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A review of price-level change and income determination concepts. Ma, Ronald Arab 1963

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A REVIEW OF PRICE-LEVEL CHANGE AND INCOME DETERMINATION CONCEPTS BY RONALD ARAB MA B» Com., London University, 19h9 A thesis submitted i n pa r t i a l fulfilment of the requirements for the degree of MASTER OF BUSINESS ADMINISTRATION in the Faculty of Commerce and Business Administration We accept this thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA A p r i l , 1963 In presenting t h i s t h e s i s i n p a r t i a l f u l f i l m e n t of the requirements for" an advanced degree at the U n i v e r s i t y of B r i t i s h Columbia, I agree that the L i b r a r y s h a l l make.it f r e e l y a v a i l a b l e for reference and study. I f u r t h e r agree that per-mission for extensive copying of t h i s t h e s i s for s c h o l a r l y purposes may be granted by the Head of my Department or by h i s representatives. I t i s understood that copying, or p u b l i -c a t i o n of t h i s t h e s i s for f i n a n c i a l gain s h a l l not be allowed without my w r i t t e n permission. Department of fl-dsi^7~2^£ye£C^ The U n i v e r s i t y of B r i t i s h Columbia, Vancouver 8, Canada. Date if- ~>h f ^> ABSTRACT The thesis seeks to find some satisfactory concept of income and contrasts economic income concepts with accounting concepts. The case for price-level accounting i s set out by i l l u s t r a t i n g from various case studies the deviation of income in real terms from reported income, and by considering the theoretical arguments i n favour of price-level accounting. Arguments against price-level accounting then follow. Principles underlying the two main schools: the purchasing power historical cost system and the current cost system are next considered followed by a demonstration and appraisal of the application of several price-level accounting systems that have been proposed. Finall y a reconciliation between economic and accounting concepts of income i s attempted, and a position i n favour of price-level accounting i s supported. TABLE OF CONTENTS Chapter Page I* WHAT IS INCOME 1 Economic Concepts of Income 5 Accounting Concepts of Income 22 Conclusions k9 Appendix A. The Basic Postulates of Accounting £6 Appendix B. Summary of Accounting Principles 58 U . THE CASE FOR PRICE-LEVEL ACCOUNTING 66 The Effect of Price Level Changes on Accounting Income 69 Adjustments i n Terms of a Constant-Value Unit 70 Adjustments i n Terms of Current Value Units 76 Appendix* Tables I - IX 79 H I . THE CASE FOR PRICE-LEVEL ACCOUNTING FURTHER CONSIDERED 89 The Function of Income Determination 89 Deficiencies i n Income Measurement 93 The Problem of Rising Prices 9$ The Case for Price-Level Adjustments 97 The Maintenance of Capital 98 Tax Considerations 101 Trade Cycle Fluctuations 103 IV. THE CASE AGAINST PRICE-LEVEL ACCOUNTING 10? The Case Against the Replacement Cost Theory 112 The Case Against the Purchasing Power Theory 122 Tax Considerations I2I4. Some Social Problems 127 V. PRICE-LEVEL ADJUSTMENTS: PRINCIPLES 129 Purchasing Power Historical Cost versus Current Cost 129 Comprehensive versus Partial Adjustments 136 Should Capital Gains, be Regarded as Income l k l Appendix. A Note on Depreciation lh3 VI. PRICE-LEVEL ADJUSTMENTS: METHODOLOGY 161 Purchasing Power Historical Cost Systems 161 The Sweeney Method 161 The Mason Method 172 The Corbin Method 175 An Appraisal of the Tbeee Methods 177 Current Cost Systems 179 Stabilization i n Terms of Replacement Cost 179 Corbin's Replacement Cost Adjustments 180 An English Approach 180 An Australian Approach I83 Realizable Profit and Business Profit 18U An Appraisal of the Current Cost Systems 19U VII. CONCLUSION 202 Postscript 209 BIBLIOGRAPHY 212 LIST OF TABLES Table I. WholesalePrice and Consumer Price Indexes, United States, 1890-1961 79 II. Wholesale Price and Consumer Price Indexes in Selected Countries, I960 and 1961 81 III. Unstabilized and Stabilized Income of Mill Agents, Inc., in United States for the years ended September 30, 1930 and 1931 82 IV. Net Profit and Surplus of Three Steel Companies, 1939-U7 and Seven Steel Companies in United Kingdom, 1 9 U 9 - 5 7 83 V. . Reported and Adjusted Income aid Other Financial Statistics of Four Companies in United States, 19U1-51 8I4. VI. Reported and Adjusted Earnings Available for Interest and Dividends of Three Major Manufacturers of Electrical Products in United States, 193?,, 191*1, and 19U6-U8 85 VII. Unadjusted and Adjusted Annual Rates of Return and Percentage Overstatement of Reported Income in Seven Industrial Groups in United States, 1951-56. 86 VIII. Wholesale Price Index, Accounting Profits, Current Income and Saving of Australian Companies, 19U5-19U6 and 1952-1953 87 IX. Reduction of Income of Five Giant Corporations in United States after Adjustments for Purchasing Power Historical Cost Depreciation, 1938-1951 88 Write-ups and Write-downs of Property, Plant and Equipment, 1925-193k: 272 IARGE INDUSTRIAL CORPORATIONS 118 1 A REVIEW OF PRICE-LEVEL CHANGE AND INCOME DETERMINATION CONCEPTS I. WHAT IS INCOME "Accountants have no complete philosophical system of thought about income$ nor i s there evidence that they have ever greatly f e l t the need for one." The function of accounts Broadly the accounting functions f a l l into two main groups: (a) the preparation of general-purpose statements, v i z . , the statement of p income for the period and the statement of the financial position of the enterprise at the end of the period, and (b) the provision of special-purpose reports which provide data for financial and costing control. While the latter function i s rapidly gaining i n importance, the f i r s t function nonetheless corresponds to the layman's concept of accounting, and the present study w i l l be primarily concerned with certain specific problems i n this area. These problems are concepts of income and income measurement with particular reference to changing price levels. 1. John B. Canning, The Economics of Accountancy, New York: The Ronald Press Company, 1929, P« 160. 2. "A f a i r determination of income for successive accounting periods i s the most important single purpose of the general accounting reports of a corporation", ¥. A. Paton, "Recent and Prospective Developments i n Accounting Theory", i n Dickinson Lectures i n  Accounting, Cambridge: Harvard University Press, 1936-37 - 1939-hO, 19U3, p. 97. -2 What i s income A. pertinent question i s , "Whose income do we wish to measure?" The economist and the accountant might well have different concepts i n mind. The economist concerns himself with the level of income which flows from a certain l e v e l of economic activity; the national income for example, i s a quantitative measure of this concept. 3 An accountant thinks of income i n a very different way. He i s not concerned w i t h the total flow of wealth i n a community nor the accretion to an individual's stock of wealth from a l l sources. The income he deals with i s that of a business enterprise, an accounting entity which may comprise an individual, a collection of individuals, a partnership or a corporation. When we consider the nature of income, we find that the economist considers p r o f i t as only one of the components of income. "Income may be derived by working f o r wages or salaries, or from owning property, land or capital equipment, which contributes to the output of goods, or from lending money ^ 3 . "National income may be defined provisionally as the net total of commodities and services (economic goods) produced by the people comprising a nation; as the tot a l of such goods received by the nation's individual members i n return f o r their assistance i n producing commodities and services; as the total of goods consumed by these individuals out of the receipts thus earned; or, f i n a l l y as the net total of desirable events enjoyed hy the same individuals i n their double capacity as producers and consumers." Simon Kuznets, in article on "National Income" i n Encyclopaedia of the Social Sciences, New York: MacMillan Company, 1950 (reprinted), Vol. XI„ p. 2 0 5 -Joan Robinson, Introduction to the Theory of Employment, London: Macmillan and Co., Ltd., 19U7, PP« 6 and7* - 3 -A comprehensive theory of profit i s propounded by J. B. Clark and others j they view profit as arising out of change i n a dynamic economy as, for example, i n the state of arts or demand and supply schedules. Thus profits are the result of disequilibrium and imperfection of competition. Other economists have attempted to define pr o f i t as a reward to one of the factors of production. Thus some economists postulate that change must be unpredictable; pr o f i t then is the return to risk and uncertainty borne by capital. ^ Others again believe that profit arises from economic change which i s deliberately inducedj i n this innovation theory the entrepreneur i s the v i t a l factor. ? It has been held that the emphasis placed by this theory on management i n i t i a t i v e i s the most satisfactory one Q i n understanding the dynamics of our modern industrial economy. Thus not only i s there no concensus of opinion among economists but the economic profit concepts do not lend themselves to objective measurement and further quantitative analysis. 5« See, for example, John Bates: Clark, The Distribution of Wealth, New York: The MacMillan Co*, 1899 and Charles A. Tut t i e , "A Functional Theory of Economic Profit" i n Jacob H. Hollander (ed.), Economic  Essays Contributed i n Honour of John Bates Clark, New York: The MacMillan Co., 1927-6 . Frank H. Knight, Risk, Uncertainty and Profit, Boston and New York: Houghton, M i f f l i n and Co., 1921• 7. Joseph A. Schurapeter, Theory of Economic Development, Cambridge: Harvard University Press, 193U• 8 . Joel Dean, Managerial Economics, JSnglewood Cliffs,, N. J.: Prentice-Hall, Inc., 1959, p. 1 2 . -k-In contrast, accountants have adopted an entirely different approach. The term 'income' i s treated as synonymous with 'profit'; at least this i s done for enterprise inoome, with which we are o concerned. 7 Accounting profit i s institutional i n conception. It i s characterized by two common features - i t is a residual figure and i t 10 is non-contractual. Further, i t comprises income from a l l sources -accounting pr o f i t may include elements of rent, labour and interest. It thus tends to be heterogenous i n nature, the extent of heterogeneity depending on the type of enterprise and, i n some cases, the nature of the business. Nonetheless, i t possesses the important merit of being measurable* Further, i t i s usually possible to make certain adjustments which w i l l eliminate the differences, or at least, minimise these differences for purposes of inter-enterprise comparisons. Though our analysis i s centred on the net income or net profit of the business enterprise, often referred to as business income, none-theless a rapprochement between the economists' and accountants' view-points i s essential. The theoretical systems of the economists provide the framework of reference against which we can test the v a l i d i t y of the concepts of income measurement developed by the accountants to account for economic activi t y * 9. The accountant also recognizes there are other sources of income, such as investment income. 10. See A. G. Pool, "The Economic and Accounting Concepts of Profit", Accounting Research, Vol. !|, No. 2, Ap r i l 1953 > PP« ll+U - 52'» -5-ECONOHIC CONCEPTS OF INCOME Income has been variously defined. Some definitions are given belowi they confirm that income i s , indeed, a controversial subject. "Income has been defined as: (l) 'the wealth measured in money which i s at the disposal of an individual or a community, per year or other unit of time'j (2) 'the inflow of satisfactions from economic goods, estimated i n money1 (Seligman); (3) 'those incomings which are i n the form of money, including payments i n kind. 1 "These definitions have some ambiguity. In general, the term i s confined to those 'satisfactions which are capable of being parted with, or are usually parted with, for money.1" There i s no one concept of income which i s generally accepted by economists; instead there are a confusing number of concepts which often conflict. We shall deal here only with those few which have been a significant influence, directly or indirectly, on the development of accounting thought on income. Fisher's income concept 1 2 It has been suggested that the income theory advocated by Irving Fisher ^ i s representative of economists' views on income and that his 1 1 . Encyclopedia Brittanica,, Chicago: William Benton (Publisher), 1959> Vol. 1 2 , p. 1 3 5 -1 2 . Canning, op. c i t . , p. II4.5. 1 3 . Irving Fisher, The Nature of Capital and Income, New; lork: Macmillan Company, 1 9 1 2 , pp. 1 0 1 et seq. -6-concept more nearly parallels that of the accountant than does the work of any other economist. "Income", according to Fisher, "consists of services, which can be defined as desirable events or the avoidance of undesirable events.... The value of an income i s the value of the services of which i t consists; i t i s measured for practical purposes i n terms of money." Elsewhere he writes: "A stock of wealth existing at a given instant of time is called capital; a flow of 15 benefits from wealth through a period of time is called income". These benefits are abstract services derived from material assets, which are themselves capital. The gross income is the value of a l l the services flowing from an a r t i c l e of wealth i n a period and the net income i s the excess of gross income over the outgo (defined as d i s -services or undesirable events)* For the community as a whole, the income received i n any stage of economic activity w i l l be equally matched against the outgo i n the succeeding stage, and the only uncancelled element i n the matching process i s f i n a l objective income, that i s , the f i n a l personal uses of wealth, ordinarily called "'consumption". The last l i n k i n the chain of income flow i s f i n a l subjective income, defined as the stream of consciousness of any human being. There are certain a f f i n i t i e s between Fisher's system and that of the accountant, Fisher conceived of income as a continuous flow of benefits, which closely approximates certain accounting doctrines of continuity, i n particular the going concern convention and the accrual 111... Irving Fisher, i n article on "Income" i n Encyclopedia of the  Social Sciences, Vol. VII, p. 623* 15* Irving Fisher, Elementary Principles of Economics, New York, 1919, p. 38. concept. Net income measured as the d i f f e r e n t i a l between gross income and outgo or disservices i s also a familiar accounting concept. Further, income as consumption i s comparable to the accountant's realization convention, that i s , income i s earned when the end-product passes Into the hands of the consumer. Nonetheless, i t i s d i f f i c u l t to j u s t i f y the extravagant claims made for the influence of Fisher's work on the development of accounting theory and practice. ^ Much of the controversial aspects i n Fisher's income concept would appear to arise from his desire to avoid double counting within the framework of community incomes. In order that both the services which go into the production of a capital instrument and the services that are derived from the capital instrument should not be included i n the income measure, he suggests that savings must be excluded i n the year i n which the savings are accumulated, since the interest on the savings w i l l be counted as income i n subsequent 17 years; he thus equates Income with consumption. Taking this premise to i t s logical conclusion, he recommends that the capital cost of an asset should be deducted as an outgo i n determining net -j Q income of the year i n which the investment took place, thus confounding not only the accountant's distinction between capital and revenue expenditure but also generally accepted economic concepts of personal and social incomes. That the author of t h i s novel concept considered i t a practicable tool of income measurement i s evident 16. See Canning, op. c i t . , p. lh$ et seq. 17* Fisher, The Nature of Capital and Income, op. c i t . , p. 108 et seq. 18. Ibid., p. 123. - 8 -i n the following quotation: "A business-man's money-income means to him the money receipts from his business, less the money expenses of obtaining them. As applied to commercial a f f a i r s , this concept i s nearly adequate, and i n fact it,coincides, as a special case, with the concept 19 of income which we have adopted." ' When applied to an enterprise, this concept would mean that only the portion of i t s profits which is withdrawn by the proprietors would be considered income, any ploughed-back profits being regarded as outgo. From an acoounting viewpoint the fallacy i n this analysis l i e s i n confusing the receiving of benefits with their eventual disposal. Further, Fisher does not appear to have dealt with the case where the savings are not invested, but are hoarded. A further application of this rule concenns the accumulation of interest* Fisher would have us regard such accumulation as an addition to the capital stockj any income earned but not consumed i s 20 not income. Indeed, he goes further and treats an increase of 21 capital from whatever cause as not giving rise to income. This i s , of course, contrary to those economic and accounting concepts which regard income as an accretion to net worth. There are other criticisms. Hicks has suggested that, since we would not regard the income of a person earning a monthly salary as n i l i n the week i n which he i s not 22 being paid, money recipts are not a good guide to income determination. 19. Ibid., p. 103. 20. Ibid., pp. 13U-5. 21. Ibid., p. 2 U 9 -22. J. R. Hicks, Value and Capital, Oxford: Clarendon Press, 1939, p. 172. -9-But this i s precisely how Fisher would have us measure a business man's income* ^ His disagreement with Hicks i s perhaps at an even more profound level than t h i s . Fisher specifically excludes from his system the concept of capital maintenance. H His income flow i s an irregular one. This is only comprehensible i n an implicit assumption of an income flow which, fundamentally, is not restrained by any considerations of periodicity i n income determination. Such an assumption would conform to conditions i n the real world, but renders Wisher's theory less useful as an economic model. Finally^ i t has been objected that the concept of community psychic income is both nebulous and invalid; since psychic income i s essentially subjective i t must vary from individual to individual and i s clearly not additive.. ^ To conclude, this particular income theory is inadequate i n i t s application to the measurement of enterprise income. It does not provide a guide to investment policy, since i n turn i t i s determined by the amount reinvested. Also, since i t does not give the rate of return on invested capital, i t cannot serve as a measure of operating efficiency* It thus f a i l s to satisfy either of the tests of a good 23* Fisher, op. c i t * , p. 103• 2h» "In actual fact i t i s seldom true...that income flows uniformly or that capital remains at a constant level." Fisher i s prepared to concede, however, the notion of standard income, " i t i s simply the income which he would receive i f he chose to keep his capital unimpaired and unincreased", but this i s not to be confused with true income. Ibid., p. 110. 2$. See L. Robbins, "Interpersonal comparisons of u t i l i t y " , Economic  Journal, December 1938, pp. 635-ifl* - 1 0 -concept which Fisher himself has set: " i t must be useful for sc i e n t i f i c analysis, and i t must harmonize with popular and 26 instinctive usage." We might b r i e f l y consider the l i k e l y effects, i f any, of price level changes on Fisher's system. His income statement would not be distorted, since both incomes and outgoes are in current dollars. There i s noi pro-rating of h i s t o r i c a l costs. However, though Fisher accepts the likelihood of differences arising between the value of the capital asset and the corresponding outgo (equals cost) and advocates the adoption of current market values i n the capital accounts, he would s t r i c t l y exclude any capital gains or losses from income. His system 27 does not permit the recognition of purchasing power gains or losses. For the economy as a whole, increased costs are equally matched by increased incomes, but incomes i n a l l intermediate stages w i l l tend to be higher i f there i s a general price r i s e , and the f i n a l objective income w i l l certainly be higher. Final subjective income w i l l not, probably, be affected. It might be argued that subjective income w i l l also rise, since the wearer w i l l derive greater satisfaction from a more expensive suit. But this is not so i f the price r i s e i s a general onej the human mind acts as an implicit deflator and subjective income i s l i k e l y toiremain as before the price change took-place. The picture i s more complicated, however, i f the increases i n specific price levels are not uniform or i f the price increases are confined 2 6 . Fisher, op. c i t . p. 103. 2 7 - See, for example, Fisher's article on "Income" i n the Encyclopedia  of the Social Sciences, op. c i t . -11-to particular commodities. Final objective income would s t i l l be greater, but we cannot say, a p r i o r i , whether the subjective income i n the community would be greater or less than before, or would remain the same. Other flow concepts of income Most economists who are unable to accept Fisher's theory of income as consumption are, nonetheless, i n broad agreement with his fundamental description of income as a flow of benefits from wealth through a period of time. Several other income concepts have been developed from this basic premise. 28 Income as produce - This i s a backward looking concept; i t provides a measure of the income obtained i n a past period. Net income i s defined as the net value which the owners of the factors of production have received as remuneration. This net value i s the difference between the value of output produced i n the period and certain items which, have been reckoned as products of previous periods and deducted to avoid double counting. There are several variations of this concept, two of which are especially relevant to accounting theory. In one the deductions for depreciation and materials consumed are based on original costs of production, thus changes i n values give r i s e to capital gains or losses which are partly included (in the case of fixed assets, that part which i s proportional to the depreciation charge) i n the income measure. In the other variant, these 28. See Erik Iandahl, "The 6oncept of Income" i n Economic Essays i n Honour of Gustav Cassel, London:. George Allen and UnwiJa, Ltd., 1933, pp. 399-i;07. -12-deductions are based on current costs of production. Provision i s thus made for the actual diminution of value of capital assets consumed in the production process, while capital gains and losses are - excluded from income. As a measure of income ex post, the concept of income as value of output less services at current prices consumed in producing that output i s theoretically the more sound. Insofar as accounting theory recognizes the accrual to economic net worth as income, the produced income concept approximates accounting income. In practice, however, accounting theory i s modified by considerations of conservatism and, to a lesser degree, objectivity; income i s generally recognized at the point of sale. Income as sales - Some economists have adopted the accounting principle of treating income as earned when a sale tates place. For example-, income has been defined as "determined when current costs have been charged at current price levels against current dollars of 29 gross revenues." In other words, income i s sales less outgoings at current prices, and this concept again does not embrace dollars of constant purchasing power. A similar approach was adopted by Keynes. He defines "the income of the entrepreneur as being the excess of the value of his finished 29. Professor Slichter, in testimony before the Joint Committee on the Economic Report, United States, December 6, 19U8, quoted i n T. S., Sanders, "Depreciation and 19U9 Price Levels", Harvard  Business Review, May 19U9, pp. 293-307. - 1 3 -30 output sold during th© period over his prime cost". The prime cost of production i s the sum of the factor cost, that i s , the amounts paid out by the entrepreneur to factors of production (exclusive of other entrepreneurs) for their current services and the user cost, which i s defined as "the amounts which he pays out to other entrepreneurs for what he has to purchase from them together with the sacrifice which he incurs by employing the equipment instead of leaving i t i d l e " . ^ But Keynes i s equivocal over whether to employ his t o r i c a l or current costs i n measuring net income. This arises from his treatment of supplementary cost, which comprises that part of depreciation which i s involuntary but not unexpected. Since i t s influence on consumption policy i s comparable to that of prime cost, the argument runs, i t should be deducted from income i n order to arrive at a net income concept. But Keynes does not believe that a quantitative estimate of supplementary cost can be based on principles alone, rather i t depends on the choice of accounting methods. He quotes with approval the endorsement of h i s t o r i c a l cost depreciation by inland revenue authorities; the employment of an unaltered pre-determined figure ensures a zero windfall gain or loss over the l i f e of the equipment taken as a whole.. He concedes that i n certain circumstances i t i s 32 reasonable to employ current cost depreciation. In any event, he would exclude unforseen changes i n market values, whether due to price 3 0 . John Maynard Keynes, The General Theory of Employment Interest and  Money, London: Macmillan and Co. Ltd., 1936, p. 53* 3 1 . Ibid., p. 2 3 . 3 2 . Ibid., pp. 5 8 - 9 . -Ik-level changes, exceptional obsolescence, or acts of God from the income measure, regarding these as windfall losses (or gains) on capital account. 33 From an accounting viewpoint, these flow concepts of income are simply not comprehensive enough. They would appear to incorporate only operating income and beg the question of what to exclude, as for example, i s profit on sale of fixed assets income, and does this depend on whether such profits are legally distributable or not? There is an even more fundamental objection to Keynsian income; the realization assumption often gives a poor and inadequate measure of obtained income, as w i l l be shown later. So far as price level changes are concerned, the income flow concepts can be defined such as to provide a measure of income ex post expressed i n current dollars, which can then be deflated to give real income. Purchasing power gains and losses are normally excluded. 3k The Hicksian theory of income - This i s the most comprehensive theory of economic income, comprising several related concepts which enjoy wide acceptance among economists and some accountants. In i t s pure form, i t i s a flow concept of income ex ante. Income i s measured by the continuous appreciation of capital goods over time. Capital values, according to this theory, are dependent on the expected future services of the capital goods discounted at the current rate of interest, due allowance being made for the risk factor; as these 33. Ibid., P- 57. 3U» J. R. Hicks, Value and Capital, Oxford: Clarendon Press, 1939, pp. 171 et seq. -15-expected future services draw nearer, capital values w i l l appreciate. Income i s thus measured by the difference between capital values at two instants of time, or where consumption i s expected to take place, by the value consumed plus or minus the difference in the two capital values. Income as interest i s thus the t o t a l sum of the consumption  and the saving expected to take place during a certain period. J ^ This concept i s further developed by Hicks, who propounds three approximations to the central meaning of income. He defines income f i r s t l y thus, "it man's income (is) the maximum value which he can consume during a week, and s t i l l expect to be as well off at the end of the week as he was at the beginning." But i f i t i s expected that the rate of interest, that i s , the marginal productivity of capital, would change, then the central meaning of income i s expressed more adequately by the second proposition. "Income (is) the maximum amount the individual can spend this week, and s t i l l expect to be able to spend the same amount i n each ensuing week." ^~ When a further assumption that prices are expected to change i s introduced, a t h i r d revised definition becomes necessary* "Income... (is) the maximum amount of money which the individual can spend this week, and s t i l l expect to 35. Llndahl, op. c i t . , p., U01. 36. Hicks, op. c i t . , p. 172. 37. Ibid., p. nh--lo-be able to spend the same amount i n real terms i n each ensuing week." The concept of well-offness is essentially vague. Hicks believes that the practical purpose of income i s to serve as a guide to business men f o r prudent conduct, but the income concept is not one which the 39 theoretical economist can usefully employ. There i s an even more insurmountable d i f f i c u l t y . Since the proposed measures are i n terms of expectations, they are by definition ex ante concepts which are not measurable. In order to serve the accountant's purpose, income must be conceived ex post and the concepts redefined. Income ex post may be taken as the sum of actual consumption plus the increase (or minus the decrease) i n capital value which has taken place during the period. Income thus conceived i s no longer a flow concept; i t has a hybrid composition: i t i s dependent partly on the consumption flow and partly on changes at two instants of time. If the future can be predicted with certainty, then a l l expectations w i l l be realized and no differences would arise between ex ante and ex post income. The windfall profits or losses, that i s , the difference between the value change which has taken place and the value change which has been expected to take place, can be attributable to changes in the value of money, acts of God or the King's enemies. Or they might occur on account of changes i n specific price levels though the value of money i t s e l f remains stable. Further, whether we are measuring the capital 3 8 . Ibid. 3 9 . Ibid., p. 180. Hicks has set out the conceptual deficiencies and indeterminateness inherent i n his theory. Ibid., pp. 175-8. -17-values of individual assets or the enterprise as a whole, then changes in expectations, at the two instants of time, of future receipts, the rate of discount or the r i s k factor, are also contributing factors i n determining the income figure. ^ The Hicksian concepts correspond closely to a fundamental accounting principle - that of "maintaining capital intact". The concept of "as well-off as before" can thus be defined i n the following different ways: i t i s desired to maintain intact (a) the stock of wealth i n money terms (b) the stock of wealth i n r e a l terms, that i s , the stock of physical capital (c) the flow of wealth i n money terms ^ (d) the flow of wealth i n real terms, that i s , i n terms of purchasing power or command over goods and services (e) psychic well-offness ^ The concept of maintaining the money capital intact i s now generally considered inadequate i n periods where there are even moderate price level changes. When such changes are substantial there kO. Lindahl, op. c i t . Contrast Alexander's concept of variable income. k l . That i s , to maintain the stock of wealth such that a constant income i s derived from i t . Professor Hayek has suggested this viewpoint (Hayek, "The Maintenance of Capital", Economica, August 1935, P« 2kl et seq>) but Keynes "doubt(s) i f such an individual exists". Keynes, i b i d . , p. 60. k2. For example, lower pay i n exchange for more congenial work. The concept of subjective income i s an integral part of Fisher's system, but i t i s alien to the accounting convention of objectivity. Alexander (in "Income Measurement i n a Dynamic Economy", reprinted i n W. T. Baxter and Sidney Davidson, Studies i n Accounting Theory, Horaewood, I l l i n o i s : Richard D. Irwin, Inc., 1962) also considers income i n terms of well-being a more fundamental but unmeasurable concept i n the case cf sn individual •" i1 . . -18-i s evidence that the resultant income figure might be very misleading. Nonetheless, this is the income ex post concept which corresponds to Hick's f i r s t and best-known definition of income, and i t s adoption by the accounting profession, on account of i t s superiority over orthodox accounting principles, has often been urged. At any rate, i t i s useful to consider some of the implications of the concept, abstracting f o r the moment from our inquiry the two assumptions of changes i n the interest rate and the general price l e v e l . The increased net worth concept 3^ _ Q n e 0 f the most enthusiastic advocates of the increased net worth concept of income i s Professor Ronald Edwards, who defines enterprise income as the increase i n net worth (in money terms) of a business at two different dates, with due allowance for drawings and introduction of new capital i n the interval. This money worth at any point of time is the present value of discounted future receipts less future outgoings. ^ In other words, the proponents of this concept would have us face squarely that the problem of measuring income i s one and the same as that of valuing capital. It would be out of place to level the criticism of impracticability at Edwards, since he i s more concerned with the conceptual problem it3« This concept was discussed and analysed at considerable length by Professor Edwards, and i t s adoption by practising accountants urged i n a series of thirteen a r t i c l e s , "The Nature and Measurement of Income", The Accountant, 1938, various months. lik* S. S. Alexander, op. c i t . , points out that this does not constitute circular reasoning, since receipts are not income, but a mixture of income and return of principal. To measure this year's income, we need to know a l l future receipts, but not future incomes. -19 ' than i t s practical application. Nevertheless c l a r i t y of concept should lead to good practice. What i s the number of future years the receipts of which are to be discounted? The answer to this i s that after a certain number of future years which can be mathematically calculated given the rate of discount, the present value of the net receipts of the more distant years w i l l be so small that they may UK be safely disregarded. ^ There are more basic criticisms. The discount rate must be based on two factors, the present rate of interest and the degree of risk of not realizing the future pro f i t s . The latter i s essentially a subjective valuation. While Edwards claims that this valuation i s made every- time a business changes hands complications arise i n the abisence of a buyer. This form of valuation only takes place when there i s a sale, amalgamation or liquidations of a business, that i s , where there are two parties to bargain over the price. Moreover, the concept of income as an increase in net worth i s not, i n fact, a reli a b l e guide to consumption. The concept does not exclude capital gain from income, and, as Fisher has pointed out, "the capitalization at any point of time of future expected income is not i t s e l f income, and....an increase i n this capitalization from one point of time to another i s not income - except potentially". An attempt to base consumption on such potential income, i t i s argued, i s i n r e a l i t y a consumption of capital. The objection may not be a v a l i d h$. The principle i s the same as that i n calcjilating the present value of a perpetual bond.. U 6 . Fisher, article on "Income" i n Encyclopedia of the Social Sciences, op. c i t . - 2 0 -one. It begs the definition of capital. Further, given a certain degree of hindsight, the concept does tend to average out income, and though this might not accord with actual observed events, i t may not altogether be a bad thing, since consumption i n practice does tend to be evened out. Consumption policy, though, i s not Edward's prime concern. He considers that the most important function of the increased net worth concept i s to reveal the rate of return on the resources invested in the undertaking thus providing a guide to investment. The variable income concept ^ - A special case of the Hicksian concept of income ex post has been developed by Alexander, which i s particularly useful i n assessing managerial efficiency, and thus also enhances i t s usefulness as a guide to investment. Alexander also proceeds from the concept of income as an increase in the capitalized value of future expectations. But i i is proposed that under conditions of uncertainty, a distinction should be made between two components which together make up mixed economic gain: variable income and unexpected gain (or loss)* Variable income comprises the net receipts from the asset, plus or minus any value change which was^at the beginning of the period, expected to take place during the period; i t also includes kl» Sidney S. Alexander, "Income Measurement in a Dynamic Economy", published as the f i r s t of Five Monographs on Business Income by the Study Group on Business Income of the American Institute of Accountants, 1950, and reprinted i n Baxter and Davidson, Studies  i n Accounting Theory, op. c i t . A stimulating appraisal of the variable income concept can be found i n D. Solomons, "Economic and Accounting Concepts of Income", Accounting Review, Vol. XXXVI, No. 3 , July 1961, pp. 37U-83. -21-any value changes which take place as a result of managerial activity. We exclude from variable income any unpredictable value changes, which might arise on account of a change in expectations due to wrong judgments made at the beginning of the period. The merits of the variable income concept ares (a) i t satisfies the economic definition of well-offness, (b) i t reflects year to year variations i n the results of the firm's operations, (c) under certain assumptions - that going value w i l l be maintained intact when tangible equity i s maintained and price levels are constant - variable income i s the same as production profit and approximates accounting sales p r o f i t , and (d) the variable income concept i s particularly useful for assessing managerial efficiency, But the concept, useful as i t is i n emphasizing one of the main functions of income measurement, has two serious defects. As a practical measure i t would be well-nigh impossible to implement, since we are required to distinguish between value changes which are the results of good judgment and good luck respectively. The problem becomes more intractable when price level changes are taken into account. Who i s to say whether the purchase of an asset at a lower price is to be attributed to s k i l l and judgment or to external market forces? Furthermore, the concept seeks to exclude unexpected gain from income. Unexpected gain i s defined as the difference between the value I 4 8 . If expectations of future receipts have been affected by operations i n the current year, then variable income i s redefined as the net receipts from the asset, plus or minus any change i n i t s value which was expected at the beginning of the period, plus or minus the discounted value of any consequential change in expected future receipts brought about by the level of current receipts. -22-o f t h e a s s e t a t t h e e n d o f t h e p e r i o d a n d what t h a t y e a r - e n d v a l u e was e x p e c t e d t o b e a t t h e b e g i n n i n g o f t h e p e r i o d . T h u s i t w o u l d a p p e a r t h a t o n e a s p e c t o f management a b i l i t y - t h e a b i l i t y t o f o r e c a s t f u t u r e p r o f i t s - w i l l n o t b e r e f l e c t e d i n t h e v a r i a b l e i n c o m e f i g u r e , b u t i n t h e s i z e o f t h e u n e x p e c t e d g a i n o r l o s s We m i g h t t a k e a p a u s e a t t h i s j u n c t u r e t o c o n s i d e r t h e d e v e l o p m e n t o f t h e a c c o u n t a n t ' s c o n c e p t s o f i n c o m e m e a s u r e m e n t a n d t h e i r a p p l i c a t i o n . ACCOUNTING CONCEPTS OF INCOME When d o u b l e - e n t r y b o o k k e e p i n g was f i r s t d e v e l o p e d i n t h e l l i t h h9 c e n t u r y o r e a r l i e r , i t d i d n o t c o n c e r n i t s e l f w i t h i n c o m e d e t e r m i n a t i o n . S i n c e t h e e n t e r p r i s e c o m p r i s e d a s i n g l e v e n t u r e f o r m o f t r a d i n g a n d a l l a s s e t s w e r e d i s p o s e d o f a t t h e e n d o f the v e n t u r e , t h e f u n c t i o n o f t h e b o o k k e e p e r was t o r e c o r d t h e s a l e s a n d p u r c h a s e s , t h e p r o f i t o n t h e v e n t u r e b e i n g a u t o m a t i c a l l y d e t e r m i n e d . A n i m p o r t a n t c h a n g e t o o k p l a c e w i t h t h e d e v e l o p m e n t o f j o i n t s t o c k c o r p o r a t i o n s . T h e s e w e r e p e r m a n e n t f o r m s o f e n t e r p r i s e , a n d a p e r i o d i c a l d e t e r m i n a t i o n o f p r o f i t was c o n s i d e r e d n e c e s s a r y t o g u i d e p r o p r i e t o r s i n t h e i r c o n s u m p t i o n p o l i c y . The m e t h o d a d o p t e d r e f l e c t e d t h e i n f l u e n c e o f s i n g l e v e n t u r e a c c o u n t i n g . A l l a s s e t s t*ere v a l u e d k9' See M a u r i c e E . P e l o u b e t , " T h e H i s t o r i c a l B a c k g r o u n d o f A c c o u n t i n g " i n M o r t o n B a c k e r ( e d . ) , Handbook o f M o d e r n A c c o u n t i n g T h e o r y , New. Y o r k : P r e n t i c e H a l l , I n c . , 1955, P» 1U* -23-at the end of the financial period. Circulating capital was valued at cost price, except that finished goods were often valued at s e l l i n g price, and fixed capital was valued at cost less depreciation. The t o t a l of these values was compared with the total similarly computed at the beginning af the period to determine net income for the period (making due allowances f o r introduction of new capital and withdrawals). This i s , of course, the balance sheet method of computing income. It was not u n t i l the early 20th century that accountants began to compute income by matching revenue from sales against costs including depreciation. Thus depreciation accounting was evolved, i n which fixed capital i s regarded as costs which are used up as they render service i n succeeding periods. Insofar as accountants understand and accept the qualifications in their own work, i t has been claimed that they have a highly unified theory of business income. ^* The accountant's present day concept of income f a l l s into two separate but closely inter-related aspects: (a) income defined as an increase in owners' equity, and (b) income as the excess of revenue for the period over costs incurred 52 during the period. 50. See H. S. Smith, "Capital and Profits of Companies", The Accountant, k January 1890, quoted i n K. C. Keown, "The Determination of Profit -A Historical Note" i n K. C. Keown (ed.), Readings i n Australian  Accountancy, Sydney: Butterworth and Co. (Australia) Ltd. 51. Canning, op. c i t . , p. lU3« 52. "The residuum which emerges out of the matching of ej&pired costs against revenue", Morton Backer, "Determination and Measurement of Business Income by Accountants" i n Handbook of Modern Accounting  Theory, op. c i t . , p. 209. - 2k -The dominant position of the balance sheet i n the accounting scheme i s generally held to be unsatisfactory, and the modern 5k trend i s for i t to be superseded by the income statement, a trend hastened i n the United Kingdom by the statutory requirements of the English 19k8 Companies Act and in North America by the requirements of disclosure specified by the Securities and Exchange Commission. But this point has been over-emphasized i n recent accounting literature. The information required to be disclosed i n the United Kingdom does not include the all-important sales figure, nor such outgoings as purchases or advertising. The present disclosures i n the income statement are, therefore, altogether inadequate f o r analysis purposes or f o r comparison, either between enterprises or for the same enterprise over a number of years. But, more fundamentally, the income figure i s a reflection of changes i n the two balance sheets at the beginning and end of the period respectively, and i t i s the accounting principles and conventions which underlie this relationship that have given r i s e to most of the accounting problems i n income determination. 53 • M. E. Murphy (Accounting, A Social Force i n the Community, p. 9 9 ) quotes with approval B. B. Parkinson, an English Chartered Accountant, "The undue elevation of the balance sheet u n t i l more recent years i n accountancy law and literature may excuse - though i t does not ju s t i f y -hasty conclusions concerning i t s importance". 5k» "The basic trend i n accounting over the years has been the increasing influence of the income statement". George D. Bailey, "The Increasing Significance of the Income Statement", The Journal of Accountancy, January 19k8, pp. 10-19- But see also D. Solomons, op. c i t . , for a contrary opinion* 55• But details of turnover are a suggested requirement included i n the Report of the Jenkins Committee on Company Law which was set up i n U. K. to consider the desirability of new company le g i s l a t i o n . The Report was placed before Parliament on June 21 , 1962* -25-The term "accounting concepts" i s often employed i n the relevant literature, though there i s l i t t l e consensus of opinion as to i t s precise scope and meaning. For example, the economists' concepts of capital, income and asset valuation have been contrasted with corresponding concepts based on accounting practice.-^ The accountants' approach to these problems, however, i s clearly procedural and can hardly be considered conceptual. The 1957 Revision of the Accounting and Reporting Standards for Corporate Financial Statements discussed under the head of "underlying concepts": the business entity, enterprise continuity, money measurement, and realization.?7 They are very similar to a longer l i s t propounded by Paton and Littleton: the business entity, continuity of acti v i t y , measured consideration, costs attach, the matching of effort and accomplishment, and verifiable, objective evidence.^ Many authorities, however, find that the terms concepts, principles, 59 canons, postulates, conventions are often used interchangeably* 56. Some Accounting Terms and Concepts, A Report of a Joint Exploratory Committee appointed by the Institute of Chartered Accountants i n England and Wales and by the National Institute of Economic and Social Research, London: Cambridge University Press, 1951, PP«- 22 et seq. 57. "Accounting and Reporting Standards for Corporate Financial State-ments 1957 Revision" (American Accounting Association), Accounting  Review, Vol* XXXII, No. it, October 1957, pp. 536-53. 58. W* A. Paton and A. C. Littleton, An Introduction to Corporate  Accounting Standards, American Accounting Association Monograph No. 3, Iowa City: Athens Press, 1955, pp. 7-23* 59* Handbook of Modern Accounting Theory, op. c i t * , p* 212. See also George 0. May, Financial Accounting, New York, Macmillan Co., 1956, p. 1*2. - 2 6 -There would appear to be a general disagreement on terminology, the urgent resolution of which strengthens the case f o r an "accounting court'.' In general, there appear to be three orders of definitions of principle; " ( l ) source, origin or cause, (2) a fundamental truth or proposition on which many others depend; a primary truth comprehending or forming the basis of various subordinate truths, and (3) a general law or rule adopted or proposed as a guide to action: a settled ground or basis of conduct or p r a c t i c e . . . " ^ While recent developments i n accounting have emphasized the search for fundamental truths, i t i s the third definition of principle which has generally been found to underlie accounting practice i n the past. Certain of these accounting principles are b r i e f l y given below.. The entity concept The business undertaking is conceived of as an accounting entity distinct from the interests." of the owners. The rationale of this concept i s based, f i r s t l y , on law. A corporation i s a legal entity distinct from i t s shareholders; i n English legal procedure a firm, that i s , a partnership, also possesses some of the qualities of an entity. Secondly, there i s great convenience in stating the financial position of an unincorporated enterprise without taking into account the owners' assets and l i a b i l i t i e s outside the business. But probably the most important factor i s that the entity 6 0 . This was called f o r by Leonard Spacek, "The Need for an Accounting Court", Accounting Review3 July 1958, p. 3 6 8 . 6 1 . Accounting Terminology Bulletin Number 13 prepared by Committee of Terminology, American Institute of Accountants, 1953* pp. 10-11. 6 2 . See Accounting and Auditing Practice Bulletin No. 19 , issued by the Committee on Accounting and Auditing Research of the Canadian Institute of Chartered Accountants, July 1961. -27-concept i s coextensive with an economic unit. Thus i t f a c i l i t a t e s the important accounting function of measuring the rate of return on investment i n individual concerns. Though the entity concept of the accounting unit i s widely accepted, there are also certain opposing theories. The proprietory theory emphasizes the standpoint of the proprietor of a business enterprise and changes i n the proprietor's "ftet worth"; the theory has become less tenable with the development of corporate organization. Vatter finds both the entity and proprietory concepts emphasize the personalistic approach and thus do not lend themselves to objective application. He proposes i n their stead a fund theory of accounts. ^ The money postulate There are two assumptions that accountants adopt towards a monetary unit of account. One i s that they measure only those services and disservices which can be translated into money terms and that these money measures constitute vali d and useful approximations to income and net worth. The other assumption i s that the monetary unit possesses constant purchasing power, alternatively, that price level changes do not affect the accounting statements i n any significant way and therefore can be ignored, or at least that when prices change they w i l l eventually revert to their original l e v e l . The realization principle Prior to 1913 income was measured as an increase i n net worth and the convention of recognising pr o f i t on sale evolved only after the F i r s t World War. ^  The realization principle 63. William J. Vatter, The Fund theory of Accounting and Its Implications for Financial Reports, Chicago: University of Chicago Press, 19it7» 6J4. Changing Concepts of Business Income, Report of Study Group on Business Income (American Institute of Accountants), New York: Macmillan Co., 1952, p. 21. - 2 8 -conflicts with the economic concept of "income (as) the money value of 65 the net accretion to economic power between two points i n t±me"j the economist recognises profit accruing at each stage of the manufacturing process. The accrual concept i t s e l f i s familiar to the accountant; this i s how he values a fixed interest-bearing bond. It i s perhaps not untrue to assert that the accountant i s aware of the increase i n values taking place i n the manufacturing process, but he i s restrained by the consideration of two other conventions, conservatism and objectivity, from taking p r o f i t into account before a sale takes place. Realization i s , of course, the c r i t i c a l event for most types of enterprise. In gold refining where the United States government has contracted to purchase at a specified price, and i n other extractive industries whose output i s sold on an international market, p r o f i t i s recognized on the mining of the metal. Similarly, i n the rubber industry revenue i s recognized on the sale of the closing stock i n the subsequent period and i n agriculture on the harvesting of the crop. Again, where collection i s the c r i t i c a l factor, as with some professional firms, i t determines the moment of time at which pro f i t i s taken into account. The c r i t i c a l function theory of p r o f i t recognition provides, conceptually, a more v a l i d rationale of the realization 66 principle than the doctrines of conservatism and objectivity. 65. R. M. Haig, ( 1920) , quoted i n Ibid, p. 7. 66. See John H. Myers, "The C r i t i c a l Event and Recognition of Net Profit", Accounting Beview, Vol. XXXIV, No. h, October 1959, pp. 5 2 8 - 3 2 . - 2 9 -The going concern principle The concept of continuity, or as Dicksee terms i t , the assumption of permanence, has considerable influence on income measurement theory. It is the not unreasonable assumption that the business i s going to continue operations indefinitely which underlies the concept of depreciation accounting. The accountant "accordingly emphasizes the flow of costs and the 67 interpretation of assets as balances of unamortized costs". But i t can be argued that the business enterprise i n fact i s not immortal, and that we can determine the s t a t i s t i c a l expectancy of l i f e of any enterprise. Should we adopt such an approach, then where the economic l i f e of the asset exceeds the l i f e expectancy of the firm the service potential of the asset is restricted, with consequential effects on the rate of depreciation and income measurement. More generally, cancellation values w i l l be lower than accrual values for a l l assets. Thus i t i s ;.held that the going concern concept "has been useful i n broadening the scope of accounting beyond the limitations of liquidation value and of s t r i c t l y construed legal rights and ' 68 obligations". The accounting period convention The determination of enterprise income for a definite time period, sometimes referred to as the financial year of the enterprise, is of almost universal application i n accounting 69 practice. It constitutes i n effect the rationale for the matching 6 7 . Paton and Littleton, op. c i t . p« 11 . 6 8 . The Basic Postulates of Accounting, p. 3 9 . See footnote 86 for f u l l citation. 6 9 . There are minor exceptions as, for example, i n accounting for joint ventures. -30-principle. It has given rise, directly or indirectly, to many of the more intractable problems i n income measurement since the income of the enterprise cannot, i n effect, be determined with precision u n t i l i t has come to the end of i t s economic l i f e . But owing to the natural impatience of the owners to consume part or a l l of the income as i t i s being earned, accountants perforce apportion the enterprise economic l i f e into arbitrary periods, usually approximating that of a calendar year. The apportionment, however, might well be less • arbitrary than i t would appear, since many human economic act i v i t i e s are governed by events related to the seasons, in particular to the annual harvesting. Some examples are provided by an agricultural farm,, a tobacco manufacturing firm, a department store, a wine shop* The matching principle Income has been defined as the surplus 70 arising out of the matching of expired costs against revenue, or more elegantly, of effort and accomplishment. In accounting practice, the definition can be further narrowed down to the matching of sales against the cost of producing the output sold. The matching process constitutes one of the most comprehensive of the accounting concepts. It arises out of the necessity of accounting for periodical income and i t embraces the important accounting principles of accrual and deferment. Accrual accounting i s said to be superior to cash accounting, since i t matches against current income current disservices, including those for which payment has not been made. 70. Backer, op. c i t . , p. 2 0 9 . 71. Paton and Littleton, op. c i t . , pp. lU-18* -31-The principle of accrual income, which runs counter to the conservatism rule, i s infrequently applied, as i n certain cases of fixed interest-bearing securities. Deferment constitutes another way of looking at the depreciation concept; an asset i s conceived of as a bundle of deferred charges, to be associated with the current services i t renders in each successive period of i t s economic l i f e . The cost principle Accountants measure an asset at the price of acquisition. Since this is the economic value, the test of the market place, i t i s held to be objective, and further, i t has the merit of being ver i f i a b l e . The asset i s maintained i n subsequent periods at i t s original cost ostensibly for two reasons. To do otherwise for a fixed asset would run counter to the application of the continuity concept, while i n the case of a current asset, to act otherwise would be contrary to the realization principle. The cost principle has often been subjected to strong criticisms* In the f i r s t place, the principle i s not consistently applied. Where the book value of the inventory has been reduced to thelower of cost or market at the end of a financial period, the new figure wiich has incorporated a departure from cost i s accepted as the new cost figure for the subsequent period. 2^ Secondly, where the cost figure has been deflated hy means of a general price index, i n order to take purchasing power changes into account, there has i n fact beenarestatement of the cost figure i n the depreciated monetary unit, rather than a 72>. Accounting Research Bulletin Mo. 1)3, published by the American Institute of Certified Public Accountants, 1953, P* 28, quoted in Maurice Moonitz, The Basic Postulates of Accounting, op. c i t . - 3 2 -departure from the cost principle. The traditionalists who oppose this form of adjustment are defending, not historical cost, but original cost. The doctrines of conservatism and objectivity It has been held that conservatism is a philosophy or an attitude and not a 73 7k principle, l J but there are others who would disagree. Conservatism has been defined as "a reaction to uncertainty and represents i n essence merely a coinsel of caution. The proper role of conservatism i n accounting is to insure that the uncertainties and risks inherent i n any given business situation; 75 are given adequate consideration". In practice, however, the concept has been much abused; accountants generally consider i t meritorious, where an alternative exists, to understate income and net worth and overstate costs. The doctrine of objectivity, and i t s corollary the distrust of subjective valuations, have long been sacred cows i n the accounting profession. These principles appear to have been vindicated by the experience of the asset reappraisals i n the inter-war years. The 73* George R. Catlett, "Factors that Influence Accounting Principles", Journal of Accountancy, October I960, reprinted i n W* T. Baxter and Sidney Davidson, Studies i n Accounting SCheory, Homewood, Illin o i s t Richard D. Irwin, Inc., 1962, pp. 381-90. 7k- "The word 'principles' has a proper application to accounting as connoting certain fundamental qualities of good accounting, notably conservatism and consistency", George 0,. May, op. c i t * , p. kk* 75• Professor Robert L., Dixon supplied this conception of the role of conservatism - quoted i n Moonitg^, op. c i t . , p. k7» -33-influence of the objectivity principle on income measurement i s closely intertwined with the operation of several other accounting principles, as for example, the recognition of profit on sale and the emphasis on historical costs.. It has not, however, the same force as the conservatism principle. Thus, under the going concern assumption, while fixed assets are valued at cost less depreciation, current assets should property be shown at market values. The rule of lower of cost or market, however, overrides both the going concern and objectivity principles. The consistency principle The application of the consistency principle ensures comparability of the accounts of the enterprise (a) within the accounting period, (b) between one accountingperiod and another, and (c) between departments and sections within the organisation. A change to a better system i s permissible, provided that the change and i t s effects on the accounts are indicated. But i n practice this accounting principle has often been abused, and i t has sometimes served as a rationalization of and lends support to inertia.. It should be noted that the consistency rule does not apply between individual companies, even where they belong in the same industry (though advocates of uniform accounting systems believe i t should* The modern trend appears to be toward greater uniformity and consistency). The accounts, however, should be capable of being adjusted for inter-company comparability. The concept of materiality This concept is best defined as the necessity to disclose information which might lead an informed investor -3k-76 to change or modify his decision. This criterion, rather than the size of the transaction in absolute dollars or r a t i o terms, cshould serve as the guide to disclose. The concept i s concerned with the exercise of judgment; i t must not be confused with a situation which involves any compromise of an accounting principle. The adequate disclosure principle The adequate disclosure principle i s closely related to the materiality concept. The following are some brief guidelines to disclosure: a l l pertinent facts must be disclosed; the statement should be couched in precise, technical accounting terminology; the information should be properly classified and the statement must be meaningful and not misleading; any events that occurred after the balance sheet date but before the date of publication of the accounts which materially affect the general picture should be disclosed. * * -& # # # * -;c- # The above description of accounting principles appear to confirm they are primarily rules adopted as a guide to action and do not constitute a general body of theory. The defense i s sometimes made that, nonetheless, these principles have served well i n the past. It i s clear however, that certain contradictions inherent i n these accounting conventions have never been resolved. For example, the rules are at times mutually exclusive. The application of the going concern principle to asset valuation might well defeat a conservative 76.. Moonitz, i b i d . -35-philosophy when fixed asset prices f a l l j many creditors and share-holders have discovered to their dismay that balance sheet values can be overstated as well as understated (which i s the more usual state of a f f a i r s ) . The conservative principle often conflicts with f u l l disclosure; i t conflicts with consistency i n the application of the lower of cost and market rule to inventories; i t defeats i t s own purpose when overdepreciation i n one year's1 accounts leads to underdepreciation i n subsequent years. Further, there have been considerable doubts that many of these principles, even i f properly and consistently applied, are valid guidelines f o r accountants today. A conservative valuation i s not necessarily the correct or the best available figure to adopt i n accounts. The application of the realization principle i s said to distort the reported income as between accounting periods. Advocates of price .level accounting have long challenged the assumptions of the monetary postulate. The lack of an internally consistent framework of accounting principles i s attributed by some practitioners to the status of account-ing as an art rather than a science, ^ though such a view must have many c r i t i c s . Other authorities prefer to attribute the lack of fundamental laws or absolute precepts to the way accounting has evolved to serve divergent objectives. ^  Thus the auditor's opinion 77 • Garraon C. Blough, "Principles and Procedures"1, Journal of  Accountancy, Ap r i l l ° 6 l , pp. 51-53* See also Accounting  Terminology Bulletin No. 1., op. cit.., p. 9» and F. Sewell Bray, The Measurement of Profit, Oxford University press, 19h9» P« 1. For a contrary viewpoint see, for example, the writings of Professor Mary Murphy. 78. Catlett, op. c i t . - 3 6 -that the accounts "present f a i r l y the financial position .... and the results of operations for the year then ended, i n accordance with generally accepted accounting principles applied on a basis 79 consistent with that of the preceeding years" can hardly be ju s t i f i e d . It i s believed that the term "generally accepted accounting principles" f i r s t came into use as a result of the correspondence, published i n 193U, between a committee of the American Institute of Certified Public Accountants, a committee of the Controllers Institute and the New York Stock Exchange. The question of what constitutes "general acceptance" has often been asked, and i t has been suggested that these principles might have been accepted by accountants but they have at best been tolerated and at 82 times viewed with suspicion by stockholders and the general public. "So many costs can at option legitimately be anticipated or deferred, expensed or capitalized, that no corporate earnings figure i s now regarded by sophisticates as absolute and objective." ^ 79. My i t a l i c s . This i s the usual practice in North America. The reference to "generally accepted principles" i s not customary i n the United Kingdom. 80. Paul Grady, "The Quest for Accounting Principles", Journal of Accountancy, May 1962, pp. U5-50. 8 1 . See, f o r example, Accounting and Reporting Problems of the  Accounting Profession, published by Arthur Anderson & Co., September I960, p. 1. 8 2 . Leonard Spacek, "Are Accounting Principles Generally Accepted?", Journal of Accountancy, A p r i l 1961, pp. I4.I - 6 . 8 3 . Forbes Magazine, August 1 , i 9 6 0 , quoted i n Spacek, i b i d . See also John R. E. ParkeiJ, "'Profits' and Accounting Principles", The  Business Quarterly, Vol. XXVII, No. 3, F a l l 1962, pp. !?l|-9.. A fundamental objection to the defense of past service l i e s in the large transformations economic conditions have undergone i n the twentieth century. Some of the more significant changes are attributable to the complex nature of corporate organisation and the high rate of technological change. But a special problem also exists in the in s t a b i l i t y of the monetary unit. The assumption that money provides a stable measure of value no longer holds true, and the retention of the monetary postulate i n accounting practice has often led to a wide divergence between the true state of affairs and the reported figures. Accounting statements f a i l increasingly to reflect financial conditions i n the real world. The need for a logically rigorous and internally consistent framework of accounting principles has become increasingly urgent 8U to meet the needs of modern economic enterprise. (a) Company accounts have taken on a public character. They are not the sole concern of some special segment of society, but have become basic data for the investor, the consumer, the employee and the government. (b) From an economic welfare viewpoint, one of the most important functions of accounting statements i s to serve potential investors. They influence the flow of funds into alternative lines of investment and helps to procure an optimum allocation of resources. (c) They provide an important c r i t e r i a by which management performance can be judged, a function a l l the more important with the present day separation of ownership from management. 8U. See also Paton and Littleton, op. c i t . , pp. 1-3. -38-(d) Accounts also constitute a valuable management tool to aid management in the decision making process. (e) The above developments have posed new and fundamental responsibilities f o r the accounting profession. In addition, new problems are posed by two other factors, the rapid rate of technological change and price level fluctuations. A sound and comprehensive body of accounting theory must f i r s t be established and the principles formulated before satisfactory solutions to some of these problems can be evolved. It i s therefore against a background of discontent with existing practices and a generally f e l t heed for a comprehensive theory to replace the present assortment of accounting rules that the Accounting Principles Board, with sole authority to make pronouncements on accounting principles, was set up in 1958 by the American Institute of Certified Public Accountants. & relevant part of the Charter Rules of the Board as adopted by the Council of the Institute i s reproduced below: "The broad problem of financial accounting should be visualised as requiring attention at four levels: f i r s t , postulates; second, principles; third,, rules or other guides for the application of principles i n specific situations; and fourth, research. Postulates are few i n number and are the basic assumptions on which principles rest. They necessarily are derived from the economic and p o l i t i c a l environment and from the modes of thought and customs of a l l segments of the business community -39-A f a i r l y broad set of co-ordinated accounting principles should be formulated on the ba sis of the postulates .... The principles, together with the postulates, should serve as a framework of reference for the solution of detailed problems* Rules or other guides f o r the application of accounting principles in specific situations, then, should be developed i n relation to the postulates and principles previously expressed. Statements of these probably should be comparable as to subject matter with the present accounting research bulletins. They should have reasonable f l e x i b i l i t y . Adequate accounting research is necessary i n a l l of the foregoing. Pronouncements on accounting matters should be based on thoroughgoing, independent study of the matters i n question, during which consideration is given 85 to a l l points of view .... " ' Subsequently two research studieson the basic postulates and the broad principles of accounting were prepared and published i n i 9 6 0 and 1961 respectively by the Director of Accounting Research 8 5 * Arthur M. Cannon, "Discussion Notes on 'The Basic Postulates of Accounting'", Journal of Accountancy, February 1962, pp. U2-53--UO-86 (of the Institute). Though the Accounting Principles Board has found the studies too revolutionary for acceptance at the present 87 time, nonetheless, for reasons developed below, they must be regarded as the dividing watershed i n the development of accounting principles. Moonitz considers f i r st the approach that should be taken to formulate the basic postulates that underlie the accounting principles. He discards for various reasons the axiomatic approach, the ethical 88 or sociological approach, and the pragmatic approach. In a selection of methods, i t was held that "relatively heavy reliance must be placed on deductive reasoning i n the development of accounting postulates and principles. We must f i r s t recognise and define the problems to be solved, then move to their solution by careful 89 attention to what 'ought' to be the case, not what ' i s ' the case". (It must be admitted that this method seems somewhat familiar to the axiomatic approach which the author has discarded earlier.) The following statement of the function of accounting is closely related to the f i r s t f i v e postulates (A-l to A-5): 86. Maurice Moonitz, The Basic Postulates of Accounting, Accounting Research Study No. 1, published by the American Institute of Certified Public Accountants, 1961j and Robert T. Sprouse and Maurice Moonitz, A Tentative Set of Broad Accounting Principles; for Business Enterprises, Accounting Research StudyNo. 3 i 1962. 87. See "News Report"1, Journal of Accountancy, May 1962, pp. 9-10. 88. Such as the concepts of justice, truth, fairness, adaptability and consistency advocated by DR Scott, "The Basis for Accounting Principles", Accounting Review, December 19kl, pp. 3kl-U9« 8^. Moonitz, op. c i t . , p. 6. "The function of accounting i s (l) to measure the resources held by specific entities; (2) to reflect the claims against and the interests i n those entities; (3) to measure the changes in those resources, claims, and interests; (U) to assign the changes to specifiable periods of time; and (5) to express the foregoing i n 90 terms of money as a common denominator." Moonitz divides his postulates into three groups. These are reproduced i n Appendix A at the end of this chapter. Some general comments are.included below. Group A. The environment of accounting Our economy has certain characteristics: private ownership of productive resources, production for exchange and the market place, free labour and the use of money. Economic activity i s carried on mainly through the medium of business-type entities, which concentrate on producing goods and services. The allocation of scarce resources to these entities i s based on predictions which i n turn depend on past results and future estimates. These results, estimates and predictions are i n part stated i n quantitative terms. Here, then, i s located the function of accounting. Certain generalisations can be formulated against this p o l i t i c a l and economic environment i n which accounting exists. One that underlies a l l others assumes the existence of order and predic-t a b i l i t y i n human a f f a i r s . The f i v e more specific generalisations 90. Ibid., p. 23. -U2-included i n Group A deal with quantification, exchange, entities, time period and the unit of measure. Two further groups of supplementary propositions deal with accounting i t s e l f . Group B. The f i e l d of accounting The four propositions i n Group B apply over an area that is coextensive with accounting. Postulate B-2, which states that accounting data are based on past, present or future exchange prices, i s particularly thoughtprovoking. Conventionally, accounting data are based on past exchanges. It i s pointed out that this i s proper for i n i t i a l recording, provided that certain assumptions are present: arm's length bargaining, rational conduct and dealings i n an active market. The postulate i n fact seeks an 91 abandonment of cost, as conventionally defined, as the basis of accounting measurements. The concept of cost i s expanded to include 92 any "'objective measurement." Group C. The imperatives of accounting The f i v e propositions included i n Group C stress what ought to be: the goals,, objectives and standards of accounting. They are not coextensive with the f i e l d of accounting, nonetheless they have a wide applicability. Postulate C-2 defines 'objectivity' to mean "unbiased: 91. On a matter of terminology, Moonitz urges that "cost"1 should be restricted to cash transactions, and non-cash transactions should be called by other names, such as "market price"',, " f a i r value", "estimated value", etc. 92. Cannon, op. c i t . p. %2:. -1*3-subject to verification by another competent investigator. In this usage, an estimate or forecast can be objective, along with completed 93 events of the past.'1. Postulate C-3 on 'consistency' refers i t to a given entity over time periods. The postulate does not extend to inter-industry comparisons, partly because i t i s f e l t that, i n instituting a proposed change, the individual enterprise should be governed by considerations of improved efficiency rather than improved intercompany comparability. ^ The concepts of materiality and conservatism are refected as basic propositions. The study on accounting postulates i s accompanied by one on broad accounting principles. The guidelines f o r formulating the set of principles (a summary of which i s reproduced in Appendix B at the end of this chapter) are: (l) to ensure comparability of the principles with the basic postulates, ( 2 ) to carry the analysis and discussion far enough to make clear the implications of the principles, and (3) to formulate recommendations that can be reduced to practice. ^5 The authors state that the principles have been designed to meet the needs of a l l interested groups. Further, they are "relevant primarily to formal financial statements made .available to third parties as 96 representations by the management of the business enterprise." 93* Moonitz, op. c i t . , p. U 2 . 9U. Ibid*, p. U3» 95• Sprouse and Moonitz, op. c i t . , p. x. 96. Ibid., pp. 1-2 and 55. -kk' Some of the more controversial issues raised by the authors which represent significant departures from accepted accounting practice can be b r i e f l y summarised. The authors do not accept the realization principle, quoting with approval May's views that profit i s attributable to the whole process of business activity and that the realization principle gives satisfactory results only when the flow of product 97 i s reasonably uniform. The authors further find that the concern of accounting is properly with the changes in assets and debts, and the related (derived) effect on profit* There is thus a movement away from an operating pr o f i t concept back to the older concept of; profit as a change in net worth. Income measurement is thus seen as part bf the wider problem of asset valuation. Money or claims to money should be stated at their discounted future exchange prices. "The use of the market (effective) rate i n forc'e at the date the receivable was acquired w i l l result i n the recognition of the amount and rate of interest actually being earned 98 by the company under the contract entered into". With regards to other assets, i t i s recommended that inventories which are readily saleable, such as agricultural produce and precious metals, should be measured at net realizable value (a future exchange price), thus assigning the change in resources and the related p r o f i t or loss to the period 9 9 of production. " Most inventories, however, should be valued at their replacement cost ( a current exchange price ) and not their costs of acquisition. The use of current (replacement) cost has the further 97. May, op, c i t . , pp. 30-31, quoted i n Sprouse and Moonitz, i b i d . , pp. 1 3-lC^ 98. Sprouse and Moonitz, ibid,, p. 2k. 99. Ibid., p. 27. merit of distinguishing "holding" (the difference between acquisition and replacement costs) and "operating"1 (the difference between replacement cost and sel l i n g price) gains or losses. In the absence of some formal proeedure, such as a quasi-reorganisation of a; merger, fixed assets are to be carried i n i t i a l l y at acquisition cost. But the asset accounts should be restated i n terms of current replacement cost at periodic intervals, say, every five years-. Current market prices should be employed for the purpose, or in their absence, index numbers or some form of appraisal. Some broad generalizations are made i n both studies about the price level problem. The -authors quote with approval an excerpt from the minutes of the Accounting Principles Board that "the assumption i n accounting that fluctuations i n the value of the 100 dollar may be ignored i s unrealistic ....." Since a separate study on price level change and i t s impact on accounting i s under way, detailed attention on price l e v e l problems i s not included i n these two studies on accounting postulates and principles. Both studies have aroused considerable interest and comment, some of which have been highly c r i t i c a l . 1 0 1 Spacek finds the basic postulates self-evident and inadequate to serve as the basic . foundation on which sound accounting principles can be established. He would have preferred an ethical approach, and would emphasize justice, truth and fairness; the one basic accounting postulate 100. Ibid., p.. 19. 101. See, i n particular, the individual comments on the studies included at the back of the two monographs, and also Cannon, op. cit.., Grady, op., c i t . , and "Editorial", Maurice E. Peloubet, "Is Further contd. -US-underlying a l l accounting principles i s fairness - fairness to a l l 102 segments of the business community. Moonitz, on the other hand, has stated i n his monograph that -while these concepts must not be ignored, they cannot serve as the point ofcepartufce for an objective enquiry, since the concepts are subjective and themselves need standards to be capable of application. Qn the whole, Moonitz*s point of view i s more persuasive. The essential test i s that the proposed postulates should not outrage ethical values rather than that they should comprise the ethical values themselves. The controversy over the publication of the 'principles' takes place i n several areas. Advocates of the proposed principles see large merits i n the uniformity and consistency imposed on accounts, so that similar results w i l l be reported for similar events, ^he lack of authoritarian standards often leads to experimentation and from thence to misrepresentation, as i n the recent case of the Stster Kenny 105 Foundation. ' C r i t i c s , however, fear that the imposition of uniform standards w i l l lead to a loss of f l e x i b i l i t y i n meeting different 106 sets of conditions and constantly changing environment. The argument might be over relative emphasis, as most accountants are i n 101 . Contd. Uniformity Desirable or Possible?" Leonard Spacek, "Age Accounting Principles Generally Accepted?" Charles J. Gaa, "Unifor-mity i n Accounting 'Principles" 1 and Carmon G. Blough, "Principles and Procedures", i n Journal of Accountancy, A p r i l 1961. 102. Moonitz, op. c i t . , pp. 5 6 - 7 . 103 . Ibid., pp. 3-U IOI4.. Spacek, op. c i t . 105. The case of the Sister Kenny Foundation, Minnesota State, October 1961, i s reported i n Journal of Accountancy, A p r i l 1961, pp. 72-ij. 106. Peloubet, op. c i t -U7-favour of minimising areas of difference, while agreeing that dissimilar 107 situations might c a l l for differences i n accounting method. It i s also f e l t that the heavy dependence on deductive reasoning i n the approach adopted i n the research studies i s not altogether desirable. Most practitioners would prefer to see theory directly related to practice and i t s v a l i d i t y tested in the world 108 of practical a f f a i r s before acceptance. In particular, some fear that accounting w i l l become more subjective with the increased emphasis on market values, current replacement costs and appraisal data. 1 0 9 In general, i t might be concluded that these two studies represent a notable effort to develop a logically rigorous body of general theory and an internally consistent set of broad principles. Without being truly revolutionary i n scope, they depart significantly from "generally accepted accounting principles" i n deemphasizing the concepts of conservatism and realization. The concept of objectivity has been redefined to exclude subjective bias but to incorporate past, present and future transactions.. In those areas where the generally accepted principles of accrual accounting have been inconsistent, the deficiencies have been made good, as i n the recognition of market price which leads to the recognition of inventory gain as income. Another example i s 107. "Editorial"'', op. c i t . 108- See, f o r example, A. C. Littleton, Essays i n Accounting, Urbana: University of I l l i n o i s Press, 1961, p.. 376, quoted i n Grady, op. c i t . 109. Commentfc of Herbert E. Miller, in Sprouse and Moonitz, op. c i t . , p. 76. -u8-the broad u t i l i z a t i o n of the interest factor i n discounting amounts 110 receivable or payable in the future. But the largest advance l i e s in the broad and general proposal to incorporate market values and replacement costs into the accounting system, taking both the general price level change and specific price 111 changes into account. Since the studies do not treat the price level problem in any detail, they do not contain recommendations on methods of price l e v e l adjustments, the use of supplemental statements, or the equity case for making such adjustments i n the corporate sector only* They do, however, afford a foundation for what most proponents of price l e v e l accounting believe to be basic principles: (a) the maintenance of capital i n terms of the units of purchasing power invested, and (b) the statement of revenues and related costs in homogeneous current dollars. The large problems of price level changes have been well documented elsewhere, and the urgency of measures to deal with them are not in dispute. These statements of postulates and principles incorporate the price l e v e l problem within an integrated general theoretical framework* They thus constitute a milestone i n the development of accounting theory. The proposed change from cost-hased to current-valued assets and net worth i s seen by some to transcend the price level problem* 3 It i s part of the larger problem of brining statements of financial 110* See, i n particular, comment of William W. Werntz, ibid.,, p. 82. I l l * See, i n particular, Postulates A-£,B-2' and C-k, and the principles in Groups B and D. 0 -k9-condition closer to financial condition i t s e l f , which i s the fundamental purpose of the accounting function. -x- % * # -3!- * Conclusions We are now in a position to note some of the major differences between the economist's and the accountant's concepts of income. In the f i r s t place, the development of the two disciplines have proceeded along very different paths. Economics i s derived from a philosophical base and deductive reasoning. Its terms are r i g i d l y defined. In i t s theoretical models, there is no compromise with the demands of practicalities and convenience. The princples of accounting, on the other hand, have been derived from practice- Accounting texts f i r s t described what is the practice i n the majority of cases; this then later constitutes the principle. Accounting theory has been developed to take into account increasing complexities of business but the development was not systematic. Further, i t has been essentially a pragmatic approach, with practice ahead of theory. In the last decade, however, the theorists i n their model building have made large and significant advances. A further distinguishing feature is that the economist works on a larger canvas. He i s concerned not only with the income of the firm, but also with the incomes of individuals and of society as a whole. He analyses the nature of income by the source that gives rise to i t , that 112. Cannon, op. c i t - 5 0 -i s , he regards income as a reward to a factor of production. Thus he classifies economic income into interest, rent, wages and p r o f i t . When this principle is applied to the concept of national income, the economist adopts a sector approach. The interest of the accountant by contrast i s a narrow and limited one. He i s primarily interested i n the income of the enterprise arising from a l l sources, and he i s not, as a rule, interested i n the nature of such income; nor i s he interested i n the incomes of individuals or of society, abstracting in his calculations from a l l considerations of social benefits and social costs. The economist i s concerned with future events. His income concept i s based on expectations; income to him i s dependent on subjective evaluations. The accountant is concerned with a historical record of what has taken place i n the past. This concern with bygones and sunk costs has often been c r i t i c i s e d , but i t must be recognised that the framework of reference of the tasks of the two professions i s very dissimilar. The economist works with concepts and ideas; the models he builds are theoretical ones. The accountant deals with facts and the results of his work must satisfy at least the following c r i t e r i a : (a) they are capable of quantitative measurement, (b) they can be relied on and employed by disinterested third parties for their own purposes and (c) they are capable of verification by others. This i s not to justify, of course, the retention i n the accounting procedures of obsolete and unscientific conventions nor the tardiness in reappraising the framework of accounting theory i n the lig h t of economic change and developments in other disciplines* -51-To an economist the value of an asset is the present value of i t s future services. Similarly, the value of an enterprise i s the present value of future receipts net of future outgoings. But the enterprise value exceeds the sum of the values of the net assets owned hy the -enterprise by an amount which i s sometimes called goodwill. The increased net worth theory regards income as the difference between enterprise values at two points of time. This i s , however, very different from the so-called balance sheet method of computing income. The accountant records fixed assets at historical cost less depreciation and current assets at the lower of cost or market. Accounting net worth is the summation of these book values. But even where the assets are shown at current-based values, the summation of such values would s t i l l d i f f e r from economic net worth. Goodwill has; been ju d i c i a l l y defined as the probability that old customers w i l l resort to the old place.. In an economic sense, goodwill measures the difference between the net worth of an enterprise and 113 the sum t o t a l of the bookvalue of i t s net assets. Goodwill, where i t exists, i s often included at a figure which bears l i t t l e or no relationship to i t s true worth. The absence of goodwill i n the accounts or i t s writing down (unless accompanied by a decline i n earning capacity-— v Ilk in money terms) in fact constitutes the creation of a secret reserve. 113. Canning, op. cit*., p. 20,;, considers goodwill a valuation account par excellence. It exists only because some or a l l assets are not measured properly* Thus goodwill i s not i t s e l f an asset, i t i s merely the extent to which assets have not been measured correctly. I l k . The writing down of goodwill i s advocated by Merton Backer, "Determination and Measurement of Business Income by Accountants," Handbook of Modern Accounting Theory, op. cit*,, p. 236. -?2-Yet accountants counsel against the advisability of creating or writing up goodwill. Where a figure for goodwill exists, i t has usually arisen on the purchase of a business or an amalgamation. Economic income theory comprises two main schools, a flow concept and income conceived as a change at two instants of time. Accounting income is usually conceived of as operating profit determined under certain generally accepted conventions plus non-operating incomings less non-operating outgoings. An attempt at a p a r t i a l reconciliation of the two viewpoints can be found i n the following definition of economic income ex post. "Economists commonly apply the expression 'income' to mean the amount which before appropriation for direct taxation, can be distributed to the proprietors of an enterprise as a result of the operations of the accounting period, subject to the retention of amounts i n respect of depreciation and inventory adjustments which are necessary to avoid encroaching l l 1 ) on the accumulated resources of the enterprise". J But the gain (admittedly a substantial gain) i n employing a concept and terminology which are common to both professions must be balanced against a certain loss of conceptual c l a r i t y i n an economic definition of income which i s closely identified with the accounting realization principle. Accountants have assumed that the monetary unit on which the accounting structure i s based constitutes a constant measure of value, though t h i s assumption i s now seriously challenged within the profession ll?.- Some Accounting Terms and Concepts, op. c i t . , p. 22;. -53-i t s e l f . Economists, on the other hand, have long recognised the problem posed by changes i n the value of money and conceive of income i n real terms, though there i s no general agreement on the meaning of the latter nor i s i t always as ex p l i c i t l y stated as one might expect. What then of the future The principles of accounting theory and practice i n the past have incorporated, i n order of importance, the doctrines of conservatism^objectivity and consistency. These doctrines have been developed i n periods of stable price levels and i t can be claimed that they have served their purpose relatively well. Modern economic society differs from the past i n several crucial respects. F i r s t l y , the major predominant form of economic unit i s the corporate organization.. Both the structure of the corporation and business itseLf is becoming increasingly complex compared with the joint venture and sole proprietorship forms of enterprise.. Secondly, both the general and secondary price levels have become more v o l a t i l e . In particular, there is a long term tendency for the general price level to ri s e . Thirdly, modern economic processes are characterized by frequent innovations and an increasing tempo of technological change. We are concerned with the relationship of the f i r s t two developments to historical cost accounting and their effects on income measurement. A special d i f f i c u l t y that i s related to the corporate form of organization arises from the increasingly long l i f e span of the 116. The increased productivity of a new machine or a new process resulting from technological change presents special problems in income determination which is outside the scope of this paper. - 5 i i -corporate entity. Thus the cost of assets, purchased in past periods might s t i l l be charged against current production when large movements in the price level have rendered such costs obsolete. To a lesser extent, the argument can be extended to stock. The volatile nature of short-run prices might make i t desirable to consider problems of adjustment not only from year end to year end, but from month to month (any shorter time period would be impracticable, on account of time, expense and lack of available data) i f we wish the accounting figures to reflect values in some r e a l , as contrasted with monetary, sense. The.structure of accounting income theory has come under review and strong criticism i n recent years, largely against the background df fluctuating price levels. There i s at least a possi b i l i t y that one of the f r u i t s of the price level controversy i s a rapprochement between the theoretical concepts of the economists and the newly developed empirical models of the accountants. Certain qualifications to the economic concepts must be made,; i n viewof the nature of the accountant's task. In the f i r s t place, income must be defined ex post, because past income is what the accountant i s called upon to measure. Secondly, purely subjective values must be eschewed i n favour of valuations which can be tested and verified, since accounts are prepared not for the information of the proprietor alone, but also of many interested third parties. Expectations are l i k e l y to constitute an important feature i n value determination but so far as possible, these values should correspond to expectations i n the market place. -55-There would appear to be two theoretical systems of economic income which are of particular relevance.. One i s the flow concept of income as sales and the other i s the Hicksian concept of income conceived ex post as an increase i n net worth. Both concepts of income can be defined to incorporate historical costs or, alternatively, a l l incomes and outgoings i n current dollars. Whether his t o r i c a l costs or current dollars should be adopted in accounts must depend, to a large extent, on the empirical evidence of the effect of price level changes on the meaningfulness and u t i l i t y of the income figure. The income as sales concept i s closely related to accounting theory and practice. But i,t tends to understate the increase i n net worth, since accretions to value i n output are taken into account only at the point of sale.. Further, when price levels change, purchasing power gains or loses which arise from the holding of assets and l i a b i l i t i e s are not taken into account. The development of an income theory based on this concept i s therefore more limited i n scope than one based on a variant of Hicksian income. Both the flow and the Hicksian concepts of income can be found in the proposals of price level systems. Their choice depends on our goal. If we assume for the moment the i n t r i n s i c value of income deter-mination, and that the u t i l i t y of the income figure has been greatly lessened by the effect of price fluctuations, an appraisal of existing accounting techniques of income measurement becomes urgent. There would appear, however, to be several alternative approaches; to the price level problem. Should we seek to retain, more or less fundamentally unchanged, the present income statement, but with a l l items expressed i n current dollars? Or should we consider a new -56-concept of income altogether, that w i l l maintain intact the fixed assets and stocks of the enterprise i n some real sense, either in terms of i t s physical volume or productivity? Or should we extend the "maintaining capital intact" rule to include also money assets ; and l i a b i l i t i e s ? APPENDIX A* THE BASIC POSTULATES OF ACCOUNTING * Postulate A - l . Quantificati on. Quantitative data are helpful i n making rational economic decisions; i . e*, i n making choices among alternatives so that actions are correctly related to consequences. Postulate A-2* Exchange. Most of the goods and services that are produced are distributed through exchange, and are not directly consumed by the producers* Postulate A-3« En t i t i e s , (including identification of the entity). Economic activity i s carried on through specific units or entities. Any report on the activity must identify clearly the particular unit or entity involved. Postulate A-l;.. Time period (including specification of the time period). Economic activity i s carried on during specifiable periods of time. Any report on that activity must identify clearly the period of time involved. Postulate k-$. Unit of measure (including identification of the monetary unit). Money i s the common denominator i n terms of which the -57-exchangeability of goods and services, including labor, natural resources, and capital, are measured. Any peport must clearly indicate •which money (e.g., dollars, francs, pounds) i s being used. Postulate B - l . Financial statements. (Related to A-l) The results of the accounting process are expressed in a set of fundamentally related financial statements which articulate with each other and rest upon the same underlying data. Postulate B-2. Market prices (Related to A -2) . Accounting data are based on prices generated by past, present, or. future exchanges which have actually taken place or are expected to. Postulate B-3* Entities* (Related to A-3.) The results of the accounting process are expressed i n terms of specific units or entities. Bostulate B-U* Tentativeness. (Related to A-U) The results of operations for r e l a t i v e l y short periods of time are tentative whenever allocations between past, present, and future periods are required. Bostulate C - l * Continuity (including the correlative concept of limited l i f e ) . In the absence of evidence to the contrary, the entity should be viewed as remaining i n operation indefinitely. In the presence of evidence that the entity has a limited l i f e , i t should not be viewed as remaining i n operation indefinitely. Postulate C-2. Objectivity. Changes i n assets and l i a b i l i t i e s and the related effects ( i f any) on revenues, expenses, retained earnings, and the l i k e , should not be given formal recognition i n the accounts earlier than the point of time at which they can be measured i n objective terms* -58-P o s t u l a t e G-3. C o n s i s t e n c y . The p r o c e d u r e s u s e d i n a c c o u n t i n g f o r a g i v e n e n t i t y s h o u l d b e a p p r o p r i a t e f o r t h e measurement o f i t s p o s i t i o n a n d i t s a c t i v i t i e s a n d s h o u l d b e f o l l o w e d c o n s i s t e n t l y f r o m p e r i o d t o p e r i o d * P o s t u l a t e C-k> S t a b l e u n i t . A c c o u n t i n g r e p o r t s s h o u l d b e b a s e d on a s t a b l e m e a s u r i n g u n i t . P o s t u l a t e C - 5 * D i s c l o s u r e * A c c o u n t i n g r e p o r t s s h o u l d d i s c l o s e t h a t w h i c h i s n e c e s s a r y t o make t h e m n o t m i s l e a d i n g . * M a u r i c e M o o n i t z , The B a s i c P o s t u l a t e s o f A c c o u n t i n g , A c c o u n t i n g  R e s e a r c h S t u d y i f o . 1, A m e r i c a n I n s t i t u t e o f C e r t i f i e d P u b l i c A c c o u n t a n t s , 1961. L APPENDIX B . S U M A R Y OF ACCOUNTING FRINCIpS * The p r i n c i p l e s s u m m a r i s e d b e l o w a r e r e l e v a n t p r i m a r i l y t o f o r m a l f i n a n c i a l s t a t e m e n t s made a v a i l a b l e t o t h i r d p a r t i e s a s r e p r e s e n t a t i o n s b y t h e management o f t h e b u s i n e s s e n t e r p r i s e * The " b a s i c p o s t u l a t e s o f a c c o u n t i n g " d e v e l o p e d i n A c c o u n t i n g R e s e a r c h S t u d y No* 1 a r e i n t e g r a l p a r t s o f t h i s s t a t e m e n t o f p r i n c i p l e s . B r o a d p r i n c i p l e s o f a c c o u n t i n g s h o u l d n o t be f o r m u l a t e d m a i n l y f o r the p u r p o s e o f v a l i d a t i n g p o l i c i e s ( e . g . , f i n a n c i a l management, t a x a t i o n , e m p l o y e e c o m p e n s a t i o n ) e s t a b l i s h e d i n o t h e r f i e l d s , no m a t t e r how s o u n d o r d e s i r a b l e t h o s e p o l i c i e s may be i n a n d o f t h e m s e l v e s . -59-Accounting draws i t s real strength from i t s neutrality as among the demands of competing special interests. Its proper functions derive from the measurement of the resources of specific entities and of changes i n those resources. Its principles should be aimed at the achievement of those functions. The principles are as follows: A. Profit i s attributable to the whole process of business activity. Any rule or procedure, therefore, which assigns profit to a portion of the whole process should be continuously re-examined to determine the extent to which i t introduces bias into the reporting of the amount of profit assigned to specific periods of time. B. Changes i n resources should be classified among the amounts attributable to 1. Changes in the dollar (price-level changes) which lead to restate-ments of capital but not to revenues or expenses. 2. Changes in replacement costs (above or below the effect of price-level changes() which lead to elements of gain or of loss. 3» Sale or other transfer, or recognition of net realisable value, a l l of which lead to revenue or gain* U. Other causes, such as accretion or the discovery of previously un-known natural resources. C* A l l assets of the enterprise,w hether obtained by investments of owners or of creditors, or by other means, should be recorded in the accounts and reported i n the financial statements, ^he existence of an asset i s independent of the means by which i t was acquired. D. The problem of measuring (pricing, valuing) an asset i s the problem of measuring the future services, and involves at least three -60-A determination i f future services do in fact exist. For example, a building i s capable of providing space for manufacturing a c t i v i t y . An estimate of the quantity of services. For example, a building i s estimated to be usable for twenty more years, or for half of i t s estimated total l i f e . The choice of a method or basis or formula for pricing (valuing) the quantity of services arrived at under b, above. In general, the choice of a'pricing basis i s made from the following three exchange prices: (1) A past exchange price, e.g., acquisition cost or other i n i t i a l basis. When this basis i s used, p r o f i t or loss, i f any, on the asset being priced w i l l not be recognized u n t i l sale or other transfer out of the business entity. (2) A current exchange price, e. g., replacement cost. When this basis i s used, pr o f i t or loss on the asset being priced w i l l be recognized i n two stages. The f i r s t stage w i l l recognize^ part of the gain or loss i n the period or periods from time of acquisition to time of usage or other disposition; the second stage w i l l recognize the remainder of the gain or loss at the time of sale or other transfer out of the entity, measured by the difference between sale (transfer) price and replacement cost. This method is s t i l l a cost method; an asset priced on this basis i s being treated as a cost factor awaiting disposition.. (3) A future exchange price,, e. g., anticipated selling price* When this basis i s used, p r o f i t or loss, i f any, has already -61-been recognized i n the accounts* Any asset priced on this basis i s therefore being treated as though i t were a receivable, i n that sale or other transfer out of the business (including conversion into cash) w i l l result in no gain or loss, except for any interest (discount) arising from the passage of time. The proper pricing (valuation) of assets and the allocation of profit to accounting periods are dependent i n large part upon estimates of the existence of future benefits, regardless of the bases used to price the assets.. The need f o r estimates i s unavoidable and cannot be eliminated by the adoption of any formula as to pricing. 1. A l l assets i n the form of money or claims to money should be shown at their discounted present value or the equivalent. The interest rate to be employed i n the discounting process i s the market (effective) rate at the date the asset was acquired. The discounting process i s not necessary i n the case of short-term receivables where the force of interest i s small. The carrying-value of receivables should be reduced by allowances fo r uncollectible elements; estimated collection costs should be recorded i n the accounts. If the claims to money are uncertain as to time or amount of receipt, they should be recorded at their current market value. If the current market value i s so uncertain as to be unreliable, these assets should be shown at cost* 2. Inventories which are readily salable at known prices with readily predictable costs of disposal should be recorded at net realizable value, and the related revenue taken up at the same time. Other -62-inventory items should be recorded at their current (replacement) cost, and the related gain or loss separately reported. Accounting for inventories on either basis w i l l result i n recording revenues, gains, or losses before they are validated by sale but they are nevertheless components of the net profit (loss) of the period i n which they occur. Acquisition costs may be used whenever they approximate current (replacement) costs, as would probably be the case when the unit prices of inventory components are reasonably stable and turnover i s rapid. In a l l cases the basis of measurement actually employed should be "eubject to veri f i c a t i o n by another competent investigator". 3. A l l items of plant and equipment i n service, or held i n stand-by status, should be recorded at cost of acquisition or construction, with appropriate modification for the effect of the changing dollar either i n the primary statements or i n supplementary statements. In the external reports, plant and equipment should be restated i n terms of current replacement costs whenever some significant event occurs, such as a reorganization of the business entity or i t s merger with another entity or when i t becomes a subsidiary of a parent company. Even i n the absence of a significant event, the accounts could be restated at periodic intervals perhaps every five years. The development of satisfactory indexes of construction costs and of machinery and equipment prices would assist materially i n making the calculation of replacement costs feasible, practical, and objective. U. The investment (cost or other basis) i n plant and equipment should be '.amortized over the estimated service l i f e . The basis for adopting -63-a particular method of amortization for a given asset should be i t s ' a b i l i t y to produce an allocation reasonably consistent with the anticipated flow of benefits from the asset. A l l "intangibles" such as patents, copyrights, research and development, and goodwill should be recorded at cost, with appropriate modification f o r the effect of the changing dollar either i n the primary statements or i n supplementary statements. Limited term items should be amortized as expenses over their estimated l i v e s . Unlimited term items should continue to be carried as assets, without amortization. If the amount of the investment (cost or other basis) i n plant and equipment or i n the "intangibles"' has been increased or decreased as the r esuit of appraisal or the use of index-numbers, depreciation or other amortization should be based on the changed amount. E. A l l l i a b i l i t i e s of the enterprise should be recorded i n the accounts and^  reported- i n the f i n a n c i a l statements. Those l i a b i l i t i e s which c a l l for settlement i n cash should be measured by the present (discounted) value of the future payments or the equivalent. The yield (market, effective) rate of interest at date of incurrence of the l i a b i l i t y i s the pertinent rate to use i n the discounting process and i n the amortization of "discount" and "premium". "Discount" and "premium" are technical devices for relating the issue price to the principal amount and should therefore be closely-associated with principal amount i n financial statements. F* Those l i a b i l i t i e s which c a l l for settlement in goods or services (other than cash) should be measured by their agreed selling price. Profit accrues i n these cases as the stipulated services are - 6 U -performed or the goods produced or delivered. G. In a corporation, stockholders' equity should be classified into invested capital and retained earnings (earned surplus). Invested capital should,- i n turn, be classified according to source, that i s , according to the underlying nature of the transactions giving rise to invested capital. Retained earnings should include the cumulative amount of net profits and net losses, less dividentL declarations, and less amounts transferred to invested ca p i t a l . In an unincorporated business, the same plan may be followed, but the acceptable alternative i s more widely followed of reporting the total interest of each owner or group of owners at the balance sheet date. H. A statement of the results of operations should reveal the components of profit i n sufficient detail to permit comparisons and interpretations to be made. To this end, the data should be classified at least into revenues, expenses, gains, and losses. 1. In general, the revenue of an enterprise during an accounting period represents a measurement of the exchange value of the products (goods and services) of that enterprise during that period. The preceding discussion, under D (2), i s also pertinent here* 2. Broadly speaking, expenses measure the costs of the amount of revenue recognized. They may be directly associated with revenue-producing transactions themselves (e.g*, so-called "product costs") or with the accounting period in which the revenues appear (e.g., so-called "period costs"). - 6 5 -Gains include such items as the results of holding inventories through a price r i s e , the sale of assets (other than stock-in trade) at more than book value, and the settlement of l i a b i l i t i e s at less than book value. Losses include items such as the results of holding inventories through a price decline, the sale of assets (other than stock-in-trade) at less than book value or their retirment, the settlement of l i a b i l i t i e s at more than book value, and the imposition of l i a b i l i t i e s through a lawsuit. Robert T. Sprouse and Maurice Moonitz, A Tentative Set of Broad  Accounting Principles for Business Enterprises, Accounting Research Study No. 3 * American Institute of Certified Public Accountants, 1962* -66-I I . THE CASE FOR PRICE-LEVEL ACCOUNTING Changes i n the value of money There are several kinds of movements i n the time-series of important economic magnitudes, i n particular, the secular trend, business cycles, seasonal variations, disturbances attributable to non-economic factors, and the "long waves'1' covering periods of f i f t y years or more. The secular trend and business cycles are believed to have large and o important effects on price levels (as distinguished from the levels of employment and production); they are thus of special interest to accountants. Cyclical fluctuations i n the inter-war years There was a general recovery of economic act i v i t y i n most western countries after the end of World War I; the f i r s t downturn took place i n 1920, culminating i n the trough of 1922, followed by a recovery i n the following year. 1929 witnessed a further and serious decline which 3 was carried into the f i r s t half of the 1930's. These fluctuations are reflected i n the price indexes given i n Table I. ^ Secular decline i n the value of money Superimposed on these significant short term price movements i s a long term trend of decline i n the purchasing power of money. Since 1900 1. See G. von Haberler, Prosperity and Depression, Cambridge, Massachusetts: Harvard University Press, Fourth Edition, 19!?8, p» 271. 2. There are, of course, many different price lev e l s . Consideration of this aspect of the problem i s deferred to Chapters IV and V. 3. See Haberler, op. c i t . , pp. 266-7, for a graphical presentation of c y c l i c a l fluctuations i n the Unites States and European countries* it. A l l numbered tables are included i n the appendix. - 6 7 -there has been a tendency f o r the general price level to ris e , so that each successivecycle took place on higher price levels than i t s predecessor. Economists distinguish between two types of inflatio n : demand inf l a t i o n and cost i n f l a t i o n . The former i s the consequence of "too much money chasing too few goods*, the latt e r of an increase i n costs not accompanied by a r i s e i n productivity. Both causes are usually present i n an inflationary situation, an increase i n aggregate demand often affecting the price level by bringing about an increase i n manufacturers' costs where there already exists f u l l emptfJLyment of some or a l l of the factors of production* Since in f l a t i o n i s primarily a monetary phenomenon,, i t i s not unexpected that the general price l e v e l should rise during war years; ^ this is a pa r t i a l consequence of the continuous creation of credit by governments to finance their war efforts. The ri s e i n prices i n World War II was i n fact smaller than in the previous war, and i t i s the price rise after the end of the war which has been exceptional. So far as the United Kingdom i s concerned, there was on the average an annual increase of \x%-$% i n the general price level i n the following decade, a magnitude that has 7 ft not been equalled i n i t s peace time economy i n the past century. '* The 5* Council on Prices, Productivity and Incomes, F i r s t Report. London, 1958, p. 5« See also Table I. 6. The average wholesale price index: i n the United States i n 1935-1*0 was 52.2 and i n 191*7-52' was 101*.9 (19U7-U9 - 100). 7. Council on Prices, Productivity and Incomes, op* c i t . , p. i i * 8. The price rise appeared to have been less marked in more recent years, but again showed large advances i n 1961 and 1962. Retail prices (1958 - 100) o872 7U.8 81.3 1950 1951 1952! • • • • contd. -68-experience i n other countries, excluding countries whose economies have been disrupted by war or revolution and the South American republics, has been very similar, though i n most cases less pronounced.9 The following causes have been held to be responsible for the i n f l a t i o n i n the 1950's: 1 0 (a) a boom i n the industrialised nations i n consumer durables and housing which spread to private investment i n plant and equipment (b) increases i n costs, particularly wage costs, not accompanied by increased output 8. (Contd*) Retail prices (1958 - 100) 1953 83.9 195U 85.3 1955 89.2 1956 93*6 1957 97.1 1958 100.0 1959 100.6 1960 101.6 1961 105.0 1962 110.0 * * My estimate, based on figures for three quarterly periods Source; National Institute of Economic and Social Research, National  Institute Economic Review;, No. 22, November 1962, Table 9, p* 53. 9. The following table gives the median annual increase i n consumer prices, which generally reflect prices paid by wage earners and middle-income groups, i n 91 countries from 1952 to 1958. Median increase (Per cent) 1952- 53 2..1 1953- 5U 1.2 195U-55 2.U 1955- 56 3.5 1956- 57 U.O 1957- 58 2.I4 Source: "The Declining Value of Money: A Reviewof Consumer Prices", International Labour Review, Vol. IXXVIII, No* 5, November 1958, p* 507* 10. See United Nations, World Economic Survey, 1957» New York, 1958. contd. -69-(c) i n Communist countries, an increasing share of the national product allocated to consumption (d) i n the underdeveloped nations, the use of d e f i c i t financing to promote industrial expansion, leading to excess demand i n the absence of a larger agricultural output (e) there was no evidence i n the industrialised countries of excess of aggregate demand, but there were shortages of specific commodities such as coal and steel* Table II gives an indication of the i n f l a t i o n i n this period i n certain selected countries. In the ligh t of declared o f f i c i a l economic objectives, with their emphasis on achieving industrialisation or f u l l employment i n the economy, there would appear l i t t l e evidence to believe that the current ri s i n g price trend w i l l be reversed i n future years. The effect of price l e v e l changes on accounting income ^ It has sometimes been contended that money, as a unit of value, has. served i t s function relatively well, and that the minor year-to-year fluctuations i n the price level do not produce significant distortions i n the reported income figure. It can be seen from Table I, however, that there has been a substantial decline of well over $0% i n the value of money i n the past 5 0 years. Furthermore, though the United States 1 1 . (Contd.) Since 1 9 5 0 gross domestic incomes i n the United Kingdom, including a l l wages and salaries, company profits, nationalised industry surpluses and rent receipts, have more than doubled from 1 1 1 , 3 2 1 m to i 2 3 i l i 9 0 m . Over the sameperiod the gross domestic product (in terms of constant 1 9 5 8 prices) has increased by only 3 1 » 6 per cent from i l 6 , 6 9 9 m to £ 2 1 , 9 8 l m . Incomes, i n fact, have risen at an annual rate of 6 . 9 per cent over the period 1 9 5 0 to 1 9 6 1 - more than two and a half times as fast as the 2 . 5 per cent "real" growth in output. Manchester Guardian, Friday A p r i l 6 , 1 9 6 2 . 1 2 . Price level changes have significant effects, of course, on other Contd. -70-(to which the table refers) has experienced relative monetary s t a b i l i t y , nonetheless the annual rate of change i n the general price level i n some years was well above 5$. A number of case studies have been undertaken i n the United States and other countries to determine the quantitative effects of price level changes on income and other financial statements. Their results indicate that both long and short term price movements produce significant impact on accounting magnitudes. Some of the results of these case studies are b r i e f l y given below. ^ (A) Adjustments i n terms of a constant-value unit (i) One of the earliest and best known exponents of stabilized accounting was SWEENEY who applied i t s techniques i n the measurement of the corporate incomes of three enterprises i n dollars of a constant purchasing power. A water works company The selected year was the financial year of the company ended October 31, 1929. The general index stood at 177*5 both at the beginning and end of the period. Nonetheless, i t was found that the net income on operations expressed i n stabilized dollars 12. (Contd.) accounting magnitudes as well. These w i l l not be discussed, except insofar as they are pertinent to income measurement. 13. The case studies have been classified roughly into two groups, those which aim to express income i n terms of constant purchasing power, and those which adjust the income figure to current dollars. A more detailed study of the principles and methodology of the different systems i s made i n Chapter V. l i | . Henry W. Sweeney, Stabilized Accounting, New York, Harper and Bros., 1936, pp. 87, 119 and Dr9. - 7 1 -was only 65% of the reported income; when the net purchasing power losses from holding money and money assets were taken into account, realized net income was only 32% of reported income. ^ A woollen m i l l company The selected financial year ended on July 3 1 , 1929. The general index stood at 176 at the beginning and 181.5 at the end of the period, an increase of approximately 3%» Though this company had been i n existence for only two years, i n which the general price level had varied l i t t l e , there were considerable differences between the stabilized and unstabilized figures. The net operating loss expressed i n stabilized dollars was higher than the reported loss by k%> but the realized net loss for the year was only 83$ of the reported loss figure; the reason was a large net realized gain from the change i n the value of money not included i n the unstabilized accounts. A factoring company (agent for textile mills) This study covered a 2 year period ended September 3 0 , 1931* The general index stood at 182 at the beginning of the period, 165 at the end of the f i r s t year and l U 5 * 5 at the end of the second year. When the income statement has been stabilized i n the general price level of September 30,, 1931* i t i s seen that there are very substantial realized gains from holding money and money assets i n a period of declining prices, which reflect on the inadequacy of ordinary accounting procedures which do not take such gains and losses into consideration. The extent of these adjustments are given i n Table III. l 5 « Realized net income i s defined as net operating income plus net realised purchasing power gains. In this i l l u s t r a t i o n purchasing power gains and losses arose from short-term (monthly) changes i n the index and i n the holdings of money assets and l i a b i l i t i e s . 16 ( i i ) A comprehensive study was undertaken by JONES of the impact of inflation on the accounts of nine steel companies i n the United States, comprising over Q0% of output and employment i n the industry. A comparison of the aggregate accounting statements for 19U1-U7 and the adjusted purchasing power statements i n terms of 1935-39 dollars reveals the following picture: Company statements Adjusted statements in 1935-39 dollars (a) Dividends earned by a (a) Dividends not earned i n substantial margin each year any year since 19l|2 (b) Income retained $5U3m (b) Dividends, interest and taxes* paid out of capital $U09m (c) 19U6 reported income $200m (c) 19U6 real loss $88m (equivalent to $123m i i i 19U6 dollars) (d) 19U7 net income $356m (d) 19U7 net income $91m (equivalent to $lU5ni i n 19u7 dollars) (e) working capital increased by (e) working capital increased 51$ during 7-year period by 2% during 7-year period ( i i i ) BARTER ^ conducted a similar investigation of seven steel companies i n the United Kingdom', which sample i s believed to give a broad picture of the industry. A study of the accounts of three of the 16. Ralph C. Jones, "Effect of Inflation on Capital and Profits: The Record of Nine Steel Companies", Journal of Accountancy, Vol. 87, No. 1, January 19^9, pp. 9-27. 17. W. T. Baxter, "Inflation and the Accounts of Steel Companies"1, Accountancy, V o l . IXX, No. 789, May 1959, pp. 250-7 and Vol. IXX, No. 790, June 1959, pp. 3O8-U4.. The income analysis i s given after adjustments for depreciation and inventory. Purchasing power gains and losses on money assets and l i a b i l i t i e s are dealt with i n some detail separately. -73-companies covered the period 1939 to 19k7, and the f u l l study, 19U9 to 1957* Separate figures are presented for each period of adjusted income i n current pounds sterling and stabilized income expressed i n pounds of the last year i n the period. The main index employed i s that of consumers', expenditure, and the effects of a further deflation by means of an index of the replacement cost of industrial assets; of steelworks are also given. There was general agreement between the 1939-1*7 results and the l ft American study. The general index i n 1939-U7 rose on an average by 8$ a year. Corrected income i n current pounds reduced profits by some 12f# at the start of the period, 1*0^ i n the middle, and 80% i n I9U7. Current income was insufficient to cover the payment of taxes and dividends i n a l l years. The experience i n the l a t t e r period 19U9-57, when the general index rose approximately k% per annum, was different. Current income was lower than reported income by about 13$ throughout the period. There was always a surplus after distribution, i f income was expressed i n current pounds, but when replacement costs of stocks and fixed assets were taken into account, there were def i c i t s i n three years. Some of the results of t h i s study are reproduced i n Table IV. (iv) Four companies, a public u t i l i t y and three manufacturing companies, were included i n a price level study project of the AMERICAN ACCOUNTING ASSOCIATION 1 9 . The period covered was from 19U1 to 1951,. 18. See Jones, op. c i t . 19* See Ralph C Jones, Price Level Changes and Financial Statements -Case Studies of Four Companies, American Accounting Association contd. -7U-20 one i n which inflation had been most pronounced. The general procedure was to restate the f i n a n c i a l statements of each company i n terms of the December 1951 dollar, by means of the consumers' price index. It was found that (a) i n f l a t i o n had overstated the rate of return by twice as high as the adjusted figure, (b) dividends were i n excess of adjusted income, and (c) there were sizeable purchasing power losses from holding l i q u i d assets. Some of the results of the investigation are b r i e f l y summarised i n Table V. (v) In a study of three of the largest e l e c t r i c a l manufacturers JOEL 21 DEAN made use of specialised indexes to deflate each major group of assets to real terms. The period covered 1935 through 19U8, and 1935 was selected as the base year. Dean found an upward bias i n the reported income, and a tendency for the gap between reported and adjusted income figures to grow wider over time. By 19lil adjusted income was about $0% of reported income for a l l three companies. The large discrepancies between the two sets of figures i n the later years are reproduced i n Table VI. 19. (Contd.) 1955* See also Perry Mason, "The Price-Level Study of the American Accounting Association". Accounting Review, Vol. XXX, No. 1, January 1955, pp. 37-UU and Albert L. Bell, "Fixed Assets and Current Costs", Accounting Review, Vol. XXVIII, No. 1, January 1953, pp. U+-53. 20. The period 1929-UO was included i n the case study of Sargent and Company, the only one of the four .studies that covers the years of deflation and depression which followed the astock market crash of 1929 as well as the more recent period of i n f l a t i o n . 21. Joel Dean, "Measurement of Profits for Executive Decisions", Accounting Review, Vol. XXVI, No. 2, A p r i l 1951, pp. 185-96. -75-(vi) A particularly interesting study of the effects of price l e v e l 22 changes on the profits of a department store was made by CORBIN. He found that i n the period 1933 to 1952 (a) adjusted income was on an average 20$ lower than reported income, (b) adjusted rates of return on equity were 29$ lower than reported figures, (c) taxes and dividends were high relative to adjusted income figures, but there were no payments out of capital, (d) purchasing power gains and losses on money assets and l i a b i l i t i e s were substantial, and (e) growth indicators based on reported figures overstated expansion by 50% to over 100$. ( v i i ) BEAINE ^ employed a combination of ths. Sweeney and Corbin methods of price level adjustments i n computing the effects of price change on the accounts of a canner of f r u i t s and vegetables which exhibited marked seasonal variations both i n i t s sales and production costs. The selected period was the company's financial year ended January 31* 1959j the general index rose from 122.5 to 123*8 i n this period, an increase of well under 2$* Adjusted operating income expressed i n January 1959 dollars was: only 21$ of the reported figure* When total purchasing power gains on net monetary l i a b i l i t i e s were taken into account, adjusted income was 52$ of reported income. ( v i i i ) Aggregate data for inter-industry comparison have been computed by SLESINGER AND HOLLANDER who adjusted income figures relating to 22'. Donald A. Corbin, "A Case Study of Price-Level Adjustments", Accounting  Review, Vol. XXX, No. 2, A p r i l 1955, pp. 268-81 and "The Impact of Changing Prices on a Department Store", Journal of Accountancy, A p r i l 195U, pp. U30-U0. 23* Robert E. Blaine. Price Level Accounting - A Case Study* thesis submitted i n para|[tal fulfillment of the requirements for the degree of Master of Business Administration at the University of California, May 1961. contd. -76-seven industrial sectors at constant 1956 prices. In the period 1951 to 1956 i t was found that depreciation adjustments were the most important, and contributed to significant inter-industry differences. Further, those industries with relatively large inventories and net monetary assets suffered more when prices decline i n 1952'* In 1951 when the wholesale price index rose 11$, income adjustments i n the s even industrial groups ranged from 25$ to 128$; i n 1956 the index rose 3$ while the lowest and highest adjustments were 27$ and 97$ respectively. The real average rates of return on investment were lower, i n most cases subs-ta n t i a l l y lower, than the reported data for a l l industrial groups. The results of the investigation are b r i e f l y summarised i n Table VII. (B) Adjustmentsin terms of current value units A different approach to the price i n f l a t i o n problem i s advocated 25 by MATHEWS and GRANT , who proposed that adjustments should be made in respect of the replacement costs of physical assets only, v i z . , stocks and fixed assets. This technique was applied to a general study of a l l Australian companies (excluding banks and l i f e assurance companies) i n the period 19U5-U6 to 1952-53* The results, summarised i n Table VIII, show that (a) the increase i n accounting profits i n the (Contd.) 2U* R. E. Slesinger and T. E. Hollander, "The Impact of Price Level Changes on the Measurement of Business Income"1, Kyklos, Vol. XIV, Fasc. 3, 1961, pp. lpii-32. 25* Russell Mathews and John McB. Grant, Inflation and Company Finance, Sydney:. The Law Book Co. of Australasia Pty Ltd., 1 9 5 ° . See also Grant and Mathews, "Accounting Conventions, Pricing Policies and The Trade Cycle", Accounting Research, Vol. 8 , No. 2 , A p r i l 1957, pp. Iii5-61j. and "The Effect of Inflation on Company Profits and Financial Structures", Economic Record, May 1 9 5 6 . -77-period was greater than that i n current income, (b) the stock appreciation factor was exceptionally important i n this period, particularly i n 1950-51 and 1951-52, and (c) current saving was lower than expected (in other words, the amounts paid out by way of taxes and dividends were unduly high i n relation to current income i n the period), at least u n t i l 1952-53* and i t i s possible that i n some of the manufacturing 26 industries current savings over the period as a whole were negative. Partial adjustments In addition'to the above investigations into the effects of price changes on income measurement, there have also been a number of less comprehensive studies centred mainly on the depreciation of fixed assets. McNICHOLS and BOYD 2 ? l i s t e d the fixed assets of International Harvester Company at the close of i t s financial year October 31, 1951* by year of acquisition and depreciation rates. Using the wholesale price index as the deflating factor to re f l e c t general purchasing power change, they found that the adjusted cost of the assets exceeded their historical cost by k9%f with consequential effects on income measurement. 26. For a similar analysis of United Kingdom companies, see F. ¥. Paish, "Company Profits and their Distribution Since the War, D i s t r i c t  Bank Review, No. Ilk, June 1955* 27. Thomas J. McNichols and F. V i r g i l Boyd, "Adjustment of Fixed Assets to Reflect Price Level Changes"1, Accounting Review, Vol. XfEQC, No. 1 , January 1 9 5 U , pp. 1 0 6 - 1 3 . -78-The resultsof a similar study by WARNER * u of fiire giant corporations in the United States from 1938 to 1951 are given i n Table IX. A case study by BIERMfflM ^9 based on the published composite accounts of the electric u t i l i t y industry from 191*0 to 1952: established that depreciation adjustments for general price l e v e l change varied from-11$ to 16$ of the depreciation charge i n 191*0-1*5, and from 31$ to 62$ in 191*6-52. In 1952 when reported income was $9l*7m and adjusted i n -come i n 1952 dollars only |672m, the depreciation charge was understated by $275m. 28. George H.. Warner, "Depreciation on a Current Basis", Accounting Review, Vol. XXIX, No. 1*, October 1951*, pp. 628-33. 29. Harold Bierman, Jr., "The Effect of Inflation on the Computation of Income of Public Utilities"', Accounting Review, Vol. XXXI, No., 2, A p r i l 1956, pp. 258-62. The depreciation adjustment i s particularly important for public u t i l i t i e s . Reported depreciation i s 77*5$ of reported income of public u t i l i t i e s ; the corresponding figure for manufacturing companies i s 2$%. - 7 9 -APPENDTX TABLE I. WHOLESALE PRICE AND CONSUMER PRICE INDEXES AND ANNUAL PERCENTAGE CHANGES, UNITED STATES, 1890 - I96I (1957 - 59 « 100) Year Wholesale price Consumer price Year Wholesale price Consumer price index index index index 1890 30.7 1926 5U.8 61*6 1891 30.6 1927 52.3 60*5 1892 2 8 . 5 1928 53*0 59*7 1893 29.2 1929 52.1 59.7 189U 26.2 1930 1*7.3 58*2 1895 26.7 1931 39*9 53.0 1896 25*1* 1932 35.6 1*7*6 1897 25.5 1933 36*1 1*5*1 I 8 9 8 26.5 1931* 1*1*0 1*6*6 1899 28.5 1935 1*3*8 1*7.8 1900 30.7 1936 1*1*.2 U 8 . 3 1901. 30.2 1937 1*7*2 50.0 1902 32.3 1938 1*3*0 1*9.1 1903 32.6 1939 1*2.2 1*8*1* 1901* 32*7 191*0 1*3.0 1*8.8 1905 32.9 191*1 1*7.8 51.3 1906 33.9 191*2 51**0 56*8 1907 35.7 191*3 5 6 . 5 60.3 1908 3l * . U 191*1* 56*9 6 l . 3 : 1909 37.0 191*5 57*9 62 .7 1910 38.6 191*6 66*1 68 .0 1911 35*5 191*7 81*2 77*8 1912 37.8 19U8 87.9 83*8 1913 38.2 3U*5 191*9 83.5 83*0 1911* 37.3 35*0 1950 8 6 . 8 83.8 1915 38.O 35 . U 1951 96*7 90 .5 1916 U6.8 38.0 1952 91*. 0 92.5 1917 61*.3 1953 92.7 93 .2 1918 71.7 52*1* 1951* 92.9 \ 93*6 1919 75.8 60.3 1955 93.2 J 93*3 1920 81**5 69*8 1956 96*2 91**7 1921 53. 1* 62*3 1957 99.0 ; 98.0 1922 52.9 58 .1* 1958 100 . U ' 100.7 1923 55.1 59*k 1959 100.6 101.5 1921* 53.6 59.6 i960 100.7 \ 103.1 10l*>.2 J I 1925 56*6 61.1 1961 100.3 Wholesale Price Index:; Notes: (a>) The Wholesale Price Index measures average changes i n prices; of a l l commodities, produced or imported, which are sold i n primary markets of the United States. The sample includes more than 2,000 items. Because of i t s - 8 0 -broad scope, i t i s often used as a general purpose index, (b) The previous series on the 191*7-1*9 base has been coverted to the new reference base, 1957-59 = 100. Source: United States Department of Labour, Bureau of Labour Statistics, Wholesale Prices and Price Indexes, January 1962 and  February 1962, Table 6, p. 29. Consumer Price Index: Notes: (a) The Consumer Price Index measures average changes i n prices of goods and services usually bought by city families of wage earners and c l e r i c a l workers. It i s based on prices, obtained i n 1*6 c i t i e s , of about 300 selected items. (b) The previous series on the 19^ 7-1*9 base has been converted to the new reference base, 1957-59 = 100. Source: United States Department of labour, Bureau of Labour Statistics, Consumer Price Index - Historical tables of indexes on the  base 1957-59 • 100, (1962). -81-TABLE I I . WHOLESALE PRICE AND CONSUMER PRICE INDEXES IN SELECTED COUNTRIES, I 9 6 0 AND I 9 6 I (1953 - 1 0 0 ) Country Wholesale price index Consumer price index I960 1961 I960 1961 Western countries United States 100 100 111 112 Canada 10U 106 111 112 United Kingdom n.a. n.a. 121 125 France.- 130 132 13k 138 West Germany 103 105 111 Ilk New: Zealand; 110 110 12k 126 Asian countries Japan 101 105 i l k 120 India 118 121 117 118 Philippines 108 Hit 109 110 Thailand 113 122 118 126 Burma n.a. n.a. 108 112 Federation! of Malaya n.a* n.a. 91 91 South America Brazil 399 5k9 k39 607 Chile I 1109 1117 116k 1253 Venezuela 105 107 i i 112 109 n.a. denotes 'not available'. Source; United Nations, Monthly Bulletin of Statistics, Vol. XVI No. 6, June 1962, Table k6, pp. 118-26 and Table k8, pp. lk2-8. - 8 2 -TABLE I H . UNSTABILIZED AND STABILIZED INCOME OF MILL AGENTS, INC., IN UNITED STATES, FOR THE YEARS ENDED SEPTEMBER 30, 1930 AND' 1931. ($000) 1930 1931 [Jnstabilized Stabilized Unstabilized Stabilized Net income (loss) on operations 78 73 -85 -86 Net realized purchasing power gains - 96 - 135 Realized net income (loss) for year 78 169 -85 50 Net unrealized purchasing power loss -8 •x- -27 -11 Final net income (loss) for year 70 169 -112 38 # not significant Notes: (a) A l l stabilized figures are expressed i n the general price level of September 30, 1931. (b) The net unrealized loss i n the unstabilized accounts arose from the application of the rule of lower of cost or market to the securities and inventory. Source: Sweeney, op. cit», p. 11*9. -83-TABLE 17. NET PROFIT AND SURPLUS OF THREE STEEL COMPANIES, 1939-1*7. AND SEVEN STEEL COMPANIES IN UNITED KINGDOM, 1 9 1 + 9 - 1957 (1000,000) Net profit Surplus after taxes and dividends Year Reported Current Is Stabilized Reported Current £s Stabilized Three steel companies 1 9 3 9 2.1 1*9 3 . 3 -0.1* -0.7 -1.2 191*0 3.0 2.2 3*1* n.s* -0*8 -1*2; 191*1 2.2 1.3 1.7 0*1 -0.6 -0.8 1 9 1 * 2 2.0 - 1.0 1.3 0.2 -0.7 -0.9 19 1 * 3 2.2 1.3 1*6 0.2 -0.7 -0.9 191*1* 2*5 1.5 1.8 0*3 -0.7 -0*8 191*5 2-5 1 * 3 1*5 O.U -0.6 -0.7 191*6 3.5 2.1 2.3 0.6 -1.5 -1.7 1 9 1 * 7 2.1* O.U o.U 1-3 - 1 . 1 * -1.1* TOTAL 22.1* 13.0 17*2 2.7 -7*6 -9*5 Seven steel companies 191*9 1 9 * 9 17.2 23*8 7.0 -1.1. -1*5 1950 23*2 19.6 26.1 8.6 5.5 7.1* 1951 2 1 * * 8 19*6 2i*.3 8 . 8 -1*.3 -5*3 1952 3k.1 28.9 33.8 10.0 - 9 . U -11.0 1953 31* . 0 2 9 . 8 33*7 10*8 8*9 10.1 1951* 1*3-1* 38.3 1*3.0 13*9 12.6 11*.1 1955 56.2 50.1 55*1* 21*.0 6.0 6.7 1956 53*9 U6*l 1*7*6 2i**6 l i . l :k.2 1957 67*6 59.3 60.0 28.0 13*7 13*9 TOTAL 357*1 308.9 31*7.6 135.5 36.0 38.5 Notes; (a) The net profit figures in current i s and stabilized £s are shown after adjustments for general price level changes. (b) The surplus i n current i s and stabilized £s i s given after providing for replacements, taxes and distributions* (c) The earlier period's accounts are stabilized i n i.s of December 31, 19k 7 and the latter period's accounts i n Is of December 31* 1957* Source: Baxter, op* c i t . , pp. 251* and 309-10. -81*-TABLE 7. REPORTED AND ADJUSTED INCOME AND OTHER FINANCIAL STATISTICS OF FOUR COMPANIES IN UNITED STATES, 191*1-51 Reece Corp. JArmstrong Cork Co. Sargent & Co. New York Telephon Co. Reported Adjusted j Reported Adjusted Reported Adjusted Reported Adjusted 1951 Revenue as % of 191*1 Rate of return on total interest 191*1 1951 Average 19l*l-5l $ of earnings distr as dividends 191*1-1*5 191*6-51 191*1-51 Income tax rates 191*1 1951 Average 19l*l-5l Depreciation d e f i c i as % of adjusted de 191*1 1951 Average 19l*l-5l 226 1 128 j 256 H*5 201* 116 21*2 137 7.8 6.9 8.0 6.1 7.1* 1*7 7.8 l * . l * 8.8 1*.8 3.1 U.5 7.1 6.5 5-3 3*6 1.2 1.1 6.2 5.8 3.0 2.9 Lbuted 88 59 69 133 j 68 107 52 119 ] 56 fl ilk 79 89 68 29 31* 59 135 97 99 98 109 159 131 55 59 59 60 J 1*7 81* I 55 71 \ 1*6 60 71* 31* 53 1*3' 1*9 86 75 1*8 38 61 50 sncies j j Dreciation J 1 5 ! 7 28 30 21 i 25 7 33 25 .. . . . . .. , .... 2:7 26 # Too high to be significant Source: Perry Mason, op. c i t . , p. 1*0. -85-TABLE VI. REPORTED AND ADJUSTED EARNINGS AVAILABLE FOR INTEREST AND DIVIDENDS OF THREE MAJOR MANUFACTURERS OF ELECTICAL PRODUCTS IN UNITED STATES, 1935, 19l*l AND 1 9 1 * 6 - 1 * 8 ($000,000) Year General Electric Co. Westinghouse Electric Corp. Radio Corp. of America Aggregate Reported Adjusted Reported Adjusted Reported Adjusted Reportedj Adjuste 1935 31.0 30.3 10.8 10.8 5*5 5.U 1*7.3 1*6.5 19U1 60.2 32.5 21.8 8-U 10.5 .5*7 924:. 1*6.7 191*6 1*2.1* 5.6 6.9 -13.5 11.2 2.5 60.5 -5.5 1 9 1 * 7 102.7 -8.2: 52.0 -12-3 19.3 -0.8 171**0 -21.3 191*8 201.5 58.9 53.9' 2.8 21*.6 5.1 28O.O 66.7 Note: The adjusted earnings are i n constant 1935 dollars. Source: Joel Dean, op. cit*,. p. 195. -86-TABLE VII. UNADJUSTED AND ADJUSTED ANNUAL RATES OF RETURN AND PERCENTAGE OVER^ -STATEMENT OF REPORTED INCOME IN SEVEN INDUSTRIAL GROUPS IN UNITED STATES, 1951-56 Industrial classification Average annual rates of return Unadjusted Adjusted Percentage overstatement of reported income Lowest iighest Comments Agriculture, forestry and fishing 3*8 Bituminous coal and l i g n i t e U.Z Construction 3*9 Apparel and related products 3*2 A l l metal manufactures 7*0 Trade U-5 Services il.2 1*8 1.2' 3-3 2.1 5*3 3-6 2*0 1951-30$ 1953-83$ 195U- 3$ 1951-35$ 195ii-ll$ 1951-112$ 1952- 5$ 1956-27$ 195U-7 $j 195640$ 1956-33$ 1951-77$ Adjustment exceeded recorded net income in 5 out of the 6 years Least affected Widest dispersion Small price distortion Source: Slesinger and Hollander, op* c i t . -87-TABLE VIII. WHOLESALE PRICE INDEX, ACCOUNTING PROFITS, CURRENT INCOME AND SAVING OF AUSTRALIAN COMPANIES, 19l*5 - 19l*6 TO 1952 - 1953 (Aim) 191* 5-1*6 1 9 1 * 6 - 1 * 7 19U7-U8 19U8-U9 1 9 1 * 9 - 5 0 1950-51 1951-52: 1952-53 Accounting profits 13& Adjustments for stock appreciation and depreciation Current income -3 131 Current saving (current income less taxes and dividends j 2.8 Current income as percentage of accounting pro f i t j 98 Wholesale price index " 100 16U -15 1 1 * 9 3 0 91 103 197 - 1 * 2 155 221 -li8 173 273 - 7 2 201 1*20 -152 2 6 8 30 23 30 11 3 7 7 -156 221 -1*1 79 117 78 131 74 156 64 189 58 223 368 -4*8 320 83 87 226 Source: Mathews and Grant, op. c i t . , pp. k9 and 9l*. -88-TABLE IX. REDUCTION OF INCOME OF FIVE GIANT CORPORATIONS IN UNITED STATES AFTER ADJUSTMENTS FOR PURCHASING POWER HISTORICAL COST DEPRECIATION, I938 - 1951 Company Type of business Percentage reduction of reported income after taxes Ik year average, 1938-51 Post-war average, 1946-51 Consolidated Gas Public u t i l i t y Steel producer United States Steel California Packing Co. Chrysler Corporation 19 22 Food Processor 1 Durable consumer goods manufacturer Sears Roebuck & Co. Department Store 3 3k 32 12 6* k * The depreciation charge amounted to only 1% of to t a l expenses, thus the price level change effect on income was small Source: Warner,'op. c i t . , p. 632 - 8 9 -I I I . THE CASE FOR PRICE-LEVEL ACCOUNTING FURTHER CONSIDERED The function of income determination At this stage i t may be useful to ask why we measure income.. First,, as a historical record and measurement of what has happened i n the past, the income statement i s a report of stewardship. Further, the income figure i s employed to determine the tax payable and the amount distributable to proprietors.. But the historical record can also be 1 used to assist us i n making decisions affecting the future. The two most important of such decisions are concerned with income as a guide to investment policy and as a measure of operating efficiency. Certain questions now come to mind: 'Is the income figure essential f o r some or a l l of these functions?', 'Is the income concept (or are the income concepts) adequate to perform these functions?' and 'Is income measurement adequate?' Traditionalists have emphasized the role of the income statement as a report of stewardship, of the accounting for the owners of the enterprise by management of the funds that have been entrusted to them. This viewpoint offers a rationale for historical cost accounting. But i t hardly accords with the modern concept of the management function as one of the- risk bearing. In any case, the ready transferability of ownafership i n the corporate sector has deemphasized the significant position of the original providers of funds; the stakes of the new owners are based on current market values. 1. "What people wanted out of corporate income statements was information that would allow them to make decisions affecting the future." George D*. Bailey, op. c i t . -90-It i s , of course, not essential to base the tax structure on the income concept. A capital tax i s wholly feasible and an expenditure 2 tax has been proposed. Further, the income figure for tax purposes 3 is different from either accounting or economic income. It i s a figure determined by statutory provisions which are enforced irrespective of what accountants might consider 'best practice', and which further, can be replaced by a very different set of statutory provisions. ^  Income i s generally believed to be the governing factor i n dividend policy, but there are other considerations: (a) available cash, (b) creditors' protection and (c) maintenance of capital. Where income has been earned, i t does not necessarily mean that dividends can be distributed where there i s insufficient cash. But this qualification i s not a c r i t i c a l one, as i t i s not unknown for directors to borrow, funds for the purpose. In any case the income figure sets the upper limit to dividends, but i t i s less certain that creditors are being protected since past losses need not be made good, nor i s i t clear that capital i s being maintained. Accounting income i s at best a defective tool when viewed as a guide to consumption policy, insofar as i t seeks to maintain money capital 2. See Nicholas Kaldor, An Expenditure Tax, London:, Allen and Unwin,, 193>5 and Suggestions for a Comprehensive Reform of Direct Taxation, Colombo: Ceylon Government Publications Bureau, I960. 3. Surprisingly, Keynes thought Marshall was right to regard as income whatever the Income Tax Commissioners chose to treat as such. See Keynes, op. c i t - , p. 59« U.. For example, the United Kingdom Government has introduced legislation in the f i r s t half of 1962 which treats certain types of capital gains as ordinary income for tax purposes. - 9 1 -and not real capital. In a period of r i s i n g prices, this function must appear a sterile one. But there appears to be a more fundamental objection. The maintenance of capital rule i s bolstered by statute law and an impressive array of early legal precedents, but i t conflicts with the important economic concept that i n a dynamic economy scarce resources should be channelled into competing f i e l d s of investment, , both within a business and between businesses, such that the marginal return on capital i n every sphere of investment i s equal. The conflict, however, i s an apparent one for individuals and unincorporated enterprises, since the owners' knowledge of how much they may consume must be assumed to be a guide and not a determinant of consumption policy. In the case of corporations, other than those which exploit wasting assets, consumption policies, i n order to conform with statutory requirements, are perforce more r i g i d . Though essentially a historical record, the income statement i s often used to aid i n the formulation of future expectations. Manage-ment seeks to maximise returns from different departments or alternative courses of action, and i t s decisions are often based on the results of past performance. In the economy as a whole, investors seek to obtain the best yields available from investment funds at their disposal, and again the search i s based largely on comparative measures of past performance. The interaction of these two sets of investment decisions guides the economy towards operating at optimum efficiency; how closely depends on the realizations of the various expectations. £. See, for example, B. S . Yamey, "The Case Law relating to Company Dividends", reprinted i n Baxter and Davidson, op. c i t . , pp. U2.8-LU2. Later case law which rejects the maintenance of capital rule has not, on the whole, found approval i n the accounting profession. - 9 2 -Income i s then said to measure the operating efficiency of the firm, which can be identified with management efficiency. This is best given by a rate of return on the resources employed i n the previous period(s) ^. Thus the same income concept w i l l serve for an evaluation of management efficiency as well as a guide for those decisions of managers and investors which aim to maximise future expectations. Tentatively, we may conclude that the measurement of income serves two main purposes and a number of less important ones. The f i r s t major function i s a guide to consumption. It i s also a guide, and this i s the more modern concept, to the flow of scarce national resources into alternative f i e l d s of investment. The f i r s t we may term the traditional function and the second the social function of accounts. It i s sometimes contended that there i s no one ideal concept or one ideal measure of income. Rather, i n much the same way as there are different costs for different purposes, different concepts of income must be formulated and different measures computed according to the specific purposes which they are to serve. For example, the most comprehensive concepts are given i n the Hicksian definitions. But because the ex post measures of income include changes in expectations, they are not necessarily a sufficient guide to consumption i n the real world, taking cash flows into account. Again, a useful approach to the measurement 6 . The rate of return as a measure of performance sometimes leads to certain conceptual d i f f i c u l t i e s . See James H. Lorie and Leonard J. Savage, "Three Problems in Rationing Capital" i n Ezra Solomon (ed.), The Management of Corporate Capital, New York: The Free Press of Glencoe, pp. 56-66, and Ezra Solomon, "The Arithmetic of Capital-Budgeting Decisions" i n Solomon, ibi d . , p. 79. There are also criticisms of the application of the rate of return method in decentralized firms with several operating divisions. See John Dearden, "Limits on Decentralized Profit Responsibility", Harvard Business Review,, July-August 1962, pp. 81 -9 . -93-of management efficiency i s given i n the concept of variable income. It i s not a practical measure, however, because of the d i f f i c u l t y of distinguishing between the impact of management efficiency and that of forces external to the firm* Deficiencies in income measurement There i s no one consistent body of general theory into which the accounting principles of income measurement can be f i t t e d . It i s not surprising, therefore, that accounting income i s inadequate with respect to many of the functions that the income figure i s said to serve. There are those that would defend the fundamental truth of doublerentry principles on the ground that they have remained basically unchanged since the fourteenth century. But the circumstances under which corporate enterprise operates today are vastly different, F i r s t , we have replaced the single venture form of enterprise carried on by the Florentine and Venetian traders by a corporate form with very different characteristics, in particular the separation of ownership from management and the continuity of corporate enterprise. A second consideration i s that the Florentine rules are only valid given one of their basic assumptions, the maintenance of a stable price l e v e l . There are, then, the following separate problems in the accounting measurement of operating income: 1. the choice of a satisfactory income concept or concepts, which are i n theory sound and i n their practical application quantitatively measurable and independently verifiable 2. the inadequacy of accounts to measure money income, which can be further analysed to (a) accounting conventions which subsume a stable price level, and -9k-(b) accounting conventions which are not related to problems of changing price levels 3. the inadequacy of accounts to measure real income. The deficiencies i n the accounting process centre around two main, and often closely related, points: the fluctuating value of money and the matching of expenses against revenue in the accounting period. Briefly, defects i n the matching process^abstracting f o r the moment from price level changes, include the application of the realization principle and certain inconsistencies i n the application of the matching principle i t s e l f . Where the production process i s a long one, the value of the product sold has accrued i n earlier periods, whereas some of the expenses charged against revenue pertain to the current period. In other words, revenue i s , i n fact, not matched against costs incurred i n 7 earning that revenue, except on the implied assumption of an even flow of revenue and an even flow of costs. Revenue, i n the economic sense, i s earned during the production process, and not i n the f i n a l sale. A specific example of inconsistency i n the application of the matching principle can be found i n accounting for hire purchase transactions i n 9 some countries as, for example, in the United Kingdom and Australia. 7. This criticism has more or less point according to less or more indirect cost included i n the value of work-in-process carried forward. 8 . "There i s a difference between accounting and economics. In economics (and i n fact), the manufacturing process i s regarded as creating value, but i n financial accounting only the COSTS of manufacture are recognized as matching to the value of the product during the manufacturing cycle; a l l the profit (that i s , the increase i n owners equity) i s recorded at the time of the sale."' R. N . Anthony, Management Accounting, p. 6 2 , Homewood, I l l i n o i s : R. D. Irwin, I960. 9. See, f o r example, Spicer and Pegler, Book-keeping and Accounts, 15 th edition, p. 503 and Yorston, Smyth and Brown, Advanced Accounting, 3rd edition, Vol. 2 . For a proper accounting treatment of hire purchase, see Accounting for Hire Purchase Transactions, monograph published by the Australian Society of Accountants, 1958. -95-Generally, accounting practice has also been deficient i n the recognition of interest. Thus a long-term loan payable to or by the firm i s shown at i t s face value i n money terms, whereas a present value figure would conform closer to economic value and economic income. Similarly, i t i s not generally recognized, at least among English accountants, that where an interest-bearing loan i s issued at a premium (or discount), this i s tantamount to an adjustment of the interest rate, and the premium (or discount) should be written off to the interest account over the l i f e of the loan, with corresponding effects on income determination. Though important in principle, these deficiencies are overshadowed, i n quantitative terms, by the problems i n income measurement caused by changes i n the value of the unit of measurement i t s e l f . The problem of rising prices Let us f i r s t consider the general problem posed by ris i n g prices, which i s the economic condition in most countries today. Changing price levels influence the accounts i n twowayj, which have been termed 10 the money effect and the historic cost effect. The money effect i s relatively easy to appreciate, When prices r i s e , the rentier whose income i s fixed i n money terms as well as the owner of money assets are both worse off i n terms of real purchasing power. Similarly a firm which holds considerable fixed money assets, that i s , cash, book-debts, b i l l s receivable and such w i l l stand to lose from the f a l l i n value of both capital and income in real terms. The converse 1 0 . The following account i s based on W. T. Baxter, "Inflation and Accounting Profits", Westminster Bank Review, May 1952, pp. 1-8. -96-i s also true and a firm with considerable fixed money l i a b i l i t i e s , for example, creditors, preference shares, etc., w i l l gain. It i s less evident, however, that a firm which holds non-monetary assets might also be adversely affected by inflationary tendencies. Oddly enough, the gradual depletion of net worth can be attributable to the working of certain accounting conventions, in particular, the money and realization conventions and the use of historical costs in accounts which result in the overstatement of accounting profit and the consumption of real capital. One of the consequences of adopting the historical cost convention i s that receipts earned on sales i n the current period and expressed i n current dollars are compared with costs, part of which have been incurred i n previous periods and recorded i n dollars of those periods. So long as the monetary postulate holds true, the resultant profit figure i s a meaningful one. But i t ceases to be valid when there i s a significant change in the general price le v e l . Current costs and past costs are expressed in dollars of different purchasing power and are not additive (any more than i s proper to add together Canadian dollars and Malayan dollars), nor i s i t proper to deduct such past costs from current receipts. The use of the realization concept and historical costs thus lead to an overstatement of the true profit figure. Some accountants would deny this and the controversy really rests on whether the protagonists have in mind the money capital or some concept of real capital that they desire to maintain intact. The realization rule i s also said to lead to a distortion of profits between different periods. Where a current asset, say, stock shows an increase i n the current price, there i s clearly an increase in the net -97-worth of the enterprise (other things being equal) i n money terms* Whether there i s also an increase i n net worth in real terms would depend on the nature of the rise i n price, but i t clearly i s not dependent on the sale of merchandise. Much the same applies i n the case of a fixed asset, say, machinery. The fact that the demand for machinery i s a derived demand does not affect the position. Assuming that the general price level has remained stable,' there i s an unequivocal increase i n net worth i n real terms irrespective of whether the rise i n price i s on account of an increase i n the value in use of the machinery i n that particular li n e of endeavour, or i n the exchange value of the asset in some other use (its value i n use in the original firm remaining constant). Again, the increase i n net worth i s not dependent on the sale of the asset, and the principle of income measurement need not be confused with whether property has passed or whether the income i s legally distributable or not. The case for price-level adjustments We have already seen from the empirical evidence of a considerable number of case studies: that the price level error contained i n the reported profit figure i s , i n nearly every instance, a substantial one. Among the most important functions that the income figure i s said to perform is the guidance i t provides to different groups, such as managers, owners, investors, and creditors i n making business decisions. These decisions 11. This and related points are discussed i n two articles by M. J. Greener, "Profit - Fact or Fiction?", The Accountant, October 7 and October 1U, 1961. 12. Greener, ibid*,, agrees that there has been an increase i n net worth i n this last case, but does^not propose to incorporate i t into the accounts. This appears to be inconsistent with his general line of argument. -98-are concerned with choosing between alternative lines of action in the future, and the choice is based on an evaluation of past results. It i s , therefore, important for these results to be presented in as reliable a form as possible, i f the correct decisions i n the economy are to be 13 made. Apart from considerations based on the relationship of income measurement to the decision making process - and i n a dynamic economy these considerations are valid and powerful ones - the case i n favour of price-level adjustments centre round the following arguments: (a) the maintenance of capital (b) tax considerations (c) the influence of reported income data on trade cycle fluctuations. The maintenance of capital The principle of maintaining the capital invested in the enterprise intact i s accepted by both economists and accountants. The terminology is not altogether fortunate, and i t has been suggested that the accountant's task i s better defined by regarding "capital as a value fund that must be accounted for", since to maintain the capital fund 13. There w i l l always be some substantially correct and some substantially incorrect economic decisions. Since the results of only one of the alternative courses of action that existed in the past, that i s , the one actually adopted, are available, i t i s impossible to judge with any degree of certainty whether i t was the best decision. Nonetheless, i f we assume that past results are, more often than not,areliable guide to future events, then decisions predicated on an evaluation of past results are, on an average, more l i k e l y to be substantially correct decisions., With accumulated experience of how the economy works, the relative number of substantially correct decisions w i l l increase, but i t cannot improve beyond the factor of probability that past results bear to future events. lU« See, f o r example, Fisher's adverse comments. Value and Capital, op. c i t . 15. Russell Bowers, "Objections to Index Number Accounting", Accounting  Review, Vol. XXV, no. 2, A p r i l 19£0, p . 15^. - 9 9 -(or to increase or decrease i t ) i s an entrepreneurial rathear than an accounting function. There i s considerable disagreement, however, on the precise meaning of the capital concept i t s e l f . Accountants have always regarded i t as their duty to report on the stewardship of the owners' funds, and thus tend to devote their attention to the money capital invested i n the enterprise. In a period of ri s i n g prices, this interpretation might well lead to a continuous shrinking i n the scale of operations and erosion of real capital. There i s one special case i n which such a contraction might not prove unacceptable to the owners, where the price r i s e i s specific and relates to the stock while the general price level remains stable. Even so, i f the specific price rise i s a continuing or substantial one, i n d i v i s i b i l i t i e s of scale might prove an insurmountable barrier to efficient operation. There i s one other concept of maintaining money capital that should be mentioned. Hayek, i n his analysis of the rationale of maintaining capital intact, concludes that i t i s the income from the capital stock that we should seek to maintain and i t would appear that he has a money income concept i n mind. ^ Most economists, however, conceive of capital i n real terms. Pigou, in his consideration of the national dividend, argues that i t i s the stock of physical assets that should be maintained (subject to exceptions, 16 . "Such a constant income stream (of a workman) in an objective sense might provisionally be defined as consisting at every successive moment of varying collections of commodities actually bought at an aggregate price, by which the collection of commodities actually bought at the beginning of the period might have been obtained". F. A. uon Hayek, "The Maintenance of Capital". Economica .. August, 1935, P- 2 5 0 . -100-such as destruction by acts of God or war). This concept of real capital does not command general support; i n a period of rapid technological change, the concept i s , perforce, a nebulous one. It is seldom that machines on the expiry of their economic l i f e , are replaced by identical ones, though obviously this varies between 18 industries; the concept has greater v a l i d i t y when applied to stocks. Some proponents of price-level adjustments would adapt the constant stream of income theory and argue that the objective of capital maintenance i s to provide a constant stream of real income, that i s , i t i s the purchasing power committed in the investment i n the enterprise that should be maintained. Another school of thought, while conceding that expired assets should be replaced i n the most profitable form rather than by identical units, proposes that i t i s 19 the productive capacity of the plant that should be maintained. Under either of these concepts, as opposed to those incorporating money capital, the enterprise i s protected from the capital eresion effects of risi n g prices, and the economy as a whole from the unwitting process of capital disaccumulation. 17. A. C Pigou, "Net Income and Capital Depletion", Economic Journal, June 1935, PP« 235-41 and Economics of Welfare, London, Macmillan and Co., Ltd., 1952, pp. U5 et seq. 18. Some firms work on the assumption that technological progress w i l l render existing machines obsolete every five years. In industries such as tobacco and brewing the rate of innovations i s leisurely, i n others such as plastics and aircraft the rate of innovations i s exceptionally rapid. 19. Wendell P. Trumbull, "Price-Level Depreciation and Replacement Cost,"1  Accounting Review, Vol. XXXIII, No. 1, January 1958, pp 26-3U. -101 -Tax considerations There are several factors that tend to dampen the i l l effects of inflation on the erosion of capital. These are, for example, the application of the conservatism principle, the existence i n some firms of large depreciation reserves, the current transfers to reserves and what might be termed as generally accepted best practice i n the accounting 20 profession. But a reported profit figure which has been inflated by historical cost accounting procedures does entail certain problems. It might be thought by some that labour should have a larger participation i n the prosperity, and the trade unions might well exert pressure for an increase i n wage rates. Further, shareholders might look askance at what they consider an unreasonably conservative dividend policy. But the most important consideration i n this context i s the high rate of corporate taxation i n most countriesj i t i s this which has lent impetus, among academics and professional accountants alike, to the current search for a more meaningful income measure. The government i s a partner i a a l l profitable enterprises, and distribution of profits by way of taxation i s not within the discretion of the board of directors. There are, then the following important tax considerations: (a) Whether the distribution by way of taxes and dividends are paid out of profits which are determined after sufficient funds have been retained to maintain the real resources invested i n the enterprise. Otherwise, the tax on profits w i l l be partly a tax on capital and the payment of dividends might, i n fact, constitute a repayment of capital. 20. These are discussed i n the following chapter. -102-(b) Equity between the firms paying tax. The profits tax represents very large transfers of funds between individual firms and the government. It would, therefore, be desirable for the tax burden to be as f a i r l y shared as possible between the individual firms. But equity, i n this as i n a l l things, i s a matter of value judgment. We can, how-ever, note some of the effects of reported profits based on orthodox accounting conventions on the incidence of the tax burden. In the f i r s t place, the profits of firms holding large stocks and machinery w i l l be particularly distorted by the historicalccost error, and they w i l l be paying considerably more tax than other firms with the same r e a l income. There i s then a tax bias i n favour of the less capital intensive firms (and industries). Secondly, there i s also a tax bias i n favour of new firms, firms which buy new rather than second-hand machinery, and firms which purchase machinery at high prices. There w i l l also be an incentive for firms to replace their equipment early because of the ava i l a b i l i t y of i n i t i a l and investment allowances, as i n the United Kingdom (even 21 though repairs are treated for tax purposes as a current charge). * To conclude, the tax bias w i l l tend to distort the pattern of investment, not necessarily i n favour of the more efficient firms in the economy. ^ 21. The employment of these allowances constitutes an unsatisfactory compromise with the problem of maintaining capital in an inflationary period. 22. See Peter Wiles, "Corporate Taxation based on Replacement Cost", Accounting Research, Vol.. 2, No. 1, January 19f>l, pp. 77-82. - 1 0 3 -Trade cycle fluctuations The errors i n accounting profit i n periods of price movements have long been familiar to economists, and their probable effects on trade 2 3 cycle fluctuations recognised. More recent analyses of this phenomenon can be found i n the writings of Lacey ^ and Baxter. 2 ^ Briefly, accounting conventions tend to distort the profit figure when prices change through the comparison of revenue expressed in todays's dollars with certain costs expressed in dollars of past periods* Such costs comprise the valuation of the consumption of stock and fixed assets in the revenue earning process. Baxter concludes that "the depreciation error tends to make the high-price years (both before and after the peak) look better, and the low-price years look worse* The stock error instead l i f t s profits in a l l years when prices are rising, and depresses profit throughout the down-grade It appears reasonable to conclude that an error so widespread and so emphatic in i t s rhythm must have a considerable 26 influence on business sentiment." Overstatement of the accounting profit encourages an optimistic outlook i n times of inflation, while i t s understatement adds to the pessimistic outlook in times of depression. Thus the a r t i f i c i a l element i n accounts affects the level of employment, incomes and prices and intensifies trade cycle fluctuations. 23» One of the earliest analysis i s given i n F. Schmidt, Die Industriekon-junktur-ein Rechenfehler (Trade cycles - An Accounting Error), 1 9 2 7 i n which profit distortion was regarded as one of the major causative factors of trade cycles (Quoted by H. W. Singer, i n a note on "Profit Measurement and the Trade Cycle", Economic Journal, December 1914-8, p., 596)* See also Friedrich.A* Hayek, Prices and Production, London: George Routledge and Sons, Ltd., 1935, p. 151 and Gottfried Haberler, Prosperity and Depression, op. c i t * , pp. 1 * 9 - 5 0 * 21** K. Lacey, "Profit Measurement and the Trade Cycle", Economic Journal December 1 9 1 * 7 , pp. 1 * 5 6 - 7 1 * . 25. W. T. Baxter, "Inflation and Accounting Profits", Westmister -^ ank Review, May 1952, pp. 1-8 and The "Accountants Contribution to the Trade -loU-25. (Contd-) Cycle", Economica, February 1955, PP« 99-112. 26* "The Accountant's Contributioh to the Trade Cycle", ibid, p. 112., - 1 0 5 -IV. THE CASE AGAINST PRICE-LEVEL ACCOUNTING So far we have considered the arguments i n favour of a structure of accounts which would take p r i c e l level' changes into consideration. This envisages a revolutionary approach i n a profession characterised by a traditional and conservative frame of mind.. The arguments appear over-whelming ones and a merely negative attitude towards new horizons i n the development of accounting theory and practice would be unhealthy. But. there exists a strong body of opinion which a*©- not i n favour of change, or at least, of precipitate change. ^  Some of their criticisms do not stand up to c r i t i c a l examination:, many are t r i v i a l or based on misunderstandings of the proposed changes while some appear to cancel out one another. But others are more damaging, both with respect to the general principle of price level adjustments and the specific proposals themselves. A few fundamental criticisms raise very complex issues, to which no adequate answers can be given at present. In the present chapter we sha l l examine some of these counter-arguments, and, i n s i f t i n g the wheat from the chaff, try to obtaini a clearer picture of the fundamental d i f f i c u l t i e s that remain-1. See Recommendations on Accounting Principles,, op. c i t . , especially N12 and N15; Edward B. Wilcox and Howard C Greer,, "The Case Against Price-Level Adjustments i n Income Determination", Journal of Accountancy, December 1950,, pp. U 9 2 - 5 0 k ; Morris A. Copeland, "Suitable Accounting Conventions to determine Business Income", Journal of Accountancy,, February 1 9 1 * 9 , PP« 107-llj A. R. Prest,, "Replacement Cost Depreciation" 1, Accounting Research,, Vol. 1, No., 1*, July 1950, pp. 385-1*02; James L. Dohr, "Depreciation and the Price Level", Accounting Review, Vol. XXIII, No. 2, A p r i l 19l*8,, pp. 115-8; D. H. MacKenjsie, "Contemporary Theories of Corporate Profits Reporting", Accounting Review, Vol. XXIV, No. U, October 19h9, PP* 3 6 0 - 8 ; Eugene L. Zieha, "Accounting under Conditions of Changing Prices from the Debtor and Creditor Viewpoint"', Accounting Review, Vol. XXVIII, No. h, October 1953 , pp.S2/-33; James L. Dohr, "Limitations on the Usefulness of Price Level Adjustments"',, Accounting Review, Vol. contd - 1 0 6 -The two main principles which form a l o g i c a l base for historical cost accounting may be termed the 'formalized accounting' principle and the 'contract' or 'risk' principle * Under the formalized accounting principle, income is the matching of expenditures " against revenues to which they relate* This formal statement describes what the accountant does; i t is a definition of historical cost rather than a formulation of a conceptual principle. C r i t i c s have pointed out that the adoption of replacement costs is not a departure from the cost principle; that replacement costs are economic costs and the relevant costs for decision making; and that current costs are the only valid additive costs, since past costs perforce refer to money units pertaining to different periods. It has also been pointed out that under conventional accounting procedure, where a historicalccost depreciation figure has resulted i n higher reported profits when prices r i s e , this i s equivalent to a tax on the capital gains on depreciable assets;, since such gains appear.-, as a component of operating income. Conversely, when prices f a l l , lower profits result in a tax allowance on the capital loss. ^ We do not propose to enter into the controversy whether the taxation of capital 1. (contd*) XXX, No. 2 , A p r i l 1955, pp. 198-203; Abraham J. Briloff,, "Price Level Changes and Financial Statements: A C r i t i c a l Reappraisal", Accounting Review, Vol. XXXIII, No. 3 , July 1958, pp. 38O-8; etc. 2 . See Taxation and Research Committee of the Association of Certified and Corporate Accountants,, Accounting for Inflation,, London: Gee and Company (Publishers) Ltd.., 1952, pp. U6-51 . 3 . H. Norris, "Profit: Accounting Theory and Economics", Economica, August 19U5, quoted i n ibid., p. ki-ll* Alexander, op. cit.., reprinted i n Baxter and Davidson,- op* cit*,, pp. 198-9* -107-gains or a special class of capital gains i s ju s t i f i e d , or whether such gains should be taxed on the same as or a different base from ordinary income* The fallacy i n the conventional accounting process l i e s i n not distinguishing this important class of capital gains. The second principle i s a philosophical and ethical one. ^  It implies that the inadequacy of the depreciation provision in periods of inf l a t i o n is a business risk, and "attempts to contract out of such risks are attempts to secure preferential treatment at the expense of 6 the community." This argument i s not, however, a valid one, since under present accounting procedure there i s a corresponding advantage, when prices f a l l , , i n the tax allowance on the capital loss. The adoption of replacement cost accounting i s thus seen to involve the substitution of a different kind of risk, i n which capital gains and losses on account of changing price levels are distinguished from operating income. "The point at issue i s , should an existing form of r i s k be forced on industry instead of another simply because of a coincidental development of accounting technique and f i s c a l practice,, when there are significant theoretical arguments as well as compelling and urgent 7 practical reasons why i t should not."1 1 It has sometimes been asserted that there has been 'no real decline i n the value of money, and that the changes that do take place are not sufficiently large such as to affect the accounts i n any substantial 5. H. A. Briscoe, "A Case for Orthodox Profit"', The Accountant, July 7th, 1951, quoted i n Accounting for Inflation, op. c i t . , p. 50. 6. Accounting for Inflation, op»- oit«rf ^—gQ-.-~(ibid)-. 7. I b i d . p . 51. These compelling reasons subsume that capital gains are not taxable, or at least taxed at lower rates than income. - 1 0 8 -fashion. The assumption that there w i l l be no continuous f a l l i n the value of money was one of the considerations that led the Royal Commission on the Taxation of Profits and Income to reject arguments i n g favour of replacement cost depreciation. The assumption has not been ju s t i f i e d i n the light of hindsight, 9 but, i n any case, a more r e a l i s t i c approach might have been to consider alternative lines of action. Case studies in price l e v e l accounting have demonstrated that the effect on the profit figure of a relatively snail annual change i n the price level i s of a significant order of magnitude. Further, there i s also a cumulative effect, through the depreciation charge, of the price level changes i n past years. The argument has also been put forward that i t i s d i f f i c u l t , perhaps impossible, to measure changes i n the general price level with any substantial accuracy, "*-0 and some support for this can be found i n the viewpoints of certain statisticians. ^ But the consensus of opinion among most economists and statisticians i s that the employment of index numbers for the purposes for which they have 8 * The Royal Commission on the Taxation of Profits and Income was appointed by the United Kingdom Government on January 2 ! , 1 9 5 1 . It published three reports, the f i n a l report i n June 1955* See also David Walker, "The Royal Commission and Depreciation Allowances", Accounting Research V o l . 6, No. k} October 1 9 5 5 , pp. 3 6 0 - 8 1 . 9. . See footnote 8 i n Chapter I I . 1 0 . See for example, Wilcox and Greer,, op. c i t . and Changing Concepts of  Business Income, pp. 1 1 2 - 1 1 8 , 1 2 7 , 129, . etc. See also Recommendations on  Accounting Principles. Nl5,$ Price Level Changes and Financial Statements Supplementary Statement No. 2'j and Joel Dean, "Measurement of Profits f o r Executive Decisions"',. Accounting Review, Vol. XXVI, No. 2 , A p r i l 1951 , , P« 193 for a presentation of the pros and cons of t h i s classic problem. 1 1 . There i s a particularly violent attack on the theory and use of index numbers in M. J. Moroney, Facts From Figures , Penguin Books Ltd., pp. 14.8-54. -109-12 been constructed i s v a l i d and j u s t i f i e d . Index numbers are i n fact frequently used in determining wages paid by government or industry, i n wage negotiations between employers and trade unions, and sometimes 13 even in the prices paid by o f f i c i a l bodies for primary produce; they are also employed by management i n policy making and by economists and others i n analysing and interpreting the economy as a whole or i t s individual sectors* The proposal, therefore, to employ index numbers within a comprehensive structure of price l e v e l accounting would appear a feasible one. What i s essential i n any such system is a general body of theory that has claim t o conceptual v a l i d i t y rather than arithmetic accuracy, since approximation i n greater or less degree i s inherent i n the theory of index numbers itself.. It is necessary to substantiate, however, that a system of accounts based on the use of index numbers which take price level change (or changes) into consideration results i n a profit figure which is significantly different from the conventional accounting one, that the revised figure conforms to a theoretically acceptable notion of what income means, and, above a l l , that i t possesses greater u t i l i t y to users, i n particular, management, f o r different 12.. For example, no strong criticisms of the use of index numbers are found in the writings of such authorities as M.. G. Kendall* 13* "Many farmers (in the United States:) when they s e l l to the Commodity Credit Corporation receive prices that are related to the Parity Index, which measure changes i n the prices of products bought by farmers."1 Werner Z Hirsch, Introduction to Modern Statistics, New Yorkj Macmillan Co., 1957, p* 215- On the linking of wages to prices by employing index numbers andother techniques see E* M. Bernstein,, "Wage-Prince Links i n a Prolonged Inflation"', IMF  Staff Papers, Vol* VI, No* 3 , November 1958, p. 323, and A* K. Sen Gupta,, "Survey of Wage-Prince Links i n Various Countries"', Appendix J II i n Bernstein, op., cit*,, pp* 3 4 3 - 6 8 . -110-enterprises and under varying economic circumstances. So long as the adjusted profit figure consistently satisfies these conditions the charge that i t i s not an accurate figure i s adequately refuted. There i s also a related argument that a general price index does not reflect the price movements of i t s components, which might change at different rates or even in different directions. This criticism has more weight the further removed is the base year or the more pronounced the fluctuations i n the general price l e v e l - a classic index number lit problem which has long been considered by economists. However, i n the absence of abnormal conditions such as war or the threat of war, the criticism is much weakened where a new index i s constructed or the old series; i s converted to a new reference base frequently, say, every decade. Further, the argument i s primarily directed against the advocates of a 16 general purchasing power index and does not apply to those price-level systems i n which specific price indices are employed. ^ This 18 particular aspect i s examined at some length by Edwards and Bell who lh« Keynes thought the plurality of secondary price levels at least as significant (and i n the short run perhaps more so) as general purchasing power. J. M. Keynes, A Treatise on Money, London: Macmillan and Co., Ltd.., 1930, Vol. I, pp. 93-h. 15* For example, the Wholesale Price Index and the Consumer Price Index series published by the United States Bureau of Labour Statistics have been recently converted from the old 19U7-U9 base to a new reference base, 1957-59 = 100.. 16* See, for example, Price Level Changes and Financial Statements, Supplementary Statement No. 2, op. c i t . 17. As proposed by Mathews and Grant, op. c i t . , and others. 18. Edgar 0. Edwards and Philip W. Bell, The Theory and Measurement of  Business Income, Berkeley and Los Angeles: University of California Press, 1961. See especially pages 19-21 for s t a t i s t i c a l documentation based on data i n F. C. Mills The Behaviour of Prices and the index series published by the United States Bureaatof Labour St a t i s t i c s . - I l l -give i t a central place i n their thesis, which argues that correcting for individual price changes i s the more important adjustment and must be made f i r s t before the income figure i s adjusted f o r changes i n the general price l e v e l . Some of the criticisms as for example, on the part i a l character of adjustments which do not take gains and losses from the holding of 19 money and money assets into account, have been overtaken by subsequent developments i n price-level accounting theory and case studies. None-theless the emphasis placed on the adjustments to stock and the depreciation figure can be defended on several grounds; these two adjustments are quantitatively the most major ones i n the computation of operating 20 income. It i s also objected that the large number of alternative, and i n some cases conflicting, proposals would render the f i n a l acceptance of price level accounting by the profession and the business community more d i f f i c u l t . On the other hand, i t can also be argued that the p r o l i f i c number of proposals at the present experimental stage i s not only to be expected but also desirable. While i t is undoubtedly true that the adoption of adiversity of methods would create undue confusion and destroy the basis of comparability between the accounts of different companies,such an event i s unlikely to arise. The good senge of the accounting profession, the deference i t s members display towards the recommendations of the leading professional institutes and the necessity to conform with tax and other legislative requirements are a l l powerful 19* Wilcox and Greer, op. c i t . , p. U9i?. 20. The arguments presented by Mathews and Grant, op. c i t . , are given i n the following chapter. -112-forces towards a certain degree of uniformity. There w i l l perforce be a transitional period during which interested sectors of the business economy w i l l no doubt be somewhat confused and perturbed. This i s inevitable with any changes of the scope and dimension envisaged,, but a prophecy of an unduly protracted period of chaos rests on slim grounds. It i s possible that price level change adjusted statements w i l l be presented as supplementary statements i n the i n i t i a l stages of the change, eventually becoming the primary documents with orthodox accounts relegated to secondary importance. Thus comparability w i l l be preserved i n the transition period. There are also insufficient reasons to fear that members of the accounting profession might not proved equal to the 21 task: their a b i l i t i e s i n t h i s direction have been amply demonstrated. Further, as has been pointed out, price level adjustments are most essential for those companies which are quoted on the stock exchanges, and 22 such companies have competent accounting personnel. The case against the replacement cost theory ^ The replacement cost theory is often treated as synonymous with the concept of a replacement fund, that i s , the income of an enterprise i s 21. See Jones, Price Level Changes and Financial Statements Case Studies  of Four Companies, op. c i t . , p. i v . 22.. George 0. May, in comment on Wilcox and Ggeei>, op. ci t . , ; Journal of Accountancy, December 1950, pp. '50k-S» 23. Many of the criticisms of price-level accounting are developed at some length i n Wilcox and Greer,, op., c i t . -re-determined after provision has been made for the replacement of assets consumed i n earning that income. ^ Hhis would appear to presuppose that the enterprise has an indefinitely long l i f e ; i t is clear that the concept i s not meant to apply to those enterprises which exploit wasting assets. The assumption i s not altogether unreal: the l i f e span of the large industrial and commercial corporations i s a long one and there i s some evidence of a trend towards increasing longevity. There i s also the additional factor of uncertainty i n the termination of corporate existence; the latter, unlike the l i f e of a man, i s not determinable by actuarial standards. These considerations are buttressed by legislative provisions for the protection of creditors. The convention that income i s properly determined by the difference between the sale price and the original cost of the commodity sold works well enough i n periods of stable prices or where each transaction i s treated i n isolation. In an inflation, however, when replacement costs r i s e , the consumption of income without taking such increased costs into account must lead to a contraction i n the scale of operations of the enterprise and eventually to i t s liquidation. The h i s t o r i c a l costs convention i s seen as a definition of income that has; served well in the past, rather than as an axiomatic truth irrespective of changed economic conditions. 2h- This is the definition of economic income given i n Some Accounting  Terms and Concepts, op. c i t . 3 p. 3 0 , which further notes that i t constitutes one of the more important distinctions between the economic and accounting concept of income. Some accountants would reject the replacement cost concept, regarding i t as an invalid confusion of income measurement and cost recovery on the one hand and funding, a managerial function, on the other. The rationale of this viewpoint i s taken up i n the following chapter. 25.' See R.. Ma, "Births and Deaths i n the Quoted Public Company Sector i n the United Kingdom, 191*9-53", Yorkshire Bulletin of Economic and Social Research Vol., 12!, No. 2, November I960, pp. 92-3. - l i l t -There are various objections to the employment of replacement cost depreciation. One is that fixed assets are seldom replaced in kind, but the replacement concept assumes the maintenance of the physical capacity of the plant, not each actual machine. A' weightier criticism i s that the maintenance of physical capacity makes sense only in a static or slowly evolving economy. The modern economy i s characterised by technological advances, often of a revolutionary nature» against this background the controversy between money capital and r e a l capital loses much of i t s significance. *° It i s also claimed that i n view of technological progress the cost of new equipment of stated capacity tends to f a l l from year to year, so that maintaining the value of equipment by reinvesting depreciation funds w i l l involve some expansion of physical capacity. 27 i f t h i s viewpoint i s correctly taken, then conventional depreciation methods 4o provide some counterweight to the erosion of fixed assets by r i s i n g prices. It has often been claimed that one of the merits of historical cost depreciation i s that i t pinpoints efficiency, since a firm with a management far sighted enough to purchase i t s fixed assets when prices are low w i l l show consequentially larger profits (because of the-lower depreciation charge). This marriage of past and present efficiencies 26. "If a machine i s replaced with one that reduces the direct labour costs, or increases productivity, i t would (hardly seem reasonable to base depreciation on the cost of this new machine before i t has been purchased." D. H.. MacKenzie, Op. c i t . This i s har-ly a f a i r criticism; proponents of replacement cost depreciation would recommend incorporating an allowance for the increased productivity i n the adjustment. 27. Encyclopaedia Brittanica, op. c i t . , Vol. 7, p. 230 - 1 -115-implicit in the argument i s i l l u s t r a t i v e of the muddled thinking too often brough to bear on accounting problems. There are certain criticisms centred round the concept of a replacement fund and i t s sufficiency. It would hardly appear necessary to point out that even where an amount equivalent to the depreciation charge is set aside each year and invested i n a fund, the market value of which keeps pace with r i s i n g replacement costs, only that portion which was set aside i n the f i r s t year would have appreciated by the necessary extent.. But such a fund would meet evenutal replacements costs i f the annual premiums were based on current price levels; no further cS|hrge need be made i n any year for increases i n the price l w e l over that i n a past year. It i s also probably true that depreciation allowances charged i n the f i r s t years of l i f e of a new enterprise constitute a general reserve, and that current costs of replacement are met out of depreciation provisions i n current years on an increasing volume of fixed assets. This i s not to argue that depreciation should not be chafed i n the i n i t i a l years. We are concerned here with one specific aspect of the replacement problem, that i s , whether more than sufficient resources have not been retained to provide for the replacement of fixed assets. True, this would conflict with the economic concept of income as the amount that can be distributed without encroaching on the accumulated resources of the enterprise. But the more generally accepted concept of income as change in economic net worth would require a depreciation chaarge which i s equivalent to the consumption of the fixed capital i n the period. In any case the existence of such reserves would be a bulwark against encroaching prices. But these hidden reserves, by their very nature, are limited i n -116-extent and once exhausted cannot be replaced. In some years, however, substantial fixed capital expenditure might be financed out of accumulated depreciation allowances unspent in earlier years of depression. It has also been claimed that d i f f i c u l t i e s would arise when the price change does not l i e on a consistent trend, but there are instead irregular short-term fluctuations. Thus when the replacement cost of an asset rises for a number of years and thendeclines shortly before replacement is due, the company would, be holding surplus cash resources while i t s income statements i n prior years might have recorded d e f i c i t s on account of the inflated depreciation charge. Under reversed circumstance insufficient cash resourses are matched by substantial accumulated earnings* The import of the criticism i s not altogether clear, but these sorts of situationoould arise irrespective of whether price l e v e l depreciation i s adopted or not. Abstracting from extraordinary situations, doubt has also been expressed that replacement cost depreciation would provide for the amortization of an asset's original cost,, taking good years with the bad. This is attributed to two factors: (a) since expansion takes place and newplant additions are made at or near the peak of a trade cycle,, the purchase price of a machine would be higher than i t s average cost 29 over the entire period of a c y c l i c a l movement,, and (b) because of 28. For example, i n 193U-36 i n the United States. See R. F. Henderson The New Issue Market and the Finance of Industry, Cambridge,, Massachusetts: Harvard University Press, 1951* P« 51* 29. This assumes f u l l employment of resources i n both capital goods and consumer goods; industries before the peak of the cycle. - 1 1 7 -technological improvements the real cost of machinery, either i n terms' of productivity or effective l i f e , tends to decrease. The replacement cost depreciation figure i s equal or higher than the original cost only when inflationary tendencies have a greater effect than the above 3 0 influences. Largely because of tax considerations, an alternative approach widely adopted in the United States i n the 1 9 2 0 's was the appraisal and writing-up of fixed capital, on which values the revised depreciation charges were then based, despite considerable opposition from an i n f l u e n t i a l section of the accounting profession. Though the appraisals were performed i n the main by qualified engineers and valuers, i t w&s believed that I deliberate overstatement amounting to gross misrepresentation took place A 31 i n a'.large number of cases. The subsequent write-downs necessitated by the depression of the following decade, given i n the table below,,. add weight to the earlier misapprehensions. On the other hand, the reappraisals i n the corporate sector i n the United Kingdom i n recent years appear to have been conducted i n a f a i r and objective manner. One rather unexpected feature was broughtto l i g h t j there i s some indication that part of the large discrepancies between the book values and replacement cost new values of fixed assets which have necessitated i n their revaluation can be attributed to the excessive writing-off of fixed assets by way of larger than necessary depreciation provisions 32 i n past years* 3 0 . See also Jean St* G. Kerr, "Three Concepts of Business Income"', Australian  Accountant, A p r i l 1956. 3 1 . J * Fred Weston,. "Revaluations of Fixed AsBflts", Acnnnnti ng Review, Vol. XXVIII, No. 3 , July 1953, p. U86. 3 2 . See, for example, Imperial Chemical Industries Ltd*, Annual Report For the Year 1950, p. 32. -118-TABLE. WRITE-UPS AND WRITE-DOWNS OF PROPERTY, PIANT AND EQUIPMENT,. 1925-193U: 272 LARGE INDUSTRIAL CORPORATIONS (Unit: US $ 1 , 0 0 0 , 0 0 0 ) Year Write-ups Write-downs Net Write-ups 1925 28*3 12.8 15.5 1926 65.9 2k.k 111-6 1927 23.2 1 6 4 6..8 1928 2 6 . 3 68 .U -1*2.2 1929 Ih.k 128.6 - l l i i . 2 1930 2h.h 16.7 7*7 1931 5.9 19U.7 -188*8 1932 his. 251*5 -251.U 1933 0.1 117.3 -117 .2 193U n»s* 117 .U -117.3 Note: n*s* denotes 'not significant'. Sourcer S.. Fabricant, Capital Consumption and Adjustment, New York: , National Bureau of Economic Research, 1938, p. 213. Lastly we may take note of the argument that the making of an increased provision on account of higher replacement costs "has the ultimate effect of relieving posterity from the necessity of finding additional capital to meet raised price levels; and i f the present generation bears this cost i t w i l l i n effect be denying i t s e l f of part of the product of i t s own industry, i n order to make a g i f t by way of capital accumulation to those who come hereafter.""^ 33* S. W* Rowland, Depreciation Reconsidered,, Gee and Company (Publishers) Ltd*,, 1933, P* 3* - 1 1 9 -Stock is the other item i n the accounts for which some method of replacement cost accounting has been f e l t to be necessary* There i s one criticism relating to fixed assets which applies with considerably less force to stock, since stock is often replaced i n kind. But proponents of replacement cost accounting would probably wish to apply the concept even where the enterprise deals i n a constantly changing stream of commodities* There i s , however, a large body of opinion which deprecates the useof the "last-in,, first-out" principle i n accounts, which is the most widely used method of correlating sales with replacement cost* -^Its supporters have long abandoned the theory that Lifo i s a method of inventory valuation; they claimrather that i t i s 3U* A special committee of the American Institute of Accountants i n i t s report considers "the prime purpose of the 'last-in, f irst-out' principle ....* i s to bring about, i n the determination of profits i n the financial accounts, a substantial correlation between sales prices and those raw material prices w hich have been directly causative of such sales prices". (Quoted i n Changing Concepts of  Business Income, op. c i t * , p. 3 9 * ) . This viewpoint suggests that actual replacement of the stock is not a prime consideration i n employing L i f o * 35* See, for example,, AAA, Accounting Concepts and Standards underlying  Corporate Financial Statements, Supplementary Statements No. 2 „ August 1951 and No. 6 , December 3 1 , 1953 j W* A., Paton, Advanced  Accounting. New York, l?l|.l* pp. Il * 5 - 7 ; Wilcox and Greer, op. c i t . ; Maurice Moonitz,., "The Case Against Lifo as an Inventory-Pricing Formula"', Journal of Accountancy, June 1953'* PP* 6 8 2 - 9 0 ; E. B. Wilcox, "The Rise and F a l l of Lifo" 1, Journal of Accountancy,, February 19U8, pp. 9 8 - 1 0 3 ; Ubhn W* Coughlan,, "The Guises of Replacement Cost"' Accounting Review, Vol. XXXII, No. 3,, Jgly 1957, pp. k3h-h7, etc. The proponents of Lifo have been equally vociferous, as f o r example, see Maurice E. Peloubet,. "Has Lifo Fallen?", Journal of Accountancy, Ap r i l 19U8, pp. 2 9 8 - 3 0 3 ; H* T. McAnly,, "The Case for L i f o * It Realistically States Income and Is Applicable to Any Industry", Journal of Accountancy, June 1953* PP* 6 9 1 - 7 0 0 ; Arthur Hobson Dean, An Inquiry into the Nature of Business Income under Present Price  Levels, February 191*9, PP* 2 1 - 3 ; George 0 . May, Business Income " and Price Levels An Accounting Study, July 1, 191*9, pp. 1*3-6. - 1 2 0 -a flow of cost method. But i t can hardly be denied that the wide acceptance of Lifo i s not based on any theoretical considerations;; i t l i e s i n the effects on tax l i a b i l i t y i n inflationary periods.. In the United States, where express authorisation was written into the law i n 1938, ^ the employment of Lifo has become extremely popular. ^7 By contrast this method has only limited application i n the United Kingdom,, where the courts have always been unfavourably disposed towards i t s adoption f o r tax purposes.. ^ At best i t i s but a partial approach to the price level problem. It does not represent a departure from the principle of cost recovery, the adherence to which has given rise to some of i t s main deficiencies. Lifo tends to eliminate stock appreciation profits, thus sufficient resources are retained within the enterprise to maintain a constant stock turnover. But the method has also the unfortunate effect of relating the figure of closing stock (in the balance sheet) to aiprice l e v e l of many years or decades ago. The proposal that companies employing Lifo i n their 3 6 . Changing Concepts of Business Income, op. c i t . , p. 3 9 . 37* About one-third of the 600 companies included i n the AICPA Survey of Accounting Trends and Techniques, as shown i n the corporate reports for 1958,. use Lifo. Arthur Anderson and Company, Accounting  and Reporting Problems of the Accounting Profession, September I960, p. 3 8 . Minister of National Revenue v. Anaconda American Brassy Ltd. (1955)> A l l England Law. Reports,, 1956, Vol. 1, p. 20 et. sea. It was held that Lifo i s not an acceptable method for determining income for income tax purposes. The actual physical flow cannot be regarded as irrelevant,, and a r e a l i s t i c assumption must be made to identify the flow and the inventories with historic costs. This viewpoint appears to be contrary to an obiter dicta of Mr. Justice Croom-Johnson in Inland Revenue Commissioners v. Cock, Russell and Co. Ltd. (1959), The Times Law Reports, Vol. LXV, 19u9, p. 726, "Profits for income tax purposes .... are to be computed as a business man employing sound principles of commercial accounting would compute them, subject ot any statutory modification of such principles". -121-accounts should disclose the replacement value of their closing stock has often been made but this has not been generally accepted. It has been claimed also that Lifo f a i l s to eliminate price fluctuations that took place within, the accounting period; this point has l i t t l e v a l i d i t y when purchases are made at frequent intervals. A more substantial objection i s that the smooth working of this method depends on a relative s t a b i l i t y of the base stock i n quantitative terms. Otherwise, not only is the matching of cost and revenue jeopardised, but the method i s susceptible to abuse by management who can influence the reported income for the year by manipulating the level of closing stock* Where the purchasing policy i s a seasonal one, or speculative and irregular, Lifo would probably f a i l to give as close an approximation to economic income (that i s , sales less cost at current price levels) as some alternative method such as "next-in, first-out".. But for a majority of industrial and commercial enterprises i t seems to provide a practicable method of replacement cost accounting for stock, and i n the United States one that i s acceptable to the income tax authorities* Under certain circumstances:, the method is not so effective as employing actual replacement costs or specific index number adjustments to the stock figure. There i s one objection that is not relevant, that i n the absence of changes i n the general price level, the so-called inventory profits are real and should not be eliminated. ^ 9 The replacement cost concept and the general purchasing power concept represent two different approaches to price l e v e l accounting with fundamentally different objectives. 39' See Accounting Concepts and Standards underlying Corporate Financial  Statements, Supplementary Statement No. 6, op. c i t . Wilcox and Greer op* cit*,, also c r i t i c i z e Lifo against the context of the purchasing power approach* - 1 2 2 -The case against the purchasing power theory The purchasing power concept seeks to determine income after "revenues and charges against revenues are stated i n terms of units of the same purchasing power". ^° The way to achieve this i s to make adjustments based on "the over-all purchasing power of the dollar, that i s , changes i n the general price level as measured by a GENERAL price index."^ Adjustments based on the current value or replacement cost of assets are specifically excluded. This method does- not represent a departure from cost, rather i t seeks to restate historical costs i n current dollars of equivalent purchasing power. It seeks to maintain intact the capital i n terms of the units of purchasing power represented by the capital investment. It i s clear, therefore, that where the replacement cost of stock or fixed capital equipment i s changing at a different pace (or direction) from that of the general price level, the physical capacity of the enterprise i s not maintained. Whether price level accounting should concern i t s e l f primarily with replacement i s an important question that w i l l be considered i n the following chapter. A main objection to this method derives from the alleged inaccuracy of a general price index; the pros and cons of this case have been noted earlier. A weightier consideration is the d i f f i c u l t y of applying these index number adjustments at frequent intervals in order to obtain adjusted unit costs of production. Such unit cost figures might be kO. George 0 . May, Business Income and Price Levels An Accounting Study, published by the Study Group on Business Income, July 1 , 1 9 U 9 , p. k-2.. Hi.. Accounting Concepts and Standards underlying Corporate Financial  Statements,, Supplementary Statement No. 2 , op. cit., -123-required monthly or weekly for purposes of price fixing, budgeting or formulating other managerial policies.. So far the purchasing power school has been concerned mainly with income measurement and the proposed systems embrace end-of-year price level adjustments. D i f f i c u l t i e s of a complex nature are l i k e l y to arise i f i t i s desired to make short term current price level adjustments which are then carried into constantly changing stocks of work-in-progress, finished parts, etc. The criticism i s not, however, altogether relevant to the role of a purchasing power concept i n income determination. ' Not a l l accountants would agree that these complex d i f f i c u l t i e s are indeed insurmountable. In the f i r s t place, the entire accounting structure employed in the firm would have been reorientated towards price-level accountingj the mechanics of price level adjustment would be built into the accounting and costing system. Secondly,, where transactions are coded by date of occurrence and the amounts converted i n i t i a l l y into beginning-year dollars, then adjustments at the end of a current month would involve no more than converting a l l accounting figures by a single factor, to take account of the price level change between the beginning of the year and the current month. (It i s presumed that a monthly index i s employed and that i t i s considered not desirable to have more frequent adjustments). Admittedly, d i f f i c u l t y would be experienced with perpetual inventory records- The solution of this and other problems might require some ingenuity and the use of sampling techniques. -12U-1*2 Edwards and Bell have argued that while the general price level adjustment i s an important step towards truthfulness i n accounts, i t does not provide the necessary data for the evaluation of past decision on which business policy making can be based. It is proposed instead that the current values of the firm's assets should be recognised and current operating profit determined before the adjustment for the general price level change i s made. Tax considerations Much of the interest in price level accounting has arisen i n the post-war years of inflation. When prices rise i t i s alleged that the employment of orthodox accounting conventions, including the " f i r s t - i n , f i r s t - o u t " method of inventory valuation, does not maintain capital i n real terms.. To meet this problem i t has been recommended that replacement costs which exceed the depreciation charge based on historical cost should be met out of transfers to reserves. ^ But even where a cautious dividend policy i s pursued, i t i s claimed that high rates of taxation on an unduly inflated profit figure often prove prohibitive and firms are then unable to finance the maintenance of their fixed capital equipment, much less an expansionist policy, out of retained profits. This argument is often objected to on various grounds. One i s that economic development would be retarded i f there is insufficient outlet for an expanding capital market, 4^ a n ( j ^  ^ s a i s o argued that even where dividends have been paid 42* The Theory and Measurement of Business Income, op. c i t -43« See, for example, Recommendations on Accounting Principles, N12, op. c i t . 44. Abraham J. B r i l o f f , "Price Level Change and Financial Statements: A C r i t i c a l Reappraisal", op. c i t . -125-out, that part which is not consumed would be reinvested in industry though not necessarily i n the same firm. With respect to the above points, while i t i s desirable for new investment opportunities to be created to absorb new funds in the capital market, i t might be less desirable for a part of such funds to be u t i l i s e d for the maintenance of existing industrial capacity, as opposed to an expansion of such capacity. Further, i t i s much more expensive for a firm, and for industry as a whole, to resort to the capital market for funds compared with methods of internal financing, with undesirable effects on industrial efficiency and the rate of economic development. Smaller firms, in particular, w i l l be adversely affected as i t i s relatively more expensive for them to resort to methods of external funding. It i s true, of course, that part of the profits taken by way of taxation i s reinvested in the public sector, often in the provision of social overheads that lead to increased industrial efficiency, taking a longer term of view. But how genuine i s the complaint that the burden of taxation i n recent years has become a penalty for effort? It would appear, so far as the United Kingdom is concerned, that i n the last decade taxes on income fcapital and expenditure, when expressed as a ratiojffof the gross national product, have been on the decline. y £ Further, countries k5- "The following table shows the true state of a f f a i r s : Taxes on income, capital and expenditure as a percentage of gross national product 1951 - 3 1 * 3 1 9 5 6 - 2 6 . 2 1 9 5 2 - 3 0 . 3 1 9 5 7 - 26.3 1 9 5 3 - 2 8 . 3 1 9 5 8 - 2 6 . 2 195k - 2 7 . 3 1959 - 25-9 1 9 5 5 - 2 7 . 6 I 9 6 0 - 25-1 "It should be said that to include national insurance and health contributions i n taxation makes no difference to the general picture." F. livesey,, in letter to The Observer, Sunday, February 18, 1 9 6 2 . -126-such as West Germany and France, which have been taxed more heavily, U6 have also exhibited higher rates of economic growth. However, economic growth rates are subject to a large, and imperfectly understood, number of factors. Part of the reason for the economic revival on the Continent might be attributable to a relatively lenient tax treatment of retained earnings. While one company by adopting price level accounting would pay less tax when the price level rises, the same result i s unlikely to obtain for the corporate sector as a whole. There i s , of course, the pos s i b i l i t y of a planned cut i n government revenue should the lower adjusted profits in fact successively dampen the upward swing of the business cycle; f i s c a l policy i s concerned not only with the raising of revenue for finance, but also the mopping up of surplus purchasing power. Some c r i t i c s are more concerned with the inequitable distribution of the incidence of taxation between companies. It has been demonstrated, however, that assuming i t i s desired to maintain the level of government revenue then a substitution of replacement cost accounting for historical cost accounting i n the quoted company sector i n the United Kingdom i n 1950 and 1951 would have the following effects: (a) companies with larger than average stock appreciation and increases i n the prices of i t s durable assets would gain, (b) many companies most important to the prosperity of the economy, that i s , companies i n the basic and export industries, would be adversely affected, and (c) the practical effects on the incidence of taxation would not have been 46. See note i n National Institute Economic Review, March 1 9 6 l . •127 significant, though the selected years experienced the greatest amounts of stock appreciation since the war. These results appear to suggest that i f the incidence of company taxation generally i s too great, the rates of taxation are more in need of reform than the tax base i t s e l f . 4 7 Some Social problems We may, then^cautiously conclude that accounting conventions produce a distortion in reported profits. This distortion, i n times of rapid price change, may be significant enought to render the p r o f i t figure of doubtful u t i l i t y as a policy guide to management and owners. A new income concept which attempts to correct for price level changes, however, mifeht raise economic and social problems which extend beyond the boundaries of ) R income measurement. Some of these problems are: (a) The incidence of tax has always been relatedymoney income. If i t i s generally agreed that i t would be more equitable to tax companies on their real incomes, the problem of the other taxpayers i n the economy remains. There.is, of course, one important distinction. The consideration i n the corporate sector i s one of maintaining existing industrial capital, with far reaching results on the rate and direction of economic development; that ih the case of the other taxpayers i s more a question of mitigation of personal hardships. (b) Apart from the problem of an equitable readjustment i n the tax burden, the question also arises as to whether the new income concept i s to apply to other economic relationships, affecting i n particular the legal rights between debtors and creditors, and g e n e r a l ^ a l l long term contractual obligations.. When prices f a l l , the new income concept would permit a return of part of the money capital; this might tend to weaken the existing legislative safeguards for creditors' protection with respect to a return of owners capital. - 1 2 8 -G. C. Harcourt, "The Quantitative Effect of Basing Company-Taxation on Replacement Costs", Accounting Research, Vol. 9 , No.l, January 1958, pp. 1-16. See, i n particular, Recommendations on Accounting Principles, N 15, op. c i t . It has been pointed out that this criticism holds only i n the case of the purchasing power approach and does not apply to the replacement cost approach. Accounting for Inflation, op.cit., p. 57* -129-V. PRICE LEVEL ADJUSTMENTS: PRINCIPLES Purchasing power historical cost versus current cost There are two main contending schools of thought among proponents of price level accounting. Though the differences are sometimes presented as a choice between the employment of an overall general price index or specific price indexes which are relevant to the particular firm or industry, the dichotomy between the two schools i s , i n fact, a wide and basic one. The advocates of a general price index ^ are concerned primarily with changes i n the value of the measuring unit in accounts. The use of a general price index is a s t a t i s t i c a l technique intended to correct errors introduced by such changes. It does not constitute a departure from a historical cost base nor from the conventional concept of income as sales less historical costs. Indeed the proposed system i s sometimes referred to as a purchasing power historical cost system. In the general price level accounting system, historical costs are converted into constant-value units and a l l items i n the accounts are expressed at the price level of a selected base date or period. ^ There i s also sometimes 1. For example, see American Accounting Association, Price Level Changes  and Financial Statements, Supplementary Statement No. 2; R. C. Jones, Price Level Changes and Financial Statements Case Studies of Four  Companies, op. c i t . , and Effects of Price Level Changes on Business  Income, Capital and Taxes, published by American Accounting Association,, 1956, Appendix A, pp. 173-81; ty. T. Baxter, Inflation and Accounting  Profits, op., c i t . ; etc. 2. In some proposals the average-of-year price level i s used, i n others the accounts are expressed in end-of-year prices. The la t t e r system has the merit that adjusted balance sheet items are also in end-of-year dollars. - 1 3 0 -d i s s e n t a s t o t h e m o s t a p p r o p r i a t e g e n e r a l p r i c e i n d e x , t h o u g h , a s i n m o s t c o u n t r i e s w h e r e n o t m o r e t h a n o n e s u c h o f f i c i a l i n d e x i s p u b l i s h e d r e g u l a r l y , t h e s o p h i s t i c a t i o n o f t h e d i s t i n c t i o n l i e s o n a n a c a d e m i c p l a n e . I n t h e U n i t e d S t a t e s , t h e W h o l e s a l e P r i c e I n d e x a n d t h e C o n s u m e r s P r i c e I n d e x , b o t h p u b l i s h e d b y t h e B u r e a u o f L a b o u r S t a t i s t i c s , , h a v e t h e i r r e s p e c t i v e s u p p o r t e r s * O n t h e w h o l e , t h e C o n s u m e r s P r i c e I n d e x i s p r e f e r r e d , p a r t l y b e c a u s e i t c o r r e s p o n d s c l o s e l y t o t h e i m p l i c i t p r i c e d e f l a t o r s e m p l o y e d i n t h e c o m p u t a t i o n o f t h e g r o s s n a t i o n a l p r o d u c t ; i t i s a l s o l e s s v o l a t i l e t h a n a w h o l e s a l e p r i c e i n d e x . 3 T h e o r e t i c a l l y t h e c h o i c e w i l l d e p e n d o n w h e t h e r p r o f i t s a r e p a i d o u t t o s h a r e h o l d e r s o r p l o u g h e d b a c k i n t o t h e f i r m . , I n t h e f o r m e r c a s e , a c o n s u m e r s p r i c e i n d e x w o u l d b e t h e r e l e v a n t o n e t o e m p l o y , s i n c e i t i s t h e o w n e r s ' p u r c h a s i n g p o w e r t h a t i t i s d e s i r e d t o m a i n t a i n i n t a c t . S h o u l d t h e p r o f i t s b e r e t a i n e d i n t h e f i r m , h o w e v e r , t h e u s e o f a w h o l e s a l e p r i c e i n d e x w i l l c o n f o r m m o r e c l o s e l y t o a n i n c o m e c o n c e p t t h a t i s c o n c e r n e d w i t h t h e f i r m ' s c o m m a n d o v e r t h e g o o d s a n d s e r v i c e s t h a t c o n s t i t u t e i t s i n p u t s . W h e r e , a s i n t h e l a r g e n u m b e r o f c a s e s , p r o f i t s a r e p a r t l y d i s t r i b u t e d a n d p a r t l y r e t a i n e d , s o m e c o m p o s i t e f i g u r e c o m p i l e d k f r o m c o m b i n i n g t h e t w o i n d e x e s m i g h t b e t h e b e s t s o l u t i o n . B u t e v e n w h e r e a l l p r o f i t s a r e d i s t r i b u t e d , s t i l l n o t a l l d i v i d e n d s a r e c o n s u m e d a n d p a r t w i l l b e r e i n v e s t e d i n i n d u s t r y . 3 * F o r a n a c c o u n t o f t h e i m p l i c i t p r i c e d e f l a t o r s d e v e l o p e d b y t h e U n i t e d S t a t e s D e p a r t m e n t o f C o m m e r c e , a n d t h e a d v a n t a g e s g e n e r a l l y o f e m p l o y i n g t h e C o n s u m e r s P r i c e I n d e x , s e e J o n e s , E f f e c t s o f P r i c e  L e v e l C h a n g e s o n B u s i n e s s I n c o m e , C a p i t a l , a n d T a x e s , o p . c i t . , . A p p e n d i x A . U . S e e A c c o u n t i n g f o r I n f l a t i o n , o p . c i t . , p . , 57. -131-An income figure revised for changes i n the general price level would not, of course satisfy the conditions set out by one economic 5 concept, that of maintaining the r e a l resources of the f i r m . Nor does i t measure the value of the services consumed in the income earning process.. To achieve these aims i t has been proposed that the adjustments should pertain not to changes in the purchasing power of the dollar,, but to changes in the current prices of the specific assets employed in the firm. The theoretical j u s t i f i c a t i o n of current costs can be b r i e f l y stated. The discussion here w i l l be confined to an aspect of stock flow, that of pricing the issue of stock to production. To the economist the relevant concept of cost i s opportunity cost, which i s related to the problem of allocating scarce resources between alternative uses. Thus the satisfaction of one want always involves doing without something else. The true cost then i s the foregoing of the alternative.. The alternative foregone i n issuing material to production i s selling the material or holding i t . The opportunity cost i n the f i r s t case is the  value of sale at current prices, in the second case, the value of sale at current prices plus the interest on the proceeds from the date of valuation to the date of sale. If the issued stock were valued at 5 . Ibid.,, pp. 52 et seq. See also Some Accounting Terms and Concepts, op. c i t . , p. 3 0 ' 6. Accounting for Inflation, op. c i t . , Institute of Cost and Works Accountants, The Accountancy of Changing Price Levels, London, 1952j Edwards and B e l l , op. c i t . -132-replaceraent cost, that i s , the cost of purchase at current prices, this would be an approximation to the opportunity cost concept. (At one remove, i f we allow the possibility of the unit issued to production being replaced before a subsequent issue i s made, the application of Lifo w i l l give effect to what resembles a replacement cost base.) Edwards and Bell have developed two alternative concepts of p r o f i t based on a current cost approach: realizable profit which i s based on the valuation of assets and l i a b i l i t i e s at their opportunity costs or market exit values, and business profit which i s based on market entry 7 values, that i s , the current costs of acquiring the inputs used. The current cost approach i s often identified with the narrower replacement cost concept.. Various such price-level systems have been proposed; i n the main they advocate adjustments by means of (a) market values, (b) appraisals, or (c) specific price indexes. Conceptually, the use of market values - the test of the market place- i s superior to that of applying specific price indexes to the accounts. Edwards and Bell, for example, countenance the employment of appraisals or price indexes only where market values are unabtainable or inappropriate because of technological change. It should be emphasized, however, that market values are a good indication of economic values only when certain conditions are present - a large number of buyers and sellers who bargain at arm's length and actual transactions take place at prevailing prices. Such markets are unlikely to exist for many second-hand assets. Further, market values and appraisals would introduce a subjective evaluation into the accounting process and open the door to fraud and deliberate distortion c7-« Edwards and Bel l , i b i d . -133-of the income figure- Index numbers, where these are published by the government or independent bodies, are at least objective and not susceptible to manipulation by management. The arguments i n favour of making adjustments i n terms of general purchasing power are: (i) This i s the correct approach i f we assume that in f l a t i o n has become a serious economic problem and that the s t a t i s t i c a l error in accounts induced by inflation i s significant, ( i i ) The use of replacement cost indexes or other devices w i l l give, at best, a partial correction for the s t a t i s t i c a l error i n the accountsj this w i l l tend to vary inversely with the dispersion i n the secondary price levels, ( i i i ) Specialized index numbers are d i f f i c u l t to employ under conditions of rapid technological change, as for example, when the replacement cost of an existing piece of equipment i s 8 unduly high because i t i s fast becoming obsolete, and (iv) A general price index prepared by a government authority gives certain advantages of promptitude, impartiality and pr a c t i c a b i l i t y . The use of different indexes by individual firms can lead to window-dressing and fraudulent manipulation of accounts. It has also been claimed that a uniform index gives a more equitable distribution of the tax burden, between firms. 8 . Effects of Price Level Changes on Business Income, Capital, and Taxes, op. c i t . , pp. 174-5* -13li-On the other hand, advocates of the alternative system helieve that the price dispersion error i s more significant than the error caused by infla t i o n . 9 It i s not proven, however, that the dispersion is so great that i t invalidates the concept of the general price l e v e l adjustment. After a l l , economists and entrepreneurs alike constantly make decisions based on the assumption tlhat^-prices i n general are moving up or down. The problem rather i s , how w i l l general purchasing power adjustments affect a firm employing specialized plant i n producing a specialized product? So far as maintaining the physical plant or productive capacity of this firm i s concerned, i t is evident that serious deficiencies or over-provision might arise. With respect to the more general case, the most cogent arguments for specific price level adjustments are centred round the entrepreneurial functions. These adjustments are clearly necessary towards the formulation of a sound capital budget policy with respect to plant maintenance and replacement and the expansion of production f a c i l i t i e s . They are also relevant to dividend' policy, where emphasis i s 3a i d on the productive capacity of the firm rather than on what this productivity represents, i n terms of general purchasing power, to i t s owners. Certain criticisms of the purchasing power approach which relate to 10 a wider sphere than that of the individual firm have been made. To be logically consistent the principle must be extended to a l l assets including money and money assets. This i n fact i s advocated under the variant systems of stabilized accounting. It is argued that such 9. Edwards and Bell, op. c i t . , pp. 19-21. 10. Accounting for Inflation, op. c i t . , pp. 57 et seq. -135-attempts to remove the inflationary element in the accounts w i l l only accentuate the inflationary process, since otherwise part of the excess purchasing power present i n an in f l a t i o n would have been absorbed by r i s i n g prices, which deprive consumers and businesses of some of their a b i l i t y to obtain the things they originally intended to purchase* 'T^ws Argument would appear, however, to contain a weakness: the firm's command over goods and services can only be maintained at the expense of i t s owners and the government. A second criticism that stabilized accounts imply the i n e v i t a b i l i t y of continued inflation and reduces confidence in the currency and the public willingness to hold i s basically a psychological argument which cannot be verified i n any objective sense. There i s more weight to a third argument, that stabilized accounting which aims to maintain purchasing power in the corporate sector i n times of inflation requires the principle,, i n order to maintain consistency, to be extended to other economic relationships, such as wages, fixed interest and a l l other incomes. Such an extension of principle to the other sectors of the economy i s not called for under the replacement cost approach. It i s also said that the purchasing power school i s inconsistent i n i t s treatment of capital gains and losses this point i s developed i n a subsequent section. The distinctions between the two sets of proposals are important* On a conceptual plane, we are once more faced with the problem of definin real capital* The use of a general price index conforms more closely to the definition of capital as command over goods and services, while the employment of specific price indexes reflects the emphasis on replacement costs and maintaining the scale of operations. Real capital -136-i n the latter case is thus conceived in terms of physical units of plant, or, in a more sophisticated version, units of productive capacity. The significance of the distinction for accounting theory needs to be stressed. The use of a general price index does not constitute a departure from historic cost accounting, whereas the substitution of current prices i n accounts introduces a new concept of income as sales less replacement costs. It i s well nigh impossible to predicate a choice between these two r i v a l proposals on theoretical grounds alone. Both claim to r e f l e c t the Hicksian theory of income determination. In the one, emphasis i s l a i d on the consumption policy of the owners, and i n the other, on the productive capacity of the firm. Both viewpoints are v a l i d ; perhaps the f i r s t i s more related to the welfare of the individual investor, the second to industrial growth and economic progress. Where i t is proposed to apply both specific and general prices indexes (in that order)1"'', then the system r e a l l y incorporates both a new concept of income and adjustment for the s t a t i s t i c a l error i n accounts. Comprehensive versus par t i a l adjustments There i s a further problem which i s closely related to the differences i n the two concepts of real worth discussed above. The historic cost error arises from differences i n price levels at two different periods of time, so that assets consumed i n the current period are valued i n conventional accounting at the price level of earlier periods (in which they were acquired). The two items i n the determination of operating 11. Edwards and Bell, op. c i t . -137-income that are most affected by price level changes of this nature are the depreciation of fixed assets and the cost of goods sold. But'/ a change i n the economic worth of an enterprise which arises from a price l e v e l gain or loss can be attributed to holding as well as trading a c t i v i t i e s . While i t i s true that the composition of assets is primarily a financial and not a trading problem, i t might yet constitute the most important entrepreneurial function, particularly when the uncertainty of the economic climate i s reflected in significant price movements in the firm's inputs, br finished products or both. Holding gains, l i k e trading gains, are a guide to managerial efficiency. A further classification, then, can be made between those accountants who would confine price l e v e l adjustments to the operating statement only and others who take a comprehensive view of business income. The purchasing power approach i s essentially a comprehensive one. It has been pointed out, however, that there i s an inconsistency i n this system i n the treatment of capital gains. Assets i n the balance sheet are adjusted to the current purchasing power of their historical cost. Thus purchasing power price movements of assets are recognised and excluded from income as they occur. Capital gains or losses on the relative price movements of assets (that i s , where they diverge from movements i n the general price l e v e l ) , however, are recognised only on sale of the assets. Thus the income figure includes both operating income and the capital gain (or loss) on assets sold on account of the difference between current cost and adjusted historical cost. 12 . See Myron J. Gordon, "The Valuation of Accounts at Current Cost"', Accounting Review, Vol.. XXVIII, No. 3 . July 1953, pp. 373-81}. -138-A comprehensive approach can also be found i n some of the current cost accounting systems. A particularly rigorous development of such 13 an approach i s that contained in the system of Edwards and B e l l . J The authors advocated the use of market values rather than replacement cost indexes, except where market values are not obtainable. Conceptually current costs and market values can be assumed to be the same, except where the market i s imperfect, as with specialized equipment* In this system, a more consistent treatment of capital gains^also termed holding gains, i s obtained. Holding gains are of two kinds: the gains or losses on fixed assets and long-term l i a b i l i t i e s and those on money and monetary assets and l i a b i l i t i e s . Apart from the depreciation charge, the appreciation i n the current values of fixed assets and long-term l i a b i l i t i e s are unrealized. Further, that portion which i s part of the general price rise represents a monetary or unreal p r o f i t ; only the excess of the difference i n current values over the difference generated by the inflationary process can be considered r e a l . The treatment of holding gains and losses on money and monetary assets and l i a b i l i t i e s i s basically the same i n both the purchasing power and current cost approach. With regard to these assets unreal income cannot arise. There i s a real loss on holding money and money assets (such as accounts and b i l l s receivable) when the general price level rises and a real profit when i t f a l l s . The converse i s true for current l i a b i l i t i e s , which may be regarded as a hedge for money assets: thus some accountants 13o Edwards and Bell, op* cit.. -139-speak of a net monetary position.. It i s more d i f f i c u l t to classify the gains from holding money and monetary net assets, and in view of the rapid turnover of such items the assumption is usually made that a l l such purchasing power gains and losses recorded in the period have been realized. •>> The term 'comprehensive' has been used above in a technical sense to apply to those systems which place emphasis on adjustments to the balance sheet as well as the income statement, and i n some systems regarding such adjustments as part of income. Advocates of the other school argue that their own treatment gives an adequate expression of true income. This school i s mainly confined to proposals which advocate or sanction the use of specific price indexes to ensure that the replacement costs of fixed assets and inventories are wholly taken into account. This i s the approach of Mathews and Grant i n their study of the effects of 17 inflation on the Australian corporate sector. It is also the approach contained i n the proposals for price-level accounting of the (English) Institute of Cost and Works Accountants. The price-level Ik* For example, see Mason, op. cit.., pp. 10-11. 15>. Doubts have been expressed with regard to this assumption. For example, see Baxter y "Inflation and the Accounts of Steel Companies", op. c i t , p. 253-16. For a detailed analysis of the importance of holding gains, see Edwards and Be l l , op. c i t . 17. The authors emphasize that their proposals do not constitute a system of replacement cost accounting. It i s a system of historical cost accounting f o r purposes of profit measurement, with supplementary adjustments to provide a record of the current cost of depreciation and stocks sold or used. Mathews and Grant, op. c i t . , p. 21. 18., The Accountancy of Changing Price Levels, op. c i t . -lUO-accounting system contained i n the proposals of the (English) Association of Certified and Corporate Accounts i s very similar i n i t s emphasis on 19 the current valuation of fixed assets and inventories. While they recommend that this principle should be extended to the remaining assets, the proposal is given very cursory treatment and, i n any case, the effects of their valuation on a current base are insulated from the income account. It i s of interest to note the arguments of Mathews and Grant against making price l e v e l adjustments i n respect of money and monetary assets and l i a b i l i t i e s . F i r s t l y , increases i n the value of inventory caused by in f l a t i o n are usually financed by a corresponding increase i n short term l i a b i l i t i e s , i n particular bank overdrafts and creditors. There i s , therefore, the poss i b i l i t y that the revision to income on account of inventory revaluation and the consequent effect on a reserve account w i l l be n u l l i f i e d i f we also take the effect of the i n f l a t i o n on the larger volume of money l i a b i l i t i e s into account. Secondly^while there are strong practical grounds for providing for the maintenance of real capital, i t i s more d i f f i c u l t to j u s t i f y attempts to maintain the purchasing power of money assets, partly because these would represent a departure from the orthodox accounting role, and partly becasue they would raise wide social problems of equity i n taxation and debtor-creditor relation-ships. ^ 19• Accounting for Inflation, op. c i t . 20. Mathews and Grant, op. c i t . , pp. 21-3•• -ua-Should capital gains be regarded as income Alexander considers that one of the three main conceptual problems 21 i n income theory i s the inclusion versus exclusion of capital gains. An expected gain, as for example, that on an appreciation bond, i s clearly income. It would appear that for most purposes an unexpected gain should also be regarded as income. For tax considerations, the a b i l i t y to bear taxes i s certainly higher* Capital gains cannot be regarded, as has been contended, as merely a revision of an e s t i m a t e t h e r e must have been a pr o f i t at some stage. But capital gains tend to be concentrated i n time, that i s , at the point of sale of the asset. Hence i t would appear equitable to tax such gains at a reduced rate. It i s interesting to note that i n accounting procedure, where a historical cost figure for depreciation has led i n an inflation to higher reported profits, this w i l l lead to the spreading of taxation on an important class of capital gains over the l i f e of the asset, since such gains w i l l appear as a component of operating income. When prices 22 f a l l , there w i l l be a corresponding tax allowance for the capital loss. Not a l l advocates of comprehensive price level systems would agree on the above viewpoint. It must be admitted that at least so far as the long-term assets and l i a b i l i t i e s are concerned, the windfall gains 21* Alexander, op. c i t . , i n Baxter and Davidson, op. c i t . , p. 199* The other two conceptual problems are real versus money income, and accrual versus realization as the criterion for timing of a gain or loss. 22. Ibid*, pp. 196 et seq. -1U2-are contingent on a continuation of the current price trends, or at least on the maintenance of the current price l e v e l . Therefore, while i t might be useful to compute such unrealized gains there i s no general consensus of opinion as to whether such gains should be included i n the income statement, or i f they are so shown, that segregation of real and unreal or monetary holding gains i s important* Mason presents some of the arguments for and against the inclusion of pmchasing power gains and losses i n the income statement thus: "There are differences of opinion as to the proper location in the adjusted financial statements of the purchasing-power gains and losses. Some f e e l that a l l such amounts should appear in the income statement i n order to show more completely the eurrent effect of price-level changes.. It can be argued, however that unt i l the bonds are paid and the cash balance i s spen&, such gains and losses are unrealized and should, therefore, not appear in the current operating statement. S t i l l another interpretation i s that the rapid turnover of the current assets and l i a b i l i t i e s j u s t i f ies showing the gains-and losses on the net current monetary position i n the income statement, but that so-called "gains" or "losses" on bonds payable are not income or loss to the business enterprise as such but are rather capital adjustments between the bondholders and stockholders - as prices ri s e , there is a tentative or provisional shift of interest^ from the bondholders to the stockholders and when prices f a l l , the reverse movement takes place 22a.. Perry Mason, PricegLevel Changes and Financial Statements, op. c i t . , pp. 23-U. -1U3-There i s also an important theoretical consideration in favour of excluding purchasing power gains from income. It has been asserted that they partake more of the nature of capital profits of a temporary character, rather than ordinary income, ^hey should therefore be reinvested so as to secure the owners in perpetuity an additional income 23 equal to that which i s consumed during the transition period* APPENDIX. A NOTE ON DEPRECIATION Fixed assets are conventionally shown at cost of purchase less accumulated depreciation. This is now a statutory requirement under the English 19U8 Companies Act, so far as the published accounts of public companies are concerned.. ^  Under the straight l i n e method, the annual depreciation factor i s determined by a simple equation - cost less 23. Hayek, "The Maintenance of Capital", Economica, August 1935, p. 2 6 4 . 2 l | . The purpose of this requirement i s not altogether clear (and so f a r as this writer knows, the point has never been discussed). An unwarranted respect for historical costs would appear insufficient reason. It is>probable that for a going concern, a ratio might exist between i t s fixed assets and the depreciation provision which could be considered healthy. Under the 50 Per Cent Theory i t i s believed that where plant i n a stable firm consists of various assets of different ages f i f t y per cent -would have been depreciated (see James C. Bonbright, The Valuation of Property, New York and London: McGraw-Hill Book Co*, Inc., 1937, p. 209). But the ratio w i l l depend on a number of factors: whether the firm i s expanding or contracting, whether i t purchases second-hand plant or sells existing plant* There seems scope here for an empirical study. -1UU-scrap value divided by the estimated number of years of l i f e . In many cases the scrap value i s regarded as n i l or insignificant. The l i f e of the asset which i s the shorter of the l i f e determined by (a) physical wear and tear, taking the maintenance policy of the firm into account, (b) obsolescence, and (c) where a machine has been installed to exploit a wasting asset, the period of exploitation, or i n the case of a machine with a specialized function the period determined by the effective and sufficient demand for i t s products.. The convention of providing for depreciation has a long history more ancient than the double entry principle i t s e l f . As far as Roman times, the author of a text on architecture l a i d down the rule that i n valuing a masonry wall, one-eightieth of i t s cost should be deducted f o r each year i t has stood, assuming that such a wall has a l i f e of eighty years. Here i s a clear recognition of depreciation based on historical cost and of the straight line method as well. ^ But i t i s clear that there i s considerable confusion with regard to the nature of the depreciation factor, as practised by accountants. It has been described variously as a loss, a provision for a loss, a recovery of a loss, a decrease i n the value of assets and a maintenance of assets. It i s evident i t cannot be a l l these things. According to Bonbright, the technical meanings attached to the term 27 "depreciation" are variants of four basic concepts: (a) impaired serviceableness 2$. Quoted in Henry R. Hatfield, "What they say about Depreciation", Accounting Review, Vol. XI, No. 1, March 1936, pp. 18-26. 26. Ibid. 27. Bonbright, op. c i t . Vol. I, p. 183. -1U5-(b) f a l l in value (c) difference i n value, and (d) amortized cost. Bonbright, however, was concerned primarily with problems of property appraisal. The more restricted connotation that accounting theory gives to the term i s borne out i n the following definitions: "Depreciation i s an accounting charge for the cost of durable property spread over i t s economic l i f e . Depreciation covers wear and tear from use, physical deterioration from age and exposure to the elements and obsolescence, that i s , loss of usefulness arising from a v a i l a b i l i t y of newer and more efficient types of goods serving the same purpose" "Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage ( i f any), over the estimated useful l i f e of the unit (which may be a group of assets) i n a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is t he portion of the total charge under such a system that i s allocated to the year. Although the allocation may properly take into accountoccurrences during the year, i t i s not intended to be a measurement of the effect of a l l such occurrences 28. Encyclopaedia Brittanica, op. c i t . , Vol. 7, p. 230. 29' American Institute of Accountants, Accounting Terminology Bulletins, Number 1, Review' and Resume, 1953, p. 25* - 1 1 * 6 -"Broadly speaking, depreciation is the loss, not restored by current maintenance, which i s due to a l l the factors causing the ultimate retirjraent of the property. These factors include wear and tear, decay, * 30 inadequacy and obsolescenee". "Plant cost i s an extreme form of prepayment; depreciation accounting 31 is the means by which such prepayment i s assigned to production". Depreciation i n the accounting sense is s t r i c t l y a systematic method of cost allocation; i t is a bookkeeping entry designed to spread the cost of purchase of the asset i n some equitable manner over i t s effective l i f e . T n e confusion may be traced to what the accountant i s doing and what i s generally assumed (by the layman, i f not by the accountant himself) that he is doing. He i s not: (a) measuring the decrease i n the value of assets, (b) setting aside funds for the replacement of assets, or (c) charging cost to production. Let us take each of these points i n turn. Depreciation must be distinguished from depletion which is the 32 using up of a wasting asset, such as a t i n ^ mine. The depletion concept reflects a reduction of value.. But the situation i s different for a fixed asset which is not also a wasting asset., ^he value of the 3 0 . United States Supreme Court, i n Lindheimer v. I l l i n o i s B e ll Telephone  Somapny, 292 U. S. l£L ( 1 9 3 U ) , quoted in ibid.., p. 2 0 . 31. W. A. Paton and A. C. Littleton, An Introduction to Corporate  Accounting Standards, American Accounting Association Monograph No. 3 , 1 9 5 5 , p. 88. 3 2 * But contrast this principle with the definition of the National Association of Railroad and U t i l i t i e s Commissioner (Report of Special Committee  on Depreciation, "Depreciation Principles and Methods", 1 9 3 8 , pp 8-10) which includes "among the causes to be given consideration .... the exhaustion of natural resources." (Quoted in Accounting Terminology  Bulletins, op. c i t . p. 2 1 ) . -147-asset may f a l l through a decrease i n future earning capacity, either i n absolute, physical terms throughwear and tear, i n relative physical terms through the production of more efficient machines, or i n money terms through a decline i n the demand for i t s output. The value of the services rendered by the machine may decline evenly over time through wear and tear or the original volume of services may be maintained for the greater part of i t s llljte with a steep f a l l i n the 33 last few years. The depreciation provision, on the other hand, when plotted presents a smooth curve which does not take recognisance of non-mathmatical factors. Depreciation must also be distinguished from fluctuations i n market price, as for example, the f a l l in market value of a one day old car. Depreciation, of course,* does not "provide funds"., The confusion here i s , f i r s t l y , between a bookkeeping entry and a separate financial transaction* Secondly, the object of the capital maintenance rule is to maintain the capital invested i n the enterprise intact, i n money terms at least, and not the individual assets, ^he point, however, might have been overemphasized. Admittedly, only trading revenue can provide funds, but a charge for depreciation does retain funds which might other-wise have been distributed., ^urther, given a stable price level and the general state of arts, and where profits are being made, then a strong case might be made for a replacement of asset motivation i n the depreciation concept.- Certainly most economists believe this i s the most important 33. See Earl A. Saliers, Depreciation, Principles and Applications, 3rd edition, New York, 1939, p~ 84, quoted i n G. T. Webb, Depreciation  og Fixed Assets in Accountancy and Economics, The Law Book Co. of Australasia Pty. Ltd., 1954, P» 11. -U i8 -function i n providing for depreciation, which figure they take to represent the value of the fixed assets consumed i n production. ^5 The decision to replace the asset has, of course, no relationship to the depreciation provision, and i t i s d i f f i c u l t to understand how this misconception of the accountant's function i n charging depreciation could have arisen. The decision to replace must be based on an opportunity cost concept, how best to u t i l i s e scarce resources; i t i s furthermore an entrepreneurial function. The misunderstanding between accountants and economists on the nature of depreciation arises partly from the different emphasis they have l a i d on i t s two aspects. The accountant has been concerned with the debit side of the depreciation entry, with cost recovery and income measurement. The economist, on the other hand, has been largely concerned with i t s credit aspect, that i s , the maintenance of fixed •y/L capital consumed i n the production process. 34. For example, J. A. Hobson, The Science of Wealth, 193U, P» 72j R. A. D. Egerton, "The Capital Coefficient and the Rate of Depreciation" 1, Economic Journal, March 1953, p* 112j F. W. Taussig,, Principles of  Economics, 3rd edition revised, New York, 1921,, Vol.. 1, pp. 77-85 G. D.. H. Cole, Money - Its Present and Future, London. 1944, pp. H I and 295j R* G. Hawtrey, Capital and Employment, London,. 1937, pp* hi? 80 and 95; Edward Cannon,-, Wealth, 3rd edition, London, 192.8, p. 155; and others given i n G. T. Webb, op. cit... p. 113 et seq. See also Some Accounting Terms and Concepts, op. cit.,, p. 30. 35* Keynes,, however, distinguishes between user cost depreciation and depreciation on account of the effluxion of time and obsolescence. 36. Keynes was also conerned with the effect of the large depreciation provisions in companies accounts on the levels of economic activity and employment. J. M. Keynes, The General Theory of Employment  Interest and Money,- op. c i t . , pp. 98-104. -11*9-It has also been claimed that one of the principal purposes of providing for depreciation i s "to recover the cost of the asset from the selling price of the product of the asset during the useful l i f e 37 of the asset". A problem i s posed when certain costs are incurred in an earlier period, but the services rendered extend over subsequent periods. These costs, irrespective of how they are allocated to later periods, might be very different from current price levels; past costs are then mistakenly identified with 'actual' costs of production.. The essence of historical cost accounting i s to relate yesterday's costs to to-day's income and the degree of distortion i n the income figure i n a period of changing price levels depends on the capital intensity of the productive process and the effective l i f e of the 39 machines. The more capital intensive the mode of production, the 37. Another principal purpose i s "to maintain capital investment intact". Machinery and A l l i e d Products Institute, Depreciation Reserve  Policies, Chicago, 1936, p. 7. 38. D. Solomons, "Income - True and False", The Accountants Journal October 19U8. 39" The effect of historical cost depreciation can lead to strange results.. Thus a firm, which has paid a high figure for an asset, w i l l show a greater net worth i n the balance sheet and a smaller profit i n the income account (through a larger provision for depreciation) than an identical firm making otherwise identical profits but which had bought the same asset at a lower price.. The study of the balance sheets and income statements of the two firms would therefore lead to conflicting conclusions most puzzling to a potential investor. Fundamentally, the a b i l i t y to earn profits which i n turn determines net worth, does not depend on the cost of purchase of assets i n an earlier period, except insofar as this has affected the cash position. -150-longer the economic l i f e of the asset and the more violent the price change, then the greater i s the incomedistortion that arises from the writing off of unexpired historical costs. It i s evidently i l l o g i c a l to treat as a cost of current production an expense that i s related to prices decades ago and the distortion is particularly large where a period of intensive inflation, such as the war years, intervenes. The situation has been succinctly stated: "after a f a l l of prices, depreciation overrates the using up of capital .since prices and activity (are) both much lower after a r i s e of prices, the opposite i s true". ^ Much of the agitation i n recent years for a new concept of depreciation can be traced to tax considerations. Historic cost depreciation would appear to impose an inequitable tax burden on capital intensive firms.. In the United States, at least, considerable amelioration i s given to firms with large investments in inventories when prices and replacement costs r i s e , through the acceptance of the Lifo concept in accounts for tax purposes. The replacement cost concept for fixed plant, however, has not gained similar recognition either i n the United States or the United Kingdom. In the latter country, some encouragement in new, investment i s fostered by the granting of i n i t i a l allowances and investment allowances. In the United States some form of r e l i e f has been obtained by the recognition of accelerated depreciation allowances. hO. Encyclopaedia Brittanica, op. cit.., Vol. 7, p. 231. Ul. But a number of firms continue to employ the straight line method for various reasons: lack of appreciation of the tax advantages given by an accelerated depreciation method, fear of disturbing agreed l i f e estimates of existing plant,, undesirable effects of reporting a lower income figure such as loss of goodwill, etc. With regards -151-These take, i n the main, two forms: the reducing balance method (which has always been the accepted tax method i n the United Kingdom) and the sum-of-the-years' digits method. Though the amounts written off are restricted to the capital cost of the asset, the larger write-offs i n the earlier years provide a permanent tax gain, taking the present value factor into account, and assuming that the firm remains profitable and the tax rate constant. This gain i s multiplied many times for a firm which replaces a portion of i t s assets annually, and i n particular for 1x2 a rapidly expanding enterprise. 4 These and other tax concessions of a similar kind serve to spotlight the urgency and magnitude of the problem. But they have an essentially makeshift nature and their primary function i s to lighten the tax burden of firms with heavy fixed capital investments. They do not directly impinge on the replacement problem or thatoof measuring the ) ^  value of services consumed. As we have seen, price level adjustments do not i n themselves provide for the retention of the right amount of funds for the replacement of assets, nor for the avai l a b i l i t y of such funds when replacement takes place. These are entrepreneurial functions, not accounting functions. 1+1. (Contd.) to capital investment, less than half of a large number of firms included in an enquiry i n 1959 stated that they woul raise their capital expenditures i f allowances were liberalized. See Leonard E. Morrisey, The Many Sides of Depreciation,, published by the Amos Tuck School of Business, Administration, I960, pp. 11+-16. 1+2'. Ibid., pp. 9 - 1 3 -1+3- See arguments presented i n Chapters III and 17. -152-Nonetheless, there exists a division of opinion in the current cost school as to whether the depreciation provision should be based on current replacement cost or whether past deficiencies should be made good and included i n the current year's provision. The second approach conforms to the Pigoy'ian concept of income, ^ but i t does not measure the current costs of using fixed assets. The prevalent trend favours the f i r s t approach, which though i t does not accumulate an exact amount of cover for replacement, " i t does i n fact provide the opportunity for rioing HQ (since) these cost recoveries are held i n the form of assets." ^ The approach conforms to the concept of measuring the current values of service vis-its- consumed in the productive process on a practical plane, i t has been pointed out that where inflation has been rapid or adjustment for past inflation has been long delayed,, prior deficiencies can be very substantial. Most adjustments i n foreign countries have attempted to correct for deficiencies i n subsequent years, but the scope of the revalorization measures introduced i n France and Italy in the post-War years have extended to past as well as subsequent years. ^ 1+U. "From the joint work of the whole mass of productive factors there comes an (annual) in-flowing stream of output. This i s gross real income. When what i s required to maintain capital intact i s substracted from this, there is l e f t net real income", A. C. Pigou, "Maintaining Capital Intact", Economica, August 191+ 1 , p. 271, quoted in Accounting for Inflation, op. c i t . , pp. 52-3. This approach i s recommended i n The Institute of C 0st and Works Accountants, The Accountancy of Changing Price Levels, op. c i t . , p. 53-1+5- Accounting for Inflation, op. c i t . , p. 8 9 . 1+6. Ibid., pp. 110 et. seq. See also George Terborgh, Realistic Depreciation  Policy, A MAPI Study, 195U, P- 135--153-The depreciation provision i n a purchasing power system also provides a p a r t i a l solution to the replacement problem. When the general price level rises, the depreciation figure w i l l be appreciably higher than that under historic cost accounting, and the gap w i l l increase directly with the extent of the price r i s e , ^here are two situations i n which a less desirable result w i l l obtain i n a purchasing power system than in the conventional system. One i s where the general price level and the replacement costs of specific assets are moving i n opposite directions; the other i s where the general price l e v e l i s above both replacement and historic costs, and the divergence between the replacement cost and the general price l e v e l i s greater than that between the replacement and historic costs. tt * tt tt tt tt tt tt tt The crux of the depreciation problem l i e s i n the "characteristic of durable goods that they comprise a bundle of inputs (or cost units) which produce a stream of outputs coming forth over a sequence of short periods, and, as Wicksell and Hayek have emphasized, there is i n most instances no way of linking particular units of input with particular units of output i n the sense that we can say that a units of input produce the output of period I, b units of input the output of period II, and so on. A l l we can say i s that a l l the inputs embodied i n the durable good are jointly responsible for the whole stream of output.." ^ In other words, U7» Friedrich and Vera Lutz, The theory of investment of the firm, Princeton: Princeton University Press, 1951, PP* 6-7. there i s "'a technical jointness of supply of the services of the )i8 T equipment over the successive short periods." ^ ihus the depreciation problem can be likened to a very special type of joint costs problem. The inadequacy of joint costs allocation for purposes of policy decisions i s now generally recognised, but the method does provide some workable means of inventory valuation. The various depreciation conventions cannot be said to perform a similar task for fixed assets. What function, then, should a depreciation concept serve? An answer on which there i s wide agreement among accountants i s that depreciation should provide a means of matching costs against revenue. Some accountants believe that the proper cost i n this context is the cost of exhaustion of usefulness of the asset, that i s , i t i s the measure of j. 9 the value of service units consumed in the production process. U 7 Such a concept i s , of course, much more meaningful and has more relevance for decision making than an allocation of the purchase price; i t i s incorporated into the price-level accounting system proposed by the (English) Association of Certified ^ nd Corporate Accountants. Alternatively, the proper cost can be conceived as a measure of the loss of service potential of the asset; this concept di f f e r s from the service units concept i n that i t taks the discount factor into account. The fallacy of the historical cost depreciation concept l i e s in confusing cost with value. The cost of acquistion of an asset measures k9- See Accounting Terminology Bulletin, op. c i t . , p. 22. It would appear that the accountant i s often asked to perform what the economist considers an impossible task. SO. Accounting for Inflation, op., c i t . -155-i t s i n i t i a l value, but i s not the outlay that j u s t i f i e s capitalization and subsequent depreciation. Rather i t i s the value that has been acquired that should be capitalized, since i f there i s no such value, there i s nothing to capitalize. Depreciation, then, i s properly regarded as the amortization of value. The pattern of depreciation 4s given by "the movement of asset values over the service l i f e " (of the asset) ... when cost i s taken as an indication of acquisition value, the excess of cost over terminal salvage, universally accepted as the lifetime depreciation, becomes the lifetime loss of'value. If loss of value i s / the appropriate measure for the entirety, i t i s logically appropriate 51 for the parts."' This would also constitute an argument for price-level depreciation. However, a depreciation figure obtained as the difference between two market values w i l l not necessarily be the same as the value of the service units consumed in the period* This i s because the pattern of depreciation appropriate to the firm w i l l d i f f e r from the market pattern, because of differences^ i n maintenance policies in individual firms. It i s thought that market pressures would force a l l firms to adopt the same optimal maintenance policy, but this w i l l be so only i f assets are classified by type of 52 output as well as by physical characteristics. The (English) Association of Certified and Corporate Accountants recommend in their price-level system that the annual pattern of depreciation should be based on the intensity of use of the maching; in that year. 5 1 . George Terborgh, op. c i t . , pp.23-l|» 5 2 . Edwards and B e l l , op. c i t . . pp* 175-6. -156-53 The underlying theory is developed at some length. The capital value of an asset (or group of assets) i s dependent on the present value of the future net earnings of the asset. The capital value of the asset at the beginning of an accounting period i s the sum of i t s capital value at the end of the period plus i t s expected earnings during the period; therefore "the expected exhaustion of (the) capital value of an asset....is equivalent to the loss of future income involved i n i t s u t i l i z a t i o n (and) i t i s this cost -which constitutes depreciation". ^ In the case of inflation, the market value of the asset at the end of the period -will be higher than expected; similarly i n the case of obsolescence i t s value w i l l be lower. But had subsequent events been foreseen at the beginning of the period, then the capital value at the beginning would have been similarly adjusted. The difference between expected and realized capital values at the close of the period constitute a capital gain or loss. Thus the depreciation charge i s dependent on the intensity of use of the asset (allowing f o r normal, obsolescence),, expressed at current price levels. It is clear that as a measure of the value of services consumed in the period, the proposed method i s undoubtedly superior to rule of thumb methods, such as the straight line and reducing balance. But the annual pattern of depreciation (expressed as a percentage) should probably contain a constant factor which would purport to measure depreciation through the effluxion of time; this sophistication may not be necessary provided the asset remains in 53• Accounting for Inflation, op. c i t . , pp. 62 et. seq. 5U. Ibid., p. 63* - I n -active service throughout i t s economic l i f e . Further, the authors did not specify how they propose to measure intensity of use; perhaps units of output or e l e c t r i c i t y consumed or some similar measure depending on the circumstances would be suitable c r i t e r i a . One further criticism that can be levied against the intensity of use approach i s that i t does not take the time value of money into account. It has also been suggested that the depreciation method should be one i n which the depreciation pattern w i l l not distort the rate of return on the asset. It i s believed that this would be achieved i f depreciation is based on the internal rate of return on the fixed asset. This rate, also known as "the marginal efficiency of capital" is familiar 55 to economists. It i s the rate of interest which equates the present value of the earning stream of the asset with the i n i t i a l cost. If expectations are unchanged, then the same rate i s used to determine the present value of future earnings at the end of the year. The depreciation i s the difference between the two values at the beginning and end of the period. If expectations are changed, then a new internal rate of return i s calculated on which the present values and depreciation are based. 5 6 Several criticisms, however, can be made of the internal rate of return approach. The asset might have a higher present value when discounted at some other rate, say, the market rate of interest taking risk. into account ythan i t s i n i t i a l cost, representing a capital gain, at the 55« J* M . Keynes, op. cit.. pp. lllyO et. seq. 5 6 . John Coughlan, "Industrial. Accounting", Accounting Review, Vol. XXXIV, Wo..3, July 1 9 5 9 , pp.. 1*15-28.. -158-o u t s e t ( g i v e n some d e g r e e o f m a r k e t i m p e r f e c t i o n ) o r a t a n y p e r i o d o f i t s e c o n o m i c l i f e . F u r t h e r , t h e i n t e r n a l r a t e o f r e t u r n must be 57 r e c a l c u l a t e d e a c h t i m e e x p e c t a t i o n s c h a n g e . A l s o , , d u a l r a t e s o f 58 r e t u r n w i l l e x i s t w h e n e v e r t h e r e i s a t e r m i n a l l o s s . . The m e t h o d i s t h e r e f o r e a m b i g u o u s when a p p l i e d t o s u c h a s s e t s a s a l e a s e w i t h <f d i l a p i d a t i o n s c l a u s e , o r a s s e t s f o r w h i c h t h e r e i s a f i n a l o u t l a y s u c h as c o s t s o f d i s m a n t l i n g a n d r e m o v a l . O t h e r t h i n g s b e i n g e q u a l , some e c o n o m i s t s recommend t h e c o s t o f 59 c a p i t a l a s b e i n g t h e p r o p e r r a t e , s i n c e t h i s s h o u l d h a v e b e e n t h e r a t e e m p l o y e d i n m a k i n g t h e i n i t i a l c a p i t a l b u d g e t i n g d e c i s i o n t o i n v e s t . The c o s t o f c a p i t a l a p p r o a c h d o e s n o t s u f f e r f r o m t h e d i s a d v a n t a g e s o f t h e i n t e r n a l r a t e o f r e t u r n ; f u r t h e r , t h e e a r n i n g s f r o m a l l a s s e t s a r e d i s c o u n t e d a t t h e same r a t e . T h e r e a r e , n o n e t h e l e s s , s e v e r a l p r o b l e m s . I n t h e f i r s t p l a c e , a f i r m ' s c o s t o f c a p i t a l i s a c o m p l e x f i g u r e w h e r e t h e c a p i t a l s t r u c t u r e c o m p r i s e s d i f f e r e n t f o r m s o f e q u i t y a n d d e b t c a p i t a l . ^ S e c o n d l y t h e 57- D i r a n B o d e n h o r n , " A n E c o n o m i s t L o o k s a t I n d u s t r i a l A c c o u n t i n g a n d D e p r e c i a t i o n " , A c c o u n t i n g R e v i e w , V o l * X X X V I , No. , U , O c t o b e r 1961, p p . . 583-88. 58. See James H . L o r i e a n d L e o n a r d J . S a v a g e , " T h r e e P r o b l e m s i n R a t i o n i n g C a p i t a l " ' a n d E z r a S o l o m o n " T h e A r i t h m e t i c o f C a p i t a l - B u d g e t i n g D e c i s i o n s " , r e p r i n t e d i n E z r a S o l o m o n ( e d ) , The Management o f C o r p o r a t e  C a p i t a l , New Y o r k : The F r e e P r e s s o f G l e n c o e , p p . 56-66 a n d p p . 7U-9 r e s p e c t i v e l y . 59* D . . B o d e n h o r n , o p . c i t . 60* E z r a S o l o m o n , " M e a s u r i n g a C o m p a n y ' s C o s t o f C a p i t a l " , r e p r i n t e d i n S o l o m o n ( e d . . ) , o p . c i t . , p p . 128-UO. A n a l t e r n a t i v e c o n c e p t o f c o s t o f c a p i t a l d e f i n e s i t " a s t h e r e t u r n t h a t c o u l d b e made b y d i v e r t i n g c a s h o u t o f t h e f i r m ' s b u s i n e s s i n t o a l t e r n a t i v e m a r k e t i n v e s t m e n t s " ( J o e l D e a n , C a p i t a l B u d g e t i n g , New Y o r k , C o l u m b i a U n i v e r s i t y P r e s s , 1951)* What t h e s e o u t s i d e a l t e r n a t i v e s a r e a n d t h e i r r a t e s o f r e t u r n a r e l a r g e l y s u b j e c t i v e . H a r r y V . R o b e r t s , " C u r r e n t P r o b l e m s i n t h e E c o n o m i c s o f C a p i t a l B u d g e t i n g " , i n i b i d , p p . 198-202. -159-discount rate has to be recalculated every time there i s a change i n the expected cost of capital} this criticism might not be valid i f the long-run cost of capital i s employed. Thirdly, the cost of capital depends on external demand and supply factors and expectations i n the money market as well ,as the capital good market,, with emphasis on the former. It might also depend to some extend on the gearing i n the firm's capital structure, though some economists believe that the average cost of capital remains the same and i s equal to the capitalization rate for pure equity capital, ^ since the lower cost on a larger proportion of loan funds would Be matched by an increase i n the cost of equity on account of the greater r i s k with a higher gearing r a t i o . Others argue that the market w i l l pay more i f there is,low gearing for the same t o t a l i t y of risk, a sort of super premium for safety, on account of the behaviour of 621 institutional investors. In any event, we have wandered a considerable distance from the concept of depreciation as a measure of the cost of exhaustion of usefulness of the asset. The rate of return approach, whether i t comprises the internal rate of return method or the cost of capital method, i s essentially subjective and depends on the evaluation of future income streams. Thus i t i s not l i k e l y to be incorporated i n a price-level accounting system which i s not i t s e l f based on the evaluation of future expectations. The above discussion 61. Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment", reprinted i n Solomon, (ed), ibid,, pp. 150-81. 62. David Durand, "Costs of Debt and Equity Funds for Business: Trends and Problems of Measurement"1, reprinted i n Solomon (ed) i b i d . , pp. 91-127. -l6o-has served to i l l u s t r a t e some of the approaches to a complex problem for which there i s no determinate solution, the divergence between the economist's and the accountant's concepts of depreciation,, and certain inherent deficiencies i n both. -161-VI. P R I C E I E V E L A D J U S T M E N T S : M E T H O D O L O G Y A . P U R C H A S I N G P O W E R H I S T O R I C A L C O S T S Y S T E M S T h e S w e e n e y m e t h o d T h e p u r p o s e o f t h e p r i c e l e v e l s y s t e m s w h i c h a d v o c a t e t h e e x m p l o y m e n t o f a g e n e r a l p r i c e i n d e x i s t o e l i m i n a t e t h e e f f e c t s o f p r i c e l e v e l c h a n g e s a n d s t a t e e a c h i t e m i n d o l l a r s o f c o n s t a n t p u r c h a s i n g p o w e r . T h e f i r s t m a j o r p i o n e e r i n g e f f o r t i s f o u n d i n t h e s y s t e m o f s t a b i l i z e d a c c o u n t i n g p r o p o s e d b y S w e e n e y i n 1 9 3 6 . . T w o a l t e r n a t i v e s y s t e m s a r e d e v e l o p e d : ( l ) a d j u s t m e n t i n t e r m s o f g e n e r a l p u r c h a s i n g p o w e r 2> (20 a d j u s t m e n t i n t e r m s o f r e p l a c e m e n t c o s t . S t a b i l i z a t i o n i n t e r m s o f g e n e r a l p u r c h a s i n g p o w e r T h i s m e t h o d i s e s s e n t i a l l y a r e s t a t e m e n t o f , r a t h e r t h a n a d e p a r t u r e f r o m h i s t o r i c a l c o s t s . S w e e n e y r e c o m m e n d s t h e u s e o f a g e n e r a l c o n s u m e r s p r i c e i n d e x , w h i c h m o n t h l y f i g u r e , a s s u m e d t o r e p r e s e n t t h e a v e r a g e c h a n g e i n t h e p r i c e s o f c o n s u m e r g o o d s f o r t h e m o n t h , w o u l d b e u s e d t o d e f l a t e t r a n s a c t i o n s i n t h a t p a r t i c u l a r m o n t h 3 i n t e r m s o f c u r r e n t d o l l a r s . T h e c u r r e n t p e r i o d a d o p t e d i n t h e s y s t e m i s t h e l a s t m o n t h o f t h e f i n a n c i a l y e a r . 1. H e n r y W . . S w e e n e y , S t a b i l i z e d A c c o u n t i n g , N e w Y o r k : H a r p e r a n d B r o s . , 1936. 2. T h i s s y s t e m i s d e s c r i b e d i n a s u b s e q u e n t s e c t i o n . 3 . S i n c e a m o n t h l y i n d e x o f c o n s u m e r s p r i c e s w a s n o t a v a i l a b l e , S w e e n e y m a d e u s e o f a g e n e r a l p r i c e i n d e x p u b l i s h e d b y t h e F e d e r a l R e s e r v e B a n k o f N e w Y o r k . -162-The Balance Sheet items are stabilized f i r s t . (a) Fixed assets must be "aged"', that i s , analysed according to dates of acquisition, before they can be restated i n current dollars of the year i n which stabilizing accounting is f i r s t put into effect. This procedure is often the most time consuming, but i t w i l l not be necessary to repeat the analysis i n subsequent years. (b) For inventory, i t i s assumed that the Fifo' method of pricing issues is i n operation. The conversion factor 4 employed w i l l depend on the rate of turnover. F o r example, assuming stock i s turned over four times a year, the conversion factor w i l l be based on the average index figure in the last quarter. (c) Money and money assets, that i s , claims expressed i n fixed dollar amounts such as accounts receivable, are already expressed i n terms of current dollars and require no adjustment. (d) Equity capital i s stabilized by the conversion factor which i s appropriate for the year (or month) in which the capital was contributed. (e) The provision for depreciation i s stabilized by the conversion factor adopted for the relevant fixed asset. (f) Current l i a b i l i t i e s , as with money assets, are not stabilized. (g) The figure of stabilized retained earnings, which i n Sweeney's system i s a residual figure, i s given by the surplus of* d e f i c i t arising on the difference between the stabilized items on the two sides of the balance sheet. h. The conversion factor is the price index for the current period divide/^ by the price index for the relevant period which relates to the transaction. - -163-(h) The increase i n stabilized retained earnings comparing the amounts at the beginning and end of the year, represents the retained earnings for the current year. This gives the stabilized net income, after dividends paid are taken into account. In computing the stabilized income for the year, Sweeney considered i t essential to separate the realized and unrealized gains or losses. The procedure for computing the realized gains and losses on money and money assets and l i a b i l i t i e s i s as follows: Assuming a rising price l e v e l (a) the realized loss on money and money assets held during the.year i s given by the sum of the opening balance and receipts during the year less the sum of the closing balance and disbursements (including dividends paid) during the year, a l l items expressed in stabilized dollars. (b) the realized gain on money l i a b i l i t i e s i s given by the sum of l i a b i l i t i e s at the beginning of the year and l i a b i l i t i e s incurred during the year less the sum of l i a b i l i t i e s at the end of the year and l i a b i l i t i e s discharged during the year, a l l items expressed i n stabilized dollars. The procedure for computing the unrealized gains and losses on money and money assets and l i a b i l i t i e s i s as follows: Assuming a rising price level (a) the unrealized loss from the holding of cash i s the difference between the cash held at the end of the year in current dollars and i t s purchasing power at the date(s) of receipt, assuming that outgoings are on a Fifo basis. (b) The unrealized loss on other money assets i s computed i n a similar manner. (c) The unrealized gain on money l i a b i l i t i e s i s computed in a similar manner. - 1 6 1 * -Thus the net unrealized earnings figure i s obtained and realized net income for the year can be derived as a residual figure. It is the difference between the stabilized net income for the year and net unrealized earnings. Realized net income i s also the sum of operating profit and the realized gains on money and money assets and l i a b i l i t i e s . . Stabilized operating profit i s the difference between sales and the cost of goods sold and other expense items, adjusted by conversion factors appropriate to the months i n which the sales took place or the expenses were incurred. Sweeney, however, considered i t impracticable to adjust for expenses, i n view of the large number and complex varieties of expense items. Thus the figure of stabilized operating profit i s obtained i n the indirect manner described i n the preceding paragraph, while that of cost of goods sold and other expenses i s obtained as a residual balancing figure. -165-Illustration The following data pertain to Company Y: Comparative Balance Sheet (As reported) December 31, 1961 December 31, 1962 Net current assets Cash $ 60,000 $ 75,000 Inventory 90,000 100,000 150,000 175,000 less Current l i a b i l i t i e s 25,000 25,000 Net current assets $125,000 $150,000 Fixed assets Fixed assets $200,000 |200,000 less Accumulated depreciation (70,000) (80,000) $130,000 $120,000 Total net assets $225,000 $270,000 Equities Bonds payable $ 80,000 $ 80,000 Capital stock 150,000 150,000 Retained earnings 25,000 u0,000 Total equities $255,000 $270,000 Income Statement For the Year 1962 (As reported) Sales $415,000 less Cost of goods sold 390,000 Gross profit 25,000 less Depreciation 10.000 Balance to retained earnings $15,000 5. This i l l u s t r a t i o n and the subsequent appraisal lean heavily on the arguments presented i n Blaine, op a cit» -166-1962 Cash sales Purchases Payments Conversion on account on account factor F i r s t quarter $1005900 #200,000 $ 50,000 1.08 Second quarter 100,000 50,000 50,000 1*05 Third quarter 200,000 50,000 100,000 1.02 Fourth quarter 15,000 100,000 200,000 1.01 Fourth quarter, 1961 1.10 January 1, 1962 1.10 December 31, 1962 1..00 January-December average, 1962. 1.0U The annual inventory turnover i s four times, so that the inventory at January 1, 1962: has been acquired at the average price level for the fourth quarter of 1961, and the inventory at December 31, 1962 has been acquired at the average price level for the fourth quarter of 1962. The inventory cost flow i s based on the F i f o method. The equity capital was subscribed and the fixed assets purchased when the conversion factor stood at 1.20. The rate of depreciation on the fixed assets i s at 10$ straight-line. •^or simplicity, transactions have been classified by quarterly periods rather than months. The conversion factors are based on the price index for December 31, 1962. -167-The comparative balance sheet stabilized i n the general price level of the fourth quarter of 1962 is given below. Adjusted Comparative Balance Sheet (in December 1962* dollars) December 3 1 . 1961 December 31 , 1962 Conversion * Conversion * factor * factor Cash Inventory Current l i a b i l i t i e s Net current assets 1.10 1.10 1.10 66 ,000 99,000 165,000 27,500 137,500 1.01 75,000 101,000 176,000 25,000 151,000 Fixed assets Accumulated depreciation 1.20 1 .20 2U0,000 (8L ,000) $156,000 1 .20 1 .20 2h0,000 (96 ,000) $lhU ,000 Total net assets 1293,500 $295,000 Bonds payable Capital stock Retained earnings 1.10 1.20 88,000 180,000 25,5oo 1 .20 • f t 80,000 180,000 35 ,000 Total equities $293,500 $295,000 A residual figure. - 1 6 8 -Computation of realized gains and losses on money and money assets and l i a b i l i t i e s Sales and cash receipts As per accounts Conversion Adjusted factor  F i r s t quarter $100,000 1.08 $108,000 Second quarter 100,000 1.0J? 105,000 Third quarter 200,000 1.02 20U,000 Fourth quarter 15 ,000 1.01 15,000 $Ui5,ooo $1+32,150 Cash disbursements and decreases i n current l i a b i l i t i e s As per accounts Coversion Adjusted factor  F i r s t quarter f 50 ,000 1.08 $ 51i,000 Second quarter 5 0 , 0 0 0 1.05 52,500 Third quarter 100,000 1.02 102,000 Fourth quarter 200,000 1.01 202,000 $1,00,000 $ iqo,5oo Purchases and increases i n current l i a b i l i t i e s As per accounts Conversion Adjusted factor  F i r s t quarter $200,000 1 .08 $216,000 Second quarter 50 ,000 1.05 52,500 Third quarter 50 ,000 1.02 51,,000 Fourth quarter 100,000 1.01 101,000 $U00,000 $1+20,500 -169-ReaHzed loss on cash Balance. January 1, 1962 $ 66,000 add Adjusted cash receipts 432,150 498,150 Balance, December 31, 1962 $ 76,350 add Adjusted cash disbursements 1+10,500 1*86,850 Realized loss $ 11,300 Realized gain on money l i a b i l i t i e s Balance, January 1, 1962 $ 27^500 add Adjusted l i a b i l i t i e s incurred 1+20,500 1+1+8,000 Balance, December 31, 1962 $ 25,250 add Adjusted l i a b i l i t i e s discharged 1+10,500 1+35,750 Realized gain $ 12.2:50 Net Realized gain $ 950 -170-Computation of unrealized gains and losses on money and money assets and l i a b i l i t i e s Cash The unrealized loss i s : $15,000 (1.01) + 60,000 (1..02) - 75,000 = $1,350 Current l i a b i l i t i e s unrequited £aln $ 25,000 ( 1.01 ) - 25,000 = $ 250 Bonds payable The unrealized gain i s : $ 80,000 (1.10) - 80,000 » $ 8,000 Net unrealized gain = $ 6.900 -171-The stabilized income statement i s given below. Stabilized Income Statement  For the Year Ended December 31. 1962 Realized Sales |lO2,l50 less Cost of goods; sold Ul8,500 Gross profit 13,650 Depreciation 12,000 Operating profit l,6f>0 add Realized gain on money and money assets and l i a b i l i t i e s 950 Realized net income for the year $ 2,600 Unrealized add Unrealized gain on money and money assets and l i a b i l i t i e s $ 6,900 Total net income for the year $ 9,500 * * This i s the difference between adjusted retained earnings at the beginning and end of the year. -172-The Mason method A fundamentally similar system to the Sweeney approach has been proposed by the American Accounting Association. The basic concepts and 6 7 methods have been described by Mason and others associated with the research project on price-level accounting sponsored by the Association. The deflating factor recommended i s the Consumers' Price Index published by the United States Bureau of Labour S t a t i s t i c s . The base period could be the base year of the index, the f i r s t year of the company, or the current year. It is believed that the last month in the current financial year would make the most suitable base per i o d f o r the conversion of the accounts. Using the same i l l u s t r a t i o n as for Sweeney's method, the comparative balance sheet adjusted under the Mason approach would be identical with Sweeney's stabilized figures.. The t o t a l net income for the year i s there-fore the same under both methods, $ 9 , £00.. The differences i n the Mason approach are located in the different treatment of the adjustments to the income statement. There i s an explicit assumption of an even flow of transactions throughout the year, so that i t i s appropriate to apply the average annual index i n making the adjustments. 9 6. Perry Mason, Price-Level Changes and Financial Statements, op. c i t . 7. See, in particular, R. C. Jones, Price Level Changes and Financial Statements Case Studies of Four Companies, op. c i t . , for an application of the proposed techniques to case studies and subsequent interpretation of the adjusted data. 9* Where the flow of transactions i s seasonal or irregular, the condition i s f u l f i l l e d only i f the price index remained at the same level throughout the year, and the condition is not f u l f i l l e d i f there has been an even rate of change i n the price le v e l . -173-Unlike Sweeney, the Mason approach includes direct adjustments to 10 the cost of goods sold. Inventory, January 1 Purchases during the year Inventory, December 31 Cost of goods sold 90,000 (1*10) $ 99,000 400,000 (l.OU) 100,000 (l.Ol) 416,000 515,000 101,000 $414,000 The adjusted income statement i s given below. Adjusted Income Statement For the Year 1962. Reported Conversion factor $415,000 I..O4 390,000 (various) 25,000 10,000 1.20 Sales Cost of goods Sold Gross Profit Depreciation Net operating income $15,000 Adjusted $431,600 UL4,000 17,600 12,000 $ 5,600 The adjusted amount of retained earnings shown i n the balance sheet is a residual figure. They represent the accumulations of retained earnings since the beginning of the firm's l i f e , and the amounts are completely adjusted f o r price level changes in preceding years plus or minus the gains and losses; on monetary assets and l i a b i l i t i e s . The adjusted operating income for the year and the adjusted retained earnings for the 10. It i s assumed in the i l l u s t r a t i o n that the F i f 0 method of inventory pricing has been used. Mason also explains the technique for adjusting inventory priced on a Lifo base* Mason, op. c i t . , p. 17* -17U-year can be reconciled by taking into account the purchasing power gain on the bond l i a b i l i t y and the purchasing power loss on the net current monetary position.. Net Current Monetary Position (As reported) December 3 1 , 1961 December 3 1 , 1962. Cash I 6 0 , 0 0 0 $ 75,000 less Current l i a b i l i t i e s 25 ,000 25 ,000 Net current monetary position $ 35 ,000 $ 5 0 , 0 0 0 The $35,000 at the beginning of the year suffers a f a l l i n purchasing power of 1.10 - 1 .00 points; the increase i n the net monetary position of $15,000 suffers a f a l l i n purchasing power of 1..0U - 1 .00 points. 0 The t o t a l loss i s thus $ U , 1 0 0 . Statement of Adjusted Retained Earnings  For the Year 1962 Adjusted operating income $ 5 , 6 0 0 Purchasing-power gain for the year: Gain on bonds payable $ 8 ,000 Lass on net current monetary position (U , 100) 3 ,900 Adjusted retained earnings or total net income $ 9 ,500 -175-The (Sorbin method Corbin was guided i n his case study of a department store's accounts over a twenty year period by the recommendations on price-level accounting of the American Accounting Association Study Group on Business Income. The Corbin method, therefore, conforms to the basic principles of the system described by Mason and adopted i n other case studies. There are, however, two important differences. (a) Corbin made use of monthly price indexes instead of the annual average figure i n his adjustments. His income statement, therefore, resembles Sweeney's adjusted figures rather than Mason's. (b) The gain or loss from being a debtor or creditor, that i s , on the net monetary position, i s a residual figure which ties the income statement into the retained earnings analysis i n the balance sheet. Let s]_ = adjusted surplus or retained earnings at year-beginning S2 = adjusted surplus or retained earnings at year-end g = gain or loss on net balance of monetary items i = adjusted net income excluding gain or loss on net balance of monetary items . . i + g = adjusted net income including gain or loss on net balance of monetary items d = adjusted dividends s s x + ( i + g) - d = s2) . . g = s 2 + d - {si + i ) The Corbin approach differs from that of Sweeney i n that detailed adjustments are made to the cost of goods sold and other expense items,, while the net figure of purchasing power gain (or loss) i s derived as a -176-residual balance. Thus i n Corbin 1s system, as i n Mason's, no distinction i s made between realised and unrealized gain (or loss) on inventory items. The cost of goods sold i s computed as follows: f ) Inventory, January 1 $90,000 (1*10) $ 99,000 Purchases, adjusted quarterly u2Q,500 519,500" Inventory, December 31 100,000 (1.01) 101,000 Cost of goods sold $kl8,500 The adjusted income statement is given below. Adjusted Income Statement  For the Year ended December 31, 1962 Sales $ U32,l50 less Cost of goods sold l).l8,500 Gross profit 13*650 Depreciation 12,000 Operating profit 1 ,650 Gain on monetary items 7.850 *-Total net income for the year $ 9,500 # A residual figure - 1 7 7 -An appraisal of the three methods The Mason approach specifically assumes there i s an even flow of transactions throughout the year. Alternatively, where the price level might have risen (or fallen) at the beginning of the year i t remains at the same level throughout the year. Under any other condition, the employment of an annual average index figure i s l i k e l y to give misleading results. It must be admitted that either of the above condition might well be unrealistic. Most businesses are subject to seasonal as well as irregular fluctuations i n their transactions, while modern economic conditions are not conducive to the maintenance of a stable price level throughout the year. While the adjusted t o t a l net income figure is the same i n a l l three systems, adjusted operating income obtained under the Mason approach is $ 5 , 6 0 0 , which i s significantly different from the figure of $ 1 , 6 5 0 given by the Sweeney and Corbin methods. This substantial difference has arisen wholly on account of the failure of the Mason approach to take short-term fluctuations i n the volume of transactions and the price level into consideration. There i s a collateral effect on the estimates of purchasing power gains and losses. The Mason approach gives a loss on the net current monetary position of $ U , 1 0 0 , : while the net purchasing power loss (both realised and unrealized) from holding cash, after taking the purchasing power gains on current l i a b i l i t i e s into account, under the Sweeney system is only $ 1 5 0 (loss on cash, $ 1 2 , 6 5 0 - gain on current l i a b i l i t i e s , $ 1 2 , 5 0 0 ) . The discrepancy has arisen from the implicit assumption in the Mason system that the net current monetary position has increased steadily -178-from $ 3 5 , 0 0 0 at the beginning of the year to $50,000 at the end of the year. The true net current monetary positions at the beginning of the year and at the end of each quarter are given below. Net Current Monetary Positions, 1962'. Cash Current l i a b i l i t i e s Net current monetary position Conversion factor January 1 $60,000 25 ,000 35,000 1.10 F i r s t Second Third Fourth quarter quarter quarter quarter $110,000 $160,000 $260,000 $ 75,000 175.0QO 175 .QOO 125,000 20 ,000 (65,000) (15,000) 135,000 50,000 1.08 1.05 1.02 1.01 It should be emphasized, however that for those businesses not subject to seasonal or other fluctuations i n their sales, purchases and credit policies, the Mason method does offer a relatively simple and acceptable method of price-level adjustment. It i s true that realized and unrealized gains and losses are not distinguished, but i n view of the rapid turnover of most money assets and l i a b i l i t i e s the distinction might not be of much significance. It would s t i l l be desirable to state the purchasing power gains or losses on long-term l i a b i l i t i e s separately from those on current monetary items. Mason is aware of the simplifying nature of his basic assumption. "If there are any significant seasonal variations and i f the change i n the price level during the year i s sizeable, i t may be necessary to use a more refined procedure." 11 . Ibid, p. 1 6 . -1.79-The defect i n the Sweeney system is that i t does not provide for a price level adjusted statement of cost of goods manufactured. The defect i n the Corbin system l i e s i n the lack of classification of the gains and losses on money and money assets and l i a b i l i t i e s . An approach which provides for the independent calculation of cost of goods sold and purchasing power gains and losses^combining complementary techniques 12 i n the Sweeney and Corbin methods would overcome these defects. B. CURRENT COST SYSTEMS 13 Stabilization i n terms of replacement cost Unlike the better known system of stabilized accounting usually associated with Sweeney, stabilization i n terms of replacement cost represents a departure from historic costs. The procedures do not dif f e r fundamentally between the two systems. The recommended techniques for stabilizing in terms of replacement cost are: (a) Fixed assets, inventory and investments are stabilized i n terms of replacement cost. In most cases a replacement cost index i s used, but Sweeney treats reproduction cost and appraisal as synonymous with replacement cost. 12. Blain, op. c i t . 13. Sweeney, op. c i t . , pp. Uu-53--180-.(b) Fixed assets are shown at replacement cost new less a provision for depreciation, which i s calculated at the appropriate percentage of the stabilized figure. (c) The depreciation expense for the year is stabilized on the basis of the general price level and not the replacement cost of the respective assets. (d) The treatment of other items in the balance sheet and income statement are the same as i n the purchasing power stabilization system. Corbin 1s replacement cost adjustments Corbin took one further step which is not included in the recommendations of the Study Group on Business Income. He made further adjustments for the assets, already expressed i n current dollars, which are based on specific index numbers and other indirect valuation methods (presumably to refl e c t replacement costs).. The difference between the purchasing power historical cost and current values of assets i s shown as unrealized i n the capital section of the balance sheet. Thus only asset and proprietorship amounts are changed by the additional adjustments, while net income remains the same.. An English approach >^ The current cost approach is also advocated by the (English) Association of Certified and Corporate Accountants. Ik. Corbin, op. c i t . 15. Taxation and Research Committee of the Association of Certified and Corporate Accountants, Accounting for Inflation A Study of  Techniques under Conditions of Changing Price Levels, London: Gee and Company (Publishers) Ltd., 19S2. -181-The proposed technique for adjusting fixed assets consists i n : "(a) applying depreciation rates, based on the proportionate exhaustion involved i n asset operation daring the current period,, to the undepreciated current replacement cost, and (b) deducting this charge from the remaining value of the asset which held at the commencement of the period, after having revalued this on to a current basis. "The f i r s t operation secures a recovery of the c osts of exhaustion of an asset on a current cost basis, the second brings the remaining value of the asset into the same dimension of value .... "The actual calculation underlying the technique may either be (a) of a detailed kind based on costs indicated i n manufacturers' certi f i e d current price l i s t s ; (b) of a grouped kind based on index numbers of fixed asset costs,, or, i n suitable cases, (c) based on revaluations." ^ * In order to balance the accounts, an asset revaluation reserve, which i s regarded as a capital reserve, i s introduced on the l i a b i l i t i e s side of the balance sheet. It i s recommended that "Depreciation ought to be charged according to the actual intensity of use of an asset during a given period on the 17 basis of current asset replacement costs." 1 The pattern of depreciation thus differs from those ihi other price level systems where depreciation is determined under the straight li n e or reducing balance methods. The 16. Ibid., pp. 65-6. 17. Ibid.., p.. 65* -182-authors did not suggest possible measures of plant use, but presumably c r i t e r i a based on units of output or units of power consumed i n the period would be acceptable.. With regard to inventories, i t i s recommended that raw materials and semi-processed goods consumed as well as the stocks of raw materials, semi-processed goods and finished goods on hand at the end of the period should be valued on the basis of current costs. Current costs are defined as current replacement costs at the time of absorption or at year-end for residual stocks. "Actual replacement costs used should be those quoted in suppliers' current price l i s t s , latest invoiced prices or, i n special cases, those arrived at by the application of index numbers." It is recognized that, in the absence of a mechanized costing system, considerable d i f f i c u l t i e s might arise i n applying these thechniques to a large and diverse number of stock items; in such event, some approximatory technique such as Lifo might be practicable,, depending on the relevant circumstances of the particular enterprise. Money and monetary claims need no adjustment, since they are identical with current values. Securities, trade investments and investments in subsidiaries should be shown in the balance sheet at current market values "with proper reconciliation being affected in the capital • reconciliation account and a contra entry, representing the loss or gain 19 over the period, made in the asset revaluation reserve." The revaluation, therefore, has no effect on the income figure.. 18.. Ibid., p. 81. 19. Ibid.,, p. 81*. -183-20 An Australian approach Mathews and Grant recommend certan procedures that should be adopted in theory to counteract the accounting effects of inflation on the profit statements of companies, and proceed to apply these procedures to a quantitative analysis of the incomes and savings i n the Australian corporate sector from 19a5-4o to 1952-53* The concept of current income is expressed by the following equation: Current income = Accounting profit - (Stock appreciation + Depreciation adjustment) Stock appreciation i s the difference between the opening stock valued at historical cost and at current cost. Current cost for this purposeiis taken to be the recorded oostlprice ofostocks most recently acquired and recorded on closing stock schedules of price l i s t s . The depreciation adjustment is the difference between depreciation based on historical cost and depreciation based on current replacement of fixed assets.. Replacement cost may be ascertained from price l i s t s , but generally specific price indexes which measure the replacement cost of groups of assets which are representative of those employed in the firm are adequate. Current replacement value i s assumed to be the average replacement value i n the accounting period; i n a period of steadily ri s i n g prices, this i s approximately the same as the replacement value i n the middle of the accounting period. 20. Russel Mathews and John McB.. Grant. Inflation and Company Finance,. Sydney: The Law Book Co. of Australasia Pjsy Ltd., 1958. -18U-Mathews and Grant envisage adjustments to fixed assets and inventory are in themselves adequate to correct the inflationary effect and are not i n favour of making adjustments to other items i n the balance sheet and operating statement. Realizable profit and business profit ^1 A comprehensive theory of business income has been formulated by Edwards and B e l l . They develop two alternative concepts of income which incorporate price level change, realizable profit and business profit. Both are current cost concepts which emphasize the greater importance of changes i n secondary price levels relative to changes in the purchasing power of money. The concept of realizable p r o f i t calls for valuation of the assets and l i a b i l i t i e s at their opportunity costs or market exit values. That i s to say, theyshould be estimated at values that could currently be realized i f the assets were sold outside the firm without further processing at the best prices immediately obtainable. If prices are constant, then realizable profit is the difference between opportunity costs at the beginning and end of a production cycle. This is the operating profit which has arisen because some of the assets have changed their form. The theory i s then developed to incorporate changing prices. Assuming that production i s timeless and only holding act i v i t i e s take time, then capital gains would arise from the difference in opportunity cost values at the beginning and end of a holding interval,, from a change i n dates alone. The use of exit values involves a production 2 1 . Edgar 0 . Edwards and Philip W., Bell, The Theory and Measurement of Business Income, Berkeley and Los Angeles: University of California Press, 1 9 6 1 . -185-or accrual c r i t e r i o n which constitutes a s i g n i f i c a n t departure from the r e a l i z a t i o n p r i n c i p l e i n accounting theory. (There are also considerationsof u t i l i t y which make the realizable p r o f i t concept less a t t r a c t i v e then the alternative concept under a number o i economic 22 conditions) .. The alternative concept that i s advocated i s business p r o f i t , which i s based on market entry values, that i s , the current costsoof acquiring the inputs used. From the balance sheet approach, business p r o f i t f o r the period i s the difference between the current value of assets less current value of l i a b i l i t i e s at the two dates. As an income concept i t i s based on the r e a l i z a t i o n p r i n c i p l e . Thus i t can be derived within the h i s t o r i c cost structure of the orthodox accounting system. Business p r o f i t i s defined as current operating p r o f i t plus realizable cost savings. Realizable cost savings are the increase i n current costs of assets held during the period; by means of t h i s approach current values are incorporated ihto the balance sheet. In computing business p r o f i t a subsidiary p r o f i t concept i s f i r s t developed; r e a l i z e d p r o f i t (which i s equal to accounting p r o f i t ) - The two components of r e a l i z e d p r o f i t are current operating p r o f i t and holding gains. Holding gains comprise both r e a l i z e d c a p i t a l gains and r e a l i z e d cost savings. The relationship between r e a l i z e d p r o f i t aecT" 22}; Edwards and B e l l consider that f o r going concerns current cost data may be more meaningful than opportunity cost data. The former relate to a long run view, the l a t t e r to a short run. Further, the r e a l i z a b l e p r o f i t concept represents tb/ more substantial departure from accepted accounting p r i n c i p l e s . Hence the techniques of p r i c e - l e v e l accounting have been developed only f o r the business p r o f i t approach-- 1 8 6 -a n d b u s i n e s s p r o f i t c a n be s t a t e d t h u s : g a i n s i n t h e c u r r e n t v a l u e s o f a s s e t s a r e r e c o r d e d as t h e y a r i s e a s r e a l i z a b l e c o s t s a v i n g s , w h i c h a r e t r a n s f o r m e d i n t o r e a l i z e d c o s t s a v i n g s (6r r e a l i z e d c a p i t a l g a i n s ) o n t h e c o n s u m p t i o n ( o r s a l e ) o f t h e a s s e t s . T h o u g h r e a l i z e d p r o f i t i s e q u a l t o a c c o u n t i n g p r o f i t t h e f o r m e r i s a s u p e r i o r p r o f i t m e a s u r e . A c c o u n t i n g p r o f i t i s composed o f a c c o u n t i n g o p e r a t i n g p r o f i t a n d r e a l i z e d c a p i t a l g a i n s w h i c h a r e g a i n s o n p r o c e e d s f r o m t h e i r r e g u l a r s a l e o f a s s e t s o v e r t h e i r h i s t o r i c c o s t s . The d e f e c t i n t h i s c o n v e n t i o n a l m e a s u r e l i e s i n t h e a d m i x t u r e i n a c c o u n t i n g o p e r a t i n g p r o f i t o f two s e p a r a t e e l e m e n t s : c u r r e n t o p e r a t i n g p r o f i t w h i c h i s t h e e x c e s s o f s a l e s o v e r c o s t s a t c u r r e n t p r i c e s , a n d r e a l i z e d c o s t s a v i n g s w h i c h a r e t h e e x c e s s o f c u r r e n t c o s t o v e r h i s t o r i c c o s t o f i n p u t s . . C o m p u t a t i o n o f b u s i n e s s p r o f i t a n d r e a l i z e d p r o f i t ( a ) I n v e n t o r i e s The r e l a t i o n s h i p s b e t w e e n t h e d i f f e r e n t i n c o m e c o n c e p t s o f a c c o u n t i n g p r o f i t , r e a l i z e d p r o f i t a n d b u s i n e s s p r o f i t c a n be s e e n i n t h e a c c o u n t i n g f o r i n v e n t o r i e s . ( i ) A c c o u n t i n g p r o f i t = s a l e s a t c u r r e n t p r i c e s - h i s t o r i c c o s t o f m a t e r i a l s u s e d ( i i ) R e a l i z e d p r o f i t = C u r r e n t o p e r a t i n g p r o f i t + r e a l i z e d c o s t s a v i n g s C u r r e n t o p e r a t i n g p r o f i t = s a l e s a t c u r r e n t p r i c e s - c u r r e n t c o s t o f m a t e r i a l s u s e d R e a l i z e d c o s t s a v i n g s = C u r r e n t c o s t o f m a t e r i a l s u s e d - h i s t o r i c ( o r F i f o ) c o s t The c u r r e n t c o s t o f m a t e r i a l s u s e d i s d e t e r m i n e d b y t h e q u a n t i t y s o l d o r consumed m u l t i p l i e d b y t h e w e i g h t e d a v e r a g e p u r c h a s e p r i c e i n t h e p e r i o d . T h i s i s a n a p p r o x i m a t i o n o n l y ; t h e o r e t i c a l l y e a c h t i m e -187-a unit i s sold or consumed i t s current cost should be obtained on that date. ( i i i ) Business profit == Current operating profit + realizable cost savings Realizable cost savings for the period is the sum of the realizable cost savings on the i n i t i a l and f i n a l inventories. This assumes that the i n i t i a l inventory was held u n t i l the mid-point i n the period, and the f i n a l inventory was then purchased. Realizable cost savings on i n i t i a l inventory = I n i t i a l inventory (units) x (average purchase price - purchase price at beginning of period) Realizable cost savings on f i n a l inventory = Final inventory (units) x (purchase price at end of period -average purchase price) (b) Fixed assets The current costs of fixed assets should be based on the market purchase price of new assets, but where quality changes are significant two other methods may be employed: (a) appraisal (b) price index numbers. The United States Bureau of labour Statistics compiles composite indexes fo r various groups and sub-groups of fixed assets. The procedure for calculating the depreciation charge does not vary from that i n conventional accounting: (a) estimating asset l i f e , (b) estimating the pattern the asset services w i l l form over time (or production), and (c) applying this pattern to the base. -188-Realized cost savings = Current cost depreciation - historic cost depreciation Realizable cost savings are calculated similarly as for inventories. The realizable cost savings in the period i s the sum^ f of the realizable cost savings on the current cost of the asset at the beginning and end of the period.. Let n «*- number of years of economic l i f e of the asset a = number of years from date of purchase to beginning of period c^ = current cost of asset at beginning of period C2 = current cost of asset at end of period ca =• average current cost of asset i n period Realizable cost savings = ^n-a x (ca - c l ) | + |n-(a+l) x (c2-c a) (c) Other assets and l i a b i l i t i e s (i) Cash and other short-term cash claims such as accounts receivable and payable, require no adjustment., ( i i ) Securities promising no fixed returns should be valued at current cost. This w i l l give r i s e to realizable cost savings; when sold, they w i l l y i e l d realized capital gains. The income from the s e c u r i t i e s is i n terms of current values and requires no adjustment.. ( i i i ) Fixed return securities* In the case of bonds receivable and payable, adjustments to a current cost base are necessary for the capital sum and also the periodic payments, since these are contractual and not currently declared. -189-l l l u s t r a t i o n A firm has issued at par $600,000 worth of k% 5-year bonds in a previous year. At the beginning of the current year, the market value of the bonds was at par but dropped to $597,073 at year-end on account of a rise i n the interest rate to S%» Realizable cost savings are: On bonds ($600,000 - 597,073) - $ 2,927 On interest expense (Average market interest rate - contracted rate h%) x $600,000 = $ 3,000 $ 5,927 Realized cost savings are $3,000 on the interest expense. The current cost of the loan capital i s $2u,000 + $3,.000 or $ 27,000. Theoretically a l l contracted items, such as rent income and expense, require adjustment similar to bond interest. -190. Illustration The same i l l u s t r a t i o n i s shown below as that employed for the purchasing power approach. Certain additional information i s available: December 31, 1962' Assets Cash Inventory Fixed assets, depreciated L i a b i l i t i e s Current Fixed (bond) Equities Capital stock Realized surplus Unrealized surplus savings Historic cost $ 75,000 100,000 120,000 $295.000 $ 25,000 80,000 $105,000 $150,000 $ 1+0,000 $190,000 Current cost $ 75,000 120 ,000 204,000  $399,000 $ 25,000 70,000 $ 95 ..000 $ 150,000 Uo,ooo 114,000 $ 3 OU , 0 0 0 The quantities and unit prices for inventories were: Qty.- Unit price Total Inventory January 1, 1962 90,,000 $1..00 $90,000 Inventory December 31, 1962 83,333 Purchases, 1962 374,000 1.30 100,,000 cl.07 (av.)400,000 - 1 9 1 -Market values for the fixed assets were not obtainable. Their, current costs have been based on a specific price index. The assets were bought at $ 2 0 0 , , 0 0 0 when the index stood at 1 2 0 . The index at the beginning and end of the current year was respectively 1 8 0 and 2 0 U . The economic l i f e i s 20 years and straight line depreciation i s appropriate. The current value of the bond at the beginning of the year was at par. Bond interest has been ignored* Inventory Current cost of materials consumed = 3 8 0 , 6 6 7 units x $ 1 . 0 7 • ftJj.07.3'OQ Realized cost savings = $ U 0 7 , 3 0 0 - 3 9 0 , 0 0 0 " $ 1 7 . 3 0 0 Realizable cost savings = 9 0 , 0 0 0 ($1. .07 - 1 . 0 0 ) + 8 3 , 3 3 3 ( $ 1 . 2 0 - 1 . 0 7 ) = $17,100 Fixed assets Current depreciation l / 2 0 x V 2 | " ( l | 0 x 2 0 ^ 0 0 0 ) + ^ x 2 0 0 , 0 0 0 ) j -Jfel6_j3QQ. Realized cost savings = $ 1 6 , 0 0 0 - 1 0 , 0 0 0 = J | 6 . 0 0 Q . Realizable cost savings = 1 3 / 2 0 ( 1 9 2 - 1 8 0 x 2 0 0 0 0 0 ^ + i g . ( 20U-192 } 2 0 ( 1 2 0 X * u u > u u u ' = $2:g,000 Bond Realizable cost savings = $ 8 0 , 0 0 0 - 7 0 , 0 0 0 =• $ 1 0 , 0 0 0 -192-A&justed Income Statement For the Year 1962 Sales $415,000 less Cost of goods sold 407,300 Gross profit 7,700 less Depreciation 16,000 Current operating loss $ 8,300 Realized cost savings On cost of materials $ 17,300 Depreciation 6,000 $ 23,300 Realized profit $ 15,000 Current operating loss 8 ,300 Realizable cost savings On inventories $ 17,100 fixed assets 25,000 bond 10,000 $ 52,100 Business profit $ 43 ,800 Concepts of r e a l profit Edwards and Bell believe that the general price level should be taken into account only after adjustments for changes in the prices of individual assets and l i a b i l i t i e s have already been made. Current operating profit i s stated in average current year dollars and no further correction i s necessary. Elements of f i / c t i o n a l profit exist -195-only in the measures of holding activities, on account of movements in the prices of assets and l i a b i l i t i e s i n proportion to the general price change. The elimination of such fictional profits transform the money concepts of business profit and realized profit into real profit concepts. Illustration December 51. 1959 December 51» I960 Fixed assets, at cost $ 2,000 $ 2,000 less Allowance for depreciation 900 1,000 $ 1,100 9 1,000 Valuation adjustment 550 700 Current cost $ 1.650 $ 1.700 The general price index was 80 at the time the assets were pur-chased, 98 at the beginning of the current period I960, 100 at the average-of-the-period, and 102 at the end of the period. -193a-The fictional realizable cost savings are: On i n i t i a l balance, g | • $1,650 = $67.35 On increments, — • (l,700 - 1,650) = 1.00 Fictional realizable cost savings In end dollars (index = 102) $68.55 In average dollars (index = 100) $67.01 The computation of fictional realizable cost savings i s necessary for net money claims, securities, inventories, fixed assets and bonds. The fictional realized capital gains are: 100-80 80— x $100 = $25 These fictional capital gains have been expressed i n average dollars. In end dollars, they amount to $25.50. -19k-The computation of f i c t i o n a l realized gains i s necessary for net money claims (in this case a l l realizable cost savings are considered as realized gains), assets sold during the period, materials consumed and depreciation expense. An appraisal of the current cost systems Sweeney's stabilized accounting system i s primarily concerned with the use of a homogeneous measuring unit, and not with the method of valuation as such. Replacement costs i n his system express the current general purchasing power of the assets as much as price level adjustments of their historic costs. Sweeney gives the following explanation for his treatment of depreciation expense. "'Because stabilized accounting i s primarily concerned with the maintenance of capital on the basis of general purchasing power, i t depreciates original cost adjusted for any intervening change in the general price le v e l , instead of depreciating 23 cost of replacement." There i s a certain lack of conceptual c l a r i t y i n this approach, however, since i f the asset values shown in the balance sheet are meant to reflect economic r e a l i t i e s , then a change in such values should be incorporated i n the income statement. This would also be i n line with current accounting though^ that a change in a reserve account should be reflected i n the income statement. Much the same criticism applies to Corbin 1s replacement cost adjustments. The outstanding merit of Mathews and Grant's proposals l i e s i n their simplicity. "The procedures recommended do not constitute a system of replacement-cost accounting. They contemplate the continuation of historical cost accounting for purposes of profit measurement, with 23. Sweeney, op. c i t . , p. 3>1« -195-supplementary adjustments to provide a record of the current cost of depreciation and stocks sold or used." ^ 4 It i s claimed that the current income figure i n this approach provides substantially for the maintenance of the real value of the investment in plant and inventory. It i s therefore a better guide for the formulation of tax and dividendlpolicies. Because of their simplicity and the use of supplementary statements, these proposals are more l i k e l y . to win approval from a large section of the accounting profession and business community. The concept, however, has several defects. Current values are not reflected in the balance sheet. In the income statement, seasonal patterns in sales and purchases and other expense items are not taken into account.. Thus i t can be argued that the proposed adjustments f a l l short of matching revenues and costs and expenses at current prices. The adjusted depreciation expense i s based on the average replacement value half-way through the accounting peridd. The valuation of the opening inventory at the cost price of stocks most recently acquired w i l l not, however, bring the treatment of cost of goods sold in line with that of depreciation expense. It i s pointed out that i t has been assumed that stocks have turned over at least onee during the year, so that the 25 closing inventory i s valued at current prices. But where there has been a rapid turnover, these current prices w i l l pertain to a later part of the period and i n order for the cost of goods sold to reflect 2k* Mathews and Grant, op. c i t . , p. 21. 25. Ibid, p. 25. -196-average current prices of the year, the volume of opening and closing inventory must be the same. There i s one further discrepancy which might arise. The figure of purchases in the trading account refers pon the average, to an earl i e r period than sales, thus we are comparing two unlike quantities- The distortion might be substantial, since purchases far exceed the average inventory held. But the distortion per unit must be smaller because of the shorter time-lag between purchases and sales than between the two inventory figures. How much less w i l l depend on the rate of stock turnover.. The authors contend that there are strong theoretical arguments against making adjustments to items other than the physical assets, v i z . inventories and fixed assets, and that the deflation of incomes, i n terms of constant purchasing power, belongs to the realm of the statistician rather than the accountant. Nonetheless, when there are susbtantial purchasing power gains and losses from the holding a c t i v i t i e s of the firm (which do not cancel one another), then the proposed adjustments are l i k e l y to f a l l short of performing the primary function of accounting which i s "to accumulate and communicate information essential to an 27 understanding of the activities of an enterprise ...." The authors of the price-level accounting system advocated by the (English) Association of Certified and Corporate Accountants believe that their proposals secure: 27. American Accounting Association, Accounting and Reporting Standards  for Corporate Financial Statements and Preceding Statements and  Supplements (Columbus, 1957) , p. 1--197-"(a) a proper computation of business income, and (b) a correct valuation of capital assets, by bringing a l l values ?8 into the same time dimension." As with other proponents of current cost systems, the authors believe that the maintenance of the physical capacity invested in industry i s of paramount importance. They are less concerned with the distortion and loss of comparability of the accounting documents caused by changes i n the value of money. The proposal to base depreciation on the intensity 29 of use of the machine has certain merits. The principle of current valuation i s applied to a l l assets, with the contra entries, representing the losses or gains over the period, made in the assets revaluation reserve.. Capital gains and losses are effectively insulated from the income statement and are not regarded as income. Thus obeisance i s made to the principle of recognising income only on realization at the sacrifice of introducing a fundamental i l l o g i c a l i t y into the system. Edwards and Bell's thesis constitutes a rigourous framework of accounting income theory. Of the two income concepts, realizable profit and business profits jthey have selected the latter for a detailed exposition of applied theory, partly because business profit does not represent a radical departure from conventional accounting principles, and partly because i t provides management with a long-term view. If current operating profit "exceeds interest on the current cost of the firm's assets at the beginning of the period, (then) the productive 2 8 . Accounting for Inflation, op., c i t . , p. 9U« 2 9 . See Chapter V . -198-process of the firm is worth continuing." ^ It thus indicates the most profitable of various alternative production processes and evaluates the firm as a going concern. It i s the alternative concept of realizable p f o f i t , however, which i s based on the opportunity costs (market exit values^) of the assets and l i a b i l i t e s , that has special relevance to the shortr-run problems of the enterprise.. This profit figure indicates whether the firm should have operated during the period. Since management must make a choice on practical grounds between accumulating market entry values or market exit values, i t would appear that business profit i s the more useful concept of the two., Conceptually, current market prices are a better approximation to economic values than the employment of index numbers or appraisals. The use of index numbers i s assumed to give values which approximate market values, but this w i l l not be so where the market i s imperfect, or where there has been a technological change with reference to the specific asset or to the broad class of assets on which the index is based. Market values, on the other hand, take the impact of technological change automatically into account. Where market values are based on the replacement cost new of machines or where recoft**se i s made to adjust-ments by means of index numbers, then accounting values might further deviate from economic values because of the necessity to impute a depreciation factor. This qualification can be extended to apply to the valuation of goods-in-process which are not traded. ^Oa 3 0 . Edwards and B e l l , op., c i t . . p. 9 9 . 30a.. Lutz and Lutz, op. c i t . , p. 213. -199-T h e r e a r e o f t e n s u b s t a n t i a l p r a c t i c a l d i f f i c u l t i e s i n e m p l o y i n g 3 1 m a r k e t v a l u e s . F o r e x a m p l e , m a c h i n e r y i s embedded i n t h e c e m e n t f l o o r o f a f a c t o r y b u i l d i n g . How a r e t h e s e p a r a t e m a r k e t v a l u e s f o r t h e m a c h i n e r y , t h e b u i l d i n g a n d t h e l a n d on w h i c h i t s t a n d s t o be e s t a b l i s h e d ? If s e p a r a t e v a l u e s c a n n o t b e e s t a b l i s h e d , what t h e n c o n s t i t u t e s a n a s s e t ' s v a l u e ? F u r t h e r , m a r k e t v a l u e s i n t r o d u c e a s u b j e c t i v e e v a l u a t i o n i n t o t h e a c c o u n t i n g p r o c e s s - a n i m p o r t a n t c o n s i d e r a t i o n w h e r e t h e r e v i s e d income f i g u r e s a r e i n t e n d e d t o b r i n g a b o u t a r e d i s t r i b u t i o n o f t h e t a x b u r d e n among c o r p o r a t e t a x p a y e r s . . T h e r e i s a f u r t h e r c r i t i c i s m o f a p r a c t i c a l n a t u r e . Though t h e a u t h o r s s t a t e t h a t t e c h n i q u e s c a n be d e v i s e d t o make p r i c e l e v e l a d j u s t m e n t s on a d a y - t o - d a y b a s i s , o r a t t h e y e a r - e n d , t h e i l l u s t r a t i o n s c o n t a i n e d i n t h e t e x t p e r t a i n w h o l l y t o t h e l a t t e r . The d i f f i c u l t i e s o f i n c o r p o r a t i n g p r i c e l e v e l a d j u s t m e n t s i n t h e a c c o u n t i n g s t r u c t u r e on a s h o r t t e r m b a s i s , w h e t h e r f o r t h e p u r p o s e s o f c o m p a r i n g p e r f o r m a n c e w i t h p r e - d e t e r m i n e d s t a n d a r d s o r i n p r o v i d i n g a d j u s t e d u n i t c o s t s o f p r o d u c t i o n , c o n s t i t u t e one o f t h e more s e r i o u s o b j e c t i o n s r a i s e d b y W i l c o x a n d G r e e r . ^ F r o m o u r i l l u s t r a t i o n , i t c a n b e s e e n t h a t t h e r e p o r t e d a c c o u n t i n g p r o f i t o f $ 1 5 , 0 0 0 i s composed o f : ( a ) C u r r e n t o p e r a t i n g l o s s ( $ 8 , 3 0 0 ) ( b ) R e a l i z e d c o s t s a v i n g s on c o s t o f m a t e r i a l s 17,300 ( c ) R e a l i z e d c o s t s a v i n g on d e p r e c i a t i o n $ 6 , 0 0 0 0 1 . See C h a p t e r V . 3 2 . W i j c o x a n d G r e e r , o p . c i t . . -200-Since the operating loss i s stated i n current dollars, i t can be compared with the operating p r o f i t of fl,65>0 obtained i n the stabilized accounting system. The differences can be traced to the following factors: (a) The sales figure in the stabilized system i s stated in terms of year-end dollars.. It has been adjusted for seasonal changes i n sales and i n the general price index. Sales have not been adjusted a i i * i n the current cost system. (b) In the stabilized system the i n i t i a l and f i n a l inventories and purchases are expressed in year-end dollars to give the adjusted figure of cost of goods sold.. In the current cost system, the cost of goods sold i s obtained from the quantity sold times the weighted average purchase price i n the period. Theoretically each time a unit i s sold, i t s current cost should be obtained on that date. (c) Depreciation expense in the stabilized system is given by applyingtihe historical cost depreciation rate to the original cost of the asset expressed in year-end dollars., Depreciation expense in the current cost system i s given by applying the historical cost depreciation rate to the replacement cost new of the asset, taking the average for the period. In the il l u s t r a t i o n , the replacement cost has been based on the specific price index.. It can be seen that differences are bound to arise i n the figure of operating profit under the two systems. Where there i s a wide divergency between the current values of the assets and changes i n the general price level (as was the case i n the il l u s t r a t i o n ) , then these differences are l i k e l y to be substantial. Even where changes i n the value of money and in secondary price levels are of the same order of magnitude1, there - 2 0 1 -w i l l s t i l l be differences on account of the different treatment accorded to sales and cost of goods sold i n the respective systems. While the current cost approach f a i l s to adjust for variations i n sales, i t s treatment of cost of goods sold is conceptually superior to that i n stabilized accounting. But assumptions under either system can be modified or changed i f they proved to be unrealistic i n the practical world. A choice between adopting either one of these two main schools of price-level accounting must be predicated on other, and more fundamentaljgrounds. -202-VII. CONCLUSION "For i t i s only when a person has a certain belief, and is sure of the principles on which his belief rests that he can be said to possess sci e n t i f i c knowledge, as, i f he i s not more sure; of his principles or pEemisses than of his conclusion, his scientific knowledge, i f he possesses i t , w i l l be only accidental." 1 Empirical evidence has shown that a period of r i s i n g prices i s attended by a continuing erosion of industrial capital, the handmaid of the process being "generally accepted accounting principles." It is possible, then, for the amounts paid out by way of taxes and dividends to be unduly high relative to current income and a danger exists of such payments being made out of capital. This can be rephrased: realized savings (that i s , ex post savings) i n industry afid- less than anticipated savings (that i s , ex ante savings) i n the preceding period, and for some industries and firms current savings might be negative, with deleterious effects on the rate of economic growth. It i s also argued that the reported profit figure i s unduly large when prices are rising, and unduly small when prices are f a l l i n g . Thus the way accountants measure profit contributes to the waves of business optimism 2 and pessimism and accentuates cyc l i c a l fluctuations. Further, i t i s 1. The Nicomachean Ethics of Aristotle, translated by J . E. C. Walldon, London: Macmillan and Co., 1892, p. 182. 2.. Some economists contend such fluctuations perform a useful and essential r o l e . See for example, Schumpeter, The Theory of  Economic Development, op. c i t . -203-claimed that a money income tax base gives rise to an inequitable allocation of the tax burden among firms. Since a consideration of equity is necessarily subjective, this leads us to the central problem of defining our objective. Unfortunately we find, not one ideal concept of income, but a number of conflicting concepts. The one that is most often quoted and, therefore, presumably commands the widest support is the Hicksian concept of income as the difference between the discounted net worth of an enterprise at two points of time. In turn discounted net worth depends on the pattern of the future earnings stream and the rate of interest. The assumption is made that this future stream and its time distribution is known or can be estimated by the owners. There is also some disagreement as to which discount factor is the appropriate one to employ. Some 3 economists would use the going rate of interest, an approach that stems from the classical economic concept of the short-term marginal costcof funds. Others, however, argue that in the long run i t is the firm's cost of capital that should be employed for finding the present value of its earnings stream. This cost of capital can be conceived as a borrowing rate. If this is assumed to be a constant, i t would be identical with the capitalization rate of a pure equity stream, or i t can be assumed to be an increasing function of the outstanding debt. Alternatively the cost of capital can be conceived as a lending rate "measured by the expected rate of return on equity investments outside the firm that appear to the entrepreneur to involve a degree of riskiness similar to those contemplated with^in the firm."^ Under conditions of uncertainty, we 3. Ronald Edwards, op. ci t . U. H. V. Roberts, op. cit . . pp. 199-200. ^ O b -must take into account also changes i n the owners' expectations about future earnings and their pattern i n time, and changes in the interest rate and the price level* The theory of income outlined above i s highly subjective, though conceptually i t gives the best measure of the change in the owners' well-offness. But i s i s not relevant to the accountant's task. A related concept t& the increase i n net worth theory i s that of tangible equity-change income.. This i s defined as "the change over the year i n the value of the corporation's equity exclusive of the capitalised value of i t s own expectj[future earning power (going value)". The difference between the sum total of the present values of the net assets, which are the discounted values of their respective earnings streams, and the net worth of the enterprise as a whole i s going value or goodwill. A consideration of changes i n goodwill is excluded from the income concepts in a l l price-level systems, either e x p l i c i t l y or otherwise, because of "the nebulous character of this margin and the subjective 6 element that might be involved i n i t s estimation." It i s also sometimes argued that since goodwill can only be knowijon the actual sale of the firm, i t i s a liquidation concept and i s of no consequence to the firm so long as i t remains a going concern. The accountant, then, might attempt to measure tangible equity-change income from the present values of the assets. The lower limit to the present value of future receipts is set by an asset's selling S« See Alexander, op. c i t . , pp. Ihl et. seqy 6.. Accounting for Inflation, op. cit.., p. 85. See also Edwards and Bell op. c i t . , p. q5« -205-price, that i s , what the asset would realize i f sold i n the market. The upper limit i s set by i t s replacement cost, since i f present value i s higher than replacement cost, i t would benefit the entrepreneur 7 to purchase more machines or duplicate his business. But there are large qualifications. With regard to the floor level there are several considerations. The market for secondhand assets i s an imperfect one. Few entrepreneurs have the f a c i l i t i e s to make frequent sales of individual pieces of their fixed equipment. Also, an asset i s often part of a machine complex which must be considered as a whole; in some firms this interdependence might extend to the entire organization. Further, many entrepreneurs continue i n a particular line of business for various reasons, even where i t would have been more profitable to have disposed of i t . The upper limit too might be inoperative because of monopolistic rights or a situation in which there is i n d i v i s i b i l i t y of capital and a limited market. But i t i s believed that market values do approach present values of assets f a i r l y closely under normal conditions. In particular, replacement costs give a close approximation to discounted future net recipts in industries which are not contracting industries. ^ A reconciliation between the accounting income concepts propounded 9 by.Edwards and Bell and tike variants of tangible equity-change income are given below. 7. Ronald Edwards, op. c i t . , pp. 112-3. • 8 . TbifL, 9 . Edwards and B e l l , op. c i t . -206-Realizable profit = operating profit (production profit) +• capital gains = Tangible equity-change income (assets at selling prices) Business profit = current operating profit (realization profit) + realizable cost savings - Tangible equity-change income (-assets at replacement costs) Edwards and Bell have argued convincingly that business pr o f i t would be the preferable one of the two income concepts to adopt. ^ Current operating profit, furthermore, also conforms to another economic concept of income as sales less costs expressed in current dollars. 1 1 But the concept of sales less costs in current dollars i s capable of two different interpretations along the lines of the controversy posed by the two main price-level accounting systems. It i s essential to stress that the f i n a l arbiter of any proposed change must be founded in the enhanced u t i l i t y of the financial statements to management and investors. Management i s concerned with the optimum allocation of resources. Thus a current cost income concept which implies the maintenance of the productive capacity of the enterprise is not only the most useful but also the only relevant concept to the decgision making process. Investors, however, are motivated by a different goal* they seek to maximise the y i e l d on their investments. 10. Ibid.,, pp. 98-109. 11. Some economists, for example Keynes and Slichter propose this concept. See Chapter I . -207-From the viewpoint of the consumption policy of the owners, a purchasing power concept which seeks to maintain a constant stream of real income is more desirable. Alexander suggests that this i s also the more 12 acceptable concept to economists and some accountants. The two concepts do not necessarily produce similar resultant income figures, except by accident. Where the production costs of capital goods specific to the industry or firm are increasing rapidly, an income concept based on maintaining a constant stream of income i n terms of command over goods and services i n general might not leave the productive capacity of the plant unimpaired. The same results obtain when stock prices are r i s i n g faster than the general price level, but the consequences, as a rule, are not so dire as with the erosion of the fixed equipment. Similarly, the maintenance of the physical scale of operations might not be adequate to provide the ownjfers a constant stream of income in money or real terms. One of the conditions of the former i s an unchanged money demand for a constant outputj..the latter requires, i n addition, an unchanged relative position of the specific price level i n the structure of general prices. Income i s an all-inclusive concept. Accountants have long been familiar with the notion that there are different costs according to the purpose they are intended to serve. Similarly, i t would appear necessary to incorporate both income measures i f i t i s desired to correct for the price level change as well as to reflect replacement costs of the physical assets. 12. Alexander, op. c i t . , p. 19U. -208-Edwards and Bell hold that secondary price levels are the important consideration since current costs are the crucial costs for decision making, and thus also for the evaluation of managerial performance. But real data adjusted for changes in the general price level are also necessary.. They give the r e a l rate of return on the resources employed and the real burden of taxation; further, the comparability of the profit figure i s enhanced. Tus i n their system, current market values are f i r s t incorporated i n the accounts, after which the holding gains and losses are deflated to give a measure of business profit in real terms. There i s , however, an alternative approach. Many accountants believe that one of the most important functions of financial statements is to f a c i l i t a t e the comparison of net worth and operating results of one firm or one period with another. This comparability is lost when the value of the monetary unit i t s e l f i s changing. Current cost adjustments, insofar as they take into account only changes in the current values of physical assets, restore only part of the comparability. Thus i t i s argued that the financial statements should be deflated i n terms of a general price index i n order to correct for the s t a t i s t i c a l f allacy. Replacement cost adjustments might then be made for a l l assets provided reasonably objective adjustment factors are available. Advocates of this approach would probably emphasize that the purchasing power adjustment made i n the f i r s t instance merely seeks to correct a s t a t i s t i c a l error and restore comparability to the accounts. It does not introduce a new income concept. Current cost adjustments, however represent a departure from the traditional concept to what might be termed a neo-Pigovian theory, of income. -209-Postscript There i s one objection to the implementation of price-level accounting which is. d i f f i c u l t to answer: " . . . . i n an economy in which many contractual relations are expressed in money terms certain inequities would be introduced by measuring business income i n real terms while government obligations, corporate bonds, and bank deposits were s t i l l fixed i n money terms." Theoretically, the only satisfactory solution would be to extend the principle i n the concept of real income to the t o t a l i t y of economic transactions i n society. But there is another consideration. F u l l employment, economic progress and prosperity are dependent, to a large extent, on the economic development of the private sector, i n which the corporation i s the single most important economic unit. The point to be resolved, therefore, i s posed by a weighing, on the one hand, of considerations of equity against certain inherent dangers to the economic well-being of the corporate sector and the country as a whole, on the other. Most countries which have f e l t the damaging effects of inflation on industrial efficiency have taken action to alleviate the situation. In the main, such action has consisted of partial measures ranging from the granting of i n i t i a l and investment allowances for fixed assets i n the United Kingdom, and the employment of Lifo techniques and accelerated 13. Ibid..,, p. 199. See also Chapter IV., Ii;., On the significant role of the corporation in modern society, see, for example, Adolf A. Berle, Jr. and Gardiner C. Means, The Modern  Corporation and Private Property, New York: The Macmillan Co., 1935 and Peter F. Drucker, Concept of the Corporation, New York: The John Day Co.., I9I46. -210-depreciation in the United States to the revaluation measures of Belgium and the series of revalorization measures in France and Italy after the war.. ^ There have not been many examples of a comprehensive approach to the price level problem. One was the adoption of stabilized accounting in Germany in the runaway inflation of the 1920's. Another i s the practical application ofj(current cost concept in the consolidated accounts of N. V. Philips' Gloeilampenfabrieken i n recent years. The problem of income determination i n the corporate sector i s , i n the last analysis, found to be intimately related to the rate of economic growth.. A study group of the American Institute of Accountants wrote i n 19f>2!: "Ultimately .... the definition of income may become a p o l i t i c a l question, and be determined by the attitude of legislators toward savings £and) industrial growth" 18 For a general description of these measures, see Accounting for  Inflation, op. c i t . , Appendix, pp. 99-lUU* In "revaluation", an asset i s expertly assessed and then written up at i t s current selling price under 'revalorization 1 the asset value i s written up by reference to ajf general price index. Ibid., p. 106. 16. A. Goudeket, "An Application of Replacement Value Theory", Journal  of Accountancy. July I960, pp., 37-U7* 17. Changing Concepts of Business Income, op. c i t . , p. 19-18. In one country at least, income determination has been made a tool for maintaining a high rate of business investment and economic growth. "At the end of the f i s c a l period the directors have to decide how much profit to report. Theyconsider such things as the effect that the reported profit may have on forthcoming wage negotiations, the amount of dividerj/ds they want to pay, and a proper relation between dividends and income. When the directors have determined -211-1 8 . (Contd.) approximately what profit they want to report, they t e l l the accountant to find the easiest way to adjust the books to achieve the desired figure".. John P. Shelton "A Tax Incentive for Stabilizing Business Investment", National Tax Journal, September 1956, p. 232, quoted i n Sidney Davidson, "Depreciation, Income Taxes and Growth," Accounting Research, Vol. 8 , No. 3 , July 1957, pp. 191-205. -212-B I B L I O G R A P H Y -213-BIBLIOGRAPHY I. BOOKS American Accounting Association. Accounting Concepts and Standards  underlying Corporate Financial Statements, various years. American Accounting Association, Accounting and Reporting Standards  for Corporate Financial Statements and Preceding Statements and  Supplements. Columbus, 1957. American Institute of Accountants, Report of Study Group on Business Income, Changing Concepts of Business Income, New York: Macmillan Co.,, 1952. American Institute of Accountants, Committee of Terminology, Accounting  Terminology Bulletin Number 1. 1953* Anderson, Arthur, and Co. Accounting and Reporting Problems of the  Accounting Profession, I960. Anthony, R. N. Management Accounting, Homewood, I l l i n o i s : R. D. Irwin, I960. Association of Certified and Corporate Accountants, Taxation and Research Committee, Accounting for Inflation, London: Gee and Company (Publishers) Ltd., 1952. Backer, Morton (ed.). Handbook of Modern Accounting Theory, New York. Prentice HaU, Inc., 19^1 Baxter, W. T. and Davidson, Sidney (ed.). Studies i n Accounting Theory, Homewood, I l l i n o i s : Richard D. Irwin, Inc., 1962. Berle, Adolf A., J r . and Means, Gardiner C. The Modern Corporation  and Private Property, New York. The Macmillan co., 1935* Blaine, Robert E. Price-Level Accounting - A Case Study, thesis submitted i n partial fulfilment of the requirements for the degree of Master of Business Administration at the University of California, May 1961. Boribright, James C. The Valuation of Property, New York and London: McGraw-Hill Book Coj Inc., 1937* Bray, F. Sewell. The Measurement of Profit, Oxford University Press, 191*9* Canadian Institute of Chartered Accountants, Committee on Accounting and Auditing Research, Accounting and Auditing Practice Bulletins, various numbers. Canning, John B. The Economics of Accountancy, New York: The Ronald Press Company, 1929. Clark, John Bates. The Distribution of Wealth, New York: The MacMillan Co., 1899, -211;-Council on Prices, Productivity and Incomes, First Report, London, 1958. Dean, Arthur Hobson. An Inquiry Into the Nature of Business Income under  Present Price Levels. 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