Tentative of Broad Acccounting Priciples For Business Enterprises

University of Mississippi
eGrove
American Institute of Certified Public Accountants
Guides, Handbooks and Manuals
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1-1-1962
Tentative set of broad accounting principles for

business enterprises; Accounting research study no.
03
Robert Thomas, 1922-2007 Sprouse
Maurice Moonitz
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Sprouse, Robert Thomas, 1922-2007 and Moonitz, Maurice, "Tentative set of broad accounting principles for business enterprises;
Accounting research study no. 03" (1962). Guides, Handbooks and Manuals. 149.
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AN
3
A C C O U N T I N G
A TENTATIVE SET
OF BROAD ACCOUNTING
R E S E A R C H
PRINCIPLES FOR
BUSINESS ENTERPRISES
S T U D Y
By Robert T. Sprouse, Ph.D. and Maurice Moonitz, Ph.D., CPA

A I C P A
This research study is published for discussion purposes. I t does not represent
the official position of the American Institute of Certified Public Accountants.
S T A T E M E N T O F P O L IC Y
The Director of Accounting Research of the American Institute of Certi

fied Public Accountants publishes this accounting research study under his
authority to circulate the results of the research activities of his staff.
Accounting research studies are designed to provide professional ac
countants and others interested in the development of accounting with a
discussion and documentation of accounting problems. The studies are
intended to be informative, but tentative only. They furnish a vehicle for
the exposure of matters for consideration and experimentation prior to the
issuance of pronouncements by the Accounting Principles Board.
The responsibility for this study is that of the Director of Accounting
Research and those who have been associated with him in the project. The
conclusions and recommendations have not been approved, disapproved, or
otherwise acted upon by the Accounting Principles Board, the only agency
of the American Institute of Certified Public Accountants having authority
to make or approve public pronouncements on accounting principles. The
study does not necessarily reflect the views of the Board, nor has it been
acted upon by the membership or by the governing body of the Institute.
Individuals and groups are invited to express their views in writing on
the conclusions and recommendations contained in this study. These views
will be considered by the Accounting Principles Board in forming its own
conclusions on the subject.
A TENTATIVE S E T
OF BROAD ACCOUNTING
PRINCIPLES FOR
ACCOUNTING
RESEARCH
STUDY NO. 3
A TENTATIVE SET
OF BROAD ACCOUNTING
PRINCIPLES FOR
By Robert T. Sprouse, Ph.D.

University of California
and
Maurice Moonitz, Ph.D., CPA
American Institute of CPAs
AMERICAN
INSTITUTE
OF CPAs
Copyright 1962 by the
American Institute of Certified Public Accountants
666 Fifth Ave., New York 19, N. Y.
This research study is published for discussion purposes. It does not

represent the official position of the American Institute of Certified Public
Accountants.
A m e ric a n I n s t i t u t e o f C e r tif ie d P u b lic A c c o u n ta n ts
666 Fifth Avenue New York 19, N. Y.
Statement by
the Accounting Principles Board
The Accounting Principles Board has received Accounting Research Study
No. 3, “A Tentative Set of Broad Accounting Principles for Business Enter
prises,” by Robert T. Sprouse and Maurice Moonitz. The Board previously
had received Accounting Research Study No. 1, “The Basic Postulates of
Accounting,” by Maurice Moonitz. Study No. 1 was published in Septem
ber 1961 and Study No. 3 is scheduled for publication toward the end of
April 1962.
In the opinion of the Director of Accounting Research, these two studies
comply with the instructions to the Accounting Research Division to make
a study of the basic postulates and broad principles of accounting. Prior
to its publication, Study No. 3 has been read and commented upon by a
limited number of people in the field of accounting. Their reactions range
from endorsement of the ideas set forth in the study of “Broad Principles”
to misgivings that compliance with the recommendations set forth by the
authors would lead to misleading financial statements. The Board is there
fore treating these two studies (the one on "Postulates” and the other on
“Principles”) as conscientious attempts by the accounting research staff to
resolve major accounting issues which, however, contain inferences and
recommendations in part of a speculative and tentative nature.
The Board feels that there is ample room for improvement in present
generally accepted accounting principles and a need to narrow or eliminate
areas of difference which now exist. It hopes the studies will stimulate
constructive comment and discussion in the areas of the basic postulates and
the broad principles of accounting. Accounting principles and practices
should be adapted to meet changing times and conditions, and, therefore,
there should be experimentation with new principles and new forms of
reporting to meet these conditions. The Board believes, however, that while
these studies are a valuable contribution to accounting thinking, they are
too radically different from present generally accepted accounting principles
for acceptance at this time.
After a period of exposure and consideration, some of the specific rec
ommendations in these studies may prove acceptable to the Board while
others may not. The Board therefore will await the results of this exposure
and consideration before taking further action on these studies.
April 13, 1962
Table of Contents
Page
P R E F A C E .....................................................................................................................................ix
Chapter
1............................................................................................. 1
Introduction, 1
Definition of financial statements, 3
Balance Sheet and Income Statement, 4
The Foundation for the Principles, 6
Postulate A-1. Quantification, 6
Postulate A-2. Exchange, 6
Postulate A-3. Entities, 6
Postulate A-4. Time period, 6
Postulate A-5. Unit of measure, 6
Postulate B-1. Financial statements, 6
Postulate B-2. Market prices, 6
Postulate B-3. Entities, 6
Postulate B-4. Tentativeness, 7
Postulate C-1. Continuity, 7
Postulate C-2. Objectivity, 7
Postulate C-3. Consistency, 7
Postulate C-4. Stable unit, 7
Postulate C-5. Disclosure, 7
Definitions, 8
Financial statements, 8
Assets, 8
Cost, 8
Depreciation accounting, 8
Depreciation for any given period, 8
Liabilities, 8
Owners’ equity, 9
Invested capital, 9
Retained earnings, 9
Net profit, 9
Net loss, 9
Revenue, 9
Expense, 9
Gains, 9
Losses, 9
v
Chapter Page
2 ............................................................................................................... 10
Broad Principles and Historical Limitations, 10
Profit and Business Activity, 10
The realization of profit, 13
The determination of profit and the valuation of
assets, 15
Note on the price-level problem, 17
3 19
Nature of Assets, 19
Definition of Assets, 20
Asset with zero value, 21
Asset Forms, 21
4 23
Measurement of Assets, 23
Money or claims to money, 24
Other assets: general considerations, 25
Inventories, 27
Comparison with current procedures, 30
Plant and equipment, 32
Land, 35
The “intangibles,” 36
Investments, 36
5 37
The Nature of Liabilities and Owners Equities, 37
Measurement of Liabilities, 39
Measurement of Owners’ Equities—Business
Corporations, 41
Invested Capital, 42
Retained Earnings (Earned Surplus), 43
Unincorporated Business, 44
6 45
'Nature of Profit, 45
Revenue, 46
Expense, 49
Gains and Losses, 50
Corrections of the Measurements of Prior Periods'
Earnings, 52
vi
Chapter Page
7. SUMMMARY . 53
Definitions, 53
Financial statements, 53
Assets, 54
Cost, 54
Depreciation for any given period, 54
Liabilities, 54
Owners' equity, 54
Invested capital, 54
Retained earnings, 54
Net profit, 54
Net loss, 54
Revenue, 54
Expense, 54
Gains, 54
Losses, 54
Summary of Principles, 55
COMMENTS OF ANDREW B A R R ..............................................................................60
COMMENTS OF CARMAN G. B L O U G H ..................................................................60
COMMENTS OF ARTHUR M . CANNON................................................................. 63
COMMENTS OF OSCAR S. G E L L E IN ....................................................................... 6 6
COMMENTS OF PAUL G R A D Y ................................................................................... 67
COMMENTS OF HERBERT E . M I L L E R ..................................................................76
COMMENTS OF LEONARD S P A C E K ........................................................................77
COMMENTS OF W ILLIA M W . W E R N T Z ............................................................79
COMMENTS OF JOHN H. Z E B L E Y , JR ................................................................... 83
SELECTED BIBLIOGRAPHY............................................................................................... 84
vii
Preface
This study is a companion to Accounting Research Study No. 1, "The

Basic Postulates of Accounting,” by Maurice Moonitz, and completes
the initial assignment of the Accounting Research Division of the
American Institute of Certified Public Accountants to study the basic
postulates and the broad principles of accounting. The first draft of
this study was prepared by Robert Sprouse. It was then entirely
reworked in the light of the findings of the postulates study in order to
integrate the two projects.
As in the case of the postulates study, the members of two advisory
committees rendered valuable assistance at all stages of the work. The
committee on broad accounting principles was under the chairmanship
of John H. Zebley, Jr., with Andrew Barr, Carman G. Blough, Paul
Grady, George S. Hills, and Herbert E. Miller as the other members.
The committee on basic accounting postulates consisted of Arthur M.
Cannon, as chairman, Martin R. Gainsbrugh, Oscar S. Gellein, C. A.
Moyer, Leonard Spacek, and William W. Werntz. Members of these
advisory committees reviewed the plan for research in its early stages,
acted as a sounding board for conclusions reached by the staff, and
advised the Director of Accounting Research as to the suitability of
the study for publication. The responsibility for the study, however,
is that of the Director of Accounting Research, and not that of the
members of the advisory committees. The association of the members
of the advisory committees with this project does not constitute an
endorsement by them of the findings or the recommendations set forth.
Under the rules of procedure of the Research Division, however, each
member of an advisory committee has the right to have his comments
included in the published study, if he so desires. In this regard we
call attention to the views of Andrew Barr, Carman G. Blough, Arthur
M. Cannon, Oscar S. Gellein, Paul Grady, Herbert E. Miller, Leonard
Spacek, William W. Werntz, and John H. Zebley, Jr. which follow
immediately after the concluding chapter of our study.
Throughout this project we have tried to hold to three guidelines,
ix
(1) to make sure that the principles we set forth were compatible
with the “basic postulates” of Accounting Research Study No. 1, (2 )
to carry the analysis, discussion, and illustrations far enough to make
clear the implications of the principles but not so far as to convert
the study into a handbook or manual of procedure, and (3 ) to formu
late recommendations that can actually be reduced to practice in the
light of the present level of knowledge about economic and business
affairs.
New York, N. Y., April 1962 T. S p r o u s e

R o b ert
Associate Professor of Accounting
University of California
M a u r ic e M o o n it z
Director of Accounting Research
American Institute of CPAs
X
1
Introduction
Accounting is concerned with the administration of economic re
sources. Since most productive resources are owned or controlled by
business enterprises, accounting has received its greatest challenge
as well as opportunity from their problems. Accounting supplies much
of the comprehensive and dependable information that management
needs to control and administer the resources in its charge efficiently
and productively. It also supplies the data that management needs
to fulfill its responsibility to report to owners, creditors, government,
and others with bona fide interests. In turn, these owners, creditors,
government, and others rely on accounting reports to assist them in
determining and evaluating the performance of management and the 1
business system.
The principles of financial accounting that are developed in this
study are designed to meet the needs of all interested groups. Ac
cordingly, they are necessarily set forth in broad terms of objectives
and major criteria. The complexities of modem business make it neces
sary to formulate more specific rules, beyond the principles themselves.
In a dynamic world, detailed rules need to be altered as conditions or
modes of thought change. But changes in the detailed rules do not
necessarily affect the broad principles and basic postulates, all of which
are comprehended in the term, generally accepted accounting prin
ciples.
Many forces have been at work over the past half century or more in
shaping the specific content of accounting and of published financial
statements. Two are of special importance:
(a) The need to determine if the “capital” of the accounting entity
has increased, decreased, or remained the same. This need is wide
spread, almost universal.
In the context of the business enterprise, “capital” has usually been
defined as identical with the ownership interests, but other uses are
permissible. For example, “capital” is also frequently defined to cover
the interests of all contributors of “permanent” capital, whether the
contributors hold shares of stock or evidences of indebtedness.
CHAPTER 1: INTRODUCTION
In the context of the entity without ownership interests (e.g.,

schools, churches, clubs, charitable organizations, governmental agen
cies, and other "nonprofit” organizations), "capital” is identified with
the resources entrusted to the entity or dedicated to the furtherance
of its objectives, and described by a variety of terms, such as fund
balances, fund equity, principal or corpus (of an estate or trust).
(b ) The need to determine the amount of profit subject to income
tax. This need is restricted by definition to those entities subject to
a tax measured by profit.
The question as to whether capital has been maintained or not is
of some importance in all forms of economic organization, is especially
important in the case of business enterprises, and, historically, has been
most important in the case of the business corporation. As the Study
Group has said, "Financial accounting becomes especially necessary
when forms of business organization are created in which management
and beneficial ownership may be disassociated; it has grown in impor
tance with the development of the private limited liability company.” 1
The consequent need to determine if a proposed distribution would
2 impair capital or not has made the amount of "profits available for
dividends” particularly significant.2
On balance the impact of income taxation on accounting practice
and its theory has been beneficial even though some tax rules are not
in accord with sound accounting. For one thing the taxing authorities
insist on books and records to support the tax return; for another thing
1 Study Group on Business Income, Changing Concepts of Business In

come (New York, 1952), pp. 21-22.
2 b i b l i o g r a p h i c a l n o t e : These developments can be traced in numerous
sources. A convenient source on “profits available for dividends” is Henry
Rand Hatfield’s Accounting: Its Principles and Its Problems (New York,
1927). The references at the end of each of his chapters cover the develop
ments in England and the U. S., and, to a lesser extent, in Germany and
France. Later (1941-42) Hatfield delivered the Dickinson Lectures, at
Harvard, published by the Harvard University Press in 1943 under the title
“Surplus and Dividends,” in which the same developments are reviewed
and brought up to date.
Starting in 1947, the Study Group on Business Income, financed jointly
by the American Institute of Certified Public Accountants and The Rocke
feller Foundation, conducted an extensive investigation, culminating in the
publication of its report under the title, Changing Concepts of Business
Income (New York, 1952). As part of its deliberations, the Study Group
published a series of special studies, the titles of which are listed in the
“Bibliography” of the Study Group’s report. These studies, together with
the amount and timing of the tax depend in large measure on the
results of the accounting process. A climate is therefore created in
which the resolution of accounting issues has important practical
consequences and discussion of accounting issues on all levels is
fostered.
The broad principles of accounting should apply just as much to
unincorporated as to incorporated enterprises. The combined effect
of the dividend and tax questions, however, has focused attention on
the financial statements of publicly held corporations. As one result,
“generally accepted accounting principles” have been formulated in
recent years largely to meet the problems of the corporation with
widespread share ownership. This development is understandable and
natural, perhaps inevitable. We shall endeavor, however, to view the
problems in a broader perspective, to develop principles that are more
widely applicable.
We also wish to point out that the principles developed below are
not intended to restrain or restrict the compilation and presentation of
other kinds of accounting or statistical data for internal purposes or
as supplementary information included in a published report as part 3
of the disclosure of significant information and as an aid to interpreta
tion of the financial data. In administering the enterprise, business
management always has needed and always will need data outside the
formal financial statements. We see no conflict, for example, between
(1) the compilation of data as to actual shipments of the current year,
unfilled orders at various times during the current year, and estimated
shipments of the next year, as a basis for planning operations, and (2)
the restriction of “revenue,” in a formal statement of the results of
operations of the same company, to shipments actually made, without
reference to unfilled orders or estimated shipments. The principles we
are concerned with are those which are relevant to the preparation of
formal reports on some aspect of financial position or of the results
of operations—reports which are made available to third parties as
representations by the management of the enterprise.
Definition of financial statements. The committee on auditing pro
the report itself, constitute a rich source of information and analysis on the
impact of business organization, tax laws, changing prices, and other forces,
on financial accounting.
A more recent source, somewhat specialized, is The Law of Accounting
and Financial Statements, by George S. Hills of the New York Bar, pub
lished by Little, Brown & Company, Boston, in 1957.
cedure has defined “financial statements” as those which purport to

show financial position and results of operations.3 For a given business
corporation they usually consist of a balance sheet, an income state
ment, an analysis of retained earnings, and an analysis of other changes
in stockholders’ equity. By extension of this definition, we include
supporting schedules (e.g., giving details of inventories or of plant
and equipment), elaborations of special aspects of business activity
(e.g., a statement or analysis of “cash flow”), rearrangements of under
lying data (e.g., a statement of source and application of funds), and
supplementary statements (e.g., a statement incorporating the effects
of price-level changes). The limits of the definition are implied in
Postulate B-1 which states that “the results of the accounting process
are expressed in a set of fundamentally related financial statements
which articulate with each other and rest upon the same underlying
data”4 (emphasis added).
In the interest of brevity, the discussion in this monograph centers
upon the balance sheet and the earnings statement as the two most
strategic financial statements. This concentration should not, however,
4 be construed as a denial of either the function or the importance of
any other financial statement which falls within the scope of the
definition given above.
Balance Sheet and Income Statement

One of the more apparent results of the influence of the forces re
ferred to above was the shift from emphasis on the statement of finan
cial position (balance sheet) to the statement of the results of opera
tions (earnings statement). This development is expressed in the
“Introduction” to Accounting Research Bulletin No. 43.5
. . . the problems in the field of accounting have increasingly
come to be considered from the standpoint of the buyer or seller
of an interest in an enterprise, with consequent increased recog
nition of the income statement and a tendency to restrict nar
rowly charges and credits to surplus. The fairest possible presen
tation of periodic net income, with neither material overstatement
nor understatement, is important, since the results of operations
3 Statement on Auditing Procedure No. 28, “Special Reports.” 1957. Para

graph 5.
4 The complete set of “basic postulates” is given on pages 6 and 7.
5 Restatement and Revision of Accounting Research Bulletins, American
Institute of Certified Public Accountants (New York, 1953), p. 7, par 3.
CHAPTER 1: BALANCE SHEET AND INCOME STATEMENT
are significant not only to prospective buyers of an interest in the

enterprise but also to prospective sellers. With the increasing
importance of the income statement there has been a tendency
to regard the balance sheet as the connecting link between suc
cessive income statements; however, this concept should not ob
scure the fact that the balance sheet has significant uses of its
own.
The results of the shift to the earnings statement have been mixed.
Some improvements have occurred, for example, with regard to the
classification of revenue, expense, and profit. In addition the extent
of disclosure of operating results and trends has vastly improved. At
the same time, however, a marked retrogression has occurred with
respect to certain elements of the balance sheet, notably inventories
and plant and equipment, and with respect to the related diversity of
acceptable methods of measuring expenses in the income statement.
Since the late 1930’s, for example, the last-in-first-out ( Lifo) method
of inventory pricing has been recognized as equally acceptable with
the first-in-first-out (Fifo) method. This has created a situation in
which identical business transactions result in substantially different 5
figures for cost of goods sold and for inventories, depending upon the
use of Lifo or of Fifo. Similarly, the existence of two acceptable tax
methods for treating intangible drilling costs in the oil industry is
paralleled by two acceptable methods for treating them in the financial
statements. The result again is to find identical business events re
ported in markedly dissimilar ways.
Both experience and abstract analysis tell us in unmistakable terms
that any attempt in accounting to emphasize either the balance sheet
or the income statement to the virtual exclusion of the other is bound
to give disappointing results. Neither lives in isolation from the
other. Both must be considered in an integrated attack on the problem
of financial reporting.
The time seems ripe for a thorough review of the problems of
accounting. Experience is available to indicate the strengths and
weaknesses of the balance-sheet and income-statement approaches.
The way to avoid the undesirable features of either one can be seen.
The past has also produced a wealth of studies and pronouncements by
accounting organizations ( e.g., American Institute of Certified Public
Accountants, American Accounting Association, National Association
of Accountants, Controllers Institute, English and Canadian Insti
tutes) and by individual investigators (e.g., Dickinson, Hatfield, May,
Paton, Canning, Littleton) to give us the essential analytical frame
CHAPTER 1: BALANCE SHEET AND INCOME STATEMENT
work. The Division of Accounting Research of the American Institute

of Certified Public Accountants published its study of the postulates of
accounting on October 1, 1961.6 That study serves as a point of de
parture for a more specific attack on the problems of accounting.
The Foundation for the Principles

The basic postulates themselves are listed below for ease of refer
ence:
Postulate A-1. Quantification. Quantitative data are helpful
in making rational economic decisions; i.e., in making choices
among alternatives so that actions are correctly related to conse
quences.
Postulate A-2. Exchange. Most of the goods and services that
are produced are distributed through exchange, and are not
directly consumed by the producers.
Postulate A-3. Entities (including identification of the entity).
Economic activity is carried on through specific units or entities.
Any report on the activity must identify clearly the particular
unit or entity involved.
6
Postulate A-4. Time period (including specification of the
time period). Economic activity is carried on during specifiable
periods of time. Any report on that activity must identify clearly
the period of time involved.
Postulate A-5. Unit of measure (including identification of
the monetary unit). Money is the common denominator in terms
of which the exchangeability of goods and services, including
labor, natural resources, and capital, are measured. Any report
must clearly indicate which money ( e.g., dollars, francs, pounds)
is being used.
Postulate B-1. Financial statements. (Related to A-1.) The
results of the accounting process are expressed in a set of funda
mentally related financial statements which articulate with each
other and rest upon the same underlying data.
Postulate B-2. Market prices. (Related to A-2.) Accounting
data are based on prices generated by past, present, or future
exchanges which have actually taken place or are expected to.
Postulate B-3. Entities. (Related to A-3.) The results of the
accounting process are expressed in terms of specific units or
entities
6 Maurice Moonitz, “The Basic Postulates of Accounting.” Accounting

Research Study No. 1. American Institute of Certified Public Accountants.
1961.
CHAPTER 1: THE FOUNDATION FOR THE PRINCIPLES
Postulate B-4. Tentativeness. (Related to A-4.) The results

of operations for relatively short periods of time are tentative
whenever allocations between past, present, and future periods
are required.
Postulate C-1. Continuity (including the correlative concept
of limited life). 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.
Postulate C-2. Objectivity. 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.
Postulate C-3. Consistency. The procedures used in account
ing for a given entity should be appropriate for the measure
ment of its position and its activities and should be followed
consistently from period to period.
Postulate C-4. Stable unit. Accounting reports should be based
on a stable measuring unit.
Postulate C-5. Disclosure. Accounting reports should disclose 7
that which is necessary to make them not misleading.
The first five postulates (A-1 to A-5, inc.) led to the following state
ment of the functions of accounting:7
(1) to measure the resources held by specific entities
(2) to reflect the claims against and the interests in those entities
(3) to measure the changes in those resources, claims, and in
terests
(4) to assign the changes to specifiable periods of time
(5) to express the foregoing in terms of money as a common de
nominator
The kinds of evidence, analysis, and reasoning that led to the pre
ceding postulates and functions are summarized as follows in the
postulates study (p. 5 1 ):
Economic activity is carried on by human beings interacting
with their environment. This type of interaction of human effort
(labor) and natural resources takes place through the medium of
entities which are used as organizing units for the purpose of
producing goods and services. In this process the existing re
sources must be allocated by some means among the available
7 op. cit. p. 23.

CHAPTER 1: THE FOUNDATION FOR THE PRINCIPLES
alternatives. To make these allocations properly, predictions as

to the outcome of the available alternatives are essential. Re
sults of the past and estimates of the future are used to form
these predictions. These results, estimates and predictions are
couched in part in quantitative terms so that comparisons and
evaluations can be facilitated. Accounting is one form of quanti
tative expression that is widely used.
In their economic aspects, all organized societies of which we
have knowledge are concerned with the production and distribu
tion of wealth; all use entities of one kind or another to accom
plish the result. Accordingly, accounting is and always will be
closely identified with wealth and with entities.
Specifically, we observe that every single example of accounting
in actual or potential use deals with some aspect of wealth—its
creation, its form, its consumption, its safeguarding, its magni
tude, its augmentation, or its diminution. And every aspect of
this wealth is assignable or attributable to one or more entities.
Definitions
For convenience, the definitions of the principal terms used in this
8 study are listed immediately below, as well as in the Summary ( Chap
ter 7). Each definition is developed or explained in its appropriate
place in the discussion in Chapters 2-6, inclusive.
Financial statements are those which purport to show financial
position and results of operations, including supporting schedules,
elaborations on special aspects of business activity, rearrangements
of underlying data, and supplementary statements.
Assets represent expected future economic benefits, rights to which
have been acquired by the enterprise as a result of some current or
past transaction.
Cost is a forgoing, a sacrifice made to secure benefits, and is meas
ured by an exchange price.
Depreciation accounting is the process of allocating the cost or other
basis of measurement of the services rendered by items of plant and
equipment to the products or periods that used those services.
Depreciation for any given period is the cost or other basis of the
services used up in that period.
Liabilities are obligations to convey assets or perform services, obli
gations resulting from past or current transactions and requiring
settlement in the future.
CHAPTER 1: DEFINITIONS
Owners' equity is represented by the amount of the residual interest

in the assets of an enterprise.
Invested capital is that portion of stockholders’ equity which arose
from the commitment of assets to the corporation or from the conver
sion of retained earnings and which will not be withdrawn or reduced
except as permitted by law. Retained earnings (earned surplus) is the
portion which arose from operations and has not been converted into
invested capital.
Net profit (earnings, income) or net loss for an accounting period
is the increase (decrease) in owners’ equity, assuming no changes in
the amount of invested capital either from price-level changes or from
additional investments and no distribution to the owners. Revenue is
the increase in net assets of an enterprise as a result of the production
or delivery of goods and the rendering of services. Expense is the
decrease in net assets as a result of the use of economic services in
the creation of revenues or of the imposition of taxes by governmental
units. Gains are increases in net assets other than those resulting from
additions to invested capital or from revenues. Losses are decreases 9
in net assets other than those resulting from reductions in invested
capital or from expenses.
The term “distributions” refers to transfers of assets or of claims to
assets to owners.
2
Broad Principles and Historical Limitations

In order to make the transition from the postulates as set forth above
to the principles developed in this study, some additional steps are
necessary. The first is a clear recognition that broad principles must
transcend the historical limitations of profits “available for dividends” or
“subject to income tax.” This is not to say that the effects of dividends
and of taxes should be ignored; to do so would ignore a significant
part of the environment in which accounting operates. Rather the task
is to formulate those principles which will enable us to measure the
10 resources held by specific entities and the related changes before
consideration of taxes and dividends. The measurements should be
independent of the dividend and the tax questions but, at the same
time, should facilitate the solution of those questions, as well as of
others related to financial position and operating results. Put another
way, broad principles of accounting should not be formulated mainly
for the purpose of making good, or validating, so to speak, the prin
ciples of sound dividend or tax policy. In the foreseeable future, inci
dentally, another major force will bear more heavily on accounting,
namely, the growing interest of employees and their unions, expressed
now in financial terms through “fringe” benefits, including pension
plans. Unless accountants are forearmed, they could slip into accept
ance of accounting “principles” which are not independent expressions
of the results of accounting considerations but instead simply validate
the policies established in the field of collective bargaining.
Profit and Business Activity

The second step is to bear in mind the major point that profit is
attributable to the whole process of business activity, not just to the
moment of sale. On this point, George O. May has stated:
Manifestly, when a laborious process of manufacture and sale
culminates in the delivery of the product at a profit, that profit
CHAPTER 2: PROFIT AND BUSINESS ACTIVITY
is not attributable, except conventionally, to the moment when

the sale or delivery occurred.1
Recently, William A. Paton has said:
If there is a major point upon which there is general agreement
in accounting it is that revenue results from the over-all process
of production... .2
With this point as a basis, the principles necessary to implement it can
be formulated.
As we shall see shortly, reliance on “realization” for the recognition
of profit does not imply that profit arises only at the moment of sale.
Instead it implies something that may or may not be true in a given set
of circumstances, namely, that satisfactory results emerge if profit is
consistently recognized only at time of sale. Whether or not satisfac
tory results do in fact emerge needs to be determined for each set of
circumstances. Accrual accounting already provides an attitude, a
point of view, and a procedure to allocate profit among the appropriate
periods. Accrual accounting in essence attempts to reflect the financial
effects of business transactions when they occur, rather than at the
time of the occurrence of some restricted set of events, such as the 11
receipt or outlay of cash.
Profit is a function of an increase in the net resources of the business
entity. The measurement of the components of profit (revenue, ex
pense, gain, and loss) must accordingly rest on measurements in the
area of assets and liabilities.
Not all changes in the assets and liabilities of a business entity are,
however, elements in the determination of net profit or loss. Increases
in assets, for example, accompanying the issuance of bonds or of shares
of stock do not signal revenues, nor does the retirement of bonds or
stock indicate expense. Changes of this type are clearly of importance,
as everyone recognizes, and therefore are to be recorded and accounted
for. Before a calculation can be made of net profit or loss, the status
of all the assets and all the liabilities must be reviewed to determine
the changes that have occurred. To do otherwise is to walk in the
footsteps of the past by recognizing only certain kinds of changes and
refusing to recognize other kinds. Such a procedure puts the cart
before the horse. The principal task of accounting is to measure the
1 Financial Accounting, Macmillan (New York, 1943), p. 30.

2 “ ‘Deferred income’—a misnomer,” Journal of Accountancy, Sept. 1961,
p. 39.
history of the resources held by economic entities, to measure all of

the resources and all of the changes. As this is done, the changes can
be classified to show those which enter into the determination of net
profit, and those which do not. In addition, the amount of net profit
can be further analyzed to indicate, for example, the portion which
could prudently or legally be declared as dividends, or that has not yet
been reported for tax purposes. As long as certain kinds of changes
are ignored, even though the evidence is there, financial accounting
will continue to be exposed to the risk of serving merely to validate
policies as to distributability or taxability of earnings, policies deter
mined mainly by forces outside the control of accountants.
The kinds of changes that are involved were described in “The Basic
Postulates of Accounting” in connection with the discussion of the pos
tulate on market prices —“accounting data are based on prices gen
erated by past, present, or future exchanges which have actually taken
place or are expected to.”3 Financial events (transactions) involving
at least two accounting entities are almost always recognized in a
satisfactory manner. Examples of these transactions are the purchases
12 and sales of goods and services, the lending and borrowing of money,
and the receipt and payment of cash. Other changes occur, however,
such as movements in the market prices (e.g., replacement costs, or
selling prices) of specific goods and services as well as movements in
the general level of prices.
If these other changes are to be recognized, how can they be meas
ured? The “imperative” on objectivity states that changes should not
be recognized “earlier than the point of time at which they can be
measured in objective terms.” Even when rephrased in positive fash
ion to state that changes should be recognized “at the earliest point
of time at which they can be measured in objective terms” the “im
perative” requires objective measurement.4 Accounting, however, al
ready uses a wide range of measures —replacement costs in “cost or
market” calculations, index numbers of specific commodities or groups
of similar commodities in “dollar-value Lifo,” estimates of net realiz
able values in accounting for by-products, for obsolete or obsolescent
goods or equipment and the like, as well as canceled checks and unpaid
3 This is Postulate B-2. The discussion in “Basic Postulates” starts on

page 28 of that publication.
4 The “imperative’' on objectivity is Postulate C-2, set forth on page 7,
above. The “corollary” in positive form and related discussion will be
found on pages 41-43 of “Basic Postulates."
invoices. The use of this wide range of measures is definitely in

accord with the function of accounting and should be integrated into
its principles.5
The realization of profit. Much attention has been given in account
ing to the problem of the allocation of revenues and expenses to
relatively short periods of time. Other aspects have not been com
pletely neglected but on the whole they have been subordinated to
this central issue of periodic profit determination. In order to reduce
the problem to manageable proportions, accounting practice has relied
heavily on “realization” as a guide, namely, that revenue arises at
point of sale.6
The following lengthy passage by George O. May is pertinent for
the light it throws on the reasoning behind this guide:7
The problem of allocation of income to particular short periods
obviously offers great difficulty—indeed, it is the point at which
conventional treatment becomes indispensable, and it must be
recognized that some conventions are scarcely in harmony with
the facts.
Manifestly, when a laborious process of manufacture and sale 13
culminates in the delivery of the product at a profit, that profit
is not attributable, except conventionally, to the moment when
the sale or delivery occurred. The accounting convention which
makes such an attribution is justified only by its demonstrated
practical utility.
It is instructive to consider how it happens that a rule which is
violative of fact produces results that are practically useful and
reliable. The explanation is that in the normal business there are
at any one moment transactions at every stage of the production
of profit, from beginning to end. If the distribution were exactly
uniform, an allocation of income according to the proportion of
completion of each unit would produce the same result as the
attribution of the entire profit to a single stage.
A number of conclusions immediately suggest themselves: first,
that the convention is valid for the greatest variety of purposes
where the flow of product is most uniform; second, that it is
likely to be more generally valid for a longer than for a shorter
period; and third, that its applicability is seriously open to ques
tion for some purposes where the final consummation is irregular
5 See also Harold Arnett, “What Does ‘Objectivity’ Mean to Account

ants?” Journal of Accountancy, May 1961, pp. 63-68.
6 This is the version of “realization” used by the Study Group on Business
Income in its report, Changing Concepts of Business Income (1952), p. 19.
7 Financial Accounting (1943), pp. 30-31.
in time and in amount. Thus, the rule is almost completely valid

in regard to a business which is turning out a standard product
in relatively small units at a reasonably stable rate of produc
tion. It is less generally valid—or, to put it otherwise, the figure
of profit reached is less generally significant—in the case of a
company engaged in building large units, such as battleships, or
carrying out construction contracts.
These considerations throw a useful light on the problem of the
changing uses of accounts; they also explain a tendency which
has been notable during the last fifty years in the accounting
treatment of large contracts and similar enterprises. In earlier
days, when the use of accounts as an indication of earning capac
ity was not considered, and when conservatism was clearly a
virtue, the procedure of treating the gain on even a large contract
as arising at the moment of its completion was unobjectionable—
any other method might have resulted in taking credit for a profit
that might never be earned. In recent years there has developed
a much greater readiness to take credit for profits on uncom
pleted transactions, in order to secure a more useful guide to
earning capacity. . . .
14 Two points are noteworthy in the passage quoted: ( 1 ) the clear

recognition that profit is attributable to the whole process of business
activity, not just to the moment of sale, and (2 ) the clear recognition
that “realization at point of sale” will give satisfactory results only
when the flow of product is reasonably uniform. The first point is
always valid because it describes an attribute of business activity
which is universally true. The second point makes “realization” a
statistical generalization, an assertion about the validity of a con
venient method of measurement. This convenient method can produce
results which are satisfactory or unsatisfactory at any one point of
time or can be satisfactory at one point of time and unsatisfactory at
another. This so-called “realization postulate” is therefore in reality
a statistical generalization, and can accordingly be applied or not,
depending on whether it fits the situation under review.
“Realization” is a term that is used in a variety of ways in account
ing. A staff study indicates, for example, that one or more of the fol
lowing tests have been used to determine if an item is realized or not:
1. It had to be earned.
2. It had to be the result of a conversion brought about in a transac
tion between the enterprise and someone external to it.
3. It had to be the result of a legal sale or similar process (related
to 2, above).
4. It had to be severed from capital.

5. It had to be in distributable form (related to 4, above).
6. It had to be evidenced by liquid assets (related to 5, above).
7. Its effects on the enterprise had to be the subject of accurate
measurement or of estimates with a high degree of reliability.
No useful purpose would be served in this study by trying to de

termine which of these seven tests is valid and which is not. Instead,
we note the widespread use of a concept of realization in accounting
and that its use implies (among other things) a distinction between
realized and unrealized elements of net profit. We will use the term
occasionally because its use is so deeply embedded in accounting ter
minology, but we cannot accept it as an essential feature of account
ing because the concept lacks analytical precision. Instead, our con
cern is with the real elements, the changes in assets and debts, and
the related (derived) effect on profit.
Furthermore, principles and procedures based on “realization” are
in more or less continual conflict with the postulate of continuity
(going concern). "Realization” leads to a shift from the primary objec 15
tive of accurate reflection of business and economic activity to the
sale, which is only one phase of that economic activity.
The determination of profit and the valuation of assets. The formal
relationships among the determination of profit, its allocation to ac
counting periods, and the valuation (pricing) of assets have been
worked out in the following sources, among others. The first two are
the more complete and sophisticated treatments. The latter two rely
heavily on the first two for support:
K e n n e th E. B o u ld in g , Economic Analysis. 3rd Edition. 1955.
Chapter 38.
J o h n B. C a n n in g , Economics of Accountancy, 1929. Chapters
6-12, inc.
E d w a r d G. N e ls o n , “The Relationship Between the Balance
Sheet and the Profit and Loss Statement,” Accounting Review,
April 1942, pp. 132-41. (This article is based on Canning.)
R eed K. S to r e y , “Cash Movements and Periodic Income Deter
mination,” Accounting Review, July 1960, pp. 449-54. (This
article synthesizes the preceding work on the subject.)
The gist of the analyses that have been made of this problem is
that difficulties exist mainly because prices (including interest rates)
in the future are not known. If they were known, or could be esti
CHAPTER 2; PROFIT AND BUSINESS ACTIVITY
mated with a high degree of accuracy, profit calculated by comparing

financial position at two points of time would be the same as profit
calculated by comparing (matching) revenues and expenses. Either
method could be followed, and no distinction between “realized” and
"unrealized” would be necessary.
In the face of changing prices, however, the tendency is to defer
recognition of profit until sale, or other appropriate point of realiza
tion, with the following consequences:
1. Changes in the specific prices of individual items, such as in
ventories, or plant and equipment, are not recorded until "realized.”
The total profit is reflected in the period of realization and not appor
tioned to the periods during which the profit accrued. The balance
sheet and earnings statement are forcibly linked by keeping inven
tories, plant, and equipment at historical cost, even though current
costs are higher, so that their valuation is a by-product of the realiza
tion rule, as applied to the determination of profit, and not of an inde
pendent determination of the asset itself.
2. Changes in the dollar itself (as measured by an index of the
16 general price level) are not reflected at all at any time, so that their
effect is confused and mixed in with the effect of changes in specific
prices. Some portion of what is reported as profit (loss) should ac
tually be classified as a restatement of capital resulting from a change
in the measuring unit.
To visualize the problem in its simplest terms, assume that an item
of merchandise is acquired for $3,000 in Year I and is sold for $5,400
in Year II. Both at the end of Year I and at date of sale, its replace
ment cost is $3,600. Two kinds of questions need to be considered:
(1 ) Is the increment (gain, “profit” ) of $2,400 attributable entirely
to Year II, to Year I, or to both? (2 ) Is the increment a gain, or is
it partly or wholly something else?
With respect to the first question, we could assert that the total
increment of $2,400 belongs to Year II, a gain of approximately 45%
on sales. In line with this assertion the item would be recorded at its
cost of $3,000 at the end of Year I, not at its market (replacement)
cost of $3,600. Alternatively, we could assert that $600 of the incre
ment belongs to Year I, because the item was bought at a low price
and held through a price rise, and that $1,800 belongs to Year II, a
gain of 33 1/3% on sales. Under this assertion, the item would be re
flected at $3,600 at the end of Year I, giving the reader of the balance
sheet current information on the inventory.
CHAPTER 2 : PROFIT AND BUSINESS ACTIVITY
With respect to the second question, we need to know the behavior

of the dollar in its function as a “standard of value” or measuring rod.
The behavior of the dollar can be measured indirectly by means of
the behavior of prices in general as expressed by an appropriate index
number. To the extent that the increment of $2,400 is attributable
to a shrinkage in the dollar (a rise in the price level), it is not a realized
profit either of Year I or of Year II, but is instead a mere restatement
in terms of the changed dollar of the capital invested in the enterprise.
We observe that it is technically feasible to reflect changes in some
assets in a more timely fashion, and thereby give more current in
formation in the balance sheet. In this connection we propose to use
a classification that distinguishes among (a) the amount attributable
to changes in the dollar (price-level changes), (b ) the amount at
tributable to the acquisition of goods and services prior to their utiliza
tion, and (c ) the amount attributable to sales in a current market.
The horizon of accounting for the results of operations can be ex
panded in this manner beyond the limits now imposed. At the same
time it will continue to be based on objective, verifiable evidence.
Its usefulness to management, to investors, and to others can accord 17
ingly be greatly increased.
We also point out that any realization rule that is rigorously applied
involves the risk of reporting the wrong amount of profit in the wrong
period as specific prices change, and of reporting capital restatements
as profit or loss when the general price-level changes. Accounting
should avoid both dangers to the greatest extent possible.
Note on the price-level problem. At its meeting on April 28, 1961,

the Accounting Principles Board of the American Institute of Certified
Public Accountants took the action summarized in the following ex
cerpt from its minutes:
. . . the Board. . . agreed that the assumption in accounting that
fluctuations in the value of the dollar may be ignored is unreal
istic, 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 paid to the use of supplementary statements as a means of
disclosure.
As the preceding discussion indicates, we are in agreement with
the Board that "the assumption in accounting that fluctuations in the
value of the dollar may be ignored is unrealistic... " Furthermore,

because a separate study is under way to explore the price-level prob
lem, we have not, in this study, given any detailed attention to its
impact on accounting. That detailed attention is given in the study
now under way, the results of which should be published in the near
future.
18
3
Nature of Assets
The concept of assets is related to the concept of economic (i.e.,
scarce) resources. To come within the purview of “assets,” the scarce
resources must be assignable to specific entities, must be capable of
exchange (transfer), either separately or as part of a related group,
and must be expressible in terms of money. These attributes are con
sistent with the discussion in the preceding study of “The Basic Postu
lates of Accounting.” To be applicable to accounting analysis, how
ever, a further refining of the concept of assets is necessary.
About the turn of the century, Colonel Charles E. Sprague described
“assets” as a store of services to be received. Forty years later, Paton
19
and Littleton pointed out that “ ‘service’ is the significant element
behind the accounts, that is, service-potentialities, which, when ex
changed, bring still other service-potentialities into the enterprise.”1
A few years later, Vatter concluded that “assets are economic in na
ture; they are embodiments of future want satisfaction in the form
of service potentials that may be transformed, exchanged, or stored
against future events. Whatever means or method is employed to
measure assets (cost, price, appraisal, or arbitrary valuation), assets
are service potentials, not physical things, legal rights, or money
claims.”2 In 1953, the committee on terminology published its de
finition:3
Something represented by a debit balance that is or would be
1W. A. Paton and A. C. Littleton, An Introduction to Corporate Ac

counting Standards, 1940, p. 13.
2 W. J. Vatter, The Fund Theory of Accounting and Its Implications for
Financial Reports, 1947, p. 17. Vatter makes the necessary separation
between the nature of an asset and the method used to measure it.
Chapter 2 of Vatter’s Fund Theory contains an excellent discussion of the
problem of terminology, and is especially incisive in its analysis of other
definitions of “asset ”
3 American Institute of Certified Public Accountants, Accounting Ter
minology Bulletin No. 1, “Review and Resume,” p. 13, par. 26.
CHAPTER 3: NATURE OF ASSETS
properly carried forward upon a closing of books of account

according to the rules or principles of accounting (provided
such debit balance is not in effect a negative balance applicable
to a liability), on the basis that it represents either a property
right or value acquired or an expenditure made which has
created a property right or is properly applicable to the future.
Thus, plant, accounts receivable, inventory, and a deferred
charge are all assets in balance-sheet classification. (emphasis
added).
The Committee on Concepts and Standards of the American Ac
counting Association stated that “assets are economic resources de
voted to business purposes within a specific accounting entity; they
are aggregates of service-potentials available for or beneficial to ex
pected operations.”4
Definition of Assets
For brevity, then, the following definition of assets will be employed
in this study: Assets represent expected future economic benefits,
20 rights to which have been acquired by the enterprise as a result of
some current or past transaction.
The adjectives “expected” and “future” are used to convey the no
tion that some degree of uncertainty attaches to all assets with respect
to the actual emergence of the benefits. The uncertainty may be
minimal, as in the case of holdings of cash or of U. S. Government
bonds. It may be considerable, as in the case of the so-called “in
tangibles.”
The adjective “economic” is used to indicate that the benefits in
view are scarce and therefore possess some exchange value, now or
in the future. The benefits which constitute the essential element in
“assets” may conceivably not be worth very much. If, for example,
the “out-of-pocket” costs of operating a piece of equipment exceed
the revenues it produces, the equipment is worth only its scrap (sal
vage, secondhand) value. This, however, is a problem of measure
ment. The point of emphasis here is simply that “high-cost” resources
may still be “economic” resources, and therefore qualify as assets.
The term “transaction” in the definition refers to the event that
brought the asset into the entity; “current or past” is used to exclude
“future.” For example, a piece of equipment already acquired and in
4 “Accounting and reporting standards for corporate financial statements

—1957 Revision,” Accounting Review, Oct. 1957, p. 538.
CHAPTER 3: DEFINITION OF ASSETS
use usually represents an asset, but equipment which, according to

present plans, is to be acquired next year does not constitute an exist
ing but merely a budgeted asset.
The apparent ability to render future economic benefits is the at
tribute which makes resources valuable; that which is incapable of
rendering future benefits under any set of conditions has no value and
is therefore not an asset. Accordingly, the asset status of a resource
is usually temporary. Most assets are capable of providing only a
limited quantity of economic services or are capable of providing
economic services for only a limited period of time. When those
services have been dissipated or the time has elapsed, the asset status
expires.
An enterprise may retain an object whose economic services appear
to have been exhausted but which may be given new economic life
and, therefore, new value as a result of repair, overhaul, or other form
of rejuvenation. If such a resource requires frequent periodic rejuvena
tion, its economic usefulness and its value may become exhausted at
the end of each period.
Asset with zero value. An example of this limiting case will help 21
clarify the concept of “economic benefit.” Assume that a drill press
is inoperative now but can be restored to service by appropriate repairs
costing $500, after which it can produce 10,000 units of work. The
lowest cost for which these 10,000 units of work can be done by any
known and available alternative is $500. The drill press has a net
value, before repairs, of zero, yet it is capable of rendering services
at a price. But this is true in virtually every case—any unit of plant
or equipment requires some cost to make it operative. In the usual
case, however, the benefits to be derived are worth more than the
additional costs to be incurred to obtain them. As a result, the item
has a positive value which is conventionally recorded on a net basis
(i.e., the excess of the benefits to be derived over the future cost of
obtaining them). The asset with zero or nominal value is simply the
special case in which the benefits and costs (both future) are equal.
Asset Forms
The forms in which assets exist and the natures of the economic
services which assets are capable of providing are extremely diverse.
Some assets are in the form of cash or claims to cash whose economic
usefulness lies in its function as a store of value and as a medium of
exchange. Some assets, such as materials and supplies, are represented
CHAPTER 3: ASSET FORMS
by tangible objects whose physical substance is ordinarily utilized.

Materials will be physically transformed into a finished product and
finished product will be transferred to customers in exchange for cash
and claims to cash. Other assets, such as plant and equipment, have
tangible existence but are utilized in obtaining shelter, mechanical
assistance, and the other economic services which they are capable
of providing. Even when such assets are no longer capable of render
ing valuable services, their physical substance may be virtually un
changed. Other assets, such as unexpired insurance, patents, and good
will, have no tangible existence. The future services to be derived
from them may be the result of some contractual arrangement, other
legal right, or perhaps some unique economic characteristic. Or
ganization costs and research and development costs also fall within
the class of assets, even though they have no tangible existence, be
cause they create or embody future economic benefits. Bond discount,
however, which is frequently grouped with assets in published reports
(often as a “deferred charge”) possesses none of the attributes of an
asset under the criteria set forth above, nor under any of the defini
22 tions cited, except possibly that of the committee on terminology of
the American Institute of Certified Public Accountants.5
5 Bond discount is discussed more fully in the section on “Measurement

of Liabilities,” pp. 39 to 41.
4
Measurement of Assets
Because the value of assets, indeed their existence, depends upon
the future economic services they are capable of rendering to the
business enterprise, the dollar amounts identified with assets should
be related to those anticipated benefits. In other words, the problem
of measuring (pricing, valuing) an asset is the problem of measuring
the future services, and involves at least three steps:
1. A determination if future services do in fact exist. For example,

a building is capable of providing space for manufacturing activity.
2. An estimate of the quantity of services. For example, a building 23
is estimated to be useable for 20 more years, or for half of its estimated
total life.
3. The choice of a method or basis or formula for pricing (valuing)
the quantity of services arrived at under 2, above. In general, the
choice of a pricing basis is made from the following three exchange
prices:
(a ) A past exchange price, e.g., acquisition cost or other initial basis.

When this basis is used, profit or loss, if any, on the asset being
priced will not be recognized until sale or other transfer out of
the business entity.
(b ) A current exchange price, e.g., replacement cost. When this ba
sis is used, profit or loss on the asset being priced will be recog
nized in two stages. The first stage will recognize part of the
gain or loss in the period or periods from time of acquisition
to time of usage or other disposition; the second stage will
recognize the remainder of the gain or loss at the time of sale
or other transfer out of the entity, measured by the difference
between sale (transfer) price and replacement cost. This method
is still a cost method; an asset priced on this basis is being
treated as a cost factor awaiting disposition.
CHAPTER 4: MEASUREMENT OF ASSETS
(c ) A future exchange price, e.g., anticipated selling price. When

this basis is used, profit or loss, if any, has already been recog
nized in the accounts. Any asset priced on this basis is, therefore,
being treated as though it were a receivable, in that sale or other
transfer out of the business ( including conversion into cash) will
result in no gain or loss, except for any interest (discount)
arising from the passage of time.
The relative merits of these three bases are discussed in the re
mainder of this chapter in terms of specific examples and applications.
It should be clear at this point that the proper pricing (valuation) of
assets and the allocation of profit to accounting periods are dependent
in large part upon estimates of the existence of future benefits, regard
less of the bases used to price the assets. The need for estimates is
unavoidable and cannot be eliminated by the adoption of any formula
as to pricing.
For the purposes of measurement, all assets can be classified accord
ing to the ease or difficulty with which the relationship to anticipated
24 benefits can be established. One such classification is the division into
(a) assets in the form of money or claims to money, and (b ) all other
assets.
Money or claims to money. As a general rule, the valuation of
these assets should be based on the amount of cash into which they
will be converted, that is, their discounted future exchange prices.
Cash itself, whether represented by bank deposits or coins and cur
rency, is measured by count and summation. Domestic holdings are
then valued at their face amount; convertible foreign holdings are
translated into the domestic equivalent.
Receivables (accounts, notes, loans, advances generally) constitute
monetary assets whose value is measured ideally by the present ( dis
counted) value of the future cash receipts to be derived from them.
For the sake of accuracy, a rate of interest (discount) should be
explicitly employed in calculating the present value of long-term re
ceivables. The use of the market (effective) rate in force at the date
the receivable was acquired will result in a recognition of the amount
and rate of interest actually being earned by the company under the
contract entered into.1 In the case of short-term receivables, the period
1 See the discussion of long-term liabilities on page 39, for an extended

discussion of this point.
of time until collection is typically so short that the force of interest

( at the rates that have prevailed in this country in recent years) may
be ignored. Accordingly, short-term receivables are usually measured
by the net amount expected to be collected, after making allowance
for uncollectibles, cash discounts, etc.
Investments in marketable securities having known maturity values
and dates and held as a secondary cash reserve may be valued
along similar lines, but since they may be converted into cash momen
tarily their current market price is usually more significant as a
measure of their worth to the enterprise.
Where securities of this class will be converted into cash by resale
rather than by redemption at maturity, as in the case of shares of
stock, they should be measured by their current market price.
The measurement of marketable securities at current market price
offers several distinct advantages:
1. Current market price represents objective information with re
spect to the amount of cash into which the securities may be con
verted. If current market price is used consistently the reports of
operations covering periods during which temporary investments are 25
held will throw some light on results of decisions to hold or to sell
them. If, for example, market price rises in one period and declines
in the next, while securities are held, the loss sustained by failure to
sell at a higher price will be revealed.2
2. The measurement of marketable securities at current market
price eliminates the anomaly whereby otherwise identical and inter
changeable securities are carried at different amounts merely because
they were acquired at different prices.
Other assets: general considerations. The conversion into cash of
assets other than money and claims to money is usually indirect and
therefore characterized by more uncertainty than the money items.
As a consequence and with some notable exceptions, their valuation
is based on past or present rather than future exchange prices.
Cost is an exchange price, a forgoing, a sacrifice made to secure
benefit. In financial accounting, the forgoing or sacrifice at date of
acquisition is represented by a current or future diminution in cash
or other assets.
The measurement of these other assets is frequently made by the
2 The use of current market price in this connection is permitted by

Postulate C-2 on objectivity. See page 7.
process of aggregating the costs of acquiring them and of bringing

them to their existing condition and location. This procedure has two
important attributes. One, each acquisition cost represents the evalua
tion of the market at that time and therefore represents prima facie
evidence of an objective (i.e., unbiased, impersonal) appraisal of the
economic value of the assets. And two, that appraisal is supported by
one or more overt transactions and is therefore capable of independent
verification. As emphasized by W. A. Paton, “cost is significant pri
marily because it approximates fair value at date of acquisition. Cost
is not of basic importance because it represents an amount paid; it
is important as a measure of the value of what is acquired.” “Thus,
it is really values that are the basic data of accounting, and costs are
important only because they are the most dependable measures of
initial values of goods and services flowing into the enterprise through
ordinary market transactions.”3
Assets may be acquired by donation or a similar means without in
curring costs directly, as where communities supply land or plant
in exchange for a promise to employ a given number of people for a
26 specified period of time. Assets may also be acquired in exchange for
shares of stock or other equity in the enterprise. In these cases, costs
in the sense described above do not exist. Accordingly, the initial
measurement of these assets must be based on other evidence, such
as current market price or appraisal. The essential point is that the
existence of an asset (future economic services) is independent of
the means by which it was acquired although the means (e.g., for
cash or for debt) may be used as a measure of the size of the services
acquired.
Subsequent to acquisition, events may demonstrate that acquisition
cost or other initial basis no longer represents a useful measure of
future benefits for a particular asset. As obvious examples, oil or other
valuable natural resources may be discovered on enterprise land hold
ings acquired initially for other purposes or unforeseen obsolescence
of a product or process may occur. In cases of this type and of others
in which initial basis is no longer a useful or representative measure
a different basis should be adopted. Where they exist and are deter
minable, current market prices may be used, whether they are higher
or lower than acquisition cost or other initial value. Market price is
3 The first passage quoted is from “Cost and Value in Accounting,"

Journal of Accountancy, Mar. 1946, p. 193; the second is from “Accounting
Procedures and Private Enterprise,” ibid., Apr. 1948, p. 288.
an exchange price which is ordinarily independent of the plans or ex

pectations of the individual entity. It therefore represents a neutral,
objective evaluation of economic benefits. Since people act in the
present and the future, and not in the past, current market price is
preferable to past, all other things being equal. Current market price
is also superior to past market price (acquisition cost) as a measure
of the “forgoing” or “sacrifice” involved in the use or other disposi
tion of the asset.
If reliable current market prices are not available for the specific
asset under review, at least two alternative methods of measurement
may be used. One is the use of an index number specially designed
to measure the movements in the prices of a specific item or group
of similar items, such as the available indexes of various commodity
prices or of construction costs. The other alternative is the use of an
independent appraisal of the specific item involved.
Inventories. Inventories are destined for sale to customers in one
turnover period, a period which for many commodities is relatively
short. As a consequence, whenever the ultimate proceeds from sale
can be established, the data should be recorded in the accounts. As 27
a specific case in point, inventories which are readily salable at known
prices with negligible costs of disposal, or with known or readily pre
dictable costs of disposal, should be measured at net realizable value
(i.e., anticipated sales proceeds less costs of completion and disposal).
These conditions are most likely to exist in the cases of certain agri
cultural products and the products of certain extractive industries.
Cotton, wheat, com, oats, rye, soy beans, barley, raw sugar, coffee
beans, gold, silver, copper, and crude oil are but a few of the products
which are already accounted for in this manner. By-products of all
types are also commonly measured and accounted for at net realizable
value.4
This procedure will have the result of assigning most if not all of the
change in resources and the related profit or loss to the period of pro
duction (or other activity) when the actual effort was made. While
it leads to the same result, it differs in attitude from the one expressed
4 For convenience throughout the discussion of inventories, a perpetual-

inventory system is assumed, so that “cost of goods sold” is merely the
result of a transfer from the inventory account to expense, and not the
result of a separate calculation of a residual, as under the periodic-in
ventory method of calculation. The discussion could be restated in terms
of a periodic-inventory system. The results, however, are the same under
either procedure.
in Chapter 4 (Inventory Pricing) of Accounting Research Bulletin

No. 43. That source recognizes the acceptability of stating inventories
above cost “only in exceptional cases,” specifically, “precious metals
having a fixed monetary value with no substantial cost of marketing”
and “other exceptions” which can be justified by “inability to deter
mine appropriate costs, immediate marketability at quoted market
price, and the characteristic of unit interchangeability” (p. 34).
Instead of classifying this procedure as “exceptional” we find it to
be in keeping with the major objectives of accounting. Measurement
of inventories at net realizable value is the preferred method whenever
the measurement is objectively determinable. Historical cost is far
from a satisfactory basis for pricing inventories because it rarely re
flects either present utility or future benefits. Its alleged major ad
vantage in the case of inventories is its definiteness. But where a more
useful measure (e.g., net realizable value or current replacement cost)
is available and is also capable of close estimate and prediction, it
should take precedence over historical cost. In centering their atten
tion on “verification,” accountants frequently select less useful instead
28 of more useful procedures. Verifiability ( definiteness, objectivity) is
a necessary condition for the use of any procedure in any rational ac
counting, but it is not a sufficient condition. Other attributes need
to be considered and a choice made from the array of all procedures
which meet the test of objectivity.
In many cases, however, inventories cannot satisfactorily be priced
at net realizable value ( a future exchange price). Even where selling
prices are determinable, the amount which can readily be sold, the
length of time required in order to accomplish the sales, and the selling
and disposal costs are apt to be uncertain and incapable of adequate
verification. Under these circumstances, the treatment of inventories
as though they were receivables is not justified. Instead, they are still
in the category of “costs awaiting disposition.” The choice, therefore,
lies between a past and a present exchange price.
The consistent use of acquisition cost (a past exchange price) as a
valuation basis results in the deferral of any gain or loss that may be
accruing until the item is sold or otherwise disposed of. As a conse
quence, inventory valuations are out of date and relate not to the
present or to the future but to the past. Furthermore, as soon as two
or more items in the inventory are acquired at different dates, the
acquisition costs do not even relate to the same point of time.
Since the use of a future exchange price is ruled out as inapplicable
in these cases, and a past exchange price as defective, we are left
CHAPTER At MEASUREMENT OF ASSETS
logically with the possibility of using a current exchange price, or

replacement cost. The use of current (replacement) cost as the basis
for inventory measurement eliminates the need for any assumption as
to the flow of actual costs incurred. The current cost of inventories
is the same whether the related underlying records and tax returns
are based on an assumption of a last-in, first-out flow of actual costs
incurred, a first-in, first-out flow, a weighted average, or specific iden
tification. Measurement of inventories at current cost means that
goods sold ( expense) should also be measured at current cost, thereby
accomplishing the avowed purpose of the last-in, first-out method. It
also means that inventory on hand will be measured at a figure which
is at least as useful, if not more useful, than the one derived by the
use of first-in, first-out.
The relevance of current (replacement) cost to a going concern is
underlined whenever the enterprise continues to manufacture or pur
chase the items contained in its inventory. This behavior creates a
forceful presumption that current (replacement) costs represent at
least the minimum economic value of those items to the enterprise.
The use of current (replacement) cost has the further advantage of 29
introducing a clean-cut distinction in the accounts between profit from
holding an item through a price rise or fall, and profit from “operating
margins,” that is, the difference between sales price and current (re
placement) cost of the goods sold. To record “holding” gains or losses
completely would require the adjustment of each item of finished
goods to current cost at the moment of sale, and of unsold items of
all inventory classes (finished goods, work in process, materials and
supplies) at the end of each accounting period. In this manner, the
transfer from finished goods to cost of goods sold would always be at
the most current cost, and the unsold items would also appear at the
most current cost in the balance-sheet. This procedure can be sim
plified in most cases, however, by adjusting the finished goods account
to current cost periodically at the end of each month or calendar
quarter, and not at the moment of sale. This adjusted figure would
then be used during the succeeding month or quarter to cost out all
goods sold during that period. The resultant inaccuracy in the separa
tion of “holding” and “operating” gains or losses would not be sig
nificant unless costs were changing rapidly and substantially.5
5 The excellent term "holding gains or losses” is taken from E. O.

Edwards and P. W. Bell, The Theory and Measurement of Business
Income. 1961.
This “holding” gain or loss should be included as an integral part

of the profit calculation, classified along with the related gain or loss
on goods sold, for the following reasons:
1. The changes in prices have occurred, they are objectively de

termined, and the accounting entity is clearly affected. Furthermore,
“ultimate realization” is reasonably assured because current cost is
below current selling price by a normal profit margin. As a result,
no useful purpose is served by delaying recognition of the changes.
2. The separate disclosure of “holding” and “operating” gains (losses)
is of significance in analyzing and interpreting the results of opera
tions. This disclosure is most readily accomplished by inclusion of
the data in the formal records and financial statements.
3. The amount of the “unrealized” element is of significance in
connection with income taxes and may be with respect to the legal
aspects of dividend policy. The disclosure of this amount is readily
accomplished by reporting the extent and the effect of the adjustment
30 made to beginning and ending inventories.
Comparison with current procedures. According to Chapter 4 of

Accounting Research Bulletin No. 43, “the primary basis of accounting
for inventories is cost, which has been defined generally as the price
paid or consideration given to acquire an asset.” However, “a depar
ture from the cost basis of pricing the inventory is required where
the utility of the goods is no longer as great as its cost. Where there
is evidence that the utility of goods, in their disposal in the ordinary
course of business, will be less than cost, whether due to physical
deterioration, obsolescence, change in price levels, or other causes,
the difference should be recognized as a loss of the current period.
The measurement of such losses is accomplished by applying the rule
of pricing inventories at cost or market, whichever is lower” (pp.
30-31). “. . . the term market means current replacement cost (by pur
chase or by reproduction, as the case may be) . . . ” (p. 31). “The term
market is . . . to be interpreted as indicating utility on the inventory
date and may be thought of in terms of equivalent expenditure which
would have to be made in the ordinary course at that date to procure
corresponding utility. As a general guide, utility is indicated primarily
by the current cost of replacement of the goods as they would be
obtained by purchase or reproduction” (p. 31).
Exceptions to the “general guide” are recognized which place re
liance on net realizable value. “Replacement or reproduction prices

would not be appropriate as a measure of utility when the estimated
sales value, reduced by the costs of completion and disposal, is lower,
in which case the realizable value so determined more appropriately
measures utility. Furthermore, where the evidence indicates that cost
will be recovered with an approximately normal profit upon sale in
the ordinary course of business, no loss should be recognized even
though replacement or reproduction costs are lower” (p. 31).
By contrast with the emphasis in Chapter 4 of Accounting Research
Bulletin No. 43 on acquisition cost and on the lower of acquisition cost
or market, we extend the use of current (replacement) cost to the
cases where it exceeds acquisition cost. The rationale for our position
is identical with that cited in support of the use of replacement cost
when it is lower than actual cost, namely, that “as a general guide,
utility is indicated primarily by the current cost of replacement of the
goods as they would be obtained by purchase or reproduction” (p. 31).
The “cost or market, whichever is lower” rule has been defended
on the grounds that (1 ) it results in the recognition of “a loss of
utility” in the period during which that loss takes place, and (2 ) it 31
prevents the measurement of inventory items at amounts which are in
excess of the amount which can be recovered in the future when the
inventory items are used or sold. The rule has long been criticized,
primarily on the basis of its inherent inconsistency. If current replace
ment cost is objective, definite, verifiable and more useful when it is
lower than acquisition cost, it also possesses those attributes when it
is greater. By the use of current replacement cost, a change in “utility”
is recognized in the period when the change takes place. And inven
tory items would still be measured at amounts which are below cur
rent selling prices by the amount of the operating margin (gross
profit).
Some have argued that the recognition of gains in a manner similar
to that for losses is not acceptable because of (1 ) the need for “con
servatism” (i.e., the need to recognize losses but not to anticipate
gains), and (2) the absence of “realization.” Conservatism of this
type is, however, short-lived. The recognition of a loss this period
and the accompanying reduction in reported profit inevitably means
an offsetting increase in some future period. More serious, however,
is the incompatibility of this type of conservatism with consistency,
and the inherent lack of fairness in its application to inventories. The
recognition of “unrealized losses” accompanied by the nonrecognition
of “unrealized gains” produces information which discriminates in
favor of those acquiring as opposed to those disposing of equities.

Assuming that the market value of an enterprise’s securities are af
fected to some extent by its financial position and the results of its
operations as reported in its financial statements, consider the effect
on an enterprise of a substantial “unrealized loss” on marketable securi
ties (recognized by application of the rule of cost or market, which
ever is lower) and an unrealized but unrecognized gain of the same
amount on inventories.
The absence of realization is no bar to the use of current (replace
ment) costs for inventories. The “cost or market” rule has served a
useful purpose in this regard. It has trained accountants to detect,
measure, and evaluate current (replacement) costs so that an exten
sion of their use becomes both practical and natural.
Plant and equipment. “Plant and equipment” refers to those tangi

ble assets having limited useful life and held by the business enter
prise for the purpose of facilitating the creation and distribution of
goods and services. The useful life of plant and equipment is limited
32 by physical factors, such as deterioration resulting from utilization
and the action of the elements and by functional factors, such as
obsolescence and inadequacy. Accordingly, with utilization and the
passage of time, there is a diminution in the remaining useful services
which items of plant and equipment are capable of providing. This
diminution when expressed in financial terms is referred to as de
preciation.
As in the case of newly acquired assets (other than money and
claims to money), the initial basis of measurement for items of plant
and equipment is acquisition cost or the equivalent. All items of plant
and equipment that are serviceable should be reflected in the accounts
and included in any statement of financial position. Items that are
no longer in service should be removed from the accounts, or classified
separately as idle plant or equipment.
The “economic benefits” that these assets provide take the form of
a stream or series of services, such as shelter in the case of buildings,
transportation in the case of automotive equipment, and lifting power
in the case of cranes and hoists. Even though the investment in these
assets takes the form of an investment in a physical object, an imple
ment, it is the services that the object is capable of providing that
are sought after and acquired. The physical object itself is a scarce
good, thereby giving rise to an exchange price, as well as a basis for
classifying and measuring it initially in the accounts. The services
that the object provides are also scarce, providing a basis for treating
them in the accounts in a manner similar to the treatment of other
(scarce) goods and services. At the level of measurement, then, we
are concerned primarily with the measurement of scarce services, those
that have been used up, and those that still remain.
The root of the special difficulties in measuring plant and equipment
lies in the distinction, described above, between the physical object
itself and the services it is capable of providing. The market for the
physical object is a present market; the market for the services is a
future market, except for the services immediately available. Take the
case of an office building: if buyers and sellers could forecast ac
curately their need for office space and its availability at all relevant
times in the future, the office building would have a current (market)
value equal to the present (discounted) value of the rents (less out-
of-pocket expenses) on the offices it contains. But the forecasts that
have to be made of the market for future office space are the subject
of a wide margin of error precisely because they deal with the future,
whereas the market for office buildings is an existing market. As a
result, practical considerations focus on the instrumentality ( the office 33
building), not on the economic benefits (office space provided by the
building). And accounting similarly focuses on the instrument, and
not on the benefits it is capable of providing.
Except where the results of some formal procedure, such as an
appraisal or a quasi-reorganization, have been incorporated in the
records, these assets are almost always carried at acquisition cost,
because, in the first place, these assets are acquired and held to be
used up, not to be sold as stock-in-trade. They do not represent
potential revenues, as do the inventories, and therefore are not amen
able to treatment as though they were receivables. As a consequence
“net realizable value” has no relevance, except as a measure of scrap
or secondhand value; the problem of allocating revenues correctly to
periods, clearly so important in connection with inventories, does not
arise here. In the second place, many (though by no means all) of
these assets are highly specific so that they cannot be transferred
readily to others (again, except as scrap or salvage). The consequence
here is that a “current market price” does not exist for most of these
cases, even if we were inclined to use it.
To continue to carry these assets at acquisition cost does have the
unavoidable consequence, however, of combining (a) the gains
(losses) attributable to changes in prices between acquisition and
usage with (b ) the gains (losses) attributable to operations in a cur
rent market. For example, if a drill press cost $10,000 five years ago
and has a replacement cost, new, of $15,000 (general price level re
maining unchanged), the fact that the enterprise is operating with
low-cost equipment (relatively speaking) will show up in enhanced
profits from operations. The fact that part of the profit is the result
of “buying cheap” and “using dear,” so to speak, will not be revealed.
To reveal this fact requires the use of the current (replacement) cost of
the services rendered by these assets and the separate classification of
the related gain or loss. This procedure is already used extensively in
the internal accounting reports of large industrial companies. Its exten
sion to the external reports is worth serious consideration.6
In the external reports, plant and equipment should be restated in
terms of current replacement costs whenever some significant event
occurs, such as a reorganization of the business entity or its merger
with another entity or when it becomes a subsidiary of a parent com
pany. Even in the absence of a significant event, the accounts could
be restated at periodic intervals, perhaps every five years. The devel
opment of satisfactory indexes of construction costs and of machinery
and equipment prices would assist materially in making the calculation
34 of replacement costs feasible, practical, and objective.
Depreciation accounting. Depreciation accounting is the process of
allocating the cost or other basis of the services rendered by items of
plant and equipment to the products or periods that used those services.
Depreciation for any given accounting period, then, is the cost, or other
basis, of the services used up in that period.
Whatever the difficulties may be that are attendant upon making
these calculations, the allocations should be made in a systematic and
rational manner. Different methods of estimation are appropriate in
different circumstances. The basis for adopting a particular method of
estimation for a given asset should be its ability to produce an alloca
tion reasonably consistent with the anticipated flow of benefits from
the asset. Accordingly, the “undepreciated cost” should reflect a rea
sonable estimate of unused service units.
The preceding discussion of depreciation appears to be compatible
with the definition adopted by the committee on terminology of the
American Institute of Certified Public Accountants.7
6 E. O. Edwards and P. W. Bell discuss this problem at some length

in The Theory and Measurement of Business Income. 1961.
7 Accounting Terminology Bulletin No. 1, “Review and Résumé” (1953),
p. 25.
For comparison, the committee’s definitions are given below:

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. It is a process of allocation, not of valuation.
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.
Land. In general, urban land is capable of rendering its services for

an infinite period of time. Hence, neither the utilization of land nor
the passage of time causes a diminution in the amount of future
services which land is capable of providing. Accordingly, its value
subsequent to the date of acquisition is not diminished because of
expired services.
Where the utilization of land involves the extraction of natural
resources, however, their amount is limited. The diminution of natural 35
resources by extraction or dissipation is known as depletion. In measur
ing the carrying value of such lands subsequent to the date of acqui
sition, the estimated amount of accumulated depletion is deducted
from the cost or other basis before depletion. The measurement of
the amount of accumulated depletion at any point of time requires the
allocation of carrying value before depletion between (a) the resources
which have thus far been extracted and (b ) the resources and any
other services which remain available for utilization.
Agricultural land poses a problem of maintaining its fertility and
hence its ability to render valuable services indefinitely. Historically,
the usefulness of certain lands for agricultural purposes has been
exhausted or seriously impaired. Where this condition is likely to
occur, accumulated depletion should be recognized in the same manner
as in the case of other natural resources. With modern scientific farm
ing methods, however, the fertility of agricultural land may be main
tained, if not improved. Where that is the case there is no diminution
of future services and the measurement of the value of those lands
does not involve an estimate of accumulated depletion.
In all these cases (urban land, natural resources, agricultural land)
the use of acquisition cost as a basis of measurement frequently results
in the presentation of out-of-date information in published financial
statements. Accordingly, serious consideration should be given to a
restatement of these items in current terms at reasonable intervals

(perhaps every five years). If this is done, the financial statements
should disclose the date of the last restatement. The related increase
( decrease) in owners’ equity should be separately classified.
The “intangibles.” The preceding discussion of plant and equipment
is also applicable to patents, copyrights, research and development
costs, goodwill, and the like. In one sense, these items represent assets
in their “purest” form because their value depends directly on “future
economic benefits” and not indirectly on some physical implement or
tool that is capable of providing benefits. Their very “purity” as
assets (services) makes them difficult to deal with, however, because
current or future exchange prices for them often do not exist. The
consequence is that these items are notoriously difficult to evaluate
and therefore should probably be carried at acquisition cost in the
absence of compelling evidence that their value is markedly different.
“Intangibles” of limited term should be amortized as production cost
or expense over their estimated service lives. Unlimited-term items
should continue to be carried as assets, without amortization.
36
Investments. The reference here is to investments other than mar
ketable securities held as a secondary cash reserve. Temporary holdings
were discussed in a preceding section ( see page 25).
A separate research study is now under way in the Accounting Re
search Division of the Institute on the subject of “intercorporate
investments” which will consider virtually all of the important prob
lems that arise in accounting for investments generally. We will there
fore not comment at length on this topic but instead observe that
investments (a) represent an interest in some other entity’s operations
and (b ) are usually held for the long term and not for sale or other
liquidation in the foreseeable future.
5
The Nature of Liabilities and Owners’ Equities

The liabilities of a business enterprise are its obligations to convey
assets or perform services, obligations resulting from past or current
transactions and requiring settlement in the future. The term “obliga
tions” connotes a claim or series of claims against the business enter
prise, each of which has a known or reasonably determinable maturity
date and an independent value which is known or reasonably measur
able. Settlement of a specific obligation may involve payment in cash 37
or in other assets, or the performance of services. Ultimate settlement
may be postponed by the substitution of another obligation. At the
option of the obligee (the creditor), the liability may on occasion be
settled by conversion into an ownership interest. Neither the maturity
date nor the value of the obligation needs to be known precisely for
the obligation to constitute a liability of the enterprise. Further, the
specific party with whom ultimate settlement must be made need not
be immediately identifiable. For example, warranties are liabilities
which may require settlement within a time period which must be
estimated, in an amount which cannot be estimated with complete
accuracy, and to persons who are not known at the time the warranty
creates an obligation.
The preceding definition and comments are compatible with the
legal attitude as summarized in Corpus Juris Secundum, vol. 53, p. 17:
The term (liability) has been variously defined as meaning
amenability or responsibility to law; . . . the state of being
bound or obliged in law or justice to do, pay, or make good
something; . . . the state or condition of one who is under
obligation to do at once or at some future time something which
may be enforced by action. ( White v. Green, 105 Iowa 181,
74 N.W. 929 adds: “It may exist without the right of immediate
enforcement.”) It is a condition which creates a duty to per
form an act.
CHAPTER 5: THE NATURE OF LIABILITIES AND OWNERS’ EQUITIES
The owners’ equity is represented by the amount of the residual

interest in the assets of an enterprise. The owners’ equity is dis
tinguishable from liabilities on two grounds: first, the amount of the
owners’ equity is residual in nature while the maturity values of lia
bilities are independently determined. Whenever a change in assets
is not exactly offset by a change in liabilities, or vice versa, the differ
ence is automatically reflected in the owners’ equity as the residual
interest. Second, liabilities are in a continuous and irresistible process
of maturing while the owners’ equity matures only at the volition of
the owners of the business enterprise or their representatives or upon
ultimate liquidation. Thus, liabilities are obligations, the amounts and
maturities of which are not solely within the control of the business
enterprise. The owners’ equity does not constitute an obligation be
cause, ordinarily, the business enterprise is not legally or equitably
compelled to provide payments or services to owners other than by the
decision of the owners or their representatives. Only in the final stages
of liquidations, as owners’ equities may be converted into obligations
of known amounts with impending maturities, do they completely
38 disappear as a class of interests having separate and distinct significance
from that of liabilities.
In the normal course of events in a business corporation, for example,
the declaration of a cash dividend effects a transfer of the amount of
the dividend from stockholders’ equity to liabilities. The declaration
creates an obligation of fixed amount and known maturity, an obliga
tion which is no longer within the control of the business enterprise.
On the other hand, the declaration of a “stock dividend” (i.e.,
issuance by a corporation of its own shares pro rata to its shareholders
without new consideration) does not result in a transfer from stock
holders’ equity to liabilities. The declaration of a stock dividend does
not create an obligation requiring settlement by the payment of cash
or other assets or the delivery of agreed-upon goods or the performance
of agreed-upon services. The issuance of additional shares without
new consideration merely constitutes an increase in the number of
shares which represent total stockholders’ equity without affecting that
total.
Liabilities sometimes exist in a form which may be converted into
owners’ equity at the option of the obligee. For example, bond
indentures may provide that under certain prescribed conditions bonds
can be exchanged for shares of stock at the option of the bondholder.
Until conversion occurs, these bonds are liabilities. Upon conversion
there is an increase in stockholders’ equity and a reduction of liabilities.
CHAPTER 5: THE NATURE OF LIABILITIES AND OWNERS’ EQUITIES
Until actual exchange, the bonds have a known maturity date and
maturity value.
Measurement of Liabilities
To measure a liability is to determine the “weight” or the “burden”
of the obligation on the balance sheet date. This “burden” is the
lowest amount for which the obligation could be effectively discharged.
If, for example, payment in cash now will discharge the liability, that
amount of cash is the measure of the liability, even though in fact
payment is delayed. If the creditor will not or cannot accept cash
now in discharge of the liability, the appropriate amount is that sum
which, if invested now (e.g., in a sinking fund), will provide the sums
needed at maturity, even though in fact no explicit sinking fund or
other investment device is actually used.
From the standpoint of measurement, two broad types of liabilities
can be distinguished. The one type calls for settlement in cash; the
other type calls for settlement in a form other than cash.
The amounts of those obligations calling for settlement in cash 39
should be measured by the future payments, discounted to the present
by the use of a market (yield, effective) rate of interest. Where short
term obligations explicitly recognize the element of interest, as in the
case of certain promissory notes, that factor should be recognized in
the measurement of the liability. Where the short-term obligations do
not explicitly recognize the element of interest, as in the case of trade
accounts payable, the force of interest is ordinarily negligible because
the span between the future payment and the present measurement
is short.
In the case of long-term liabilities, the force of interest is significant
and should be recognized. Hence, in the case of long-term debt, the
liability is properly measured by the present ( discounted) value of all
future payments to be made under the contract. These future pay
ments include periodic “interest” payments and all “principal” pay
ments, whether in installments or in a lump sum at maturity. Ordi
narily the pertinent rate of interest for determining present value is the
yield rate of interest at the date of issue ( also called the effective rate
or market rate), which may differ from the nominal or coupon rate in
the contract itself.
Where the resultant present value differs from the amount due at
maturity, the amount of the liability is measured by deducting the
amount of the “discount” from the maturity payment or adding the
CHAPTER 5: MEASUREMENT OF LIABILITIES
amount of the “premium” to the maturity payment. A “discount” does

not represent an embodiment of future economic benefits and accord
ingly cannot constitute an asset. A “premium” has no characteristic
which differentiates it from any other part of the liability. It represents
an integral part of the amount received (borrowed) in exchange for
a contract to make future payments, and is repaid as the provisions of
the contract are complied with.
To illustrate, assume that X Co. issues 5% bonds maturing in 20
years, coupons payable semiannually. If the current market rate of
interest is 5 ½%, the bonds can be offered to yield that rate, in which
case they will be priced at a fraction under 94. Alternatively, if they
are put out for bid, the highest price offered will be slightly under 94.
In either case, the rate of 5 ½% is the factor which equates the issue
price and the stream of cash payments promised in the bond contract.
The discount of six points below par is simply a technical device for
relating issue price to principal amount.
This yield or market rate of 5 ½% measures the financial cost to the
issuer and is therefore the appropriate rate to use in accounting for
40 what has happened. The use of this rate will not, however, indicate
whether the borrowing continues to be advantageous. If, for example,
interest rates should rise to 6%, the market price of this bond issue
should fall, indicating that the issue of bonds at 5 ½ % was advan
tageous to the borrower. If, on the other hand, interest rates have
fallen to 5%, the market price should rise, indicating that the original
issue was disadvantageous. The related “gain” or “loss” can be realized
(from the standpoint of the ownership interest) by paying off the
issue at the market price, or, if the issue cannot be paid off in this
manner, by investing an equivalent amount in other securities at the
market rate. If (a) the bonds are callable before maturity, (b ) interest
rates are dropping and (c ) the issuer does not wish to use cash on
hand, he can borrow new money at the lower rate to pay off the old
debt. In such a case, the loss is the sum of the call premium and the
unamortized discount on the old issue. It is also based upon the
results of a completed transaction and can accordingly be so reflected
in the accounts. The new issue should therefore be carried at its own
issue price since that price reflects the cost of borrowed money in the
market situation prevailing at that time.1
We conclude that the accounting practice of using the yield
1 This conclusion differs from the one expressed in Chapter 15 of
Accounting Research Bulletin No. 43, “Unamortized Discount, Issue Cost,
and Redemption Premium on Bonds Refunded.” In that chapter the
CHAPTER 5: MEASUREMENT OF LIABILITIES
(market) rate at date of issue until a bond issue is retired is sound

because it reflects the interest burden which the issuer is in fact
bearing. It does not, however, reflect whether or not the burden is
too high or too low in terms of the changes which may have taken
place in interest rates. For that purpose a supplementary analysis is
necessary.
Liabilities calling for settlement by the delivery of goods or the
performance of services ordinarily arise from deposits or other advances
by customers for goods or services to be supplied later. Liabilities of
this type should be measured by the amount of the deposit or advance
which ordinarily is equal to the agreed-upon exchange price of those
goods and services. For example, the obligations resulting from the
collection of subscriptions by a magazine publishing enterprise or the
collection of premiums by an insurance company should be measured
by the amounts of the advance collections. As the magazines are
produced and delivered or the insurance coverage provided, revenue
should be recognized in the accounts. No profit can accrue prior to
the performance of the agreed obligation to produce goods or to per
form services. 41
Measurement of Owners’ Equities— Business Corporations

Historically, accounting for stockholders’ equities, perhaps more
than any other aspect of accounting, has been strongly influenced by
legal concepts and statutory provisions.2 Financial statements, how
ever, are primarily economic rather than legal documents and, accord
ingly, an accounting which reflects the basic economic distinctions is
paramount.3
committee on accounting procedure expressed the opinion that

(a) to write off unamortized discount in full in the year of refunding
is acceptable.
(b) to distribute the write-off over the remainder of the original life
of the bonds refunded is the preferred method.
(c) to amortize the discount over the life of the new issue is not ac
ceptable.
2 Accounting Research Bulletin No. 12. “Report of Committee on Termi
nology,” dated September 1941, contained the suggestion that designations
be used “which would make it clear that the balances in this section . . .
emphasize the distinction between (1) legal capital, (2) capital in excess
of legal capital, and (3) undivided profits.” (p. 109.)
3 Accounting Research Bulletin No. 39, “Recommendation of Subcom
mittee on Terminology—Discontinuance of the Use of the Term ‘Surplus,’ ”
CHAPTER 5: MEASUREMENT OF OWNERS’ EQUITIES— BUSINESS CORPORATIONS
In accounting for stockholders’ equities, therefore, a fundamental

distinction is maintained between invested capital and retained earn
ings. Invested capital refers to the portion of stockholders’ equity
which arose from the commitment of assets to the enterprise, including
transfers from retained earnings, and which will not be withdrawn or
reduced except as permitted by law. Retained earnings or earned
surplus designates the portion of stockholders’ equity which arose from
operations. The amount of retained earnings is uncommitted in the
sense that the board of directors has the power to decide (a) to dis
tribute assets to stockholders as a share of the earnings of the enter
prise and thereby reduce the amount of earnings retained, or (b ) to
designate some part or all of the amount of retained earnings as
invested capital.
A distinction between invested capital and retained earnings has
relevance to stockholders. For example, when cash dividends are
distributed, stockholders are entitled to assurance that they are based
on current or past profits and do not constitute merely a return of
some of the cash or other assets originally invested in the enterprise or
42 of previous earnings converted into invested capital. The distinction
between invested capital and retained earnings is also significant from
the viewpoint of creditors. Invested capital constitutes a buffer against
enterprise losses. These losses must exceed the amount of retained
earnings and stockholders’ invested capital before creditors’ equities
are impaired.
Invested Capital
Invested capital may be further classified according to source, that
is, according to the underlying nature of the transactions giving rise
to the invested capital. In this way, invested capital may be identified
with transactions involving shareholders (e.g., stock issues, treasury-
stock transactions), transactions involving persons other than share
holders (e.g., gifts, subsidies, grants-in-aid), and those restatements
which reflect the change in the size of the dollar ( price-level changes).
Frequently, the invested capital associated with shares of stock is
dated Oct. 1949, recommended that in describing the components of stock

holders’ equities, the use of certain legal terminology should be discon
tinued and that “consideration should be given primarily to the sources
from which the proprietary capital was derived” (p. 296). This view was
reiterated in Accounting Terminology Bulletin No. 1, “Review and Résumé,”
1953 (p. 30).
CHAPTER 5: INVESTED CAPITAL
classified as capital stock and invested capital in excess of par or stated

values of capital stock. The significance of the amount of capital stock
is purely legal in nature. In legal terminology it is usually referred to
as the amount of “stated capital.” It measures the portion of stock
holders’ equity which is most directly related to the number of shares
of stock issued and which typically cannot be reduced except under
restrictive statutory proceedings. Capital stock is subdivided accord
ing to those amounts attributable to each authorized class of stock, e.g.,
the amounts attributable to preferred and to common stock. The
amount of each class of stock is usually measured by the aggregate par
value of shares issued or the aggregate stated values of shares issued
without par value.
Any excess of the amount of consideration received for shares
over their stated value is also invested capital, since it represents an
integral part of the stockholders’ contributions. The terms “capital
surplus” or “paid-in surplus” are widely used in state corporation
statutes and in the accounting literature to describe this excess. It is
surplus in the sense that, although it constitutes a portion of the capital
of the business enterprise, it is in excess of the amount of “stated 43
capital” and, accordingly, its reduction is usually subject to a lesser
degree of statutory limitation. It is usually classified separately.
The committee on terminology of the American Institute of Certified
Public Accountants has urged that ". . in the balance-sheet presenta
tion of stockholders’ equity . . . the use of the term surplus (whether
standing alone or in such combinations as capital surplus, paid-in
surplus, earned surplus, appraisal surplus, etc.) be discontinued.” 4
The term, invested capital in excess of par or stated value of capital
stock, has been appearing in published financial reports with increasing
frequency. This subclassification of invested capital is not necessary
but when properly arranged it does permit information of an essen
tially legal nature to be disclosed.
Retained Earnings (Earned Surplus)

The amount of retained earnings is measured by the cumulative
amount of net profits and net losses of the business enterprise, less
the amount of dividends and less any amount of retained earnings
formally transferred to invested capital. A negative balance of retained
earnings is often referred to as a deficit.
4 Accounting Terminology Bulletin No. 1, op. cit., p. 30.

CHAPTER 5: RETAINED EARNINGS (EARNED SURPLUS)
Retained earnings in the broad sense include both realized and

unrealized components. A restatement of plant and equipment, for
example, from acquisition cost to current replacement cost, after al
lowance for any change in the price level, is in the nature of an unreal
ized gain (loss) and should be so classified and described. Thus, if a
piece of land acquired for $50,000 (price level at 100) is now re
corded at its current replacement cost of $100,000 (price level at 160),
$30,000 of the increase is a restatement of the capital originally in
vested in the land, and $20,000 is a gain which could be realized by
sale or equivalent conversion of the land at $100,000.
The transfer of amounts from the status of retained earnings to the
status of invested capital may be made separately or may be made in
conjunction with the distribution to shareholders of additional shares
of stock ( so-called stock dividend). In either case, the amount trans
ferred loses its identity as having been derived from the retention of
earnings, and the stockholders’ equity accounts no longer are classified
strictly according to source.
44
Unincorporated Business
The distinction between invested capital and retained earnings is
also significant for unincorporated businesses. Whether it is necessary
to reflect the distinction in separate owners’ equity accounts, however,
depends upon the relationship of the owner or owners to the operations
of the enterprise. Because there are no statutory restrictions on with
drawals of equity, the distinction between invested capital and re
tained earnings is not particularly significant to creditors. As one
result, owners’ equity accounts are usually not classified according to
source but, instead, tend to show the interest of each owner at the
balance-sheet date.
As the relationship of owners to the financial affairs of the enterprise
becomes more remote, however, the corporate pattern becomes more
relevant. A business owned by partners, for example, some of whom
may not be active in the business or some of whom may be engaged in
nonfinancial duties should provide financial information to its owners
which is similar in detail to that required for the stockholders of a
corporation. There is, however, at least one important additional
requirement. Where the equities of partners are not equal and are
not evidenced by any common denominator such as shares of stock,
information with respect to the equity of each owner should also be
available.
6
Nature of Profit
The net profit (earnings, income) of a business enterprise during any
given period of time is the amount of the increase in the owners’
equity, assuming no changes in the amount of invested capital during
the period either from price-level changes or from additional invest
ments and no distributions of any sort to the owners. The term “dis
tributions” refers to assets (e.g., a dividend in cash or in kind) or
claims to assets (e.g., a scrip dividend).
Hence, in the absence of changes in the amount of invested capital,
the equities of owners will be increased only if some amount less than 45
enterprise earnings is distributed to them; an enterprise can make
distributions to owners in an amount in excess of the amount of its
earnings only by contracting their equity; and, if it is desired to main
tain the previous amount of the owners’ equity, the amount of current
earnings is the amount which can be distributed to them. This implies
no judgment as to the distribution policy which ought to be followed.
Even in the presence of profits, assets may not be in distributable form,
and, even if they were, their disposition is a matter for the owners or
their representatives to decide.
The earning process is a continuous one, taking place over the
entire life of a business enterprise. The need for interim measurements
during the life of the enterprise leads to the use of relatively short
accounting periods such as the year. Inevitably, this means that alloca
tions between past, present, and future periods must be made and, as
a result, measurements of profit during short periods of time are
tentative. ( Postulate B-4.)
In general, the accounting process must provide more than a meas
urement of the net amount earned during a period of time. Informa
tion about the components of profit is needed as a basis for evaluating
the past and forecasting the future. Properly measured and properly
labeled information about these components can then be arranged to
examine and to emphasize various relationships. The appropriate de
CHAPTER 6: NATURE OF PROFIT
gree of detail is a matter of judgment and depends upon the use to be

made of the information.
Revenue
Revenue is the increase in the net assets of an enterprise as a result
of the production or delivery of goods and the rendering of services.
“Net assets” refer to the excess of assets over liabilities; the amount
of net assets is necessarily equal to the amount of owners’ equity.
Hence, revenues may result from increases in assets, decreases in lia
bilities, or some combination of the two.
Revenues are measured by the amount of the increase in enterprise
assets or decrease in enterprise liabilities resulting from the production
or delivery of goods and the rendering of services, without considera
tion of the related reductions in assets or increases in liabilities which
may also occur. For example, when sales are made on account, the
amount of revenue is usually measured by the amount of the increase
in accounts receivable. Amounts included in the prices charged cus
46 tomers, however, which for any reason are not expected to be collected
do not constitute increases in assets and hence do not result in rev
enues. Accordingly, sales discounts, allowances, returns, and uncol
lectible amounts should be deducted in the measurement of revenues.
Similarly, amounts collected or receivable from customers which do
not reflect a product supplied or a service rendered do not result in
revenues of that enterprise. For example, an advance of the costs of
transportation provided by another enterprise or sales taxes billed to
customers and payable to a governmental agency should not be in
cluded in revenues. In cases of this type the enterprise is acting merely
as an agent, advancing or collecting funds for the convenience of
another.
In general, then, the revenue of an enterprise during a period of
time represents a measurement of the exchange value of the products
(goods or services) of that enterprise during that period. This repre
sents a measurement having considerable economic significance and
one which is often useful in making interperiod and intercompany
comparisons and projections.
The committee on terminology has formulated a definition, repro
duced below, which is broader than the one used in this study. We
make a distinction between “revenues” and “gains” (see section on
“gains and losses,” page 50), whereas the committee includes gains as
a subdivision of revenue. Otherwise the two definitions are com
patible:
CHAPTER 6: REVENUE
Revenue results from the sale of goods and the rendering of

services and is measured by the charge made to customers,
clients, or tenants for goods and services furnished to them. It
also includes gains from the sale or exchange of assets (other
than stock in trade), interest and dividends earned on invest
ments, and other increases in the owners’ equity except those
arising from capital contributions and capital adjustments.1
Revenues should be identified with the period during which the

major economic activities necessary to the creation and disposition of
goods and services have been accomplished, provided objective meas
urements of the results of those activities are available. These two
conditions, i.e., accomplishment of major economic activity and objec
tivity of measurement, are fulfilled at different stages of activity in
different cases, sometimes as late as time of delivery of product or the
performance of a service, in other cases, at an earlier point of time.2
For example, in some cases, sales, including determination of price,
precede production. “Major economic activity” is then identified with
production, and revenues should be recognized as production takes
place. Where more than one period is required for completion, rev
47
enues should be apportioned in relation to the amount of production
accomplished each period. These particular conditions are found in
the case of contracts involving the construction of buildings, ships,
roads, dams, etc.
Similarly, major economic activity is complete upon the production
of a commodity which has a ready market at a known price, e.g.,
certain minerals and certain agricultural products. The enterprise can
dispose of products of this type with little or no marketing activity.
For these commodities the costs of disposal are either negligible or
readily predictable. Accordingly, the measurement of revenues and
related costs associated with the product are objectively determinable
at the time of production.
If the producing enterprise should utilize the marketable commodity
in the manufacture of other products, revenues from the additional
activity should be recognized in accordance with the same basic
criteria. This can be illustrated by the case of a company which
mines and smelts a metal having a ready market at a known price and
which utilizes some of that metal in the manufacture of a product
which does not have that kind of a market. Upon the production of
1 Committee on Terminology. Accounting Terminology Bulletin No. 2,

“Proceeds, Revenue, Income, Profit, and Earnings,” p. 34.
2 See Postulate C-2 on objectivity, page 7.
CHAPTER 6: REVENUE
the marketable metal, one major activity is complete. Accordingly, any

inventory of that metal should be measured by its net realizable value,
(i.e., estimated selling price, less cost to complete and sell) and the
revenue from the mining and smelting activity of the current period
is measured by the net realizable value of the metal produced during
the current period. In addition, when this metal is used in further
manufacturing activity, it should be charged to production at this same
net realizable value.
Revenues from services should be reflected in the period during
which those services are provided. Certain services, such as the use of
money and the use of facilities, are provided continuously. In cases
of this type, the rates at which revenues accrue, e.g., the interest rate
and the rental rate, are typically fixed in advance and revenues should
accordingly be recognized on the basis of passage of time.
Because services cannot be stored, they are generally marketed
before they are created. If the marketing activity is an important and
costly one, some portion of revenues is reasonably attributable to it.
For example, the operations of finance companies and of leasing com
48 panies involve substantial preliminary work before receipts from cus
tomers or clients materialize. Not all of the revenues of those com
panies are earned during the periods of collections from customers;
some of it is clearly earned by the preliminary activities. Accordingly,
the revenues should be allocated to accounting periods on some sys
tematic basis.
On the other hand, even though the major economic activities may
be considered accomplished at the time of sale and delivery of product
or at the time of performance of service, with a price definitely
established at that time, the amount of collection costs and probability
of collection may be highly uncertain. In cases of this type revenues
should still be measured by the same criteria as those developed above,
but special attention must be paid to an evaluation of the related
receivables, and adequate allowances for uncollectibles should be
made. In addition, estimates of collection costs should be made and
recorded in the accounts.
Collectibility of receivables is not necessarily less predictable be
cause collections are scheduled in installments. The postponement of
recognition of revenues until they can be measured by actual cash
receipt is not in accordance with the concept of an accrual accounting.
Any uncertainty as to collectibility should be expressed by a separately
calculated and separately disclosed estimate of uncollectibles rather
than by a postponement of the recognition of revenue.
CHAPTER 6: EXPENSE
Expense
Expense is the decrease in net assets as a result of the use of eco
nomic services in the creation of revenues or of the imposition of
taxes by governmental units. Expense is measured by the amount of
the decrease in assets or the increase in liabilities related to the pro
duction and delivery of goods and the rendering of services, without
considering the related revenues which are usually present.
The following definition and discussion of “expense” by the com
mittee on terminology of the American Institute of Certified Public
Accountants are broader than the position developed in this study
because the committee includes “losses” in its definition whereas we
distinguish the two. (See section on “gains and losses,” page 50.)
Otherwise the two definitions are compatible.
Expense in its broadest sense includes all expired costs which are
deductible from revenues. In income statements, distinctions
are often made between various types of expired costs by cap
tions or titles including such terms as cost, expense, or loss, e.g.,
cost of goods or services sold, operating expenses, selling and
administrative expenses, and loss on sale of property. These dis 49
tinctions seem generally useful, and indicate that the narrower
use of the term expense refers to such items as operating, selling
or administrative expenses, interest, and taxes.3
If the economic services emanating from a group of enterprise assets
are transferred to another group of enterprise assets, there has been no
expiration; from the standpoint of net assets, there has merely been
a transformation in the form in which those economic services are
held. Hence, the utilization of materials, labor, and facilities in the
manufacture of a product is not the occasion for the recognition of
expense. When the product is sold, however, its usefulness to the
enterprise will indeed have expired, and the recognition of expense
(usually as “cost of goods sold”) is appropriate.
Expenses may be identified with a particular period of time in either
of two ways:
1. They may be directly identified with particular revenue-pro

ducing transactions which have been recognized during the accounting
period, e.g., the cost of the goods that are sold and delivered during
that period of time, or a specified sales commission on those goods.

“Cost, Expense, and Loss,” p. 42.
CHAPTER 6: EXPENSE
2. They may be identified with the accounting period but cannot

be directly identified with particular revenue-producing transactions,
e.g., the rent of administrative offices for the year, the salaries of
administrative personnel, or taxes measured by the results of opera
tions.
“Cost of goods sold” is measured by the decrease in inventory

resulting from its transfer to customers, as exemplified in the “per
petual inventory” method. As indicated earlier, in the discussion of
measurement of assets,4 inventories should be measured by their most
recently established current value (realizable or replacement).
In this way the sacrifice incurred in relinquishing inventory is
measured in current and meaningful terms and is “matched” with
revenue received from the sale, measured in the same current and
meaningful terms. The advantages of measuring cost of goods sold
and revenues from sales in consistent current terms have long been
stressed as the primary justification for the use of the last-in—first-out
assumption of flow of inventory costs in profit calculations. We have
50 accepted this position in principle and extended it to the inventory
items themselves.
Gains and Losses

“Gains” are increases in net assets other than (a) those resulting
from investments by owners or (b ) those resulting from revenues.
“Losses” are decreases in net assets, other than (a ) those resulting
from distributions to owners or (b ) those resulting from expenses.
Broadly speaking, profit arises from the supplying of goods and
services. Revenues and expenses represent the components of profit,
so to speak, and are centered heavily on the rendering of a service or
the production of a product. Other events occur, however, which
affect profit and which therefore should be taken into account. Their
nature is such that they should be separately classified in the financial
statements in order to increase the usefulness of the data for compara
tive purposes.
In the determination of earnings, the effects of changes in current
costs of inventory are important and therefore should be reported.
The inclusion of this information in the accounts will assist in dis
4 See discussion in Chapter 4, “Inventories,” pp. 27-32.

CHAPTER 6: GAINS AND LOSSES
closing the extent to which the net profit or loss is the result of
changed operating margins, or of price fluctuations during the period
the inventory was held. Information of this type is vital whether or
not the accounts also disclose the influence of changes in the dollar
(price-level changes).
The significance of changes in current costs is different from that of
changes in the operating margin. Operating margins are recurring
and relatively controllable; their measurement has greater predictive
value. Accordingly, separate measurement of operating margins and
of price gains and losses is recommended so that separate analysis
and interpretation can be made.
Gains may, therefore, result from (1 ) the sale of assets, other than
inventory, for more than book value; (2) the increase in the current
value of inventories; or (3) the settlement of liabilities for less than
book value (for example, bonds issued at par, reacquired at a dis
count).
Losses may result from (1 ) the sale of assets, other than inventory,
for less than book value; (2 ) the decline in the current value of inven
tories; (3 ) the diminution or elimination of assets other than as the 51
result of use or sale (e.g., as the result of flood, fire, or abandonment);
(4 ) the settlement of liabilities for a consideration in excess of book
value (for example, bonds issued at par, reacquired at a premium);
or (5 ) the involuntary incurrence of liabilities; e.g., as the result of
a lawsuit.
The committee on terminology conceives of “loss” either as the
antonym for “net profit” or as a subdivision of “expense,” as developed
in the following excerpt:
Loss is (1) the excess of all expenses, in the broad sense of that
word, over revenues for a period, or (2) the excess of all or the
appropriate portion of the cost of assets over related proceeds, if
any, when the items are sold, abandoned, or either wholly or
partially destroyed by casualty or otherwise written off. When
losses such as those described in (2) above are deducted from
revenues, they are expenses in the broad sense of that term.5
The general problem of “nonoperating gains and losses” (including
the correction of errors, discussed briefly below) is analyzed in Chapter
8, “Income and Earned Surplus,” of Accounting Research Bulletin No.
43. The conclusion reached by the committee on accounting pro

“Cost, Expense, and Loss,” p. 42.
CHAPTER 6: GAINS AND LOSSES
cedure, as expressed in paragraph 11 of that chapter, is that a pre

sumption exists “that all items of profit and loss recognized during the
period are to be used in determining the figure reported as net
income.” Excluded, however, are items which meet two conditions,
namely, ( a ) "in the aggregate are material in relation to the company’s
net income” and ( b ) “are clearly not identifiable with or do not result
from the usual or typical business operations of the period.” Our
conclusions seem to be consonant with those of the committee on
accounting procedure, at least in broad outline.
Corrections of the Measurements of Prior Periods’ Earnings

In almost all formal analysis, the discussion of the measurement of
earnings assumes the absence of error in the accounting. Specifically,
“the amount of the owners’ equity in the enterprise at the beginning
of the period” is assumed to be measured properly, and similarly for
current measurements. If errors have in fact occurred, their correction
affects all measurements of owners’ equity since the error was com
52 mitted. Accordingly, corrections of errors that are material in their
effect on the financial statements should not enter into the determina
tion of earnings as a separate item for the period during which the
error was discovered. A correction of a past error of this type does not
constitute a revenue, an expense, a gain, or a loss of the current period.
Errors made in prior periods may, of course, affect a related item
of the current period. For example, if last period’s ending inventory
was understated, then this period’s opening inventory is likewise
understated. The understatement affects the accounts of both periods.
The correction for last period is made through retained earnings; the
correction for this period is made as a matter of routine in the
accounts of the current period.
7
SUMMARY
This study is an extension of Accounting Research Study No. 1.1

It extends the analysis contained in “Basic Postulates” by applying it to
the broad area of accounting for business enterprises. As a result, the
emphasis in the postulates study on the measurement of wealth in the
hands of economic entities becomes more specific in this study as an
examination of the assets and liabilities, and related revenues and
expenses, gains and losses, of business enterprises. The concept of
profit becomes the focus of attention which leads to an examination 53
of assets and liabilities in order to find the appropriate bases for
measuring the results of operations for relatively short periods of time.
In accordance with the emphasis in the postulates study, this study
of broad principles takes the position that ideally all assets (and
liabilities) should be recognized, as well as all changes that can be
objectively determined. In addition to those changes which result
from explicit transactions with other entities, this study recommends
the recognition of price-level changes, of movements in replacement
costs, and of changes from other causes, again provided that the evi
dence is objectively determinable.
The principles that are listed below are those recommended by the
authors of this study, and have not been reviewed by the Accounting
Principles Board of the American Institute of Certified Public Ac
countants. Before stating the principles that are recommended by
the authors, certain definitions are given of key terms and concepts.
Definitions
Financial statements are those which purport to show financial posi
tion and results of operations, including supporting schedules, elabora
1 Maurice Moonitz, “The Basic Postulates of Accounting.” 1961.

CHAPTER 7: DEFINITIONS
tions of special aspects of business activity, rearrangements of under

lying data, and supplementary statements.
Assets represent expected future economic benefits, rights to which
have been acquired by the enterprise as a result of some current or past
transaction.
Cost is a forgoing, a sacrifice made to secure benefits, and is measured
by an exchange price.
Depreciation accounting is the process of allocating the cost or other
basis of measurement of the services rendered by items of plant and
equipment to the products or periods that used those services. D epre
ciation for any given period is the cost or other basis of the services
used up in that period.
Liabilities are obligations to convey assets or perform services,
obligations resulting from past or current transactions and requiring
settlement in the future.
54 Owners’ equity is represented by the amount of the residual interest

in the assets of an enterprise.
Invested capital is that portion of stockholders’ equity which arose
from the commitment of assets to the corporation or from the conver
sion of retained earnings and which will not be withdrawn or reduced
except as permitted by law. Retained earnings (earned surplus) is the
portion which arose from operations and has not been converted into
invested capital.
Net profit ( earnings, income) or net loss for an accounting period

is the increase (decrease) in owners’ equity, assuming no changes in
the amount of invested capital either from price-level changes or from
additional investments and no distribution to the owners. Revenue is
the increase in net assets of an enterprise as a result of the production
or delivery of goods and the rendering of services. Expense is the
decrease in net assets as a result of the use of economic services in the
creation of revenues or of the imposition of taxes by governmental
units. Gains are increases in net assets other than those resulting from
additions to invested capital or from revenues. Losses are decreases in
net assets other than those resulting from reductions in invested capital
or from expenses.
The term “distributions” refers to transfers of assets or of claims to
assets to owners.
CHAPTER 7: SUMMARY OF PRINCIPLES
Sum m ary of Principles

The principles summarized below are relevant primarily to formal
financial statements made available to third parties as representations
by the management of the business enterprise. The "basic postulates
of accounting” developed in Accounting Research Study No. 1 are
integral parts of this statement of principles.
Broad principles of accounting should not be formulated mainly
for the purpose of validating policies (e.g., financial management,
taxation, employee compensation) established in other fields, no mat
ter how sound or desirable those policies may be in and of themselves.
Accounting draws its real strength from its neutrality as among the
demands of competing special interests. Its proper functions derive
from the measurement of the resources of specific entities and of
changes in those resources. Its principles should be aimed at the
achievement of those functions.
The principles developed in this study are as follows:
A. Profit is attributable to the whole process of business activity.
Any rule or procedure, therefore, which assigns profit to a portion of
the whole process should be continuously re-examined to determine
the extent to which it introduces bias into the reporting of the amount
of profit assigned to specific periods of time.
B. Changes in resources should be classified among the amounts
attributable to
1. Changes in the dollar (price-level changes) which lead to restate
ments of capital but not to revenues or expenses.
2. Changes in replacement costs ( above or below the effect of price-
level changes) which lead to elements of gain or of loss.
3. Sale or other transfer, or recognition of net realizable value, all
of which lead to revenue or gain.
4. Other causes, such as accretion or the discovery of previously un
known natural resources.
C. All assets of the enterprise, whether obtained by investments of
owners or of creditors, or by other means, should be recorded in the
accounts and reported in the financial statements. The existence of
an asset is independent of the means by which it was acquired.
D. The problem of measuring (pricing, valuing) an asset is the
problem of measuring the future services, and involves at least three

steps:
a. A determination if future services do in fact exist. For example,
a building is capable of providing space for manufacturing activity.
b. An estimate of the quantity of services. For example, a building
is estimated to be usable for twenty more years, or for half of its
estimated total life.
c. The choice of a method or basis or formula for pricing (valuing)
the quantity of services arrived at under b, above. In general,
the choice of a pricing basis is made from the following three
exchange prices:
(1) A past exchange price, e.g., acquisition cost or other initial

basis. When this basis is used, profit or loss, if any, on the
asset being priced will not be recognized until sale or other
transfer out of the business entity.
(2) A current exchange price, e.g., replacement cost. When this
basis is used, profit or loss on the asset being priced will be
recognized in two stages. The first stage will recognize part
of the gain or loss in the period or periods from time of ac
quisition to time of usage or other disposition; the second
stage will recognize the remainder of the gain or loss at the
time of sale or other transfer out of the entity, measured by
the difference between sale (transfer) price and replacement
cost. This method is still a cost method; an asset priced on
this basis is being treated as a cost factor awaiting disposition.
(3) A future exchange price, e.g., anticipated selling price. When
this basis is used, profit or loss, if any, has already been
recognized in the accounts. Any asset priced on this basis
is therefore being treated as though it were a receivable, in
that sale or other transfer out of the business (including con
version into cash) will result in no gain or loss, except for any
interest (discount) arising from the passage of time.
The proper pricing (valuation) of assets and the allocation of profit
to accounting periods are dependent in large part upon estimates of
the existence of future benefits, regardless of the bases used to price
the assets. The need for estimates is unavoidable and cannot be
eliminated by the adoption of any formula as to pricing.
1. All assets in the form of money or claims to money should be
CHAPTER 7s SUMMARY OF PRINCIPLES
shown at their discounted present value or the equivalent. The

interest rate to be employed in the discounting process is the
market (effective) rate at the date the asset was acquired.
The discounting process is not necessary in the case of short-term
receivables where the force of interest is small. The carrying-value
of receivables should be reduced by allowances for uncollectible
elements; estimated collection costs should be recorded in the
accounts.
If the claims to money are uncertain as to time or amount of
receipt, they should be recorded at their current market value.
If the current market value is so uncertain as to be unreliable,
these assets should be shown at cost.
2. Inventories which are readily salable at known prices with readily
predictable costs of disposal should be recorded at net realizable
value, and the related revenue taken up at the same time. Other
inventory items should be recorded at their current (replacement)
cost, and the related gain or loss separately reported. Accounting
for inventories on either basis will result in recording revenues,
gains, or losses before they are validated by sale but they are
nevertheless components of the net profit (loss) of the period in
which they occur.
Acquisition costs may be used whenever they approximate cur
rent (replacement) costs, as would probably be the case when
the unit prices of inventory components are reasonably stable and
turnover is rapid. In all cases the basis of measurement actually
employed should be “subject to verification by another competent
investigator.”
3. All items of plant and equipment in service, or held in stand-by
status, should be recorded at cost of acquisition or construction,
with appropriate modification for the effect of the changing dollar
either in the primary statements or in supplementary statements.
In the external reports, plant and equipment should be restated
in terms of current replacement costs whenever some significant
event occurs, such as a reorganization of the business entity or its
merger with another entity or when it becomes a subsidiary of
a parent company. Even in the absence of a significant event, the
accounts could be restated at periodic intervals, perhaps every five
years. The development of satisfactory indexes of construction
costs and of machinery and equipment prices would assist materially
in making the calculation of replacement costs feasible, practical,
and objective.
4. The investment (cost or other basis) in plant and equipment

should be amortized over the estimated service life. The basis for
adopting a particular method of amortization for a given asset
should be its ability to produce an allocation reasonably consistent
with the anticipated flow of benefits from the asset.
5. All "intangibles” such as patents, copyrights, research and develop
ment, and goodwill should be recorded at cost, with appropriate
modification for the effect of the changing dollar either in the
primary statements or in supplementary statements. Limited term
items should be amortized as expenses over their estimated lives.
Unlimited term items should continue to be carried as assets,
without amortization.
If the amount of the investment (cost or other basis) in plant
and equipment or in the “intangibles” has been increased or de
creased as the result of appraisal or the use of index-numbers,
depreciation or other amortization should be based on the changed
amount.
E. All liabilities of the enterprise should be recorded in the ac

counts and reported in the financial statements. Those liabilities
which call for settlement in cash should be measured by the present
(discounted) value of the future payments or the equivalent. The
yield (market, effective) rate of interest at date of incurrence of the
liability is the pertinent rate to use in the discounting process and
in the amortization of “discount” and “premium.” “Discount” and
“premium” are technical devices for relating the issue price to the
principal amount and should therefore be closely associated with
principal amount in financial statements.
F. Those liabilities which call for settlement in goods or services

(other than cash) should be measured by their agreed selling price.
Profit accrues in these cases as the stipulated services are performed
or the goods produced or delivered.
G. In a corporation, stockholders’ equity should be classified into
invested capital and retained earnings (earned surplus). Invested
capital should, in turn, be classified according to source, that is, ac
cording to the underlying nature of the transactions giving rise to
invested capital.
Retained earnings should include the cumulative amount of net
profits and net losses, less dividend declarations, and less amounts
transferred to invested capital.
In an unincorporated business, the same plan may be followed, but

the acceptable alternative is more widely followed of reporting the
total interest of each owner or group of owners at the balance
sheet date.
H. A statement of the results of operations should reveal the com

ponents of profit in sufficient detail to permit comparisons and inter
pretations to be made. To this end, the data should be classified at
least into revenues, expenses, gains, and losses.
1. In general, the revenue of an enterprise during an accounting

period represents a measurement of the exchange value of the
products (goods and services) of that enterprise during that pe
riod. The preceding discussion, under D (2 ), is also pertinent here.
2. Broadly speaking, expenses measure the costs of the amount of
revenue recognized. They may be directly associated with rev
enue-producing transactions themselves (e.g., so-called "product
costs”) or with the accounting period in which the revenues appear
(e.g., so-called “period costs”).
3. Gains include such items as the results of holding inventories
through a price rise, the sale of assets (other than stock-in-trade)
at more than book value, and the settlement of liabilities at less
than book value. Losses include items such as the results of hold
ing inventories through a price decline, the sale of assets (other
than stock-in-trade) at less than book value or their retirement,
the settlement of liabilities at more than book value, and the
imposition of liabilities through a lawsuit.
Comments of Andrew Barr
This “Tentative Set of Broad Accounting Principles for Business
Enterprises” must be recognized as a statement of what the authors
believe generally accepted accounting principles should be rather than
what they are today. As stated, they include significant departures
from present practice and hence require critical examination and test
ing. In some respects, the proposals might be tested during a con
version period by means of supplementary statements. However,
indiscriminate application of the principles could result in false and
misleading financial statements and might tend to undermine the
confidence of the public in all published financial statements.
Comments of Carman G. Blough

This “Tentative Set of Broad Accounting Principles for Business
Enterprises” is a notable contribution to the literature of our profession
and a commendable presentation of the views of its authors as to what
accounting principles ought to be. As a research study of accounting
principles designed to be a guide in the solution of the numerous day
to day problems of the profession, however, it leaves much to be de
sired.
Accounting principles are not theoretical hypotheses untried in
practice or tried and discarded as impractical. Accounting has been
evolutionary, just as have the principles of the other arts, law and medi
cine, for example. Experience teaches us many things as to what will
work and what will not. Some of the so-called “principles” set forth
in this document have never been even experimented with, to say
nothing of having been proved practical. Others have been experi
mented with in a very, very few cases, the results of which have been
far from convincing as to their practicality or their general accepta
bility. Still others have been tried and found so lacking in objectivity
as to lend themselves to misrepresentation and distortion. An example
of each may help to clarify these points.
1. The idea of recognizing profit on the sale of an asset in two stages

is certainly one that has never been tried. The revaluation of raw
materials, goods in process and finished goods at “current exchange-
price” with a resulting recognition of any increase as profit, would not
be too difficult, though onerous enough, if it were to be done only with
respect to inventories on hand at the close of a fiscal period, but to
attempt it on a continuous basis strikes me as being highly impractical.
Certain types of perpetual inventory records may possibly lend them
selves to such adjustments without undue effort and expense, but what
of the innumerable situations in which adherence to such a principle
would be tremendously burdensome, if not impossible?
The argument is made that this is consistent with our present
method of valuing inventories at the lower of cost or market. It should
be noted, however, that the cost or market rule, which is now gener
ally followed, relates only to the inventories on hand at the balance-
sheet date. Furthermore, the convention of anticipating losses but not
profits is one of the oldest principles of accounting. It has evolved 61
from, and has been proven desirable by, the experiences of businessmen
for generations. Consistency has its place, and in some accounting mat
ters it is of paramount importance, but there are limitations both to its
usefulness and to its applicability. Experience has demonstrated that
it is sound business policy to wait until profits are realized before they
are reported while providing for losses as soon as they are apparent.
Too many businesses have gone into bankruptcy for not observing such
a principle to warrant brushing it aside merely because it seems not
to be internally consistent.
It seems to me that until the practicability of the proposed method
has been tested under varying conditions and more convincing argu
ments are made as to the usefulness of the information so obtained, it
would be unwise to consider it a principle.
2. Adjustments of financial statements to give effect to the results

of price-level changes have been experimented with in several studies
referred to in this document. However, even with the encouragement
given to furnish supplementary information as to the effect of such
changes on financial statements which was contained in the Accounting
Research Bulletins of the AICPA’s committee on accounting procedure
and in the statements of the American Accounting Associations Com
mittee on Concepts and Standards, the number of companies that have
evidenced any interest in following the proposal could be counted on
the fingers of one hand.
Although the Accounting Principles Board has agreed that “the
assumption in accounting, that fluctuations in the value of the dollar
may be ignored, is unrealistic,” and has requested the accounting re
search staff to study the matter, it cannot be said that the Board has
reached the conclusion that the financial statements should be adjusted
to give effect to changes in the price level. Indeed, in stating its wishes
to the staff it specifically requested that recommendations be made for
the disclosure of the effect of price-level changes on the financial state
ments with special attention to the use of supplementary statements
as a means of disclosure. While the Board may decide that there
should be adjustments to the financial statements themselves, this is
a long way from being a foregone conclusion. In the circumstances,
it can hardly be demonstrated that there is presently any authority for
stating that the adjustment of accounts for price-level changes is an
accounting principle.
3. The idea that “plant and equipment should be restated in terms
of current replacement costs” whenever some significant event occurs,
otherwise at “periodic intervals, perhaps every five years,” is an old
and discarded idea with only a slightly new twist. Shades of the 1920s!
Those of us who remember how impossible it was to determine the
fairness or reasonableness of the results of an appraisal shudder at the
idea of going through it all over again. The mere fact, if it be a fact,
that under current methods calculation of replacement costs are “fea
sible, practical, and objective” does not validate replacement cost as
a meaningful figure. The reasons why replacement cost lacks signifi
cance, by itself, as a measure of current value have been dealt with
so often by so many that there would be no merit in repeating them
here.
There is plenty of room for improvement in the field of accounting
principles and much need to narrow or eliminate areas of differences
that now exist, but it would seem that a logical and cohesive statement
of basic principles selected from the many which have been found
workable and useful would be a logical beginning.
This is not to say that we must look only to the past. Technical
developments may afford an opportunity for accepting accounting
principles that would have been out of the question heretofore. Ac
counting must constantly evolve to meet changing conditions, to use
improved methods and to give effect to constructive forward thinking.
However, before we discard the principles that have served us long
and well in preference to new and untried ones, it would seem essential
to show that a more cohesive and logical body of principles would
result, that financial reports would be more meaningful and useful and
that it would be practical to put the new ones into effect. This, it seems
to me, has not been done in the study before us.
Comments of Arthur M. Cannon

This tentative statement of accounting principles is an excellent job.
It is courageous but not revolutionary in the things that it says that
need to be said and the improvements that are proposed. These im
provements will go far in the direction of truly reflecting “financial
condition and results of operations” in the statements that purport to 63
make such representations.
I am particularly pleased with the proposal to price inventories at
current values, realizable value when readily available and otherwise
replacement cost. I would go further in the same direction in the areas
of fixed assets, though I recognize the distinction between current
assets as those held for relatively prompt liquidation and fixed assets
as those held for productive use over a long period. Since I am familiar
with real estate, I would not find it difficult to accept a current value
principle for valuation of land and buildings based on expert and inde
pendent appraisal reviewed by the accountant. That kind of evidence
is just as good and, in some cases, better than evidence we are using
already in other areas. I am sure that persons familiar with machinery
and equipment would find it equally easy to accept the notion of re
appraisal thereof to current value from time to time.
In setting out current values on the balance sheet and thus causing it
to become a more adequate and useful approximation of financial con
dition, it is important to recognize that, in the related statement of in
come, we will be recognizing explicitly more different kinds of changes
in stockholders equity than we have heretofore. In addition to results
of ordinary operations, the income and surplus statement will show
the effect of revaluing for price-level changes, the effect of revaluing
for changes in prices of specific articles or commodities, and other
gains or losses. What are referred to as gains or losses from “holding”
assets means changes in prices of particular items apart from over-all
changes in the general price level. Like all averages, the changes in
general price level conceal at least as much as they reveal. There is
a tremendous variety and range of individual changes within that
average—some above and some below, some very widely divergent,
and some going one direction while the average goes the other, etc.
These individual changes probably mean more than the over-all price-
level change in evaluating the financial condition of a particular
business.
Let me use an illustration. The other day we made a mortgage loan
for the construction of a new shopping center in San Jose, California,
a very fast growing area. The land in question was the sole asset of
the owner, and he had purchased it as a farm for $8,000 about fifteen
years ago. It was currently appraised at $300,000, and we made a
mortgage loan of $350,000 for the new construction, the total value
when completed to be $650,000. The over-all price level in the period
the farmer held the land approximately doubled. If we accountants
64 prepared a statement for this farmer just before the indicated trans
action, we would show the asset at $8,000 and net worth at $8,000
(other items excluded). If we took the price-level change into ac
count, we would show the asset at $16,000 and the net worth at the
same amount. The change in the price level is trivial in comparison
with the over-all change in value. After the construction and the loan
are completed, a traditional accountant’s statement would show the
land and buildings at $358,000, the loan at $350,000 and the net worth
at $8,000, and, if the price-level change were recognized, then the asset
would be $366,000, the loan $350,000, and the net worth $16,000. This
statement of financial condition is a long way from financial condition,
whether based on cost or whether based on cost adjusted for the price-
level change. What is needed, of course, is to show the land at its
current value, $300,000—in which case the total asset will be $650,000,
the loan $350,000 and the net worth $300,000. In that net worth should
be reflected cost $8,000, adjustment by reason of price-level change,
another $8,000, and appreciation by reason of holding in a rising mar
ket, $284,000.
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 col
umns, and with the net worth at cost in both columns but with appre
ciation reflected in the current value column. I have seen no effort to
break down that appreciation between the specific and the general
price change. I think it desirable to show that breakdown between
the specific and the general, but the overriding requirement is to bring
the total and actual current value onto the statement. I have seen bor
rowers 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.
I should like to comment also on the comments of Messrs. Paul
Grady and Leonard Spacek reproduced herein. I have the highest
regard for both of them and for their opinions. However, Mr. Grady’s
statement is essentially a defense of the status quo and that is not the
task of the Accounting Principles Board. The charter rules of the
Board are perfectly definite as follows:
The general purpose of the Institute in the field of financial ac
counting should be to advance the written expression of what
constitutes generally accepted accounting principles, for the 65
guidance of its members and of others. This means something
more than a survey of existing practice. It means continuing
effort to determine appropriate practice and to narrow the areas
of difference and inconsistency in practice. In accomplishing
this, reliance should be placed on persuasion rather than on
compulsion. The Institute, however, can, and should, take defi
nite steps to lead in the thinking on unsettled and controversial
issues.
As to Mr. Spacek’s statement, he says the published accounting pos
tulates and these accounting principles are a set of unsupported opin
ions, but no fair-minded reader of either of these monographs, each
of considerable length, could join in that opinion. On the contrary,
it is Mr. Spacek who states a personal opinion unsupported by
argument and expects to carry it by the very vehemence of his assault.
He is welcome to his opinion and it will have weight with many as it
does with me, but he is wrong to say that these monographs are no
more than personal opinions.
The present monograph on principles goes well now with the pre
vious monograph on postulates and the significance of the latter be
comes much more apparent. I think, perhaps, the postulates mono
graph might now be rewritten somewhat and condensed somewhat to
make the transition to the principles a little more ready and obvious.
We are squarely on the track of the special research committee's
plan and the charter rules of the Board. It will be easier to develop
rules for specific situations with these principles before us. The think
ing and exposition that went into the postulates provided a good base
for the principles. Most important, we are about to make the great
stride from cost-based to current-valued assets and net worth in finan
cial statements.
Comments of Oscar S. Gellein

Mr. Gellein believes that publication of the research study will serve
no useful purpose and likely will delay development of the broad prin
66 ciples comprehended in generally accepted accounting principles. He
further believes that orderly development of accounting principles
requires completion of two phases of research or study before a public
judgment is sought concerning acceptability of the principles.
The two steps, one as important as the other, are (a) formulation of
a theory by processes of logic and (b ) tests of the theory for practica
bility and reasonableness. Logic can produce many theories of ac
counting as it has produced varying theories in other fields. Operative
accounting principles derive from the theory that satisfies tests of use
fulness in the varying circumstances of accounting.
The research study, for example, places conservatism and realization
in less important positions than they have conventionally occupied,
and redefines standards of objectivity. Significant recasting of long
standing accounting principles calls for proof by way of both analysis
and tests that the new is more useful than the old. Mr. Gellein believes
that the research study does not furnish this proof.
Comments of Paul Grady
In the summer of 1961, Paul Grady, as a member of the project advisory
committee on broad accounting principles, submitted some detailed criti
cisms of an earlier draft of this study. He later prepared the more extended
statement that follows. With the addition of three introductory paragraphs
(omitted in the material that follows) it will appear as an article in the
May 1962 issue of The Journal of Accountancy, the same issue in which
the summary chapter of this research study will appear. This statement sets
forth his comments on the approach taken in these research studies as well
as his suggested summary of what a statement of generally accepted ac
counting principles should contain.
As a member of the project advisory committee on broad accounting
principles, Mr. Grady is entitled to have his comments included in this
research study. I have chosen to publish this relatively long statement in
lieu of a shorter one in order to assist the reader in focusing more sharply
on the issues involved.
M a u r ic e M o o n it z , Director of Accounting Research
Some fifteen years ago, the committee on auditing procedure, of 67

which I was chairman (1944-48), was engaged in the study of the
meaning of “generally accepted auditing standards.” As is the case
with “generally accepted accounting principles,” the term “gener
ally accepted” had been used in the standard form reports of certi
fied public accountants for several years without any explicit definition.
Undoubtedly, the task of dealing with accounting principles is more
difficult than the task we had with auditing standards. It is suggested,
however, that there may be points of similarity which are worthy of
consideration by members of the Accounting Principles Board.
Take All the Time That Is Needed

The first point is the matter of time required for completion of the
task. It required three years for the committee on auditing procedure
to produce the tentative statement on “Generally Accepted Auditing
Standards —Their Meaning and Significance.” A fourth year was
required for discussion in the profession before the summary of stand
ards was approved by the members of the Institute. It is reasonable
to expect the accounting principles project to take a longer period of
time, both due to the nature of the problem and to the use of the
accounting research studies as forerunners of decisions by the Account
ing Principles Board. Accordingly, it is recommended that the Board
ignore any pressures that may develop toward speeding up the pro
gram. This is not a crisis problem and time to be gained is not worth
the risk of sacrificing quality in the decisions to be reached.
Nature of the Quest

A research study, the purpose of which is discovery of new lines of
reasoning and new demonstrable facts, will necessarily be of a dif
ferent character than one whose purpose is to analyze existing facts
and to organize the lines of reasoning into a more understandable
and more useful pattern. The committee on auditing procedure had
no difficulty reaching an early conclusion that our study of generally
accepted auditing standards was not a discovery mission.
In introducing the three major papers on auditing standards at the
1947 annual meeting of the Institute, the chairman of the committee
made the following comment:
Toward the end of his career Sir Isaac Newton said he felt like
a small boy at the seashore who had discovered a few shells but
68 had before him the vast unexplored ocean. The only common
point between this remark and the committee on auditing pro
cedure is that we are now at the seashore [Atlantic City]. The
work of the committee has not been a discovery mission, because
the auditing standards with which we are dealing have been
inherent in the accounting profession from the beginning. Our
endeavor has been more in the nature of a screening process
to separate the “shells” of standards from the “sands” of pro
cedures and to arrange the standards in a useful pattern.
It may be well to recall the utter simplicity of the general or per
sonal standards —proficiency, independence and due care. The seven
further standards grouped under field work and reporting are to a
large degree cross-sectional classifications for the purpose of illustrat
ing more clearly the application of the basic standards. Proficiency
and independence, in a sense, are prerequisites to professional audit
ing work, and accordingly due care may be regarded as the active
pervading theme in generally accepted auditing standards.
The term “generally accepted accounting principles” first came into
use in the reports of certified public accountants as the result of the
correspondence, published in 1934, between an Institute committee,
a committee of the Controllers Institute, and the New York Stock
Exchange. It was generally recognized that there were areas in which
alternative accounting practices were prevalent. This was one of the
reasons for the suggestion in the correspondence that a statement of
the corporation’s major accounting policies be approved by directors
and made available to stockholders. The term “generally accepted"
contained an element of restriction since it required, obviously, a
broader band of acceptance than merely the practice of one corpora
tion, and the judgment of what was generally accepted was left to
the certified public accountant.
The identification and description of generally accepted accounting
principles necessarily embraces more than the professional work of
certified public accountants and must reach back to the primary steps
by which management meets its accountabilities to investors and
others having legitimate interests in the business enterprise. While this
makes the quest more difficult, it does not convert it into a discovery
mission. The problem is largely one of identification of the principles,
on which there is general agreement, and of developing a useful pat
tern of arrangement or classification. It seems clear that the Institute
has the responsibility of establishing an inventory of current generally
accepted accounting principles before, or at least separate from, under
taking substantial changes.
69
A Blending of Logic and Common Sense
In a brief discussion of the method to be followed in the studies
of postulates and principles, the Director of Accounting Research
said:1
We are driven to the conclusion, then, that relatively heavy re
liance must be placed on deductive reasoning in the development
of accounting postulates and principles. We must first recognize
and define the problems to be solved, then move to their solution
by careful attention to what “ought” to be the case, not what “is”
the case. Hopefully, the two, “ought” and “is,” will not be too far
apart but we have no reason to expect them to be identical.
This attitude seems to place a greater burden on theory and logic
than has been expected in the past even by those who have specialized
in theory. In 1939 Professor A. C. Littleton said:2
Accounting theory, since it has grown largely out of accounting
practice, may seem to serve principally as a means of explaining
1 Maurice Moonitz, “The Basic Postulates of Accounting” Accounting

Research Study No. 1, American Institute of Certified Public Accountants.
1961, p. 6.
2 A. C. Littleton, Essays on Accountancy, University of Illinois Press.
1961, p. 376.
and illuminating what is done in accounting. But theory has a
further obligation, that of strengthening practice by subjecting
customs to analysis and testing their justification by finding the
relation of customary ideas to basic concepts and purposes.
Nine years later (1948) the same educator in discussing the ap
plication of theory to a problem said:3
Perhaps theory can help, if we do not expect too much. Theory,
you will agree, can be an aid to understanding and understand
ing united with practical wisdom can carry us a long way toward
a good choice. Perhaps it is too much to expect either theory or
practice to be completely satisfactory alone. I am convinced that
theory could not [be of help in the particular situation], for
theory does not direct; when we use theory we do not seek to
prescribe. We are only trying to analyze, to understand, to per
suade. Theory therefore must consist of explanations, definitions,
reasons, justifications, persuasions. And only sometimes of sup
positions and hypotheses.
Accountancy is a very practical art and has been called the “lan
guage of business” to briefly indicate its important intelligence and
70 communication function. The Accounting Principles Board’s most
difficult task may well be to see that the logic and theory of the
research studies are given a proper blending with common sense and
business judgment in the Board’s own conclusions. In this connection
these words of Justice Holmes seem quite appropriate:4
. . . the whole outline of the law, as it stands today, is the
resultant of a conflict between logic and good sense—the one
striving to carry fictions out to consistent results, the other re
straining and at last overcoming that effort when the results
become too manifestly unjust.
. . . the logical method and form flatter that longing for cer
tainty and for repose which is in every human mind. But cer
tainty is illusion, and repose is not the destiny of man.
It seems to me there would be great merit in having a brief summary
of generally accepted accounting principles for business enterprise as
of the present time. Theoretical explanations, reasons, justifications
and logical criticisms should be presented in such volume as may seem
appropriate but the summary should stand out for its own practical
uses. For whatever it may be worth, such a suggested summary is
submitted in the following pages.
3 Ibid., p. 310.
4 Oliver Wendell Holmes, Collected Legal Papers, Harcourt, Brace & Co.
1920, pp. 101 and 181.
Principles of Financial Accounting for Business Corporations
Accounting serves many purposes in the broad fabric of incorporated
business enterprises. The most important is to supply the comprehen
sive and dependable information required in order that management
may fulfill its fiduciary accountabilities to stockholders, creditors,
government and others having bona fide interests. The principles of
financial accounting for corporate business enterprise logically and
usefully may be classified in relation to these fiduciary accountabili
ties. Such principles are necessarily stated in broad terms of objec
tives and major criteria and the complexities facing modern business
make more definitive rules necessary to implement the principles in
relation to the pertinent circumstances of the time. In a changing
world it naturally follows that detailed rules not only may but should
be changed to meet changes in conditions or in the mode of thought
of the business community and that such changes do not necessarily
affect the broader principles and postulates all of which are com
prehended in the term generally accepted accounting principles. In
this context, the principles of financial accounting for corporate busi
ness enterprise are summarized as follows: 71
A. Account for sales, revenues, income, cost of sales, expenses,

gains and losses in such manner as to fairly present the results of
operations for the period or periods of time covered.
1. Sales, revenues and income should not be anticipated. Accordingly,
there must be proper cutoff accounting at the beginning and end
of the period or periods.
2. Costs of sales and expenses should be appropriately matched
against the periodic sales and revenues. It follows that there must
be proper cutoff accounting for inventories and liabilities for costs
and expenses at the beginning and end of the period or periods.
3. Appropriate charges should be made for depreciation and deple
tion of fixed assets and for amortization of other deferred costs.
4. Proper distribution of costs should be made as between fixed
assets, inventories, maintenance and expense. Direct costs are
usually identifiable and common costs applicable to more than one
activity should be distributed on appropriate cost incurrence bases
such as time or use factors.
5. Nonrecurring and extraordinary gains and losses should be shown
separately from the ordinary and usual operations.
6. There is a strong presumption that all gains and losses will be in
cluded in periodic income statements unless they are of such mag
nitude in relation to revenues and expenses from regular operations
as to cause the statements to be misleading.
7. If accounting principles in the determination of periodic results
have not been consistently maintained, the effect of the change
should be stated.
B. Account for the equity capital invested by stockholders through
contribution of assets or retained earnings in a meaningful manner
on a cumulative basis and as to changes during the period or periods
covered.
1. In case there are two or more classes of stock, account for the
equity capital invested by each and disclose the rights and pref
erences to dividends and to principal in liquidation.
2. From a financial viewpoint the capital invested by stockholders
is the corpus of the enterprise and its identity should be fully
maintained. Any inroads in capital resulting from operating defi
cits, losses of any nature, or dividend distributions in excess of
earnings, should be accounted for both currently and on a cumula
72 tive basis.
3. In case of substantial monetary inflation appropriate conversion
adjustments should be undertaken in order that the capital of the
enterprise may be maintained in terms of the purchasing power in
vested by the stockholders.
4. All charges and credits to retained earnings and to any paid-in or
other capital surplus accounts should be disclosed for the period
or periods covered.
5. There should be no commingling of retained earnings with capital
surplus items. Retained earnings should represent the cumulative
balance of periodic earnings less dividend distributions in cash or
stock, plus or minus gains and losses of such magnitude as not
to be properly included in periodic earnings. Retained earnings
may also be decreased by transfers to capital stock accounts
through appropriate formal corporate action. Accumulated deficit
accounts may not be eliminated against capital accounts or capital
surplus except by appropriate formal corporate action approved
by stockholders which establishes a new base line of accountability.
C. Account for the assets invested in the enterprise by stockholders
(through property contributed or retained earnings) or by creditors
in a meaningful manner so that when considered with the liabilities
and equity capital of stockholders there will be a fair presentation of
the financial position of the enterprise both at the beginning and end
of period. It should be understood that financial position or balance
sheet statements do not purport to show either present values of assets
to the enterprise or values which might be realized in liquidation.
1. Items classified as current assets should be carried at not more
than is reasonably expected to be realized in the normal course
of the business operations. Cash should be segregated between
unrestricted and restricted items and the inclusion of the latter in
current assets must be justified by their nature. Receivables should
be reduced by allowance accounts to cover expected collection or
other losses. Receivables from officers or affiliated companies
should be shown separately. Inventories should be carried at direct
costs plus factory overhead costs and the basis of determination
(i.e., Lifo, Fifo or average) should be stated. Prepaid items should
be properly chargeable to future periods.
2. Fixed assets should be carried at cost of acquisition or construc
tion, adjusted or converted when necessary to reflect substantial
changes in the purchasing power of the monetary unit. Cost of
73
land should ordinarily be shown separately. Cost of construction
includes direct costs and overhead costs incurred, such as engineer
ing, supervision and administration, interest and taxes. Items
treated as fixed assets should have at least one year of expected
useful life to the enterprise and normally the life is considerably
longer. Practicable yardsticks or criteria should be established in
order that consistent distinctions may be made between fixed
assets, operating expenses and maintenance. Ordinarily, this should
be accomplished by creating a catalogue of property units to be
included in fixed assets, any lesser items to be charged to current
expense.
3. Appropriate provision or allowances should be made in order to
charge operations with the investment in depreciable assets over
the estimated life thereof. The accumulated allowances, less prop
erty retirements, should be shown as a deduction from fixed assets.
4. Long-term investments in securities ordinarily should be carried at
cost. Where market quotations are available the aggregate quoted
amounts should be disclosed. Investments in affiliates should be
segregated from other investments.
5. The costs of intangible items, such as debt discount and expense,
patents, copyrights, research and development (if deferred) and
goodwill should be shown separately. Limited term items should
be amortized against earnings over their estimated lives. The policy
in regard to amortization of unlimited term intangibles should be
disclosed.
6. The nature and extent of hypothecated or pledged assets should
be shown.
D. Account for all known liabilities in a meaningful manner in
order that their summarization, considered together with the state
ment of assets and equity invested by stockholders, will fairly present
the financial position of the enterprise at the beginning and end of
the period.
1. All known liabilities should be recorded regardless of whether the
definite amount is determinable. If the amounts cannot be rea
sonably approximated, the nature of the items should be disclosed
in the face of the summary of liabilities or by footnote.
2. Current liabilities should include items payable within one year
from the end of the period or the end of the operating business
cycle used in the classification of current assets. Accounts should
74 be shown separately for notes payable to bankers, notes payable
to others, accounts payable (may include payrolls), Federal in
come taxes accrued, other accrued taxes, accounts or notes payable
to officers and accounts or notes payable to affiliates.
3. Long-term liabilities should be described and due dates and rates
of interest shown.
4. The nature and extent to which specific liabilities are a preferred
lien on assets should be shown.
Probably the only unexpected item in the foregoing summary is
the requirement for price-level adjustments when there are substan
tial fluctuations in the purchasing power of the monetary unit. Some
months ago the Accounting Principles Board agreed that the assump
tion in accounting that fluctuations in the value of the dollar may be
ignored is unrealistic. This seems clear-cut approval of the principle
of price-level adjustments. It is recognized, of course, that the study
project is not completed and that it will have to deal with such mat
ters as criteria for determining what are substantial fluctuations, for
the selection of indices for measurement of purchasing power varia
tions and whether to use supplemental statements.
In my view, recognition of the necessity for price-level adjustments
is the greatest forward step ever taken in accounting. It closes the
gap of disharmony which has existed between inventory and fixed
asset accounting since the introduction and approval of Lifo method.
Of even greater importance, it affords a sturdy foundation for the fol
lowing basic concepts and objectives for financial accounting:
1. The purchasing power of equity capital invested in an enter
prise, either by assets contributed by stockholders or by retained earn
ings, must be maintained in statements of financial position.
2. Periodic business income is to be determined by the matching
of revenues and related costs and expenses—all stated in homogeneous
current monetary units.
It will be noted that the pervading theme of the summary is the
fiduciary accountability of management to investors in the business
enterprise. This term is not used in any legalistic sense but rather in
the broader concept of responsibilities which most managements of
business enterprise in America have shown toward investors and others
having legitimate interests. The structure of the summary is related
to the types of financial statements now considered essential, but there
is ample flexibility to introduce other forms when and if they become
essential. It is believed, also, that more detailed rules of accounting,
such as the ARB’s previously issued, or similar rules to be issued by
the Accounting Principles Board in the future, may be related mean 75
ingfully to the salient points in the summary.
Accounting Progress a Continuous Process

Previously, reference has been made to the time required for the com
pletion of the basic projects on accounting postulates and principles
and, of course, time will also be required for the several special topics
on which research projects have been undertaken. There seems to be
a tendency by some members of the profession to equate this pause
in the technical legislative process of the Institute with a stoppage in
accounting progress. Such an attitude is a serious error.
From the beginning, progress in accounting has been evolutionary
rather than revolutionary. The greatest force for progress has been
the persuasive efforts of individual certified public accountants in
urging the adoption of the better of alternative practices by their
clients. Every client is entitled to the best judgment and advice of
the accountant, who must not be stopped by the first line of resistance
even though the client’s practice is not so bad as to require qualifica
tion. Often it will be found that the objections stated by lower levels
of management are not shared by the upper levels. If it is objectively,
competently and courageously applied, the scrub brush of good ac
crual accounting holds the solution to most of the dingy areas of
accounting practice.
Comments of Herbert E. Miller
It is apparent that the tentative set of broad accounting principles
is not an attempt merely to enumerate prevailing practices or to list
those areas in which there is majority support. The tentative set is
constructive and challenging, but, if the recommendations made
therein are adopted, I believe that the accounting process will, on
balance, become more subjective. This is attributable to the greater
reliance placed on such information as net realizable values, market
values, current replacement costs, and appraisal data. Although the
authors have been careful to point out the importance of using objec
tive information in support of the valuation methods advocated, much
will depend on whether reasonably uniform tests are developed and
applied in connection with the use of the “new” information and
whether the “new” valuation bases become widely enough adopted to
give published financial statements some appearance of conformity.
I am not suggesting that greater subjectivity as such will be bad for
accounting, but it is a matter worthy of serious consideration.
76 In my opinion, there is a related but perhaps more significant worry
that could arise with the publication of this study. This is traceable
to the fact that important changes are recommended without submit
ting any guide lines indicating to the profession how it might move
from the position it now supports (admittedly not a place susceptible
of precise description) to the position advocated by Drs. Sprouse and
Moonitz. In view of the proposed further relaxation of the realization
rule and the modification of our cost concepts (permitting “cost or
higher” as well as cost or lower), I am fearful of abuses and a lessening
of confidence in published financial statements. Such prospects might
be avoided if some way could be found to assure widespread and quick
adoption of the broad principles set forth in the research study. Ideally,
the matter of implementation should have been studied concurrently.
It seems to me that the absence of any plans or suggestions for tran
sition and adoption not only increases the risk of abuse and uncertainty,
but detracts from the chances for the research effort to receive the
consideration it deserves.
Comments of Leonard Spacek
The principal purpose of the two research studies on accounting
postulates and principles by the Accounting Research Division of the
American Institute of Certified Public Accountants is to establish a
sound foundation for and a general framework of accounting theory
so that financial accounting and the resulting financial reporting will
meet the current needs of all segments of our society. If this is to be
achieved, a necessary prerequisite is an accurate and clear statement
of the purposes and objectives of accounting. From such a starting
point, the foundation and the structure must be built step by step,
each supported by comprehensive and logical reasoning relating it
to the purposes and objectives, and each strengthening the others in
a co-ordinated manner.
As indicated in my comments on the research study relating to “The
Basic Postulates of Accounting” ( Accounting Research Study No. 1,
page 56), I do not consider that the propositions there advanced as
constituting the basic postulates afford an adequate foundation or
basis for the formulation of accounting principles. This research study 77
on the broad accounting principles further reveals the complete lack
of such a foundation in either study. The accounting principles pre
sented are neither adequately supported nor successfully defended;
this becomes evident when, with respect to each, the simple question
is asked—why?
The introduction to this study states: “The principles of financial
accounting that are developed in this study are designed to meet the
needs of all interested groups.” (Reference in this regard is made to
management, owners, creditors, government, and others with bona
fide interests.) This objective is excellent, but the subsequent discus
sion leading up to the statement of principles represents a series of
personal opinions that are not supported in any significant manner as
to how or why the so-called principles “meet the needs of all interested
groups,” or as to why the conclusions represent a sound and co
ordinated framework of accounting theory. Furthermore, there is
very little attempt to demonstrate how these principles flow from or
are based on the postulates set forth in the previous study. This is
understandable, of course, since the self-evident observations or pro
positions advanced as basic postulates in that study cannot provide
a suitable foundation for the formulation of accounting principles, nor
do those postulates afford an objective guide against which to test
the principles proposed.
While my criticism relates more to what is not said than to what
is said, there are a number of statements in this study with which
I do not agree. But, no purpose would be served by commenting
thereon in any detail. At this stage of the research program, it is more
important to discuss the bases for the conclusions presented; other
wise, only unsupported personal opinions based on obscure premises
would be in controversy.
True research involves a critical and objective analysis in consid
erable depth of the logic and the reasoning underlying the conclu
sions reached. The reasoning set forth in this study is, in my opinion,
inadequate, incomplete, superficial and lacking in logical support.
As an example of what I have in mind, the principles developed
include the statements that: (1 ) inventories that can be sold merely
by making delivery should be recorded at net realizable value and
other inventory items should be recorded at their current (replace
ment) cost; (2 ) plant and equipment and “intangibles” should be
recorded at cost with appropriate modification for price-level changes
(it is stated that such modification may be done in supplementary
78 statements, in which event the recorded costs in the accounts would
not be adjusted); and (3 ) the investment in plant and equipment and
“limited-term intangibles” should be amortized over their estimated
lives and “unlimited-term intangibles” should be carried as assets with
out amortization. The study does not give adequate reasons as to
why these principles are logical and defensible in relation to each
other and why they “meet the needs of all interested groups,” i.e.,
produce fair results for all segments of the business community (man
agement, labor, stockholders, creditors, customers and the public).
These first two research studies must be considered together. They
do not set forth the basic postulates and principles that should un
derlie the accounting for and presentation of financial position and
results of operations in a broad sense. This over-all viewpoint is
discussed in a general way in Chapter 2, with no reasoning or con
clusions of any consequence, and is referred to somewhat indirectly
in subsequent chapters and in the statement of principles. However,
a discussion of assets, liabilities, revenue and costs is premature and
meaningless until the basic principles that will result in a fair pres
entation of the facts in the form of financial accounting and financial
reporting are determined. This fairness of accounting and reporting
must be for and to people, and these people represent the various
segments of our society.
Research projects are in process for such complicated accounting
problems as those related to accounting for income taxes, business
combinations (poolings of interests), intercorporate investments, pen
sions, price-level changes, and a number of others. The broad account
ing principles as set forth in this study do not offer well supported
standards and guides for the solution of these problems. Without
such standards and guides, those who are conducting these other re
search studies will be giving their own opinions without any clear-cut
support from the basic structure of accounting theory.
Accounting research, if it is to be worthy of that name, must ac
complish what has been done in many other fields of knowledge —
determine exactly what is needed in the public interest and then
establish those principles which meet that need on a sound and logical
basis. In my opinion, these two studies on the postulates and princi
ples have not done this; and, until this is done, the results of further
research studies involving accounting practices in various areas can
not be persuasive or effectual.
79
Comments of William W. Werntz

( N o t e : These comments were received in the form of a letter to the
Director of Accounting Research . )
I have finally had the opportunity to read with some care the Feb
ruary 1962 draft of “A Tentative Set of Broad Accounting Principles
for Business Enterprises” which you and Dr. Sprouse have prepared.
The care and thoughtfulness with which you have approached this
task is self-evident.
I regret to have to say that I think it would be a disservice for this
study to be published in its present form. I am in agreement with you
that it was not your task merely to seek to describe existing practices.
On the other hand, I am extremely fearful that, in the way in which
the document has been prepared, there is an inadequate distinction
between practices which have received general acceptance to date
and those which you propose as additions to or changes in existing
practices. It is evident that effort has been made to make this dis
tinction, but I do not think the result goes far enough. In the hands
of some, I fear the study would be used indiscriminately as authority
for financial presentations that under present circumstances would be
misleading.
Even granting for the moment the desirability and acceptability of
all of the substantive proposals, I feel the document should not be
published unless it contains ground rules for a transition to the new
basis. Lacking such discussion, it should, as a minimum, state quite
clearly at the outset that certain of the proposals which are made are
presently not in accordance with generally accepted accounting prin
ciples. I would go further and suggest that at an early point in the
document there be a separate summary statement of those proposals
which you regard as departures from generally accepted accounting
principles so there could be no possible misunderstanding on this score.
I am also unhappy at the imbalance of the treatment as between
varying sectors of accounting principles. For example, there is an
exhaustive discussion of the use of the interest factor in discount
ing liabilities and the treatment to be accorded such discount. On the
80 other hand, the whole problem of intangible assets is dismissed, as
I see it, in a single paragraph, and then largely by reference to the
discussion of plant and equipment. Similarly, so far as I can de
termine, no mention is made of the problem of tax allocation. I
realize this is under separate study, but your study purports to cover
broad accounting principles, and some mention of this with a reference
to the study, as is done in other cases, should be made. There are a
number of other similar situations.
The treatment of the problem of realization is unsatisfactory in my
opinion. To begin with, the discussion leaves the definite impression
that sale as the point of realization is a minority practice, or, perhaps,
that it should be. To the best of my knowledge, precisely the contrary
is true. There are, of course, a number of well defined types of business
in which another basis is utilized but these, with the possible exception
of long-term contracts, are relatively infrequent. Note in this con
nection the use of the word “sometimes” at page 47 which clearly
seems to imply that "sale” is only occasionally the point at which to
recognize revenues.
My second objection is to the concept of recognizing profit for in
come purposes (a) where replacement cost is higher than acquisition
cost, and (b ) where an intermediate product has a ready market, as
in the case of some metals. You, of course, are quite correct that
replacement cost is utilized to write down inventories at the present
time. It is true also that there are methods of determining or calculat
ing replacement cost as a basis for comparing it with acquisition cost.
In such present usage, however, it is merely a method of estimating a
probable inability to recover acquisition cost. It is not a method of
introducing new values into the balance sheet.
I have exactly the same feelings with respect to the use of appraisals
of real property. When used to allocate cost as between items of
property or to write down property, I see no objection, as the appraisal
is again only a method of estimating a loss. Where appraisals result
in a net write-up, I have seen only a few cases in which I would want
to introduce such values into the balance sheet and the present or
future determination of earnings. Certainly I would not think of this
as a once-every-five-years concept.
It is my opinion that realistic market prices are not nearly so wide
spread as would be necessary if your theory were to be adopted.
Possibly the clearest case is that of the stock market quotations them
selves. While these quotations are probably satisfactory for valuing
most individual investors’ holdings, they often have little or no bearing
on the market value of a large holding. Moreover, the factors that 81
determine the “market quotation,” I am beginning to believe, are
coming to have less and less to do with the values that should be
used in preparing sets of financial statements. If your proposal (as
to replacement cost) is utilized with respect to the component units
of even a modest-sized inventory, the problem of identification of a
market or replacement price becomes enormous. As to fixed assets,
we need only consider the variety of “appraisals” that can be obtained
on request. Moreover, to me there is a vast difference between using
a price quotation as a means of estimating a loss and using the same
quotation as a means of recognizing a profit to be reflected in the
accounts. The latter requires a far higher degree of exactness and
objectivity than the former.
I also do not understand your philosophy in saying that replacement
cost is still a cost method. I would not agree with this when it is
higher than acquisition cost.
Widespread use of implied interest rates to discount amounts re
ceivable or payable in the future, in my opinion, is neither feasible
nor desirable. I recognize that this principle has been used, at times
rather frequently, in certain types of accounting calculations. The
extension of its use into areas where there is no agreed-upon interest
rate involves a considerable area of problem. In view of normal fluc
tuations of fram in g s between years, I do not believe there is any “in
terest rate” that can be identified as the rate which a given company
is apt to earn, such rate to be applied on the assumption that this is
how useful the delay in payment is to the company. Nor am I very
happy about arbitrarily using the prime rate, or some arbitrarily de
termined higher rate.
I am interested to note that at page 40 you indicate that no adjust
ment need be made should the interest rate change. Granted that a
change can be identified, it would seem to me no more difficult and
no less important to apply than the concepts which you developed as
to holding gains.
Conceptually, your treatment of the correction of errors is probably
sound. However, it has certain major drawbacks in practice. For
one thing, we all know that short-period calculations of earnings neces
sarily involve a great deal of judgment and many estimates. If these
are biased in one direction or the other, then under your proposal
the corrections are passed through surplus rather than income, and
the income statements necessarily have a long-term overstatement
or understatement. If there is no bias or conscious prejudice, I think
a very good argument can be made that errors discovered in a given
period should find reflection in that period’s income statement except
in highly unusual situations. It might even be desirable to show them
separately on the theory that in a broad general way they may help
to measure the amount of errors probably inherent in the current
figures. In all events, I think you should point out that if the corrective
entry is really material, it should preferably result in a restatement
of the previous years’ figures for comparison with the current year,
particularly if the error affects primarily the next previous year.
In conclusion, it seems to me that your study largely reflects what
is currently understood to be generally accepted accounting principles
with two major exceptions—(1 ) the very broad and general proposal
to use market values in place of cost on the balance sheet and in the
income statement, including therein both specific price changes and
price-level changes, and (2) a very broad utilization of the interest
factor in discounting amounts receivable or payable in the future.
I again emphasize that if the study is to be published (which I hope
it will not in its present form), these two major changes, at least,
should be described early in the study so that the reader will be
forewarned as to the proposals that you are making rather than to
have to read the whole document to come upon them.
Comments of John H. Zebley, Jr.
This study contributes very little to establishing a foundation which
may be used by the profession in narrowing the differences of opinion
that exist in practice as to what constitutes “generally accepted ac
counting principles” and, in my opinion, will need to be supplemented
and explained by further studies before the goal set by the special
committee begins to come into view.
83
Selected Bibliography
(The items listed below were selected primarily for their relevance to
this research project. No attempt has been made to trace ideas to their
sources or to compile a definitive bibliography on accounting postulates
and principles. General reference works, including textbooks and manuals,
have been omitted.)
S., “Income measurement in a dynamic economy,” Five

A l e x a n d e r , S id n e y
Monographs on Business Income, Study Group on Business Income.
American Institute of Certified Public Accountants. 1950.
A m e r ic a n A c c o u n t in g A ss o c ia t io n , Executive Committee. “A tentative
statement of accounting principles affecting corporate reports,” Account
ing Review, June 1936, pp. 187-91.
84 A m e r ic a n A c c o u n t in g A sso c ia t io n , Executive Committee. “Accounting
principles underlying corporate financial statements,” Accounting Re
view, June 1941, pp. 133-39.
A m e r ic a n A c c o u n t in g A ss o c ia t io n , Executive Committee. “Accounting
concepts and standards underlying corporate financial statements—1948
revision,” Accounting Review, Oct. 1948, pp. 339-44.
A m e r ic a n A c c o u n t in g A ss o c ia t io n , Committee on Concepts and Stand
ards. “Accounting and reporting standards for corporate financial state
ments—1957 revision,” Accounting Review, Oct. 1957, pp. 536-46.
A m e r ic a n I n s t it u t e o f C e r t i f i e d P u b l ic A c c o u n t a n t s , Accounting Re
search and Terminology Bulletins (Final Edition). 1961.
A r t h u r A n d e r s e n & Co. Accounting and Reporting Problems of the Ac
counting Profession. (Privately printed.) Sept. 1960.
A r n e t t , H a r o ld E., “What does ‘objectivity’ mean to accountants?” Journal
of Accountancy, May 1961, pp. 63-68.
B ed fo r d , N o r t o n M., “A critical analysis of accounting concepts of income,”
Accounting Review, Oct. 1951, pp. 526-37. Discussion restricted to the
1948 “Revision” of the American Accounting Association and to the
Accounting Research Bulletins issued to 1951.
B e r l e , A. A., J r ., “Accounting and the law,” Accounting Review, Mar. 1938,
pp. 9-15.
B l o u g h , C a r m a n G., "Accounting principles and their application,” in
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University of Mississippi

Tentative set of broad accounting principles for

Follow this and additional works at: https://egrove.olemiss.edu/aicpa_guides

By Robert T. Sprouse, Ph.D. and Maurice Moonitz, Ph.D., CPA

The Director of Accounting Research of the American Institute of Certi­

By Robert T. Sprouse, Ph.D.

This research study is published for discussion purposes. It does not

COMMENTS OF ANDREW B A R R ..............................................................................60

COMMENTS OF CARMAN G. B L O U G H ..................................................................60

COMMENTS OF ARTHUR M . CANNON................................................................. 63

COMMENTS OF OSCAR S. G E L L E IN ....................................................................... 6 6

COMMENTS OF PAUL G R A D Y ................................................................................... 67

COMMENTS OF HERBERT E . M I L L E R ..................................................................76

COMMENTS OF LEONARD S P A C E K ........................................................................77

COMMENTS OF W ILLIA M W . W E R N T Z ............................................................79

COMMENTS OF JOHN H. Z E B L E Y , JR ................................................................... 83

This study is a companion to Accounting Research Study No. 1, "The

New York, N. Y., April 1962 T. S p r o u s e

In the context of the entity without ownership interests (e.g.,

1 Study Group on Business Income, Changing Concepts of Business In­

cedure has defined “financial statements” as those which purport to

Balance Sheet and Income Statement

3 Statement on Auditing Procedure No. 28, “Special Reports.” 1957. Para­

are significant not only to prospective buyers of an interest in the

work. The Division of Accounting Research of the American Institute

The Foundation for the Principles

6 Maurice Moonitz, “The Basic Postulates of Accounting.” Accounting

Postulate B-4. Tentativeness. (Related to A-4.) The results

7 op. cit. p. 23.

alternatives. To make these allocations properly, predictions as

Owners' equity is represented by the amount of the residual interest

Broad Principles and Historical Limitations

Profit and Business Activity

is not attributable, except conventionally, to the moment when

1 Financial Accounting, Macmillan (New York, 1943), p. 30.

history of the resources held by economic entities, to measure all of

3 This is Postulate B-2. The discussion in “Basic Postulates” starts on

invoices. The use of this wide range of measures is definitely in

5 See also Harold Arnett, “What Does ‘Objectivity’ Mean to Account­

in time and in amount. Thus, the rule is almost completely valid

14 Two points are noteworthy in the passage quoted: ( 1 ) the clear

4. It had to be severed from capital.

No useful purpose would be served in this study by trying to de­

mated with a high degree of accuracy, profit calculated by comparing

With respect to the second question, we need to know the behavior

Note on the price-level problem. At its meeting on April 28, 1961,

value of the dollar may be ignored is unrealistic... " Furthermore,

1W. A. Paton and A. C. Littleton, An Introduction to Corporate Ac­

properly carried forward upon a closing of books of account

4 “Accounting and reporting standards for corporate financial statements

use usually represents an asset, but equipment which, according to

by tangible objects whose physical substance is ordinarily utilized.

5 Bond discount is discussed more fully in the section on “Measurement

1. A determination if future services do in fact exist. For example,

(a ) A past exchange price, e.g., acquisition cost or other initial basis.

(c ) A future exchange price, e.g., anticipated selling price. When

1 See the discussion of long-term liabilities on page 39, for an extended

of time until collection is typically so short that the force of interest

2 The use of current market price in this connection is permitted by

The Director of Accounting Research of the American Institute of Certi

1 Study Group on Business Income, Changing Concepts of Business In

3 Statement on Auditing Procedure No. 28, “Special Reports.” 1957. Para

5 See also Harold Arnett, “What Does ‘Objectivity’ Mean to Account

No useful purpose would be served in this study by trying to de

1W. A. Paton and A. C. Littleton, An Introduction to Corporate Ac

an exchange price which is ordinarily independent of the plans or ex

1. The changes in prices have occurred, they are objectively de

Plant and equipment. “Plant and equipment” refers to those tangi

dated Oct. 1949, recommended that in describing the components of stock

1. They may be directly identified with particular revenue-pro

cedure, as expressed in paragraph 11 of that chapter, is that a pre

tions of special aspects of business activity, rearrangements of under

E. All liabilities of the enterprise should be recorded in the ac

H. A statement of the results of operations should reveal the com