Modeling Earnings Under Two Types of Risk

Abstract

This paper develops a unified framework for earnings measurement by introducing two types of risk: inflow-related risk and outflow-related risk. Using the concept of risk tolerance—the acceptable level of stock-related risk—the framework spans the full range of earnings measures, from conservative cash-based accounting to forward-looking economic income. The analysis shows that (i) the asymmetry between inflows and outflows is central to earnings recognition, (ii) varying risk tolerance explains practices such as historical cost and depreciation, and (iii) realization, matching, and conservatism can be reconciled within a risk-based model. The contribution lies in formally linking risk tolerance to the stock–flow structure of accounting, providing a clearer representation of how uncertainty shapes earnings measurement. The framework offers implications for both theory and practice while also facing limitations, including its stylized two-period setting and simplified risk measure. These point to directions for future extensions and empirical validation.