Accounting for long-lived productive resources

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Title:
Accounting for long-lived productive resources the development and evaluation of general energy systems measurement procedures
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Long-lived productive resources, Accounting for
General energy systems measurement procedures
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x, 220 leaves : ill. ; 28 cm.
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Boyles, Jesse Varnel, 1946-
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Thesis--University of Florida.
Bibliography:
Includes bibliographical references (leaves 198-218).
Statement of Responsibility:
by Jesse Varnel Boyles.
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Typescript.
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Vita.

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Full Text









ACCOUNTING FOR LON!G-LIVED PRODUCTIVE RESOURCES--
THE DEVELOPMENT AND EVALUATION OF GENERAL
ENERGY SYSTEMS MEASUREMENT PROCEDURES









By

JESSE VARNEL BOYLES III


A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL
OF THE UNIVERSITY OF FLORIDA
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY










UNIVERSITY OF FLORIDA


1975













ACKNOWLEDGMENTS


A dissertation could never be accomplished without

the encouragement, guidance, and assistance of many indi-

viduals. For guidance and assistance I am indebted to my

dissertation committee, Dr. S.C. Yu, Chairman, Dr. I.J.

Goffman, Dr. C.D. Kylstra, and Dr. H.T. Odum. As especial

note of gratitude goes to Dr. S.C. Yu, Chairman, whose

expertise in the fields of philosophy and accounting was

most beneficial to the completion of this work, and to

Dr. C.D. Kylstra for his invaluable guidance, enlightened

criticism, and for the many hours of patient counseling

which he provided. Also, to Dr. Blaine Roberts and Dr. Paul

Roberts a note of thanks is extended for the criticisms and

encouragement provided during the early phases of the inquiry.

To Ms. Kitty Hinton, Mrs. Donna Hutcherson, and

Miss Debbie Dixon a note of appreciation is extended for the

editorial assistance provided and for the many hours of

typing and retyping.

Finally, for all the encouragement, patience, and

quiet acceptance of the most difficult situations during the

whole period of my graduate study, I will never be able to

find words to express my gratitude to my mother, my father,

and my wife, Pidge.














TABLE OF CONTENTS


Page

ACKONWLEDGMENTS ii

LIST OF TABLES vi

LIST OF FIGURES vii

ABSTRACT viii

CHAPTER I INTRODUCTION .......................... 1

Energy, Economics and Accounting......... 3
Management Evaluation by Outside
Parties Using Accounting Data--
A Brief Description.................... 4
The Problem Inherent in Accounting
for Long-lived Productive Resources... 7
Purpose of Research...................... 10
Methodology ............................. 12
The Development of the General Energy
Systems Ratio of Exchange Estimation
Model................................. 22
The Evaluation of the General Energy
Systems Ratio of Exchange Estimation
Model.................................. 23
Notes................................... 27

CHAPTER II DETERMINATION OF VALUATION COEFFICIENTS--
A CRUCIAL PROBLEM FOR ACCOUNTING......... 28

The Problem in Historical Perspective... 30
Currently Accepted Accounting Prodedures
for Recording and Reporting Trans-
actions Dealing with Long-Lived
Resources--A Brief Summary............ 36
Criticisms of Current Practice........... 38
Recognition and Reporting of Current
Acquisition Exchange Ratios Including
the Associated Holding Gains and Losses 43
The Measurement of Current Acquisition
Exchange Ratios ................ ........ 58
Conclusions............................. 63
Notes ..................................... 64


iii









TABLE OF CONTENTS (CONTINUED)


Page
CHAPTER III GENERAL ENERGY SYSTEMS THEORY--
A BASIC DESCRIPTION....................... 67

Thermodynamics--The Science of Energy.... 69
Energy and Man in Historical Perspective. 75
Energy Systems Theory and Economics....... 83
Conclusions.............................. 99
Notes.................................... 104

CHAPTER IV GENERAL ENERGY SYSTEMS PRICE MODEL........ 106

The General Energy Systems Currency
Exchange Model......................... 108
The Concept of Economic Efficiency........ 109
Implementation of the General Energy
Systems Exchange Ratio Model--A
Hypothetical Analysis.................. 118
Notes .................................... 134

CHAPTER V THE GENERAL ENERGY SYSTEMS PRICE MODEL--
AN EVALUATION OF ITS USEFULNESS FOR
DETERMINING VALUATION COEFFICIENTS FOR
USE IN ACCOUNTING........................ 135

The Question of Logical Consistency--
An Evaluation.......................... 136
Estimated Ratios of Exchange Accurately
Reflect Actual Current Ratios of
Exchange--An Evaluation .............. 154
The General Energy Systems Methodology
Will Provide Objective Estimates of
Current Replacement Cost--An
Evaluation............................. 163

CHAPTER VI SUMMARY AND CONCLUSIONS. ................. 164

Criticisms of Current Accounting
Practice with Respect to Long-Lived
Productive Resources................... 165
A Description of the Problematic
Situation.............................. 167
A Description of the General Energy
Systems Approach........................ 169
The Energy System's Ratio of Exchange
Measurement Model ..................... 177
Evaluation of the General Energy
Systems Ratio of Exchange Model ........ 179








TABLE OF CONTENTS (CONTINUED)



The Duties of the AICPA................. 182
Final Comments ........................... 182

APPENDIX............................................. 183

SELECTED BIBLIOGRAPHY.............................. .198

BIOGRAPHICAL SKETCH.. ................................. 219














LIST OF TABLES


Table No. Page

1 CONVERSION FACTORS FOR ENERGY MEASURING
UNITS.................................... 70

2 THE ENERGY CONTENT OF VARIOUS FUELS........ 74

3 SOURCES OF INANIMATE ENERGY AS THEY
FIRST APPEARED AT DIFFERENT STAGES OF
CIVILIZATION .............................. 82

4 PRICE AND QUANTITY INDICES.................. 121

5 ILLUSTRATION OF THE OUTPUT OF A SPECIAL
COMMITTEE FORMED TO COLLECT AND CALCULATE
ECONOMIC RATIO OF EXCHANGE DATA ULITIZING
GENERAL ENERGY SYSTEMS THEORY............. 125

6 CALCULATIONS MADE BY AN ACCOUNTANT IN
IMPLEMENTING THE GENERAL ENERGY SYSTEMS
RATIO OF EXCHANGE MODEL.................... 131

7 COMPUTATION OF THE AVERAGE PRICE PER
UNIT OF ENERGY INPUT EQUIVALENT FOR
COMPANY A'S 1974 MANUFACTURING
FACILITIES FOR THE YEAR 1978............... 133














LIST OF FIGURES

Figure No. Page

1 ILLUSTRATION OF A MARKET ECONOMY 91

2 ENERGY FLOW DIAGRAM OF AN ECONOMIC
SYSTEM 94

3 XYZ COMPANY: ENERGY DIAGRAM OF A
PRODUCER OF FABRICATED METAL
PRODUCTS 185

4 ABC COMPANY; ENERGY DIAGRAM OF A
PRODUCER OF FABRICATED METAL
PRODUCTS 188

5 ENERGY FLOW DIAGRAM OF THE METAL
WORKING MACHINERY SUBSYSTEM OF
THE CAPITAL STRUCTURE PRODUCER'S
SYSTEM 191

6 ENERGY FLOW DIAGRAM OF THE U.S.
ECONOMY 196


vii









Abstract of Dissertation Presented to the
Graduate Council of the University of Florida
In Partial Fulfillment of the Requirements for the
Degree of Doctor of Philosophy


ACCOUNTING FOR LONG-LIVED PRODUCTIVE RESOURCES--
THE DEVELOPMENT AND EVALUATION OF GENERAL
ENERGY SYSTEMS MEASUREMENT PROCEDURES

By

Jesse Varnel Boyles III

May, 1975

Chairman: Dr. Shih C. Yu
Major Department: Business Administration

In a market economy, money functions as the motivator

(via the operation of the profit system within the con-

straints of man's social system) that determines what goods

and services will be produced, who will produce them, and

how they will be produced. Accounting is the responsible

communication subsystem within man's social system which

reports the relevant economic information that is being

communicated by monetary transactions (i.e. money flows).

A necessary step for this communication process is the

determination of the appropriate measurement base to be used

as the valuation coefficient for long-lived productive re-

sources. This determination requires investigation of two

basic questions. First, which measurement base provides the

most useful data to decision-makers? Extensive review of

previously completed work in this area leads to the

conclusion that the answer to this inquiry requires additional


viii








empirical investigation into the behavioral reactions of

decision-makers to accounting information.

Secondly, how is the selected measurement base to be

calculated? The primary purpose of this study is to develop

and evaluate the use of general energy system statistical

procedures for calculating a measurement base in terms of

current replacement cost.


General Energy Systems Theory


The basic concepts of general energy systems theory

may be stated as follows:

1. All economic goods and services are the result

of some form of work which generally can be physically

measured and stated in terms of energy equivalent measure-

ment units.

2. Money is paid for most goods and services; there-

fore, it may be concluded that money circulates counter to

energy. Accordingly, money serves as a feedback mechanism

for communicating to producers the "form" of energy flow

desired by consumers.

3. Any economic good or service can be measured in

terms of either an "energy equivalent" or a "currency based"

common measurement equivalent.

The General Energy Systems Ratio of Exchange Model

the observed relationships between energy and money

are utilized to formulate a model to calculate an average









price per unit of energy for any specific, or any aggregate

grouping of, economic goodss. This energy price may then

be used to estimate the ratio of exchange, for the current

time period, for any specified economic good(s), including

long-lived productive resourcess.


Evaluation of the Model

The general energy systems model is evaluated with

reference to the most commonly observed criticisms of earlier

research efforts to estimate replacement cost by calculating

current ratios of exchange. The conclusions resulting from

this evaluation may be summarized as follows:

1. The general energy systems model is internally

consistent. Furthermore, its results are logically consis-

tent with those expected utilizing currently accepted eco-

nomic price theory.

2. The energy systems model enables the investigator

to identify that portion of any overall price change for a

long-lived resource which is caused either by changes in

productive efficiency or by changes in input transformation

efficiency.

3. Whether the energy systems approach will provide
"objective" estimates of current replacement cost is an empiri-

cal question which cannot be resolved at this time due to

data limitations.



Chairman













CHAPTER I
INTRODUCTION


In man's diverse, technologically advanced social

system money has evolved as the principal measurement unit

for expressing exchange relationships between the myriad of

heterogeneous goods and services commonly encountered. A

price, then, is the ratio of a number of monetary units to

a related quantity of some physical good or service. There-

fore, the price of a good represents the command which that

particular good exerts on money, and indirectly, the com-

mand it has on all goods and services by way of their

monetary prices. For example, if wheat sells for $4.00 per

ton and corn for $3.00 per ton, then ten tons of wheat can

be sold for $40, which can be used to buy 13 and 1/3 tons

of corn. Thus, in an exchange relationship ten tons of

wheat will command 13 and 1/3 tons of corn. Moreover, as

supplies of the myriad of goods available in an economy

change along with changes in consumer preferences, the ex-

change ratios (prices) of all goods constantly change.

With reference to accounting purposes, two kinds of

prices may be identified. The most obvious may be termed

the ratio of exchange and it is the ratio of the amount of









money paid in an actual economic transaction to the physi-

cal quantity of economic goods received in exchange for the

money. Thus, if ten dollars is paid for two shirts, the

ratio of exchange is five dollars per shirt. A second

kind of price may be referred to as a valuation coefficient

and is generally thought to be less obvious than the first.2

Valuation is the process whereby the equivalent in some

measure of value is calculated for a physical quantity of

the objects being valued regardless of whether these objects

are going to be exchanged. Thus, the valuation coefficient

is the ratio between the units of the measure of value and

the quantity, expressed in some physical terms, of the

object which is valued.3 For example, a shirt identical to

the ones referred to above, may be valued at five dollars,

which is simply a figure expressing the equivalent of the

shirt in some measure of value whether it is exchanged

or not.

Although exchange ratios typically refer to actual

or potential flows of exchange (currency for physical goods

or vice versa) and valuation coefficients typically refer

to stocks or storage of physical objects, valuation

coefficients are generally based in some way or another on

exchange ratios, past, present, or future. Thus, a valu-

ation may be made by recording the original exchange ratio



*References are listed at the end of the chapters.








when the object last participated in an exchange (when it

was purchased) and by making some allowance for depreci-

ation, or appreciation, since that exchange. Or it may be

made by observing the actual exchange ratios of similar

objects which are being exchanged at the moment. Or it may

be made by estimating the ratio at which the object will be

exchanged at some future date.


Energy, Economics, and AccountinQ


Economics is concerned with invest, ;ting the ex-

change component within man's social system. Therefore,

economists are primarily concerned with analyzing and ex-

plaining the motivational and behavioral responses of pro-

ducers and consumers to changing exchange relationships.

Moreover, economic studies typically involve analysis of

what is referred to in energy systems theory as money feed-

back loops.4 All production units and consumer units are

interconnected by these feedback loops as, in the absence

of such a connecting feedback, a given unit will cease to

function as a viable economic entity as soon as its storage

of resources are consumed. That is, each production unit is

also a consumer unit; likewise, each consumer unit must be

a production unit providing either useful services or useful

goods to some other unit. Therefore, each unit of society

must have an output of something for which money is received,









and each unit then spends at least a portion of those

receipts purchasing the resource inputs that it needs in

order to continue to produce its output. Moreover, economic

analysis has shown that any producer unit, over the long

run, must receive for its output at least a dollar amount

equal to the cost of the resource inputs needed to make that

output or it will eventually cease to function as a viable

economic entity.

Within this economic system the function of ac-

counting may be stated as to collect, process, and report

to outside parties, as well as to management, information

concerning the currency flows of specific accounting

entities. In other words, the function of the accounting

component within man's social system is to provide infor-

mation to the individuals within the social system who

operate the control levers which direct work flows toward

useful ends for the whole of society. Moreover, the infor-

mation provided should enable the users of such information

to make better decisions concerning their planning and

control functions than if they operated without the

information.


Management Evaluation by Outside Parties Using
Accounting Data--A Brief Description


When considering any economic venture, decision-

makers balance that which is expected to be given against





5



that which is expected to be received and the venture is

started only if the latter appears to be in excess the

former. Since the purpose of accounting is to furnisi, the

information necessary to evaluate past managerial judgment

(via evaluation of the actual results of current economic

activity), it appears that the most relevant and useful

evaluation method is the association of accomplishment

with effort. However, as there are many heterogeneous input

and output goods available, each of which provides

varying degrees of satisfaction, or economic utility, to

individual entities, some standard measuring unit must be

used. Thus, currency has evolved as the common denominator

for describing different commodities in terms of a standard

measuring unit and the association of giving with receiving

in accounting is accomplished by way of currency flows.

Inflows of currency in exchange for goods and services are

referred to as revenues and are used as a measure of

accomplishment; outflows are called expenses (or costs),

and are used as a measure of effort. Moreover, an excess

of revenue over expenses (which is referred to as income)

indicates that the goods and services which management has

elected to provide have proved acceptable in the market; an

excess of expenses over revenue (a loss) indicates the goods

and services provided are not acceptable at an asking price

high enough to generate income. Because this basic









technique for evaluating the results of economic activity

has existed for many years, accountants have developed a

very refined set of procedures so as to explicitly attempt

to match expenses incurred against revenue earned (this

process is generally referred to as accural accounting).

Also, a financial statement, the income statement, has been

developed to communicate revenue and expense data. However,

when a specific entity's management team is evaluated via

comparison with other management teams the evaluation pro-

cedure generally includes an additional step. That is,

evaluation is accomplished by relating the income earned

through the efforts of each management team, considering

also the capital (i.e. the currency value of all the heter-

ogeneous resources employed) required by each to produce

the given income (in other words, by comparing the re-

spective rates of return on investment). Thus, proper

economic evaluation includes not only the examination of

an entity's income statement, but also an analysis of the

storage of productive resources utilized by the entity.

Accordingly, accountants have developed a financial state-

ment, the statement of financial position, which communi-

cates information concerning the storage of productive

resources.









The Problem Inherent in Accounting for
Long-Lived Productive Resources


Traditionally, accounting has performed the infor-

mation processing and reporting function by matching valua-

tion coefficients for resource inputs, based on acquisition

exchange ratios, against the revenue earned by utilizing

these resource inputs in providing output. This procedure

results in very few significant conceptual problems as long

as resource inputs are completely utilized within a short

time after acquisition. However, serious problems do arise

in the situation where input resources have a long life in

the sense that they aid in producing the revenues over a

number of accounting time intervals.

These problems come about because information users

require firms to report the results of financial transac-

tions for abritrary intervals of time at the end of which

there are many incomplete transactions, particularly with

respect to long-lived productive resources. For instance,

a company purchases machinery which is used for producing

a given product and this machinery will be used for ten

years. Accounting conventions require the results of

operations to be reported annually by matching dollar in-

flows (revenues) against dollar outflows (expenses). How-

ever, the outflow required to obtain the machinery cannot

be matched against the inflow for the year of acquisition









because the inflows of future years are affected by

utilizing the machinery in those years. Therefore, the

accounting profession has adopted the conceptual notion

that long-life productive resources represent bundles of

future services, some portion of which is assumed to be

consumed during each accounting period of its useful life.

This implicit recognition of an allocation problem raises

two difficult conceptual questions with respect to prices.

First, given that the objective is to match ex-

penses with revenues, what should be done if the ratio of

exchange for services identical to those purchased in one

time interval changes in a future time interval? This

raises the possibility that entities will match a different

dollar expense against their revenue solely because they

purchased identical services at different times. Second,

how should the bundles of remaining services be valued for

the statement of financial position at historical cost

to reflect the acquisition exchange ratio for the services,

at some current value to reflect the assets subject to

management's control at a given point in time, or by use of

some other measurement base for determining the appropriate

valuation coefficient?

The answers to these two related questions indicate

not only the appropriate analytical interpretation to be

given to income statements, but also the appropriate









evaluation to be applied in analyzing statements of fi-

nancial position. This point may be illustrated by consid-

ering the following examples. First, consider the situation

where the ratio of exchange for a given long-lived resource

increases and the price of the output produced by use of

this input also rises. Matching the lower allocated

original cost against current revenue will give an upward

bias to the excess of receipts over cost resulting from

operations. Second, consider the situation where the price

of the input resource rises without a compensating increase

in the price of the output that the resource is utilized

in producing. As there is a normal relationship between

investment in a long-lived productive resource and the rate

of return expected from its utilization, it may be that it

is inadvisable to replace this productive resource as it

is currently utilized. However, this low rate of return

on an investment may not be apparent if the lower original

cost is being matched against current revenue and the

resulting net income is being divided by the original cost

in determining the rate of return. Only by matching the

higher replacement (or reproduction) cost against current

revenue and dividing the resulting operating income figure

by the higher current cost will the reduced rate of return

be reflected by the return on investment computation.









In recognition of these difficulties a substantial

body of accounting literature has evolved consisting of

proposed solutions and criticisms of these solutions. The

proposed solutions include periodically determining the net

present value for the firm as a whole, determining the

current ratio of exchange for specific assets (either input

or output exchange ratio), adjusting acquisition exchange

ratios by either specific price indexes or general price

indexes, and finally additional theoretical justification

in support of acquisition exchange ratios as valuation

coefficients. None of these alternatvies to historical cost

have been found acceptable in practice, generally because

of implementation problems.


Purpose of Research


A general energy systems analysis of economic ac-

tivity views money payments as feedback loops to reward the

recipient of such money payments; the reward being given in

exchange for the economic goods and services provided.

These economic goods and services are all energy manifesta-

tions because any resource input, as well as any resulting

output, is the result of work and work can always be meas-

ured in terms of energy equivalent units. Therefore,

the price received for a long-lived productive resource








divided by the total energy equivalent of the resource

inputs needed to produce that productive resource represents

the average price per unit of energy used in this particular

fashion. In other words, in the energy systems' analytical

framework, an average price per unit of energy is determined

by relating money flows with energy flows and it will vary

over time in response to either changing prices for the

output resources or changing productive efficiencies in

using resource inputs for the production of output re-

sources. Prices for productive resources may change because

of changes in the demand-supply conditions of either the

resource input market or the productive resource market,

and also because of changes in the efficiency of the long-

lived productive resource itself. Since the average price

per unit of energy is based upon the market price of the

long-lived productive resources produced and sold in the

current time interval, it appears the general energy sys-

tems' analytical framework may provide an acceptable

methodology for estimating the current acquisition exchange

ratios to be used as valuation coefficients for financial

accounting. Therefore, the problem at hand is to develop

and evaluate an energy systems methodology for measuring

current ratios of exchange for long-lived productive

resources, previously acquired and currently utilized by an









accounting entity. Evaluation shall be accomplished with

respect to certain objectives defined as ends-in-view.


Methodology


This inquiry will be conducted within the philoso-

phical framework of the scientific method as espoused by

Dewey.5 As with all inquiry, Dewey's scientific method

begins with a problematic situation. A problematic situa-

tion is a disequilibrium condition within the inquirer

himself which results in tensions and felt needs. The

attempt to move into an equilibrium status and thus relieve

tension results in inquiry. Therefore, "problematic is a

property of the situation which includes, among other items,

the inquirer himself--the process of inquiry results from a

combination of undifferentiated facts: a yearning by the

inquirer for resolution of the tension and the unidentified

ability to form hypotheses and specify ends-in-view."6

Dewey emphasized that inquiry should always be

related to reducing tensions; therefore, situations with

problematic content should be expressed in terms of models

that employ the means-consequence format with consequences

being continuously related to ends-in-view.* This inquiry


*Ends-in-view may be described as expected relationships
which would result in an equilibrium status being achieved
and tensions being reduced.









will express no particular preference for a means-

consequence format for models. However, it is felt that

the propositions being investigal id should be expressed

in a form that allows the invest -,tor to determine whether

it is true or false.* Like Dewey, this writer believes

that propositions should be continuously related to the

ends-in-view necessary to resolve the problem.

Since Dewey's framework of inquiry takes on the

characteristics of the traditional, interpreted, logical

system, the test of efficiency and truth employed in this

inquiry are precisely those employed to test any hypotheti-

cal model. In addition, this inquiry will stress the unity

of the inquiry process. That is, no attempt will be made

to partition the process into induction-deduction,



*In Dewey's system of inquiry propositions are not true
or false during the process of inquiry: they are efficient
or inefficient for resolving the problem. Truth is
undefined during the process of inquiry and can be em-
ployed tentatively only after inquiry stops. In other
words, inquiry consists of making all sorts of judgments
with regard to relative efficiency of means, the relevancy
of data, the importance of ends-in-view, and so on; but for
Dewey the practical aspects of truth and falsity become
questions of warranted assertibility. While inquiry is in
process, applicable propositions are relatively efficient
or inefficient and no assertion regarding their truth is
warranted. At the conclusion (defined in terms of agree-
ment between predicted and actual consequences) of the
specific inquiry and assertion about the correspondence of
actual and predicted consequences may or may not be
warranted.7









rationalism-empiricism, and other such classifications.

Rejection of these classification schemes emphasizes the

necessity of theoretical verification by both logical

reasoning and empirical correspondence between actual and

predicted outcomes before any conclusions concerning a

proposition's degree of warranted assertibility can be

stated. In other words, it is recognized that a scientific

investigation by reasoning, with no experimental interpreta-

tion, is not sufficient, and theory separated from actual

doing is not realistic. Accordingly, this inquiry will

emphasize the necessity of both logical reasoning and

empirical investigation of propositions before warranted

conclusions can be stated.


The Problematic Situation

The disequilibrium condition, the felt needs, and

the necessity for further research have been examined above.

In Chapter II of this inquiry these problems will be devel-

oped in greater detail. Specifically, the historical

evolution of current accounting practices, with particular

reference to the principal developments within man's social

system which have influenced the development of the account-

ing component of the information-communication subsystem,

will be examined. The criticisms of using acquisition ex-

change ratios as the measurement base for valuation









coefficients will also be discussed, including a rather

comprehensive summary of the debate between supporters of

the use of acquisition exchange ratios and the critics of

such a measurement base. The inclusion of this background

information is for the following purpose: (1) to provide

greater insight concerning the problematic situation; (2)

to justify logically some of the underlying assumptions

stated below; and (3) to describe the conceptual basis for

the working propositions to be used in evaluating a general

energy systems price model.


The Ends-in-View

The ends-in-view refer to the consequences neces-

sary in order to reduce the tensions which have resulted in

the inquiry. Therefore, since the energy systems price

model is a proposed approach for measuring long-lived

resource currency values, this writer feels it should be

evaluated in light of the criticisms of previously proposed

methods for accomplishing the same objective. In following

this procedure, it is hoped that assertions can be stated

concerning the efficiency or inefficiency of the energy

systems approach in resolving the valuation coefficient con-

flict within the accounting profession. Accordingly, the

ends-in-view developed below are based on the criticisms of

other proposed methods for estimating current cost data

(these criticisms will be discussed in Chapter II).









It must be explicitly recognized that accounting

operations are subject to certain legal and moral restric-

tions. For instance, accountants are expected to render

unbiased information to outside parties. Accordingly, the

most frequently cited criterion for evaluating the accept-

ability of a particular accounting measurement is

objectivity (assuming the measurement method generates

data relevant to the user and is capable of practical

implementation). However, before objectivity can be

established as a desired quality inherent in any proposed

measurement system, it must be precisely defined. "Rather

than basing the definition of objectivity on the existence

of objective factors that are independent of persons who

perceive them, it is far more realistic to define ob-

jectivity to mean simply the consensus among a given group

of observers or measurers. Therefore, objectivity is seen

to be a function not only of the object being measured but

also of the measure and the measurement system used."8

Objectivity, thus defined, exists only as a matter of

degree in any event. But examination of the accounting

literature reveals that if the proposed alternative measure-

ment system involves either discounting future service

potential or appraisal values, there is too wide of a

dispersion of the measure's opinions for their consensus

(where consensus is some average of their opinions) to be









considered objective. Therefore, any proposed method for

estimating current cost must be evaluated by considering

the degree of empirical correspondence between the measures

generated by different groups of observers applying that

same specific measurement method.

A second end-in-view is concerned with the question

of the accuracy of the measurement. Here the term accurate

refers to the degree of empirical correspondence between

a given measurement.and the ideal representation of the

measured attribute of an object. Obviously, accountants

strive to obtain the most accurate measures possible within

time and cost limitations. The ideal measurement base for

long-lived productive resources is the net present value

of future potential services. One economic assertion is

that a market price established in arms' length transactions

between competing parties best reflects an aggregate

evaluation by purchasers of the present dollar value for the

future benefits to be received as a result of owning the

resource.* However, changes in the prices of long-lived

resources result from many interacting factors, such as

changes in the supply and demand for the various resource


* The logical reasoning for this assertion is discussed
on Pages 60-61.








inputs needed to produce the long-lived resource or for

the productive resource itself, changes in the overall

productive efficiency of the processes which supply these

resources, and changes in the ability of the productive

resources to perform their desired function. Thus, any

estimation procedure must be evaluated in light of how well

it segregates and integrates these various related com-

ponents of any given price change in determining the most

accurate estimated exchange ratio.

Thirdly, the data collection and processing pro-

cedures for generating ratio of exchange estimates must be

logically consistent.


Research Constraints

It is realized by the inquirer that the nature of

this research effort forces inquiry to proceed subject to

certain limitations. These research constraints are

identified as follows:

First, this inquiry is primarily an interdisci-

plinary, exploratory inquiry dealing with the development

of a new system of analysis which will provide greater

insight concerning economic relationships. Therefore, it

is probable that the inquiry will end before any of the

working hypotheses attain warranted assertibility. In

other words, the tentative hypotheses are formulated for

the purpose of directing exploratory research; thus, the









only contribution of this effort may be to clarify concepts

and show the direction for future research.

Furthermore, as this inquiry is concerned with a

somewhat recently developed methodology, there is a decided

lack of data available for empirical testing. Therefore,

most of the empirical testing may have to be simulation

with hypothetical data. The data inputs necessary for

operation of the general energy systems price model include:

1. The currency flow which would be received by

all producers of any specified long-lived productive

resource during any given time interval, assuming that all

output produced by those producers during the given time

period was also sold during that time interval.

2. The total quantity of resource inputs--expressed

in terms of energy measurement equivalents--needed by the

producers to manufacture the specified output.

3. The quantity of specified output produced with

the stated resource inputs during the particular time

interval.

4. The quantity of output per unit of resource

input which can be produced by utilizing the specified

productive resource in a given production activity.

All of this data is currently readily available

except the energy flows for resource inputs. However, to

answer any doubt concerning the feasibility of operational








application of this methodology due to lack of data, it

may be noted that extensive research is ongoing at the

present time by Bruce Hannon of the Energy Research Group

at the University of Illinois, Resources for the Future,

Stanford Research Institute, the State of Oregon, Regional,

State, and Local Growth Planning Agencies, the Energy

Center at the University of Florida, and many other govern-

mental and private research agencies to obtain the missing

data. While these research efforts are primarily related

to determining where energy use can be cut with the least

economic pain in the event of another Arab embargo, it is

precisely the same data that is needed to relate energy

flows with dollar flows in making a general energy systems

price model operational.

Thirdly, this inquiry is restricted to long-lived

resources as there has generally been no substantial objec-

tive to the use of acquisition cost as a measurement base

for measuring expenses other than depreciation. This may be

due to the fact that the expirations of service value of

things such as raw materials, labor, insurance, and so on

are relatively close to the time of their acquisition.


The Assumptions of the Inquiry

The first underlying assumption of this inquiry is

an economic assumption which may be stated as being composed

of two related assertions. The first one states that









productive resources have money value only because of the

future services they are expected to provide. In addition,

the ratio of exchange for a specified resource in a free

exchange marketplace is believed to represent a fair, aver-

age aggregate of the opinion of all buyers and sellers

operating in that market concerning the estimated present

value of those future services. A corrollary second

assertion states that two resources, identical in all

respects, would command identical market prices at a given

instant in time in the same marketplace. This, in turn,

implies that two resources, identical in all respects except

that one is more efficient in the transformation of input

resources into desired output than the other, would com-

mand different money prices which would be proportional to

their difference in efficiency.

A second assumption is that man performs work in

order to supply goods and services for himself. This

assumption is necessary to the construction of the pro-

ductive efficiency and relative input transformation

efficiency indexes developed in Chapter IV.

A third assumption is that users of accounting

information desire financial statements based on valuation

coefficients determined with reference to a measurement

base other than acquisition exchange ratios. In other

words, it is assumed that the most relevant or useful









measurement base to be used in financial accounting is the

current period's reproduction exchange ratio (or replacement

exchange ratio). This particular assumption is discussed

in detail in Chapter II.


The Development of the Energy Systems Ratio of Exchange Model

The energy systems price model for long-lived

productive resources will be developed in two steps. First,

general energy systems theory will be described in Chapter

III including a discussion of ratio of exchange relation-

ships when using an energy systems approach. In general,

the discussion of this chapter is expected to provide the

underlying conceptual framework necessary for relating

energy flows to money flows. Second, in Chapter IV, the

energy systems concept (basically the relationships between

energy flows and money flows) developed in Chapter III

will be applied to the specific problem at hand: develop-

ment of an energy systems price model for estimating

reproduction or replacement ratios of exchange for

long-lived productive resources. This model may be

mathematically expressed as follows:


qiPi
est E.


Where: Pest = the estimated price per unit of

input resource expressed in terms








of constant quality energy heat

units;

qi = the quantity of output i produced

during a given time interval;

pi = average price per unit of output
i during the given time interval;

Ei = the energy equivalents of all the

resource inputs utilized to produce

qi"

The Evaluation of the General Energy
Systems Ratio of Exchange Estimation Model


As stated above, the purpose of this inquiry is two-

fold: (1) to develop a methodology for estimating re-

placement exchange ratios based on energy systems concepts

and (2) to provide a preliminary evaluation of the effi-

ciency of such procedures in resolving the conflict, among

accountants, concerning long-lived resource accounting

procedures. Therefore, in Chapter V, the general energy

systems model, developed in Chapter IV, will be evaluated

by way of the tentative, working hypotheses stated below.

These general hypotheses are stated and discussed in greater

detail as follows:

1. The conceptual ftamewotk o6 the general energy

systems approach is logically consistent. In order to

become widely accepted, any theory must be logically








consistent, both internally and with related theories which

are accepted. Accordingly, the following two subhypotheses

may be stated with respect to this first general hypothesis:

a. The general-t ene/tgy systems ratio of exchange

estimation mode. is lntenally consistent.

b. The. e.sutiing price estimates ane togicaLty

consistent with the ratios o6 exchange expected in Light of

cute.ntly accepted economic ptice theory.

2. The gene.ta energy systems approach provides

accurate estimates o6 the current keptoduction (or te-

placement) cost o6 a specified tong-lived productive

tesourtce. One objection to the use of current market prices

for new productive resources (designed to perform a similar

function that an older resource is currently providing) as

a measure of the current cost of an older resource is that

the newer style is not the same as the older. The newer

resource is produced using current technology for trans-

forming resource inputs into outputs and such production

techniques may be different than the technology existing

at the time the older style was produced. Furthermore, the

newer resource may be more efficient in performing the

function it is purchased to perform than the older resource.

Both of these factors will interact with all other factors

which cause demand and supply to change in determining the

market price of the new resource. Therefore, in determining

the most accurate exchange ratio which can be used as the








valuation coefficient for an older resource, it is neces-

sary to be able to segregate that portion of the difference

between the current market price of a newer resource and

the acquisition price of the older resource that is caused

by the differences in both the efficiency of producing the

resources and the ability of the resources to perform their

designed function. Accordingly, in evaluating the energy

system's measurement procedures it is necessary to examine

the following subhopotheses:

a. The energy system's approach pAovides

ptoceduAes Sot identifying and segLegating estimates o6 that

portion o6 a change in the price o6 a productive. esoutce

that is caused by changes in the e. iciZency of producing

the resource.

b. The energy system's approach pAovides

prccedue.s 6oL identifying and seg.e.gating estimates o6

those portions o6 a change in the price o6 a long-lived

tesouLce which aAe the. esu.t o6 changes in the input

ttanfjoamation e.6iciency (i.e. the ability o6 the. tesouLce

to pefL6oLm the tasks it was designed and acquired to

pe.fo60m).
.c. There is a high de.gee o6 empitical co,-

respondence between an energy systems estimate o6 the

cuLte.nt eptacement cost fot a long-lived pAoductive

res.outce and the observed ratio o6 exchange. jor this

identical t.ecuce in a competitive market transaction.








3. The energy asytems appAoach fot estimating

cuAtent replacement oa trepoduction cost can be made opeta-

tional such that there is reasonable statistical corULrea-

tion between the estimates provided even when dif6eJrent

gt.oups of observers appZy the measucLrement procedures in

generating estimates. This general hypothesis is

explicitly focusing on the objectivity end-in-view. In

reality, it is asking if the energy system's method of

generating current ratios of exchange can be made opera-

tional in such a fashion that all C.P.A.'s would generate

approximately the same estimates given a specific fact

situation. This particular question is a strictly empirical

inquiry which requires examination of the dispersion of

current cost estimates for a specified resource when dif-

ferent groups of C.P.A.'s are provided with identical

information and told to estimate current cost using

general energy systems procedures.








NOTES


1. Kenneth Boulding, Economic Analysis--Volume II (New
York: Harper and Row, 1966), p. 25.

2. Ibid, p. 26.

3. Ibid.

4. Howard T. Odum, Environment, Power and Society (New
York: Wiley-Interscience, 1971), pp. 174-176).

5. John Dewey, Logic, The Theory of Inquiry (New York:
Holt, Rinehart, and Winston, Inc., 938.

6. Carl T. Devine, "Book Review--Development of Accounting
Thought by H.T. Deinzer," The Accounting Review
(January 1966), p. 189.

7. Ibid, p. 190.

8. Yuji Ijiri and Robert Jaedicke, "Reliability and
Objectivity of Accounting Measurements," The Accounting
Review, (July 1966), p. 476.













CHAPTER II
DETERMINATION OF VALUATION COEFFICIENTS--A
CRUCIAL PROBLEM FOR ACCOUNTING

Before continuing with a detailed examination of

the problematic situation, it is necessary to provide de-

finitions of potential measurement bases commonly encountered

in accounting literature. Measurement in this inquiry refers

to the assignment of valuation coefficients to non-homogeneous

resources for the purpose of making them additive by express-

ing their quantities in terms of a common unit of measurement.

The term measurement base will be used to refer to the

particular exchange ratio concept employed as the valuation

coefficient necessary to the measurement process. It should

be noted that this list of measurement bases includes both

those which are actually in use for current financial

accounting purposes and those which have been proposed for

future implementation.

1. Historic or acquisition cost. Historical cost

represents the dollars used to record the original trans-

action with outside persons or accounting entities in- the

acquisition of economic resources. This is the measurement

base currently accepted in accounting practice with some

exceptions in specified situations.








2. Price-level restatements or stabilized ac-

counting. This is historic cost, as defined above, restated

to eliminate the effects of general inflation or deflation

(i.e. to express the common denominator currency in units

of equivalent purchasing power) on the financial state-

ments.

3. Reproduction or replacement cost. This is the

cost in current dollars of reproducing an asset presently

held. The new asset may be identical in all respects to

the older asset or it may be similar only in that it can be

used for accomplishing the same purposes as the older re-

source.

4. Forced sales price. This is the amount which

can be obtained by selling a resource in the firm's

possession under circumstances such as bankruptcy pro-

ceedings.

5. Current cash equivalent. This is the price

obtained in the regular market place in the normal course

of business over a reasonable period of time. It is some-

times referred to as the quoted market price or the orderly

liquidation value.

6. Present value of future benefits. This amount

is the discounted flow of net cash benefits traceable to

the resource. Generally, the net benefits are very dif-

ficult to measure precisely, but in perfectly competitive

markets the discounted present value of net cash receipts








is assumed to be equal to the current selling price.

Furthermore, reproduction cost is assumed to approximate

the present value of the cost necessary to recreate the

resource.


The Problem in Historical Perspective


Historical studies indicate that pre-double entry

bookkeeping evolved primarily as a means of accounting for

resources. "Stewards kept accounting records not for the

entity's sake, but for their own use in order to control

the resources for which they were responsible. There was

no clear distinction between profits and capital and thus

no tradition of precise income determination to impose a

discipline on asset measurement and amortization." In

these historical periods, the manager of a venture was in

most cases the owner and debtor-creditor relationships

rarely existed. Ventures generally were short-lived, and

as such, management's judgments were subject to evaluation

at the end of a given venture when total liquidation oc-

curred.

As exchange relationships became more complex and

more frequent, merchants felt the need to periodically

summarize the results of their trading performance. Thus,

income calculation became a major bookkeeping problem and

the double-entry system evolved. Consequently, accountants

developed a mechanism "to replace unspecified, subjective









views of income with a quantitative, uniform calculation

which made gross profit essentially the difference between

buying and selling prices."2 This unsophisticated account-

ing system worked reasonably well during that period of

time when most business ventures were of a trading nature

and there was not extensive separation of ownership, manage-

ment, creditors, laborers, and customers.

With the advent of the industrial revolution, ac-

counting problems became increasingly complicated relative

to those encountered in a mercantile, trading era. Manu-

facturing facilities required large aggregations of capital

which could be acquired only by many people pooling their

resources and this sometimes resulted in widely dispersed

ownership. Moreover, these widely dispersed owners began

to show a tendency to hire professional managers to operate

their businesses. Furthermore, the large capital require-

ments led to a great deal of borrowing and lending activity.

Thus, the need arose for information which would enable

creditors to evaluate the security of their loans and owners

to evaluate the ability of managers.

In addition, the need to acquire long-lived re-

sources for manufacturing operations encouraged the advent

of the corporation to insure operating continuity. This,

in turn, further accentuated the need for periodic evalua-

tions of managerial activity and business resources.

Moreover, periodic reckonings were legally required as a









prelude to dividend payments. As stated by Littleton,

"attempts to determine the income earned during a particular

period of time for an entity with an indefinite life natu-

rally led to a system of accrual and deferrals. This meant

the use of goods and services, not merely their purchase,

created expense; also sales rather than cash collections

signalled the earning of income."3

During the late 1800's, a series of court decisions,

reinforced by statutes, required dividends to be declared

only from earnings. In response, accountants developed

very detailed resource measurement and depreciation methods

in order to make the necessary distinction between capital

and income. Even so, income calculations still showed

little sophistication, precision, or consistency. More-

over as it became accepted that the computation of the

annual income available for dividends was a primary ac-

counting task, conservatism became the dominant accounting

principle to which others were subordinated when they came

into conflict.

Systematic understatement of asset values
was thought necessary to offset managerial
manipulation and to offer bankers, who
were the most influential group of state-
ment users, security against inflated col-
lateral values. This concept was strengthened
by over thirty years of steady price declines
following the War Between the States.4

During the early twentieth century, several corol-

lary accounting principles evolved out of reference to








conservatism, the most important of which was the going

concern concept. "This concept implied an obligation to

maintain plant and equipment resources intact during a

company's indefinite existence by requiring that provision

be made for recovery of the capital invested in the re-

sources before dividends were paid."5 Furthermore, it

brought with it the idea that long-lived resources should

not be revalued unless such changes reflected the exchange

ratio to the going concern. This made historical cost both

conservative (i.e. the resource must be worth to the ac-

counting entity at least what the entity was willing to

pay for it) and convenient (i.e. easy to verify the origi-

nal transaction price). In other words, "it became common

for original exchange ratios to be defended in terms of

either the historical nature of accounting or the need for

conservation rather than in terms of the need for objec-

tive evidence of the economic sacrifice the entity has made

currently by using productive resources for its particular

operations."6

These concepts of conservatism coupled with the

going concern notion* were greatly strengthened by the ap-

pearance of the income tax laws. Since the tax was on in-

come, not on wealth, there had to be an objective, legally


*Which resulted in long-lived productive resources being
measured in terms of original exchange ratios and these
historical costs being assigned to time intervals for pur-
poses of being matched against revenue in order to determine
the accounting period income.









authorized way to determine a year's income. "By defining

taxable income as the excess of cash receipts over cash pay-

ments, these early tax laws made it necessary to measure

income separately from the capital which generated it.

Therefore, from the first, a realization rule was an integral

part of income taxation and any increase in wealth had to be

confirmed by some event or transaction, normally the receipt

of money, before profit was said to exist."7 This intent

was explicitly made clear when the courts defined taxable in-

come as "not a growth or increment of value in the investment,

but a gain, a profit, something of exchangeable value pro-

ceeding from the property, severed from the capital...."8

Thus, the realization rule emphasizes the disposition of

assets or their separation from the Firm in an exchange

transaction before changes in ratios of exchange may be rec-

ognized and this view remains the dominant one in accounting

and law today.

Court decisions in both the dividend payment area

and the income tax area supported the idea that resources

should be valued based on acquisition exchange ratios until

they result in an effective addition to the wealth of the

holder as evidenced by a severance of gain from capital.

Accountants gradually modified their concepts to coincide

with these legal concepts as the "legal notions were somewhat

supported by the doctrine of conservatism coupled with an

incomplete going concern concept."9 This modification was








greatly hastened by the severe inflation of the 1920's being

followed by severe deflation, resulting from economic col-

lapse, in the 1930's. The overall effect of such an

economic climate was to give rise to the conclusion that

currency exchange ratios for resources "have no more real

tangibility than the thinnest of thin air...thus the chief

functions of the accountant must relate to past transac-

tions or current binding contracts and other factors must

be kept to a minimum."10 In other words, "every fact re-

corded in the financial statements must have resulted from

accomplished financial transactions modified by an attempt

to assign to proper time intervals all revenue and ex-

penses."11

However, some accounting theorists took issue with

this conclusion and accepted the economist's concepts of in-

come and resource valuation coefficients. For instance,

John Canning proposed a theory of resource measurement

transplanted from economics and contended that the proper

valuation coefficient of any resource should be based on

the present value of expected benefits.12 Furthermore,

changes in valuation coefficients (resulting from changes

in expected future benefits) affect income and this effect

should be recognized in the accounts as soon as reliable

estimates can be obtained. "This view of resource measure-

ment and income determination has proved more theoretically

defensible and consistent than that of the traditional









accountant as evidenced by the fact that accounting

theorists since the 1950's have tried to reconcile economic

and accounting concepts in order to give accounting a sound

conceptual basis and make accounting techniques consistent

with what is now considered good theory." 3 In the overall

picture, these efforts have not received a very warm recep-

tion, even though major disagreement concerning resource

management and income determination have continued to plague

the accounting profession.

The accountant's professional relationship to his

client and the public may be one of the most significant

reasons why accounting practice has not evolved consistent

with economic theory.

Not being as vulnerable to third party
liability the economist is less inclined
to seek protection in such doctrines as
objectivity and conservatism. Accordingly,
the greatest difference between the ac-
counting and economic approaches in this
area is the economist's willingness to
recognize the effects of inflation, holding
gains and losses, increments to goodwill,
and other exchange ratio changes as they
accrue. He would insist on measuring a
person's "well-offness" at the moment when
exchange ratios change, not at the time of
an external transaction which provides
undisputable evidence of a change.14


Currently Accepted Accounting Procedures for
Recording and Reporting Transactions Dealing
with Long-Lived Resources--A Brief Summary


Examination of some of the currently accepted

accounting procedures with respect to long-lived productive









resources provides some evidence which indicates the over-

whelming influence that legal considerations (which have

evolved in the dividend payment area, the income tax area,

and the third party legal liability area as discussed above)

have exerted over the development of the theoretical founda-

tion of accounting.

The principal valuation coefficient in accounting

is the acquisition exchange ratio (or historic cost) which

is the original money (or money equivalent) investment

necessary to acquire resources in market transactions. How-

ever, there are some exceptions to this rule such as lower

of cost or market for both inventories and temporary invest-

ments. Also, there are distortions of this cost concept

which result in either the income statement or the state-

ment of financial position being made more accurate at the

expense of the other--one example is an inventory flow

assumption such as LIFO versus FIFO. Moreover, there is

implicit acknowledgement of changes in valuation coeffi-

cients from acquisition exchange ratios without the formal

recording of the changes through the use of footnotes and

parenthetical comments to financial statements, as well as

management comments concerning the entity and its opera-

tions.

Gains (from holding resources) are generally

recognized and reported only to the extent that they are

realized in market transactions, but losses are sometimes








anticipated by writing down resource valuation coefficients

before disposition. Furthermore, the actual gains and

losses realized on the disposition of long-lived productive

resources are generally reported in a different manner from

ordinary sales of product or service because the amounts

realized and reported in the time period of disposition may

include exchange ratio changes that have occurred in a prior

period or periods.


Criticisms of Current Practice

Criticism of current accounting practice with respect

to long-lived resources generally is concerned with the

determination of their proper measurement base. Moreover,

this particular controversy has implications for both the

statement of financial position and the income statement.

Briefly stated, the statement of financial position attempts

to convey information to statement readers concerning the

stocks or storage of various resources controlled by

management at a given instant of time (these quantities

being measured in terms of a common unit of measure--

dollars), as well as the claims (in terms of debt or equity)

against these resources. Since the heterogeneous physical

resources are expressed and combined in terms of currency

units, the resulting dollar totals indicate resource

storage only indirectly by virtue of the fact that the

expressed dollar totals represent command on all goods and









services by way of the price mechanism. However, as the

acquisition exchange ratios for resources are continually

changing, a sum of measurements based on acquisition exchange

ratios, each from a different instant in time, conveys in-

accurate information converning the valuation equivalents

of the resources available to management at a specific point

in time. The only solution which would both correct the

inaccuracy and allow resources to continue to be measured

in terms of currency is to determine the valuation coeffi-

cients for all resources in terms of the exchange ratios

prevailing at the same instant in time. In other words,

the exchange ratios to be used as valuation coefficients for

measuring the resources owned must not be out of time

relationship with one another.

The income statement attempts to convey information

concerning the results of operations for a specified time

interval. The utilization of a long-lived productive

resource is reflected in the net income computation by way

of the depreciation charge. Depreciation is an explicit

recognition that a time will come when it will no longer

be worthwhile to utilize a unit of an entity's long-lived

productive resources. The unit may be no longer useful to

the owner because of the physical deterioration of the unit,

because of a change in demand for the output of a facility,

or because a technical improvement of one kind or another

has made the unit obsolete. But the fact remains that the









services of long-lived productive resources are almost

always eventually consumed. Depreciation accounting then

is the effort to charge the cost of such services--like

other applicable expenses--to the revenues earned during a

given accounting period in a systematic, equitable manner.

In other words, there are two independent
aspects of the cost allocations arising
from depreciation. The first is the timing
of the cost recoveries which refers to their
distribution among accounting periods and is
a function of the depreciation method employed
(straight-line, and so on). The second is
the total dollar amount allocated which is a
function of the choice of measurement base
(historical dollar cost, replacement cost,
and so on). And neither of these is related
to a third aspect which is the estimate of
a resource's useful life.15

Applying the currently accepted accounting pro-

cedures for associating effort with accomplishment in ac-

counting for long-lived productive resources results in a

measurement rule which requires the cost associated with the

utilization of these resources to be determined by allocating

the original monetary cost to accounting time periods. How-

ever, the ratios of exchange for all the stored resources

change over time; thus, the accounting assumption that costs

somehow attach like barnacles to various long-lived resources

obscures the association of sacrifice and benefit that is

considered relevant for proper decisions and actions. For

example, if the replacement cost of a resource has risen

since the time of its acquisition, the amount allocated

certainly does not represent the current cost of resource









utilization. Income determined by using such a measurement

basis may not properly communicate the change in economic

position resulting from operations since it is determined by

matching revenue based on current sales prices with cost

based on past period prices. Thus, conventional accounting

treats the effects of price changes for long-lived productive

resources as though they were a component of operating pro-

fits or losses which they are not. Expressed another way,

with current accounting procedures, income arises from two

related, but to some extent independent, sources: (a) the

margin between the actual selling price for the output and

the current acquisition of the input resources needed to

produce the output; and (b) the so-called gain or loss

arising from a change in the price of input factors between

the time of their acquisition and the time of sale of the

output produced by utilizing these inputs.* The first

source is considered an operating result over which

management can exert considerable influence. The second is

considered a holding result over which management can

probably exert little, if any, control, although, it may be



*This second source is generally referred to as a holding
gain or loss. Expressed another way, holding gains and
losses represent changes, over a time period, in exchange
ratios of resources and liabilities held during that
period. This concept implies that a base amount can be
compared with an adjusted exchange ratio either at the
end of the period or during the period, if disposal takes
place, in order to measure a change in value.









said, management should anticipate such price changes. In

any event, it appears inappropriate to combine these two

sources into one operating figure as is now done. It is

felt that more meaningful accounting information can be com-

municated if these two sources are segregated and analyzed

separately.

For over fifty years debate has continued between

steadfast defenders of acquisition exchange ratios as

valuation coefficients and equally adamant advocates of the

use of some current cost concept. In general, the arguments

have centered on whether the above described distortions of

accounting information are significant enough for concern.

In other words, the accounting problem being debated seems

to be concerned with a single question: should the valua-

tion coefficients reflect current exchange ratios (as

opposed to acquisition exchange ratios) in light of the fact

that such a procedure would require explicit recognition

both in the accounts and in financial reports of changes in

ratios of exchange without the tangible evidence of a

specific market transaction? In dealing with this question,

there appear to be two areas of critical concern: should

valuation coefficients, based upon current acquisition ex-

change ratios, and the resulting holding gains and losses

be recognized in the accounts and reported in the financial

statements; and how should current acquisition exchange








ratios be measured? The arguments of both sides of the de-

bate will be presented in the following sections.


Recognition and Reporting of Current Acquisition
Exc; ge Ratios Including the Associated
Holding Gains and Losses


The debate concerning the recognition and reporting

of acquisition exchange ratios has generally centered around

the following briefly summarized points:

1. Some accountants feel that "the cure is worse

than the ailment as current costs are not objective."16

That is, historical cost is relatively easier to objec-

tively verify than current cost; "the fact that current

cost, in some instances, is very difficult to ascertain is

perhaps the greatest objection most accountants have to

it."17 This objection to current cost clearly illustrates

the influence of potential third party legal liability

over accounting. It is feared that the use of exchange

ratios which are not absolutely verifiable will open the

door for manipulation and charges of collusion. Advocates

of a change to current cost counter this objection by

stating "even historical cost is only a tentative figure...

accounting deals largely with judgments and estimates, not

with certainty. Values are always more or less conjectural

and unstable."18 Furthermore, it is asserted that periodic

income measurement under the best of conditions is no more

than a good guess:









The argument that recognizing appreciation
would call for recording unrealized profits
is not correct, since all accruals are
based on the unrealized transactions in the
same sense. Furthermore, appreciation can
in many instances be estimated more accu-
rately than depreciation or decline in 19
value due to deterioration or handling.

2. It is stated that the same problems for alloca-

tion of cost to accounting periods remain. For instance,

is depreciation to be determined

a. By overall industry experience?

b. By traditional straight-line method as

applied to production units or time periods bolstered by

engineering estimates of the total remaining service poten-

tial as reestimated periodically?

c. By any of several practices permitted by

the income tax laws or government regulatory bodies?


Advocates of current cost would properly respond that this

objection has nothing whatsoever to do with the problem at

hand. The problem of allocation of service potential to ac-

counting periods must be equally as difficult, and somewhat

abritrary, regardless of which-measurement base is used. In

other words, it is a problem independent of the measurement

base question.

3. Defenders of historical cost also object to cur-

rent cost on the grounds that historical cost more clearly

results in the purposes of accounting being fulfilled. One

point frequently noted is that accounting records should be









maintained in such a manner that income which is legally

available for dividends is reflected. If this purpose is

accepted accountants are forced to adopt the legal notion of

realization and its corollary principle that the measurement

base shall not be changed from the acquisition exchange

ratio (except to reflect loss of service potential) until

such time as an exchange transaction with an outside party

occurs. Accountants must accept this result because court

decisions and statutes have generally forbid cash dividends

to be paid out of retained earnings arising from either

unrealized appreciation in the value or the revaluation of

long-lived resources. The obvious response to this objec-

tion is that computation of legal dividend income based on

acquisition exchange ratios can be accomplished concurrently

with the computation of financial income based on current

exchange ratios similar to what is now done for income tax

purposes.

4. Some accountants feel that the use of acquisi-

tion exchange ratios is so bound up with the evolution of

double-entry bookkeeping that radical departures from it,

such as current costing, could threaten an integration of

real and nominal accounts. And this integration is felt to

be far more important than the particular valuation coeffi-

cients which are being related to individual resources and

liabilities. In other words, historical cost is the only

measurement base which requires,.as an integral part of its





46


measurement procedure, that every actual change in the dollar

amounts associated with resources of an entity be recorded

by relating inputs and outputs. This relating of inputs and

outputs is necessary so that original cost can be traced and

identified; thus, it is an automatic control feature which

may be missing with current cost. These accountants

generally feel footnotes and parenthetical notations are

an effective means of providing information concerning

exchange ratios differing from acquisition cost. The

response to this objection is to ask the question: are

accountants willing to sacrifice the accuracy of currency

measurements for resources and be content to present rather

artificial amounts in financial statements, despite the con-

ceptual problems associated with justifying inconsistent

theory, in order to mathematically tie the income statement

to the balance sheet?

5. It is noted that historical cost provides the

background of the story of the way in which management has

functioned by reflecting only actual transactions. More-

over, "a primary objective of accounting is the protection

of resources (stewardship) and this means the primary

concern is with the allocation of real and actual cost to

accounting periods and output, and by no stretch of the

imagination can current cost be relevant to such a process.aO

A current cost advocate would respond to such an objection

by stating that in large businesses the profitable use of








resources is more important than either their physical

protection or a history of their acquisition. And for

financial statements to provide relevant data about a firm

whose ownership interests are constantly changing hands

requires the fairest and most objective possible presenta-

tion of current financial events. Furthermore, if there are

such things as real and actual cost of production, they must

surely be the cost in the current competitive situation.

The exchange ratio paid for a resource at some time in the

past certainly has no current economic significance except

possibly for evaluating management's stewardship. Thus, if

one of the objectives of accounting is to record and report

accurate information with respect to present financial

condition, then it follows that accountants should adopt a

measurement base which furnishes current and up-to-date

information.

6. In any list of objections to current cost the

concept of conservatism arises. Simply stated, this

principle implies that no profits should be anticipated,

but all losses should be provided for. This notion appears

to be a carryover from the early days of accounting when

stewardship was the prime bookkeeping motive and most

business ventures were short-lived. As stated by

Chatfield:

In this setting, where the main account-
ing responsibility was protection of









resources, conservatism was natural and
rational. The steward would be foolish to
raise expectations which might not be
borne out by subsequent events and no one
is misled so long as ownership interests
were not exchanged. However, a shift in
emphasis during the 1930's toward the
income statement caused problems in the
application of conservatism as profits,
as well as asset values, had to be stated
conservatively. This is much less con-
sistent a process than resource measurement
conservatism. For instance, reducing
valuation coefficients when current market
prices fall below original cost reduces
current income but may inflate future
income.

Thus, conservatism strengthens objections
to departures from acquisition exchange
ratios in order to discourage manipulation
for smoothing income and creating secret
reserves.21

Current cost supporters respond to the conservatism

objection by pointing out that it is important not to con-

fuse conservatism with downright understatement when

passing judgment as to which procedure is the most advisable.

7. Some advocates of current cost have justified

their position in light of rampant inflation (which has been

characteristic of the world economy since 1946) on the

grounds that steady increases in prices have the effect of

impairing stockholder's equity and encouraging the creation

of secret reserves. Defenders of historical cost have

interpreted this to mean that demand for current cost is

based on the premise that it is not only the duty of








management to keep intact original investment in dollars

by allocating historical cost to expense as the resource is

physically utilized, but it must also maintain the real capi-

tal invested, measured in terms of productive capacity and

present price level, so that there will be sufficient re-

covery of dollar cost to allow full replacement of pro-

ductive capacity in the future. This conclusion raises all

sorts of problems with respect to current cost.

First, it is argued that the cost of using long-

lived resources has little significance in the policy for

pricing a firm's output. That is, selling prices are not

determined by the addition of a profit percentage to cost

(except possibly in the case of a regulated industry). In

other words, it is being noted that demand is an im-

portant element in the determination of selling prices since

all companies must compete for the consumer's dollar, regard-

less of how high their cost may be. Supporters of current

cost will agree that cost increases do not always lead to

higher sales prices of output as the cost of an activity

does not give it value, rather, it is the value of the

results of the activity that justifies the incurrence of

costs. However, "one cannot deny that in a highly com-

petitive industry a large proportion of the losses is due

to the failure to keep dependable cost.22 A firm whose
"management is ignorant of its actual cost is a dangerous

competitor only until the firm has lost a considerable








portion of its capital through pricing below cost."23 Fur-

thermore, advocates of current cost do not completely agree

that cost does not influence selling prices. They agree

such may be true in the short run under conditions where the

size of facilities cannot be easily altered and demand

conditions are expected to be the most important variable

influencing the selling price of output. However, this is

not true if the time interval is sufficiently long for quan-

tity of output to be altered. Therefore, to say cost has

little influence on price is to confuse short period analy-

sis with long period analysis. Moreover, insofar as there

is any relationship between selling prices and cost of long-

lived resources, it tends to be between selling prices and

current cost (because these would be the cost incurred

either by new producers entering the industry or by the old

producers who are replacing facilities). In other words,

the conclusion is reached that it is only by "considering

current cost that decision-makers are able to proceed in-

telligently in making long-run decisions as to which products

should be concentrated upon and which methods and processes

of production should be followed."24

Secondly, defenders of acquisition exchange ratios

argue that a firm may not wish to produce the same output

or use the same resources in the future, thus, there is no

need to provide for replacement. Supporters of current cost

concepts would also realize that on many occasions the








current "use value" of resources to the accounting entity

which owns them may be lower than the current replacement

cost* and that if such a condition continues the productive

resources will not be replaced at the end of their useful

lives. In other words, the current replacement cost does

not necessarily represent the value of resources to the

going concern unless the entity is continuing to acquire

such resources at current cost. However, the question of

importance to the accountant is how to measure the costs of

producing the output that is actually being produced cur-

rently. In other words, in providing information concerning

the present use of resources the only relevant amounts are

the costs today of producing the output actually being pro-

duced; "to say that the firm may produce different output--

or the same output differently--in the future raises ques-

tions concerning the reorientation of the business objectives

of the firm which are not related to the topic of inquiry here."25

Thirdly, it is pointed out that full recovery of

replacement cost would require a knowledge of what a

resource will cost at the time of its replacement, and this

is certainly a matter of speculation. Current cost


*According to economic theory when value exceeds current re-
production cost under conditions of perfect competition addi-
tional units will be built. The output of additional supply
reduces the net return of all units (value declines) and the
cost of producing additional units may rise. These two in-
fluences will continue until value equals reproduction cost.
If reproduction cost exceeds value similar adjustments in
the opposite direction take place. However, there may be
sustained transition periods when there is a divergence
between the two.








advocates respond by noting that adequate funds for

replacement of physical resources will not be a *'.aranteed

result of using current acquisition exchange ra;. s as

valuation coefficients. For example, if prices are in a

long-term upswing the sum of each year's current cost over

the life of a long-lived resource will not equal the cost

of replacement in the last accounting period the resource

is used.

Finally, it is noted that the function of account-

ing is to allocate the cost of resources as equitably as

possible against the revenue produced by utilizing these

resources and this problem is quite different from the

problem of financing the replacement of resources. In

response, it is stated that most current cost supporters

do not advocate maintenance of real capital as an end

itself. Rather, it is noted that business prudence requires

accounting methods which report cost and profits as accu-

rately as may be determined given the practical constraint

of the cost of information versus the benefit from having

it. But the methods of providing accurate accounting data

will not necessarily treat related problems as separate and

distinct. In other words, the fact current costing may have

financing implications should not detract from its usfelness

in helping to solve financial reporting problems.

8. Perhaps the strongest conceptual objection to

current cost is found in the notion of relevance. Simply









stated, the area of concern is why it is necessary to give

up "objectivity" in external reporting for relevance and

accuracy when accountants do not seem to know what infor-

mation statement users think is relevant for their evalua-

tions. However, the response to this criticism by current

cost advocates represents the strongest conceptual case

for a current cost measurement base. This response can be

summarized as follows:

a. Current cost represents an estimate of the

amount it would cost today to obtain the same or equivalent

bundle of services; therefore, it "represents the best

measure of the current economic sacrifice incurred by the

firm when the resources inputs are utilized in earning the

current revenue."26 Moreover, as all the costs would be

computed on the basis of current economic exchange ratios,

the "matching of current revenue with current costs will

be more meaningful because the decisions formulated there-

from would be made on the basis of present economic data

rather than past data."27

b. The activities of an entity can be segregated

into two basic parts--operating and holding. Operating re-

sults stem from the sale of goods and services and may be

defined as the difference between the selling prices of the

output and the cost of producing the output, both measured

in current dollars. The results of holding activities come

about because of changes in the exchange ratios of resources








which are the inputs needed to produce a particular output.

As currently reported, business income may be composed of

both of these elements, although the primary objective of

most ventures is to sell a product or service and make a

profit while doing so. As income from holding activity

is apt to be fortiutous and unpredictable (because it comes

about by factors largely beyond managerial control such as

general price level movements, changes in exchange ratios

resulting from technological advances, changes in tastes

that affect demand for the firm's product, and alterations

in factors affecting the supply of items held by the firm),

such income needs to be segregated from operating results if

the reported financial statements are to be interpreted

meaningfully.

Indirect incorporation of holding gains and
losses into net income and misstatement of
the exchange ratios for resources under
management control may lead to distortion
of decision making if economic decisions
are based solely upon analysis of financial
statements. Current costing minimizes this
distortion by allowing separate analysis of
holding operations and operating results.28

Thus, the use of current cost in the matching of cost

against revenues would explicitly show the results of each

of these two activities. Moreover, "the holding gains and

losses would be recognized in the accounting period when

the change in value occurs rather than in the period when

the asset is sold."29








c. As noted above the "summation of current

exchange ratios for resources is more meaningful than the

addition of acquisition exchange ratios, which represent

cost from different time periods, because such a sum will

more closely indicate the physical quantity of various
,,30
resources and their current economic significance."30

d. Having the resources owned, as well as an

accounting period's expenses, measured on a "current basis

would make rate of return on investment computations more

meaningful."31

e. If all firms consistently reported current

values interperiod, interindustry, and interfirm statement

comparison would be more meaningful.

f. Current cost information is vital to proper

management planning and evaluation. For example, if cur-

rent exchange ratios have increased greatly it may be to

the advantage of the owners for management to revise its

maintenance and repair policy in order to extend the

service life of present equipment, particularly if output

selling price increases have not matched or exceeded cost

increases. Also, it is beyond doubt that current exchange

ratios are of prime importance in all property insurance

matters. Moreover, in financing by bonds and other credit

instruments it is imperative that the current exchange

ratios of the long-lived resources be recognized, "because

not only would the borrower be placed at a disadvantage








if this were not done, but also a rather awkward situation

would be presented in the balance sheet if the liability

were for a sum greater than the cost of the property pledged
32
as security."32

Examination of the debate between defenders of an

acquisition exchange ratio measurement base.and advocates

of a current ratio of exchange concept, even in a briefly

summarized form, enables the investigation to gain more

explicit insight into the problem. These eight points of

conflict can be summarized in terms of two basic considera-

tions. The first indicates the defenders of acquisition

exchange ratios strongly feel that accounting data must be

objective (statistically verifiable in the sense that dif-

ferent groups of measurers will determine nearly identical

measurements) in order to avoid third party legal liability

as that concept has evolved via case law. The objectivity

argument has been the roughest obstacle for the measurement

base concepts previously proposed by advocates of current

cost to overcome. Therefore, the logical conclusion is

reached that many of the conflicts described above will

cease if the measurement procedures can provide a method-

ology for determining objective measurements of both cur-

rent acquisition exchange ratios and the associated holding

gains and losses. The above reasoning then provides the

conceptual justification for the tentative general hypo-

thesis summarized as follows:








The energy jy sttems app.toach fot estimating current

keptacement or Aeprtoduction cost can be made operational

such that thete i.L reasonabee statistical. cocetCation between

the estimates provided, even when uach estimates aAe. made by

difet.ent gAoups o6 measu.LretLs (i.e. such ope.tational pto-

cedurLes provide objective estimates o0 cuatent acquLisition

exchange .atios).

On the other hand, the second consideration being

debated in the points of conflict, which were summarized

above, may be stated as follows: does current cost in the

financial statements provide the most useful information

given the specific sets of users and the decisions they

address themselves to when using the reported financial

information? Logical reasoning, comparing the difference

between the conceptual ideal of what information should be

conveyed by the statement of income and the statement of

financial position versus what information actually appears

to be conveyed (discussed in Chapter I), suggest informa-

tion based on current acquisition exchange ratios must be

more useful. Hence, the justification for the assumption,

stated in Chapter I, that data based on current cost data

provides the most useful information to statement users.

It was necessary to state this assertion in the

form of an assumption because the scientific.method of

investigation requires empirical verification before the

results of inquiry can attain a "warranted assertion"









status. Empirical verification of such a hypothesis would

require an examination of the motivational-behavioral

responses of the users of financial statement data to that

data, and this type of inquiry is beyond the scope of the

current investigation.

In summary, it must be stated that no warranted

conclusion can be reached concerning the propriety of

recognizing and reporting current acquisition exchange

ratios until the "usefulness to users of financial data"

question can be empirically resolved. However, it does

appear that a substantial portion of the objections to a

current cost measurement base concept would cease provided

a methodology for determining objective measures of current

acquisition exchange ratios can be obtained. Therefore,

this inquiry will be concerned with an energy systems

methodology for measuring current replacement or reproduc-

tion cost.


The Measurement of Current Acquisition
Exchange Ratios

The problem of measuring current acquisition ex-

change ratios for resources is essentially statistical in

nature. In determining which modified measurement base is

to be applied, it is necessary to analyze the statistical

properties of various accounting numbers. In simple terms,

what is desired is a measurement base which will provide

the most accurate estimate possible of the current exchange









ratio for acquiring the services consumed during the

operations of the current period. Therefore, what is

desired is an estimate of either reproduction cost or re-

placement cost. However, as stated above, accountants

desire a measurement methodology which provides objective

measurements in order to reduce the possibility of third

party liability.

Therefore, this inquiry will emphasize the develop-

ment of a logically consistent methodology for estimating

statistically objective or verifiable, as well as accurate,

estimates of current replacement or reproduction cost for

resources owned by an accounting entity. This objective

is consistent with the American Accounting Association's

Committee on Concepts and Standards-Long-Lived Aspects

recommendations as evidenced by the following statement:

The current cost of obtaining the same or
equivalent services should be the basis
for valuation of assets subsequent to
acquisition. Where there is an established
market for assets of like kind and condi-
tion quoted acquisition prices may provide
the most objective evidence of current
cost. Where there is no established market
for assets of like kind and condition, cur-
rent cost may be estimated by reference to
the purchase price of assets which provide
equivalent service capacity. The purchase
of such substitute should be adjusted for
differences in operating characteristics
such as cost, capacity, and quality. In
other cases, adjustment of historical cost
by the use of specific price indexes may
provide acceptable approximations of cur-
rent cost. Appraisals are acceptable only
if they are based on the above methods of
estimating current cost. Whenever there is
no objective method of determining the









current cost of obtaining the same or equivalent
services, original acquisition cost should con-
tinue as the basis for valuation.33

The techniques suggested for obtaining estimates of

reproduction or replacement cost include the use of ap-

praisals, the use of current market prices, and the use of

specific price indexes. There are two objections to the

use of appraisals in obtaining current cost estimates.

Perhaps the stronger of the two is the subjective judgment

inherent in the appraisal process. Rarely, if ever, will

two independent appraisers establish the same dollar amount

as the replacement cost of a given productive resource and

sometimes the difference can be substantial. Another

problem is the high cost of obtaining appraisals, particu-

larly in terms of the benefits of having current cost

versus the cost of obtaining them.

The use of market prices for obtaining replacement

exchange ratios may be justified as follows: a long-lived

productive resource is valuable because of the future

services which it will render; furthermore, the subjective

process of discounting involved in the translation of

future benefits to present exchange ratios precedes the

exchange activities carried on by buyers and sellers who

enter the market. Since the exchange ratio resulting from

market activity represents the collective judgment of all

the users of a particular resource concerning the present

currency worth of the future services, market prices









implicitly provide an objective estimate of the net pr -ent

value of the resource.* Such an argument is undoubtably

correct provided similar resources, of similar age, in

similar condition are actively traded in an established

market. However, very little research has been done con-

cerning the availability of such market data, and that

which has been done has indicated a lack of available in-

formation of this type. Therefore, more extensive empiri-

cal investigation is necessary before any conclusions are

warranted.

A third method generally suggested is the use of

specific price indexes to adjust the historical cost of

specified resources to their current cost assuming such

resources are new. This method is analogous to the use of

market prices, except that it requires only that resources

capable of similar uses are currently being produced. The

objections to the procedure have centered mainly on three

areas. First, any economic price index is constructed by

some weighting process whereby quantities are held constant

and prices are allowed to vary. There are substantial

questions concerning the accuracy of any price index when

its construction is based on the arbitrary selection of a

set of weights. For example, consider the following

situation:



*This discussion provides the logical justification for
the assumption stated in Chapter I that market prices
approximate the discounted flow of net cash benefits.








Beginning of Time Interval End of Time Interval

Wheat 50 bushels @ $2.00 per 80 bushels @ $2.50 per
bushel bushel

Corn 100 bushels @ $ .50 per 50 bushels @ $1.00 per
bushel bushel

Constructing a price index for wheat and corn using begin-

ning of the period weights shows prices have increased by

50 percent; however, the same index constructed using end-

of-the-period weights shows prices have increased by about

35 percent. Which is correct? Secondly, there is a

question concerning how specific a given index must be in

order to achieve the desired degree of accuracy. "Any

index, though specific to whatever group of assets it re-

presents is not specific to any single one of the assets

in the group, whose relative price changes are dispersed

around the index."34 Previous research indicates "very

little statistical accuracy is gained by the use of the

most specific indexes currently available at very little

cost."35 Thirdly, the criticism has been voiced that any

given price index can measure only overall changes in

ratios of exchange as there is no available methodology

for segregating price changes caused by changes in re-

source quality from price changes caused by changes in

productive efficiency in producing resources from price

changes caused by a myriad of other things which affect

either long-run or short-run supply and demand.









Objections to the use of these methods of estimating

a replacement or reproduction cost again illustrate the

importance of the objectivity concept; but the importance

of accurate information is also pointed out. Accordingly,

it is necessary to establish another tentative general

hypothesis in order to properly evaluate an energy systems

approach for estimating replacement cost. This hypothesis

may be stated as follows: the genMea energy systems

approach provides accurate estimates o6 the cuttent te-

production (ort eplacemenit) cost o a speci-ied long-lived

productive resource.


Conclusions


The purpose of this chapter is to convey to the

reader a description of the historical evolution of the

accounting problem* under consideration, the previously

proposed solutions, and the objections to those solutions..

It is believed that a comprehensive study of the proble-

matic situation, even though in very summarized form,

allows the inquirer to gain further insight concerning the

various interactions inherent in the economic, political,

and legal environment which exert pressures on the com-

ponent issues of the problem.


*The measurement of long-lived resources. This problem
includes the selection of the appropriate measurement
base to be used as the valuation coefficient.








Second, the background information developed is

used to provide the logical justification for some of the

more important assumptions necessary to the inquiry. Also,

the logical reasoning involved in choosing the general

working hypotheses proposed in order to evaluate the gen-

eral energy system approach to measuring current acquisi-

tion exchange ratios is described.

Finally, it has been stated that this inquiry is

constrained to the development and evaluation of a

measurement system. In this chapter, it is noted that

development of a logically consistent, empirically veri-

fiable, and objective measurement system is not expected

to completely resolve the accounting problem because of

the "relevance to user needs" issue. However, having such

a measurement system will narrow the scope of the contro-

versy and thus aid in final resolution of the problem.


NOTES


1. Michael Chatfield, A History of Accounting Thought,
(Hinsdale, Illinois: The Dryden Press, 1974), p. 254.

2. A.C. Littleton, The Structure of Accounting Theory
(Iowa City: American Accounting Association, 1953),
p. 27.

3. A.C. Littleton, "Contrasting Theories of Profit," The
Accounting Review (March 1936), p. 12.

4. Michael Chatfield, op. cit., pp. 232 and 255.

5. Ibid., p. 232.








6. Reed K. Storey, "Revenue Realization, Going Concern,
and Measurement of Income," The Accounting Review
(April 1959), p. 236-237.

7. Michael Chatfield, op. cit., p. 255.

8. Ibid., p. 256 as quoted there from U.S. Supreme
Court, Eisner v. Macomber, 1920.

9. Reed K. Storey, op. cit., p. 236.

10. Charles B. Couchman, "Limitations of the Present
Balance Sheet," Journal of Accountancy (October 1928),
p. 258.

11. D.A. Litherland, "Fixed Asset Replacement a Half
Century Ago," The Accounting Review (October 1951),
p. 475.

12. John B. Canning, The Economics of Accountancy, (New
York: Ronald Press, 1929).

13. Michael Chatfield, op. cit., p. 262.

14. Ibid., p. 262.

15. Willard J. Graham, "Depreciation and Capital Replace-
ment in an Inflationary Economy," The Accounting Review
(July 1959), p. 367.

16. H.C. Daines, "Changing Objectives of Accounting," The
Accounting Review (June 1929), p. 98.

17. Ibid., p. 101.

18. W.A. Paton, Accounting Theory (New York: Ronald Press,
1922; reprinted by Accounting Studies Press, Chicago,
1962), p. 293.

19. J.D. Edwards and Roland F. Salmonson, Contributions
of Four Accounting Pioneers, (East Lansing: Michigan
State University, 1961), p. 176.

20. D.R. Scott, "Valuation for Depreciation and the
Financing of Replacements," The Accounting Review
(December 1929), p. 222.

21. Michael Chatfield, op. cit., p. 238.

22. G.L. Hull, "Plant Appraisals--Their Treatment in the
Accounts," The Accounting Review (December 1927),
p. 305-306.









23. Ibid., p. 305-306.

24. Ibid., p. 305-306.

25. Eric L. Kohler, "Why Not Retain Historical Cost,"
Journal of Accountancy (October 1963), p. 38.

26. William A. Paton, "Depreciation and the Price
Level--A Symposium," The Accounting Review (April
1948), p. 121.

27. Willard J. Graham, op. cit., p. 360-371.

28. Edgar 0. Edwards and Philip W. Bell, The Theory and
Measurement of Business Income (Berkeley and Los
Angeles: The University of California Press, 1961),
p. 138.

29. Ibid., p. 136.

30. G.L. Hull, op. cit., p. 304.

31. Ibid., p. 304-305.

32. Ibid., p. 305.

33. American Accounting Association, Committee on Concepts
and Standards--Long-Lived Assets, "Accounting for Land,
Buildings, and Equipment," Supplementary Statement No.
1, The Accounting Review (July 1964), p. 698.

34. Charles A. Tritschler, "Statistical Criteria for
Asset Valuation by Specific Price Index," The
Accounting Review (January 1969), p. 100.


35. Ibid., pp. 99-123.













CHAPTER III
GENERAL ENERGY SYSTEMS THEORY--A BASIC DESCRIPTION


In this chapter general energy systems theory will

be discussed including an examination of the relationship

between energy and economics. However, before this dis-

cussion begins, it is necessary to provide clear defini-

tions of the terms energy, power, and work. In physics,

energy refers to the capacity to do work,* work is done

when a body is moved by force; and power is defined as

energy per unit of time, such as energy per second.1

These definitions can be clarified by considering

some concepts commonly used in physics.

The absolute unit of work in the Centimetre-
Gramme-Second system is one erg. It is a
very small unit, being the work done when a
body of 1.02 milligrammes weight is lifted
vertically by one centimetre against the
gravitational force at sea level. Ten
million ergs are called a joule and a joule
per second is a power unit called a watt. A
kilowatt (1000 watts) is the practical unit
of power. However, horsepower is another
power unit defined as work of 550 foot-pounds
per second or .745476 kilowatts. Since power
is energy divided by time, the product of
power and time is energy. A practical unit
for energy is the kilowatt hour; that is, the
work done by a one kilowatt engine in one
hour. It will lift a load of one metric ton
over a difference in level of 1119 feet.2


*Or the capacity to alter relationships between man and
his environment.








Potential energy may be thought of as "stored work;"

in other words, it describes the capacity to perform work or

the energy available to carry out processes and account for

phenomena. The classic illustration of potential energy is

restated by Hans Thirring using a mechanical energy example

which defines potential energy in terms of a

heavy body on a higher level which can do
work by descending to a lower level and
hoisting (by means of a rope and pulley)
a load from a lower level. In this situa-
tion potential energy is defined as the
product of its weight and the height
above a certain zero level. Potential
energy must be related to a certain zero
level because a body cannot do work by
losing its potential energy unless it is
allowed to descend to a lower level.3

Mechanical energy may be calculated in terms of motion,

force, and distance. Thirring states that one way to define

mechanical energy is

to set up an aribtrary unit to measure force
(such as pounds) and another to measure
distance (such as the foot); the composite
figure when both are multiplied together is
energy in terms of a measure of weight (foot-
pounds). However, to measure force in mo-
tion requires a new dimension--acceleration,
the rate of change of speed of movement. The
specific relationship between rate of motion
and the energy required to produce it has
been established empirically as: energy
equals one-half the mass times the velocity
squared (e=mmv2). Therefore, if mass remains
unchanged, to increase the rate of motion of
an object requires energy in proportion to
the square of the velocity. Moreover, if
there is an object moving at a given velo-
city, the above expression provides a
mathematical expression of its ability to
do work.4








In physics it is noted that when an object falls

from a higher level to the ground, its original potential

energy (while stationary at the higher level) is converted

into kinetic energy (potential energy in the form of a

moving object) during the fall and afterwards, partly con-

verted into mechanical work by making a hole in the ground

and partly dissipated into the invisible motion of its single

molecules and atoms. The kinetic energy of the invisible

molecular motion of a body is nothing else but its heat con-

tent. In other words, heat is the energy of the disordered

and invisible motion of the atoms and molecules of a body.

Therefore, both heat and mechanical work are forms of energy.

Because each is a form of energy it is possible to convert

heat to mechanical work and mechanical work to heat. Like-

wise, there are conversion factors for converting the

measuring units for mechanical work to the measuring units

for heat. For instance, a kilowatt hour is a measure of

mechanical work; a BTU (British Thermal Unit) is a measure

of heat; and one kilowatt hour equals 3412.75 BTU's.*

Energy, then, can be measured in terms of either heat units

or mechanical work units.

Thermodynamics--The Science of Energy

Since energy can be converted from one form to

another and since it is desirable for man to accomplish


*See Table 1 for other conversion factors.








TABLE 1. CONVERSION FACTORS FOR ENERGY MEASURING UNITS




Gram-calorie (gcal) amount of heat necessary to
raise 1 gram of water one degree centigrade
at fifteen degrees centigrade.

Kilogram-calorie (kcal) 1,000 gram-calories.

British Thermal Unit (B.T.U.) = amount of heat
necessary to raise one pound of water one
degree fahrenheit = 252 gcal = .252 kcal.

Joule = .24 gcal = .74 foot-pounds.

Watt = one Joule per second = 14.3 gcal per minute
= 3-7 x 10-7 horsepower hours.

Kilowatt = 1,000 watts

Kilowatt hour (kwh) = 3412.75 B.T.U.'s = 860.013
kcal = 1.34 horsepower hours.

Horsepower = 550 foot-pound per second = 10.688
kcal per minute = .745476 kilowatts.

Horsepower Hour = 2544.48 B.T.U.'s = 641.56 kcal.


Source: U.S. Bureau of Mines








this conversion, a scientific body of knowledge, usually

referred to as thermodynamics (from the Greek roots there

meaning heat and dynamics meaning power), has evolved in

this area. Thermodynamics is a branch of physics which

defines and interprets the relationships between energy,

heat and work.

British scientist James P. Joule established a

mathematical measure of the exact relationship between heat

and work, which led to the establishment of a principle cal-

led the First Law of Thermodynamics (or the Law of Conserva-

tism of Energy).5 Basically, this principle states that

energy may be transformed from one form into another, but it

is never created or destroyed. Sunlight, for instance, is a

form of energy which can be transformed into work, heat, or the

potential energy of food (energy stored as matter), depend-

ing on the situation but none is destroyed. This means that

energy, which by natural and artificial processes is per-

manently converted from one form into another, is never

lost or generated from nothing.

This law encouraged Joule to attempt to devise a

system for generating a large amount of work by exploiting

very small changes in temperature. However, these efforts

were not successful and resulted in stating of the Second

Law of Thermodynamics by one of his students. The Second

Law may be stated in several ways as follows: No process

involving an energy transformation will occur unless some of








the potential energy is degraded from a concentrated form

into a dispersed form; or, because some energy is always

dispersed into unusable heat energy no transformation of

energy (i.e. the transformation of heat into mechanical work,

or vice versa) is 100 percent efficient. In other words,

even though the First Law of Thermodynamics states that

energy can neither be destroyed nor created, another process

results in available energy continuously changing to a lower,

less usable form.* It is this process which is referred to

as the Second Law of Thermodynamics (or as some prefer, the

entropy** law). This law is used to describe the processes

of energy conversion in many systems, including those of

physics, biology, and ecology. For instance, a heat


*The first law is not violated as energy is neither created
nor destroyed; however, potential energy is degraded from a
form capable of driving phenomena into a form that is not
capable of doing so; although, even as random heat, tech-
nically, energy still exists as molecular motion.

**Entropy (from a Greek word meaning transformation) is
a term used to describe the relationship of energy to a pro-
cess. Furthermore, the terms "high entropy" and "low
entropy are used to designate available energy for use in
a given system (whether a power plant, automobile engine,
or an ecological system). Available energy is always low
entropy, and can be used for something. For example, a
pound of coal can be burned to produce electricity; there-
fore, the coal is low entropy. High entropy is energy
which is unavailable for use; for example, the heat
rejected from the power plant cannot be collected and used
to produce more electricity. In other words, low entropy
has a high degree of order and high entropy has great
disorder with respect to the system in question. For this
reason, low entropy refers to high quality energy and high
entropy to low quality energy.









engine is a process which converts some of the original

energy content of fuel (see Table 2 for the energy content of

various fuels) to mechanical work through operation of the

engine and dissipates the rest as waste heat (it is waste

because it has lost the potential for driving a process). A

second example which can be described would occur in ecosys-

tems where low entropy is achieved by a continual dissipa-

tion of energy of high utility (for example sunlight which

is capable of driving the photosynthesis process or plant

glucose which drives the respiration process) to energy of

low utility (low utility in the sense that it has no

potential for driving phenomenon).

Another way of understanding the entropy law is to

visualize the entropy process in terms of the degree of dis-

order. Thus, different forms of energy can be arranged in

an order, the highest form of which is the one with the

least disorder or entropy. Moreover, energy with the low-

est entropy has the greatest potential to perform work and

may be degraded into a lower form (to high entropy entropy),

but can never be wholly converted back into a higher form..

It is possible to transform energy from a less useful to a

more useful form, but only at the expense of degrading a

fraction of the initial amount of potential energy present.

Therefore, "the real message of the entropy law is that

energy, unlike most resources, cannot be recycled. The total

potential, or capacity to do work, in a given amount of









TABLE 2. THE ENERGY CONTENT OF VARIOUS FUELS (IN MILLIONS
OF BTU'S)


Bituminous Coal

Pennsylvania Anthracite Coal

Kerosene


Gasoline (motor fuel)

Gasoline (aviation)

Fuel Oil (Grades 1-4)

Fuel Oil (Grades 5-6)

Crude Oil

Petroleum Coke

Coal Coke

Coke Breeze

Wood

Natural Gas Liquids

Wellhead Natural Gas

Natural Gas (dry)


26.20

25.40

5.67


5.22

5.05

5.83

6.29

5.80

30.12

24.80

21.00

20.96

4.01

1 .08

1.03


per short ton

per short ton

per barrel
(42 gal.)

per barrel

per barrel

per barrel

per barrel

per barrel

per short ton

per short ton

per short ton

per cord

per barrel

per cubic foot

per cubic foot


Source: U.S. Bureau of Mines









energy can be used only once; and, having been used, cannot

be recaptured in its entirety."6


Energy and Man in Historical Perspective


Man, like all living organisms is a consumer of

energy (or is an energy convertor), because animal life

depends on metabolism fuelled by food, which supplies to

the body the necessary amount of energy. Thirring describes

the energetic of the human body as follows:

The total energy resulting from 'burning'
the food-fuel in the process of metabolism
is used for different purposes, among which
there are three which play a dominant role:

1) Chemical energy used for building up
and regenerating the living tissues of the
body.

2) Energy needed for doing muscular and
mental work.

3) Heat for compensating the losses by7
conduction, radiation, and evaporation.

Beyond the biological minimum the amount of energy

required by man is set by the goals he seeks. Because few,

if any, societies exist where men voluntarily choose to

exert no more energy than that which is required for sur-

vival, manipulation of energy has been an essential com-

ponent of man's society. "Although primitive people and

most animals can alter their behavior to adapt to changing

environmental restriction, the reverse ability to sub-

stantially alter the environment is uniquely man's."8 From









their earliest earth origins, human beings have continually

sought "to minimize their labor by the use of tools. During

the late Paleolithic period--some 12,000 to 20,000 years

ago--cave dwellers in southern Europe painted images of what

may well have been the first machine, or sophisticated tool

used by man. On the cave walls are pictured traps used for

capturing mammoth and bison."9 By using this trap, early

hunters were able to increase the probability of their

existence. They stretched their available biological

energy, in the form of food, by utilizing tools to con-

struct the trap and provide themselves more energy in the

form of flesh of the bison and mammoth. Muscular work, done

by laborers, housewives, slaves, and domestic animals, con-

tributed the greatest proportion of mechanical work among

civilized nations in former times, and still does among

primitive peoples today. "Man power and animal power is

physiological energy and is denoted by the term 'animate

energy' which means the potential energy is maintained by

food and fodder."10

On the other hand, "purely physical energy is main-

tained by using fuel, wind, water-power, and other such

sources, and it is designated as inanimate energy."11 These

different sources of inanimate energy can replace one an-

other, but inanimate energy sources can be exchanged for

food resources only indirectly by subsidizing production








of fertilizers, farm equipment, transportation equipment,

and so on. The prehistoric domestication of animals re-

presented a multiplication in the power resources available

to man but not by very significant amounts. During this

time, the power available limited man's ability to irri-

gate, cultivate, and survive. It has been the application

of inanimate energy which caused the decisive steps in the

evolution of man's society.* The most vital discovery of

the Stone Age was how to make fire by rubbing together two

pieces of wood. This revolutionary discovery has many re-

percussions in the history of energy. For early man fire

meant light, heat, protection, and a number of other

things.

The most significant of these other things is that

"the application of fire and its heat led to the transition

from the Stone Age to the Bronze Age and then to the Iron

Age by making possible the production of higher quality

tools."12 So energy facilitated the creation of capital

goods in the form of tools from nature's raw materials, and



*Leslie A. White of the University of Michigan suggested
that cultural evolution can be measured in terms of the
increasing amount of energy harnessed per capital per annum.
In other words, the development of energy sources that are
independent of immediate biological processes has been the
factor of greatest importance and this is a yardstick that
seems generally to agree with human experience: Industrial-
ized societies harness many times more energy per capital per
annum than nonindustrialized ones and in areas where the
two have competed the nonindustrialized societies have in-
evitably been displaced, absorbed, or destroyed.









the tools thus created were of a higher quality than the

earlier tools made by using the raw materials in substan-

tially natural form. In addition, energy in the form of

heat for warmth increased the size of the world's habitable

area. However, Thirring states that man eventually dis-

covered that energy could be used for purposes other than

for warmth.

For thousands of years, through all the pre-
historic ages, heat was the only form of
inanimate energy used by man. As noted
earlier, to do the work necessary to supply
food, clothing, and shelter man had to use
his own muscles or those of his slaves or
animals. It was only in historic ages, many
millennia after the invention of fire, that
a small part of human and animal labor began
to be replaced by machines using the natural
forces of water and wind.'3

The Chinese were probably the first to use wind-

mills. Waterwheels, originally devised by the Babylonians

for irrigation, were used in the Roman Empire for driving

mills such as saw-mills and hammer-mills. The early ap-

plication of water power is described by Chauncy Starr as

follows:

The horizontal water-wheel used by the Romans,
which operated by exploiting natural differ-
ences in elevation, operated with a power
capacity of perhaps .3 kilowatt. By the
fourth century the vertical waterwheel had
been developed to provide about two kilowatts
of power. These wheels were primarily used
for grinding cereals and similar mechanical
tasks. By the sixteenth century the water-
wheel was by far the most important prime
mover, providing the foundation for the in-
dustrialization of western Europe. By the
seventeenth century its power output was
reaching very significant levels. The








famous Versailles waterworks at Marly-la-
Machine is believed to have had power of 56
kilowatts.14

The windmill first appeared in western Europe in

the twelfth century. It was variously used for grinding

grain, for hoisting materials from mines and for pumping

water. The windmill had a respectable capacity ranging

from several kilowatts to as much as 12 kilowatts. Starr

then describes the evolution of using fossil fuel energy to

supply mechanical power as follows:

The development of the steam prime mover is
relatively modern compared with the windmill
and the waterwheel. As early as one A.D.
Hero of Alexandria demonstrated the famous
Sphere of Aeolus, a steam reaction turbine
on a toy scale. Not until the seventeenth
century was steam used effectively. At
this time Thomas Savery invented a steam
pump which was a pistonless device using
the vacuum of condensing steam to pump water.
Early in the eighteenth century engines using
a moving piston were developed as power
sources of several kilowatts. The steam
engine was the first mechanical prime mover
to provide basic mobility. It was some
time, however, before this mobility was used.
The early Industrial Revolution was based on
the waterwheel and the windmill as prime
movers. Thus, the location of industrial
centers, factories, and cities was primarily
determined by the availability of those
power sources. It was the geographic
limitation on the expansion of water power
that gave the steam engine an opportunity
to continue the growth of manufacturing
centers. The first use of the steam engine
was an auxiliary to the waterwheel: to pump
water to an elevation sufficient to increase
the wheel's power. It was not until the
middle of the nineteenth century that the
steam engine became a principal prime mover
for the manufacturing industry of the
western world. The contribution of large








power machines to the social development
became important after 1700. Since 1900 a
steadily growing variety of smaller power-
conversion devices have been introduced
whose chief virtue is mobility. From 1700
on, the power output of energy conversion
devices has increased about 10,000 times.
Most of this growth has occurred in the
last 100 years so it has had its major
impact only recently. It is this
technological capacity that makes recent
decades reflect accelerated energy
utilization.15

The growth of energy use has been so rapid in the

recent past because utilization of energy depends on two

factors: available resources and the technological skill

to convert energy resources to useful heat and work. Energy

resources have always been obtainable from the environment;

however, power devices capable of converting the energy into

useful work have been a recent historical development. The

development of these prime movers (energy converters) re-

quired and supported the technology of iron and steel

fabrication and it involved the rise of the railroads.

In summary, it has been shown that the use of energy

has been a key to the supply of food, to physical comfort,

and to improving the quality of life beyond the rudimentary

activities necessary for survival. Furthermore, man uses

energy converters other than his own body to achieve his

ends and the energy these converters make available to him

is measurable. Moreover, the relative advantage of using

converters over using man's own physical effort may be

calculated.








The growth of the world's population and the mani-

festations of greater per capital affluence all appear to

show significant increases in parallel with the growth in

energy use. In other words, as put by Ray Rappaport,

the increasing size and complexity of human
organization is related to man's increasing
ability to harness energy. The relationship
is not a simple one; rather, it is one of
mutual causation. For example, increases
in the available energy allow increases in
the size and differentiation of human
societies. Increased numbers and increas-
ingly complex organizations require still
more energy to sustain them and at the
same time facilitate the development of
new techniques for capturing more energy
and so on. Simultaneously with this growth
rapid developments in learning,in the arts,
and in technologies of all kinds can gen-
erally be observed.16

Although one must be cautious when dealing with

pluralistic and interacting relations, a strong case can be

made for the proposition that the productive utilization of

energy has played a primary role in shaping the science and

culture of the past 350 years. This proposition finds some

support in the relation that it is possible to observe

today between the per capital consumption of energy for

heat, light, and work and the per capital gross national

product of various nations.

Table 3 provides a rough idea as to how, in the

evolution of human civilization, new sources and new

applications of inanimate energy were added to existing

sources for providing industrial and transportation power
as well as domestic and industry heat.









Table 3. Sources of Inanimate Energy as They First Appeared
at Different Stages of Civilization



Stage of
Human Domestic Industrial Industrial Transportation
Development Heat Heat Power Power


Animal Stage

Primitive
Cave Man

Prehistoric
Civilization

Antiquity


Since about
1250

Since about
1400

Since about
1710

Since about
1820

Since about
1890

Since about
1900

Since about
1955


wood
fire

wood
fire

wood
fire

wood
fire

coal



coal


coal


coal


oil
products

oil
products


wood
fire

wood
fire

coal


coal



coal


coal


coal


electricity


electricity


wind
water

wind
water

wind
water


steam


steam


wind


wind


wind



wind


steam


electricity electricity

electricity petroleum
motors


atomic
power


atomic
power


Source: Hans Thirring Energy for Man: Windmills to Nuclear
Power (Bloomington, Indiana: Indiana University
Press, 1958), p. 32.








Energy Systems Theory and Economics


For purposes of this paper, economics will be

restricted to the study of that "subsystem of the total

social system which deals primarily with exchange, the

institutions of exchange, and with the goods or services

which are exchanged."17* Exchange will take the form of

mutually agreeable roles where one person says to another,

"you do something I want and I'll do something you want."

Within this context, "economics becomes concerned with the

allocation of the scarce means and resources available to

satisfy the varied and unending wants of the social sys-

tem."18

Where exchange opportunities are continually avail-

able, it pays for people to specialize in the production of

one commodity which can be exchanged for other commodities

similarly produced by specialized producers. For instance,

the U.S. economy is a vast network of exchanges or trade

where individuals are dependent upon each other. An

individual does not as a general rule produce for himself

any significant portion of the goods and services that he

wants and needs. Indeed, he lacks the technical skill

required to produce a host of the manufactured goods that


*The total social system consists of all the people in the
world, all the roles they occupy, all their patterns of
behavior, and all their interactions with the other systems
and subsystems of the world which form a total system of
the planet earth.








are an integral part of his standard of living. Any attempt

by one individual to produce such a variety of things for

himself would be very inefficient and wasteful, if not

impossible. Accordingly, the bulk of the goods and ser-

vices utilized by Americans are purchased from a large

number of private business firms. These organizations

specialize in various phases of the highly complex task of

transforming the resources of labor, capital, and natural

raw materials into commodities and services.

In this type of market economy, an economic concept

which may be called the "terms-of-trade" becomes important

because every human being or organization within the social

system has inputs from and outputs to the rest of the so-
19
cial system.19 The "terms-of-trade" refers to the ratio of

physical inputs received to the physical outputs provided

in exchange and is an important concept in understanding

economic behavior. Typically, favorable "terms-of-trade"

means a lot of input is received relative to the number of

units of output given up. However, when the inputs and

outputs are heterogeneous aggregates oF all sorts of things,

the problem of measuring and communicating the results of

exchange activity (in other words, the problem of measuring

one relative to another), of necessity, involves valua-

tion.20

Money is the most common measure of value; thus,

for the existence of a market system it is necessary that









economic activity be organized in terms of making and

spending money. In other words, in any exchange, "terms-

of-trade" may be measured by the ratio of what one party

gives relative to what he receives and if money is one of

the things exchanged, the ratio of exchange becomes what

is referred to, in economic terminology, as a price.

Moreover, receiving more input for the same dollar output

means a lower price per unit of input purchased, and, thus,

an improvement in the "terms-of-trade."

In the market economic system, the survival of an

organization, such as the firm, depends on its capacity to

produce outputs of a total value at least equal to the

acquisition cost of its inputs. For instance, there is the

theory that in a perfectly competitive market the price of

each product in an equilibrium will be equal to the average

total cost of the marginal firm. The average price is the

total revenue (money inflow) divided by the physical quan-

tity of the output commodity or commodities, and the

average total cost is the total dollar value of all the

inputs divided by the physical quantity of the output

commodity. The theory can also be stated as follows: in

an equilibrium of the price system the total money revenue

of the marginal firm must be equal to its total cost,

including rent and normal renumeration of capital.

In energy systems theory, the whole economic pro-

cess is regarded as one by which "the world is organized









into structures of increasing improbability with the

accompanying degradation of potential (low entropy) energy

to high entropy energy as required by the Second Law of
2y1 *
Thermodyna:ics.2*" Therefore, the process of production

consists of transforming inputs of higher probability (i.e.

high entropy) items (such as soils, ores, and raw materials

of all kinds) into outputs of much less probable things

(such as automobiles, buildings, and so on) by utilizing

available energy (i.e. performing work).22 However, con-

sumption processes then continually wear down these im-

probable structures into more probable items, such as dust,

soil, chemical minerals, heat, and so on.23

With respect to any system (social, natural, bio-

logical, economic, and so on), three broad kinds of inputs

and outputs can be identified:

1. Information for organizing, operating and

maintaining all the components and functions of the system

itself;

2. Matter in the form of either organized or

random structures; and

3. Potential energy or work.

When energy is either an input or an output of a par-

ticular system, one or some combination of three types of

work will occur:



*Recall entropy is the term used in thermodynamics to desig-
nate the magnitude of disorder. High entropy refers to a
high level of disorder and low entropy to a high degree of
order.









a. Storing work which involves the force of one

potential energy source directed against the back force from

another potential energy storage. It can be shown that the

power flow when storing energy at an optimum rate requires

a 50 percent drain. Therefore, the energy cost of the

process can be measured either by the energy stored or by

the total power flow, which is twice the storage rate when

the process operates in optimal fashion.24

b. Processing work in which power flows from

the

energy source and passes through the
system, arranging matter but effecting
no storage and no final acceleration.
All the energy eventually degrades
into the heat drain, but first useful
ends are accomplished. Thus, work done
against frictional forces to accomplish
rearrangement without storage leads to
100 percent drain; however, arrangement
of structure is a necessary principal
task in preserving or establishing any
kind of order, whether it involves the
maintenance of a living being or the
operation of an industry. The energy
cost of the process is not measured in
terms of the energy stored, for none
is stored; but it may be measured by
the power delivered to accomplish the
work.25

c. A third kind of work involves the flow of

potential energy from its storage into the acceleration of

objects. That is, energy is passed from storage into the

kinetic energy of the object. But this class of energy

flow is only a relative energy transfer and not a true energy

transformation as were the prior two. This is because the









work done in acceleration requires no heat-sink dispersal

and the energy stored in kinetic form is still available to

drive other kinds of work. Thus, energy flows involving

accelerations and work against inertial forces are not

energetic transformations in the same sense that those re-

quiring loss of potential energy are.26

Although all inputs and outputs can be arranged in

one of the above three classifications, it is important to

note that each of the three may take a large number of dif-

ferent forms. Also, output of more organized and improbable

structures can occur only if at least one of the three types

of work is performed by a system. The Second Law of

Thermodynamics states that this requires potential energy

to be degraded from low entropy to high entropy energy.

Moreover, it is possible to determine the heat value of the

energy degraded in accomplishing the necessary work to trans-

form inputs into a desired output.

For economic exchange almost any commodity can be

used as money, provided it is generally acceptable to sellers

in exchange. It is the function of money that is important.

As the medium of exchange, it serves as generalized pur-

chasing power. Instead of being forced to seek out that

particular person who has just exactly what is desired and

who is willing to barter it for exactly the commodity owned,

individuals can trade with money which greatly simplifies

the system of exchange. In other words, when people earn









money by supplying labor and other services, they are ex-

changing these resources for the ability to obtain a portion

of the current output of goods and services.

The market economic system may be broadly illustra-

ted in Figure 1. It is seen that business firms purchase

natural resources (previously discussed as the input termed

matter), and hire services (potential energy input) from

the owners of these inputs. The money payments made for

these in the form of wages, interest, rents, and so on

become the disposable income of the labor system.* In turn,

the individuals and families that comprise the labor system

spend their disposable income for the goods** and services

produced by businesses, thereby creating the demands which

businesses try to satisfy in their attempt to earn money

profits. As Figure 1 illustrates, there is a continuous

flow of money payments from consumers in the labor system

to business firms and back to the labor system, the latter

matches a flow in the opposite direction of productive

services and finished goods and services. It is the opposite



*Here the labor system refers to all of the individual
people living in a specified social system.

**An economic good (either an energy processor, termed
capital equipment and consumer durables in economics, or
a nondurable consumable) may be defined in energy systems
terminology as a high probability natural resource which
has been changed--by degrading low entropy potential energy
in the performance of work--into a low probability, highly
organized form of the type desired by man for use in his
living process or social system.













FIGURE 1 LEGEND


1. Natural resources (money payments go to labor system
since raw materials are owned by people).

2. Productive services and natural resources utilized.

3. Productive services.

4. Payments for productive services and natural resources
by users of these items.

5. Income of individuals who provide useful services.

6. Money payments for the finished goods provided by
business firms.

7. Finished goods used and consumed by people.

8. Output of finished goods for people.

9. Money payments made by people to obtain finished
goods.

10. The flow of used (degraded)energy and matter back to
the natural system. The matter is recycled by
natural processes and the degraded energy (i.e.
heat) radiates from the earth.