taxes. Individuals spend disposable income on
necessities, such as housing, food, and transportation. Discretionary income is the money that remains
after paying all necessary expenses. People spend discretionary income on items like vacations,
restaurant meals, cable television, and movies.

In a recession, individuals tend to be more prudent with their discretionary income. For example, a
family may use their discretionary income to make extra payments on their mortgage or save it for an
unexpected expense.

Disposable income is typically higher than discretionary income within the same household because
expenses of necessary items are not removed from the disposable income. Both measures can be used
to project the amount of consumer spending. However, either measure must also take into account the
willingness of people to make purchases.

Examples of Income

For private individuals, ordinary income is usually only made up of the salaries and wages they earn
from their employers pretax. If, for example, a person works a customer service job at Target and earns
$3,000 per month, his annual ordinary income would be $36,000, derived as $3,000 x 12. If he has no
other income sources, this is the amount that would be taxed on his year-end tax return as gross
income.
Additionally, if the same person also owned a rental property and earned $1,000 a month in rental
income, his ordinary income would increase to $48,000 per year. If the same person earned $1,500 in
qualified municipal bond interest payments, that portion of income would be tax-exempt.

For businesses, ordinary income is the pretax profit earned from selling its product or service. For
example, the retailer, Target, had $69.5 million worth of total sales or revenue in the year ended in
January 2017. The company had $48.9 million in costs of goods sold (COGS) and $15.6 million in total
operating expenses. Target’s ordinary income was $5 million8 , derived as follows:

$69,500,000 - $48,900,000 - $15,600,000

This is the amount of income that would be taxed for the year. However, businesses are required to pay
taxes quarterly.

What is Accounting Income?

Accounting income is the profit a company retains after paying off all relevant expenses from sales
revenue earned. It is synonymous with net income, which is most often found at the end of the income
statement. The metric differs from gross income in that the latter accounts for only direct expenses,
whereas accounting income also takes into consideration all indirect expenses.

Accounting Income

Taxable Income

Taxable income is regulated by the definitions of the U.S. Internal Revenue Service (IRS) (or the
corresponding tax authority) of income or expenses, and it does not necessarily match with the
accounting or economic income approach. Taxable income is used to determine the taxes payable.
Often, the taxable income line item will immediately precede accounting income in the income
statement. The difference between taxable income and accounting income is the deduction via taxes
paid.
Accounting Conservatism

Accounting income is heavily related to accounting conservatism because the latter stresses not
overstating income or assets. It is used when there is uncertainty in the outcome of a transaction (e.g.,
when a stock value increases or a property gains value due to a valuation), but there is no certainty for
realizing the operation (converting it into cash).

How is Accounting Income Calculated?

As part of the income statement, accounting income is calculated starting with sales revenue. This is the
amount of revenue earned through the sale of goods or services. From that amount, direct costs for
producing the goods or providing the services are deducted to find gross profit.

From here, most indirect expenses are deducted to find EBITDA (Earnings Before Interest, Taxes,
Depreciation, and Amortization). The indirect expenses include but are not limited to, indirect labor
costs, marketing costs, rent, professional fees, and meals and entertainment. Depreciation,
amortization, interest, and taxes are not deducted before the EBITDA line item, but instead after.

From EBITDA, companies will often deduct Depreciation and Amortization to find EBIT. EBIT less Interest
Expenses results in EBT, which stands for Earnings Before Tax. EBT is also sometimes known as Taxable
Income, although there are some cases where EBT and Taxable Income differ, due to the type of
deductions and tax liabilities that apply to a given company.

Finally, when taxes are deducted from EBT, we arrive at accounting or net income.

What Affects Accounting Income?

Accounting income is the bottom line in the income statement and is therefore affected by every other
line item appearing before it. In that sense, the amount that a company can declare will be a function of
the revenue realization and expense matching rules that apply to it.
In most cases, accounting income is tied to the rules of accrual accounting. It means that accountants
will often follow IFRS or GAAP rules to derive the figure, although such rules may differ between
different countries.

Does Accounting Income differ from Cash Receipts?

The short answer is yes. While there are exceptional cases where accounting income equals the amount
of cash received by the company, it will differ due to the timing of cash collection and revenue
recognition. For example, in the case of accounts receivables, revenue is recognized immediately, but
cash is not recognized until later.

Accounting Income and the Cash Flow Statement

However, accounting income is a key point in calculating the cash flow statement. Under the indirect
cash flow method, it is the first line item. From here, changes in cash due to operations, financing, and
investing are added or subtracted to find the net change in cash in any given period.

Accounting Income and the Balance Sheet

While not appearing as a line item in the balance sheet, accounting income directly affects one of the
line items. A positive amount in a period will increase retained earnings, depending on how much in
dividends is paid. In fact, the change in retained earnings can be calculated as accounting income less
dividends paid.

For example, a company that earns $100,000 in accounting income will experience a $100,000 increase
in retained earnings if no dividends are paid. The company keeps all of the revenue it earns in the
period. However, if half of this is paid out to shareholders, the company will only record $50,000 in
retained earnings from said income.
Key Takeaways

The financial importance of each of the concepts described above lets us identify the key factors of
businesses. As a key line item in two of the core financial statements, accounting income is an important
metric that any accountant or financial analyst should know. More importantly, it connects the three
financial statements. Understanding accounting income is therefore also an important step in building a
financial valuation model.