REPLACEMENT COSTING AND THE MAINTENANCEOF PRODUCTIVE CAPACITY CONCEPT OFBUSINESS

INCOME--THEORY AND APPLICATION

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Authors Gress, Edward Jules, 1940-

Publisher The University of Arizona.

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GRESS, Edward Jules, 194-0-REPLACEMENT COSTING AND THE MAINTENANCE OF PRODUCTIVE CAPACITY CONCEPT OF BUSINESS INCOME—THEORY AND APPLICATION.

University of Arizona, Ph.D., 1970 Accounting

University Microfilms, A XERQ\ Company, Ann Arbor, Michigan

THIS DISSERTATION HAS BEEN MICROFILMED EXACTLY AS RECEIVED

REPLACEMENT COSTING AND THE MAINTENANCE OF PRODUCTIVE

CAPACITY CONCEPT OF BUSINESS INCOME —

THEORY AND APPLICATION

by

Edward Jules Gress

A Dissertation Submitted to the Faculty of the

BUSINESS ADMINISTRATION COMMITTEE

In Partial Fulfillment of the Requirements For the Degree of

DOCTOR OF PHILOSOPHY

In the Graduate College

THE UNIVERSITY OF ARIZONA

19 7 0

THE UNIVERSITY OF ARIZONA

GRADUATE COLLEGE

I hereby recommend that this dissertation prepared under my

direction by Edward Jules Gress

entitled Replacement Costing and the Maintenance of Productive Ca­

pacity Concept of Business Income—Theory and Application

be accepted as fulfilling the dissertation requirement of the

degree of Doctor of Philosophy

"3-V9 Dissertation Director Date

After inspection of the dissertation, the following members

of the Final Examination Committee concur in its approval and

recommend its acceptance:*

3- >q-~7o

m.

JZ

£

3 - z-o - 7a

3 /±* /~? »

3/ra j/?d

*This approval and acceptance is contingent on the candidate's adequate performance and defense of this dissertation at the final oral examination. The inclusion of this sheet bound into the library copy of the dissertation is evidence of satisfactory performance at the final examination.

PLEASE NOTE:

Not original copy. Some pages have indistinct print. Filmed as received.

UNIVERSITY MICROFILMS.

STATEMENT BY AUTHOR

This dissertation has been submitted in partial fulfillment of requirements for an advanced degree at The University of Arizona and is deposited in the University Library to be made available to bor­rowers under rules of the Library.

Brief quotations from this dissertation are allowable without special permission, provided that accurate acknowledgment of source is made. Requests for permission for extended quotation from or re­production of this manuscript in whole or in part may be granted by the head of the major department or the Dean of the Graduate College when in his judrment the proposed use of the material is in the in­terests of scholarship. In all other instances, however, permission must be obtained from the author.

SIGNED:

TO MY WIFE KETTY

AND MY TWO CHILDREN ALBERT AND RICHARD

iii

ACKNOWLEDGMENTS

The author wishes to express his deep gratitude to Dr. Marilynn

G. Winborne under whose kind and constructive supervision this disser­

tation was written. Particular mention is extended to Dr. Edward S.

Lynn for his valuable comments and to Dr. George Summers of the Division

of Economic and Business Research at The University of Arizona for his

guidance, in the statistical work.

The application of replacement costing and the maintenance of

productive capacity concept of business income would not have been

successful without the full cooperation of the president, the budget

director, and the assistant production manager of the firm selected for

this study. Their willingness to make available the necessary infor­

mation and the time they took out from their busy schedule are greatly

appreciated.

Finally, the author is grateful to his wife and two children

for their patience during the many months of research and writing.

iv

TABLE OF CONTENTS

Page

LIST OF TABLES ix

LIST OF ILLUSTRATIONS xi

ABSTRACT xii

1. INTRODUCTION 1

Statement of the Problem 2 Purpose and Plan of the Study 3 Terminology 6

2. NEEDS OF FINANCIAL STATEMENT USERS AND LIMITATIONS OF CONVENTIONAL FINANCIAL STATEMENTS 9

Needs of Financial Statement Users 10 Assumed Needs of Financial Statement Users 11 Empirical Studies on the Desirability of Adjusting Financial Statements for Purchasing Power and Specific Price Changes ..... lU

limitations of Conventional Financial Statements 19 Income Statement Orientation and Conservatism in Financial Statements ..... 19

Problem of Replacement of Fixed Assets at Higher Prices 2k

Bias Against Present Stockholders 3b

3. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 38 Going Concern Convention 39

Relationship to the Entity Concept 39 Justification for Historical Cost UO

Stable Monetary Unit Convention UO Extent of Price Changes U2 Purchasing Power of the Business Entity U3

Historical Cost Convention U6 Relationship to Evidence Requirement U6 Departures from Historical Cost U8

Verifiable and Objective Evidence Convention $0 Explanation and Interrelationship of Terms ...... £l Accounting Implications

v

vi

TABLE OF CONTENTS—Continued

Page

The Position of the American Institute of Certified Public Accountants 55

The Position of the Securities and Exchange Commission . . 58 The Position of the American Accounting Association ... 59

U. SELECTED CONCEPTS OF BUSINESS INCOME 63

Nature of Income 6U Income in Accounting 66

The American Institute of Certified Public Accountants' Definition of Income . . 67

Other Accounting Definitions of Income 68 Income in Economics 69 Proposals to Change Conventional Accounting Income .... 73

Edwards and Bell's Concept of Income 73 Chambers' Concept of Income 75 Concept of Income Underlying ARS No. 1 and ARS No. 3 • 76 Concept of Income Underlying the AAA A Statement

of Basic Accounting Theory 78 Attempts to Apply Unconventional Income Concepts 78

The Dickers on Study 79. The Dockweiler Study 80 The Voth Study 81 Concluding Note 81

5. THE MAINTENANCE OF PRODUCTIVE CAPACITY CONCEPT 82

Statement of the Maintenance of Productive Capacity Concept 83 Purpose of the Concept 8U Measurement of Business Income 86 Determination of Financial Position 89 Articulation of Income Statement and Balance Sheet . . 89

Measurement of the Maintenance of Productive Capacity ... 90 Ideal Measurement 90 Practical Considerations 91 Technological Changes and Unique Assets 93

vii

TABLE OF CONTENTS—Continued

Page

6. HYPOTHETICAL APPLICATION OF THE PRODUCTIVE CAPACITY CONCEPT . . 96

Periodic Depreciation Based on Replacement Cost at the End of Each Period 97 Financial Statements 97 Discussion of Illustration 100

Eventual vs. Current Replacement Cost 102 Accumulated Depreciation Based on Replacement Cost at the End of Each Period 103

The Case for the Increasing Depreciation Charge 108 The Adjustment Procedure . ........... 110

7. APPLICATION OF THE PRODUCTIVE CAPACITY CONCEPT TO THE FINANCIAL STATEMENTS OF X CO 115

The Conventional Financial Statements 115 The Adjustment Procedure 119

Current Assets and Noncurrent Notes Receivable .... 119 Plant and Equipment 120 Sundry Investments 132 Deposits and Other Assets 133 Equities 133 Income Statement Accounts 13U

The Adjusted Financial Statements of X Co 13U

8. EVALUATION OF THE ADJUSTED FINANCIAL STATEMENTS OF X CO. ... Ihk

Analysis of Statements 1U5 Rate of Return on Average Stockholders' Equity .... lU6 Earnings per Share lU6 Rate of Return on Total Revenue 1U7 Asset Turnover 1U7 Rate of Return on Average Assets 11*8 Rate of Federal and State Income Taxes on Income

Before Taxes 1U8 Concluding Note Hi9

Reaction of the Management of X Co, . . 1U9 Consideration of Profitability Position 151 Consideration of Borrowing Capability 152 Consideration of Dividend Policy 153 Consideration of Technological Changes . . 15U General Comment 155

Objectivity of the Adjusted Statements 156

viii

TABLE OF CONTENTS—Continued

Page

9. CONCLUSIONS l£7

APPENDIX 1: EXTENT OF PRICE CHANGES 163

APPENDIX 2: CORRESPONDENCE WITH THE CHIEF ACCOUNTANT OF THE SECURITIES AND EXCHANGE COMMISSION ... 167

APPENDIX 3: COMPUTATIONS SUPPORTING THE ADJUSTED FINANCIAL STATEMENTS OF X CO 170

LIST OF REFERENCES 180

LIST OF TABLES

Table Page

1. Company A: Historical-Dollar Income Statement for Each of the Years 1 through 5 27

2. Company A: Comparative Historical-Dollar Balance Sheets at Selected Dates 28

3. Company A: Data Used in Illustration of Periodic De­preciation Based on Replacement Cost at the End of Each Period . . 98

U. Company A: Comparative Income Statements and Other Data, Maintenance of Productive Capacity 3asis (Periodic Depreciation Based on Replacement Cost at the End of E a c h P e r i o d ) , f o r Y e a r s 1 t h r o u g h ̂ . . . . . 9 9

5. Company A: Comparative Replacement Cost Balance Sheets (Periodic Depreciation Based on Replacement Cost at the End of Each Period) at Selected Dates 101

6. Company A: Data Used in Illustration of Accumulated Depreciation Based on Replacement Cost at the End of Each Period 105

7. Company A: Comparative Income Statements and Other Data, Maintenance of Productive Capacity Basis (Accumulated Depreciation Based on Replacement Cost at the End of Each Period), for Years 1 through £ 106

8. Company A: Comparative Replacement Cost Ealance Sheets (Accumulated Depreciation Based on Replacement Cost at the End of Each Period) at Selected Dates 107

9. Company A: Illustrative Adjusting Entries at the End of Year 1 through 5 112

10. X Co.: Comparative Historical-Dollar Balance Sheets, December 31> 1967 and 1966 116

11. X Co.: Historical-Dollar Income Statement for the year 1967 118

ix

LIST OF TABLES—Continued

x

Table Page

12. X Co.: Comparative Historical-Dollar and Replacement Cost Balance Sheets, December 31, 1967 135

13. X Co.: Comparative Historical-Dollar and Replacement Cost Balance Sheets, December 31, 1966 137

lit. X Co.: Comparative Income Statement on a Historical-Dollar and Maintenance of Productive Capacity Basis for the year 1967 139

15. X Co.: Comparative Replacement Cost Balance Sheets, December 31, 1967 and 1966 (in December 31, 1967, Dollars) 11*1

16. Selected Comparative Financial Ratios Applied to the Financial Statements of X Co 100

17. Selected Price Indices for the Years 1958 to 1968 ...... 165

/

i

I i i

LIST OF ILLUSTRATIONS

Figure Page

1. Sample of Letter of Request for Price Quotations Sent to Manufacturers and Agents of Machinery and Equipment ........ 126

2. Relative Movement in Selected Price Indices, 1958-1968 . . . 161*

xi

ABSTRACT

This dissertation develops the maintenance of productive ca­

pacity concept of business income in a cohesive theoretical framework

and applies the concept to an industrial firm in order to demonstrate

the objectivity of such application.

It is argued that the needs of external users of financial

statements are better served by a balance sheet prepared on a current

replacement cost basis and by an income statement prepared on a mainte­

nance of productive capacity basis. A replacement cost balance sheet

reports the current replacement cost of assets and the current value

of owners' equity and thus is a better statement of financial condition

than a conventional balance sheet. An income statement prepared on a

maintenance of productive capacity basis reports an income figure that

can be all distributed in dividends without impairing the productive

capacity of the business enterprise. Such an income figure also repre­

sents the increase in command over goods and services reinvested by

management through curtailment of the amount of dividends distributed.

The maintenance of productive capacity concept of business

income is in accord with the going concern convention. In a period of

rising prices, conventional income does not represent an amount that

can be severed without curtailing the productive capacity of a business

enterprise. In order to maintain capacity and provide for the conti­

nuity of operations in a period of rising prices, management must

xii

xiii

resort to unexplained accumulation of retained earnings or its ap­

propriation. The amount of such accumulation and/or appropriation is

arbitrary, as conventional accounting does not provide a systematic

computation of the curtailment of income necessary to maintain pro­

ductive capacity.

The unconventional income concepts developed by Edwards and

Bell, Chambers, Sprouse and Moonitz, and by the AAA Committee to Pre­

pare a Statement of Basic Accounting Theory call for the recognition of

current costs on the balance sheet but do not advocate a concept of

income that permits maintenance of productive capacity. The treatment

of the advance in current replacement costs as an element of business

income is contrary to the principles of the maintenance of productive

capacity concept. Such an advance represents an adjustment of owners'

equity—an amount that must be retained permanently to maintain

capacity.

Hicks' concept of income provides the basis for the development

of the maintenance of productive capacity concept of business income.

According to Hicks, the purpose of income computation is to provide an

indication of the amount individuals can consume without impoverishing

themselves. From Hicks' definition of the income of an individual and

from the three approximations to the central meaning that he gives, the

income of a business organization becomes the maximum amount that can

be paid in dividends to owners while expecting to keep the same pro­

ductive capacity of the business at the end as at the beginning of

xiv

the period. Hicks, however, is not concerned with the accounting

application of his concept.

The comprehensive application of current replacement costing by

accounting researchers in the U.S. has been rare. The few attempts that

have been made were not successful in obtaining price quotations from

suppliers. In this dissertation, responses for price quotations were

obtained on a one hundred per cent basis for assets with an established

market, though in numerous cases requests for price quotations were made

several years after the date of purchase. The current replacement cost

of unique assets such as land, buildings, and improvements was estimated

by means of appraisals and specific price indices. The conclusion

reached is that the application of current replacement costs can be done

with sufficient objectivity to warrant the expression of an unqualified

opinion by an independent auditor.

CHAPTER 1

INTRODUCTION

Accounting plays a vital role in present day economies. The

size of modern corporations, the separation of management and owner­

ship, the complexity of business decisions, and the multitude of

reports filed with various government agencies are a challenge to

accountants and render accounting an essential tool of modern business.

Many individuals and parties depend on financial statements in evalu­

ating the performance, the credit-rating, and the management of

business organizations. Investors, present and prospective, make use

of published financial statements in reaching decisions as to pur­

chase and sale of securities. The management of business enterprises

depends on detailed records in their day-to-day business decisions

and in the formulation of dividend and investment policies and

decisions to expand or shut down plants.

The financial statements made available for external reporting

purposes are prepared in accordance with a set of generally accepted

accounting principles, and their fairness is usually attested to by

an independent public accountant. The reports submitted to manage­

ment do not have to conform to accepted external reporting practice.

Management is in a position to request and obtain financial information

1

in any manner that suits its needs. This study is primarily concerned

with the presentation of financial statements to external users.

Statement of the Problem

Financial statements have been criticized as being not suf­

ficiently informative and sometimes misleading. In a period of rising

prices, a balance sheet prepared in accordance with generally accepted

accounting principles fails to show the current value of assets and

the current value of stockholders' investment. Similarly, an income

statement prepared in accordance with conventional accounting practice

does not report an income figure that can be distributed in dividends

without impairing the productive capacity of the enterprise. This

has led to a concern in financial circles as to the adequacy of gener­

ally accepted accounting principles for the determination of financial

position and the results of operations of business enterprises. This

concern is evidenced in publications of the American Institute of

1. The primary importance of financial reports to external users of financial statements, especially present and prospective stockholders of business enterprises, was recognized in Accounting Research Bulletin No. 1 issued in September 1939 and repeated in the Introduction to Accounting Research Bulletin No. h3 issued in June 1953. See American Institute of Certified Public Accountants, APB Accounting Principles: Original Pronouncements as of May 1, 1968, Vol. 2 (New York: AICPA, 1968), p. 6005. The Accounting Research Bulletins, the Accounting Terminology Bulletins and the APB Opinions of the AICPA that were in force as of Hay 1, 1968, were published in the above booklet. Reference to any ARB, ATB or APB Opinion will be made to the 1968 publication.

3

Certified Public Accountants (AICPA), the American Accounting Associ­

ation (AAA), other accounting groups, individual accountants, econo­

mists, and the financial press.

The criticisms raised are mainly a result of accountants'

(1) adherence to the assumption of a stable monetary unit in view of

evidence of changes in the purchasing power of the dollar, (2) ad­

herence to original cost despite marked changes in the replacement

cost of assets, and (3) insistence on verifiable, objective evidence

in recording changes in assets, liability, and equity accounts. The

assumption of a stable monetary unit, the use of historical cost, and

the insistence on verifiable, objective evidence are not isolated

issues. These three accounting conventions are related one to another

and to the body of generally accepted accounting conventions. They

will be discussed in detail in Chapter 3.

Purpose and Plan of the Study

The purpose of this study is to develop a cohesive theoretical

framework for the preparation of a balance sheet on a replacement cost

basis and the computation of income on a maintenance of productive

capacity basis. This study also demonstrates that the data necessary

to implement the proposed theory can be obtained with sufficient compe­

tent evidential matter to satisfy the requirements of an independent

public accountant.

The theory leading to the preparation of a replacement cost

balance sheet and an income statement on a maintenance of productive

capacity basis, hereafter referred to as the maintenance of productive

capacity theory, is developed in Chapters 2 through 6. The objectivity

of preparing such statements is tested in Chapters 7 and 8, where the

theory is applied to the financial statements of an industrial firm in

Tucson, Arizona.

In Chapter 2 the needs of financial statement users and some

limitations of conventional financial statements are discussed. The

needs of external statement users have been investigated by several,

but all too few, empirical studies. These studies present conflicting

conclusions as to the desire of statement users to be presented with

financial statements adjusted for price level changes and/or specific

price changes. The discussion of the limitations of conventional

financial statements emphasizes the inadequacy of the information

provided for the guidance of management to maintain productive ca­

pacity in a period of rising prices.

Conventional accounting principles relevant to the development

of the maintenance of productive capacity theory are discussed in

Chapter 3. The accounting conventions discussed are the going concern,

stable monetary unit, historical cost, and verifiable and objective

evidence. It is argued that the continuity of operations is not an

assumption for the convenience of accountants but a valid postulate.

The analysis of the selected accounting conventions is followed by a

presentation of the position of the American Institute of Certified

Public Accountants, the Securities and Exchange Commission, and the

American Accounting Association on the subject of general price level

and specific price adjustments.

5

Selected concepts of business income are discussed in Chapter U.

These include the accounting concept, the concept of income in econo­

mics formulated by J. R. Hicks,^ Edwards and Bell's concept developed

O in their The Theory and Measurement of Business Income as well as a

few other unconventional concepts. A brief discussion of actual appli­

cations of unconventional concepts of income is also presented in

Chapter U. Hicks' concept of income provides the basis for the state­

ment of the maintenance of productive capacity concept of business

income in Chapter $. Chapter 5 also includes a discussion of the

measurement of business income under the maintenance of productive

capacity concept.

Chapter 6 consists of a hypothetical application of the mainte­

nance of productive capacity theory. The chapter also includes a

presentation of the accounting procedures necessary for such appli­

cation.

In Chapter 7, the financial statements of a business firm in

Tucson, Arizona, are converted to a replacement cost basis and to a

maintenance of productive capacity basis. Various adjustment pro­

cedures are presented with emphasis on the verifiability and objec­

tivity of such procedures. The adjusted statements are evaluated in

1. Value and Capital (Oxford: The Clarendon Press, 19U6).

2. (Berkeley and Los Angeles: University of California Press, 1961).

6

Chapter 8. This evaluation includes the application of selected

financial ratios to the conventional and the adjusted statements

and a discussion of the reaction of the management of the company

to the adjusted statements. Conclusions are presented in Chapter 9.

Terminology

The term price level change is used in this study to refer

to changes in the purchasing power of the monetary unit as measured

by a general price level index. This is in conformity with the

terminology adopted in Statement of the Accounting Principles 3oard

No. 3.^" The terms purchasing power change and price level change

are used interchangeably throughout this study.

The term specific price change refers to the change in the

replacement cost of a specific asset. Price change is used as a

generic term to refer to changes in prices whether resulting from

p purchasing power changes or from specific price changes.

Conventional accounting is used to refer to accounting based

on generally accepted accounting principles. The terms historical-

dollar balance sheet and historical-dollar income statement refer,

1. "Financial Statements Restated for General Price-Level Changes" (New York: AICPA, 1969).

2. The distinction between the terms price level change and specific price change is made to avoid the confusion evidenced in the past of using the terms interchangeably. For examples of this con­fusion see E. Stewart Freeman, "How to Show Effects of Changp in Value of Dollar Yet Preserve Cost Basis in Accounting," The Journal of Accountancy, 85 (February, 19U8), pn. 113-17j and Samuel J. Broad, "The Impact of Rising Prices Upon Accounting Procedures," The Journal of Accountancy, 86 (July, 19U8), pp. 10-21.

7

in accordance with the recommendation in Statement of the Accounting

Principles Board No. 3, to the statements of financial position and

results of operations that are prepared in accordance with conventional

accounting procedures. Historical-dollar balance sheet and convention­

al balance sheet are used interchangeably, as are the terms historical-

dollar income statement and conventional income statement.

The term replacement cost refers to the expenditure needed to

replace an asset in use by an identical asset as of a given date.

Such an expenditure includes the invoice price less any discount plus

appropriate charges for freight, installation, taxes, and the like.

The replacement cost of assets that cannot be replaced by identical

units due to technological innovations or other factors is the cost

of assets of equivalent productive capacity. To illustrate, if a

machine with a productive capacity of 100 units per hour can be re­

placed only by a machine capable of producing 200 units per hour, the

replacement cost of the first machine is equal to one-half the acqui­

sition cost of the second machine; the first machine has a productive

capacity equivalent to one-half the productive capacity of the second.

A balance sheet prepared on a replacement cost basis is called a

replacement cost balance sheet. The terms replacement cost and current

cost are used interchangeably.

The term productive capacity of a business firm refers to

the ability of a firm to produce and distribute a given quantity of

goods and services. This is measured, as of a given date, by the

amount of money required to maintain the resources comprising the

productive capacity of the enterprise.

The terms principle, convention, concept, assumption, postu­

late, and doctrine are used interchangeably.

CHAPTER 2

NEEDS OF FINANCIAL STATEMENT USERS AND LIMITATIONS OF CONVENTIONAL FINANCIAL STATEMENTS

Various parties are interested in the financial statements of

business enterprises. These parties include present and prospective

stockholders, internal management, financial analysts, credit grantors,

suppliers of goods and services, government agencies, labor unions, and

employees. The interests of these different parties are diverse, and

it may not be reasonable to expect one set of financial statements to

satisfy all interests.

Internal management can obtain the information desired but has

tended to restrict dissemination of information beyond that contained

in traditional annual reports for fear of yielding competitive ad­

vantage. Government agencies may prescribe certain accounting pro­

cedures, request specific information, and require reports prepared

on specific forms. Long-term credit grantors are also in a position

to obtain information that is not contained in published annual

reports. Most of the remaining users of financial statements, how­

ever, have to be content with a balance sheet and an income statement

prepared in accordance with generally accepted accounting principles.

The irony is that the investors—the owners of the business—have

9

little say in what information is presented to them, and they may

not even be in a position to know what information is technically

feasible.^"

Needs of Financial Statement Users

It is unfortunate that accountants have not determined the

needs of the various users of financial statements but instead have

proceeded to make their own decisions as to the quality and type of

information to be reported. Unrelated attempts have been made by

various researchers at different times to determine the needs of

external statement users.^ These isolated studies have not quelled

speculations as to external users' needs.

1. Speaking in an accounting symposium about the power of managers in modern corporations, J. A. Livingston, a financial col­umnist, said: "They [the managers} control the stockholders, the equity owners, instead of being controlled by them." See "What's Wrong with Financial Reporting?" The Journal of Accountancy, 112 (August, 1961), p. 29.

2. The public's acceptance of financial statements was briefly discussed by the Staff of The Journal of Accountancy, "What the Public Thinks About Financial Statements," The Journal of Accountancy, 83 (June, 19U7), pp. I487-89. This article was based on a survey conducted by the Controllership Foundation.

3. See for example Daniel J. Hennessy, "Survey Reveals Infor­mation People Want to Know about a Corporation," The Journal of Accountancy , 86 (September, 19U8), pp. 22U-27; A. J. O'Hara, "Reports to Stockholders," The Journal of Accountancy, 81 (February, 19U6), pp. Il5-19i and R. K. Kautz, Financial Reporting by Diversified Companies (New York: Financial Executives Research Foundation, 1968).

Assumed Needs of Financial Statement Users

It may be asserted that stockholders are interested in the

value and profitability of their investment and in assurances as to

the prospects for and growth of future dividends; they may also be

interested in the amount of income diverted for internal growth.

Financial analysts are interested in a variety of financial infor­

mation, including economic and financial trends in the industry and

information about management. Credit grantors are concerned with

the ability of the borrower firms to repay their obligations as they

mature. Suppliers are interested in the creditworthiness of their

clients and in the continuity of their patronage. Labor unions are

mainly interested in obtaining the highest pay to their members,

and as such they are concerned with the profitability of business

enterprises. Employees are interested in job security and oppor­

tunities for advancement and promotion. Society at large may be

interested in the efficiency of the use of scarce resources. It

would be a happy situation if it were conceivable for one set of

financial statements to provide information to satisfy the needs of

all parties concerned.

This dissertation does not purport to provide suggestions

for the improvement of the usefulness of financial statements to all

interfested parties. It is contended here that the consistent appli­

cation of the productive capacity concept will produce a statement

of financial position and an income statement that will be of more

benefit to those with long-term interests than those prepared using

conventional accounting procedures. Conventional financial state­

ments may continue for some time to be required for income tax

purposes and possibly for other legal and contractual purposes.

Knowledge of the current replacement cost of the assets

committed to the operations of a business enterprise, and hence a

knowledge of the current value of owners1 equity, should be im­

portant to various parties. Stockholders will obtain book value

per share and rates of return on assets and equity that are more

significant than the figures obtained from conventional statements.

Credit grantors will have access to more meaningful asset values

than are currently produced using original cost. Management will

be held accountable for the current cost of assets and owners'

equity, which will provide a more stringent evaluation of manage­

ment's performance.

The computation of income under the productive capacity

concept will result in an income figure that can be completely dis­

tributed in dividends without impairing the productive capacity of

the enterprise. Such an income figure will also provide information

as to the increase •'n the command over goods and services that is

being ploughed back into the business should the directors decide

not to pay all reported income in dividends. In a period of price

changes, conventional income does not represent an amount that can

be paid in dividends without changing the productive capacity of

the firm. Knowledge of severable income should be important to stock­

holders and creditors. Stockholders will be informed of the maximum

amount that can be paid in dividends without impairing capacity, and

credit grantors will be informed of the source of their loan re­

payments, capital or income. /

In a study to determine the need for and methods of reporting

data by conglomerates, the rate of return on common stock equity,,

the rate of return on total assets, and the ratio of net ineome to

sales were rated by financial analysts as the most useful measures

of profitability."*" Such rates can be misleading if they are based

on conventional accounting data. All these rates make use of con-

p ventional net income in the numerator. However, net income is a

hodge-podge of revenues and expenses stated in dollars of different

purchasing power. The denominators are not perfect either. Ad­

herence to historical cost in a period of rising prices leads to an

understatement of assets and owners' equity. Two companies identi­

cal" in all respects except for the fact that their fixed assets have

been acquired at different costs will have different net income

figures, different asset values, and hence different rates of return.

The consistent preparation of a balance sheet on a replacement cost

1. Mautz, op. cit., p. 1J>1.

2. The fact that preferred dividends will be subtracted from and interest added to conventional income will not alter this dis­cussion.

3. Kenneth MacNeal gave three illustrations in the form of humorous fables to demonstrate a few problems created by conventional accounting procedures. See his Truth in Accounting (Philadelphia, Pa. University of Philadelphia Press, 1939), pp. 2-15.

Ik

basis and the income statement on a maintenance of productive capacity

basis will produce rates of return that are significant, consistent,

and comparable over time and among companies.

Empirical Studies on the Desirability of Adjusting Financial Statements for Purchasing Power and Specific Price Changes

Very little empirical work has been done in determining the

desirability of having financial statements adjusted for price level

changes or specific price changes. Empirical investigations of this

nature may be biased, since the findings are likely to depend on the

wording of the question and on the atmosphere in which the respondent

replies. Below are the results of a few such investigations.

The 1957 AICPA Opinion Survey. In July 1957, the AICPA sent

questionnaires to 669 corporate executives, selected from different

industries, and to educators, soliciting their opinions mainly on

the desirability of the disclosure of current cost depreciation in

corporate reports and on the methods of disclosure."1' Respondents

were told to assume that current cost can be objectively determined.

Completed questionnaires were received from H06 respondents

comprising 331 corporate executives and 75 educators. The re­

spondents were 3 to 1 in favor of disclosing the current dollar cost

of depreciation in corporate reports. Those in favor gave as reasons

1. For a complete report on the survey and its results, see Technical Services Department of the American Institute of Certified Public Accountants, "Opinion Survey on Price-Level Adjustment of Depreciation," The Journal of Accountancy, 105 (April, 1958), pp. 36-U3. The discussion in this section is based on the results of that survey.

1

15

the overstatement of income in the absence of such an adjustment,

the need for depreciation charges to provide for the replacement of

fixed assets, and the desirability of providing investors with

additional information. Those opposed stated that new concepts in

accounting would be confusing and misleading and that such an ad­

justment would be difficult to implement. The majority of those in

favor of disclosing depreciation on a current cost basis preferred

disclosure in a supplementary form, preferably in footnotes. The

survey also revealed that respondents did not consider that increases

in prices could be counterbalanced by technological improvements.

This survey did not claim to be representative of corporate

executives and educators. However, it did reveal the opinion of some

corporate executives and educators on a vital issue.

The Korngren Study. Financial analysts are possibly the major

users of financial statements. They represent a large body of in­

vestors, and as such their viewpoint has been given much weight by /

accountants. The position of analysts on the subject of price changes

has not been well established. Some empirical studies have reported

that financial analysts preferred to use financial statements adjusted

for price level or specific price changes; other studies have shown

that analysts did not care for such adjustments.

After interviewing $1 financial analysts and studying the

literature on security investment, Charles T. Horngren concluded that

financial analysts did not favor the adjustment of financial statements

16

for price level or for specific price changes.Not a single analyst

interviewed attempted to make adjustments for price changes. All the

analysts thought in terms of current dollars because they were

mainly concerned with cash flows. Their main interest was in the

comparison of cash inflow with expenditure commitments over the past

few years and with the projection into the future of such comparisons

for a one-year period at least. In this process they made the serious

error of considering depreciation to be a source of cash. Horngren

cites several quotations from analysts' reports in which they refer

to depreciation as a source of cash and compare it with expenditure

commitments.

The Estes Survey. In March 1967, Ralph W. Estes mailed

questionnaires to a random sample of 300 financial analysts, 300 bank

loan officers and credit men, and 300 financial executives to de­

termine the usefulness of the disclosure of current values and

historical data adjusted for price level changes to external users

p of financial statements. The external users were identified as

investors, current and prospective, and lenders. The users were

1. "Security Analysts and the Price Level," The Accounting Review, XXX (October, 1955), PP« 575-81. The discussion in this section is based on Horngren's findings.

2. For details of the study, see "An Assessment of the Usefulness of Current Cost and Price-Level Information by Financial Statement Users," Journal of Accounting Research, 6 (Autumn, 1968), pp. 200-7. The discussion in this section depends on the above article.

17

approached through a sample of The Institute of Chartered Financial

Analysts, the National Association of Bank Loan Officers and Credit

Men (Robert Morris Associates), and the Financial Executives Institute

because these organizations have needs that parallel those of in­

vestors and lenders.

The respondents were told to assume that the information

could be accurately and objectively determined and that it would be

presented in supplementary form as recommended by the American Ac­

counting Association Committee to Prepare a Statement of Basic

Accounting Theory in A Statement of Basic Accounting Theory.^"

Replies were received from 98 financial analysts, lUU bank

loan officers and credit men, and 96 financial executives, comprising

an overall response of 37.6,^. Responses indicated that an overall

81)2 considered current replacement cost values to be useful with only

19/o considering them not useful. On the subject of price level

adjustment of historical data, only an overall 70$ considered such

adjustment to be useful with 30$ indicating it to be not useful.

Estes1 findings should be contrasted to Horngren's findings.

As mentioned earlier, results depend on the question asked and on

the atmosphere created for the respondent. Perhaps Estes obtained

the above results because his respondents were told that the AAA

issued a statement recommending parallel reporting and possibly

1. (Evanston, 111.: AAA, 1966). Some of the recommendations of this study will be discussed in Chapters 3 and U.

because they were also told to assume that the data can be accurately

and objectively obtained. Estes recognized the possible existence

of bias.

The National Association of Accountants Study. The NAA con­

ducted a study"'" to determine the needs of financial statement users

and especially to determine the accounting measures that most commonly

enter into credit and investment decisions. One phase of the study

involved the collection of empirical evidence to test the validity

of the assumption that current replacement costing results in more

useful external financial reports.

Depth interviews were conducted with 72 financial analysts

affiliated with U3 firms, with 7h bank officers associated with 33

banks, and with 109 corporate executives in 70 corporations. There

was no claim that the sample chosen was representative of financial

analysts, bankers, and corporate executives; the declared objective

was to solicit the best practice and opinion rather than repre­

sentative opinion.

One of the findings of the study is that interviewees almost

unanimously were opposed to the recognition of the advance in re­

placement costs as an element of income. However, 90% of the security

analysts and 60% of the bankers interviewed indicated that disclosure

1. Morton Backer, Financial Reporting for Security Investment and Credit Decisions (Unpublished preliminary draft, 1968). The NAA was very kind to make a copy of the preliminary draft available for the purposes of this dissertation, and their kindness is appreciatively acknowledged.

19

of current replacement costs on the balance sheet will result in a more

useful balance sheet than the conventional statement.

Limitations of Conventional Financial Statements

A full presentation of the limitations of conventional fi­

nancial statements is beyond the limits of this dissertation. Selected

limitations relevant to the development of the maintenance of productive

capacity concept are discussed below.

Income Statement Orientation and Conservatism in Financial Statements

For many years the balance sheet was considered to be the major

external accounting report of a business enterprise. The desire to have

balance sheets prepared for commercial credit purposes was one of the

factors that influenced the development of modern accounting. Empha­

sis was placed on the liquidity and solvency of the borrowing firm as

primary factors in assuring that a debtor firm would be able to pay its

p debts and maintain its capital. Care was taken that no overstatement

of asset valuations occurred, and this was implemented by adhering to

the doctrine of conservatism.^

1. W. A. Paton and A. C. Littleton, An Introduction to Corpo­rate Accounting Standards, American Accounting Association Monograph No. 3 (Evanston, 111.: AAA, 19U0), p. 12.

2. Curtis Holt Stanley, Objectivity in Accounting (Ann Arbor, Mich.: The University of Michigan, 1965), p. 67.

3. The following quotation from Eldon S. Hendriksen, Accounting Theory (Homewood, 111.: Richard D. Irwin, Inc., 1965), PP« 93-U portrays the nature of conservatism:

The term "conservatism" is generally used to mean that ac­countants should report the lowest of several possible values

20

As initially developed, conservatism was associated with the

debt-paying ability of a debtor firm and with the preparation of its

financial position. Conservatism was analogous to "the engineering

'factor of safety1 idea as an expression of the human desire to be 'on

the safe side1 The doctrine of conservatism was called upon to

restrain business firms from inflating assets to obtain more credit.

When profitability rather than current liquidity was accepted as a

more appropriate measure of financial safety, conservatism was adopted

in the income determination area. It was felt that the understatement

O of assets and income was less misleading than their overstatement.

Conservative accounting procedures such as the cost or market,

3 whichever is lower rule for the valuation of short-term marketable

for assets and revenues and the highest of several possible values for liabilities and expenses. It also implies that expenses should be recognized sooner rather than later and that revenues should be recognized later than sooner.

Thus under conservatism, net assets and net income are more likely to be understated than overstated.

1. Stephen Gilman, Accounting Concepts of Profit (New York: The Ronald Press, 1939), p. 232.

2. Thomas Henry Sanders, Henry Rand Hatfield and Underhill Moore, A Statement of Accounting Principles (New York: AICPA, 1938), p. 12. A security analyst, J. M. Galanis, in his article, "Some Short­comings of Financial Statements From the Security Analyst's Point of View," The Journal of Accountancy, 8U (November, 19U7), pp. 368-75* took issue with conservatism in the following statement on p. 368: "The analyst deplores a policy of overconservative accounting as much as underconservative accounting. No one is more sensitive to the fact that the former leads to the latter practice in later years."

3. For an historical survey of the development of the cost or market, whichever is lower rule see R. H. Parker, "Lower of Cost and Market in Britain and the United States: An Historical Survey," Abacus, 1 (December, 1965), pp. 156-72.

21

investments and inventories, the last-in, first-out method of inventory

valuation, and the insistence on historical cost as the basis for the

valuation of fixed assets have contributed to the lack of current sig­

nificance of the reported values on the balance sheet. The growth of

the corporate form of business enterprise and the resulting emergence

of a large number of investors have led to a shift in emphasis from the

balance sheet to the income statement. On this subject, the Committee

on Accounting Procedure of the AICPA gave the following statement in

Accounting Research Bulletin No. 1 issued in September 1939:

. . . the problems in the field of accounting have increasingly come to be considered from the standpoint of buyer or seller of an interest in an enterprise, with consequent increased recognition of the significance of the income statement . . . The fairest possible presentation of periodic net income, with neither material overstatement nor understatement, is important, since the results of operations are significant not only to prospective buyers of an interest in the enter­prise but also to prospective sellers.1

In the correspondence between the Special Committee on Co-operation with

Stock Exchanges of the American Institute of (Certified Public) Ac­

countants and the Committee on Stock List of the New York Stock Ex­

change, the Institute's Committee wrote that "... the income account

is usually far more important than the balance sheet. In point of fact,

the changes in the balance-sheet from year to year are usually more

2 significant than the balance-sheets themselves."

1. AICPA, op. cit., p. 6005. Emphasis supplied.

2. American Institute of ^Certified Public] Accountants, Audit of Corporate Accounts (New York: AICPA, 193b)> p. 10.

22

Speaking in an accounting symposium from the viewpoint of an

institutional investor, Arthur M. Cannon said:

. . . the tendency of accountants to strongly emphasize the income statement and de-emphasize the balance sheet is not, "in my judgment, entirely shared by investment analysts. We find the financial position of great importance, particularly in relation to debt securities. I would say that, in my own judgment, the two statements should be ranked of equal importance.1

The emergence of the income statement as the primary financial

statement in modern accounting has led to the importance of a proper

matching of revenues and expenses. Revenues are expressed in recent

terms, whereas expenses are stated in a variety of costs, some current

and others old. The computation of cost of goods sold on a last-in,

first-out basis is an attempt to state this item of expense in as

p far as possible in most recent terms. Most of the individual operating

expense items represent disbursements made in current periods and

as such are expressed in current terms. Depreciation, however, is

expressed in old costs—in dollars of the year of acquisition of the

depreciable items of plant property. Reporting some of the expenses

on the income statement in terms of historical costs in a period of

rising prices results in an overstatement of income. Overstatement of

1. "What's Wrong with Financial Reporting?" p. 32.

2. Most of the publications dealing with the adjustment of historical cost made this point. For example see John W. McEachren, "Use of Replacement Figures in Cost Accounting for Pricing and Income-Statement Purposes," The Journal of Accountancy, 88 (July, 19li9), pp. 21-7; Maurice E. Peloubet, "An Indictment of the Accounting Pro­fession for Failing to Deal with Effects of Inflation," The Journal of Accountancy, 96 (December, 1953), pp. 715-22; and Carman G. Blough, "Replacement and Excess Construction Costs," The Journal of Accountancy, 8U (October, 19U7), pp. 333-36.

23

income may result in dividend declarations of a size which will de­

crease productive capacity, "*• and such overstatement will obscure in­

ternal growth of the firm due to the inevitable overstatement of

retained earnings. The reluctance of management to report conventional

(overstated) income in a period of rising prices was expressed by

Carman G. Blough in the following statement:

. • . there is great reluctance to report the profits that are needed, beyond the dividend requirements, to provide enough funds to replace plant and equipment at high price levels. This reluctance is well founded. Stockholders are hard to convince that increased profits should not be dis­tributed as dividends; labor increases its claims for compen­sation; political demagogues harangue on the excessiveness of corporate income; and enemies of our political order use it to stir up prejudices against private enterprise.2

In an attempt to curb the overstatement of conventional income, ac­

counting procedures such as accelerated depreciation, last-in, first-

out, and tax allocation are adopted.

1. This point was very often mentioned in the literature. See for example Harvey M. Spear, "Depreciation Accounting Under Changing Price Levels," The Accounting Review, XXIV (October, 19U9), pp. 369-78; Robert N. Peck, "Use of Appraisals Urged in Present Depreciation Dilemma," The Journal of Accountancy, 8U (December, 19h7), pp. U59-60; W. H. Garbade, "Current Replacement Costs and Corporate Earnings," The Journal of Accountancy, 86 (July, 19U8), pp. U9-50; Rufus Wixon, "The Measurement and Administration of Income," The Accounting Review, XXIV (April, 19U9), pp. 18U-90; William A. Paton, "Depreciation—Concept and Measurement," The Journal of Accountancy, 108 (October, 1959), pp. 38-U3; and Paul Grady, "Economic Depreciation," The Journal of Accountancy, 107 (April, 1959), pp. 5U-60.

2. Dlough, op. cit., p. 33U.

2U

Problem of Replacement of Fixed Assets at Higher Prices

Accountants have asserted that accounting is a

and revenue allocation to different accounting periods

sentially a process of asset valuation.* In 19UU> the

Terminology of the AICPA gave the following definition

accounting and of depreciation: e

Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capi­tal assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a system­atic and rational manner. Depreciation for the year is the portion of the total charge under such a system that is allo­cated to the year. Although the allocation may properly take into account occurrences during the year, it is not intended to be a measurement of the effect of all such occurrences.2

In the accounting process of determination of business income,

a portion of the depreciable original cost of fixed assets is charged

periodically against the revenue of the period. Such a depreciation

charge does not represent a current outflow of working capital.^ If

1. This point was made in a Statement issued in 1936 by the Executive Committee of the AAA. See American Accounting Association, Accounting and Reporting Standards for Corporate Financial Statements and Preceding Statements and Supplements (Evanston, 111.: AAA, 1957), p. 61. The Statements and Supplementary Statements of the AAA between 1936 and 1957 are contained in the publication cited in this footnote. See also Paton and Littleton, op. cit., p. 127.

2. AICPA, op. cit., p. 9513.

3. It should be recognized that at the time a depreciable asset is purchased working capital will be reduced by an amount equal to the cost of the asset unless the asset is acquired through the issuance of long-term debt or capital stock. Payment of long-term debt will reduce working capital in excess of cost by the amount of interest.

process of cost

and not es-

Committee on

of depreciation

25

operations are profitable and a business firms pays annual dividends in

an amount equal to the net income reported on its conventional income

statement, the working capital of the firm will increase annually by an

amount equal to the depreciation charge.^" By the time an asset is fully

depreciated, working capital will have been increased by an amount equal

2 to the cost of the asset. To be more precise, working capital will

increase by that amount charged to revenue over the life of the assetj

working capital will increase by an amount equal to the cost of the

asset only when an asset is sold at its book value.

If at the end of the useful life of an asset it can be replaced

only at a higher price, the working capital accumulated through depreci­

ation will not be sufficient to replace the retired asset. If, on the

other hand, the replacement cost of the asset is less than its histori­

cal cost, the firm will have resources that will exceed those required

3 to replace the asset and maintain capacity.

1. For simplicity of discussion, all revenues and expenses other than depreciation are assumed to affect working capital.

2. The recovery of the original cost of a depreciable asset does not have to remain in the form of working capital but may be in­vested in plant and equipment. However, in order to facilitate the discussion, it will be assumed that no such investment takes place.

3. It has been argued that a business firm can pay all its con­ventional income in dividends and yet grow without additional financing provided (1) the price of assets remains unchanged, (2) assets are perfectly divisible, and (3) the working capital increase in an amount equal to the periodic depreciation is in the form of cash that is rein­vested annually in plant and equipment. See Yuji Ijiri, "PRD," Stanford Graduate School of Business Bulletin. Winter, 1966, pp. 16-9. It is contended in this dissertation that the adoption of replacement costing eliminates the requisite assumptions made by Ijiri in his model and precludes any doubt as to the amount of income which can be distributed without impairing productive capacity.

It should be emphasized that "the continuity of earning ca­

pacity depends upon economic forces and the skill of management, not

upon accounting."^ Accounting provides information that may be used

by management in the decision-making process. The inadequacy of the

information provided by conventional accounting procedures in a period

of price changes is illustrated in the simplified example below.

Illustration on the Inadequacy of Conventional Accounting to

Provide Information to Help in the Maintenance of Productive Capacity

in a Period of Rising Prices. The assumptions and data on which this

illustration is based will be used subsequently with some modifications

in illustrations in Chapter 6. These are given below:

1. Company A starts business at the beginning of year 1 with a capital

of $10,000 cash which is immediately invested in a machine.

2. The machine in question is the only asset needed in the operations

of Company A, has an estimated useful life of 5 years, and will

be depreciated on a straight-line basis.

3. All transactions are on a cash basis except for depreciation.

U. The revenue from operations amounts to $10,000 annually, and

expenses other than depreciation amount to $5,000 per year.

5. To simplify the illustration, Company A is not subject to income

tax.

6. The policy of Company A is to pay in dividends all the income re­

ported on the income statement the same year it is earned.

1. Alvin R. Jennings, "Present-Day Challenges in Financial Reporting," The Journal of Accountancy, 105 (January, 1958), p. 28.

27

7. The owners and the management of Company A desire to stay in the

same line of business indefinitely.

The historical-dollar income statement for each of the first

five years appears in Table 1 below. Since all income is paid in divi­

dends the same year it is earned, the stockholders' equity will remain

TABLE 1

COMPANY A HISTORICAL-DOLLAR INCOME STATEMENT FOR EACH OF THE YEARS 1 THROUGH $

Revenue from operations

Expenses:

Depreciation

Other expenses

NET INCOME

$ 10,000

$ 2,000

$.000 7,000

$ 3,000

unchanged. The cash balance of Company A will increase by $2,000 by

the end of each year, this increase being the difference between the

revenues earned during the year and received in cash and expenses and

dividends paid out of cash. The increase in cash balance is equal to

the depreciation charge each year.

Table 2 on page 28 shows the comparative historical-dollar

balance sheets of Company A at the beginning of year 1 and at the end

of each year for the first five years.

TABLE 2

COMPANY A COMPARATIVE HISTORICAL-DOLLAR BALANCE SHEETS

AT SELECTED DATES

Beginning of Year 1

End of Year 1

End of Year 2

End of Year 3

End of Year U

End of Year $

ASSETS

Cash $ - $ 2,000 $ U,000 $ 6,000 $ 8,000 $10,000

Machinery at cost $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

Accumulated depreciation 2,000 U,000 6,000 8,000 10,000

Book value of machinery $10,000 $ 8,000 $ 6,000 $ U.ooo $ 2,000 $ -

TOTAL ASSETS $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

EQUITIES

Capital stock $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

Retained earnings — -- -- «•

TOTAL EQUITIES $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

29

Table 2 demonstrates that conventional accounting procedures

provide adequate information to guide management in maintaining the

money capital invested in a business enterprise. Company A started

at the beginning of year 1 with a cash balance of $10,000 and a capital

in the same amount and ended year f> with $10,000 in cash and a capital

of $10,000. The computation of conventional income provided a guide­

line as to the maximum amount that can be paid in dividends without

impairing the money capital of the business organization. This income

was $15,000 for the five-year period.

If Company A wants to continue operations as a going concern,

it will have to replace its only asset at the end of year 5. If at

that time the replacement cost of the asset in question is $12,000,

then Company A cannot remain a going concern without resorting to

outside financing, the company has only $10,000 on hand. The $10,000

may be sufficient to buy an asset of a smaller capacity. If this

latter alternative is chosen, then Company A would be forced to curtail

its productive capacity.

The problem facing Company A can be looked at from a different

angle. Company A at the end of year 5 has the same amount of cash—

$10,000—as at the beginning of year 1. If the general price level

as measured by an appropriate price level index has increased, then

the $10,000 cash at the end of year $ will have a lower purchasing

power than the $10,000 cash at the beginning of year 1. Thus, con­

ventional accounting records the number of dollars invested in an organ­

ization but not necessarily their purchasing power. If in this

illustration the price level between the beginning of year 1 and the

end of year 5 has increased by 10$, then Company A would have suffered

a general price-level loss-*- of $1,000 in that interval of time as

measured by prices prevailing at the end of year 5.

The question that is raised at this point relates to the sig­

nificance of the $3,000 annual income reported under conventional ac­

counting. The $3,000 is not an amount that can be paid in dividends

p without impairing the productive capacity of the business enterprise.

The above discussion is based on the assumption that both the

price level and the replacement cost of the specific asset used by

Company A have increased. It is conceivable that both may decline or

that they may move in opposite directions. If the replacement cost

of the machine declined, then Company A will need less than $10,000 to

replace its retired asset. If the latter case is true, Company A could

have paid in dividends more than $15,000 of reported income during the

first five-year period and still have been able to maintain its pro­

ductive capacity as a going concern. Or, as is usually the case, if

the payment of dividends in an amount greater than reported conventional

income is illegal, then Company A can grow in size, since it will have

1. General price-level loss is the recommended term for purchasing power loss as recommended in Statement of the Accounting Principles Board Mo. 3.

2. The possibility of distributing capital in the form of dividends and taxes was well discussed in the article by Willard J. Graham, "The Effects of Changing Price Levels Upon the Determination, Reporting, and Interpretation of Income," The Accounting Review, XXIV (January, 19U9), pp. 16-26.

31

cash at the end of year 5 that exceeds the amount required to replace

existing productive facilities. It should be pointed out here that a

decline in prices over time is the exception rather than the rule as

demonstrated by statistical evidence in Appendix 1, yet such a phe­

nomenon should not be ruled out.

The financial problem faced by a business firm in actual

practice may be less acute than the one demonstrated in the above

simplified example. The periodic increase in working capital equal to

the depreciation charge, when realized in cash, does not lie idle in

the vaults of the firm. To the extent that a business firm is able

to reinvest such resources profitably, the financial burden of re­

placing assets at higher prices is alleviated. The results of manage­

ment's decision to invest or not to invest are separate and distinct

economic events and should be so measured in financial accounting. The

use of investment income to reduce depreciation charges is tantamount

to non-disclosure via offsetting.

Appropriation of Retained Earnings as a Conventional Accounting

Tool to Provide for the Replacement of Fixed Assets in a Period of

Rising Prices. Accountants maintain that the replacement of fixed

assets is not an accounting problem but rather a financial management

problem. They contend that in a period of rising prices management

should resort to the appropriation of income in order to provide for

32

the replacement of fixed assets at higher prices.* The following

statement on this subject is obtained from Chapter 9A of ARB No. U3s

The Committee recognizes that the common forms of financial statements may permit misunderstanding as to the amount which a corporation has available for distribution in the form of dividends, higher wages, or lower prices for the company's products. When prices have risen appreciably since original investments in plant and facilities were made, a substantial portion of net income as currently re­ported must be reinvested in the business in order to maintain assets at the same level of productivity at the end of a year as at the beginning.

Stockholders, employees, and the general public should be informed that a business must be able to retain out of profits amounts siifficient to replace productive facilities at current prices if it is to stay in business.2

The above statement indicates that accountants admit that they

report income figures that cannot be distributed as dividends if the

business organization is to continue to function as a going concern.

This means that in a period of rising prices the reported accounting

1. Lawrence L. Vance in "Current Problems and Accounting Theory," The Accounting Review, XIX (July, 19l|lt), pp. 231-38, dis­tinguished between three types of "reserves": valuation, liability, and surplus. Unfortunately most writers have not specified the intent of a retained earnings appropriation. The absence of such clear-cut distinctions and the resulting confusion was the topic of the excellent article by E. A. Kracke, "The Surplus Debate Begets Surplusage," The Journal of Accountancy, 81 (April, 19U6), pp. 273-81.

2. AICPA, op. cit., p. 6032. Emphasis supplied. This po­sition was exemplified in an editorial in The Journal of Accountancy. See John L. Carey, "Depreciation and Inflation," The Journal of Ac­countancy, 8U (October, 19k7)> pp. 265-66. The enthusiasm of business­men for depreciation based on replacement costs was noted as was the fact that the appropriation of retained earnings was the obvious (because it was generally accepted accounting practice and the former was not) answer to inflation.

/

33

income should be pared down in order to maintain the productive ca­

pacity of the enterprise."'" If a portion of reported income has to be

retained permanently in order to provide for the replacement of assets

at higher prices and to maintain productive capacity of the enterprise,

then the question is whether such a portion is really income.

During and immediately following World War II, there was a

concern about losses arising from the war and the restoration of fa­

cilities to peaceful production. This led to the issuance of ARB

No. 13^ in January 19^2 and ARB No. 26^ in October 191*6. These bulle­

tins sanctioned the creation of wartime reserves by charges against

income. Wartime losses as they materialized were to be charged against

these reserves. In July 1951, the AICPA withdrew these bulletins.

Granting the fact that the productive capacity of an enterprise

can be maintained by resorting to the appropriation of retained

earnings, conventional accounting does not provide management with a

1. The necessity of curtailing income distributions to provide for increased replacement costs was pointed out in many articles follow­ing the end of World War II, as was the fact that "accounting has heretofore provided no vehicle in the field of net-worth accounting to aid in expressing the reasonable nature of such reservations." George F. Wyman, "Is Surplus The Reserve?" The Accounting Review, XXIII (July, 19U8), p. 287. Also see F. Sewell Bray, "English Accountant Agrees with Proposal to State Current Costs," The Journal of Accountancy, 86 (December, 19^8), pp. 1*78-81.

2. Committee on Accounting Procedure of the AICPA, "Accounting for Special Reserves Arising Out of the War" (New York: AICPA).

3. Committee on Accounting Procedure of the AICPA, "Accounting for the Use of Special War Reserves" (New York: AICPA).

3h

scientific computation of the required appropriation of earnings—the

dividend restriction necessary to maintain the continuity of operations.

The thesis developed in this dissertation is that accounting should be

based on a concept of income that will provide information adequate to

enable the business firm to perpetuate itself as a going- concern. The

income of a business enterprise reported on its income statement should

represent an amount that can be severed without impairing the productive

capacity of the firm. Such an income concept will be discussed in

Chapter f>.

Bias Against Present Stockholders

The opinion paragraph of the short form independent auditor's

report certifies that in the auditor's opinion the balance sheet, the

income statement, and the statement of retained earnings "present fairly

the financial position . . . and the results of . . . operations . . .

in conformity with generally accepted accounting principles . . . ."

It should be noted that in Article 2, Rule 2-02, of Regulation S-X of

the Securities and Exchange Commission dealing with certification of

statements there is no reference to fairness of financial statements."®"

The word fair is defined in Webster's New Collegiate Dictionary

as "6. a Characterized by frankness, honesty, impartiality, or candor;

1. United States Securities and Exchange Commission, Regulation S-X Governing Form and Content of Financial Statements as in Effect July 1$, 1962 (Washington, D.C.: U. S. Government Printing Office, 1962;, pp. 2-3.

35 t

just, b In conformity with the established rules of a game, task,

etc."'*' As used in the opinion paragraph, the word fairness refers

to conformity with generally accepted accounting principles rather

than to honesty or impartiality of the financial statements.

Conformity with generally accepted accounting principles does

not necessarily produce financial statements that are honest, impartial

and free from bias to all users of financial statements. It has been

asserted by many accountants that conservatism favors the future in­

vestor over the present stockholder. Stephen Gilman expressed this

position in the following statement: "For some unexplained reason,

the protection of the incoming investor has seemed to be a matter of

greater importance than discouragement of one whose holdings have

2 already been acquired." As a result of the bias against present in­

vestors, some investors may be led to believe that the corporation

they invested in is less successful than it actually is and may be

induced to sell their investments for less than the real value of such

investments.

R. J. Chambers produced empirical evidence on the value of the

stock of seventeen Australian corporations that were taken over by

3 bids. The bidders had inside information on the affairs of the

1. Second edition (1956), p. 297.

2. Gilman, op. cit., p. 235. See also Harold Bierman, Jr., "Myths and Accountants," The Accounting Review, XL (July, 1965)* p. 5U2.

3. "Financial Information and the Securities Market," Abacus, 1 (September, 1965), pp. 19-21. Chambers' discussion is based on a table listing the change in the market value of 17 corporations. In the analysis of the table Chambers refers to 18 corporations rather than 17.

corporations. The market price of the stock of all the corporations

examined by Chambers increased substantially over a short period of

time (two to three months) after the bids took place. In the case of

four corporations the rise in market price was more than 1$0%, while

in the case of only eight corporations was the rise in market price

less than 100^. Chambers pointed out that the stockholders of those

firms were not well informed about the affairs of the firms they in­

vested in, for their investments were worth much more than they were

led to believe.

It is maintained in this dissertation that the restatement of

historical figures to a current replacement cost basis will produce

financial statements that are more compatible with the needs of

statement users assumed at the beginning of this chapter. A balance

sheet portraying current costs can appropriately be called a statement

of financial position, whereas a conventional balance sheet is a

"table of scraps left over after a banquet of income measurement.11

A balance sheet prepared on a replacement cost basis will show stock­

holders' equity stated in terms of current dollars and will thus pro­

vide a fair measure of the current worth of the owners' equity. The

measurement of the current worth of the owners' equity should theo­

retically include the recording of the current value of goodwill, but

such a refinement has to be deleted due to the subjective nature of

1. Jim G. Ashburne, "A Forward Looking Statement of Financial Position," The Accounting Review, XXXVII (July, 1962), p. U75.

37

obtaining a value for goodwill. The preparation of an iivcme statement

on a maintenance of productive capacity basis will present depreciation,

amortization, and other expenses restated in current terms to permit a

better measure of income.

In order for the accountant to be fair to users of financial

statements, especially to present and prospective stockholders, his

role will have to become akin to that of a judge as stated by Howard

Ross in The Elusive Art of Accountancy:

The accountant has somewhat similar problems to a Judge attempting to assess the amount of damages in a court case. The Judge must determine damages at an amount that will be fair to plaintiff and to defendant. He cannot "play it safe" by setting damages that are certainly not too high, so as to be sure he is not being unfair to the defendant, and vice versa. The accountant has much the same obligation to be fair to both buyer and seller.^

1. (New York: The Ronald Press, 1966), p. 86.

CHAPTER 3

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Generally accepted accounting principles have evolved over tine

through experience. They are "essential to the effective functioning

of any business organization, particularly the corporate form."^" They

are applied in the issuance of a standard short form opinion by an

independent accountant, and they must be evaluated in the light of their

impact on auditing. No attempt will be made here to discuss all the

accounting concepts that comprise the body of generally accepted ac-

counting principles.c Instead, the discussion will center on those

accounting conventions important to the development of the maintenance

of productive capacity concept. The accounting conventions analyzed

are the going concern, stable monetary unit, historical cost, and

verifiable and objective evidence. This analysis will be followed by

the presentation of the position of the American Institute of Certified

Public Accountants, the Securities and Exchange Commission, and the

American Accounting Association on the subject of price changes.

1. AICPA, op. cit., p. 6005.

2, Generally accepted accounting principles were best codified by Paul Grady in "Inventory of Generally Accepted Accounting Principles for Business Enterprises," Accounting Research Study No. 7 (New York: AICPA, 1965).

38

3 9

Going Concern Convention

Accounting for business enterprises is based on the going con­

cern or continuity of operations assumption. This assumption has been

stated as follows: "In the absence of evidence to the contrary, the

entity should be viewed as remaining in operation indefinitely. In

the presence of evidence that the entity has a limited life, it should

not be viewed as remaining in operation indefinitely."^

In the absence of evidence to the contrary, it is assumed that

the plans and programs of the business enterprise will be carried to

completion. "Thus the assets of the enterprise are expected to have

continuing usefulness for the general purpose for which they were ac-

2 quired, and its liabilities are expected to be paid at maturity." If

the enterprise is to be able to carry its plans and programs to com­

pletion, to operate as a going concern, then the assets must be replaced

as they are retired.

Relationship to the Entity Concept

The business concern is separate and distinct from its owners.

The modern corporation is run by professional management and has a

constantly changing composition of shareholders. A business concern

1. Maurice Moonitz, "The Basic Postulates of Accounting," Ac­counting Research Study No. 1 (New York: AICPA, 1961), p. 53. For a historical survey of the emergence of the going concern assumption, see A. C. Littleton, Accounting Evolution To 1900 (New York: American Insti­tute Publishing Co., 1933), PP» 2U2-57.

2. AAA, op. cit., p. 2.

Uo

has normally three types of assets: (l) cash and receivables, (2) in­

vestments for monetary gains, and (3) productive assets. Cash and re­

ceivables are non-productive but unavoidable for the operation of the

enterprise. Investments are held for monetary gains and require no

replacement per se. A firm's decision to hold or sell these investments

is based on their market price and on the firm's cash requirements. The

firm's gains or loss on these investments is equal to the difference

between their selling price (market price) and their cost adjusted for

price level changes, the same gain or loss as for an individual in­

vestor. Productive assets such as inventories, plant, and equipment

require replacement if the firm is to operate as a going concern. A

going business entity must maintain the productive capacity of such

assets before income emerges.

Justification for Historical Cost

The going concern assumption has many impacts on accounting pro­

cedures. It is used to justify the recording of accruals and the allo­

cation of historical costs and revenues by time periods. It is also

a justification for the necessary tentativeness assumption underlying

allocations and accruals as these may be affected by future events

which cannot be anticipated during the reporting period in question.

Stable Monetary Unit Convention

Accounting is based on the assumption of a constant unit of

measurement. The assumption of a stable monetary unit is undoubtedly

Ul

false and is so recognized by accountants. Paton and Littleton wrote:

The yardstick employed in accounting, unfortunately, is not a stable unit; the economic significance of the dollar, expressed in terms of the general price level, is a continuously changing amount. This means that recorded dollar cost is subject to possible misinterpretation as a measure of cost in the sense of committed purchasing power. It also means that under certain conditions the income or loss reported by conventional ac­counting procedure may not reflect the true change in economic status.1

The profession's decision not to recognize the changes in the

value of the dollar has been justified by the following arguments.

First, the change in the value of the monetary unit is so gradual that

it does not seriously distort the comparison of results between con-

o secutive accounting periods. Second, there is no sufficiently ob­

jective manner by which to determine the change in the value of the

monetary unit, since the evaluation of change depends on the selection

and use of an index number.^ Third, even if the first two arguments

fail, it is claimed by some accountants that the adjustment procedure

is too complicated to be understood and too costly to apply.^

1. Op. cit., p. 139.

2. See AAA, op. cit., footnote 2 on p. lU and also p. 61.

3. For example see Edward B. Wilcox and Howard C. Greer, "The Case Against Price-Level Adjustments in Income Determination," The Journal of Accountancy, 90 (December, 1950), pp. i;92-f>0U. It was the conclusion of the Research Department of the AICPA in "An Inquiry into the Reliability of Index Numbers," The Journal of Accountancy, 87 (April, 19U9), pp. 312-19, that no index of general price level was suitable in 19U9.

h. A summary of the controversy is available in Stephen A. Zeff, "Episodes in the Progression of Price Level Accounting in the United States," in Contemporary Studies in the Evolution of Accounting Thought, ed. by Michael Chatfield (Belmont, Calif.: Dickenson Publishing Company, Inc., 1968), pp. 316-35. The 1935 article, "Fixed Assets in

The stable monetary unit assumption has fallen to some extent

with the release of Statement of the Accounting Principles Board No. 3.

The Statement sanctioned the publication of general price-level

financial statements at the discretion of the individual firm. If a

firm elects to include adjusted statements, adjustments are to be

made on all items, and such statements are to be clearly titled and

presented as supplementary to, and not parallel to, the traditional

statements."'" The Gross National Product Implicit Price Deflator was

specified as the most appropriate index for measurement of the change

2 in the purchasing power of the dollar.

Extent of Price Changes - u *

The fact that the purchasing power of the monetary unit—the

dollar—changes continuously is well established by means of price level

indices. A discussion of the changes in some selected price level and

specific price indices is presented in Appendix 1.

Regardless of the accuracy of price indices, they point out a

serious problem—the fact that the purchasing power of the dollar is

the Balance Sheet," by T. H. Sanders, The Journal of Accountancy, 59 (April, 1935)t PP. 250-65, permits an insight of the mid-depression thinking by providing a review of arguments for asset revaluation and a scholarly rejection of any writeup above historical cost.

1. This method of presentation was suggested in 19U0 by Paton and Littleton, op. cit., p. 11*1.

2. This is in accordance with the recommendation by the Staff of the Accounting Research Division, "Reporting the Financial Effects of Price-Level ChangesAccounting Research Study No. 6 (New York: AICPA, 1963).

U3

not constant. Changes in the purchasing power of the dollar seriously

limit the usefulness of accounting data. Monetary units of different

dimensions are treated as identical5 they are added, subtracted, and

compared. As far back as 1918, Livingston Middleditch, Jr., wrote:

"To mix these [monetary] units is like mixing inches and centimeters

or measuring a field with a rubber tape-line.In the Preface to

Stabilized Accounting, Henry W. Sweeney gave the following statement:

. . . the success of the whole system of business depends upon the truthfulness of reports. The truthfulness of re­ports depends mainly upon the truthfulness of accounting. The truthfulness of accounting depends largely upon the truthfulness of the dollar—and the dollar is a liar. For it says one thing and means another.2

Purchasing Power of the Business Entity

An index of changes in the purchasing power of the dollar in­

dicates the change in the commanding power over goods and services of

the dollar in general and is not designed to measure changes in prices

of specific assets.^ a business firm may experience a change in the

1. "Should Accountants Reflect the Changing Value of the Dollar'" The Journal of Accountancy, 2$ (February, 1918), p. 11$.

2. (New York: Holt, Rinehart and Winston, Inc., 196U), p. xliii. This book was first published by Harper and Brothers, New York, in 1936.

3. Some of the implications of this difference were pointed out by J. Fred Weston, "Consistency and Changing Price Levels," The Ac­counting Review, XXIV (October, 19U9)* PP» 379-86; and by John ii. Kane, "Structural Changes and General Changes in the Price Level in Relation to Financial Reporting," The Accounting Review, XXVI (October, 1951)» pp. U96-502. The most complete treatment was provided by Stephen A. Zeff in his article, "Replacement Cost: Member of the Family, :,('elcorr.e Guest, or Intruder?" The Accounting Review, XXXVII (October, 1962), pp. 611-25.

purchasing power of its invested capital completely different from the

one indicated by a general price level index. This is so because a

particular firm operates in selected real estate, machinery, equipment,

labor, supplies, and commodity markets where the change in the prices

of these factors may not coincide with the change in the general price

level.

The determination of the change in the prices of factors bought

by a business firm is best measured by determining the current re­

placement cost of such factors. This can be achieved through appraisals

or by obtaining current cost quotations from vendors.^ Specific price

indices may be used to estimate the prices of specific assets. However,

these indices are at best approximations to the changes in the prices

of the assets with which a specific business firm deals, and only by

coincidence do they produce results corresponding to the actual change

in the prices of assets experienced by any particular firm.

To illustrate, in the case of marketable securities, the change

in the price of a particular stock cannot be determined from the Dow-

Jones Industrial Average or from any stock exchange index. The market

price of a particular stock may move in greater or lesser magnitudes

than the movements of any stock index and sometimes may move in the

opposite direction. Such a change can be determined only by obtaining

the market quotation on that particular stock. Similarly, the change

1. Chapter 7 will discuss various procedures to obtain re­placement costs.

\&

in the price of any specific asset or the change in the value of the

dollars invested in a particular asset can be determined only by ob­

taining the current replacement cost of such an asset.

The choice of the replacement cost of specific assets rather

than an index of the general price level to determine the change in

purchasing power experienced by a particular firm is in line with the

entity theory of accounting. It is contended here that it is the

purchasing power of the entity as a going concern that should be main­

tained rather than the purchasing power of stockholders as investors

or consumers. The adjustment of financial statements by means of a

general price level index measures the maintenance of the purchasing

power of the capital invested by stockholders as general consumers but

not the purchasing power of the firm as a producer of goods and services

on a going concern basis. The superiority of using current cost valu­

ation to general price level adjustment was indicated in the following

statement:

The current cost concept of income is superior to the concept of the purchasing power school. The superiority turns on the definition of the real capital to be maintained. The use of a general price index conforms more closely to the definition of capital as general command over goods and services, while the current cost school reflects the emphasis on capital as reproducible means of production. Real capital in the latter case is conceived in terms of physical units of plant or, in a more sophisticated version, units of productive capacity. The implications of this are obvious. The maintenance of the productive capacity implies the maintenance of the flow of output in real terms. If we assume that the terms of trade for the output will not improve or deteriorate vis-a-vis all other goods, then the problem can be reformulated. The choice lies between maintaining the purchasing power of the capital

stock and maintaining the purchasing power of the income flow produced by the capital.1

Historical Cost Convention

Accountants have stated very clearly that accounting is a

process of cost and revenue allocation to different accounting periods

and not a process of asset valuation. The following quotation is

obtained from the AAA 1936 Statement: "Accounting is . . . not es­

sentially a process of valuation, but the allocation of historical

costs and revenues to the current and succeeding fiscal periods."^

Relationship to Evidence Requirement

The cost adopted by accountants is original cost as evidenced

by an arm's length bargained transaction. On the date of acquisition,

original cost is the most objective measure of the fair value of the

asset.^ After the date of acquisition, original cost loses its sig­

nificance as a measure of the fair value of the asset, but it remains

objective, verifiable evidence of the transaction.

The concept of original cost is violated in current practice

when market replacement costs decline. Such a decline is recorded on

the basis of market prices without the support of an objective and veri

fiable transaction. Conservatism is often offered as a justification

1. Ronald Ma, "A Comparative Review of Some Price Level Ac­counting Systems," Abacus, 1 (December, 1965), p. 129.

2. AAA, op. cit., p. 61. Emphasis supplied.

3. Ibid., p. U.

U7

for recording the decline in market prices.^ Conservatism is offered

also as the master excuse for not recording upward deviations from

o cost. Thus conservatism overrules the concept of verifiable objective

evidence derived from a transaction.

Adherence to original cost has many implications in accounting.

In a period of rising prices, the conventional financial statements

lose their significance for their failure to disclose current costs.

Depreciation and, to an extent, cost of goods sold are reported at his­

torical costs and are matched against revenues stated in current dollars

on the income statement. This leads to the inevitable overstatement

of income,-' the potential dissipation of capital through dividend

payments, and the consequent neglect of the going concern requirements

on the firm.

1. Paton and Littleton stated that "... conservatism . . . is not a principle to guide accounting calculations of net income, but a rule of caution in interpreting the results of accounting measure­ments . . . Op. cit.t p. 128.

2. William A. Paton, "Measuring Profits Under Inflation Con­ditions: A Serious Problem for Accountants," The Journal of Accountancy, 89 (January, 1950), p. 18.

3. An example of the long-standing concern with this problem is the summary of papers presented at the Joint Conference in Chicago, December 10, 19U7, by George 0. May, "Property and Inventory Accounting as Related to Present-Day Price Levels," The Journal of Accountancy, 85 (May, 19U8), pp. U06-12, in which many of the same considerations were given to increasing costs as discussed by William S. Krebs, "Asset Appreciation, Its Economic and Accounting Significance," The Accounting Review, V (March, 1930), pp. 60-9.

Departures from Historical Cost

In the 1920's and in the late 1930's it was not uncommon for

accountants to write up fixed assets to their appraised values. The

asset writeups of the 1920's have been cited as one of the causes of

the depression in the 1930's.^ In April 19U0, the Committee on Ac­

counting Procedure of the AICPA issued ARB No. 5, which included the

following statement: "Accounting for fixed assets should normally be

based on cost and any attempt to make property accounts in general re­

flect current values is both impracticable and inexpedient."2 The

19U0 position of the Institute was reemphasized in 1953 and in 1965

An early article that advocated the recording of depreciation

on replacement cost was written by John Bauer in 1919.^ William A.

Paton took up Bauer's cause and discussed methods of recording de­

preciation on the basis of replacement cost and proposed the concurrent

adjustment of assets and of stockholders' equity.^

1. For example see Eric L. Kohler, "Why Not Retain Historical Cost?" The Journal of Accountancy, 116 (October, 1963)> pp. 35-^1.

2. "Depreciation on Appreciation" (New York: AICPA, 191*0), p. 37.

3- AICPA, op. cit., p. 6033 and also p. 6529.

U. "Renewal Costs and Business Profits in Relation to Rising Prices," The Journal of Accountancy, 28 (December, 1919), pp» 1*13-19.

5. "Depreciation, Appreciation and Productive Capacity," The Journal of Accountancy, 30 (July, 1920), pp. 1-11.

R. J. Chambers, the noted Australian accounting philosopher,

has released his comprehensive accounting system.Chambers undertook

the task, as he believed it necessary, of specifying the postulates

upon which accounting rests, deriving principles therefrom, and stating

necessary practices. Chambers' position on the use of current exit

costing is germane to the thesis of this dissertation. He contends

that original cost is not relevant beyond the moment of acquisition

and that the decision to hold or sell is made on the basis of current

selling price and expected future selling price. Where assets are

held for sale and the holder is free to sell at any time, Chambers'

position is reasonable. Exit costing is not appropriate when assets

are held for use (such as in production) under the going concern

concept. Exit costing for inventories ignores that in general a

business firm will not have complete freedom in the election to sell

or hold its products. For those assets held for sale and where freedom

of choice exists, such as temporary investments in marketable securi­

ties, exit cost is appropriate. The difference in the current and

historical costs should not be a component of disposable income, how­

ever, since realization in severable form has not occurred.

Among the economists who recommended the departure from origi­

nal cost, the most noted by accountants are Edwards and Be11.^ They

1. Towards a General Theory of Accounting (Melbourne: The Australian Society of Accountants, 1962).

2. Op. cit. A summary of the Edwards and Bell concept will be presented in Chapter U.

proposed the compilation of data, in addition to the conventional ac­

counting data, to show the results of operations based solely on current

costs and to show separately the gains and losses arising from decisions

to hold assets through periods of price and purchasing power changes.

Sprouse and Moonitz in Accounting Research Study No. 3^ proposed

the use of net realizable value for inventories and current replacement

cost for property, plant, and equipment. In 1966, a special committee

of the AAA recommended the preparation of supplementary financial

p statements based on current replacement cost data.

Verifiable and Objective Evidence Convention

Verifiability and objectivity of accounting data are essential

features of the accounting process. They are an outgrowth of pro­

fessional auditing in Great Britain. Revenues and expenditures were

considered valid only on the basis of objective evidence furnished by

bona fide transactions with independent parties and supported by veri-

fiable documents.^ The evidence requirement is critical to the public

accountant's responsibility for his clients' financial statements and

his legal liability that flows from that responsibility.^ It is also

1. "A Tentative Set of Broad Accounting Principles for Business Enterprises" (New York: AICPA, 1962).

2. American Accounting Association Committee to Prepare a Statement of Basic Accounting Theory, op. cit.

3. Paton and Littleton, op. cit., p. 18.

h. One of the auditing standards of field work is stated as follows: "Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements

£1

important to accounting as the persuasiveness of the evidence determines

when changes in real accounts will be recognized and when the emergence

of nominal accounts will be realized.^

Explanation and Interrelationship of Terms

The terms verify, evidence, and objective were explained by

Paton and Littleton, who wrote:

"To verify" means to establish the truth, to test the accuracy of a fact, to substantiate an assertion. "Evidence" is a means of ascertaining the truth or of furnishing proof. An authentic business document, for example, is a form of evi­dence that derives its validity principally from its associ­ation with an outside party. The effect of acceptable evi­dence is that it carries conviction of the truth of the fact involved. "Verifiable evidence," then, is evidence cf such a nature as to lend itself to establishing the truth. "Ob­jective" as used here relates to the expression of facts without distortion from personal bias. It is in contrast to "subjective, a word which suggests that the personal equation—state of mind, wish, intent to deceive—may affect the result. "Objective evidence" therefore is evidence which is impersonal and external to the person most concerned, in contrast with that person's unsupported opinion or desire.2

More recently, Maurice Moonitz gave the following formulation

of the concept of objectivity:

under examination." See Committee on Auditing Procedure of the American Institute of Certified Puclic Accountants, "Auditing Standards and Procedures," Statement on Auditing Procedure No. 33 (New York: AICPA, 1963), p. 16.

1. For a discussion of the realization criteria, see Robert T. Sprouse, "Observations Concerning the Realization Concept," The Ac­counting Review, XL (July, 1965)* pp. $22-26; and Earl A. Spiller, Jr., "The Revenue Postulate—Realization or Recognition?" MA Bulletin, XLIII (February, 1962), pp. Ul-7.

2. Paton and Littleton, op. cit., pp. 18-9.

52

. . . changes in assets and liabilities, and the related effects (if any) on revenues, expenses, retained earnings, and the like, should not be given formal recognition in the accounts earlier than the point of time at which they can be measured in objective terms.

If this general proposition on objectivity were expressed in positive terms, it would assert that "changes in assets . . . should be given formal recognition in the accounts at the earliest point of time at which they can be measured in objective terms." The basic (negative) form of this propo­sition does not rule out the "positive" form. The "positive" form, however, does lay down an injunction as to early recog­nition and therefore rules out the basic (negative) form.l

Moonitz uses the term objective to mean "unbiased; subject to verifi­

cation by another competent investigator"^ and he does not restrict

the term to past or current exchange transactions but states that

estimates and forecasts can be objective as well if they can be

predicted with a reasonable degree of accuracy.

The AAA Committee to Prepare a Statement of Basic Accounting

Theory recommended the use of four basic standards to evaluate ac­

counting information. These standards are (l) relevance, (2) verifi-

ability, (3) freedom from bias, and (1|) quantifiability. The standard

of verifiability "requires that essentially similar measures or con­

clusions be reached if two or more qualified persons examined the same

1. Moonitz, op. cit., pp. Ul-2. The limitations placed upon recognition by objectivity can be exemplified by the controversy stimu­lated by Accounting Research Study No. 3, and the article by John H. Myers, "The Critical Event and Recognition of Net Profit," The Ac­counting Review, XXXIV (October, 1959), pp. £28-32. This point was also made by Reuel I. Lund, "Realizable Value as a Measurement of Gross Income," The Accounting Review, XVI (December, 19hl)> pp. 373-85.

2. Moonitz, op. cit., p. 1*2.

53

data.11"'" The standard of freedom from bias "means that facts have been

impartially determined and reported. It also means that techniques

used in developing data should be free of built-in bias."

Objectivity as an accounting convention derives from a past

exchange transaction that is supported by a document. If objectivity

refers to "freedom from bias" and "verifiable by [a3 competent investi­

gator," then it can extend to the adoption of current replacement costs

and to the use of price level and specific price indices. The determi­

nation of the current replacement cost of an asset on the basis of

available market prices or on the basis of a quotation from a supplier

is free from bias and is subject to verification by an investigator.

Freedom from bias and verification also extend to the use of price

level and specific price indices. A member of the Research Staff of

the AICPA related objectivity to the utility of accounting data in

the following statement:

. . . any data which are considered useful are objective to accountants, provided they are substantiated or capable of being substantiated by an independent party. This type of evidence may range all the way from suppliers' invoices and cancelled checks, through estimates based on statistical techniques and mathematical formulas, to data derived from the use of index numbers and fair market values.3

1. Op. cit.» p. 7.

2. Ibid., p. 7.

3. Harold E. Arnett, "What Does 'Objectivity1 Mean to Ac­countants?" The Journal of Accountancy, 111 (Kay, 1961), p. 68. Emphasis supplied.

Sh

Accounting Implications

Adherence to verifiable and objective evidence in conventional

accounting requires that revenues should not be recognized until they

are realized through sale. It is only when a sale takes place—an

independent exchange transaction—that the revenue can be objectively

determined as evidenced by the cash received or the claim on cash that

arises. This emphasizes the criterion of severability in the determi­

nation of business income.-*- Similarly the change in the value of fixed

assets should not be recorded, since the change is not objectively

determined as a result of an exchange transaction. One of the rules

adopted by the membership of the AICPA in 193k and issued as part of

ARB No. 1 in September 1939 stated that:

Unrealized profit should not be credited to income account of the corporation either directly or indirectly, through the medium of charging against such unrealized profits a-mounts which would ordinarily fall to be charged against income account. Profit is deemed to be realized when a sale in the ordinary course of business is effected, unless the circumstances are such that the collection of the sale price is not reasonably assured.^

It should not be understood, however, that accounting is en­

tirely restricted to the demonstrable truth evidenced by actual cash

receipts and disbursements. In accounting, judgments and estimates

play a vital role. "A completely objective determination of

1. In current accounting practice, non-cash exchanges of assets are usually recorded on the basis of the book value of the asset given away thus eliminating the recognition of a gain as such a gain is not in severable form.

2. AICPA, op. cit., p. 6007.

depreciation, for example, would appear only when the item of equipment

was permanently retired from service, and a similar determination of

bad debts only when the customer was discharged in bankruptcy.

The Position of the American Institute of Certified Public Accountants

The AICPA has always been a strong advocate of the adherence

to historical cost despite its recognition of the limitations of his­

torical cost accounting in a period of rising prices. This position

is understandable in view of the legal liability underlying the certi­

fied public accountant's attestation function. The auditor's reliance

on verifiable and objective evidence is satisfied by the objectivity

of original cost. This position was somewhat softened in June 1969

when the Institute issued Statement of the Accounting Principles Board

No. 3 recommending the preparation, on a voluntary basis, of financial

statements adjusted for price level changes.

In ARB No. 5 issued in December 19U0 and in APB Opinion No. 6

issued in October I960, the Institute emphasized its position in

favor of adherence to original cost. The following statement is ob­

tained from APB Opinion No. 6; "The Board is of the opinion that pro­

perty, plant and equipment should not be written up by an entity to

reflect appraisal, market or current values which are above cost to

the entity."-^ One of the APB members who agreed with the above position

1. Paton and Littleton, op. cit., p. 20.

2. Cf. supra, p. U8.

3. AICPA, op. cit., p. 6?29•

did so only because he felt that current measurement techniques are

not adequate to record appraisals and he recommended the development

of techniques for such purposes.

In ARB No. 33 issued in December 19U7 and in a letter to the

members of the Institute dated October lli, 19U8, the Institute re­

cognized the fact that the management of business firms has the re­

sponsibility to provide for the replacement of fixed assets at higher

prices and has to be aware of price changes in setting selling prices

and in determining business policies. However, it was felt that

depreciation accounting should continue to be based on cost "at least

until a stable price level would make it practicable for business as

a whole to make the change at the same time."3 The Institute did not

feel that a departure from tradition was warranted at that time and

took the position that a radical change in the accounting for de­

preciation had to await "further study of the nature and concept of

business income.The Institute stated that the problem of replacement

of fixed assets at higher prices is a problem of financial management

and that when replacement costs rise appreciably, a business firm should

resort to the appropriation of reported income.-'

1. Ibid., p. 6529.

2. ARB Ko. 33 and the letter of October 1U> 19U8, were issued as Chapter 9 Section A of ARB No. It3 in June 1953.

3. AICPA, op. cit., p. 6031. Emphasis supplied.

U. Ibid., p. 6032. Such a study has yet to be issued by the AICPA.

5. Appropriations of earnings were discussed in Chapter 2.

57

In a meeting of the Accounting Principles Board of the AICPA

on April 28, 1961, the Board recognized the fallacy of the stable

monetary unit assumption and authorized a research study on this topic.

The following excerpt is derived from the minutes of the meeting:

. . . t h e B o a r d . . . a g r e e d t h a t t h e a s s u m p t i o n i n a c c o u n t i n g that fluctuations in the value of the dollar may be ignored is unrealistic, and that therefore the Director of Accounting Re­search should be instructed to set up a research project to study the problem and to prepare a report in which recommen­dations are made for the disclosure of the effect of price-level changes upon the financial statements. In this study, special attention should be made to the use of supplementary statements as a means of disclosure.1

Accordingly, Accounting Research Study No. 6 entitled "Reporting the

Effects of Price-Level Changes" written by the Staff of the Accounting

Research Division of the AICPA was published by the Institute in 1963.

This study recommended the recognition of the effects of price level

changes in data supplementary to the conventional statements.^

Accounting Research Studies do not represent the official view­

point of the AICPA. They are published to stimulate interest and dis­

cussion, to further research in the topics presented, and possibly to

serve as a basis for future AP3 Opinions. The APB, however, did not

issue an APB Opinion on the subject but instead has issued Statement of

the Accounting Principles Board No. 3 which contained the following

recommendation:

1. Quoted from The Staff of the Accounting Research Division, op. cit,, p. 1.

2. Ibid., p. U.

58

The Board believes that general price-level financial state­ments or pertinent information extracted from them present useful information not available from basic historical-dollar financial statements. General price-level information may be presented in addition to the basic historical-dollar financial statements, but general price-level financial statements should not be presented as the basic statements. The Board believes that general price-level information is not required at this time for fair presentation of financial position and results of operations in conformity with generally accepted accounting principles in the United States.^

The Position of the Securities and Exchange Commission

The SEC requires adherence to original cost in statements filed

2 with it. However, the Commission will accept for filing the financial

statements of foreign concerns that have been adjusted to reflect

current values of fixed assets. This is permitted only where such

adjustments are sanctioned in those foreign countries and are recorded

on the basis of coefficients set by the governments of those countries.

The SEC requires disclosure of such departure from original cost but

does not require restatement on the basis of original cost as required

of U.S. corporations.^

In correspondence with the Chief Accountant of the SEC on the

subject of price level changes and replacement costs, a response was

1. Op. .ext., p. 12.

2. A discussion of some current SEC rulings and subsequent court cases dealing with the misstatements caused by adherence to his­torical cost can be found in the article by Paul M. Foster, "Asset Dis­closure for Stockholder Decisions," Financial Executive, XXXV (July, 1967), pp. 28-UU.

3. Louis H. Rappaport, SEC Accounting Practice and Procedure, . 2nd Edition (New York: The Ronald Press Co., 1966), p. 26.12.

59

received from the Associate Chief Accountant which contained the

following statement: "... the Commission does not accept for filing

financial statements adjusted for purchasing power changes. The Com­

mission has on rare occasions permitted fixed assets to be carried at

appraised values." The letters of the writer and of the Associate

Chief Accountant are reproduced in Appendix 2.

The Position of the American Accounting Association

The AAA has changed its emphasis over the past 30 years from

the traditional cost-oriented financial statements to the more liberal

emphasis on the recognition of purchasing power changes and changes in

replacement costs.

In "A Tentative Statement of Accounting Principles Underlying

Corporate Financial Statements" issued in 1936, the Executive Com­

mittee of the Association emphasized its adherence to original cost

as it did not feel that the change in the price level was serious

enough to warrant its recognition in the accounts.^ This same position

was repeated in the 19hl Statement.

In a footnote to the Statement issued in 19U8, recognition was

given to the enhancement in the interpretation of financial statements

1. "A Symposium on Appreciation" which appeared in The Ac­counting Review, V (March, 1930), pp. 1-59, has no official status in the Association. The proceedings are of current interest as they pre­sent the opinions of some of the leaders in accounting of that time. The public utility reproduction costing issue and court decisions on income determination were accorded prominent treatment.

2. AAA, op. cit., p. 61.

60

that would result if consideration were given to purchasing power

changes. The footnote concludes by expressing the need for the develop­

ment of accounting concepts and standards to account for a drastic and

permanent change in prices.

Between 1950 and 195U, the Committee on Concepts and Standards

Underlying Corporate Financial Statements issued eight Supplementary

Statements to the 19U8 Statement. Supplementary Statement No. 2 issued

in 195>1 dealt with "Price Level Changes and Financial Statements" and

contained the following recommendation:

The accounting effects of the changing value of the dollar should be made the subject of intensive research and ex­perimentation; t.bje specific significance of the basic problem should be determined with as much accuracy as possible; the means of its solution, if its significance warrants, should be thoroughly investigated.2

Based on the above recommendation, the AAA published in 1955

Price Level Changes and Financial Statements: Case Studies of Four

Companies,3 written by Ralph C. Jones. This publication was followed

in 1956 by Effects of Price Level Changes on Business Income, Capital

and Taxes,^ by Ralph C. Jones, and by Price-Level Changes and Financial

Statements: Basic Concepts and Methods,^ written by Perry Kason, both

published by the Association.

1. Ibid., p. lU.

2. Ibid., p. 2U.

3. (Evanston, 111.).

U. (Evanston, 111.).

5. (Evanston, 111.).

61

In a Statement issued in 1957, the Committee on Concepts and

Standards recommends that investors be provided with supplementary

statements giving effect to changes in the purchasing power of the

monetary unit and/or changes in the prices of specific assets pending

the development of principles to adjust for price changes in the

primary statements."'" Five supplementary statements were issued to

supplement the 1957 Statement. Supplementary Statement No. 1 recommends

the immediate adoption of current cost for items of plant and equipment

with depreciation computed accordingly.^ Supplementary Statement No. 2

"5 recommends the valuation of inventory on a replacement cost basis.

In 1966, the AAA published A Statement of Basic Accounting

Theory prepared by a Committee to Prepare a Statement of Basic Ac­

counting Theory. This Committee recognizes the limitations of con­

ventional accounting data and criticizes the use of historical cost.

The Committee recommends the preparation of supplementary financial

statements on the basis of replacement cost data.^

1. AAA, op. cit., p. 9.

2. American Accounting Association Committee on Concepts and Standards—Long-Lived Assets, "Accounting for Land, Buildings, and Equipment," The Accounting Review, XXXIX (July, 196U), pp. 693-99.

3. American Accounting Association Committee on Concepts and Standards—Inventory Measurement, "A Discussion of Various Approaches to Inventory Measurement," The Accounting Review, XXXIX (July, 19610, pp. 700-lh.

U. AAA Committee to Prepare a Statement of Basic Accounting Theory, op. cit.t p. 19.

62

The publications of the AAA do not all represent the official

pronouncements of the Association or of its Executive Committee.

Nevertheless, the trend in emphasis is certainly important.

CHAPTER U

SELECTED CONCEPTS OF BUSINESS INCOME

In the previous two chapters it was pointed out that in a period

of rising prices conventional accounting practice leads to appropri­

ations of reported income to restrict dividends in order to allow for

the replacement of assets at higher prices. Thus a business firm has

to curtail the amount of reported income available for dividends if it

is to replace its assets at higher prices and continue operations. Al­

ternatively, in a period of falling prices, a firm can pay in dividends

ah amount greater than reported income and still be capable of replacing

its assets.

The issue of the replacement of assets is inseparable from the

income determination problem. This was recognized by the Committee on

Accounting Procedure of the AICPA when it stated that "Any basic change

in the accounting treatment of depreciation should await further study

of the nature and concept of business income."^

This chapter examines the concepts of business income in ac­

counting and economics to provide a background for the formulation of

the maintenance of productive capacity concept of business income in

Chapter S>» A summary of proposals of business income concepts

1. AICPA, op. cit.f p. 6032. Emphasis supplied.

63

formulated by Edwards and Bell, Chambers, ARS No. 1 and ARS No. 3, and

the AAA Committee to Prepare a Statement of Basic Accounting Theory are

presented. A summary of attempts to apply the concept of Edwards and

Bell and ARS No. 3 is presented at the end of the chapter.

Nature of Income

Income is essentially a flow of values as distinguished from

capital which is a stock of values.^ Any concept of income has to be

related to a particular capital value. Income generally can be defined

as an amount which an individual can spend without impairing the capital

value of his investment. This general definition is in agreement with

both the accountant's and the economist's conceptions of income.^ Capi­

tal, however, is conceived differently for income determination purposes

by accountants and economists; hene there arises the conflict between

their concepts of income.

The term income has been associated with a variety of concepts

related to wealth and value. It has been used widely, often with an

adjective preceding it, as in gross income, net income, taxable income,

national income, and the like

1. Irving Fisher, The Nature of Capital and Income (New York: The Macmillan Co., 1927), p. 52.

2. For a discussion of the difference between the accounting and economic concepts of income, see David Solomons, "Economic and Accounting Concepts of Income," The Accounting Review, XXXVI (July, 1961), pp. 37U-83.

3. Study Group on Business Income, Changing Concepts of Business Income (New York: The Macmillan Co., 1952), p. 5»

65

It is important to note that accountants and economists have

different interpretations of income within their own circles; it is not

expected that they would agree on a uniform concept of income. Writing

in 1906, Irving Fisher stated:

It is no exaggeration to say that at present the state of economic opinion on this important subject is deplorably con­fused and conflicting. Many writers fail to construct any definition, either because they find the task too difficult, or because they deem the concept too obvious to require defi­nition. And those who do set themselves the task of reaching a working concept of income do not find it em easy onej and authors often confess dissatisfaction with their own results.!

Fisher's comments are equally valid today. The much quoted John B.

Canning points out the confusion existing in economic circles by giving

the following statement:

. . . i n t h e w r i t i n g s o f m a n y e c o n o m i s t s , o n e f i n d s d e f i n i t i o n s of social income, of individual income, of family (or other group) income, that seem more or less, sometimes wholly, unre­lated to one another. And even in the same writings one will find implied concepts of income not accounted for by any of the explicit definitions. In some cases, indeed in a great many, economists neither express nor imply any general concept of income, but proceed to consider the distributive shares, rent, wages, interest, and sometimes profits, each of which, in a sense, is an element of income.2

It can also be said that accountants do not agree on a common

definition of income. There is too much literature on income and its

components without much agreement on the basic concept involved.

1. Op. cit., p. 101.

2. The Economics of Accountancy (New York: The Ronald Press Co., 1929), p. 1UU.

66

Furthermore, accountants have not identified the persons or groups

whose income is to be reported. Income will differ with the group

which is to benefit from it.^

Income in Accounting

Accountants may define income as the difference between revenues

earned and expenses incurred during a period of time as determined in

accordance with generally accepted accounting principles.^ This income

is equal to the difference between the owners' equity of the business

enterprise at the beginning and at the end of the period, due consider­

ation being given to changes in the owners' equity resulting from ad­

ditional investments and/or withdrawals. Accountants tend to prefer to

defins income by its components. Under this definition primary at­

tention is given to an event's impact upon revenues and expenses; under

the former, primary attention is directed towards changes in the balance

sheet accounts. The accounting definition of income presupposes that

accountants agree on a definition of revenue, its measurement, and on

what to include in the revenues of the period; and it also presupposes

that accountants agree on a definition of expense, its measurement, and

on what to consider as expenses for the period. Furthermore, the phrase

generally accepted accounting principles as used in the independent

1. For a discussion on this topic, see Hendriksen, op. cit., pp. 117-22.

2. Reliance on generally accepted accounting principles is paramount in the auditor's attestation function. The auditor's lia­bility to third parties has produced the need for reliance on hard evidence generally supported by completed transactions and for the desire to be on the safe side, hence, conservatism.

67

accountant's standard short form report implies the existence of a set

of standardized, well-defined rules used by the accountant in the ac­

counting process of the determination of business income. Unfortu­

nately, such is not the case in accounting.

The American Institute of Certified Public Accountants' Definition of Income

The Committee on Terminology of the AICPA gave the following

definition of income:

Income and profit involve net or partially net concepts and refer to amounts resulting from the deduction from revenues, or from operating revenues, of cost of goods sold, other expenses, and losses, or some of them. The terms are often used interchangeably and are generally preceded by an ap­propriate qualifying adjective or term such as "gross," oper­ating," "net . . . before income taxes," and "net."l

This definition was supported by definitions of the words revenue, ex-

pense, and loss.

For a long time accountants were not in agreement on whether

all items of revenue and expense (or more appropriately gains and

losses) realized during a period were to be included in the determi­

nation of periodic income. Fortunately, this controversy between the

current operating concept and the all-inclusive concept of income has

been resolved as a result of the issuance in 1966 of APB Opinion No. 9.^

1. AICPA, op. cit., pp. 9519-20.

2. See ibid., p. 9519 and p. 9523.

3. Ibid'., pp. 6557-62.

68

Other Accounting Definitions of Income

Below are two definitions of income. The first is obtained

from Kohler's A Dictionary for Accountants, and the second is a defi­

nition formulated ty Morton Backer.

Kohler's Definition. The following definition of income is

found in Kohler's A Dictionary for Accountants:

1. Money or money equivalent earned or accrued during an accounting period, increasing the total of previously ex­isting net assets, and arising from sales and rentals of any type of goods or services and from the receipts of gifts and windfalls from any outside source ... .1

The Dictionary further adds: "In most accounting usage, 'income' custom­

arily refers to any factor, other than additional investment, that

p increases the owner's equity in an enterprise . . . ."

Backer's Definition. Morton Backer gave the definition that

follows: "From an accounting standpoint, income is generally conceived

to be a residuum which emerges out of a matching of expired costs

against revenue earned."^

The accounting definitions of income just cited revolve around

either of two approaches. One approach treats income as an increase in

1. Second edition, p. 2U9. The inclusion of gifts in Kohler's definition of income is worth noting. Paton and Littleton exclude gifts from income, see op. cit., p. U7. The pronouncements of the AICPA and the AAA are silent on this subject.

2. Kohler, op. cit., p. 2£0.

3. Morton Backer and Philip W. Bell, "The Measurement of Business Income," in Modern Accounting Theory, ed. by Morton Backer (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1966), p. 68. Refer to pp. 68-9 for Backer's definition of cost and revenue.

net assets or owners' equity; the second refers to income as a differ­

ence between revenues and expenses. The latter approach is the more

common in accounting practice, since accountants think of income in

terms of an income statement consisting of revenues and expenses with

the balance defined as income. The two approaches, however, give

identical results.

Income in Economics

Income as discussed in this section should be distinguished from

pure profit. Pure profit is income less imputed wages of management and

imputed interest on capital. The concept of income in economics se­

lected for the purpose of this study is the one formulated by J. R.

Hicks. This concept was chosen because it has been referred to very

extensively in the accounting literature.

Hicks starts by specifying the reason for the determination of

income. According to him, "the purpose of income calculations in

practical affairs is to give people an indication of the amount which

they can consume without impoverishing themselves."-'' He defines income

for an individual as the maximum amount that the individual can consume

in a period of time and still expect to be as well off at the end of

the period as he was at the beginning. Thus the purpose of income

determination is to provide a guide for prudent conduct by individuals.

1. Hides, op. cit.f p. 172.

2. Ibid., p. 172.

70

Hicks' definition of income can be restated to apply to a

business organization. The income of a business organization is the

amount by which its capital value has increased during a period of time

taking into consideration new capital investments and drawings by the

owners. This definition corresponds to the computation of income in

accounting as the difference between owners' equity at the beginning of

the period and owners' equity at the end of the period, due consider­

ation being given to new capital investments and drawings by the owners.

The difference between the two conceptions centers on the fact that in

calculating capital value in economics expected future receipts are

capitalized, whereas in calculating owners' equity in accounting assets

are valued on the basis of their unexpired costs.

Hicks' definition of income implies that well-offness can be

measured in real terms. Hicks recognizes the fact that well-offness

cannot be measured precisely, and accordingly he gives a series of three

"approximations to the central meaning."

The first approximation (Income No. 1) is based on the as­

sumption of a stable price level and a constant rate of interest.

Income No. 1 is the maximum amount which one can spend during a period

of time while maintaining intact the capital value of prospective re-

2 ceipts in money terms.

1. See David Solomons, op. cit., p. 376.

2. Hicks, op. cit., p. 173.

Hicks states that Income No. 1 "is far from being in all

circumstances a good approximation to the central concept,and he

presents Income No. 2 which differs from the first in that it takes

account of expected changes in the rate of interest at which an in­

vestment is valued. If the rate of interest changes from period to

period, a definition of income based upon the constancy of money ca­

pital ceases to be satisfactory. Under conditions of a changing inter

est rate, income may be defined as the maximum amount that one can

spend during a period of time and still expect to be able to spend the

p same amount in each subsequent period.

The third approximation to the central meaning (Income No. 3)

takes into consideration the possibility of an expected change in

prices in certain future periods. Under this condition, income is the

maximum amount of money which one can spend during a period of time

and still expect to be able to spend the same amount in real terms in

each subsequent period.3

Income No. 3 suffers from two limitations which have been

recognized by Hicks himself. Income No. 3 is the maximum amount of

money which one can spend during a period of time and still expect to

be able to spend the same amount in real terms in each subsequent

period. Hicks recognizes that the difficulty in applying this

1. Ibid., p. 173.

2. Ibid., p. 17U.

3. Ibid., p. 17U.

72

approximation lies in the choice of the index number of prices to be

used. Kicks admits that there is no satisfactory index number for this

purpose.

The difficulty is not limited to the lack of an index number

which would be acceptable from all standpoints. Income No. 3 according

to Hicks also fails to consider durable consumption goods.^ When

durable consumption goods are accounted for, income becomes the maximum

amount one can consume (rather than spend) to be as well off at the end

of the period as he was at the beginning. The complexity of income

determination will be increased if part of the expenditure of a period

is made on durable consumption goods, thus decreasing consumption as

compared to expenditure, or if part of consumption consists of using

up durable goods that were acquired in past periods, thus making

consumption greater than expenditure. This question of durable con­

sumption goods only arises in the income determination process of indi­

viduals who are not concerned with maintaining a certain productive ca­

pacity and does not arise in the income determination process of

business organizations. In the latter case income is the maximum amount

that can be paid in dividends to owners while expecting to keep the same

productive capacity of the business entity at the end as at the be­

ginning of the period.

The preceding approximations to the central meaning presented

by Hicks deal with ex ante income and give no consideration to the

realization of these expectations. If expectations are not exactly

1. Ibid., pp. 175-76.

73

realized, the value of a prospect (i.e., the capital value of pro­

spective receipts at the end of .a period) will be greater or less than

expected. The difference between the expected capital value of a

business organization at the end of a period and that which it is actu­

ally determined to be is either a windfall profit or a windfall loss.

Ex post income is obtained by adding windfall gains to ex ante income

or by subtracting windfall losses from ex ante income.

Hicks was not concerned with the objectivity of measuring income

because he was not concerned with the evidence requirement facing an

accountant.

Proposals to Chanp;e Conventional Accounting Income

The limitations of generally accepted accounting principles

and the resulting failure of conventional accounting income to meet

the needs of financial statement users as discussed in Chapter 2 led

to proposals to change accounting income in an attempt to better serve

the needs of statement users. Four such proposals are discussed below.

Edwards and Bell's Concept of Income

Edwards and Bell have developed a concept of business income

which attempts to fill the gap between the subjective immeasurable eco­

nomic concept and the objective accounting concept. This concept has

received much attention in the accounting literature.

1. Ibid., p. 178.

7h

Edwards and Bell's theory emphasizes the distinction between

operating gains and holding gains. Operating gains or current operating

profit stand for the difference between the current value of the output

sold and the current cost of the related inputs.^" Holding gains refer

to the increase in the value of a firm's assets (and/or decrease in the

value of its liabilities) over time that results from individual price

2 changes of those assets (and/or liabilities). Operating gains are

separated from holding gains, since they result from different mana­

gerial decisions.

Current operating profit can be accepted without much challenge

since it represents a realized^ gain. The next question that arises is

what holding gains to consider. Holding gains are of two types: real­

ized holding gains and realizable (i.e., still unrealized) holding

gains. Realized holding gains arise either from the sale or the use of

an asset that has risen in price, while realizable holding gains result

from the increase in the value of assets during a certain time period.

The sum of current operating profit and realizable holding gains

is called business profit, which is a measure of the true increase in

the money value of the enterprise during the year. The sum of current

operating profit and realized holding gains is called realized profit

1. Edwards and Bell, op. cit., p. 93.

. 2. Ibid., n. 36.

3. The term realized is used in this study to refer to changes in assets, liabilities, and owners' equity accounts that are a result of consummated arm's length transactions.

and is identical in total though not in components with accounting

profit computed in accordance with generally accepted accounting

principles.^-

Edwards and Bell also discuss the purchasing power problem as

it affects the elements of business profit, namely, current operating

profit and realizable holding gains. No price level adjustment is

necessary for current operating profit, since, by definition, this

represents "the excess of the current purchasing power represented by

the current value of output over the current purchasing power repre-

2 sented by the current value of input." However, the gain resulting

from holding activities requires adjustment for changes in the purchas­

ing power of the monetary unit. The holding gain is divided into two

components s a component that arises from changes in the purchasing power

of the monetary unit, called "fictional gain," and a component arising

from an increase in the current purchasing power of the firm, called

"real gain.11 ̂

Chambers' Concept of Income

Chambers has developed a concept of income which attempts to

portray the effect of economic events on a business enterprise during

a period of time. His income concept is related to the capital value

of the enterprise which he calls residual equity. Residual equity is

1. Edwards and Bell, op. cit., p. 117.

2. Ibid., p. 12U.

3. Ibid., p. 12b. Use of the term fictional has caused much adverse comment within accounting circles.

76

equal to the difference between assets and liabilities both expressed

in terms of current cash equivalents. Current cash equivalent of assets

is the aggregate of the current selling (exit) prices of these assets,

while the current cash equivalent of liabilities is obtained by dis­

counting liabilities at the current rate of interest."*" Chambers was

not concerned with the objectivity of measuring current cash equiva­

lents .

Based on his definition of residual equity, Chambers gives the

following definition of income:

Income will therefore be defined as the increment in a period in the measure of the residual equity, provided that the increment is measured after converting the opening measure of the residual equity (or of capital) to the number of dollars which at the end of the period would have the same purchasing power as the opening measure had at the beginning.2

Chambers' concept of income considers the advance in the current selling

price of assets as an element of business income after proper adjustment

for the effect of the change in the general price level.

Concept of Income Underlying ARS No. 1 and ARS No. 3

The accounting principles developed in ARS No. 3^ were based on

the postulates of accounting developed in ARS No. 1.^ ARS No. 3

1. R. J. Chambers, Accounting, Evaluation and Economic Behavior (Englewood Cliffs, K. J.: Prentice-Hall, Inc., 1966), pp. 103-8.

2. R. J. Chambers, Accounting; and Action, 2nd edition (Sydney: The Law Book Co. of Australia Pty Ltd., 1965), p. 160.

3. Op. cit.

U. Op. cit.

77

attributed profit "to the whole process of business activity"^" and not

to the point of sale as in conventional accounting. Income was con­

sidered to represent an increase in the net resources of a business

organization. Distinction was made between purchasing power changes and

specific price changes. The change in the net resources of a firm re­

sulting from fluctuations in the purchasing power of the dollar was

considered to be a restatement of capital and not an element of business

incomej the change in net resources resulting from fluctuations in

replacement costs, recognition of net realizable value, and from other

causes such as accretion and discovery value was considered to be an

2 element of business income.

Different bases of valuation were used in measuring the assets,

the liabilities, and hence the net resources of a business enterprise.

Receivables were to be reported at net realizable value, securities at

market value, and inventories at net realizable value, thus recognizing

the profit before the sale.-^ Items of plant and equipment were to be

valued at current replacement costs.^ Intangibles were to be retained

at original cost except in the presence of compelling evidence for a

different value.^ Liabilities were to be reported at their net present

1. ARS No. 3. P. 10.

2. Ibid., p. $$.

3. Ibid., pp. 2U-30.

U. Ibid., pp. 32-6.

S. Ibid., p. 36.

78

value.^ The measurements underlying the computation of income were to

p comply with the postulate of objectivity as stated in ARS No. 1.

Concept of Income Underlying the AAA A Statement of Basic Accounting Theory

The AAA Committee to Prepare a Statement of Basic Accounting

Theory in A Statement of Basic Accounting Theory did not explicitly give

a definition of income. However, there is an income concept underlying

the discussion of accounting standards and the illustrations provided.

The Committee considered as income the advance in the current re­

placement cost of assets whenever the standards of relevance, veri-

fiability, freedom from bias, and quantifiability were met. Their

income concept also included gains and losses from purchasing power

changes.^ Unlike Edwards and Bell, and Chambers, the Committee was

concerned with the evidential requirements supporting its measure of

income.

Attempts to Apply Unconventional Income -Concepts

/

To the knowledge of this writer, three attempts besides this

dissertation have been made to apply comprehensive replacement costing

1. Ibid., pp. 39-Ul.

2. Cf. supra, pp. $1-2.

3. AAA Committee to Prepare a Statement of Basic Accounting Theory, op. cit., pp. 81-95.

79

by accounting researchers in the United States.^- Two of these attempts

were patterned after the concept of business income developed by Edwards

and Bellj "the third study was based on the accounting principles de­

veloped in ARS No. 3. These studies are discussed briefly below.

The Dickerson Study^

Peter J. Dickerson applied Edwards and Bell's concept to a small

manufacturing firm. He reported difficulty in obtaining current cost

quotations for inventories and for fixed assets. To explain the poor

response obtained from vendors, Dickerson offered the following reasons:

(l) He stated that the records of the company did not provide sufficient

descriptions; (2) the requests for price quotations were made a con­

siderable time after the purchase; and (3) the suppliers must have

considered the requests of a researcher less important than those of a

1. Several firms in different countries including the United States have attempted from time to time to adjust for price level changes and for specific price changes. These adjustments have been primarily restricted to the restatement of the depreciation charge on the income statement. For examples see Carman G. Blough, op. cit., pp. 333—365 Robert H. McCleary, "Three Applications of Price Indices in Property Accounting," NAA Bulletin, XLIII (March, 1962), pp. 35-52; Accounting Research Study I!o. o, pp. 169-72; and Stephen A. Zeff, "Episodes in the Progression of Price-Level Accounting in the United States," pp. 316-35. In the Netherlands, comprehensive replacement costing has been developed as the major thesis of the so-called "Dutch School" of accounting. The Dutch theory and method of adjustment have only been given cursory reference in accounting literature written in English possibly due to language difficulties. For an application of replacement costing in the Netherlands, see A. Goudeket, "An Application of Replacement Value Theory," The Journal of Accountancy, 110 (July, I960), pp. 37-U7.

2. Business Income—A Critical Analysis (Berkeley: University of California, 1965).

80

client."1 It was assumed that if requests had been made by the firm

suppliers probably would have responded promptly.

To complete his study, Dickerson assigned "arbitrary current

costs" to raw materials and valued the finished goods inventory at a

fixed percentage of its selling price.^ With regard to fixed assets,

Dickerson used a single index adjusted to the nearest integer to obtain

the current cost of all the categories of the firm's fixed assets.^

The Dockweiler Study^

Raymond C. Dockweiler applied Edwards and Bell's concept to a

manufacturing firm with total assets of about $20 million. Ke reported

the same difficulties experienced by Dickerson in obtaining current

cost quotations for inventories and for fixed assets.

Dockweiler obtained most of the replacement cost data by using

specific price indices. He was successful in obtaining current re­

placement costs for only 3% of the original cost of machinery and

1. Ibid., p. 10.

2. In the case of X Co., the firm used in this dissertation, requests for current cost quotations were made in the name of the company and responses were promptly received, though in many cases requests were made several years after the purchase date. The appli­cation of replacement costing to X Co. will be discussed in Chapter 7«

3. Dickerson, op. cit., p. 10.

U. Ibid., p. 16.

5. "The Practicability of Developing Multiple Financial Statements: A Case Study," The Accounting Review, XLIV (October, 1969), pp. 729-U2.

81

equipment,and he concluded "that the practicability of . . . determi-

O ning . . . replacement cost data is doubtful."

The Voth Study3

Kelvin H. Voth applied the accounting principles proposed in

ARS No. 3 to a manufacturer of farm equipment with total assets of about

$3.6 million. Voth did not attempt to obtain price quotations from

suppliers but resorted to the use of specific price indices.

Concluding Note

The approximation of replacement costs by means of specific

price indices is a simple procedure compared to the task of obtaining

current cost quotations from a multitude of vendors. The failure of

Dickerson and Dockweiler to obtain current cost quotations, and their

eventual use of specific price indices cast some doubt as to the seri­

ousness of their attempt to obtain quotations from suppliers. The

inadequate accounting records in their case firms probably could have

been reconstructed to render them more useful for the purpose of their

studies, and the requests for price quotations could have been followed

up to solicit responses.

1. Ibid., p. 736.

2. Ibid., p. 7U2.

3. "An Empirical Evaluation of Proposed Reform of Accounting Principles," (Unpublished D.B.A. Dissertation, Indiana University, 196U).

CHAPTER 5

THE MAINTENANCE OF PRODUCTIVE CAPACITY CONCEPT

The purpose of this chapter is to state the maintenance of pro­

ductive capacity concept, to review the reasons underlying its use, and

to discuss the measurement of income and financial position under this

concept. The background for the development of the maintenance of pro­

ductive capacity theory was the subject of the previous three chapters.

A summary of the essential points in that background is presented below.

In Chapter 2 it was argued that long-term equity holders will

obtain more significant information from financial statements showing

current costs on the balance sheet and on the income statement.

Chapter 2 also included a discussion of the limitations of conventional

financial statements in a period of rising prices and the accountants'

solution to the problem by resorting to the appropriation of retained

earnings.

Generally accepted accounting principles were the subject of

Chapter 3. The evidence required by an independent public accountant

in his attestation function was shown to be a primary factor behind the

adherence to the stable monetary unit and historical cost conventions

in a period of rising prices. Historical cost and objectivity are

violated whenever replacement costs decline and such a violation is

justified on the grounds of conservatism. If the evidence requirement .

82

of an independent public accountant can be discharged by reliance on

objective and verifiable data, then objective and verifiable measurement

of current replacement costs on the balance sheet and the income state­

ment should be sufficient for the auditor's purpose. The going concern

assumption of business enterprises imposes on the business entity the

requirement to maintain productive capacity and hence the adoption of

accounting procedures to measure the maintenance of that capacity.

Conventional accounting procedures accomodate the evidence

requirement of an independent accountant but do not accomodate the going

concern requirement of a business entity in a period of rising prices.

The development of a cohesive accounting theory for the accomodation of

the two requirements is needed. Hicks' concept of income in Chapter U

provides the conceptual guideline for the theory that is needed but

lacks the objectivity of measurement. Business income theories, like

the one formulated by Edwards and Bell, which treat the change in the

replacement cost of assets as a holding gain or loss (an element of

business income) fail to consider the going concern requirements of the

firm even though they can be applied in a manner to satisfy the re­

quirements of verifiable, objective evidence.

Statement of the Maintenance of Productive Capacity Concept

The productive capacity of a business firm is defined as the

ability of a firm to produce and distribute a given quantity of goods

and services during a specific time period. It is represented by the

resources necessary to maintain a certain scale of operations. These

resources include cash, receivables, inventories, manpower, managerial

skills, plant facilities, and intangibles. When the replacement cost

of the resources of the enterprise change, there will be a change in

the number of monetary units necessary to maintain the productive ca­

pacity. If the replacement cost of resources remains unchanged, pro­

ductive capacity can be retained by maintaining the original money

investment in the firm.

The application of the productive capacity concept to the de­

termination of business income yields the maintenance of productive ca­

pacity concept of business income. The maintenance of productive

capacity concept of business income is defined as the maximum amount

that can be paid in dividends by a business entity, a going concern,

without impairing the productive capacity of that entity. Thus sever­

ance is an essential criterion in the maintenance of productive capacity

concept of business income.

The application of the productive capacity concept to the de­

termination of financial position produces a balance sheet that may be

called a replacement cost balance sheet. Such a balance sheet will

reflect the current replacement cost of assets, the current value of

owners' investment, and retained earnings in an amount equal to the

internal growth of the firm.

Purpose of the Concept

The purpose of the computation of income as stated by Hicks is

"to give people an indication of the amount which they can consume

85

without impoverishing themselves."^ Thus, according to Hicks, the

computation of income is related to an objective—the desire not to

impoverish oneself. This study contends that a primary objective of

a business entity is to operate as a going concern in the sense of

being able to replace its assets as they are retired and hence maintain

a certain scale of operations. Any time a business firm does not have

the resources to replace its worn out assets its scale of operations is

impaired and the enterprise is impoverished.

It was demonstrated in Chapter 2^ that in a period of rising

replacement costs, income reported under conventional accounting repre­

sents an amount greater than that which can be severed without impairing

the scale of operations. Knowledge of the necessary restrictions upon

income distribution to maintain the scale of operations in a period of

price increases is available when income is computed on a maintenance

of productive capacity basis

Replacement costing on the balance sheet achieves a variety of

purposes. Assets are reported at their current replacement cost, re­

flecting the current cost of resources committed to the generation of

the revenue of the enterprise. Stockholders' equity is reported at

1. Kicks, op. cit., p. 172.

2. Cf. supra, pp. 26-31.

3. George 0. May in "Limitations on the Significance of In­vested Costs," The Accounting Review, XXVII (October, 19!?2), pp. U36-UO, reported on p. U38 that A. Lowes Dickinson presented a paper to the First Congress of Accountants (190U) in which "there can be observed a recognition of a distinction between profits in the broader sense and distributable profits in the narrower sense."

its current value broken down into the current value of the stock­

holders' investment and the amount of earnings retained for growth.

Measurement of Business Income

The resources of a business organization vary as to their useful

lives. Inventories may have to be replaced several times during a year,

prepaid expenses will be replaced as they expire, depreciable assets

will be replaced when they wear out or become obsolete. Income under

the maintenance of productive capacity concept is the difference between

revenues earned during a period as measured by conventional accounting

procedures and the cost of replacing the goods and services consumed

during that same period.

The computation of income outlined above does not involve a

marked departure from generally accepted accounting procedures. The

revenue of the business enterprise under the maintenance of productive

capacity basis is computed in conformity with generally accepted ac­

counting principles. The concept developed does not consider as income

the increase in the replacement cost of assets as has been recommended

by other writers, the most noted of whom are Edwards and Bell in The

Theory and Measurement of Business Income; Sprouse and Koonitz in

Accounting Research Study No. 3i and the AAA Committee to Prepare a

Statement of Basic Accounting Theory in A Statement of Basic Accounting

Theory.

1. A case against the inclusion of holding gains and losses from the computation of business income was made by Robert L. Dickens and John 0. Blackburn in "Holding Gains on Fixed Assets: An Element of

87

The argument advanced in this study is that the increase in the

replacement cost of assets represents an adjustment of the money value

of assets and not an amount that can be severed from the enterprise.

Such an increase will therefore have to be retained to maintain the

productive capacity. A business firm should retain from gross revenue

an amount equal to the replacement cost of the goods and services con­

sumed in generating the gross revenue. This means that no portion of

the replacement cost recovered from revenues should be treated as income

though the amount recovered exceeds the original cost of the goods and

services consumed.

The computation of expenses, however, does not conform with

generally accepted accounting practice. The maintenance of productive

capacity concept of business income requires that expenses be computed

on the basis of the replacement cost (rather than the original cost) of

the goods and services used up in or allocated to the process of gener­

ating the revenue of that accounting period. Critics of replacement

costing argue that the computation of replacement costs is subjective

in character and hence does not meet the test of verifiability and

objectivity required by auditing standards. The purpose of this study

Business Income?" The Accounting Review, XXXIX (April, 196U), pp. 312-29. Dickens and 31ackburn have also rejected the adoption of current replacement costing. Stephen A. Zeff and V/. David Maxwell in "Holding Gains on Fixed Assets—A Demurrer," The Accounting Review, XL (January, 1965)> pp. 65-75> have criticized the Dickens and Blackburn article and emphasized the recognition of holding gains and losses as elements of business income.

88

is to show that such a computation can be sufficiently objective and

free from bias to permit the issuance of an unqualified auditor's

opinion. This will be demonstrated in Chapter 7.

The computation of income on a maintenance of productive ca­

pacity basis is in conformity with the generally accepted going concern

convention. The maintenance of a business entity as a going concern in

a period of rising prices cannot be measured by conventional accounting

procedures, as was demonstrated in the illustration in Chapter 2. The

conventional practice of appropriating retained earnings has been re­

sorted to as a device to retain sufficient funds to provide for the

replacement of assets at higher prices. Such appropriations are not

based on scientific computations but are a result of arbitrary decisions

by management. The computation of income under the maintenance of pro­

ductive capacity concept provides a scientific measure of the required

paring down of income in order to maintain capacity.

The maintenance of productive capacity concept also complies

with the doctrine of conservatism. The productive capacity concept

does not provide for the understatement of income just for under­

statement1 s sake. In a period of rising prices, the productive capacity

concept provides a conservative measure of income systematically com­

puted to permit its distribution in dividends without impairing the

productive capacity of the business entity. The exclusion from income

of the so-called holding gains and losses is conservative in nature,

also.

89

Determination of Financial Position

The application of the productive capacity concept to the

balance sheet requires the write-up (or write-down) of assets to their

current replacement cost. This can be achieved by recording adjustments

in the conventional asset accounts or in adjunct accounts. The corre­

sponding credit (or debit) is made to a permanent stockholders' equity

account. Such an account represents the required appropriation or

capitalization of retained earnings under conventional accounting to

provide for the maintenance of productive capacity. The adjustment

procedure will be illustrated and discussed in detail in the following

chapter.

The write-up of assets to their current replacement cost is

contrary to generally accepted accounting procedures. Replacement costs

can, however, be obtained with sufficient objectivity and verifiability

to satisfy the evidential requirement of an independent public ac­

countant. This will be demonstrated in Chapter 1.

Articulation of Income Statement and Balance Sheet

The computation of income under the maintenance of productive

capacity concept can be achieved irrespective of the basis of the

valuation of assets on the balance sheet. The balance sheet can con­

tinue to report unexpired historical costs and the income statement

would show the replacement cost of the consumed resources.

On the other hand, if a balance sheet is prepared on the basis

of current replacement costs, it does not necessarily follow that the

income statement is prepared on a maintenance of productive capacity

basis. It was pointed out earlier in this chapter that those writers

who advocate the preparation of a balance sheet on a replacement cost

basis and who consider the difference between the replacement cost of

assets and their original cost as an element of income advocate an

income concept contrary to the principles behind the productive ca­

pacity concept.

The theory advanced in this study calls for the adoption of

replacement costing in the income statement and in the balance sheet

in a framework calling for the maintenance of productive capacity of

a business entity as a going concern. This theoretical framework

permits the articulation of the income statement and the balance sheet.

Measurement of the Maintenance of Productive Capacity

The problems encountered in measuring the maintenance of pro­

ductive capacity are analyzed briefly below.

Ideal Measurement

Ideally, the cost of goods and services consumed to be compared

with revenues should be the future replacement cost of the resources

used in the operations of the business. This means that in the case of

long-lived assets, the business enterprise should determine the cost to

replace such assets indefinitely far in the future. A firm can maintain

its productive capacity only when it is able to replace the resources at

the time they need to be replaced.

91

The computation of the replacement cost of assets in the future

is of a subjective nature and is not within the confines of objective

and verifiable data expected of accounting measurements. The future

holds too many uncertainties that cannot be determined or estimated

objectively in the present. The theoretically correct but immeasurable

costing procedure will have to give way to a less accurate but objective

method of measurement.

On the subject of whether accounting measurements should include

estimates and guesses relating to the future, Sidney S. Alexander wrote

in a monograph prepared for the Study Group on Business Income:

The accountant . . . has tried to eliminate the element of subjective judgment from the determination of income. He has tried to establish as nearly as possible hard and fast rules of calculation in order to eliminate the guesswork and to introduce precise measurements. But in a dynamic world subject to unforeseen changes of prices and business con­ditions, it is not possible to avoid guesswork in the de­termination of income. To the extent that the accountant can eliminate guesses, he is substituting something else for income. That something else will be a good approximation to income in a fairly static situation when prices and business prospects do not change very muchj the approximation will be very poor in a highly dynamic situation when prices and business prospects are fluctuating violently.1

Practical Considerations

As the ideal method of the determination of the future re­

placement cost of goods and services used in operations has to be re­

jected on the basis of the guesswork involved, objectivity and freedom

from bias can be restored by computing the cost of goods sold and

1. Study Group on Business Income, Five Monographs on Business Income (New York: AICPA, 19^0), pp. 6-7.

services consumed on the basis of their replacement cost at the end

of the accounting period rather than on the basis of their eventual

replacement cost. The determination of the replacement cost of goods

and services at the end of an accounting period on the basis of existing

market prices, quotations from suppliers or the use of specific price

indices is objective, free from bias and can be verified by a competent

investigator.^-

The replacement cost of an asset at the end of an accounting

period is likely to be the best approximation of its economic value.

The economic value of an asset is represented by the present value of

the future stream of net receipts the asset will produce during its

life discounted at the rate of return expected in the industry. The

computation of this economic value suffers from two main limitations:

in the first place, the projection of future receipts and their pattern

over the life of an asset is not within the realm of objective measure­

ment; and secondly, the choice of a rate of return and hence rate of

discount is arbitrary in nature. The theoretically correct but im­

measurable economic value of an asset as of a given date is best

approximated by its market replacement cost on that date. If the ac­

quisition cost of an asset seems to entrepreneurs to be far greater

than the discounted value of the future net receipts to be derived from

it, the entrepreneurs will refrain from investing in that asset. On the

1. Determination of replacement costs at the end of the ac­counting period vas the method adopted in the three attempts to apply unconventional income concepts discussed at the end of Chapter H.

93

other hand, if the acquisition cost of an asset seems to entrepreneurs

to be far less than its economic value, demand for that type of asset

will drive up its price. The price of an asset will tend to settle in

the vicinity of its estimated economic value.

The method of obtaining the replacement cost of resources con­

sumed will be discussed at length in Chapter 7 where the adjustment of

the balance sheet of X Co. to a replacement cost basis and the prepa­

ration of its income statement on a maintenance of productive capacity

basis will be illustrated and discussed.

Technological Changes and Unique Assets

Improvements in technology may occur in the interval between the

date of acquisition of an asset and its eventual replacement date.

Technological improvements may cause the assets used by a specific

organization not to be replaced by identical units. In such a case,

depreciation should be based on the cost of the asset that has an

equivalent productive capacity and which will replace the asset in use.

This method was adopted for X Co. as will be discussed in the following

chapter. For example, if a machine turns out 10 units of a product per

hour and if this machine can only be replaced by a new one that can

turn out 20 units per hour, then the depreciation on the machine in

use has to be based on one-half the cost of the new machine, such cost

being determined as of the date of replacement.

It should be admitted that growth in productive capacity some­

times may be inevitable. For example a 1970 six-cylinder pick-up truck

replacing a I960 six-cylinder pick-up truck may have a better engine

9U

that will perform better and cause less break-downs. This may cause

the new truck to operate for more hours on the road per year than its

predecessor, thus increasing the capacity of the firm. On this subject

of increase in productive capacity, Dwight R. Ladd wrote:

It must be acknowledged that the use of current replacement costs may, in come instances, involve an increase in current capacity. (The current model of a particular machine may have a higher output rating, for example). In other words, the use of replacement cost may on occasion result in the advertent inclusion of costs of growth. This does not seem a serious matter when compared with the growth costs almost surely included in conventional accounting for research, promotion, contributions, and the like. And without doubt, carefully determined replacement costs will be much closer to current values than will historical cost.l

The nature of the product produced by a particular firm may

change and necessitate a change in the means of production. Or, al­

ternatively, the technology to produce a specific product may change.

If such a change is foreseen by management, the replacement cost of the

new technology should be estimated, if possible, and depreciation com­

puted accordingly on an equivalent capacity basis. If the technological

change is not foreseen and/or the replacement cost of the new technology

cannot be reasonably estimated, then the maintenance of productive ca­

pacity cannot be objectively measured.

Another problem has to do with the obsolescence of the product

or service produced by a business enterprise coupled with the obso­

lescence of the productive facilities. If this should happen, then

the life of the business entity as a producer of that particular product

1. Contemporary Accounting and the Public (Komewood, 111.: Richard D. Irwin, Inc., 1963), p. 62.

95

or service would be brought to an end. If the firm is to stay in

business, it will have to have a fresh start and adjust its assets

and equity structure accordingly.

A further problem arises in the determination of the replacement

cost of unique assets. Such assets include land, buildings, and

specially built machinery and equipment. The periodic appraisal of

these assets is one method to obtain their replacement cost, but such

appraisals may be too costly to be used regularly. The use of specific

price indices that most closely approximate the replacement cost of

unique assets is possible. For example, the replacement cost of a

building may be obtained by the application of a building cost index

to the original cost of the structure. Another possibility is the

development of a company index or an industry index. In such a situ­

ation, an imperfect estimate is better than ignoring the problem alto­

gether and adhering to original cost. The AAA Committee on Concepts

and Standards—Long-Lived Assets had a different viewpoint for it

stated: "Whenever there is no objective method of determining the

current cost of obtaining the same or equivalent services, depreciated

acquisition should continue as the basis of valuation."^

1. Op. cit., p. 695.

CHAPTER 6

HYPOTHETICAL APPLICATION OF THE PRODUCTIVE CAPACITY CONCEPT

The application of the productive capacity concept will be

illustrated hypothetically for Company A. The discussion of this

chapter will be restricted to the valuation of a depreciable asset and

the computation of the related depreciation. The computation of other

expenses will follow the same pattern as depreciation.

Two methods of application will be illustrated. The first

method bases the periodic depreciation charge on the replacement cost

of the asset at the end of each accounting period; depreciation expense

for a period is then equal to the current cost of the depreciable asset

consumed during the yearThe second illustration bases accumulated

depreciation rather than depreciation expense on the replacement cost

of the asset at the end of each period; depreciation expense for a

period is then equal to the difference between accumulated depreciation

at the beginning and accumulated depreciation at the end of the period

with due consideration given to the retirement of assets during the

accounting period. This second method of depreciation will result in

a periodic depreciation charge equal to the current cost of the de­

preciable asset consumed during the period (as in the first method)

1. This method of depreciation was recommended among others by William A. Paton in "Depreciation—Concept and Measurement," p. 39•

96

97

plus an adjustment of previous years' depreciation charges for the ad­

vance in replacement cost occurring during the year. It will be demon­

strated that this second method is in conformity with the productive

capacity concept, whereas the former method is not.

Periodic Depreciation Based on Replacement Cost at the End of Each Period

It will be assumed as before^ that Company A operates on a cash

basis and has one depreciable asset acquired at a cost of $10,000 with

a useful life of five years. It is further assumed for the purposes of

this illustration and the following one that the replacement cost of the

asset used by Company A increases by 10$ every year with the annual

increase based on the price existing at the end of the previous year.

The replacement cost at the end of each year, depreciation of 20% based

on replacement cost at the end of each year, and accumulated depreci­

ation at the end of each year for a five-year period are shown in

Table 3 on page 98.

Financial Statements

Based on an annual revenue from operations of $10,000 and annual

expenses other than depreciation of $5,000, the income statements on a

maintenance of productive capacity basis for the first five years are

shown in Table h on page 99. Table U also shows the dividends paid each

year, the increase in cash balance during the year, and the cash balance

at the end of each year. It should be observed that the depreciation

1«. See assumptions on pp. 26-7.

TABLE 3

COMPANY A DATA USED IN ILLDSTRATION OF PERIODIC DEPRECIATION BASED ON REPLACEMENT COST

AT THE END OF EACH PERIOD

Year 1 Year 2 Year 3 Year h Year 5

Market replacement cost at end of year (10$ greater than at end of previous year) $11,000 $12,100 $13,310 $lii,6Ul $16,105

Depreciation expense for the year (20% of replacement cost at end of year) $ 2,200 $ 2,U20 $ 2,662 $ 2,928 $ 3,221

Accumulated depreciation at end of year $ 2,200 $ U,620 $ 7,282 $10,210 $13,U31

TABLE U

COMPANY A COMPARATIVE INCOME STATEMENTS AND OTHER DATA MAINTENANCE OF PRODUCTIVE CAPACITY BASIS

(PERIODIC DEPRECIATION BASED ON REPLACEMENT COST AT THE END OF EACH PERIOD) FOR YEARS 1 THROUGH 5

Year 1 Year 2 Year 3 Year U Year 5

Revenue from operations $10,000 $10,000 $10,000 $10,000 $10,000

Operating expenses:

Depreciation—per Table 3 $ 2,200 $ 2,1*20 $ 2,662 $ 2,928 $ 3,221

Other expenses 5,000 5,000 5,000 5,000 5,000

Total expenses $ 7,200 $ 7,U20 $ 7,662 $ 7,928 $ 8,221

Net income $ 2̂ 800 $ 2,580 $ 2,338 $ 2,072 $ 1,779

Dividends $ 2,800 $JL,580 $ 2,338 $ 2,072 $ 1,779

Increase in cash balance during the year $ 2,200 $ 2,U20 $ 2̂ 662 $ 2,928 $ 3,221

Cash balance at end of year $ 2,200 $ Uj620 $_7,282 $10,210 $13,U31

100

expense each year is a growing amount, since depreciation is a constant

percentage of the growing replacement cost of the asset. Because all

income is paid in dividends, the annual increase in cash balance will

equal the annual depreciation charge. The comparative replacement cost

balance sheets at the beginning of year 1 and at the end of each year

for five years appear in Table $ on page 101.

Discussion of Illustration

Company A started year 1 with cash of $10,000" and ended year 5

with cash of $13,U31. Since the replacement cost of the only asset

owned by Company A has risen to $16,105 by the end of year Company A

does not have the necessary cash to replace its worn out asset in spite

of the fact that depreciation was based on the replacement cost at the

end of the period. Total income reported by Company A during the five-

year period and paid in dividends amounted to $11,56?. It is apparent

that the reported income is not an amount that can be paid in dividends

and still provide for the maintenance of productive capacity. Had

Company A used conventional accounting procedures, it would have ended

year 5 with a cash balance of $10,000 as was illustrated in Chapter 2.

Both the $10,000 under conventional accounting and the $13,li31 when

depreciation expense is based on replacement cost at the end of the year

fall short of the $16,105 requirement to replace the worn out asset.

The $13,h31, however, is closer to the requirement than the $10,000.

1. The increase in the depreciation charge over the years of useful life will be defended later in this chapter.

TABLE 5

COMPANY A COMPARATIVE REPLACEMENT COST BALANCE SHEETS

(PERIODIC DEHIECIATIOK BASED OK REPLACEMENT COST AT THE END OF EACH PERIOD) AT SELECTED DATES

Beginning of Year 1

End of Year 1

End of Year 2

End of Year 3

End of Year U

End of Year 5

ASSETS

Cash $ - $ 2,200 $ U.620 $ 7,282 $10,210 $13,U31 Machinery at replacement cost—

end of year Accumulated depreciation

$10,000 $11,000 2,200

$12,100 U,620

$13,310 7,282

$1U,6U1 10,210

$16,105 13,U31

Undepreciated replacement cost—end of year $10,000 $ 8,800 $ 7,U80 $ 6,028 $ U,U31 $ 2,67k

TOTAL ASSETS $10,000 $11,000 $12,100 $13,310 $lh,6Ul $16,105

EQUITIES

Capital stock Adjustment of stockholders'

equity* Retained earnings

^10,000 $10,000

1,000

$10,000

2,100

$10,000

3,310

$10,000

ii,6Ul

$10,000

6,105

TOTAL EQUITIES $10,000 $11,000 $12,100 $13,310 $Hi,6Ul $16,105

*The nature of this account will be discussed later in this chapter.

102

Thus, when depreciation is based on replacement cost at the end of the

year and when the replacement cost of the asset continues to advance,

the business enterprise will not be able to replace the retired asset

from accumulated working capital.

Besides its failure to maintain the productive capacity, com­

putation of depreciation expense on the prevailing replacement cost at

the end of the year leads to another fallacious result. By the end of

year 5, the asset owned by Company A should be fully depreciated and •

should be reported at zero book value. This is not the case in the

illustration just citedj the book value of the machine at the end of

year $ is $2,6?U rather than zero. This result is absurd. This will

not be the case if accumulated depreciation is adjusted to a replacement

cost basis as will be demonstrated in the second illustration.

Eventual vs. Current Replacement Cost

The illustration just cited demonstrates that when cost of goods

sold and other operating expenses are reported on the basis of current

replacement cost at the time of their sale or use, a business firm does

not cure the limitations of conventional accounting. The only improve­

ment derived from this method of reporting is that the income statement

will present a better matching of revenues earned against the expenses

incurred. Since revenues are stated in current terms, cost of goods

sold and operating expenses will be stated in current terms as well.

Despite this improvement in the income statement, the income reported

still does not represent an amount that can be paid in dividends and

preserve the continuity of operating capacity of the business. To

103

maintain the productive capacity intact, cost of goods sold and oper­

ating expenses should be based on the eventual replacement cost—the

cost that will be incurred in the future to replace the assets expired

and/or sold—and not on the current replacement cost at the time of

use or sale. Had Company A computed depreciation on the basis of the

eventual replacement cost of $16,105, it would have ended with $16,105

in cash, an amount sufficient to replace the asset without resorting

to outside financing and without curtailing the scale of operations.

The computation of the future replacement cost cannot be ob­

jectively measured, unfortunately. The next best alternative is to

compute accumulated depreciation rather than depreciation expense on

the basis of current replacement cost at the end of each year and to

consider depreciation as the difference between two accumulated depreci­

ation amounts with due consideration being given to asset retirements

during the year. When this method of depreciation is adopted, a firm

can accumulate the resources needed to replace its assets without re­

sorting to outside financing as will be demonstrated in the illustration

below.

Accumulated Depreciation Based on Replacement Cost at the End of Each Period

The computation of depreciation expense as the difference be­

tween accumulated depreciation based on replacement cost at the be­

ginning of the period and accumulated depreciation based on replacement

cost at the end of the period with due consideration given to the re­

tirement of assets during the period, leads to the reporting of income

ioU

in an amount that can be all severed while maintaining the productive

capacity intact.

Using Company A again as an illustration and assuming the same

data as before except for the method of depreciation, replacement costs,

accumulated depreciation, and depreciation expense for the five-year

period are shown in Table 6 on page 105. Table 6 should be compared to

Table 3 on page 98.

The income statements for the first five years on a maintenance

of productive capacity basis and the comparative replacement cost

balance sheets at the end of each of the first five years appear in

Tables 7 and 3.

A study of the balance sheets reveals that Company A at the

end of year 5 has $l6,10f> in cash which is exactly equal to the cash

required to replace the asset worn out and hence maintain the pro­

ductive capacity. In the previous illustration Company A ended year $

with only $13,h31. Table 8 on page 107 also reveals that the book value

of the asset is zero at the end of year 5.

It can be argued that a firm can accumulate resources sufficient

to replace assets at higher prices without computing depreciation on the

basis of the replacement cost of assets. This is possible through the

profitable investment of the periodic increase in working capital equal

to the depreciation charge. This working capital can grow to an amount

greater than the depreciation charged over the life of an asset. The

periodic depreciation can thus be made equal to an amount that can be

TABLE 6

COMPANY A DATA USED IN ILLDSTEIATION OF ACCUMUUTED DEPRECIATION BASED ON REPLACEMENT COST

AT THE END OF EACH PERIOD

Year 1 Year 2 Year 3 Year U Year 5

$11,000 $12,100 $13,310 $1U,6U1 $16,105

$ 2,200 $ U,8U0 $ 7,986 $11,713 $16,105

$ 2,200 $ 2,6U0 $ 3,1U6 $ 3,727 $ U,392

Market replacement cost at end of year (10£ greater than at end of previous year)

Accumulated depreciation at end of year (based on replacement cost at end of year and a useful life of 5 years)

Depreciation expense for the year (difference between accumulated depreciation at beginning and end of year)

TABLE 7

COMPANY A COMPARATIVE INCOME STATEMENTS AND OTHER DATA

MAINTENANCE OF PRODUCTIVE CAPACITY BASIS (ACCUMULATED DEPRECIATION BASED ON REPLACEMENT COST AT THE END OF EACH PERIOD)

FOR YEARS 1 THROUGH 5

Year 1 Year 2 Year 3 Year U Year 5

Revenue from operations $10,000 $10,000 $10,000 $10,000 $10,000

Operating expenses:

Depreciation—per Table 6 $ 2,200 $ 2,6U0 $ 3,Hi6 $ 3,727 $ h,392

Other expenses 5,000 5,000 5,000 5,000 5,000

Total expenses $ 7,200 $ 7.6U0 $ 8,1U6 $ 8,727 $ 9,392

Net income $ 2,800 $ 2,360 $ 1,85k $ 1,273 $ 608

Dividends $ 2^800 $ 2,360 $ 1,85k $ 1,273 $ 608

Increase in cash balance during the year $ 2,200 $ 2,6U0 $ 3,lU6 $ 3,727 $ U,392

Cash balance at end of year $ 2,200 $ U,8U0 $ 7,986 $11,713 $16,105

TABLE 8

COMPANY A COMPARATIVE REPLACEMENT COST BALANCE SHEETS

(ACCUMULATED DEPRECIATION BASED ON REPLACEMENT COST AT THE END OF EACH PERIOD) AT SELECTED DATES

Beginning of Year 1

End of Year 1

End of Year 2

End of Year 3

End of Year k

End of Year 5

ASSETS

Cash $ _ $ 2,200 $ h,8h0 $ 7,986 $11,713 $16,105 Machinery at replacement cost—

end of year Accumulated depreciation

$10,000 $11,000 2,200

$12,100 U,8Uo

$13,310 7,986

$lU,6Ul 11,713

$16,105 16,105

Undepreciated replacement cost—end of year $10,000 $ 8,800 $ 7,260 $ 5.32U $ 2,928 $ -

TOTAL ASSETS $10,000 $11,000 $12,100 $13,310 $1U,6U1 $16,105

EQUITIES

Capital stock Adjustment of stockholders1

Equity* Retained earnings

$10,000 $10,000

1,000

$10,000

2,100

$10,000

3,310

$10,000

U,6Ul

$10,000

6,105

TOTAL EQUITIES $10,000 $11,000 $12,100 $13,310 $1U,6U1 $16,105

*The nature of this account will be discussed later in this chapter.

108

invested periodically at the rate the firm expects to earn on such

investment adjusted for the effect of income tax.

The constraint imposed by the accounting procedure developed in

this dissertation is the maintenance of productive capacity. To attain

this objective, it was proposed that a firm base depreciation on re­

placement costs. Computing depreciation on replacement costs is only

a first order approximation to maintain productive capacity intact,

and involves no built-in mechanism to insure the maintenance of capaci­

ty. Management's maintenance of productive capacity depends on the

correct computation of replacement cost or its accurate estimation and

upon the movement in the rate of return that can be earned on the in­

vestment of resources.

Many problems will arise if depreciation is to be modified to

account for the growth in the working capital resources. Presently the

investment of liquid resources and depreciation accounting are separate

and distinct issues, the results of which are measured separately for

external reporting purposes. Computing depreciation in a manner to

account for the growth in working capital should be a component in fi­

nancial management's decision process.

The Case for the Increasing Depreciation Charge

In the two methods to compute depreciation on a replacement cost

basis discussed in this chapter it was shown that when the replacement

costs of depreciable assets increase over time, the periodic depreciation

expense will increase in amount over the useful life of the asset. This

method is at variance with the traditional depreciation accounting

practices that favor straight-line or accelerated depreciation. The

following arguments are presented in support of the method of depreci­

ation requiring an increasing depreciation charge in a period of rising

prices:

1. This depreciation method is determined by the internally consistent

concepts of replacement costing (balance sheet) and maintenance of

productive capacity (income statement).

2. From these concepts, ideally depreciation expense starting with

year 1 should be computed on the basis of the expected future re­

placement cost at the time the asset is retired. If this eventual

replacement cost could be objectively determined, then throughout

the useful life of the asset, the depreciation charge would be the

same amount each year if straight-line depreciation is adopted or

would even be a declining charge if accelerated depreciation is

preferred. In the absence of an objective method of determining the

future replacement cost, the increasing charge method of depreci­

ation is unavoidable in a period of rising prices as it results from

an objective measurement of the periodic increase in replacement

cost.

3. Since the objective information necessary to support the theoreti­

cally ideal method will not be generally available, the depreciation

charge partly consists of a correction of previous years' depreci-

• ation. Thus depreciation expense will be overstated to the extent

that previous years' depreciation was understated. Such a

110

correction of previous years' estimates would be charged to the

current income statement in accordance with APB Opinion No. 9»^~

U. The increased depreciation charge will be recorded in a period

during which (or more accurately at the end of which) the re­

placement cost of depreciable assets increase. The rise in re­

placement cost of depreciable assets may not be an isolated event.

It generally will be accompanied by a rise in the prices of other

goods and services not excluding the goods and services sold by

the enterprise in question. The illustration presented for

Company A assumed that the dollar revenue from operations remains

the same each year despite the rise in the replacement cost of the

asset under consideration. This assumption may not comply with

reality. If the firm is to remain in operation, the price of the

goods and services sold by an enterprise will increase, even though

the increase will possibly be at different rates. If this is true,

then the increased depreciation charge results in a better matching

of revenues and expenses on the income statement in a period of

rising prices.

The Adjustment Procedure

The application of the productive capacity concept calls for

the adjustment of the balance sheet and the income statement, since the

two statements must articulate. The adjustment procedure will be illus­

trated by means of adjusting entries. The adjusting entries are based

1. AICPA, op. cit., pp. 6557-62.

Ill

on the hypothetical example developed for Company A in the previous

illustration where depreciation is based on the change in accumulated

depreciation computed on a replacement cost basis. These adjusting

entries appear in Table 9 on page 112 and are explained below. The

adjusting entries record the increase in replacement cost and the re­

lated adjustments in separate accounts. This is done in order to permit

the business firm to prepare conventional statements that may be re­

quired for tax purposes and other statutory reasons. It should be ob­

served that separate accounts were not used in the illustrations cited,

since the objective there was to prove a theoretical point rather than

discuss actual applications.

Adjusting entry 1 records the increase in the replacement cost

of the machinery by a debit to an adjunct account. This account which

has been called here "Machinery—Replacement Cost Adjustment" reflects

the increase in the replacement cost of machinery from the date of

acquisition and appears on the balance sheet following the "Machinery—

Original Cost" account. The credit is made to a permanent stockholders'

equity account which is called here "Adjustment of Stockholders1

Equity." This latter account adjusts the money value of the stock­

holders' investment (or, more accurately, the money value of the

stockholders' equity if the firm has a retained earnings balance). 'This

account is similar in nature to a permanent appropriation of retained

earnings in order to restrict the payment of dividends to permit re­

placement of assets at higher prices. In the case of Company A, in­

vestors started business by investing $10,000 in a machine. If at the

TABLE 9

COMPANY A ILLUSTRATIVE ADJUSTING ENTRIES AT THE END OF YEAR 1 THROUGH £

Year 1 Year 2 Year 3 Year li Year $

Entry Is

Dr. Machinery—Replacement ) Cost Adjustment )

Cr. Adjustment of Stockholders' ) Equity )

$ 1,000 $ 1,100 $ 1,210 $ 1,331 $ 1,U6U

Entry 2:

Dr. Depreciation Expense— ) Machinery—Original Cost )

Cr. Accumulated Depreciation— ) Machinery—Original Cost )

$ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000

Entry 3*

Dr. Depreciation Expense— ) Machinery—Deficiency in ) Original Cost Depreciation )

Cr. Accumulated Depreciation— ) Machinery—Replacement Cost ) Adjustment )

$ 200 $ 6U0 $ 1,1U6 $ 1,727 $ 2,392

113

beginning of year 6 Company A replaces its machine at a cost of $16,105*

it will then report assets of $16,105 and stockholders' equity of

$16,105. At the beginning of year 6, Company A is not better off by

$6,105—the increase in the money value of the stockholders' equity.

Company A is only as well off, since it commands only the same pro­

ductive capacity. The only difference is that the machine at the be­

ginning of year 1 cost $10,000 whereas the same capacity at the

beginning of year 6 can be acquired for $16,105.

The Adjustment of Stockholders' Equity account will not be

closed out when the particular asset is sold. This account will con­

tinue accumulating balances as long as the replacement costs of assets

increase. In case of a decline in replacement costs, the Adjustment of

Stockholders' Equity account will be reduced. It is conceivable that

such an account may be reduced to zero balance or even may appear with

a debit balance if replacement costs decrease to such an extent as to

more than offset all previous increments in replacement costs.

The "Machinery—Replacement Cost Adjustment" account will be

closed at the time of disposal of the asset to which it is related.

This account will be reduced if the market price of the asset subse­

quently declines. The account may appear with a credit balance if the

replacement cost declines rather than increases or if a decline occurs

subsequent to an increase and such a decline more than offsets the

accumulated increases.

1. The theory developed in this dissertation should apply . equally well when replacement costs decrease as when they increase.

11U

Adjusting entry 2 is the usual entry to record depreciation

based on original cost under conventional accounting. The terminology

has been changed to indicate that this depreciation is based on original

cost. Adjusting entry 3 records the additional depreciation required.

This represents the deficiency in the original cost depreciation to

meet the requirements of the maintenance of productive capacity concept.

When an asset is sold, adjustment for replacement cost as of

the date of sale should be recorded with the related adjustment for

depreciation. Assume that Company A sells its machine for $5>,£00 cash

at the beginning of year h* Reference to Table 8 on page 107 will show

that the machine is reported at a book value of $£,32U at the end of

year 3. Therefore the sale of the machine for $5>500 will yield a gain

of $176. The proceeds from the sale of the machine and the $7,986 cash

balance at the end of year 3 total $13,1*86 which is $176 in excess of

the $13,310 cash needed to replace the asset on that date to maintain

capacity. Under conventional accounting a gain of $1,500 would be

reported, the difference between the selling price and the conventional

book value on that date.

CHAPTER 7

APPLICATION OF THE PRODUCTIVE CAPACITY CONCEPT TO THE FINANCIAL STATEMENTS OF X CO.

In this chapter replacement costing and the maintenance of pro­

ductive capacity concept of business income will be applied to the fi­

nancial statements of a business firm in Tucson, Arizona. This firm,

which will be referred to as X Co., is a closely held corporation that

was organized in the 1930's. The firm was selected due to the willing­

ness of its management to cooperate and to provide the necessary data

to undertake this study.

Replacement costing will be applied to the balance sheet of

X Co. as of December 31, 1967 and 1966, and the maintenance of pro­

ductive capacity concept of business income will be applied to the

income statement for 1967. The details of obtaining the adjusted data

will be discussed with an emphasis on the objectivity and verifiability

of the adjusted data.

The Conventional Financial Statements

The comparative historical-dollar balance sheets of X Co. as of

December 31, 1967 and 1966, are shown in Table 10 on pages 116 and 117;

the historical-dollar income statement is shown in Table 11 on page 118.

These statements are the original audited statements of the company with

minor modifications as requested by the management of the company.

115

116

TABLE 10

X CO. COMPARATIVE HISTORICAL-DOLLAR BALANCE SHEETS

DECEMBER 31, 1967 AND 1966

Assets 1967 1966

Current Assets: Cash $ 57U,158 $ Accounts and notes receivable—net 387,760 Inventories 62,833 Prepaid expenses and other current assets ' 291176 39,802

Total current assets $1,053,927 $ 9U9,U27

Noncurrent notes receivable

U73,6U7 368,708 67,270

$ U8.U22 $ 51,825

Plant and Equipment: Land $ 180,000 Buildings and improvements 1,025,111 Machinery and equipment 1,675,978 Automobiles U8,13U Office furniture and equipment 117>023

Total cost of plant and equipment $3,0U6,2U6 Less accumulated depreciation 1,609,102

Book value of plant and equipment $1,U37,1UU

Other Assets: Sundry investments—at cost $ 1,000 Deposits and other assets 5U.66U

Total other assets $ 55»661|

$ 180,000 993,903

1,661,600 3S,U91 109,757

$2,980,751 1,U09,988 $1,570,763

$ 1,000 50.036

$ 51,036

TOTAL ASSETS $2,595,157 $2,623,051

117

TABLE 10—Continued

Equities 1967 1966

Current Liabilities: Accounts payable and accrued expenses $ 336,1*27 $ 378,917 Notes payable 15,535 1U,255 Income taxes payable (7,360)* 168,8U8 Deferred revenue UO«777 Ul,629

Total current liabilities $ 385I379 $ 603,6k9

Notes payable—long-terra $ 13,U92 $ 29,625

Stockholders' Equity: Contributed capital $ 523,850 $ 523,850 Retained earnings 1,672,U36 1,U65,927

Total stockholders* equity $2,196,2B5 $1,989,777

TOTAL EQUITIES $2,595,157 $2,623,051

* ( ) signifies deduction.

118

TABLE 11

X CO. HISTORICAL-DOLLAR INCOME STATEMENT

FOR THE YEAR 1967

Revenue from operations $U,38£,7£l

Expenses:

Operating expenses (other than depreciation) $3j539*100

Administrative expenses (other than depreciation) 2k7>7h2

Depreciation expense 199«760

Total expenses 3»986a602

Net income before income taxes $ 399>lh9

Provision for federal and state income taxes 192.6U0

NET INCOME $ 206,$09

119

The Adjustment Procedure

The procedure of obtaining current cost data has been the

subject of various books and articles. The most noted among these

publications are ARS No. 3» the AAA A Statement of Basic Accounting

Theory, and The Theory and Measurement of Business Income by Edwards

and Bell. The only applications to business firms of the theoretical

recommendations that have come to the attention of this writer are the

Dickerson, Dockweiler, and Voth studies that were discussed briefly in

Chapter U.

Current Assets and Noncurrent Notes Receivable

Cash, accounts receivable, and notes receivable of X Co. ac­

counted for about 90% of total current assets at the end of 1967 and

1966. The remaining 10$ consisted of inventories, prepaid expenses,

and other current assets.

c

Monetary assets comprising the cash and receivables were

properly stated in current terms, such assets do not have a replacement

cost per se. The inventories consisted of a few individual items, each

with a rapid turnover, and the inventory cost records were maintained

on a first-in first-out basis. An examination of invoices received

just prior to the end of the respective accounting periods agreed with

the inventory costs on the books. Moreover, the change in purchase

prices during the two-year period was less than 1# on the average, and

as such the adjustment of the cost of materials used on the income

statement was not warranted.

120

The caption prepaid expenses and other current assets consisted

of prepaid insurance, current deposits, and miscellaneous receivables.

In ARS No. 6, prepaid expenses are "considered the equivalent of cash"

and are classified as monetary items,^ and as such they require no

adjustment. However in the Statement of the Accounting Principles 3oard

Ko. 3, prepaid expenses, except prepaid interest on notes payable, are

treated as non-monetary items,^ and are therefore subject to price level

adjustment. Since the renewal premium of insurance policies cannot be

determined in advance, prepaid insurance was left unadjusted at its

unexpired original premium. Current deposits and miscellaneous re­

ceivables are monetary items and therefore require no adjustment.

In summary, the current assets of X Co. and the noncurrent notes

receivable were left unadjusted, since they were properly stated on a

replacement cost basis.

Plant and Equipment

The replacement cost of items of plant and equipment can be ob­

tained through either of three methods: (1) an appraisal may be ob­

tained, (2) original cost may be adjusted by means of specific price

indices, and (3) current cost quotations may be obtained from

1. Op. cit., p. 139*

2. Op. cit., p. 27.

3. The specific price indices that are most appropriate are the Implicit Price Deflators for Private Purchases of Producers' Durable Equipment by Type published in the National Income and Product Accounts of the United States, 1929-196!? and subsequent National Income Issues of the Survey of Current Business.

121

manufacturers or agents. Current cost quotations were obtained for

machinery and equipment, office furniture and equipment, and automo­

biles. A building cost index was applied to buildings and improvements

as these structures have no established market. It should be recalled

from the discussion in Chapter 3 that specific price indices at best

approximate replacement costs. Appraisals were ruled out in this study

due to the cost involved. The opinion of a few realtors was obtained

to arrive at the replacement cost of the land. The details of obtaining

the current replacement cost of items of plant and equipment are given

below.

Land. The determination of the replacement cost of land posed

a problem, land is a unique asset that is not traded on an established

market. An alternative to appraisal was to adjust the value of the land

by means of an index of land values as recommended in A Statement of

Basic Accounting Theory where it is stated that "such indices, where

prepared by independent, responsible agencies not directly concerned

with the accountant•s problems are . . . verifiable, free of significant

bias, and relevant to the user's needs.Unfortunately, no index of

land values has been compiled for the city of Tucson.

The area of the particular plot of land is 20,556 square feet

and is located in a major business sector in the city. X Co. had its

land appraised by a Chicago firm of appraisers at $U0 per square foot

in 1963, hence at a total of $822,21*0 compared to an original cost of

1. Op. cit.f p. 77.

122

$180,000. The 1963 appraisal could have been used as it is inde­

pendently obtained as evidenced by the appraiser's report, but it was

considered as a starting point since it relates to 1963 and not to the

end of 1966 or 1967.

Discussion with members of two firms of real estate appraisers,

three real estate brokers, and four employees in the Pima County As­

sessor's Office revealed that land in the vicinity of X Co.'s plant

was selling anywhere between $35 and $U5 per square foot at the end

of 1967. The exact location of the land was not identified, but from

the identification of adjacent plots, appraisers and brokers were more

inclined to choose a valuation of $U0 per square foot as of the end of

1967. The appraisers and brokers also indicated that land values in

that particular location were on the average 5,o higher at the end of

1967 than they had been at the end of 1966. Accordingly, the $1|0 per

square foot was selected as the best available measure of the re­

placement cost of the land as of the end of 1967. The replacement cost

of the land at the end of 1967 and 1966 is computed below:

December 31, 1967: 20,556 sq. ft. x $l|0 per sq. ft. B $822,2U0.

December 31, 1968: $822,2U0 • 1.05 18 $783,086.

Buildings and Improvements. Buildings and improvements are

also unique assets without an established market. The replacement

cost of a building cannot be easily determined, since a building is

rarely replaced by an identical structure.

In the absence of appraisals, the best alternative was to adjust

the cost of the buildings and improvements by means of an index for

123

building costs. The Engineering Mews Record^ publishes periodically

two indices: a Construction Cost Index and a Building Cost Index. The

Construction Cost Index was started in 1921, while the Building Cost

Index was introduced in 1938. The difference between the two indices

centers on the weight given to the skilled and unskilled labor. Due

to the faster advance in unskilled labor costs, it was necessary to

introduce an index of building costs in which skilled labor is given

more weight than in an index of construction costs. The Engineering

News Record is a highly reputable engineering periodical. Discussion

with four practicing engineers revealed that they base their cost

estimates on the indices reported in this periodical.

The original cost and the replacement cost of buildings and

improvements as determined by means of the Building Cost Index as of

December 31* 1967 and 1966, are given below:

1967 1966

Original cost $1,025,111 $ 993,903

Replacement cost 1,590,717 1,U8U,933

Machinery and Equipment. The replacement cost of the machinery

and equipment of X Co. was obtained through correspondence with manu­

facturers and agents. Such a task would be simple if a firm maintained

detailed property records showing for each item the complete description

of that item, its model and serial numbers, its original cost, and the

name and address of the vendor. Where such details are available, the

1. Published by McGraw-Hill, Inc.

12U

determination of the units acquired from a specific vendor can be easily

determined. That vendor can then be asked to give current cost quo­

tations for those items he has sold to the firm.

In the case of X Co. detailed property records were not main­

tained. The only record kept of machinery and equipment was a general

ledger account with a scanty description of the items acquired. The

matter was further complicated by the fact that many parts of original

units of machinery and equipment were acquired at different dates and

the general ledger account did not indicate whether some purchases were

additions to existing units or represented separate units by themselves.

Due to the condition of the property records of X Co., it was necessary

to reconstruct the machinery and equipment account in terms of units

with their additions in order to determine the original cost of each

unit. The assistant production manager of X Co. was successful in

preparing a list of each of the units of machinery and equipment (in­

cluding all additions) by model and serial number. His list also in­

cluded the name and address of the manufacturer or agent. The next

step was to reconcile the inventory list with the general ledger account

to determine the original cost of each unit and its additions.

The reconciliation process was successful in matching 92,0 of

the dollar cost of machinery and equipment as of December 31j 1966, with

the inventory list prepared by the assistant production manager. The

general ledger entries representing the 1967 acquisitions were all

traced to the list of machinery and equipment without any discrepancy.

The possibility of relating the unmatched 82 dollar cost as of

125

December 31, 1966, to the unchecked units on the list was rejected for

four reasons: (l) the list may have contained units that were fully

depreciated, written off from the books and retired from use, as was

proved in the case of one unitj (2) the list may have omitted a few

unitsj (3) the list may have contained units that were rented and not

owned; and (U) the general ledger account may have contained some

errors. Accordingly, the replacement cost of machinery and equipment

equal to 8% of the historical-dollar cost as of December 31, 1966, was

obtained by applying the average ratio of original cost to current re­

placement cost obtained for the other units comprising 92% of the total.

The requests for current cost quotations were mailed early in

1969. These requests were prepared on the stationery of X Co. and were

signed by the president and general manager. A sample letter of request

is presented in Figure 1 on page 126. The strategy of mailing requests

on the stationery of X Co. was adopted for two reasons: (1) a firm

desiring to adopt replacement costing will have to request the data

itself and not ask an outside party to do the job for themj and (2) the

Dickerson and Dockweiler studies indicated that requests by a researcher

are not given favorable consideration by vendors.

The letters of request included a form showing the details of

the equipment with spaces for the respondents to write their quotations

as of the dates requested. The form also contained a request that the

vendor indicate the items that were no longer produced, and in that case

1. Cf. supra., pp. 79-80.

X CO.

Date

ABC Manufacturer Any Street Any City, Any State, Zip Code

Dear Sirs:

We are currently engaged in evaluating our policies regarding plant expansion and the replacement of existing machinery and equipment.

In order to arrive at sound guiding policies, we would appreciate price quotations from you for each of the items listed on the attached sheet as of the dates indicated. Your price quotation for each item should consist of (1) your selling price exclusive of taxes, (2) your estimate of freight and insurance charges from your warehouse to Tucson, and (3) your estimate of installation costs, if appropriate.

We trust that you will complete and send us the at­tached sheet at your earliest convenience. Do not hesitate to write us should you require more clarification on the items listed.

Sincerely yours,

XYZ President and General

Manager

XYZsab

Encl.

Figure 1. Sample of letter of request for price quotations sent to manufacturers and agents of machinery and equipment.

127

he was asked to give current cost quotations for the items which repre­

sented the closest substitutes and which had an equivalent productive

capacity. It was felt that manufacturers and agents were in a better

position to determine the units that supersede others than the personnel

of the company. X Co. had several items that were superseded, and in

many cases the replacement cost of the equivalent capacity was less than

the original cost.

Twenty-four letters were mailed by regular mail. Within one

week from the date of mailing, eleven answers were received. Eleven

more were received the following week. When the two remaining requests

were not answered after one month, second requests were mailed. Second

requests were addressed personally to the general marketing managers.

Both marketing managers responded promptly. The lesson learned here is

that requests should preferably be addressed personally in order to

solicit a prompt response.

A question that may be raised at this point is whether 100>

response would have been obtained had the vendors been informed of the

purpose of such requests for current cost quotations. Five manu­

facturers called the president of X Co. to inquire about the purpose of

the request. The president indicated that the information was desired

by a researcher for research purposes. One vendor expressed in his

covering letter his willingness to correspond with the researcher and

to provide any additional information that may be desired. This indi­

cates that the manufacturers and agents may well have responded had

they known that the information was desired solely to adjust the fi­

nancial statements of X Co.

The original cost and the replacement cost of machinery and

equipment as of December 31, 1967 and 1966, are shown below. The

details of the computation appear in Appendix 3, No. 1.

1967 1966

Original cost $1,675,978 $1,661,600

Replacement cost 2,251*,796 2,118,563

Automobiles. The replacement cost of automobiles was obtained

from automobile dealers in Tucson. Replacement costs could also have

been obtained from an official guide such as Kelley Blue Book.^ How­

ever, the values quoted in Kelley Blue Book represent replacement costs

of used vehicles, and the use of such values does not provide guidance

for the maintenance of productive capacity. Manintenance of productive

capacity can be measured only when depreciation is based on the eventual

replacement cost new of the assets when they are to be replaced. The

value of an asset from a going concern point of view is its replacement

cost new adjusted for accumulated depreciation, and not its replacement

cost used.

The replacement cost of automobiles was obtained through person­

al interviews with salesmen in six different automobile dealerships in

Tucson that sell to X Co. The salesmen were presented with copies of

the original invoice and were asked to give price quotations for

1. (San Pedro, Calif.: By the Author). This guide is published bi-monthly.

129

equivalent models with the same optional equipment as of December 31>

1967 (1968 models) and December 31, 1966 (1967 models). The salesmen

were all informed of the purpose of the investigation, and they co­

operated fully.

The original cost of automobiles and their replacement cost as

obtained from salesmen1s quotations as of December 31, 1967 and 1966,

appear below:

1967 1966

Original cost $ U8,13U $ 35,1*91

Replacement cost $2t09h 37,7hO

Office Furniture and Equipment. X Co. had 5U0 items of office

furniture and equipment as of December 31, 1966. Thirty items were

acquired during 1967 and one item was written off, giving a total of

569 units as of December 31, 1967. These units ranged in original

purchase cost from $6.53 to $19,lUl.70.

As in the case of machinery and equipment, the ledger account

of office furniture and equipment did not provide adequate descriptions

for the units acquired. In many cases it was not possible to tell from

the ledger account which specific units were identical. The determi­

nation of the number of identical units would have required analysis of

vouchers and their supporting invoices. Such a project was rejected

when a preliminary analysis of the invoices revealed that some of them

were not sufficiently informative.

It was decided to estimate the current replacement cost at the

end of 1967 and 1966 by means of a sampling plan with the error to be

no more than 10$. Due to the large spread in the original cost of the

various units, a stratified random sample with an interpenetrating, or

replicated, design was adopted. The units of furniture and equipment

were stratified into £ strata on the basis of their original cost. A

stratified random sample of 86 units was selected and current cost quo­

tations of the 86 units were obtained as of December 31, 1967 and 1966.

The replacement cost of the 30 units acquired during 1967 was also

obtained as of December 31, 1967, in order to arrive at the total

current replacement cost estimate as of the end of 1967. The sampling

plan and the details of the computations are discussed in Appendix 3,

No. 2.

The current cost quotations were obtained through interviews

with the suppliers of the various units of furniture and equipment.

Most of the items were supported by original invoices. The suppliers

were told that X Co. was conducting a study of the trend in the prices

of its various units of plant and equipment, and all cooperated fully.

In the case of many accounting and calculating machines, it

was found that their replacement cost has declined substantially and

in many cases were superseded by more efficient though less costly

equipment. The suppliers were asked to estimate the ratio of the pro­

ductive capacity of the units in the possession of X Co. to the new

units in order to determine the replacement cost of an equivalent

capacity.

131

The original cost of the office furniture and equipment and

their replacement cost within - $9,332 for 1967 and - $9,078 for 1966

are shown belovr:

1967 1966

Original cost $ 117,023 ^ 109,757

Replacement cost 126,7h0 121,55U

Adjustment of the original replacement cost by means of the GNP

Implicit Price Deflator for Private Purchases of Furniture and Fixtures

gave the following values: $129,757 for 1967 and $116,933 for 1966.

Accumulated Depreciation. Accumulated depreciation based on the

replacement cost of each unit of plant and equipment can be obtained by

applying to the replacement cost the accrued depreciation percentage

based on original cost. Unfortunately, accrued depreciation percentages

on the original cost of the individual units of plant and equipment were

not readily available in X Co. The problem was solved by applying the

accumulated depreciation percentage on the total original cost of

depreciable property to the total replacement cost of the depreciable

property. Such a method does not give precise results, since the change

in replacement costs was not uniform for all items of plant and

equipment. However, in the absence of a better alternative, the use of

an overall percentage should give fairly accurate results.

Applying the accrued depreciation percentage on original cost

to the total replacement cost of the depreciable items of plant and

132

equipment gave the following accumulated depreciation figures:

$2,259,268 as of December 31, 1967, and $1,89U,188 as of December 31,

1966. The details of the computations are shown in Appendix 3* No. 3.

Sundry Investments

The sundry investments consist of 10 shares in the stock of a

corporation. These are held for "goodwill" purposes, and the management

of X Co. indicated no plans to sell them in the foreseeable future.

The stock is recorded on the books at original cost. It is not quoted

on any organized stock exchange.

Through correspondence between the budget director of X Co. and

the management of the issuing corporation, the book value of the stock

as of December 31, 1967 and 1966, was obtained. Such book value was

used to adjust the original cost of the investments. In the absence of

market quotations for long-term investments, the AM A Statement of

Basic Accounting Theory recommends the use of book value figures after

the accounts of the issuing corporation have been adjusted to a current

replacement cost basis.^ The available financial statements of the

issuing corporation were not adjusted for replacement costs and such

adjustment was outside the scope of this dissertation.

On the basis of conventional book value of the issuing corpo­

ration, the sundry investments of X Co. are then valued at $lU,U53 and

$8,933 on December 31, 1967 and 1966, respectively, as compared to an

original cost of 151,000.

1. 0£1_cit., p# 75.

133

Deposits and Other Assets

The deposits and other assets were left at their original

amount. These consisted of a deposit with the Arizona Industrial Com­

mission, deposits with a few major airlines, country club memberships,

and the cash surrender values of life insurance policies.

Equities

In accordance with the classification of monetary and non­

monetary items in Statement of the Accounting Principles Board No. 3»^"

all the liabilities of X Co. with the exception of deferred revenue are

monetary in nature and are properly stated in current terms. Deferred

revenue has no replacement per se and was therefore left unadjusted.

A balance sheet prepared on a replacement cost basis will con­

tain in its stockholders' equity section an account called Adjustment of

Stockholders' Equity. This account is the money adjustment of the his­

torical-dollar stockholders' equity and is equal to the advance in the

replacement cost of assets as was discussed in the preceding chapter.

The computation of the adjustment of stockholders' equity for X Co. is

shown in Appendix 3> No. U. The account, Adjustment of Stockholders'

Equity, permits the presentation on a replacement cost balance sheet of

the contributed capital at its original amount. The presentation of the

original investment by stockholders may be desired for legal and his­

torical purposes. Thus the original contributed capital of X Co. was

left unadjusted.

1. Op. cit., pp. 28-9.

13U

The computation of retained earnings is shown in Appendix 3,

No. 5>. The adjusted retained earnings figures as of December 31> 1967

and 1966, are markedly below the conventional figures. The decline

represents the accumulated overstatement of conventional income—the

amount that would have to be appropriated under conventional accounting

to maintain intact the productive capacity of X Co.

Income Statement Accounts

Net income under the maintenance of productive capacity repre­

sents the increase in the command over goods and services during a peri­

od of time; it is also equal to the maximum amount that can be severed

without impairing the productive capacity of the firm as measured by the

current replacement cost of such capacity.

As discussed in Chapter income under the maintenance of pro­

ductive capacity concept is equal to the conventional revenue less the

replacement cost of goods and services used during the accounting

period. In the case of X Co., the income statement items except de­

preciation are properly expressed in current terms. Depreciation based

on replacement cost for the year 196? is the difference between accumu­

lated depreciation based on replacement cost as of December 31* 1967

and 1966, after consideration of the replacement cost of assets retired

from use during 1967. This is computed in Appendix 3, No. 6.

The Adjusted Financial Statements of X Co.

The historical-dollar and the replacement cost balance sheets of

X Co. as of December 31, 1967 and 1966, are presented on a comparative

135

TABLE 12

X CO. COMPARATIVE HISTORICAL-DOLLAR AND REPUCEMENT COST

BALANCE SHEETS DECEMBER 31, 1967

Historical Replacement Assets Dollar Cost

Current Assets: Cash Accounts and notes receivable—net Inventories Prepaid expenses and other current assets Total current assets

Noncurrent notes receivable

Plant and Equipment: Land Buildings and improvements Machinery and equipment Automobiles Office furniture and equipment

Total Less accumulated depreciation

Plant and equipment—net

Other Assets: Sundry investments Deposits and other assets

Total other assets

$ 57MS8 387,760 62,833

29,176 $1,053,927

$ 180,000 1,025,111 1,675,978

U8,13U 117,023

$3,02*6,21+6 1,609.102 $l,U37llUU

$

1,000 5U,66U

$ 57U,158 387,760 62,833

29,176 $1,053,927

$ U8.U22 $ U8,U22

$ 822,2UO 1,590,717 2,25^,796

52,09U 126,7U0

$U,bU6,587 2,259,268

$2,587,319

$ 1U,U53 5U,66U

$ 69,117

TOTAL ASSETS $2,595,157 $3,758,785

I

136

TABLE 12—Continued

Equities Historical Replacement Dollar Cost

Current Liabilities: Accounts payable and accrued expenses Notes payable Income taxes payable Deferred revenue

Total current liabilities

Notes payable—long-term

Stockholders' Equity: Contributed capital Adjustment of stockholders1 equity Retained earnings

Total stockholders' equity

$ 336,U27 15,535 (7,360)* U0.777

$ 3851379 $_

336,1*27 15,535 (7,360)* UP,777

385,379

$ 13.H92 $ 13.U92

$ 523,850 $ 523,850 1,813,79U

1,672,U36 1,022,270 $2,196,286 $3,359,91)1

TOTAL EQUITIES $2,595,157 $3»758,785

* ( ) signifies deduction.

137

TABLE 13

X CO. COMPARATIVE HISTORICAL-DOLLAR AND REPLACEMENT COST

BALANCE SHEETS DECEMBER 31, 1966

Historical Replacement Assets Dollar Cost

Current Assets: Cash Accounts and notes receivable—net Inventories Prepaid expenses and other current assets Total current assets

Noncurrent notes receivable

Plant and Equipment: Land Buildings and improvements Machinery and equipment Automobiles Office furniture and equipment

Total Less accumulated depreciation

Plant and equipment—net

Other Assets: Sundry investments Deposits and other assets

Total other assets

$ U73,6U7 368,708 67,270

39,802 $ 9U9.U27

$ 180,000 993,903

1,661,600 35,U91 109,757

;?5i

$ 1,000 go,036

$ 51,036

$ U73,6U7 368,708 67,270

39,802 $ 9U9.U27

$ 51,825 $ 51,825

$ 783,086 1,U8U,933 2,118,563

37,7U0 121,55U

876 1,U09,988 1.89U.188

$1,570,763 $2*651,688

$

$"

8,933 50,036

TOTAL ASSETS $2,623,051 $3,711,909

138

TABLE 13—Continued

Historical Replacement Equities Dollar Cost

Current Liabilities: Accounts payable and accrued expenses $ 378,917 $ 378,917 Notes payable lU,255 li;,255 Income taxes payable 168,8U8 l68,8U8 Deferred revenue hit629 Ul,629

Total current liabilities $ 603,6U9 $ 603,6119

Notes payable—long-term $ 29,625 $ 29>625

Stockholders1 Equity: Contributed capital $ £23,850 $ 523,850 Adjustment of stockholders' equity — 1,573,058 Retained earnings 1,U65,927 981,727

Total stockholders' equity $1,9^9,777 $3,07^3,635

TOTAL EQUITIES $2,623,051 $3,711,909

139

TABLE Hi

X CO. COMPARATIVE INCOME STATEMENT ON A HISTORICAL-DOLLAR AND

MAINTENANCE OF PRODUCTIVE CAPACITY BASIS FOR THE YEAR 1967

Historical Productive Dollar Capacity

Revenue from operations $Uj385«75l $U»385»75l

Expenses:

Operating expenses (other than depreciation) $3>539j100 $3>539#100

Administrative expenses (other than depreciation) 2k7,7h2 2k7t7h2

Depreciation expense 199t760 365»726

Total expenses $3«986j602 $k»1^2t$6Q

Net income before income taxes $ 399*1^9 $ 233>183

Provision for federal and state income taxes 192f6U0 192»6U0

NET INCOME $ 206,509 $ U0.5U3

mo

basis in Tables 12 and 13 on pages 135 to 138. The historical-dollar

income statement and the income statement on a maintenance of productive

capacity basis for 196? are shown in comparative form in Table 3l|. on

page 139. The replacement cost balance sheets and the income statement

prepared on a maintenance of productive capacity basis are evaluated in

the following chapter.

The financial statements of any one year prepared on the basis

of current replacement costs sire properly expressed in a uniform unit of

measurement, since all items are expressed in current terms. This uni­

formity does not extend to comparative financial statements prepared on

a replacement cost basis if the purchasing power of the monetary unit

has changed during the period covered by the statements. When there has

been a change in the general purchasing power of the dollar during the

period covered by comparative statements, it is necessary to adjust the

financial statements prepared on a replacement cost basis to reflect

such a change.

The price level index as measured by the GNP Implicit Price

Deflator increased from 115.U in the fourth quarter of 1966 to 119.U in

the fourth quarter of 1967,"*" an increase of The procedures of

adjustments for price level changes have been adequately discussed in

the accounting literature, especially in Statement of the Accounting

Principles Board No. 3» and have been experimented with in practice

1. Survey of Current Business, U9 (July, 1969), p. U7-

lUl

TABLE 15

X CO. COMPARATIVE REPLACEMENT COST BALANCE SHEETS

DECEMBER 31, 1967 AND 1966 (IN DECEMBER 31, 196?, DOLLARS)

Assets 1967 1966

Current Assets: Cash $ 57h,l58 $ 1*90,083 Accounts and notes receivable—net 387,760 381,502 Inventories 62,833 69,6oU Prepaid expenses and other current assets 29,176 Ul,l83 Total current assets $1,053,927 $ 982,372

Noncurrent notes receivable $ U8,U22 $ 53,623

Plant and Equipment: Land $ 822,2U0 $ 810,259 Buildings and improvements 1,590,717 1,536,U60 Machinery and equipment 2,25U,796 2,192,077 Automobiles 52,09U 39,050 Office furniture and equipment 126,7UO 125,772

Total replacement cost of plant and equipment $U,8U6,587 $U,703,618

Less accumulated depreciation 2,259,268 1,959,916 Undepreciated replacement cost

of plant and equipment $2,587,319 $2,7U3,702

Other Assets: Sundry investments—at book value

of issuing corporation $ lU,U53 $ 9,2U3 Deposits and other assets 5U,66U 51,772

Total other assets $ 69,117 $ 61,015

TOTAL ASSETS $3,758,785 $3,8UO,712

lh2

TABLE 15—Continued

Equities 1967 1966

Current Liabilities: Accounts payable and accrued expenses $ 336,1*27 $ 392,065 Notes payable 15,535 Hi,750 Income taxes payable (7,360)a 17h,707 Deferred revenue U0,777 U3,073

Total current liabilities $ 385,379 $ 62U.595

Notes payable—long-term $ 13,U92 $ 30»653

Stockholders' Equity: Contributed capital $ 523,850° $ 523,850° Adjustment of stockholders' equity 1,813,79U 1,6U5,821C

Retained earnings 1^022^270 lt0l5»793 Total stockholders' equity $3,359f93lt k^h

TOTAL EQUITIES $31758,785 $318140,712

a. ( ) signifies deduction.

b. Kept at its original amount due to legal considerations.

c. Computed as a balancing item.

Ui3

several times.^ Though the subject of price level adjustments is not

within the confines of this dissertation, the replacement cost balance

sheet of X Co. as of December 31, 1966, was restated in terms of De­

cember 31, 1967, dollars in order to provide a better comparison of the

financial position at the end of the two years.

The price level adjusted replacement cost balance sheet as of

December 31, 1966, and the replacement cost balance sheet as of De­

cember 31, 1967, are presented in a comparative form in Table 1$ on

pages lUl and 1U2. The income statement for 1967 could also have been

similarly adjusted in terms of December 31, 1967, monetary units, but

this was not considered necessary due to the immateriality of the change

in the price level. The change in the GNP Implicit Price Deflator be­

tween the average index for 1967 and the index for the fourth quarter

of 1967 was 1.53^.

1. A recent experimentation was made by 18 corporations upon the recommendation of the AICPA in order to provide a basis for the issuance of Statement of the Accounting Principles Board No. 3• See Paul Rosenfield, "Accounting for Inflation—A Field Test," The Journal of Accountancy, 127 (June, 1969), pp. U5>-5>0. Reference was also made in Chapter 3 to Ralph Jones' Price Level Changes and Financial State­ments: Case Studies of Four Companies.

CHAPTER 8

EVALUATION OF THE ADJUSTED FINANCIAL STATEMENTS OF X CO.

The adjustment of financial statements to a replacement cost

basis must provide useful additional information not obtained from con­

ventional statements to justify undertaking the adjustment process. The

previous chapter discussed the adjustment of the balance sheets of X Co.

as of December 31j 1967 and 1966, to a current replacement cost basis

and the preparation of the income statement for 1967 on a maintenance of

productive capacity basis. This chapter is concerned with the evalu­

ation of these adjusted statements

The appraisal of the adjusted statements would be enhanced if

the adjusted statements covered a span of several years as was done in

Ralph Jones' Price Level Changes and Financial Statements: Case Studies

of Four Companies and more recently in Price-Level Adjustments of Fi­

nancial Statements—An Evaluation and Case Study of Two Public Utility

Firms by Eldon S. Hendriksen. Adjustments by means of price indices

may extend as far back as the availability of the indices permits. The

1. The phrase adjusted statements will be used in this chapter to refer to a balance sheet prepared on a replacement cost basis and to an income statement prepared on a maintenance of productive capacity basis.

2. (Pullman, Wa.: Washington State University, 1961).

lltU

A

1US

case is different when replacement cost quotations as of given prior

dates are to be obtained. In the latter case, a researcher cannot go

back for several years, vendors may not have the information readily

available and they may resent such a task.

Analysis of Statements

A study of the historical-dollar statements and the adjusted

statements of X Co. presented in Tables 12 to lU in Chapter 7 reveals

significant changes in the two sets of statements. Income on a mainte­

nance of productive capacity basis is 19*63% of the conventional income

for 1967.^" The total replacement cost of plant and equipment is $9.10%

greater than original cost as of December 31, 1967, and greater

than original cost as of December 31, 1966. Also the adjusted stock­

holders 1 equity is greater than the unadjusted stockholders' equity by

£2.98,0 at the end of 1967 and 5U.72£ at the end of 1966. These changes

will lead to marked differences in the ratios applied to the two sets

of statements.

As was stated in Chapter 2, financial analysts consider the rate

of return on common stock equity, the rate of return on total assets,

and the ratio of net income to sales as among the most useful measures

of profitability. These measures along with others will be discussed

1. Adjusted net income may not have varied in the same pro­portion if depreciation was computed in a manner to account for the growth in the working; capital resources equal to the depreciation charge. Cf. supra, p. 10U and p. 108. The results of the analysis of financial statements will depend upon the method of depreciation expense computation, under either historical cost or maintenance of productive capacity concept.

1U6

below. Computations will be based on averages wherever possible and

will be restricted to the operations of 1967.

Rate of Return on Average Stockholders1 Equity

The rates of return on average stockholders' equity for 1967

computed from the two sets of statements are given below

Conventional: x 100 = 9.87$*

Adjusted: x 100 = 1.26$.

The conventional rate of return on average stockholders' equity

is 7.83 times the adjusted rate. This means that stockholders were

under the impression that their investment was 7.83 times more profit­

able than it actually turned out to be. It would have been interesting

to compute the rate of retiirn for a successive number of prior years in

order to determine the extent of the misleading conventional compu­

tations over time.

Earnings per Share

of common stock outstanding at the end of 1967 and 1966 are shown below.

Conventional: $206,509 + 66,686 shares = $3»10.

The fact that earnings per share on a conventional basis is

about $ times the earnings per share on a maintenance of productive

The computations of earnings per share based on 66,686 shares

Adjusted: $ U0,f?U3 •» 66,686 shares = $0.61.

1. Computations are based on net income after taxes.

1U7

capacity basis is significant. The relationship between the con­

ventional and the adjusted earnings per share figures is the same as

the relationship between the conventional and the adjusted net income.

The adjusted net income is 19#6352 of the conventional income.

Rate of Return on Total Revenue

The conventional rate of return on total revenue is h*71% where­

as the adjusted rate of return on total revenue is only 0.92% which is

slightly less than 1/5 of the conventional rate. These are computed

below.

Conventional: $^36^7^1 x 100 • U.71>.

Adjusted: x 100 = 0,?2^*

Asset Turnover

The relationship between the total investment in assets and the

revenue derived from those assets is often computed along with other

measures of profitability. The asset turnover and the rate of return on

total revenue sire the components of the rate of return on total assets

which will be discussed in the following section. The asset turnover

based on the two sets of statements is computed below.

385 751 Conventional: ^(32,595,157 +'*2,623,051) = 1,68 t:LInes•

Adjusted: = 1,17 times#

UU8

Rate of Return on Average Assets

The rates of return on the average investment in assets based on

the two sets of statements appear below.

$206.^09 ^ Conventional: ^^7^, 623,0&) * 100 = 7.91?.

$Uo,f?U3 Adjusted: v 7Ck 7«c: + s-s %C$3,758,785 + -53,711,909; x 100 = 1,09/O*

The rate of return on average assets is also the product of the asset

turnover and the rate of return on total revenue. This alternative

computation is presented below.

Conventional: 1.68 times x U.71# s 7«91#»

Adjusted: 1.17 tines x 0.92# * 1.09#.

Rate of Federal and State Income Taxes on Income Before Taxes

Given the fact that in a period of rising prices conventional

income is usually greater than income on a maintenance of productive

capacity basis, it is interesting to compare the rate of income taxes

on conventional and adjusted income before taxes. These rates are

computed below.

Conventional: x 1°0 = U8.26#. $399,1U9

Adjusted: ^2,6H0 x 100 = q2.6X%. $233,1«3

The computation (82.61# 4 U8.26# = 1.71) shows that the effective tax

rate was 1.71 times the nominal rate. Computations of this nature would

1. This should be 1.07# rather than 1.09#. The difference is due to the effect of rounding.

make taxpayers aware of the actual tax burden imposed on them. It is

conceivable that a firm may be paying a tax on income when it is actu­

ally sustaining a loss as determined by its adjusted income statement.

Concluding Note

The purpose of the analysis presented above is to compare a few

selected ratios applied to the conventional and to the adjusted state­

ments covering the same time period. The objective of such a comparison

is to show the extent of the divergence of the results produced by the

two sets of statements and not to reach a conclusive decision as to the

profitability of X Co. The evaluation of the profitability of X Co.

requires the analysis of its adjusted statements over time and their

comparison with industry standards prepared on the same basis. The com­

parative ratios just discussed are presented in Table 16 on page 150.

Reaction of the Management of X Co.

The first six chapters of this dissertation along with the

adjusted statements prepared in Chapter 7 and the comparative analysis

presented in this chapter were presented to the management of X Co.

Management was asked to comment on the adjusted statements and on the

analysis derived therefrom. The budget director of the company, a

former senior in one of the larger accounting firms, was given the task

of representing the views of management. He read the material and dis­

cussed some of the findings with other executives including the major

stockholders of X Co.

150

TABLE 16

SELECTED COMPARATIVE FINANCIAL RATIOS APPLIED TO THE FINANCIAL STATEMENTS OF X CO.

Conventional Adjusted

Rate of Return on Average Stockholders' Equity 9.87$ 1.26$

Earnings per Share $3.10 $0.61

Rate of Return on Total Revenue U«71/» 0,32$

Asset Turnover (number of times) 1.68 1.17

Rate of Return on Average Assets 7.91$ 1*09%

Rate of Federal and State Income Taxes on Income Before Taxes U8.26# 82.6l£

151

The magnitude of the increase in the replacement cost of plant

and equipment was not surprising to the management of X Co. A material

change was expected since the company regularly receives catalogues that

include price lists from some major vendors. Management was very inter­

ested to know what the assets of the company would cost to replace and

was pleased to be presented with a balance sheet representing an acutual

statement of financial position. The magnitude of the change in income

was however unexpected and there was concern for the marked increase in

tax rate from U8.26$ to 82.6125.

Consideration of Profitability Position

X Co. receives periodically some industry statistics compiled

from the financial statements of a few giants in the industry that oper­

ate in other major cities. These statistics include rates of return,

asset turnovers, and other measures of profitability. The management of

X Co. never attempted to analyze the statements of the company and com­

pare them with industry averages. However, when the management was

presented with the comparative ratios, they became interested in de­

termining how the firm ranks as compared to other firms in the industry.

It turned out that the analysis of the conventional statements of X Co.

compared favorably with the industry statistics. There was, however, an

immediate recognition of the shortcomings of comparing ratios derived

from conventional statements. The equipment in other firms may be newer

or older and hence acquired at different costs. This suggested the ad­

vantage of preparing financial statements on a replacement cost basis by

all firms in the same industry. Management expressed the wish that all

132

firms in the industry prepare their statements on a maintenance of pro­

ductive capacity basis to provide a sound basis for comparisons.

The management of X Co. was annoyed at the poor results revealed

by the adjusted statements. The officers of the company would have

liked to know how their firm fared in the past several years on an ad­

justed basis in order to form an opinion as to the trend of the firm's

profitability in order to take corrective action. They became concerned

as to how to improve the profitability of the company as measured by the

adjusted statements. The company had under study several proposals that

will reduce costs and help bring them under control, expecially in the

marketing division. Management indicated an urgency in considering

these proposals.

Consideration of Borrowing Capability

Table 10 on pages 116 and 117 indicates that X Co. has an imma­

terial amount of long-term liabilities due to the fact that the company

has never depended on long-term debt. With the increased value of

assets on the adjusted statements, management believes that the firm

will now be in a better position to negotiate a substantial long-term

loan. Management intends to use the adjusted statements in applying for

a long-term loan despite the fact that the statements relate to previous

fiscal years. The company is considering a major expansion and modern­

ization program, and it is felt that the source of financing should be

long-term debt.

The relationship between the borrowing capability of a firm and

the preparation of its balance sheet on a replacement cost basis was

lf>3

pointed out by Arthur K. Cannon, an executive of Standard Insurance Co.

of Portland, Oregon, and a member in the Project Advisory Committee of

Accounting Research Study No. 1. Commenting on the Accounting Research

Study No. 3 recommendation to prepare financial statements on a current

replacement cost basis, Cannon said:

The most helpful statements of financial condition that I see among those that come across my desk every day now tend to include a two-column balance sheet with the assets valued in one column at cost and in the other at current value, with the liabilities the same in both columns, and with the net worth at cost in both columns but with appreciation reflected in the current value column ... I have seen borrowers or potential borrowers badly hurt by the use of traditional accounting statements in which assets are held to cost, liabilities re­flect loans made against current market values, and net worth may show a trivial amount or even a substantial deficit, en­tirely contrary to the facts of the situation.!

Consideration of Dividend Policy

X Co., a closely-held corporation with the major stockholders on

the payroll of the company, has no established dividend policy. Manage­

ment was fully aware, before the results of this study were brought to

its attention, that in a period of rising prices, conventional income

fails to represent an amount that can be severed without impairing the

productive capacity of the firm. The company usually ploughs back a

good part of the earnings. Management indicated that the computation of

income on a maintenance of productive capacity basis would provide them

with an appreciation of the maximum amount that could be paid in divi­

dends. Such a computation would also indicate the volume of the actual

1. Sprouse and Moonitz, op. cit., pp. 6U-£. Emphasis supplied.

15U

increase in the command over goods and services that is not distributed

through dividends. Management indicated that they are not in a position

to determine from conventional financial statements the command over

goods and services ploughed back into the firm.

Consideration of Technological Changes

The methods of operation used in the industry of X Co. have

undergone a tremendous technological improvement during the past decade.

The new technology permits the production of the services of X Co.

through completely new processes that will not make use of any of the

existing machinery and equipment in the production department. The new

processes provide a greater efficiency in operations and result in sub­

stantial savings in operating costs. Management is of the opinion that

the modern equipment required to handle the present capacity would cost

far less than the replacement cost of the present equipment.

This technological change poses an interesting question as to

whether or not depreciation should be based on the replacement cost of

the existing technology or on the cost of the new processes. Management

indicated that if the existing machinery and equipment were to disap­

pear, they would of necessity equip the firm with the new technical de­

vices. New firms entering the industry are being equipped with the

modern equipment. The problem is that the shift from the old technology

to the new one cannot be gradual. A firm can use either of the two

technologies but not both concurrently. The units of equipment of X Co.

have varying remaining useful lives and thus would not require re­

placement at one time.

1#

The management of X Co. indicated that the firm can continue

to operate for an indefinite period using the present technology and

continue to replace existing assets as they wear out. Therefore from

the standpoint of X Co. as a goihg concern, depreciation should be based

on the replacement cost of existing facilities, since existing units of

equipment will be replaced by like units when they wear out. However, a

sudden sale or scrapping of existing processes and the adoption of new

technology should not be ruled out. The change would represent a major

capital expenditure project that will have to be subjected to the

scrutiny of the tools of capital budgeting in order to determine the

desirability of making such a shift. If management finds it desirable

to adopt the new technology, then the current cost of existing facili­

ties and the depreciation thereon should be based on the equivalent pro­

ductive capacity of the new assets.

General Comment

The management of X Co. indicated that the adjusted statements

have provided very useful additional information. They felt that the

adjustment should be made a necessary procedure when the conventional

statements lose their significance in a period of rising replacement

costs. A question was raised, however, as to the cost of making the

adjustment. Unfortunately, no record was kept of the number of hours

spent on preparing the adjusted statements. Most of the time of this

writer was spent in compiling meaningful data from the accounting

records and significantly less time was spent on the actual process of

obtaining current replacement costs and preparing the adjusted

I

356

statements; consequently a firm with adequate property records should

be able to convert its statements to a maintenance of productive ca­

pacity basis within a reasonably short time and at a reasonable cost.

Objectivity of the Adjusted Statements

The procedures used in adjusting the financial statements of f

X Co. to a productive capacity basis are verifiable, objective, and free

from bias, and thus meet the requirements of an independent auditor.

Replacement cost quotations obtained from vendors on the stationery of

vendors or on forms bearing the vendors' stamp and signature provide

objective documents free from bias, since they are external evidence.

The use of appropriate specific price indices—the Building Cost Index

in the case of X Co.—compiled by independent parties is verifiable,

objective, and free from bias.

A question may be raised as to the objectivity of obtaining the

replacement cost of the land owned by X Co. Admittedly, the replacement

cost of the land is not supported by a verifiable and objective document

prepared by an independent party. Appraisals were ruled out in this

study, and an index of land values was not available. The considered

opinion of the members of the two firms of real estate appraisers, the

three real estate brokers, and the four employees in the Pima County

Assessor's Office was judged to be sufficiently objective. It turned

out that the land value obtained agreed with the value obtained by means

of an independent appraisal conducted in 1963.

CHAPTER 9

CONCLUSIONS

Financial statements prepared in accordance with generally ac­

cepted accounting procedures are based upon historical costs. With rare

exception, the only permissible deviation from historical cost is in the

event there is reasonable doubt as to the recovery of cost in the normal

course of business. In such a case, the loss is immediately recognized.

Generally accepted accounting principles, as currently understood, do

not purport to present current values on the balance sheet or to match

equivalent units within the income statement. Furthermore, generally

accepted accounting principles do not provide adequate information as to

maintenance of the productive capacity of a business enterprise. It is

the contention of this writer that adoption of current replacement

costing and the maintenance of productive capacity concept of business

income will produce more meaningful financial statements for distri­

bution to shareholders.

Use of current replacement cost for balance sheet purposes re­

sults in a more accurate presentation of the financial position of the

firm and of the shareholders' equity. Conventional statement practices

do not purport to indicate with any accuracy the amount of undistributed

prior years' income which must be retained to maintain capacity in a

period of rising prices and that amount retained for growth. Current

l£7

158

accounting practices have encouraged managements to employ devices such

as the appropriation and the capitalization of retained earnings in

order to retain sufficient resources to replace assets at higher prices.

The approach developed within this dissertation provides an objective

measurement of the amount of prior years' earnings that have been re­

tained by the firm for internal growth and therefore supplies the share­

holders with information as to the actual availability of dividends.

Many of the advocates of replacement costing have not related

the balance sheet and the income statement in a cohesive theoretical

framework. Some have directed their attention only towards the matching

of current revenues and current costs in the income statement with the i

consequent treatment of the balance sheet as a statement of residuals as

in current practice. Those who directed their attention to the balance

sheet have maintained that the advance or decline in the replacement

cost of assets represents a holding gain or loss that is part of the

income computation."'" It has been asserted in this dissertation that

this advance or decline is an adjustment of the money value of stock­

holders' equity and is not part of the income determination process.

This dissertation has related replacement costing on the balance sheet

and in the income statement in a theory that advocates the maintenance

of productive capacity.

1. Reference was made earlier to the AAA Committee to Prepare a Statement of Basic Accounting Theory in A Statement of Basic Accounting Theory, Edwards and Bell in The Theory and Measurement of Business Income, Sprouse and Moonitz in Accounting Research Study No. 3» and R. J. Chambers in Accounting, Evaluation and Economic Behavior and in Ac­counting and Action. All these publications recommend the recognition of the advance in replacement costs as income.

159

Besides the development of a theory for the articulation of a

replacement cost balance sheet and an income statement prepared on a

maintenance of productive capacity basis, an empirical case study was

conducted as to the applicability of replacement costing to the fi­

nancial statements of-an actual business enterprise. This was done in

order to demonstrate on an experimental basis the feasibility and objec­

tivity of preparing a replacement cost balance sheet and an income

statement on a maintenance of productive capacity basis. This experi­

ment was successful and proved that objective replacement costs can be

obtained.

The firm used in this study does not hold assets for which there

is no general market except for land and buildings. It is recognized

that many other firms may own assets that are sufficiently unique that

no general market quotations will be available. In this instance the

experience of a firm or the industry may well reveal an acceptable pro­

cedure by which to approximate current replacement costs. Only when

there are more attempts to actually implement replacement costing will

sufficient experience be accumulated to permit solution of the re­

placement costing problem.

A question arises concerning the frequency with which re­

placement costs should be updated once they have been obtained. The

theory developed in this study implies that the replacement cost of all

assets should be updated at the end of every accounting period. Practi­

calities of application may lead to the obtaining of actual current

costs less frequently. The ideal method of obtaining the current

160

replacement cost of fixed assets except for land and buildings is to

obtain current cost quotations from vendors. This procedure does not

have to be followed every year if it proves too costly. The replacement

costs obtained by means of vendors' quotations may be updated for a few

years after they are obtained by means of specific price indices, such

as the Implicit Price Deflators for Private Purchases of Producers'

Durable Equipment by Type. It was argued earlier in this study that the

use of specific price indices yields approximate results at best and is

therefore not recommended. However, the updating of vendors' re­

placement costs by means of an index with vendors' quotations obtained

at periodic intervals should produce sufficiently reliable replacement

costs. The periodic intervals may cover any span of years as determined

by the management of the business enterprise and as necessitated by the

movement in replacement costs. Perhaps the period of five years recom­

mended in Accounting Research Study No. 3 will prove satisfactory.

In the situation where actual replacement costs of all assets

are not to be determined annually, a firm may obtain the replacement

cost of only a portion of its assets from vendors annually and update

the remaining assets by means of specific price indices. A firm also

may find it acceptable to sample each category of assets for an esti­

mation of actual replacement costs, by category, to obtain the re­

placement costs of the sampled items. The cost movements of the sampled

items would then serve as the basis for adjusting each asset category.

It is hoped that with the adoption of replacement costing many firms

1. Op. cit., p. 57.

161

will test different procedures to obtain current replacement costs in

order to settle on procedures that best meet their objectives.

A problem that should be given consideration relates to the

attitude of vendors when faced with numerous and repeated requests for

price quotations. This problem was not investigated in this disser­

tation. It is possible that when replacement costing becomes a widely

adopted procedure, vendors will find it necessary to supply their

clients with quotations if they want to retain their business. Alterna­

tively, vendors may decide to charge a nominal fee for supplying the

necessary information. Conversation with a few local suppliers revealed

that some of them keep detailed records of the items sold to their

clients. It is possible that in those firms where records of sales are

kept by client, a computer can be programmed to prepare price quotations

to clients periodically.

Another problem that was not investigated is the possible ex­

istence of monopsony power and/or close ties between the firm requesting

current cost quotations and the suppliers. Special caution must be

taken to insure the objectivity of current cost quotations in these

instances.

A replacement cost balance sheet and an income statement pre­

pared on a maintenance of productive capacity basis provide useful if

not essential information for the users of published financial state­

ments. This study recommends that such statements become the primary

statements in financial reports to stockholders. Conventional financial

statements perhaps will continue for some time to be the primary

162

statements to allow time for statement users to familiarize themselves

with the replacement cost balance sheet and with the income statement

prepared on a maintenance of productive capacity basis. The recommended

statements during this transition period should be presented parallel

to the historical-dollar statements.

Further research needs to be undertaken to test the finding

herein that replacement cost information can be objectively determined.

These studies, hopefully, will involve business firms in various indus­

tries, not-for-profit organizations, and regulated industries. By such

efforts problem areas will be identified and industry statistics and

experience will be accumulated. Of more immediate need is the necessary

motivation for firms and accountants to investigate replacement costing.

The impetus for experimentation would be provided by studies demon­

strating a greater utility in investment decisions attaching to the

proposed statements than to conventional statements.

APPENDIX 1

EXTENT OF PRICE CHANGES

The fact that the purchasing power of the monetary unit—the

dollar—changes continuously is well established by means of price level

indices. The most noted among these indices are The Index of Change in

Prices of Goods and Services Purchased by City Wage Earner and Clerical-

Worker Families to Maintain Their Level of Living, better known as the

Consumer Price Index, and the Gross National Product Implicit Price

Deflator.

The above indices provide a measure of the ability of the dollar

to command goods and services in general over time and do not purport to

measure the change in the replacement cost of a specific asset or group

of assets over the same time period. There are, however, specific price

indices that measure on a broad basis the changes in the specific prices

of assets. These specific price indices include the Building Cost Index

and the Implicit Price Deflators for Private Purchases of Producers'

Durable Equipment by Type.

Figure 2 on page 16U shows the movement in some selected price

indices between 1958 and 1968. The figure is based on the indices shown

in Table 17 on page 165. Some of the figures were originally stated on

the basis of the year 1958 J others were converted to a 1958 base year

to facilitate the comparison.

163

16U

140

1*5

I so

125

120

115

no

|05

100

I KJ D I C E 5

< g>H p P£ F L A

... pim c£

95 •

Y E A R S 19 5e »» 6 0 61 6 1 63 64 65 66 67 68

Figure 2. Relative movement in selected price indices, 1958-1968.

Tear

1958 1959 I960 1961 1962 1963 196U 1965 1966 1967 1968

TABLE 17

SELECTED PRICE INDICES FOR THE YEARS 1958 TO 1968

1958 - 100

GNP Implicit Price Deflator

GNP Deflator for

Producers1

Durables

GNP Deflator

for Special Industry Machinery

Consumer Price Index

Wholesale Price Index

Building Cost Index

100.0 101.6 103.3 10U.6 105.8 107.2 108.9 110.9 113.9 117.6 122.3

100.0 102.0 102.2 102.1 102.2 102.3 103.1 103.9 106.0 1C9.2 111.9

100.0 103.0 105 .U 106.7 108.3 110.7 112.6 115.0 119 .U 121; .5 125.2

100.0 100.8 102 .U 103.5 10U.7 106.0 107.3 109.1 112.3 115.5 120.3

100.0 100.2 100.3 99.9 100.2 99.9 100.1 102.1 105.5 105.7 108.3

100.0 10U.U 106.6 108.3 110.6 113.2 116.6 119 .U 121;.0 128.0 137 4

Source: The National Income and Product Accounts of the United States. 1929-1965 Statistical Tables, pp. 158-61;; Survey of Current Business, U9 (July, 1969), pp. U7-9; Engi­neering News Record, 182 (March 20, 1969). Figures that were not originally stated on a 1958 = 100 basis were converted to that basis to facilitate comparison.

166

Besides the marked advance in prices revealed by Figure 2 and

Table 17, the Figure and Table show that price indices do not produce

the same results. The GNP Implicit Price Deflatort the Consumer Price

Index and the Wholesale Price Index, which are considered to be indices

of the general price level, give varying results. The GNP Implicit

Price Deflator has risen by 22.3# for the eleven-year period whereas

the Consumer Price Index has risen by 20.3# and the Wholesale Price

Index by 8.3# for the same period. This variation emphasizes the ap­

proximation obtained by means of any general price level index for

measures of changes in the price level.

/

APPENDIX 2

CORRESPONDENCE 7JITH THE CHIEF ACCOUNTANT OF THE SECURITIES AND EXCHANGE COMMISSION

167

168

T H E U N I V E R S I T Y O F A R I Z O N A T U C S O N , A R I Z O N A 8 5 7 2 1

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION DEPARTMENT OF ACCOUNTING

March 11, 1969

Mr. Andrew Barr Chief Accountant Securities & Exchange Commission Washington, D.C. 205U9

Dear Mr. Barr:

I am presently writing a Ph.D. dissertation in the area of price level changes and on the utility of conventional financial statements to financial statement users. I am of the opinion that financial statements prepared on the basis of current replacement cost are more useful to users of financial statements than the conventional ones.

I will be very grateful to you if you will:

(1) give me your personal opinion on the usefulness of (a) financial statements adjusted for purchasing

power changes, and (b) financial statements prepared on the basis of

current replacement cost;

(2) send me or refer me to the SEC Releases or other SEC material dealing with the problem of purchasing power changes and specific price changes.

I will greatly appreciate your interest in my request.

Sincerely yours,

Edward J. Gress

*cSxxt&

SECURITIES AND EXCHANGE COMMISSION WASHINGTON IB£D. C. 20549

169

OFFICE OF THE CHIEF ACCOUNTANT

March 20, 1969

Mr. Edward J. Gress College of Business and

Public Administration University of Arizona Tucson, Arizona 85721

Dear Mr. Gress:

In reply to your letter of March 11, 1969, the Commission does not accept for filing financial statements adjusted for purchasing power changes. The Commission has on rare occasions permitted fixed assets to be carried at appraised values. It is, of course, accepted practice to use appraisals to allocate to fixed assets a portion of the excess of the purchase price over net equity in the acquisition of a business.

Since inception the Commission has been faced with the dual problem of misrepresentation of values by the use of alleged appraisals in the sale of securities and the failure to disclose large increments of values in the repurchase of a corporation's own stock. Our record of action may be found in the bound volumes of the S.E.C. Decisions and Reports, which should be available in your university library. These may be identified from the Table of Decisions and Reports under Section 8(d) of the Securities Act and Section 10(b) of the Exchange Act.

Enclosed is an amicus curiae brief filed in U. S. District Court, Eastern District of New York, which states the Commission's position on certain of these matters and contains a table of citations of leading cases and other references.

The Wall StreetJournal of March 12, 1969; carried an article which stated that Judge Bartels "ordered an accounting and restitution of any damages resulting from the omission of an appraisal of outdoor advertising properties held by General Outdoor."

Sincerely yours,

LJ Associate Chief Accountant

Enclosure

APPENDIX 3

COMPUTATIONS SUPPORTING THE ADJUSTED FINANCIAL STATEMENTS OF X CO.

1. Computation of Replacement Cost of Machinery and Equipment

Current cost quotations as of December 31, 1966 and 1967, were

obtained from vendors for items costing $1,528,316 out of a total cost

of $1,661,600 comprising 92% of the original cost as of December 31,

1966. During 1967 no units of machinery and equipment were retired;

items costing $lU,378 were acquired. The current cost of the $lU,378

units was also obtained as of December 31, 1967.

Items costing $1,£28,316 had a replacement cost as follows:

As of December 31, 1966: $1,9U8,626.

As of December 31, 1967: $2,060,20U.

The ratio of replacement cost to original cost for quotations

obtained are:

As of December 31, 1966: |^28?3l6 " lt27^'

As of December 31, 1967: =

The cost of items as of December 31, 1966, for which no current

cost quotations were obtained is:

$1,661,600 - $1,528,316 = $133,2U8.

170

171

The summary of the computation is given below:

December 31

1967 1966

Replacement cost of items costing $1,528,316 $2,060,20U $1,9U8,626

Estimated replacement cost of items for which no quotations were obtained (original cost $133,28U) using ratio of replacement cost to original cost on items for which quotations were obtained:

1967: $133,21*8 x 1.3U8 179,667

1966: $133,2U8 x 1.275 169,937

1967 additions costing $lb,378 at replacement cost as of December 31, 1967 1U,925

Total replacement cost of machinery and equipment $2,25Uf796 $2,118,563

2. Computation of Replacement Cost of Office Furniture and Equipment

A listing showing the description and the original8'cost of each

of the 5U0 units of office furniture and equipment as of December 31,

1966, was prepared. Each of the 5U0 units was then assigned to one of

5 strata based upon that unit's original purchase price. All the items

within a certain stratum were then serially numbered and were preceded

by a letter indicating the specific stratum.

The number of the strata and the number of items found to be in

each stratum were as shown on the following page.

Stratum Purchase Price Range Number of Items

A $ 0 - $ 99.99 2^5

B 100 - 199.99 18U

G 200 - 299.99 65

D 300 - 399.99 20

E * 1*00 and above (up to $20,000) _16

Total 5U0

The stratum boundaries were chosen so that they would be easy

to work with and to remember. The purchase price was selected as the

stratifying variable, since it would be presumed to be rather highly

correlated with replacement costs.

Given the number of items in each of the 5 strata, it was de­

cided to vise a stratified random sample with an interpenetrating, or

replicated design. The interpenetrating arrangement was selected due

to the simplicity that results in calculating the standard error of

the total replacement cost. Again, for simplicity, it was decided to

try 10 interpenetrating stratified random samples from the list of

office furniture and equipment, obtain the total replacement cost for

each of the 10, and take the mean of the 10 totals as the best esti­

mate. The standard error associated with this mean was to be calcu­

lated from the variance among the 10 sample totals.

173

The number of random observations from each of the strata was

set as followsj

Stratum Number in Population Number in Sample

A 2

B 18U 2

C 6$ 2

D 20 1

E 16 16

The total replacement cost of the 2 items in stratum A in the first of

the 10 interpenetrating samples was multiplied by 2%$/2 to estimate

stratum A's contribution to the total. The multiples for the totals

in other strata were: B: 18Jj/2j C: 65/2; and D: 20. Since 100$ of

stratum E was included in the sample, its total was added to the sum

of the estimates of the other four strata to produce the estimates of

the grand total froi: the first of the 10 sub-samples. This process was

repeated for a total of 10 times to get the 10 sub-sample estimates.

Twenty non-duplicating 3 digit random numbers in the range

beginning with 001 and ending with 2$5 were selected for the 10 inter­

penetrating sub-samples for stratum A. Twenty fresh random numbers in

the range 001 to 18U were selected for stratum B, and so on for strata

C and D. The result was shown on page 17U.

17U

Sub-Samples

Stratum 1 2 3 k 5 6 7 8 9 10

A 1U2 199 163 205 2U7 137 18 17 70 12U A 97 161 250 221 169 192 113 1U9 116 89

B 96 175 62 109 91 73 9k 180 2k 76 B 66 75 38 103 69 108 166 138 8 122

C 8 U0 9 58 , 7 65 3k k9 51 1U C 1 39 56 36 29 16 15 k8 U7 62

D 13 18 5 10 Hi 3 1 6 8 2

Before contacting the suppliers of the items in this sample to

get replacement cost quotations as of the end of 1966 and 1967, it was

decided to check the sampling plan. This was done by executing the plan

on original purchase prices rather than replacement costs. The result

could then be compared with the known actual cost of the entire list.

The 10 sub-samples produced the following 10 estimates of original cost

of the list:

Sub-Sample Total

1 $103,03U.25 2 116,958.22 3 108,261*.61 k 118,08U.09 5 11U,793.58 6 109,919.75 7 112,159.17 8 128,365.20 9 98,035.07 10 107,597.91

. Mean $111,713.185

In accordance with the central limit theorem, these ten totals can be

assumed to comprise part of a normally distributed population of all

possible similar totals. The maximum likelihood estimate of the

17$

mean of the 10 totals is s— = i / x where s = the standard deviation X V 10 X

of the 10 sub-samples, and 10 s the number of totals used in computing

the mean total. As calculated from the above list of 10 totals,

s ^ = 65*023,098.38, from which it follows that s- = 2,£U9«96. The ̂ X

estimate of the total purchase price now becomes $111,713*19 ±

3($2,5U9.96) or $111,713 + $7,650.

A range of 6 standard errors was chosen because this range in­

cludes all but 0.0027 of a normal distribution and therefore can be

taken to be certain to include the true total, for all practical

purposes. This estimate compares very well with $109,757* the actual

original cost of the entire list of office furniture and equipment.

Since the tolerance interval (+ $7,6f>0) is well within the specified 10$

of the actual cost (+ *510,976) and since the estimate is very close to

the true cost, the sample was judged adequate.

Subsequently, a way was devised to check the standard error of

O the mean sample total, or the value of sx , which constitutes an identi­

cal check. Conservatively, the data in each of the k sampled strata

can be assumed to be rectangularly distributed within the dollar limits.

The range of each sampled stratum is $100, and the variance of a rec­

tangular density function is known to be 1A2 the square of the range.

Hence, the variance of the values in each sampled stratum is 100^/12 *

833. Then the variance sx^ can be estimated from the calculations that

follow.

176

Variance Stratum of Sample Mean Multiple Product

A 833/2 2$$2 27,082,912.5

B 833/2 181+2 ll+,101,02l+.0

C 833/2 652 1,759,712.5

D 833 202 333,200.0

sx2 = 1+3,276,81+9.0

? On the basis of a chi-square test, the value found for sx is

significantly smaller than the 65,023,098 found from the 10 sub-sample

totals. After all calculational checks failed to show any error in

either figure, it was decided to select a second, independent set of

10 sub-samples to resolve the difference in these two estimates of

the same variance. The second sample produced an estimate of $111,558

for the actual cost and sx2 was 1+3,865,562. This was sufficiently close

to the 1+3,276,81+9 estimate to support the conclusion that the 65,023,098

arose from a rare sampling fluctuation. Nonetheless, to be on the safe

side, it was decided to use the original sample for the replacement

cost estimates, and accordingly the replacement costs were obtained from

the suppliers.

When December 31, 1966, replacement cost data were used with

the original 10 sub-samples, the mean total estimate for the list was

$121,551+ + $9,078. This was one of the estimates desired, namely, the

replacement cost of office furniture and equipment as of December 31,

1966. For December 31, 1967, 1967 year-end replacement costs were used

with the 10 original sub-samples to produce an estimate of $119,795 ±

$9,332. Then the December 31, 1967, value of all items added to

V

177

inventory from December 31, 1966, to December 31* 1967, was added to

this estimate and the December 31, 1967, value of all items deleted

from inventory during 1967 was subtracted. The final resulting estimate

of the replacement cost of office furniture and equipment as of

December 31, 1967, is $126,7U0 + $9,332.

3. Computation of Accumulated Depreciation on Replacement Cost

December 31

1967 1966

Total original cost of plant and equipment $3,OU6,2U6 $2,980,751

Less original cost of land 180,000 180,000

Original cost of depreciable assets $2,866,2l|6 $2,800,751

Accumulated depreciation on original cost $1,609,102 $1,U09,988

Accumulated depreciation percentage on original cost 56.lU^ $0,3h

Total replacement cost of plant and equipment $U,8^6,587 $U,5U5,876

Less replacement cost of land 822,2U0 783,086

Replacement cost of depreciable assets $U,02U,3U7 $3,762,790

Accumulated depreciation percentage 56.lH% 50»3U%

Accumulated depreciation based on replacement cost $2,259,268 $1,89U,188

178

U. Computation of Adjustment of Stockholders' Equity

Replacement cost of plant and equipment

Sundry investments—at book value

Total replacement cost and book value of assets adjusted

Original cost of plant and equipment

Original cost of sundry investments

Total original cost of assets adjusted

Difference * Adjustment of stockholders' equity

5. Computation of Adjusted Retained Earnings

Conventional retained earnings

Less overstatement of conventional retained earnings:

Accumulated depreciation—replacement cost

Accumulated depreciation—original cost

Overstatement of retained earnings

Adjusted retained earnings

December 31

1967 1966

$U,8U6,587 $U,5U5,876

Ui,U53 8,933

$U,861,QUO $U,55H,809

$3,0U6,2U6 $2,980,751

1,000 1,000

$3,OU7,2U6 $2,981,751

$1,813,79U ''$1,573,058

December 31

1967 1966

$1,672,U36 $1,U65,927

$2,259,268 $1,89U,188

1,609,102 1.U09.988

$ 650,166 $ U8h,200

$1,022,270 $ 981,727

6. Computation of Depreciation Expense Based on Replacement Cost for 1967~

Accumulated depreciation based on replacement cost as of December 31, 1967

Accumulated depreciation based on replacement cost as of December 31, 1966

Increase in accumulated depreciation based on replacement cost

Add replacement cost of retired assets (happens to be equal to original cost)

Depreciation expense based on replacement cost for 1967

LIST OF REFERENCES

Books and Monographs

Accounting Principles Board of the American Institute of Certified Public Accountants. "Financial Statements Restated for General Price-Level Changes." Statement of the Accounting Principles Board No. 3» New York: American Institute of Certified Public Accountants, 1969.

American Accounting Association. Accounting and Reporting Standards for Corporate Financial Statements and Preceding Statements and Supplements. Evanston, 111.: American Accounting Association, iwr.

American Accounting Association Committee to Prepare a Statement of Basic Accounting Theory. A Statement of Basic Accounting Theory. Evanston, 111.: American Accounting Association, 1966.

American Institute of Certified Public Accountants. APB Accounting Principles: Original Pronouncements as of ??ay 1, 1966. Vol. 2. New York: American Institute of Certified Public Accountants, 1968.

. Audit of Corporate Accounts. New York: American Institute of Certified Public Accountants, 193U.

Backer, Morton, and Bell, Philip W. "The Measurement of Business Income." Modern Accounting Theory. Edited by Morton Backer. Englewood Cliffs, !)i.J.: Prentice-Hall, Inc., 1966.

Canning, John B. The Economics of Accountancy. New York: The Ronald Press Co., 1929.

Chambers, R. J. Accounting and Action. Sydney: The Law Book Co. of Australia Pty Ltd., 1965.

. Accounting, Evaluation and Economic Behavior. Englewood Cliffs, K.J.s Prentice-Hall, Inc., 1966.

. Towards a General Theory of Accounting. Melbourne: The Australian Society of Accountants, 1962.

180

181

Committee on Accounting Procedure. "Accounting for Special Reserves Arising Out of the War." Accounting Research Bulletin No. 13. New York: American Institute of Certified Public Accountants, 191*2.

. "Accounting for the Use of Special War Reserves." Accounting Research Bulletin No. 26. New York: American Institute of Certified Public Accountants, 19U6.

. "Depreciation on Appreciation." Accounting Research Bulletin No. 5» New York: American Institute of Certified Public Ac­countants, 19U0.

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Dickerson, Peter J. Business Income—A Critical Analysis. Berkeley: University of California, 1965.

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Gilman, Stephen. Accounting Concepts of Profit. New York: The Ronald Press, 1939.

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Hendriksen, Eldon S. Accounting Theory. Homewood, 111.: Richard D. Irwin, Inc., 1965.

. Price-Level Adjustments of Financial Statements—An Evalu­ation and Case Study of Two Public Utility Firms. Pullman, ,\a.i Washington State University, 19t>l.

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Kelley Blue Book. San Pedro, Calif: By the Author, 29000 So. Western Avenue.

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MacNeal, Kenneth. Truth in Accounting. Philadelphia, Pa.: University of Philadelphia Press, 1939.

Mason, Perry. Price-Level Changes and Financial Statements: Basic Concepts and Eethods. Evanston, 111.: American Accounting Association, 1956.

Mautz, R. K. Financial Reporting by Diversified Companies. New York: Financial Executives liesearch Foundation, 1968.

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Paton, W. A. and Littleton, A. C. An Introduction to Corporate Ac­counting Standards. American Accounting Association Monograph No. 3. Evanston, 111.: American Accounting Association, 19U0.

Rappaport, Louis H. SEC Accounting Practice and Procedure. 2nd ed. New York: The Ronald Press Co., 1966.

Ross, Howard. The Elusive Art of Accountancy. New York: The Ronald Press, 1966.

Sanders, Thomas Henryj Hatfield, Henry Rand; and Moore, Underhill. A Statement of Accounting Principles. Kew York: American Institute of Certified Public Accountants, 1938*

Sprouse, Robert T., and Koonitz, Maurice. "A Tentative Set of Broad Accounting Principles for Business Enterprises." Accounting Research Study No. 3. New York: American Institute of Certi­fied Public Accountants, 1962.

Staff of the Accounting Research Division. "Reporting the Financial Effects of Price-Level Changes." Accounting Research Study No. 6. New York: American Institute of Certified Public Accountants, 1963.

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Sweeney, Henry W. Stabilized Accounting. New York: Holt, Rinehart and Winston, Inc., 196U.

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Periodicals

American Accounting Association Committee on Concepts and Standards— Inventory Measurement. "A Discussion of Various Approaches to Inventory Measurement." The Accounting Review, XXXIX (July, 196U), pp. 700-1)4.

American Accounting Association Committee on Concepts and Standards— Long-Lived Assets. "Accounting for Land, Buildings, and Equipment." The Accounting Review, XXXIX (July, I96I4.), pp. 693-9.

"A Symposium on Appreciation." The Accounting Review, V (March, 1930), pp. 1-59.

Arnett, Harold E. "What Does 'Objectivity' Mean to Accountants?" The Journal of Accountancy, 111 (May, 1961), pp. 63-8.

Ashburne, Jim G. "A Forward Looking Statement of Financial Position." The Accounting Review, XXXVII (July, 1962), pp. U75-8.

Bauer, John. "Renewal Costs and Business Profits in Relation to Rising. Prices." The Journal of Accountancy, 28 (December, 1919), pp. U13-9.

18U

Bierman, Harold, Jr. "Myths and Accountants." The Accounting Review, XL (July, 1965), pp. 5U1-6.

Blough, Carman G. "Replacement and Excess Construction Costs." The Journal of Accountancy, 8U (October, 19U7), pp. 333-6.

Bray, F. Sewell. "English Accountant Agrees with Proposal to State Current Costs." The Journal of Accountancy, 86 (December, 19U8), pp. U78-81.

Broad, Samuel J. "The Impact of Rising Prices Upon Accounting Pro­cedures." The Journal of Accountancy, 86 (July, 19U8), pp. 10-21.

Carey, John L. "Depreciation and Inflation." The Journal of Ac­countancy, 8U (October, 19U7), pp. 265-b.

Chambers, R. J. "Financial Information and the Securities Market." Abacus, 1 (September, 1965), pp. 3-30.

Dickens, Robert L., and Blackburn, John 0. "Holding Gains on Fixed Assets: An Element of Business Income?" The Accounting Review, XXXIX (April, 196U), pp. 312-29.

Dockweiler, Raymond C. "The Practicability of Developing Multiple Financial Statements: A Case Study." The Accounting Review, XLIV (October, 1969), pp. 729-U2.

"Engineering News-Record Indexes of Cost Trends." Engineering News Record, 182 (March 20, 1969), pp. 90-3.

Estes, Ralph W. "An Assessment of the Usefulness of Current Cost and Price-Level Information by Financial Statement Users." Journal of Accounting Research, 6 (Autumn, 1968), pp. 200-7.

Foster, Paul M. "Asset Disclosure for Stockholder Decisions." Fi-nancial Executive, XXXV (July, 1967), pp. 28-UU.

Freeman, E. Stewart. "How to Show Effects of Change in Value of Dollar Yet Preserve Cost Basis in Accounting." The Journal of Ac­countancy. 85 (February, 19U8), pp. 113-7.

Galanis, J. M. "Some Shortcomings of Financial Statements From the Security Analyst's Point of View." The Journal of Accountancy, 8U (November, 1947), pp. 368-75*

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185

Goudeket, A. "An Application of Replacement Value Theory." The Journal of Accountancy, 110 (July, I960), pp. 37—U7•

Grady, Paul. "Economic Depreciation." The Journal of Accountancy, 107 (April, 1959), PP. 5U-60.

Graham, Willard J. "The Effects of Changing Price Levels Upon the Determination, Reporting, and Interpretation of Income." The Accounting Review, XXIV (January, 19^9), pp. 16-26.

Hennessy, Daniel J. "Survey Reveals Information People Want to Know about a Corporation." The Journal of Accountancy, 86 (Sep­tember, 19U8), pp. 22U-7.

Horngren, Charles T. "Security Analysts and the Price Level." The Accounting Review, XXX (October, 19$$), pp. 575-81.

Iji, Yuji. "PRD." Stanford Graduate School of Business Bulletin, Winter, 1966, pp. 16-9.

Jennings, Alvin R. "Present-Day Challenges in Financial Reporting." The Journal of Accountancy, 105 (January, 1958), pp. 28-3U.

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Kohler, Eric L. "Why Mot Retain Historical Cost?" The Journal of Accountancy, 116 (October, 19o3), po. 35-Ul.

Kracke, E. A. "The Surplus Debate Begets Surplusage." The Journal of Accountancy, 81 (April, 19U6), pp. 273-81.

Krebs, William S. "Asset Appreciation, Its Economic and Accounting Significance." The Accounting Review, V (March, 1930), pp. 60-9.

Lund, Reuel I. "Realizable Value as a Measurement of Gross Income." The Accounting Review, XVI (December, 19Ul), pp. 373-85.

McCleary, Robert H. "Three Applications of Price Indices in Property Accounting." NAA Bulletin, XLIII (March, 1962), pp. 35-52.

Ma, Ronald. "A Comparative Review of Some Price Level Accounting Systems." Abacus, 1 (December, 1965), pp. 107-30.

McEachren, John W. "Use of Replacement Figures in Cost Accounting for Pricing and Income-Statement Purposes." The Journal of Ac­countancy, 88 (July, 19U9), pp. 21-7.

186

May, George 0. "Limitations on the Significance of Invested Costs - " The Accounting Review, XXVII (October, 1952), pp. Ii36-U0.

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Myers, John H. "The Critical Event and Recognition of Net Profit." The Accounting Review, XXXIV (October, 1959), pp. 528-32.

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Parker, R. H. "Lower of Cost and Market in Britain and the United. States: An Historical Survey." Abacus, 1 (December, 1965), pp. 156-72.

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. "Depreciation—Concept and Measurement." The Journal of* Accountancy, 108 (October, 1959), pp. 38-1*3

. "Measuring Profits Under Inflation Conditions: A Serioizs Problem for Accountants." The Journal of Accountancy, 89 (January, 1950), pp. 16-27.

Peck, Robert !\T. "Use of Appraisals Urged in Present Depreciation. " The Journal of Accountancy, 81+ (December, 19U7), pp. U5>9-60.

Peloubet, Maurice E. "An Indictment of the Accounting Profession for Failing to Deal with Effects of Inflation." The Journal of Accountancy, 96 (December, 1953), pp. 715-22.

Research Department of the American Institute of Certified Public Accountants. "An Inquiry into the Reliability of Index Numbers." The Journal of Accountancy, 87 (April, 19U9). pp. 312-9.

Rosenfield, Paul. "Accounting for Inflation—A Field Test." The Journal of Accountancy, 127 (June, 1969), pp. U5-50.

Sanders, T. H. "Fixed Assets in the Balance Sheet." The Journal of Accountancy, 59 (April, 1935), pp» 250-65.

187

Solomons, David. "Economic and Accounting Concepts of Income." The Accounting Review, XXXVI (July, 1961), pp. 37U-83.

Spear, Harvey M. "Depreciation Accounting Under Changing Price Levels." The Accounting Review, XXIV (October, 19h9), PP» 369-78.

Spiller, Earl A., Jr. "The Revenue Postulate—Realization or Recog­nition?" NAA Bulletin, XLIII (February, 1962), pp. Ul-7.

Sprouse, Robert T. "Observations Concerning the Realization Concept." The Accounting Review, XL (July, 1965), pp. 522-6.

Staff of The Journal of Accountancy. "What the Public Thinks About Financial Statements." The Journal of Accountancy, 83 (June, 19U7), PP. U67-9.

Survey of Current Business, U9 (July, 1969).

Technical Services Department of the American Institute of Certified Public Accountants. "Opinion Survey on Price-Level Adjustment of Depreciation." The Journal of Accountancy, 105 (April, 1958), pp. 36-H3.

Vance, Lawrence L. "Current Problems and Accounting Theory." The Accounting Review, XIX (July, 19UU), PP« 231-8.

"What's Wrong with Financial Reporting?" The Journal of Accountancy, 112 (August, 1961), pp. 28-33.

Weston, J. Fred. "Consistency and Changing Price Levels." The Ac­counting Review, XXIV (October, 19U9), pp« 379-86.

Wilcox, Edward B., and Greer, Howard C. "The Case Against Price-Level Adjustments in Income Determination." The Journal of Ac­countancy, 90 (December, 1950), pp. U92-50U.

Wixon, Rufus. "The Measurement and Administration of Income." The Accounting Review, XXIV (April, 19U9), pp. 18U-90.

Wyman, George F. "Is Surplus The Reserve?" The Accounting Review, XXIII (July, 19U8), pp. 285-8.

Zeff, Stephen A., and Maxwell, W. David. "Holding Gains on Fixed Assets—A Demurrer." The Accounting Review, XL (January, 1965), PP. 65-75.

. "Replacement Cost: Member of the Family, Welcome Guest, or Intruder?" The Accounting Review, XXXVII (October, 1962), pp. 611-25.

Unpublished Material

188

Backer, Morton. Financial Reporting for Security Investment and Credit Decisions'! New York: Unpublished draft, 1968.

Voth, Melvin H. "An Empirical Evaluation of Proposed Reform of Ac­counting Principles." Unpublished D.B.A. dissertation, Indiana University, 196U.