1943-183-02-The Nature of the Financial Accounting Process

8/13/2019 1943-183-02-The Nature of the Financial Accounting Process

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The Nature of the Financial Accounting Process

Author(s): George O. MaySource: The Accounting Review, Vol. 18, No. 3 (Jul., 1943), pp. 189-193Published by: American Accounting AssociationStable URL: http://www.jstor.org/stable/240761.

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h e ccounting eviewVOL.XVIII JULY, 1943 No. 3

THE NATURE OF THE FINANCIALACCOUNTING PROCESS*GEORGE0. MAYA COUNTING has been defined by acommittee of the American Insti-

tute of Accountants as the art ofrecording, classifying and summarizing,in a significant manner and in terms ofmoney, transactions and events which are,in part at least, of a financial character,and interpreting the results thereof. It isan art, not a science, but an art of wideand varied usefulness. The purely re-cording function of accounting, though in-dispensable, concerns only technicians. Itsanalytical and interpretive functions are oftwo kinds. One type of analysis is intendedto afford aid to management in the con-duct of business and is of interest mainlyto executives. The other type leads to thepresentation of statements relating to thefinancial position and results of operationsof a business for the guidance of directors,stockholders, credit grantors, and others.This process of financial accounting,therefore, possesses a wide importance forpersons who are neither accountants norexecutives.Many accountants are reluctant to ad-mit that accounting is based on nothingof a higher order of sanctity than conven-tions. However, it is apparent that this isnecessarily true of accounting as it is, forinstance, of business law. In these fieldsthere are no principles, in the fundamentalsense of that w, rd, on which we can build;* Adapted from materials prepared for a forthcomingbook by the same author.

and the distinctions among laws, rules,standards, and conventions lie not in theirnature but in the kind of sanctions bywhich they are enforced. Accounting pro-cedures have in the main been the resultof common agreement among accountants,although they have to some extent, andparticularly in recent years, been influ-enced by laws or regulations.Conventions, to have authority, mustbe well conceived. Accounting conventionsshould be well conceived in relation to atleast three things: first, the uses of ac-counts; second, the social and economicconcepts of the time and place; and, third,the modes of thought of the people. Itfollows that as economic and social con-cepts or modes of thought change, ac-counting concepts may have to changewith them.The first point for consideration is,therefore, the major uses of financialstatements. We can recognize at least tendistinguishable uses:

1. As a report of stewardship2. As a basis for fiscal policy3. As a criterionof the legality of divi-dends4. As a guide to wise dividend action5. As a basis for the granting of credit6. As information for prospective in-vestors in an enterprise7. As a guide to the value of invest-ments already made8. As an aid to government supervision


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190 The AccountingReview9. As a basis for price or rate regulation10. As a basis for taxationGeneral-purpose statements are notsuitable in all of these cases; in some in-

stances, special-purpose statements arecalled for. This has become increasinglyrecognized in respect of rate or price con-trol and taxation, and it should also berecognized, for reasons which I shall indi-cate later, in respect of informationfor newinvestors-or, in other words, for theprospectus-and also in some cases forthe determination of the legality of a divi-dend. But even if these purposes are elimi-nated, there remain at least six which areexpected to be served by general-purposestatements.It is immediately apparent that anygeneral-purpose statements cannot be ex-pected to serve all the purposes equallywell-indeed, if they are to be appropriatefor the major uses, it is likely that theywill not serve some other purposes evenreasonably well. It becomes necessary,therefore, to consider which are to be re-garded as the controlling objectives, andto view the possibility of changes therein.Accounting conventions must take cog-nizance of the social and economic con-cepts of the time and place. Conventionswhich are acceptable in a pioneer, free-enterprise economy may not be equallyappropriate in a more mature, free-enter-prise economy, and may lose their validityentirely in a controlled economy. Someexisting accounting conventions seem toassume implicitly the existence of laissezfaire and may require reconsideration asprices, interest rates, and other vital ele--ments become the subject of consciousgovernment control. Under this head mustbe considered, also, the forms of businessorganization and changes either in the na-ture of the dominant type or types or inthe laws governing them. Systems of tax-ation and legal decisions growing out ofthem also influenceaccounting concepts.

The third and last consideration whichhas been mentionedas affectingaccountingconventions is the modes of thought of thepeople. The extent and the nature of legalinfluence in business affairswill affect theconventions; those developed in the at-mosphere of the common law will differfrom those evolved under a civil code sys-tem. So, too, a people thinking in terms ofcapital value and a people thinking interms of annual value will naturally reachdifferent conclusions on some points, as isevidenced by the American and Britishattitudes towards capital gains and lossesin taxation and accounting.The relevance and importance of suchconsiderations as these have been bornein on me by the events of the forty-fiveyears of my experience in American ac-counting. Within this time we have movedfrom what might be called the last daysof a pioneer, free-enterpriseeconomy to aperiod in which a large and growing seg-ment of enterprise is under a substantialmeasureof government control. The majorpart of the development of the corporationas the typical formof businessorganizationhas occurredwithin the same period; therehas been a marked movement toward theseparation of beneficial ownership frommanagement.Beginning with the control over railroadaccounting given to the Interstate Com-merce Commission in 1907, we have seena steady growth of accounting by pre-scription,and a shift from the common-lawmode of thought towards that of the civilcode.The laxness of our corporationlaws andthe ease of reincorporationhave impairedthe significance of the corporation asan accounting unit. The extension ofintercorporate holdings has increased theimportance of accounting for interest,dividends, and other forms of transferredincome; manifestly, such accounting in-volves different problems from those


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The Nature of the Financial Accounting Process 191encountered in dealing with primary in-come, such as that from manufacturing.The creation of a wide variety of forms ofcapital obligations has rised questions asto the accounting significance of legal dis-tinctions, often highly artificial, betweenbonds and stocks and between interest anddividends.Perhaps the most significant change ofall is the shift of emphasis from the balancesheet to the income statement, and par-ticularly to the income statement as aguide to earningcapacity rather than as anindication of accretions to disposable in-come.It is appropriate,next, to considerwhatalternative approaches to the problem offormulating or revising the conventionsof financial accounting are open to us.First of all, there is a choice between thevalue and the cost approach, or perhapsrather a question as to how the two canbest be combined. This combination is il-lustrated in the custom of carrying inven-tories at cost or market value, whicheveris lower-one of the oldest of accountingpractices.There is a choice between different con-cepts of income and between differenttheories of allocation of income to periods.We have the concept according to whichincome arises gradually, and the conceptwhich treats income as arisingat a momentwhen realization is deemed to have oc-curred.Here again, both concepts in prac-tice are adopted to some, but not to anunchanging, extent. Today, the interestingquestion is presented whether accountingis likely to move in the direction of a morecomplete adherence to the realization con-cept of income or towards wider applica-tion of the doctrine of gradual accrual.There is also a choice between the enter-prise as the accounting unit and the legalentity that carrieson the enterprise as theaccounting unit. The system of consoli-dated accounts, freely employed in cor-

porate reporting, is a departure from thestrict separate-entity theory. In recentyears, the adoption by public service com-missions of the concept of cost to the firstperson who devoted property to the publicservice, as the basis of propertyaccountingof the present owners, has created a newinterest in enterprise accounting, of whichit is a crude and inadequate variant, andalong with it a new series of problems.The range of possible choice of conven-tions might be extended if some postu-lates, commonly adopted, were discarded.It is, for instance, generally assumed thatfinancial statements must be in a continu-ous, related series, but it may be arguedthat there is no absolute compulsion thatthey should be. The problemof continuitypresents difficulties when a substantialchange of conventions occurs-as, for in-stance, when public utility corporationsare required for financial accounting pur-poses (and not merely for rate purposes)to account for property on the basis ofthe cost to the firstpurchaserwho devotedthe property to public service, instead ofon the traditional basis of cost to them-selves; or when straight-line depreciationaccounting is substituted for other meth-ods of dealing with property consumptionwhich have been employed and sanctionedfor decades.Again, the monetary unit is generallyassumed to be substantially constant invalue, but at times this assumption of sta-bility has to be abandoned,with the resultthat accounting conventions have to bemodified.The choice of conventions in financialaccounting, as in cost accounting, is tosome extent affected by the conflict amongconsiderationsof speed, accuracy, and ex-pense. The accountant is called upon toproduce general-purposestatements withina few weeks of the completion of the fiscalperiod to which they relate. These reportsare expected to be final and to serve a


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192 TheAccountingReiewgreat diversity of purposes. Delay inpreparation might permit of greater re-finement but might impair the usefulnessof the statements; hence conventions mustbe such as to be capable of prompt appli-cation.In a pioneer economy, the great oppor-tunity for making profits is likely to liein participating in the growth of the coun-try and in the accompanying increase ofvalues. At such a time capital will be rela-tively scarce, whereas labor-particularlyif there is free immigration-may beplentiful. These causes will contribute tomake capital investment relatively small;and the proportion of assets that are read-ily salable, and may be expected to berealized in a short time, will be compara-tively high.In such circumstances, the value ap-proach to accounting has a strong appeal.In readingAmericanaccounting literature,it is surprising to find how generally ac-counting has been described as a processof valuation, how this view has been main-tained down to a rather recent date, andhow pronounced and rapid the change ofview has been. In a more mature economy,when greater capital resources, and, per-haps, changes in labor conditions also,tend to produce constantly increasing capi-tal investment, business units becomelarger and enterprisesmore complex. Thenthe valuation approach becomes imprac-ticable and resort to cost as the primaryline of approachbecomesalmost inevitable.The change from a value basis to a costbasis is of great importance in relation tosuch questions as the rate base and thesurplus assets theory of limitation ofdividends. It is undeniable, though notfully recognized outside the profession,that books of large enterprises are keptpredominantly on a cost basis and do not,therefore, constitute evidence of the valueof either the enterpriseas a whole or of theseparate assets thereof, particularly the

capital assets. This might be deemed to bea serious defect of accounting proceduresexcept for two considerations-first, thatthe value of the enterpriseis seldom a ma-terial fact for consideration; and, second,that when it is, it can be measured onlyby looking ahead. For this purpose, thesole relevance of accounts of the past is asa means of throwing light on the prospectsfor the future. These considerations haveadditional force if the implicit assumptionthat the monetary unit remains stable iswidely at variance with reality-as, for in-stance, in the case of property acquired be-fore a substantial decline in the purchasingpower of the monetary unit such as oc-curred between 1913 and 1920.Forty-five years ago the external in-fluence acting on accounting with thegreatest effect was that of the creditgrantor. In recent years there has been amarked shift of emphasis, and the use ofaccounting statements as a guide in thepurchase or sale of securities has been moreheavily stressed as a result of the efforts toimpart liquidity to investments in long-term enterprises. In the early days, con-servatism was the cardinal virtue of ac-counting; now, the virtue of conservatismis questioned, and the greater emphasis ison consistency. At that time, also, uniformclassifications that were binding on par-ticular forms of enterpriseswerepracticallyunknown. Today, they are numerous andincreasing in number and scope.In this article the only objects have beento bringout the true nature of the account-ing process and to advance the thoughtthat accounting conventions are not some-thing fixed and unalterable,but somethingthat, like the law, should have elements ofstability and of flexibility. Times arechanging and accounting conventions willchange with them. Today, a study of thehistorical development of accounting con-ventions and of the causes which havebrought about change may be more useful


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StructuralFundamentals f Financial Statements 193than a description of present practice. Ithas frequently been saudthat the changesrevealed by successive balance sheets aremore significant than the individual bal-

ance sheets themselves. The same may betrue of the conventions upon which bal-ance sheets are based.

STRUCTURAL FUNDAMENTALSOF FINANCIAL STATEMENTSHOWARDC. GREER

NCOUNTINGliterature is rich withdiscussions of the analysis and in-terpretation of financial state-ments. It contains surprisinglylittle on theorganization and presentation of account-ing data to facilitate analysis and inter-pretation. Progress in this field seems tohave been left largely to the accidents ofpractice and personal inclination.'The first step towardmaking accountingstatements tell an understandablestory isto arrange them properly. If the groupingand the sequence of items are logical,statements interpret themselves. Suitableemphasis and proportion bring out salientfacts clearly. Adroit combination andplacement of items suggest significant re-lationships.Consistent treatment of the variousclasses of elements in all financial state-ments would soon lead even the casualreaderto a better appreciationof the basicfinancial aspects of business activities andtheir results. These now are often over-looked or misunderstood because of thethoughtless and haphazardarrangementofmany published accounting reports.1 The author recently examined the tables of contentsof a dozen textbooks on general accounting subjectswithout finding a chapter purporting to deal primarily

with organization, arrangement, or presentation of ac-counting statements. The body of the texts is almostequally barren of discussion on this subject.

The correct presentation of a balancesheet or an income statement is not simplya matter of taste or precedent. Certaintruths are inherent in an accounting forbusiness activities and results, and theyshould be recognized in accounting state-ments. A careless draftsman may ignorethem, but he does not change their im-portance by so doing.BASIC RELATIONSHIPS

What are the essential facts about thecondition and the results of a business en-terprise? This article attempts to pointout some which are commonly overlooked,and to suggest how they may be illumi-nated by a logical arrangementof financialstatements.To arrive at a sound basis of arrange-ment and presentation it is necessary toconsider-(a) The nature of the balance sheet(b) The nature of the income statement(c) The relationshipsbetween themIn all three directions the study will befocused almost at once on relationships.Since one accounting fact assumes sig-nificance only in relation to another, com-parison is inherent in every accounting

analysis. What are these relationships,andwhat are the methods of presenting them?

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1943-183-02-The Nature of the Financial Accounting Process