The Theory and Measurement of Business Income

The Theory and Measurement of

Business Income

The Theory and Measurement of

Business Income

By EDGAR O. EDWARDS PHILIP W. BELL

University of California Press

BERKELEY AND LOS ANGELES 1964

University of California Press Berkeley and Los Angeles, California

Cambridge University Press London, England

© 1961 by The Regents of the University of California

Second Printing, 1964 Library of Congress Catalog Card Number: 61-7534 Printed in the United States of America

To Our Parents

Preface

This book is an attempt to develop a meaningful theory of business income and to show how it can be applied in terms of accounting records and reports. It attacks directly problems which, because they have fallen in that no mans land between economics and accounting, have seldom been explored systematically. And when such efforts have been made, as in the case of Irving Fisher’s The Nature of Capital and Income, they have not received the attention they deserve.

The need for development of a rigorous concept of business income, one which rests on sound theoretical underpinnings yet is measurable in practice, is indisputable. Business income is one of the key elements of information upon which the functioning of a private, free enterprise economy depends. A proper measure of such income is essential for sound business management, for the internal evaluation of business decisions taken in the past in order to make better decisions relating to an uncertain future. It is needed by persons or groups outside the firm, such as investors, creditors, and even regulatory agencies to judge the performance of individual firms and make comparisons among different firms or groups of firms, for such outsiders also influence the allocation of resources in the economy. Finally, a sound concept of business income is essential if there is to be equity in matters of taxation.

The problem of income measurement has been an especially perplexing one in part because economists have approached it with essentially subjective concepts derived from expectations concerning future events, while accountants have insisted on objectivity and the measurement of actual, unfortunately often historic, events. The apparent impasse between these two points of view has led many to resign themselves to the impossibility of reconciliation, and thus has tended to widen the gap between the two disciplines. Yet, except for the difference in perspective, the two often deal with related problems and rely on similar data. Because both points of view have proved themselves so useful in regard to their own special problems, a reconciliation is needed which does not at the same time destroy either the subjective approach of the economist or the accountant’s emphasis on objective events. Our major theoretical effort is directed to this end.

The central concept of business income which emerges depends upon objective events but differs in many respects from the traditional concept employed by accountants. While many readers may feel inclined to skim over the theoretical half of the book, the developments there are necessary, we feel, to a full understanding of the limitations inherent in the traditional accounting concept and of the modifications necessary to eliminate them. These modifications depend upon an understanding of the theory of the behavior of the firm under conditions of uncertainty, and upon the relating of concepts of value to this behavior. They also depend upon a clear recognition of the distinction between changes in prices of individual asset and liability items and changes in the general price level. In part we are trying in this work to fill the void indicated by Professors Moonitz and Nelson in their 1960 survey of accounting theory:

If accountants and businessmen are so indifferent to the impact of inflation that they ignore it in their financial statements, why should Congress and the Treasury be ready to recognize it in the income tax return? And if the type of tax relief we do get is unpalatable to us as theorists, to what extent does the fault lie in our failure to develop a clear, cogent theory of the relationship among changes in individual prices, in the general price-level, and the conventional standards underlying the preparation of financial statements?1

While one principal concept of income, a concept which we term business profit, stems from the theoretical chapters relating to the theory of the firm, we recognize that business income measurements serve many purposes, from the evaluation of business decisions through reports to owners and tax authorities to the aggregation of data on industries and the economy as a whole. Accounting techniques are needed, therefore, which are sufficiently flexible to provide data for the business profit concept as well as for certain additional profit concepts, shown to be intimately related to business profit, but techniques which at the same time do not burden the firm with the unnecessary cost of multiple daily records. The second half of the book is devoted to the development of such techniques. We attempt to demonstrate the feasibility of accumulating data which can be used in a flexible manner to yield all the necessary measures of profit and their components, but which nevertheless involve only end-of-period adjustments in accounts maintained according to existing practices.

The principal stumbling block to the implementation of such a system, the matter of practicality, is examined in the concluding chapter. We feel that this hurdle, however, may be largely imaginary, a product of viewing current needs against historic resources. In a dynamic economy even criteria of practicality are subject to rapid change.

In works of close joint authorship, such as this, the responsibility for the writing of individual chapters is often hazy even before they are put on paper and tends to become very much blurred during the process of revision and rewriting. The ideas basic to Part One, however, were originally worked out by Mr. Edwards while he was in Sweden in 1954-55 as a John Simon Guggenheim Memorial Fellow on leave from Princeton University.

It is literally impossible to identify all those who have been land enough to read parts or all of the manuscript at one stage or another and who have contributed comments. Especially helpful were Professors W. T. Baxter, of the London School of Economics, S. T. Beza, of Princeton University, D. S. Brothers, of Rice University, S. Davidson, of the University of Chicago, L. A. Doyle and M. Moonitz, of the University of California, Berkeley, G. V. Rimlinger, of Rice University, A. W. Sametz, of New York University, and J. Worley, of Vanderbilt University, each of whom read all of an early draft of the manuscript and offered many thoughtful suggestions. We have also been aided by various of our students who have worked through parts of the manuscript or debated some of the ideas contained therein with us.

Mr. Edwards wishes to acknowledge support from the Guggenheim Foundation for help in financing his year in Sweden in 1954-55, and from the Ford Foundation for research funds administered through Princeton University during the summer of 1958. Mr. Bell wishes to acknowledge support from the Social Science Research Council and the Earhart Foundation for help in financing a year of research in London in 1956-57. Both authors are indebted to the Institute of Business and Economic Research of the University of California for financing the typing of the final manuscript. Finally, but only because it is customary, we wish to express appreciation to our wives, who have held their breath, if not their tongues, while grudgingly typing draft after draft.

Edgar O. Edwards

Hargrove Professor of Economics

Rice University

Philip W. Bell

Associate Professor of Economics Haverford College

1 M. Moonitz and C. L. Nelson, Recent Developments in Accounting Theory, Accounting Review 35 (April, 1960), p. 213.

Contents 1

Contents 1

I The Problem and the Challenge:

DEMAND FOR DATA IN A DYNAMIC ECONOMY

Managerial Competition

Evaluation of Business Decisions

SUPPLY OF DATA AND THE STATIONARY STATE

The Necessary Assumptions for Validity: The Stationary State

Substitution of Three Accounting Conventions

THE GAP AND THE DEGREE OF ERROR

Price Level Error

Price Dispersion Error

EFFORTS TO CLOSE THE GAP

Real Income and the Price Level School

Economic Concept of Income

DIFFERENTIAL PRICE MOVEMENTS AND THE THEORY OF BUSINESS PROFIT

II Core of the Theory:

Economic Plan of the Firm Nature of Profit Maximization

Subjective Value as a Criterion in Business Decisions

SUBJECTIVE PROFIT AND EVALUATION OF BUSINESS DECISIONS

Expected Subjective Profit

Subjective Profit of a Past Period

AN ALTERNATIVE FORMULATION: REALIZABLE PROFIT

Expected Realizable Profit

Conversion of Subjective Goodwill into Market Value

Realizable Profit and Evaluation of Expectations Relationship between ex post Realizable and Subjective Profit

General Significance of Realizable Profit

Levels of Decision Evaluation

APPENDIX A: DETERMINATION OF SUBJECTIVE VALUES

APPENDIX B: A RECONCILIATION OF REALIZABLE PROFIT AND SUBJECTIVE VALUE

III The Theory Extended:

CONCEPTS OF VALUE AND COST Dual Flow of Assets through Production

Distinction between Operating Profit and Holding Gains

The Dimensions of Value

REALIZABLE PROFIT AND ITS COMPONENTS

Opportunity Cost: The Basis for Valuation

Production Moments and Holding Intervals

The Realizable Profit Matrix

Treatment of Sales and Acquisitions

Characteristics of Realizable Profit Summarized

BUSINESS PROFIT AND ITS COMPONENTS Production and Time Dimensions of the Realization Criterion

Current Cost: The Basis for Valuation

The Business Profit Matrix

Characteristics of Business Profit Summarized

THE CONCEPTS COMPARED AND THE THEORY EXTENDED

Comparison in Terms of Internal Uses

Comparison in Terms of External Uses

The Concepts Related

Some Practical Considerations

IV Consolidation of the Theory:

THE COMPONENTS IDENTIFIED

Current Operating Profit and Realizable Cost Savings

Realized Cost Savings

Realized Capital Gains

THREE CONCEPTS OF MONEY PROFIT:

Accounting Profit and Its Limitations

Accounting Principles for Developing Realized Profit

Accounting Principles for Developing Business Profit

Some Advantages of Flexibility in Accounts

MODIFICATIONS INTRODUCED FOR PRICE LEVEL CHANGES

Real and Fictional Elements of Capital Gains and Cost Savings

Modified Concepts of Measurable Profit

Intertemporal Comparisons

SUMMARY OF PROFIT CONCEPTS

V Application to Inventories

IMPORTANCE OF INVENTORY VALUES IN COST OF GOODS SOLD

PRINCIPLES OF INVENTORY COSTING

The FIFO Method

The LIFO Method

The Current Cost Method Computing Current Costs, Asset Values, and Profit Components

Introducing Current Costs into the Accounts

COMPARISON OF PROFIT CONCEPTS FOR A GIVEN PERIOD

COMPARISON OF PROFIT CONCEPTS OVER TIME

SUMMARY AND A LOOK AHEAD

VI Application to Fixed Assets:

IMPORTANCE OF FIXED ASSET VALUES IN MEASUREMENT OF PROFIT

DEPRECIATION OF FIXED ASSETS: PRINCIPLES AND PROCEDURES WHEN PRICES ARE FIXED

Determination of Asset Life

Pattern of Asset Services and Timing of Depreciation Charges

ADJUSTING FOR PRICE CHANGES: THE CURRENT COST METHOD

Computing Current Costs

Profit Components and Balance Sheet Values

Introducing Current Costs into the Accounts

COMPARISON OF PROFIT CONCEPTS

VII Concepts of Money Profit:

TREATMENT OF MONEY CLAIMS

Cash and Other Short-Term Claims

Securities Promising No Fixed Return

Fixed Return Securities

END-OF-PERIOD ADJUSTMENT PROCESS

THE FUNDAMENTAL STATEMENTS

USEFULNESS OF CURRENT COST DATA

Decision-Making and Evaluation

Stability and Cyclical Effects of Current Operating Profit and Holding Gains

Tax Effects of Current Cost Data

VIII Concepts of Real Profit:

COMPUTATION OF BASIC DATA

Fictional Realizable Cost Savings

Fictional Realized Cost Savings and Capital Gains

Computation of Real Gains

THE FUNDAMENTAL STATEMENTS Real Profit Statement

Real Comparative Balance Sheet

Statements Wholly in End-of-Period Dollars

THE ACCOUNTS AND THE ACCOUNTING TECHNIQUE

A COMPARISON WITH PRICE-LEVEL-ADJUSTED HISTORIC COST DATA

USEFULNESS OF REAL DATA

Relevance for Decision-Making and Evaluation

Measurement of Real Rates of Return

Real Burden of Taxes

IX Summary and Conclusions:

GENERAL OBJECTIVES OF ACCOUNTING MEASUREMENT

PROFIT-OBIENTED BEHAVIOR OF THE BUSINESS FIRM

IMPLICATIONS FOR ACCOUNTING

NATURE OF REQUIRED MODIFICATIONS

Opportunity Cost versus Current Cost Values

Proper Separation of Operating and Holding Gains

Recognition of Gains As They Accrue

Separation of Real and Fictional Gains

THE ACCOUNTING TECHNIQUES

THE HURDLE OF PRACTICALITY

Extensive Codification an Obstacle to Change

The Practical Matter of Objectivity

The Search for Accuracy

Difficulties Introduced by Technological Change

Complexity and the Question of Costs

The Training Problem

Selected Bibliography

Index

I The Problem and the Challenge:

ECONOMIC NEEDS AND ACCOUNTING RESPONSIBILITIES

The suggestion that accounting and economics are related sciences is not a new one. Both are intimately concerned with the activities of the business firm, and in this context both deal with similar variables and their impact on profit. Yet the difference in time perspective which distinguishes the two sciences from each other has served also to keep them further apart than logic would suggest. It is true, of course, that for much of economics the past is dead, whereas for much of accounting it is the future which is nonexistent. Economics deals with the future and the decisions which will determine that future, while accounting is primarily concerned with historical description. It is our contention, however, that this difference in time perspective, far from being a divisive factor, provides the principal relationship between accounting and economics. We intend to establish this relationship in this chapter, to explore the function of accounting data in this light, and to examine briefly the extent to which existing accounting principles and various suggestions for their modification fulfill this function.

DEMAND FOR DATA IN A DYNAMIC ECONOMY

The economics of the firm is essentially the economics of decision-making: How should the managers of a firm allocate its resources in order to maximize profit? The kind of decisions that must be made can be grouped, in accounting terminology, under three headings: (1) what value of assets to hold at any time (the expansion problem), (2) in what form to hold these assets (the composition problem), and (3) how to finance the holdings of assets (the financial problem). To make these kinds of decisions, for example, whether to replace a machine, to develop a new research laboratory, to build a new plant, to produce a new product, to select a different process of production, management must entertain expectations about future events. If we leave luck aside for a moment, the successful management is one that acts upon expectations that are relatively accurate. And any management that can increase the relative accuracy of its expectations and the ability of the firm to act upon those expectations should increase the profitability of the firm.

Managerial Competition

This pressure to increase what we might call managerial ability is a product of a dynamic society. In a stationary state where tastes, technique, and resources remain constant through time,1 such pressures are nonexistent because the future is certain. The existence of certainty about the future follows automatically from the conditions of constant demand for and supply of both factors and products. It is uncertainty that breeds a demand for managerial ability and creates the pressures to increase that ability over time. Tastes, technology, and resources are in fact constantly changing, and the uncertainty that accompanies these changes makes business decisions necessary. As efforts are made to increase the ability of management to collect and communicate data, to develop relationships among variables, to analyze data according to these relationships, and to act upon the resulting information, the profit-making potential of a firm may increase. Whether this potential will be successfully realized or not depends upon the changing complexity of the problems management must analyze. If this complexity increases more rapidly than the managerial ability needed to solve them, profit realized by a firm may well decline. One of the important contributors to problem complexity is undoubtedly the rate of increase of managerial ability in competitive firms. To be successful over time, then, a firm must not only employ top-level management but it must also be geared to increase its managerial ability at a rate at least as great as that in business generally. It is a high relative, not absolute, level of managerial ability that is most likely to result in higher profit.

The hypothesis that managerial ability tends to increase over time accords closely with observable facts. The increasing proportion of managerial personnel to nonmanagerial personnel, the weight given higher education in the recruitment of junior executives, the intensified executive training programs in many business firms, the increasing emphasis on product and market research, experiments in managerial organization, and the development of extensive computation centers are but a few examples of the abundant evidence.

1 lrThe stationary state also implies that savings and investment are zero, that income equals product, that actual prices experienced by entrepreneurs equal prices expected by them, and that the money rate of interest equals the real rate of interest. See J. R. Hicks, Value and Capital, pp. 117-119.

Evaluation of Business Decisions

It is in the evaluating of business decisions, we believe, that the demand for accounting data exists. For unless one holds firmly that all decisions are essentially intuitive in nature, the improvement of managerial ability and related decision-making processes must lean heavily upon an evaluation of past decisions. And of all the alternative courses of action considered in past decisions, the most important one, of course, is the alternative that was in fact adopted. We suggest, therefore, that a principal function of accounting data is to serve as a fundamental tool in the evaluation of past decisions, a function that would clearly not exist in a stationary state.1

The mass of accounting data is accumulated voluntarily by the individual firm. It is true, of course, that the demands of certain external parties influence the kind of data gathered by the business firm. The tax authorities, the owners of the firm, security analysts, and the public at large should probably be counted among those who influence the kind of data produced. Nevertheless, the bulk of accounting data is never made available to people outside of the business firm itself. Thus it seems safe to conclude that accounting information must principally serve the functions of management. In this sense accounting data serve as a means of protecting against fraud or theft; but, much more important, the data serve as a means of evaluating business decisions, thereby contributing (1) to the control of current events in the production process, (2) to the formulation of better decisions in the future, and (3) to the modification of the decision-making process itself. It is the development of data to serve the evaluation function that is of primary concern to us in this book.

The overwhelming test of the adequacy of accounting data as developed for any particular period must be their comparability with the expectations originally specified for that period. Where economics deals with a set of expectations and an expected profit which represents a summary of those expectations, accounting attempts to develop a list of actual events and the actual profit which results from them. Properly formulated, a comparison of these two views of the events of a period should reveal errors in expectations, and these errors, properly analyzed, should serve as a basis for altering events where such control is possible or for altering expectations where the events themselves cannot be controlled. For example, if the amount of raw material used in production is higher than expected, an attempt might be made to reduce waste, but if the price at which it is purchased is market-determined and higher than expected, management would probably alter its expectations of that price in the future. The effective isolation of errors in expectations requires, of course, that the accounting data developed be directly comparable with the set of expectations originally specified. This means clearly that, insofar as possible, accounting data must measure the actual events of a particular period, no more and no less. Events of earlier periods must not be confused with events of the current period; nor must any events of the current period be omitted. We shall find this criterion useful in evaluating the existing set of accounting principles.

While accounting data must serve internal functions first, it does not follow that the kind of data developed will be useless if made available to outsiders. That outside users of accounting data such as stockholders, stock analysts, labor union officials, government statisticians and policy makers, and economists are mostly by-product beneficiaries is undeniable. Certain data are made available to tax authorities and regulatory agencies as a matter of law, but other external users cannot insist on data of any kind; rather they must be satisfied with what is offered them. Nevertheless, both a growing sense of social responsibility and an awareness of what may be considerable self-interest at stake are leading businessmen to be more and more concerned about the external users of accounting data. Further, many outside uses of accounting data may be of help to the businessman himself. Economists’ research on business growth, efficiency, and relative profitability, for example, may contribute directly to the improvement of business decisions; business managers are coming to depend upon national income data, input-output tables, flow-of- funds reports, and the like in making plans for the future. Published accounting data should serve other social functions as well: promoting a more efficient allocation of capital, calling attention to monopoly profits, and providing relative profitability figures to potential entrants into an industry, for example. Whether the kind of data developed for the internal purposes of the business firm will serve these external functions equally well is a matter we shall want to investigate. But just as management uses such data primarily for purposes of evaluation, most external uses involve similar evaluations. It should not be surprising then if the same set of accounting principles can be used to develop data suitable to external as well as to internal users.

It has been pointed out that if the demand for data is predicated largely upon the existence of change and uncertainty in the economy, accounting data, to be most useful, should be designed to report changes as they occur. Unfortunately, the kind of accounting data currently being developed for both internal and external users falls far short of this ideal. To highlight this deficiency, we shall take as our first task the demonstration that traditional accounting procedures are predicated implicitly on the utter absence of change.

1 a For an excellent discussion of this hypothesis, see H. V. Finston, Managerial Development: Challenge to Accountants, pp. 32-35. (For full citation of references, see Selected Bibliography.)

SUPPLY OF DATA AND THE STATIONARY STATE

Over a great many years, going back before the famous treatise by Pacioli on double-entry bookkeeping, accounting has slowly been developed into a systematic body of knowledge through gradual acceptance of certain ad hoc conventions and principles which can be applied to specific problems.1 When this complex of practices is peeled away and the basic framework laid bare, it is clear that present-day accounting would yield accurate and truthful results only under very special circumstances. A critical analysis of the premises underlying accounting practices and of the conventions and principles which accountants follow in order to bypass these obviously unreal assumptions will help to indicate the nature of the gap between the demand for and supply of accounting data.

1 ⁸For some interesting early history of some of these developments, see W. T. Baxter, Studies in Accounting and A. C. Littleton and B. S. Yamey, Studies in the History of Accounting, as well as Littleton’s older Accounting Evolution to 1900. The best treatment of the development of specific principles and conventions is Littleton’s Structure of Accounting Theory.

The Necessary Assumptions for Validity:

The Stationary State

The basic purposes of accounting are to measure for a business unit1 its efforts (costs), its accomplishments (revenues), its sue-cess (the difference) over time, and its position (what it owns and owes) at any moment of time. These purposes are represented among a firm’s published reports by the profit and loss statement and the balance sheet. The functional assumptions of accounting outlined below are a description of a set of conditions under which these statements, as presently compiled, would be complete, truthful, and unambiguous.

1. Money unit of account assumption.—It must be assumed that all activities and properties relevant to the firm can be measured in terms of money and that the purchasing power of money is stable so that its uses as a unit of account and as a standard of value are complete, truthful, and unambiguous.

2. Cost-market value identity assumption.—It must be assumed that the cost of anything purchased or produced is equal to its market value. In its raw form this means that the present market value of plant and equipment and the values of its services can be derived from its original cost. It also implies that the costs of all factors of production attach to the product produced and that this accumulated cost is equal to the market value of the product. Keeping records in terms of cost is therefore a legitimate practice.

3. Certainty assumption.—It must be assumed that the future is known to the firm for certain. Only then can the allocation of costs and revenues among past, present, and future periods be certain. This is necessary if the operations of a continuing firm are to be measured accurately for fiscal periods.

The accountant might hesitate to accept these assumptions as his own, but they are necessary to ensure the accuracy of the data he collects. He does (1) keep records in money terms, (2) measure values in terms of costs, and (3) make reports for fiscal periods. If data collected and reported in this fashion are to yield complete, truthful, and unambiguous results, (1) all raw data must be measurable in money units and prices must be constant, (2) cost and market value must be identical, and (3) knowledge of pertinent future events must be certain. Only then would the techniques the accountant applies be safe from criticism.

It is perhaps paradoxical that the practical science or art of accounting can be related, even remotely, to such unreal assumptions. Yet all elements of a firm’s operation and position must be measurable in money terms if statements are to reflect the full relevance to the firm of its activities. The relevant elements must be identifiable, and appropriate values must be assignable. The unit in which these values are measured must be stable if ambiguity is to be avoided; the difficulty of comparing money profits over time when the price level has been changing is an abvious example of possible ambiguity. Few would deny the necessity of the first assumption if current accounting techniques are to yield the desired results.

The identity of cost and value is a harsh assumption. Yet recordkeeping on the basis of cost can be fully vindicated only if the condition holds. The current position of a firm suggests a description in terms of market values. To develop such a description in the records would necessitate the recognition of profit as market values change rather than at the point of sale (goods in process, for example, could not otherwise be recorded at market value). Thus, in order to describe completely and truthfully with present accounting techniques the current position of a firm and its profit as it accrues, recorded costs must be equal to market values.2

The certainty assumption is necessary if the arbitrary allocations of cost among different periods is to be unambiguous. Because many firms have a long life span the development of interim statements and the use of the fiscal period device are mandatory. But the accurate measurement of the operations of a firm for short periods requires, in addition, that the firm be in possession of complete and certain knowledge of future events. The cost of a plant whose use extends over several fiscal periods cannot be allocated correctly among periods without this full advance knowledge of the extent and value of its use in future periods. Without certainty, errors in judgment would often be discovered after cost allocations had been made, and some errors might never be fully determined.

To summarize, present accounting practices would be fully valid only if prices, quantities, and qualities of both factors and products were unchanging over time, i.e., if there were a stable general price level (the first assumption), stable individual prices (the second assumption), and perfect certainty about the future (the third assumption). But this is a situation clearly