Group Title: study of various measurement bases and their effect on periodic income determination
Title: A Study of various measurement bases and their effect on periodic income determination
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Title: A Study of various measurement bases and their effect on periodic income determination
Alternate Title: Measurement bases and their effect on peiodic income determination
Physical Description: vi, 194 leaves ; 28 cm.
Language: English
Creator: Sanders, Howard Preston, 1938-
Publisher: University of Florida
Place of Publication: Gainesville, Fla.
Publication Date: 1967
Copyright Date: 1967
Subject: Income accounting   ( lcsh )
Accounting thesis Ph. D   ( lcsh )
Dissertations, Academic -- Accounting -- UF   ( lcsh )
Genre: bibliography   ( marcgt )
non-fiction   ( marcgt )
Thesis: Thesis - University of Florida.
Bibliography: Bibliography: leaves 182-194.
Additional Physical Form: Also available on World Wide Web
General Note: Manuscript copy.
General Note: Vita.
 Record Information
Bibliographic ID: UF00097841
Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: alephbibnum - 000554293
oclc - 13385461
notis - ACX9127


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August, 1967


The author wishles to express his appreciation

to Dr. W. b. Stone, under whose supervision this investi-

gation was comnpleted. ~Apreciationl is also expressed to

Dr. R. H. Biodgett, Pr. G;. W. Fristoe, Dr. W. M. Howard,

and Dr. D. D. Ray who served on the author's committees

and to Dr. L. J. jenninger anld Dr. R. Bizonl who each

served temporarily as chairman while the investigation

was underway.

The author wishes to express his gratitude to

his wife, Shirley, w~ho spent many hours typingc the manu-

script, proofreading, giving general assistance, and

most of all--giving constant moral support.




ACKNOWLYIDGMENTS ................................. Li


I. INTRJOUCTlON ............................ 1

Internal Use of Accounting Statements 2
Planning the Future ................. 2
Controlling the Present ..........., 4
Evaluating the Past ............,,,.. 4
Stewardship .............. ........... 5
External Use of Accounting Statements C,
Investors and Prospective Investors 7
Creditors and Prospective Creditors 9
Social Control Agencies ..........., 11
Labor Unions ..............,,........ 11
Comparison of Internal and Oxternal
Users .............................,, 12
Purpose ...,,.......................... 13
Scope ................................. 15
Method ......................,,........ 17


Introduction .......................... 18
TPhe Nature of Measurement ..........., 19
Types of Scales ....................... 21
Kinds of Heasurement ................ 25
Impact of Measurement on Accounting ... 26
Definitions of Accounting .......,.., 26
Imp~ortance of Measurement in Account-
ing ................,,,,.......... 27
Basic Structure of the Business
Measurement Process ............... 29
Measurement and Value ............... 74
Accuracy ..................,,........ 36
Accuracy in Sciences .............. 36
Probability and Doeree of brror ... 37
Scales in Accounting ............... 38
Kinds of Measurement in Accountin: .. 39)
Criteria for Comparing Measurement
Methods ........................... WO
Suolmary ............................. 411


Ill. HISTORICAL CUST ......................... 42

Introduction .......................... 42
Definition of Hlistorical Cost ......... 113
Related Conlcepts Underlying: Accountinp:
Statements .......................... )r5
Going Concern ....................... 45
Timeu Periods ........................ 47
Realization .......................,.. 48
Matching ............................ 50
Objectivity ......................... 51
Conservatiism ........................ 52
Suranary ............................. 53
T~he Realization Concept ............... 51)
Historical Goveloipnent of the Reall-
zation Concpt .................... 5L(
The Frosnt Status ................. 56
Currently accepted exceptions to
the general rule for realization 62
Surnmary ........................... 64
affects on Accounting jtatemnents and
Criticisms .......................... 65
Compgarability ....................... 68
Alternative methods ............... 68
Price-level changes ............... 69
Uniformity .......................... 71
Alternative methods .............. 71
Judgment .......................... 72
Prico-Lovel changess ............... 73
Management .......................... 73
Investors and Prospective Investors 74
Other hxternal Users ................ 83
juanmrary ............................... 83

IV. CURI1ast COST ............................ 86

introduction .......................... 86
Income .............................. 87
Prioo-lovl Adjustment Assuaption ... 89
Variations of the Current Cost Concept 90
Awards and Uall's Concept .......... 91
Sprouse and lMoonitz's Concept ....... 99
Other Curront: Cost Concepts ......... 107
Th~e Miost De~sirable of theJ Current
Cost Concopts ..................... 110
HoldinJ gains and losses .......... 111
quality of gains and losses .... 112
Production Incomea ................. 114

-iv -

Comparison with the ilistorical Cost
Concept ............................. 118
Usefulness .......................... 118
Accounting Statements ............ 119
Inventory valuation ............ 121
Other asset valuations .......... 122
Unrealized income ............... 122
Dual accounting statements ...... 123
Implications for cost accounting .. 123
Inventory flow assumption ....... 123
Absorption costing vs, direct
costing controversy ........... 124
Objectivity ......................... 124
Feasibility ......................... 127
Summary ..............,................. 128

V. Nbr RKSALI'ABLI VALUSj .................... 130)

Introduction .......................... 130)
RaJtionate of Not Realizable Valule ... 193
Variations of the Net Healizable Value
Concept ............................. 135
American Accounting Association ..... 135
John B. Canning: ................. ... 137
Sprouse and Moonits ................. 138
Actual Use of Net Realizable Value .... 142
Contrast with the H~istoricall Cost Con-
cept ................................ 144
Objectivity ......................... 144
Usefulness .......................... 145
Accounting statements ............ 146
Feasibility ......................... 148
Contrast with the Current Cost Concept 148
HIolding Gains and Losses ........... 149
Objectivity ....................... 119
Usefulness ........................ L5L
Feasibility ....................... 152
Production Income ............,..... 152
Summary ............................... 153

VI. UISCOUNTED CASH FLOW .................... 154

Introduction .......................... 154
Economic Concept ...................... 157
Subjectivity .......................... 157
Compiarison with other Measurement Baseos 158
Historical Cost ..................... 158
Current Cost ........................ 159
Net Realizable Value ................ 160
Sulamary ............................... 160

VII. SUMM~ARY AND CON9CLUSIONS ................. 162

UIBLI3J<.RAPHY .................................... 182


Table Page

1. Four Types of Scales .. .... .. .. 22

2. A ClassificatiLon of Scales of Measurement .. 23

3. An Array of Value Concepts . .. .. . .

4. A Comparison of Realization and Healizable
Criteria . ... .. .. .. .. . 98

- vi



Accounting statements are the tangible product

of the accounting process. TIhe product is of no impor-

tance within itself; the importance of accounting

statements is in the service they render to statement

users. The following paragraphs comprise a discussion

of accounting statements largely in terms of those who

read theme and the purposes for which they read them.

The mrost familiar accounting statements are the

balance sheet and the income statement. The number of

types of statements for internal users is almost end-

less. with certain practical limits, management may

prepare or have prepared any statement that may be use-

ful to them. The external users have a more limited

supply of statements, being limited largely to what is

known as the published financial statemsents. The pub-

lished rfnancial statements are the representations of

management to outsiders. The published financial

statements usually consist of the balance sheet, the

income statement, and the analysis of owners' equity

(retained earnings, in the case of a corporation), but

-1 -


they may include other statements and details such as

the source and application of funds statement.

The users of accounting statements can be

divided, at least roughly, into two classes: internal

users and external users. The internal users of account-

ing statements are all those who participate in the man-

agement of the enterprise at any echelon. External

users include investors (both present and prospective),

creditors (both present and prospective), social con-

trol agencies (such as governmental units), labor

unions, employees, consumers, and the general public.

Internal Use of Accounting Statements

The internal users of accounting statements

are the various levels of management. Any given moember

of management is concerned primarily with accounting

statements dealing with his area of responsibility

and over which~ he has authority.

The chief function of management is decision

making. Managerial decisions may be divided into three

areas: planning, controlling, and evaluating. Account-

ing statements are utilized in aiding management in

recognizing the need for decisions and in guiding

management in making the decisions in all three areas.

Planning the future

The three areas of concern to management may

be thought of as a cycle. A discussion of the three

areas may begin with any one. The planning area has


been chosen because this would be the first area of

interest to the management of a newly organized or

prospective entity. After the enterprise is underway,

planning : is of continuous concern to mana::ement,

some writers express the view thiat accounting:

deals only with past events. This concept of accounting:

would exclude from the realm of accounting statements

those deaFLnd with the future, such as various types of

budgets. Accountin:: as used in this study Is intended

to include estimates of and prospects for the future

as well as records of the past.

After an entity is underway it is at once in

the planning: area, the controlling : area, and the evalu-

atin.: area. The three areas may be thoullht of separately

in the sense that a member of management may direct his

attention toward only one area at a time. For example,

mnanagecment may focus its attention on theu plannin.: area

as a new fiscal year approaches.

Plans for the future are made after a careful

evaluation of the past. experience in the past mnay

serve as a euide to the future. Friends may be indi-

cated, For example. Che accountin.5 statements for prior

accounting ; periods are a major source of information in

makint financial plans For subsequent periods, After

an entity begins business, plannin:: requires an ovalu-

ation of the past as well as a consideration of thle



Controlling the Present

Controlling the present implies the carrying

out of plans made in the past. Controlling, as used

here, includes the concepts of coordinating and moti-


Management follows the activities of an entity

closely to see that there is compliance with the plans.

Timely cost accounting reports which can be compared

with the budgets are almost essential in this area,

Management may decide to alter plans even after an

accounting period has begun in order to control the

enterprise activities. Such changes may require spe-

oial studies and revised budgets. interim accounting

statements such as the balance sheet, income statement,

and source and application of funds are useful. Such

interim statements provide management with information

concerning current status before it is too late to

make changes and corrections. It is probable that

these interim statements would do nothing more than

help point out a problem. Further analysis would be

necessary to learn details.

Evalurating the Parst

Evaluation is the prooess of determining what

has been accomplished and the implications of these

past accomplishments. An effective way to determine

what has been accomplished is to compare results with

-5 -

the plan. the balance sheet, the incomeo statement, and

other accounting statements are used by management in

evaluating thre past.

M:anagemeant is ordinarily interested in much

more detail than the external statement users. tixternal

users look at the entity as a whole, while mana rment

is interested in the constituent elements. For this

reason, management may require detailed reports which

explain various sections of the general-purpose state-

ments or answer specific questions which arise.

Evaluation of the past is a prerequisite for

and biends into the planning area. except for the

beGinninC an~i end of entity operations, no area need

be consideredl the first area or thle last area. Planning:

the future, controlling the present, and evaluating: the

past are sepnents of an endless cycle of manaigerial



in a sense moanagemont uses the general-purpose

statements for external reporting in performin- its

stewa~rdship accounting: responsibility to investors and

creditors and in porformin : its public-duty responsI-

bility to the :eneral public. These evaluations of

the past are assumed to fulfill manaGement's responsi-

bility to outsiders. "bxternal reportin? has been

traditionally oriented towardl historical stewardship

-6 -

aspects, while internal reporting has been much more

concerned with current and future events" (1, P. 521).

External Use of Accounting Statements

The external users compose a more heterogeneous

group than the internal users. Mlost external users

have one thing in commson with each other; their primary

sources of information concerning the financial affairs

of an entity are the published financial statements.

The term financial statements is less broad than the

term accounting statements. Financial statements are

defined by Sprouse and Moonits as follows "Financia

statements are those which purport to show financial

position and results of operations, including support-

ing schedules, elaborations of special aspects of

business activity, rearrangements of underlying data,

and supplementary statements" (2, p. 8).

Some external users have sources of information

in addition to the published financial statements.

Creditors and potential creditors may require of manaeB-

ment more detailed information such as plans concerning

the future. Social agencies such as governmental units

can and do require large quantities and various types

of data. Labor unions may sometimes acquire additional

data. The investors and potential investors, as a

group, have few other sources of information. They

must rely, directly or indirectly, on published finan-

cial statements. As individuals, they may have an

- 7-

inside track, but this is not considered a significant


An important purpose of accounting data is to

aid external users in making decisions. As the type

of decisions to be made varies with the user, each type

of user will be discussed separately.

Investors and Prospective Investors

The general-purpose statements distributed to

investors and available to prospective investors are

prepared largely from the stewardship point of view.

Management has an obligation to investors and pro-

spective investors to provide information which will

ss~er as a basis for decisions as well as to fulfill

its stewardship responsibility. The Study Group on

Business Income says: "The annual finanotal state-

ments of corporations are primarily reports of steward-

ship, and the methods of presentation should be

determined with constant regard to that primary pur-

pose; but when corporations seek the advantage of

maarkcetability for their securities they inour an

obligation of disclosure to investors generally"

(3, P. 108).

The investor must make certain decisions con-

cerning his investment. Should he retain or terminate

his investment in a given enterprise? If he terminates

his investment, should he invest in other entities?


If he retains his investment, should he increase or

decrease it? These are some of the most important

decisions to be made.

The type of information used anrd needed by

investors is difficult to determine because investors'

motives are not easy to analyze. The investor may be

interested in dividends, appreciation, risk, and

diversity. Any given investor might assign different

w-eights to these various motives. Some investors may

be unable to analyze their motives. It is likely that

many investors have never tried to do so. Institu-

tional investors are likely to have more definite

motives than individual investors, Investors must

have rather clearly defined motives in order to use

financial statements effootively in the decision-

making process.

Once the investor has established his motives

for the investment he must determine how his invest-

ment measures up to the motives. This is best done

by comparing an investment with alternative invest-

ments. Also, a comparison of the financial statements

from year to year may indicate trends.

The potential investor faces essentially the

same decisions as a current investor. The main

difference is that comparison must be made between

the present use of money and the prospective invest-

ment as well as between alternative investments and uses.

S9 -

Creditors and P~rospective Creditors

Creditors are interested in the debtor's finan-

cial ability and willingness to repay debts. Pho

willingness factor is important but rather difficult

to evaluate. A debtors reputation and his financial

status are guides to his willingness to repay debts.

The better off financially a debtor is, the more Likely

hre is willing : to repay debts. It is generally assumed

that a debtor is willin,: to repay debts if he has a

good reputation and is financially able to doe so.

Creditors are seldom faced with the need to

makeo decisions concernin; current debts. Thnre is

usually nothing to do except wait for the maturity of

the principle, or perhaps to collect interest payments

and installments on the principle. bvon when they are

not faced with decisions, creditors are interested in

the debtor's ability to repay debts. This will involve

short-run ability or lonI-run ability depending on the

length of thle loan period.

the general-purpose financial statements are

used to help determlne a firm's financial ability to

repay deabts. Pho relationship of current assets to

ourrent liabilities is a -uide to short-run ability

to repay debts, lhe debtor's earning power and the

size of other long-term debts are guide~s to lontg-run

ability to repay debts. The ;eneral-purpose financial

- 10

statements are intended to present this type of infor-


There are times and situations which require

decisions by creditors concerning outstanding debts.

The contract between the debtor and creditor may require

the debtor to perform specific acts. For example, he

may be required to place funds into a special sinking

fund for the retirement of the debt, The creditor wants

to know if the debtor is meeting such requirements.

There is the possibility that credit obligations

such as notes and bonds may be sold to others before

their maturity. The creditor does not necessarily have

to hold an obligation until maturity. A decision may

be made at any time to terminate a given credit position.

There is the possibility that legal proceedings

may be necessary to collect a debt from a debtor. Some-

times a creditor will find it necessary to initiate

legal proceedings; even bankruptcy proceedings may be

necessary. The creditor needs to be in a position to

foresee the necessity of such proceedings.

For the prospective creditor or the creditor

who is considering making additional loans to a debtor,

decisions must be made concerning whether or not to

make a loan, what amount to loan, and what contractual

requirements are to be imposed upon the debtor. The

published financial statements of the debtor may be

helpful in making these decisions. More detail than

- 11 -

is usually included in the published financial state-

mlents is desired by the prospective creditor. Addi-

tional information may be obtained through more detailed

statoments or through personal interviews with the

debtor (or prospective debtor) or his representatives.

Information is also available from those who are already

familiar with the credit standing of the prospective


Social Control Agencies

Social control agenotes usually prescribe their

own form of accounting statements. These statements,

usually prepared by the entities themselves or their

agents, provide the basis for various types of taxes

and controls. The social control agencies also use

accounting statements in making decisions concerning

types of control, types and amounts of taxes, and means

of enforcing regulations,

Labor Unions

Labor unions are interested in ascertaining

the financial condition of the entities in which its

members are employed. The unions' main objectives are

to determine what benefits to ask for and to determine

a bargaining procedure.

Employees, consumers, and the Beneral public

as a group have less specific needs than other groups

of users. In general they are interested in products

* 12-

and services being sold at fair prices and factors of

production being paid fair prices.

Comparison of Internal and External Users

In the preceding paragraphs. many of the various

uses made of accounting statements by internal and

external users have been briefly summarized. For

internal users, the type of information and the quantity

of detail depends upon the level of responsibility and

authority. The lower levels require more detail than

higher levels. The published financial statements, or

"general purpose" finlancial statements, are not designed

to cover specific areas of responsibility and give the

amount of detail needed by lower levels of management.

Higher levels of management are more likely tD

find the published financial statements useful. How*

ever, this is likely to be just a starting point for

analysing the operations of an entity. It is likely

that top management does not desire details of every

item in the financial statements; only certain items

require more detail,

Moonitz emphasizes the different needs of

internal and external users in taking the position


published financial statements (usually in the
form of annual reports to stockholders) should
be designed to inform all important nonmarnagerial
groups by presenting a report on management, not
for management. .. We can no longer, however,
operate on the assumption of a harmony of intorests,

S13 -

that what is good reporting for investors is also
good reporting for management, and vice-versa,,
The investor is interested in results, not in
methods of decision-making by management (4, p. 179).

Investors, creditors, and other external users

need information about the plans and accomplishments

of management in order to make the best decisions. The

needs of m~anacoment, in general, differ from the exter-

nal users. Of course, various levels of management

need information on the effectiveness of lower levels

over which they have responsibility, Maanagement needs

information for planning, control, and evaluating.

This requires much more information than that contained

in the published financial statements.

The significance of accounting is reflected by

the use made of accounting statements and other account-

ing information by those internal and external to the

entity. These users and their general needs have been


The ways in which accounting statements are

used and the reasons for their use are not definite.

This has been the subject of some recent research, and

it is likely that even more research will be conducted

in this area in the near future. Although some of this

research utilizes the deductive approach, the empirical

approach is moare common. It is assumed in this study

that accounting statements are read and that the


readers utilize the information for the decision-making

process. "It is evident that accounting maeasuremaents

do represent information for decision-makers and since

decision-makers do read accounting reports, the Impli-

cation is strong that accounting measurements must

have speciflo behavioral implications, not mere general

tendencies in the long run" (5. p. 212).

Assuming: the basic needs of those who use

accounting information, this writer fools that the

basic problem in accounting is the method of measure-

ment to be used. For example, investors may wish to

know the amount of income earned over a given period

of time. Various amounts of income would be determined,

depending upon the method used to measure income as

several methods are available.

The purpose of this paper is to analyze and

compare the most prominent of the measurement methods,

or bases. The measurement bases chosen for inclusion

are historical cost, current cost, net realizable

value, and discounted cash flow.

The writer hopes that this study will provide

the reader with

1. An understanding of the maJor measurement

(valuation) bases by explaining each, explain-

ing and comparing the different interpretations

for each.

- 15 -

2. A demonstration of the likely effect of each

of the bases on the measurement of financial

position and periodic income.

This study is prepared largely from the point

of view of business enterprisses i. e., enterprises

organized for profit. This is not to say that it has

no application to entities such as hospitals, charitable

organizations, and Imunicipalities, but that the emphasis

is on business enterprises.

One of the most important concepts underlying

accounting as practiced today is original cost, or

historical cost. This concept is generally accepted

in the determination of periodic income. The use of

this concept may have certain weaknesses. It may result

in asset values on the balance sheet which do not

reflect the worth of the assets. If asset value

increases or decreases are some~times not recognized,

gains or losses occur which may not appear on the

income statement. Revenue may be thought of as being

earned throughout the production and selling process

or throughout the selling and rendering of services.

Whon the historical cost concept is used, revenue is

not usually recognized in the accounting records until

a specific event such as a sale taesr place. These

weaknesses may be used as the basis for the suggestion

- 16

that there mary be alternatives to the historical cost

conncnt which would be more uiseful. The major portion

of Lbts ytudy is a diiscuusion of those alternatives.

ihe principles of monaulroitrnt and thpir imspor-

tance nnd application to accountin- aru tlscussed in

Chapter i1. rt is rmiphasizedl thant accountin: Is a

syst a of mneauriesent.

Clas~ter 111 iJ a discussion of thr >r at yc

:oncraLly nce~ti measure entcn cncep7t--historical cost.

h" WriterlS Int ntionu are t? sho~w the tomanct of the

historical co t concept alon: with a relat 4l concept,

the realiztiton concent, on tlie accountin itatements

and cslaecliitl on the inconm statements, Saknesses

atree 'y referred to arn discussed in drotn in ordrlr

to sw "st the nneed for altcrnative m asureme~nt conrccits.

nhaster 11 is a discussion of curr nt cout.

Current cost Is ai nameo chroso ay this wrriter to einco~n-

pass aov ral conca(,ts wrhich, include market valur,

opp'Ortunity cost, and rapieencomnt cost. All the concep~ts

in thris arra are divided into two catnrrories which are

disonrssc ds parately. one cateory includes all current

costs whiich wouid included prodluction incooe before a

*,~e tR'0 pl aC. while thr other cat (ory Fxoludes such

current coStJ.

Jvst as to r. are several variations of what

thts writer refers to as current cost therz are aluo

- 17 -

several variations of not realiz~able valua, Chapter V

Is al discussion of these concepts.

The discounted cash flow concept isr discussed

Ln Chapter Vti. Th~is may be referroid to as ths economic

concept of inemee

Chapters TV. V, an I VI include: a compairison of

tbo measur :cent b~asr prnsonted In that chapter with the

meansurem noL base (or bases) pres-,nted in Lkhe ,rior

cHapt r (or chap~tirs). Thuns, each of the fou1r measu1re-

ment coie pts Jresented is compared with all of the

other three neasuronelnt concepts.

Are1 suimmary and conclutsions constituted Chlapter


This study is based on library research and

lo(:ical analysis. 4o empirical study has been utilized.

Extensive empirical research would be necessary to

determine how accountin:: statements are actually used,

the re~liance pinced up~on themo, the? chaniles dlesired by

statement users, and the measurement methods which would

be most useful to users. For lackr of such research,

the writer relies upon his own assumptions and the

assumptions which have been made by other writers,




Measuremeont was at one time closely bound to

mnathemnatics. It is perhaps difficult to say whether

measuremnent had its beginning: in mathematics or mlathe-

matics had its beginning in measurement. shole-number

arithmetic and scales of numerosity (called numbering

in common usage) grew up together. "The numroursity

of collections of objects .. constitutes the oldest

and one of the most basic scales of mleasuroemnt"

(6, pp. 19-20).

The idea that measurement theory applies to

accounting is not new. Accounting has always been

concerned with moasurement just as it has been con-

cerned with arithmetic. There has been an increased

emphasis recently in the application of measurement

theory to the social sciences which include account-


The first part of this chapter is a discussion

of measuremeant theory. Types of scales and kinds of

measurement are included. Theu application of

- 18 -

- 19 -

measurement theory to accounting is discussed in the

second half of this chapter.

The Nature of Measurement

in common usage the terna "measurement" and

"measure" have a multitude of meanings. As used in

this paper the terms have much more narrow meoanings

than in common usage. Several definitions of measure-

ment as used here are given in the following paragraph,

S. S. Stevens, one of the leaders in the field

of modern measurement theory, defines measurement as

"the assignments of numerals to objects or events

according to rule--any rule" (6, p. 19). B. Ilussell,

another authority on the subject, gives this defini-

tion: "Mleasurement of magnitudes is, in its most

general sense, any method by which a unique and recip-

rocal correspondence is established between all or

some of the magnitudes of a kind and all or some of

the numbers, integral, rational, or real as the case

may be" (7, p. 176, quoted in 8, p. 13). N. R. Camp-

bell gives a definition very similar to that given by

Hussell. Mleasuremnent is "the assignment of numerals

to represent properties of material systems other than

number, in virtue of the laws governing these properties"

(9, quoted in 8, p. 13),

iharren S. Torgerson points out that, though

there are slight differences in these definitions, all

three deal with the same general problem concerning

- 20

"the process and rationale involved in the construction

of a scale or measuring device and the properties that

can be ascrthed to it" (8, p,. 13). In common usage

measurement usually refers to the application of a

scalo; in this paper measurement refers to the con-

struction of a scale. "Measurcomen as used here refers

to t:he p~rocess by which t~he yardstick is developed, and

not to its u~se once it h~as been established . ."

(8, P. 14).

According to Targerson, an object is not

meausuredl; properties of an object are measured. ("Pro-

porties are essentially thre observable aspects or

characteristics of thle empirical world" C8, p. 9 .)

The dofinitions of Russell and Campholl given above

indicate that properties are measured rather than

objects. Stevense definition indicates that objects

themselves can be measured.

Stevens considers his definition to be loss

restrictive. "Rostrictive definitions of measurement

have toppled as the practico of measurement, outrunning

legilsltion, has forced us to broaden and generalise

our conceptions" (6, p. 18). Stevens considers his

definition "liberal and open-handed" and realizes it

is unacceptable to some (6, p. 18). Hlis definition

includes more clrssification as a form of measurement.

-21 -

Tylpos of Scntes

Mncaurement of properties requires the asslyn-

ment of numeorals to represent the properties. A one-

to-one relationship must exist between the quantities

of the proporties and the number system. Exie number

system used must have the following features:

1. Orrdered numbers,

2. ,rderod differences between numibers,

9. A ulniqlue origin, "zero."

These three features may be called order, distance, and

origin (:8, pp. 14-13).

Vhen numbers are assigned to objects "`so that

the relations between the numbers reflect the relations

between the objects themselves with refspect to thie

property" (8), a scale of measurement haes been estab-

l ished.

JO the three characteristics listed above

(order, distance, and origin), only order is necssarily

involved in the usual meaning of measurement. Pho other

two characteristics may or may not be involved in a

given mrasurrement. If a scale necessariLy involves

order but may or may not involve distant and orkgin,

there are four possible combinations of these three

characteristics as prcsonted in Table 1 (6, p. 16).

Order is implied in the ordinal scalP "so that

the order of the numbers corresponds to the order of

magntitude of the instances" (6l, p. 16). T~he interval

-22 -

scale has the feature of the ordinal scale with an

added feature of a meaningful size of the distance

between pairs of numbers. AZn interval scale with a

natural origin is called a ratio scale (8, p. 16),



No Natural origin Natural Origin

No Distance Ordinal Ordinal Scale
Sale !ith Natural

Ulstance Interval Ratio
Scale Scale

stevens adds to these conventional scales a

lower scale which he calls the nominal scale (see

Stevens' table on the following page--Table 2)

(6, p. 25). "An array of categories or classes made

distinct through the label of numnerals is considered

to be the natural basis of measurement and is called

the nominal scale." (10, p. 58). The ordinal scalo

is next in hierarchy. Et "consists of classes--

characterized by numerals--which are subject to order

rank in conformity with the numerals assigned"

(10, p. 59). The next scale, the interval scale,

enforces regularity of class-interval. The last

scale, the ratio scale, requires n zero-point thiat

is not arbitrarily chosen but given somehow beyond

more convention" (10, P. 59).



Scale Basic cnpirical rlathaemtical Typical
opera\tions Group! structure izamples

Nominlal Determination P'ermutation

* Measurement is the assignment of numerals to events or
objects according to rule. Thle rules for four kinds of
scales are tabulated above. The basic operations needed
to create a given scale are all those listed in the second
column, down to and including the operation listed oppo-
site the scale. The third column gives the~ mathematical
transformations that leave the scale form invariant. Any
numeral x on a scale can be replaced by another numeral
x', where x' is the function of x listed in column 3.

of equality

group 7
I' = f(*)
where f(x)
m~oans any

Isotonic group
I' = f(x)
clhere f(x)
means any

Linetar or
affine group
x' aa + b
a > 0

"Numnbering" of
football players
Assignmoent of type
or modlol numbers
to classes

Hardness of
jtreet numbers
Grades of leather,
lumber, wool, OtC.
Intelligence test
raw scores

or Colsius)
rimeo (calendar)
test standardd
scores" (2)

L-n;:th, density,
w~ork, time
interval, etc.
(Plankine or
Loudness (sones)
Srightness (brils)

Ordlinal Datormination
of greater or

Interval Determination
of tle
equality of
intervals or
of differences

Ratio Determination
of the
of ratios

I' ex
cO >0

~th nominal scale, involves thr assignment of

numaerals to thea object itself rather than to the pro-

parties of the object. This would not be considered

measurement at all by somef definitions such as the

conventional definitions rgiven by nussell and Campbell,

Thus, Steeves considers msore Olassification as measurre-

ment while some authorities would not (8, p. 9),

Stev~ens also inclCudes Ysoe eXampleS in the

other sc+1es which may not, by definition, be con-

sidered neasurement by RusselL and Campboll. rHe

inclu-`os street minumbrs as an example of the ordinal

scale, position as an oxample of the interval sealo,

andi numerosity as an example of the ratio scale.

Ct : a 0>des not reco niz~e an ordinal seate

wiith a natural Irickn,. Authorities ot~hnr than Stevens

and Targerson prasont still more variations in scales.

inch of Stevnns' scales after the first "igrows

out of thre .,rocedlin& one by introdu~cing an additional

property or condition, thus restricting: its application

to a smnaller but more speolfic area than that of the

preceding: iical" (10. p. 58). Tfhe classification of

soalJs i; based on how much information is rouresefnted

by thea numeraLs (L8, p. 21). Thes amount of freedom in

assigning numbers decreases av oneo goos down the scale--

either Stevons' or the coniventional scales.

- 25 -

hinds of 40asuremecnt

Andns of Informnation represented by numerals

"amounts to a consideration of the sorts of men~ning

attributed in a particular scale to those charactorts-

tics of order, distance, and origin that are rrpres!?nted"

(8, 2). orgerson gives three ways in which those

characteristics might obtain meaninR:

1. iharough Laws relating thle property to other

proporties--derived measuremecnts.

2. "y arbitrary dlefinition--flat meoasuremennt.

3. T'hrouuh natural laws relatin: various qjuantities

of the construct t to each o ther--fundamren ta

measuremesnt (8,. pp. 21-22).

There is no necessary relationship between types

of scales and Kinds of leasurement. A particular scale

of measurement is not limited to any p~articular kind

of measurament. (t(, p. 22).

"Theu view has been hold that the assignment of

numoerals to objects other than by the procedures

involved in fundamental or derived mreasurcment is not

measurement at all" (6, p. 22). 4ome experts disagree

with this and feel that a more general definition is

needled to include fiat measurements.

- 26 -

Impact of Merlsuremenlt on Ancoonlntin7

Definitions of Accounting

Accounting, by definition, is concerned with

measurement. It is generally accepted that financial

data is the subject of the measurement process.

"Accounting is a discipline concerned writh

the quantitative description and projection of the

income circulation and of wealth aggregates by means

of a mnethlod based on the followringq set of basic

assumptions: monetary values, time intervals, struc-

ture, duality, aggregation,. economic objects, inequity

of monetary claims, economic agents, entities, eco-

nomic transactions, valuation, realization, classifi-

cation, data input, duration, extension, materiality,

and allocation" (10, p. 19). Quantitative description,

as used in this definition, implies measurement.

Accounting is the art of measuring and comlmuni-
cating financial information. Trhis statement is
not sh~ocking or even surprising, yet the acknow-
ledgemeant that accounting is; concerned uith
measurement is the first necessary step towards
a longe united rev'olution inr accounting. This
revolution is not restricted to accounting; it
hlas already taken place in other discipliness where
measuremecnt is crucial. For example, the classi-
cel ouncepts of me~asuremient in physics and psycho-
logCy have already undergone drastic changes. It
la ime For roestictive definitions of measuremecnt
in accounting to topple (11, p. 501).

Accounting might even be considlered a theory

of measurement: "Since the main functions of account-

inE are classification and evaluation, the thought of

-27 -

interpreting6 acourba Snc is a :.lhygr] of mneasurement is

not farfetch~ed andc soundsb plausibrle" (10, p. 94).

Theae areo repre~sentative def~inlitions of account-

inL' idlich emphasirze the measurement aspect.

Importance of Hlensurement in Accounting

Galileo demonstrated "that qluantification is

the best and most accurate way to acquire empirical

knowledge." He indicated thu maxim in this proverb:

pleasuree all that is measurable and attempt; to mrake

measurable that which is not yet so" (10, PP. 54-55).

"The basis of accounting is measurement" (12,

p. ix). The purpose of accounting is to measure. Or

perhaps the purpose of accountingc could be better

expressed as: to measure financial data, Financial

data nay be arranged in the form of financial state-

ments. Thus, the two primary financial statements

measures financial position and the results of operations.

Other financial statements meas~ure changes in retained

earnings, the flow of working capital, and the flow

of cash. Accounting may also be used to measure finan-

cial dlata such as the cost of products, variations

between the actual and standard costs of products, and

the differences in costs and revenues between alter-


Measurement is concerned with the quantitative

aspects of objcts. Byr tradition, at least, accounting

is concerned with the quantitative aspects of objects.


Perhapls aclcouninglr -ouldl ' c no rrrne with oterc

eprect:;; perhaps; accovetfin= sihonll~r repol~rt fct~s and

con~ti~n:enries whlich do not halve: a direct impact; upon

c,Rntitative aspects of objects. A hrart attack suf-

fere~d by the president of a businosw corporationl may

be of more interests to the stockholders than much of

the data tha~t is reported--the amount of goodwill car-

ried on thec books, for exaraple. Traditionallly, goodwill

carried on the corporations books is reported on the

balance sheet; a heart attack suffered by the president

is not mentioned in the financial statements. it mray

be argued that the president's heart attack will be

reflected in the finanotal statements in the future

by moans If reducedi profitability, but theJre is ai time

Ing. The3re are those wsho argue, or at least suggest,

thie possibility of extending accounting: to nonquanti-

tative aspects of objects.

Thei reqluirement that measureoant be "in tesras of
rea; 7"~ has persi~sted, dominating the notions of
"sC:nifisan t m~annar" and "evants," rrhenr an evont
occurs whose impact may be hidhly significant for
the flinuietal (or other) welfare of an entity, the
decision to record it or not in theo accounting
recr~ast Ht11 be ma~de on the basio of whether it can
be expreBssed in terms of monoy: consequently ~avonts
of a trivial nature are roenrded whi1, ly orantous
occurrenc-s which are quantifiable but to which a
dollar vntul cnnilt be attached--e.g., doubling
shanre of market, nulmber of lost saleCs---or non-
quantifiable cronts, such as the choice of a next
president, are effectively ignored (1?, p. 28).

gy tradition, accounting: has confined its

quantitative measurement larg~oly to monetary terms,

Measurement of other quantitative aspects of objects,

- 29 -

such as the physical units of production during a given

moonth, is wilthin the range of accounting, but such

measurement has not gained the status of measuremjnt

in moneltaryy sterns.

13asic Structure of the Busine~s
Measurolement Process

Thle follow~ing structure of thec business measuro-

aent process has been suggested by Paul Kircher:

1. Detterm~ination of thle objectives of the business
entity--the purpose which is to be served in a
particular situation.

2. Determination of thle types of factors whiich
wight serve to attain the objective.

3. Selection of the key aspoots of the factors--
the aspects which are to be measured.

LI. Chloice of:

(a) a monsuring method:

(b) a mcasuiring unit.

5. Application of the tooasuring unit to the object
to be measured--the central action of muasure--

6. Analysis of the measuremont--relating it to
other mreasuremuents otherr in time or in kind).

7. Evaluating the effectiveness of the measurement
by determining, the extent to which it assisted
in the atttainmnent of the objective (14, p. 68).

"A central problem we face is to define the

properties of a business (or 'attributes,' as same have

cellod them) thlat accounting should seekr to measure"

(151 p. 257). The first three components of the

structuro are important but not included within the

main purpose of this paper. Thet profit motive is usually


agssummed t~o be the pJrimary purpose of business enterprise.

Entities other than business entities have other objeo-


The main purpose of business firms is to
increase the economic resources under their control
through their activities. E:ven though business
firms have many other objectives, their snoccess or
failure is primarily evaluated on the basis of the
increase or decrease in the economic resources over
which they have control (16, p. 151).

The subgoals of business enterprise have been

given more attention in recent years than before. Sub-

goals may include importance in industry, growth, cash

flows, customer goodwill, and public service. It is

difficult to measure subcoals. "In most cases our

ability to isolate specific benefits from a general

system is inaodeq~uate and we are simply not able to

generate enough information for mneaningful mneasure-

ments" (17. P. 24). Therefore, the assumption is made

in this paper thait accountinY is primarily concerned

with the measurement of profit.

The selling of products andl the rendering; of

services are usually considered to be the means of

obtaining : the objectives, The financial aspects of

rendering: services and selling: products are th~e key

aspects to be measuredl. "Accounting: measurement is

primarily concerned within the measurement of assets and

income" (18, p. 151). As has already been suggested.

there are accountants who suggest the extontion of

measurement to aspects other than financial aspects.

- 31 -

bxtenidd disonssion of th~is point is not *ithin thr

scope of study.

Accountants cannot always measure what they

want to mas~nure~. If the primary 6oal of a business

enterprise is to make a profit, nocounting should

measure the amount of profit. There is no perfect way

to mreaslr-e profit. "T'he accountant's approach to this

problem is to substitute someuthing: that can be measured

for the t!Lings we would like to measure if we were more

competent" (13, p. 90). This is referredl to as ursing:

surrogates, or substitutes. "Accouitnting data as well

as other types of business information are surrogates

whichi the decision-maker uses to carry out the decision

process" (201, p. 192).

The basic measuremn~ut Lask of accountinge is the

selectionl f a mioasuring: malthodl and a measuring unilt.

The measurin& unit is the lang~uage in which the results

may be expressed. The choice of a language is one of

the decisions a measurer must makeo. "Tha neasurer must

develop a language which adequately commnunicates to

another person whiat the useur must Jo to utilize the

information contained in the measurement" (21, p. SS).

Az dileiana arises inl the selection of a lan-

guage. C. lost Chlurchmain h~as expressed the dileawina

this way:

The clearer a language the more confusing it Is
to most people. Precise laneuages narrow the class
of users but increase the degree of refinement that
any user can attain. The proper balance between


breadth and depth is: the linguistic decision
problem of measurement (21, p. 87).

Accounting expresses financial data in mnonetary

terms. Tuus, in the United States, the language of

accounting is usually the dollar. The selection of the

dollar as the measuring unit does not solve the measur-

ing unit problems. A significant difficulty to be

solved concerns how to deal with the changing purchas-

ing power of a dollar. Are measurements to be made

in terms of dollars with no recognition made of the

changed purchasing power between two points in time?

"Measurementss of financial position and income based

on numbers of dollars without regard for any differences

in the economic significance of those dollars are cruder

economic measurements than we are capable of providing"

(22, p. 110).

Thre choice of a measuring methoed is the central

theme of this paper. "Incomne and wealth are dependent

upon the choice of measuremoent rules" (16, p. 221).

Several possibilities are suggested, discussed, and

compared. "Accounting is a measurement system which

is plageod by the existence of alternative measurement

methods" (23, p. 474).

The fifth part of the structure is the act of

applying: a measurement method. This is measuremlent

according to the common use of theo word and is not

relevant to this study.


The sixth component of the structure is the

use, or application, of the results of the measurement.

This use actually has implications for the selection

of a measuring method and a mrasuring unit. "The

measurement procedures undlerlying any set of accounting

information are inevitably linked to the purpose for

which that information is provided" (22, p. 101),

in advocating measurement procedures in accounting,
it is mandatory at the outset to specify the pur-
pose for which the measurements are intended. Thea
attribute to be measured and the unit of measure-
miont to be utilized thion must be demonstrably con-
sistent with that purpose (22, p. 102).

if the primary goal of a business enterprise

is to make a profit, then accounting should make a

contribution toward this goal. Accounting should make

a contribution to whatever the goals of a business

might be. Therefore, evaluating the effectiveness of

the measurement in attaining an entity's objectives

is an integral part of the measurement process.

The Final results of the measurement process

is really tbo deciding factor in determining which

measurement method and unit is best. According to

Ijiri, "if people are likely to behave in a more

'desirable' manner in response to the values of assets

and income prepared under one set of weights than

under another set of weights, then and only then we

can say that one set of weights is better than another"

Carl Derinn has set forth the following similar

li st as typical conrditions (anrd preconditions) for

accounrtin3 measuremlent:

1. S.oifying anid ordering worthy objectives;

2, Dtermnining dcoisions and information needed
to accomplish objectives;

3. Identifying and ordering individuals with
legitimate claims to information;

S. Usciding which events are relevant to achieving
these objectives;

5, DouidinL: what aspects of theo events should be

6, Adopting a set of feasible measurement scales
and rules thatt will yield an advance in objec-
tives (17, p. 17).

Number three is the only condition listed by

Da~vine which is essentially different from those listed

by Kiroher. Devine points out that an ethical aspoot

is involved in ordering~ individuals and that accounting

should be concerned with this othical as~ect.

bleasuremen~t and Va~lue

Measurement is a torul. which has ganined prestige

in the field of accounting in recent years, As measure-

me~nt imilies (or reprOsents) accuracy, it posslibly is

used as a status symblol. Perhaps the use of meoasure-

ment in the physion~l sciences is imitated by the social


Spouse says accountants are really talking:

about the measurement of value. "TChe relevant attri-

bute with which we are essentially concerned is that

- 5 -

of value: the measurement process in which we are

fundamentally engaged may be properly described as

valuation" (22, p. 107). The tern measurement is used

because of the emotional effect of the use of the term

value. "The terms value and valuation have an unfor-

tunate tendonoy to arouse emotional reactions among

some ."(22, p. 107). By using the word measurement,

accountants may avoid using the word valuation. "Mleas-

uroment, on the other hand, is an innocuous term as wonl

as a prestigious one; it is not branded with the emo-

tional stigma attached to valua~tion" (22, pp. 107-8).

Sprouse believes that accountants should

recognize valuation as the relevant attribute in report-

ing to the stockholders of a business enterprise. The

finanotal accounting process "could be improved enor-

mously by a clear-cut recognition of value as the

relevant attribute"(a22 p. 108).

R. J. Chambors has a different view of the

relationship between measurement and valuation. "It

seems .. that greater clarity of argument is possi-

ble if the distinction is made between acts of valuation

which always have reference to the future, and acts of

measurement which have reference to the past and

present" (24, p. 92). Chambers believes accountants

are interested in measurement--not valuation. Most

accountants, as Sprouse, do not make such a distinction.


In common usage, measurement implies accuracy.

Results of measurement (numnerals) are often taken as

fact. A given person weighs one hundred sixty pounds.

A room is fifteen feet wide and twenty-four feet long.

These measurements may not be accurate. The given

person may weigh one hundred sixty pounds and three

ounces. The measurement couldl be even more nearly

exact, using even smaller units than ounces. There

are degrees of accuracy; it is not essential to be com-

plcatly accurate. In fact complete accuracy may be

impossible. Comoplete accuracy might not be recognizedi

if obtained.

The decree of accuracy to be obtained by any

measurement (accounting or other) depends upon the

purpose for which the measurement is made. If a room

is being measured for wall-to-wall carpet, the measure-

mont should be within perhaps one-fourth inch of the

actual dimensions. If the dimensions are obtained to

determine the number of square feet per student for

testing purposes, measurements might well be rounded

off to the nearost foot.

Accur;acy in Scienocs

The physical sciences are sometimes thouGht

of as being exact. Chambers says "the presumption that

the exact sciences provide measurements which are

paragons of accuracy is false" (24. P. 45). Even in

- 37 -

thle exact sciences, "the degree of accuracy song~ht is

thle dle ree n-czssary for practical purposes" (2b, p. 45).

Chamblers applies this idea to accounting, The

current cash equivalent (hts proposed measurement) can

be found for all1 assets withi some derree of accuracy

Probability and Degree of Error

Compylete accuracy in accounting is never pos-

sible. Furthermore, it may be impractical to obtain

complete accuracy or highly accurate data even if it

were possible. Therefore, the uiser of financial data

should be aware of thle degrou of accuracy reflected in

the Financial data being utilized, Perhnaps financial

statements should indicate the probability and degree

of horror inaerent in measurement methods used and in

the results of thle measurement. "The information of

measurement is considerably enhanced if the degree of

accuracy or error of the pertinent measuremient is

known' (10, p. Y0).

Probability has been given very little con-

sideration in accounting although it is interesting

to notice that "the usual ordering of assets on the

balance sheet, by chance or otherwise, tends to follow

the level of confidence In the measurements" (17,

p. 22).

The accountant's attempts to disclose pre-
cision are crude indeed, but, worse, it is possi-
ble that hre omits important information simply

- 38 -

because his methods of conveying precision are so
crude. A littlo-explored alternative estimates
probability numbers for both the amount to be paid
and the possibility of hlaving to pay at all and
derives an expected value for the unfavorable
prospect (17, p. 22).

Scates in Accountin;:

Stevens' nominal scale would include the chart

of accounts within the range of measurement,

with the rejection of Stevens' approach, the
designation of arseasurement: would be unduly denied
to those systems. "Unduly," because these systems
still extract significant information for compari-
son in research and practical decision making,
informantion thiat often can efficiently be trans-
mitted by numerals only (10, p. 63),

Theo nominal scale although basic to the account-
ing: process is neither the only nor thle most impor-
tant scale pertaining to our discipline, The
evaluatisn process--the core of theoretical account-
ancy--utilizes the ratio scale; statement analysts
p~rimaarily wrorke with ordinal scales; and certain
aspects of cost accounting can be considered as
applying the interval scale (10, p. 68).

Standard costing is an example of the use of thre intor-

val scale. The dollar scale is a ratio scale.

"There are, however, instances of multiple

measuremnent, the dimensions of which are measured on

scales that differ froms each other; the accounting

transaction is one of these cases . ." (10, p. 74).

The chart of accounts (nominal scale) is used in

classifying the debits and the credits of a transaction.

The time dimension Is measured by an interval scale.

The dollar amount is measured on a ratio seate,

Kindls of Monsuremeant in Accountin7

"Most of the economic and accounting measures

belong in the category of measurement by fiat, which

is reflected in a certain definitional arbitrariness

of our discipline" (10, p. 79). Mattessich emphasiaes

that neither fundamental nor derived measurement is

used to much extent in accounting:

There neither exists at present the possi-
bility to inf-or accountin,- values through~ "rratural
laws" (i.e., by fundamental measutrement) nor
through a combination of two or more fundamental
measures that rsulu]t in derived measurement. Most
of the economic ani accounting msasures belong in
the category of measurement by fiat, which is
reflected in a certain definitional arbitrariness
of our discipline (10, p. 79).

Carl T. Devine feels that attempts by Torgerson,

Mattessioh, and others to find fundamental measurements

tend to be fruitless endeavors.

Measurement is a process that requires extremely
hiGh Levels of abstraction. In this sense all
mseasurement is fiat measurement, for somes identi-
ftable property must be isolated and related to
objectives (17, p. 14).

Sprouse suggests, on the other hand, that

direct measurements are of ten used in accounting.

Examples include the measurement of assets such as

receivables and payables (22, p. 111). Hie recognizes

the fact that fiat measurement is more often used.

The value of an asset can be measured directlL
only if information is available concerning amounts
of future cash flows, timing of such cash flows,
and the appropriate rate of discount. In addition,
if the future cash flows are measured In dollars,
either it must be assumed that the purchasing
power of the dollar is constant or information
concerning future price-level changes is required.


In the absnceno of jufficienrtly reliable information
about these factors, direct monsuremeont of the
value of an a~sst Is not feasible; indirect ineas-
uremennt procedures, such as the use of acquisition
cost anld thle ulse of replactua~nt cost, m~ust ba
adopted (22, p. 111).

Crit ri.* for .-s earrn. Jer~...rnt ltl.Y.

The American Accounting Associationl's AZ SEtat-

ment of a ac Accounting Theory published in 1966 sug-

gested thle following four accounting standards:

1. nnlovance (Usefulness)

2. Vorifiabiflity

3. Freedow from bias

4. :cuantifiability (25, P ?).

Ilthese four accounting standards mighlt wall serve as

critorbia for the selectionl of th~e most approzriatej

meoasurement meithod.

The Harvard Business School Acco~untingr Rounrd

Table held in 1966 presented a slightly different set

of criteria for measuroments

1, objectivity

Twro rellat~ed requiromaunts:

(a) Certain standards should be used in pre-

senting financial accounting information,


(b) It should be feasible to verity financial

accountling information.

2. Usefulness

3, Feasibility (25, pp. 18-19).

- #1

A combination of these criteria will be u~sed

in dijcussing and coamaring the various mueasureme-nt

miethuds. The combilned list follows:

1. Xulevance (Usefulness)

2. Objectivity

(e) Verifiability

(b) Freedom from bias

3. Fueasibility

4. Quantifinbility

Maspsuremeont is the assignnment of numerals to

objects or properties of objects to represent such

objects or properties. Accounting, as it relates to

quantification, is a systemn of measuremnent.

iioasurement is an internal part of the physi-

cal sciences and the soolul sciencres. The nature of

meoasurement has beern discussed in rather broad terms

in this chapter because mousurement theory applios to

such a broad area.

.Measuremeant theory has beeni related to account-

ing in the latter part of the chapter in morn specific

terms. It *as concluded that the selection of a

muesurement method is one of the mnost significant

problems of accounting.




thlis chanpteor is the first inl a series of four

chapters whlich discuss major measurement methods, or

bases. The present chapter is a study of a measure-

ment base which may be called historical cost (or

original cost;). Hlistoricnl cost is generally accepted

for use in nooounting statements. Thlis chapter is

largely a discussion and criticismo of accounting, state-

ments as they are currently prepared.

Thle chapter begins with a definlition of his-

torical cost. Th~is is followed by a discussion of

some related concepts which underly the preparation

of accounting statements. As the realization concept

and the historical cost concept are closely related

the realization concept is of particular concern in

this chapter. The historical development of the reali-

zation concept is followed by a discussion of the

present status of the concept.

TLhe last part of thle chapter concerns the

effects of historical cost and related concepts.

- 62 -

especially thle realization concept, on accounting

statements. Thle use of this measurement basis is9


Definition of Historical Cost

Accounting statomocnts are prepared in terms of

historical, or original, cost. W~hen assets are acquired

they are recorded at cost, a measure of the current

exchange value at that time. Historical cost is thle

cost arrived at in the transaction concerned; histori-

cal cost is transaction price. A record is made when

a transaction occurs between an enterprise and another

party. Thle dollar amount of the transaction is con-

sidered to be an objective basis for the valuation of

that which is exchangeod. This dollar amount, trans-

action price, is the historical cost of that which is

recorded. Assets remain on the books at cost (or cost

adjusted for such factors as depreciation) as long as

they are owned by the enterprise.

There are a few exceptions in practice to the

historical cost concept, but in general when an eniter-

prise oxpects to operate indefinitely, the original

cost concept, or historical cost concept, is adhered

to in the preparation of accounting statements. The

following quote probably represents the attitude of

accountants as exemplified in practice.

Accounting is .. not essentially a process
of valuation, but the allocation of historical


costs and revenues to the current and succeeding
fiscal periods. .. If values other than
urnamortized costs are to be quoted they should be
expressed .. only as collateral notations for
information purposes. .. There seems to be no
sound reason for repeated adjustments of asset
values for the ordinary changes in price levels
commonly experienced from one generation to another.
...A history of cost and cost amortization is
a consistent record of actual occurrences ..
and constitutes an essential starting point in
financial interprotations (27, pp. 61-62).

T~his quote from the 1936 American Accounting

Assoolation Statement (A Tentative Statement of Account-

ingq Priscioles Underlying Corporate Financial State-

monts) represented the attitude of the Executive Com-

mnittee at that timae toward historical cost.

The historical cost concept is criticized with

varying degrees of severeness. As an illustration a

quote is rriven here fromn Harry 'I. Kamlph:

Conventional balance sheets and operating state-
ments have become so distorted that they are of
little or no guidance for decision-making purposes,

without taking into consideration current
values, we find it impossible to reach valid con-
clusions or develop fully revealing; information on
such twportant matters as:

1. Return on total capital emnployed.

2. Return on capital equity or stockholders'

9. optimum mortgage loan financing terms.

b. Necessary coverage under fire and compre-
hensive insurance pollicts and proof of

5. evaluation of specific segments of an
operation or an entire business for pur-
poses of purchase, sale or merger.

6. Costs and profits measured in terms of
current values rather than often moislead-
ing book or original values (28, p. 17),

Related Concepts Underlyint:
Accounting Statements

The following concepts are closely rotated to

the historical cost concept and also, like the histori-

cal cost concept, underlie the accounting statements.

Presently accepted methods of accounting include all

of these concepts.

Going Concern

There was a time when the venture was the pre-

dominant form of business enterprise, AS ventures

lasted for only a relatively short period of time, an

accounting was usually made only at the end of the

venture. The venture form of business enterprise is

almost completely gone. It has been replaced by

business enterprises which remain in existence for

long periods of time. Although thousands of enter-

prises go out of existence each year, a majority of

business enterprises, especially medium and large-sire

ones, have lives of indefinite length.

Since business enterprises usually operate for

Long periods of time and are not expected to discon-

tinue in the immediate future, they may be assumed to

have a continuous life. This "continuity concept,"

or "going concern concept," assumes that business

- 6 -

enterprises remain in oxistenoce indefinitely unless

there is evionce to the contrary.

AccountinC statements are Kenerally prepared

on this assumption. The primary imipact of this concept

is on the valuation of assets. Thiis assuaption has

implications for income moasuremnent due to thle inter-

relationship of the balance sheoet and the income state-


Accountants hanve generally felt that since

Liquidation values may be of little importance to a

going concern, this continuity of life concept is used

as julstification for another concept, the cost concept.

The following quotation from Heanry Rand HantlieLd's

Modern Accounting: points out the insignificance of

liquidation values.

The proper value is that which they have to the
holding: concern, and not that which thecy might
have to other persons, whether these persons are
ordinary customers, or those who mniiht bid on the
assets at a liquidation sale. The value is that
which they have to the company as thon existing:
and not to a company in the hands of a receiver,
or one closing up its accounts and going out of
business (39, p. 81).

This quote does not mention how to arrive at

the value to the holding concern. This does not

necessarily imply a historical cost basis. Reed A.

Storoy quotes LHatfield as saying the going concern is

not usually taken to its logical conclusion which would

be to value merchandise at net realizable value. A

Logical application of the going concern concept would

- 47-

be the mqasurement of firedl ;rssts at cost; because

changes in rnine from one period to another which are

not expected to be realized by the sale of the fixed

asset are not as relevant as cha~niges in value of our-

rent assets, especially thosea which will be conver~ted

into cash in the nar futurre, Storey says, "Thea failure

to carry thle going concern assumptlion to itJ logicalI

conclusion left a gap in accounting theory- which was

filled by the realization concept" (90, p. 237),

It is the realization convention which requires
valuation of all unrnalized (i. e., unsold) assets
at cost, whether they be rfird r:ssets or unsold

The area of complementarity between the reali-
aation and going concern conventions lies in the
area of fixed assets, whereas the area of basic
conflict lies in the area of current assets....
In this arena the realization convention is clearly
dominant in modern accounting (30, pp. 237-38).

Time Periods

Undesr the venture fore of business enterprise,

an accounoting was made upon tha completionn of thle

venture. Thie amount of business income earned can

best be determined at that time. Mlon there is con-

tinuity of life, it is not feasible to wait until the

end of the enterprise life to meaasure income.

The time-pariod convention has developed to

broea the life of an enterprise into arbitrary time

periods. This arbitrary timo period is usually a year.

The calendar year is used by many enterprises. 'This

may be a carryover from an agricultural society in


which thle calendar year was the natural business year.

Many business enterprises ear now using what is

consider a natural business year for their particular

type of business.

accourntingi for a business entity bry time periods

6ives interested parties useful information about the

enterprise before its life is over, Some accuracy is

sacrificed for timeliness.


Since accounting attempts to measure income

by time periods there must be a criterion to determine

when income arises. The realization concept has

developeBd to meet this need. The? dominant Interpre-

tantion is that a changer in value has taken place with

sufficient objectivity to warrant recognition in the

accounts. A sale is usually thought of as having

sufficient objectivity and is generally the accepted

oriterton for realization. The realization concept is

related to the original cost cone ,t in thlat assets are

recorded at original cost until realization is deemned

to have taken place.

The development of the realization concept

helped brinZ about the development of the historical

cost concept. "The assertion by the Court of the

realization postulate lent support to the proposition

that, until realized, assets should be carried at cost,


and thrus contributed to the building up in accounting

literature of a so-called 'traditional cost principle'"

(3. r. 27).

Like the historical cost concept. the reali-

ration concept is also based on transaction price.

No increase in the value of an asset is recorded until

another transaction occurs. TIhe realization concept

delays the recognition of revenue until a sale or some

other sufficiently objective event occurs. This means

that the usefulness of accounting may be impaired by

the time delay.

No doubt, everyone would like timely reports
that are also conclusive, but for the most part
the two conditions (timeliness and conclusiveness)
are in conflict. in most cases accountants have
chosen to be more conclusive rather than more
timely in their recognition of changes that have
occurred, thereby exposing themselves to the
charge that their reports (issued at frequent
intervals) are less useful than they could be
(31, pp. 33-34).

In emphasizing the importance of the evaluation

of past decisions, Edwards and Bell point out that "'if

the demand for data is predicated largely upon the

existence of change and uncertainty in the economy,

accountinR data, to be most useful, should be designed

to report changes as they occur" (32, pp. 5-6).

Like the historical cost concept, the reali-

zation concept results In some limitations in the

determination of periodic income. 'The realization

concept will be disonssed In more detail in a subsequent

section of this chapter. Enough has been said to

- 50 -

indicate that the realization concept may limit the

usefulness of accounting statements.


While the realization concept determines the

period in which revenue is to be recognized, the match-

ing concept determines what costs become oxponsos to be

matched against revenue. The matching concept means

that those costs which were necessary to attain the

revenue of the period should be matched with the revenue.

The expenses which apply to a given period are

those which can be matched with the revenue which is

recognized during that period. The following statement

is made in the 1957 revision of Accountinq and Heport-

in:: Standards for Corporate Financial Statemnents: "The

com~mittee advocates that costs (defined as product and

service factors given up) should be related to revenues

realized within a specific period on the basis of somae

discernible positive correlation of such costs with the

recognized revenues" (33, p. 969).

In all significant cases where there is uncer-
tainty, revenue is the controlling classification.
It becomes the guide to action, the focal point
which mankes matching~ effectual in areas of uncor-
tainty (34, p. 738).

The matching process developed when the "in-

creased not worth" concept gave way to the "realization"

test of income. "It became common to speak of income

determination as being ebssntially a process of matching

- 51 -

costs and revenues" (3, p. 38). The timing of revenue

recognition determines to a Inrgo extent the timing of

expense recognition and therefore the timing of not

income recognition, Matching is necessary to determine

the not increase in assets which Is similar to "increased

not worth" because not assets equal net worth.


Objectivity Is difficult to define. A key word

in the definition of objectivity is "unbiased."

Maurice Moonitz defines objectivity as "unbiased, sub-

ject to verification by another competent investigator"

(31, p. 42). This implies that many individuals would

reach approximately the sam.e conclusions.

HlaroLd iE. Arnett gives the following explanation

of objectivity:

Financial information is objective when:

1. It; is free from personal opinion and bias,
which further requires

a. that there actually be an exchange of
something for something, both having "value,"

(1) this exchange be the result of an arm's
length transaction between independent

(2) this exchange be capable of beingi
accurately measurable in dollars,

(3) that one of the negotiating parties
in the exchange be the unit for which
the accounting is being done,

2. It is substantiated or capable of being sub-
stantiated by an independent investigator
(35. p. 65),

- 52 -

Thcre are oegroos of objectivity. Accuracy is

significant Ln detenaning whether or not data is

objective. "If an item can be measured with reason-

able accuracy, it assumes a large degree of objec-

tivity" (36, p. 251).

Objectivity is considered to be an outstanding

characteristic of historical cost and the realization



Conservatism is sometimes expressed as: Pro-

vide for all losses; anticidate no profits. Paul Grady,

in his loventory of Generally Acceptedl Accounting Prin-

ciples for businesss iEnterorises, explains theu concept

of conservatism as follows:

FFOro the viewpoint of generally accepted
accounting principles, the concept of conservatism
comp~rehends the tuin ideas that:

Sales, revenue and income are not to be antici-
pated, Recognition ordinarily requires consummation
of sale and delivery, and

All known liabilities or losses should be
recorded regardless of whether the definite amounts
are determinable (37, p. 36).

Grady notes the close relationship between the

conservatism concept and the realization concept by

saying: that the above ideas "often have been dealt with

as a separate concept of 'rcalization'" (371 p. 36).

Conlservatisa is actually a technique For

delaying thle recognition of revenue. Realiantion and

conservatism are related because tho realization concept

- 53 -

is a fairly conservative concept in that profits are

not anticipated very far in advance of the actual

receipt of cash, Zash receipts would usually be the

most conservative method of recogniring revenue. Theore

are exceptions to this statement such as the advance of

cash before a product is delivered or services are ren-


Historical cost is also a conservative concept.

The lower-of-cost-or-market valuation method of inven-

tory valuation is even more conservative.


Th~e concepts discussed above are considered

among thoe most basic accounting conIcepts. It is genl-

erally recognized that the use of those concepts aloni:

with other generally accepted accounting princi,,les

and procerdures results in accounting statements which

have limitations.

Thris discurssin of these basic concepts is

intended to show thiat accounting statement are know~-

ingly prepared under assumptions which will not result

in perfection. It is the purpose of a latter section

of this chapter to point out weakrnesses in accounting

statements due to the use of those concepts. It is

the purpose of subsequent chapters to discuss alterna-

tive measurement bases which insight result in better

accounting statements.

- 5L -

Historical cost may be thought of as the measure-

ment base wh~ichi is largely controlling in the preparation

of accounting statements. It is closely related to the

other concepts discussed: here, but it is especially

related to the realization concept. The realization

concept may be thought of as the application of the

historical cost concept. Because of the imsportance of

the realization concept in current-day accounting, the

following section of this chapter is devoted to this


The Realization Conqcpt

he realization concept is thle currently accepted

basij for revenue recognition. According to the soost

comnmonly accdptedl ruaning: of realization, revenue should

be recognized wihen a sale takes place. There8 are other

meanings for realization and criteria for recognition

as are indicated later in this section. This section

considers the historical development of thie concept andl

its present status.

Historical Development of the
realization Concept

Iho Study Group on Business Income points out

thrat the postulate of roalization is of quite mnodern


A review of accounting, legal, and economici
literature suggests that the realization postulate
was not accepted prior to the First iorld krar. In
1913 leading authorities in all these fields in

- SS-

Granlt Blritan ard.nd Amria s~oorand~ to agroo on the
"increase in net worth" concept of income (except
in th- case of "per;,lnnont" enterprises), though
the way in which it could best be implemented was
not settled, and unrealized appreciation was not
perhaps deemed to be a part of "income from opera-
tions" (3, pp. 23-24).

As an example, the Study Oroup quoted the

following: statement b~y A. L. Dick;inson in his Account-

ine Prnotice and Procedure (1913):

In the widest possible view, profits may be
stated as the realized increment in value of the
whole amount invested in an undertaking; and,
conversely, loss is the realized decrement in
such value. Inasmuch, however, as the ultimate
realization of the original investment is fromi
the nature of things deferred for a long period
of years, during which parti3t realizations are
continually taking: place, it becomes necessary
to fall back on estimates of value at c-rtann
definite periods, and to consider as profit or
loss; the estimated inorsase or decrease between
any two such periods (3, p. 24),

W. A. Paton also accepted an increase in value

theory. He makes the following statement in his

Accounting Theory, published in 19221

The liberal view that, ideally, all bona fide
value changes in either direction, from whatever
cause, should be reflected in the accounts has
been adopted without argument. .. This logical
position is the proper one for the professional
accountant, at least as a starting point (38,
p. vii).

In those early years of the current century,

the realization concept did not have its current status.

The events of the times probably brought about the

almost complete acceptance of the realization concept.

The sixteenthl amendtmont in 1913 may have had

a great effect on the creation and acceptance of the

realization conce~pl (3, p. nC). 3ela:rlndear case of

disnolr, v. Member, in 1310 also madecl a contribution to

thle realizatlion concept. In1 this decision, Charles

Evans, Hughos said:

It isi of the essance of income that it should b~e
realized. .. Income necessarily implies separa-
tion anld roalir-ntion. .. 3he incroase in the
value of lands due to growth prosperity of the
cormlunity is not income until it is realized
(Eisnler v. M~acomober, 25 U. S, 188, 195 (1920.).)

The economic exporience of the 1930's falirly

well finalized the elimination of the increase-in-

value concept.

The realination concept had Cained acceptance

by 193b an: evidenced by the first of six rul0s or

principles- adoptud by the Aulcticatn Inrtit~ute of Account-

ants that year: "Profit is dueesod to be realized when

a salj in tha ordinary course of business is effooted,

unless the circumstances are such that the collection

of the salo price is not reasnanbly assured" (33,

p,. 423;,

The Present Status

Erelization is currontly the generally acoupted

criterion for revenue recognition. Recog~nition refers

to the timing of recording revenue on the books of an

enterprise. T~he realization concept, used as a guide

to revenue recognition, is primarily a timing device.

"The test of realization is used to determine when to

recog~nize e particular item" (36, p. 251). "Thes entire

-57 -

income from sale arises at the m~oment when realization

is doeemd to take place" (3, pp. 19-20). 13ecause costs

and revenues are matched to determine income, income is

assumed to arise when the recognition of revenue takes


There are somo differences of opinion on the

exact moaning of the realization concept. The 1957

Statement by the American Accounting Association Com-

mittee on Concepts and Standards Underlying Corporate

Financial Statements defines the realization concept

as follows:

The essential meaning of realization is that a
change in an asset or liability has become
sufficiently definite and objective to warrant
recognition in the accounts. This recognition
may rest on an exchange transaction between inde-
pendent parties, or on established trade practices,
or on terms of a contract performance of which is
considered to be virtually certain. It may depend
on the stability of a banking system, the enforce-
ability of commercial agreements, or the ability
of a highly organized market to facilitate the
conversion of an asset into another form (27, p. 3).

~lhe key words in this definition are "change~"

and "sufficiently definite and objective." According

to Floyd w. Cindal, this definition implies that "the

change may have taken place prior to the time it became

sufficiently definite and objective for recognition"

(96, p. 251).

Floyd W. Windal defines realization by using

the three key ideas from the definition just quoted:

The realization of income takes place--that
is, income comes into existence--when certain
criteria have been fulfilled in connection with

- 58 -

a not asset increase. Excluded are increases caused
by gifts or additional owner investment. Among
other criteria acre the~so:

'. Theu gain or increase must be confirmod by some
event or transaction such as theo receipt of
cash or property, relief fromn liability, or a
change in the nature of leal rights.

2. The gain or increase must be subject to objec-
tive measuromont.

7. The Can~r or in~crease mlust be definite and
irrevocable (40, p. 36).

Inherent in these definitions is the criterion

that revenue must have been economically earned before

or at the point it is recognized (41, p. 43). "h~conomni-

cally earned" means that a value increment has taken

place due to the oe-rations of an enterprise. "Reve-

nues are nffectively earned when substantially all of

these activities necessary for and associated with the

production of those revenues have been completed" (41,

Other criteria have been used in determining

when realisation takes place. Ilobert T. Sprouse and

Maurice Moonitz list tests which have been used to

determine if an item Is realised or not:

1. It had to be earned.

2. It had to be the result of a conversion brought
about in a transaction between the enterprise
and someone external to it.

3. It had to be the result of a legal sale or
similar process (related to 2, above).

4. Lt had to be severed from capital.

- 59 -

5. It had to be in distributable form (related
to 4, above).

6. It had to be evidenced by liquid assets (related
to 5, above).

7. Its effects on the enterprise had to be the
subject of accurate measurement or of estimates
with a high degree of reliability (2,
pp. 14-15).

The Amorican Accounting Association 1964 Con-

capts and Standards Research Study Committee on The

Realization Concept also presents its view of the

realization concept:

When should realization be considered to have
been achieved in a revenue transactions Three
factors have generally been considered sufficient
in answering this questions

1. The nature of the asset received;

2. The presence of a market transaction;

3. The extent to which services have been per-
formed (42, p. 314).

It is difficult to be precise about w~hat is the
current prevailing practice, but it appears that
presently accepted tests for realization require
receipt of a current (or liquid) asset capable of
objective measurement in a market transaction for
services rendered (42, p. 314).

The 19)57 Statement has been amended by the work of

this 1964 Concepts and Standards Research Study Com-

mittee. The conclusions of the committee cannot be

classified as Generally accepted. In this sense,

the conclusions and recommendations cannot be con-

sidered as part of the present status of the reall-

zation concept. They are included here because they

have been made, and in this sense they affect the

present status of realization.

- 60 -

t'he following two problems were discussed by

the committee:

1. Transactions associated with the exchango of
goods and services between the accounting
entity andl somes independent, external g~roup.
These are referred to .. as revenue trans-

2. Changes in the value of resources during the
time they are held by the firm. These are
referred to . as holding fains and losses

The committee arrived at these conclusions:

''The comml~ittee unanimously recommends that the efforts

of changes In value of all assets, other than good-

will, that can be supported by adequate evidence be

recorded in the accounts" (42, p. 312). "A majority

of the commaittee recommends that 'unrealized' changes

in the value of assets should not be included in the

computation of reported not income, but should be

shown on the incomeo statement below the not income

line" (42, pi. 312).

In considerinZ shen realization should be

regarded to have been achieved in a revenue trans-

action, the committee made the following docisionsr

1. naturee of Asset Received--The committee
recommends continued adherence to a policy of
requiring objective evidence of the valuation
of the asset received before recognizing
realized revenue. .. The comm~ittoo would
stress measurability, and not liquidity, as
thle essential attrib~ute required for recogn1-
tion of realized revenue.

2. Presence of a Markot Transaction--There is
general acceptance of the view that a market
transaction is necessary for revenue to be
realized. The committee concurs in this

- 61 -

3. Bten t of Service Perf ormed--Trradi tionally,
in establishing a realization test, account-
ants have considered the degree to which the
seller hlas furnished the services being pur-
chased. TIhe committee is suggesting that
another factor is more relevant, namely,
whether the seller has performed an action
which is the crucial vent in the process
of earning revenue. This crucial event may
be something distinct from the rendering of
services to the customer (42, pp. 915-16).

There is often some confusion between the

terms recognitionn" and "realization." Robert T.

Sprouse has made some observations concerning this

confusion. "Prior to 1957, the term realizationn'

was widely used and I think g~enerally understood"

(43, p. 522), The general meaning of realization

was expressed by the P'aton and Littleton monograph:

Revenue is realized, according to the dominant
view, when it is evidenced by cash receipts or
receivables, or other new liquid assets. Implicit
here are two tests: (1) conversion through legal
sale or similar process: (2) validation through
the acquisition of liquid assets (44, p. 49),

The definition given in the 1957 Revision

suggested that revenue is realized when it can be

recognized in the aooounts, Sprouse refers to this

as a "drastically different concept of realization.

...This concept renders realization devoid of any

special meaning; realization is made merely a synonym

for recognition" (43, p. 522).

The two terms, realization and recognition,

are often used interchangeably. As the realization

concept is presently accepted as a guide in the timing

of revenue recognition, then realization and recognition

- 2 -

take placn at; the same timc. The occurrence of one

implies thle occurrence of the other. In comrmonl usage,

the two tlrms often imply the stme thing.

Recognition of revenue on the basis of the

realization concept Goes not necessarily imply that

it is the only "corroct" method of recogniaing revenue.

Sprouse and! Moonitz express this idea as follows:

Reliance on "realization" for the recognition of
profit does not imply that profit arises only at
t.he moment of sale. Instead it imuplies something
that may or may not he true in a given set of
circumsutanes, namely, that satisfactory results
emerge if profit is consistently recognized only
at time of sale (2, p. 11).

Currently accepted exceptions
To the igeneral rule for realization

Althoughn in current practice realization is

usually deemed to take place at the point of sale,

there are exceptions to this general rule. For example,

in unusual circumstances realization is deemed to take

place when ph-ysical production occurs rather than when

a sale takes place. In order for realization to take

place due to physical production, "production must be

accomplished either by a binding contract For sale of

the product or by a market of a certain character"

(45, p. 94). Certain metals (such as gold, silver,

and copper), farm products (such as cotton, wheat,

corn, oats, rye, soy beans, barley, raw sugar, and

coffee beans), crude oil, and securities meet these

requirements. The market price or contract price is

- 63-

used as basis for determining yrovnue. Markrtt prico

may be used although it may vary somewhat from period

to period,

A changes in value between the date of completed

production and the date of sale dloes not imply that

early recognition was incorroot. nussell Dowers makes

the followings statement concerning wheat:

The quoted price used in the inventory might differ
from the price of sale, but this gain or loss need
not be looked upon as an error in making: the
previous estimate of ralus. it is properly assigTned
to the period between the date of completed physical
production and date of sale and should be attributed
to speculation rather than to wheat growing, Any
gain or loss could of course be analyzed into
interest, storage service, and market fluctuation
(b5. p. 95).

Even incomplete physical production may be

appropriate for realization to take place. Bowers

suggests three ways in which income may be objectively

measured which are particularly applicable to incom-

pleted contracts:

1. A completed transaction between parties of
independent interest.

2. Apportionment between fiscal periods on an
objectively determinable basis, the total for
the various periods being determined by a
completed contract.

3, Reference to price in a market of a certain
recognized character (45. p. 105).

Shipbuilding is one example of incomplete

physical production in which it is customary to recog-

nine revenue before physical production is complete

and legal title is conveyed to the purchaser.

- 66 -

:)ther presently osaopted excrntionls to the~

reaulization rula include ropincoment costs in cost-or-

market calculations, index numbers of specific commodi-

ties or g~roups of similar counnedities in dollar-value

Lifo, ami estinates of net realizable value of by-

droducts andi obsol-te =oods and equ~ipmno~t.

Miase several exceptions to the realization

concept tidicate that ourreit practice covers a fairly

wide range. Carmnan C. BElough h\ar ephasited the widle

range of practice in considering incomec to be realized:

It; what tirae, or in what Stage of a transaction
should income be considered as having boon realizedl
Uhile it is generally understood that income should
be recognieed when services are rendered or goods
delivered, in practice the time of taking it up
rangos all the way from the time of production, as
in the case of somec mining enterprises, to the tim~e
thle cash is received, as is sometimes done in the
case of installment sales (46, p. 39).


Thre realization concept is a fairly recent

development inl accounting, having developed early in

the present century. At present it is a generally

accepted concept.

The usual interpretation of the realization

concept is thiat; revenue may be recognized when a sale

takes place. Realization is the usual guide, or

criterion, to revenue recognition. Here are some

exceptions to the general interpretation of the reali-

zation concept. Exceptions involve the valuation of

- 65 -

assets such as certain metals, agricultural products,

socurities, and other assets such as ships which

require an unusually long period of time for con-


affects on Accounting Statements
And Criticisms

Accounting statements are currently prepared

under the historical cost concept of measuremnent, As

has boon pointed out, the realization concept is an

important concept related to this measurement base.

The purpose of this section is to point out some of

the shortcomings which result when thle historical cost

measurement base is used.

Accountants themselves recognize shortcomings

in accounting statements. Hloward I. Ross made the

following statement in a presidential address at an

annual meeting of the Canadian Institute of Chartered

Accountants: "Thle basio problem which I would like

to concentrate on today is posed by the paradoxical

fact that accountants appear to divide their time,

perhaps almost equally, between preaching, on the one

hand, the great importance of publishing regular

financial statements and insisting, on the other hand,

that one who relies on financial statements, in almost

any of the circumstances in which one would normally

turn to them, is likely to be mislead" (47. p. 68),

- 66 -

An obvious problem inherent in the use of the

historical cost concapt is that accounting data do

not reflect values (except by chance). (It should be

remembered that historical cost is not Intended to

measure value.) The following gquote by idwards and

Bell emphasizes this in discussing the effect of the

application of the realization concept:

Instead of assumning the identity of cost and
value, accountants have adopted the convention of
recorrnizinq profit only upon sale; no pretense is
made of measuring profit as it accrues either in
production or as a result of simply holding assets
as their prices rise. Reporting assets at historic
cost represents a consistent application of this
convention; a record at market value would involve
a reoognition of gain prior to sale. Those who
use accounting data are fairly warned by this
convention thant the interpretation of a firm's
position or operation on the basis of market value
is not the responsibility of the accountant as
record-keeper. The accountant shares the inter-
pretative responsibility with other members of
mnanagement, however (32, p. 10).

even though a statement user may realize that

the statements were prepared under the realization

concept, it is likely that he may not realize the full

implications of the use of this concept. iidwards and

Hell point out the following two limitations which

result fromn thie use of the realization convention:

1. Within the framework of present accounting
practices, no capital gains or losses are
recorded as they arise, I.e., as individual
prices change; this liaitation in turn has
three main implications:

a. The capital gains (losses) for any one
period are incomplete; i.e., they are not
recognized until the assets are sold or
used in the production of goods which are
sold, and profit is thierefore understated

- 67 -

b. bom ecaiital gains (losses) of former
periods are recognized as capital gains
(losses) of this period wrhen assets w-ich
have risen in price over an extended period
of time are sold in this period, thus over_-
stating (understating) profit;

c. Balance sheet values are badly distorted.

2. Capital gains and losses which are realized
through use of' anl aasst whose price has changed
and thle subsequent sale of the product for which
theu asset was used are included as part of normal
operating profit although the profit results
frou. holding activities rather than using
activities per so; thus difficulty stems from
keeping records at original jurchlase cost with
the result, for example, that one of the expense
deductions from; operating revenue is depreciation
based on the historic cost value of the fixed
asset (32, pp. 10-11).

Theicse limitations result because the retaliation

convention requires a sales transaction. The concept

does not recogniso holdinF. gains and losses, 1, e.,

changes in1 individual prices. Another major limitation

implicit in the use of the realization convention is

the failure to recognize changes in value as production

takeos place and as services are rendered.

The realization convention has the effect of

assigning to just one stop--the sale--in a whole series

of steps the entire credit for having earned the resulting

income. Since "income accrues to an individual or a

business in something like a continuous strome,." it

may be illogical to assign all income to only one

step (48, pp. 80-81).

In defense of the sale as a test of income

realized, "it is the last vital step in the longer

- 63 -

business process which indicates that the task is now

comglet,d and thea income fully e~arnled" (4-3, ;,. 81).

The objectives of accounting statziments were

discussed generally in Chapter I in terms of those who

use them. In that chapter no attempt was made to

evaluate howr well accountinR s~tatments meet their

objectives?. Some commennts w~ill now be: mado concerning

how wuell accounting statements prepared under the hlis-

torical cost basis of measursrnont meest the objectives.

Just as the objectives were classified by types of

users, thOse commennts concerning how well objCetives

are met will be by typ~e of uiser except that the prob-

lems of comparability and uniformity are discussed

first; as th.,se two p~roblems are faced by both external

and internal statemont users.


Doth internal and external users of accounting

statements are interested in comparability, that is,

companrine the accounting statements of a particular

entity over a period of time. Comparison of those

statements should indicate trends.

Accounting statements for different periods

may not be comparable for two principal reasons: alter-

native methods and price-level changes.

Alternative methods

Generally accepted accounting principles include

alternative methods of handling: some problems, (However,


"generally accepted accounting principles" should be

applied consistently from year to year. ) If a method

of handling a problem is changed, the effort of this

change should be shown for thle year in wrhich the change

took place. Comparability Is lost if a change inl method

is not explained. Compa~rability is also lost between

the years before the change and years subsequent to

the change.

The possibility of using alternative methods

in accounting not only presents the problem of compara-

bility but also presents the question of howv different

managerial decisions would be if an alternative method

had been used. This Involves the problem of comparison

of actual results with ihat would have occurred under

alternative procedures. Although business games have

been used to determine the effect of alternative proco-

dures, conclusive evidence has not been found. llliam

J. Bruns, Jr., after using business games, decided that

"for most of the decisions and results, there were no

major differences in results among the games using dif-

ferent inventory valuation methods" (49, p. 349). ihn

the other hand, Thomas R. Dyckmlan reached the opposite

conclusion in one study but the same conclusion in a

second study (50, P. 175).

Price-level changes

Although hiistorical cost is used in accounting

statement preparation, it is an accepted fact that the

- 70 -

price level has risen substantially during the past few

decadles, Illse prte~e-lev~el changes may cause an entity

to appear to be orowino faster than it is. The assets

currently purchased, es~peially thP fixed assets,

usually cost more than thrly did in thle past. Thlus, an

entity may appear to own more assets than it did in

the east. cn the other hand, if most of an entity's

assets were purchased at a low price Level, it will

not comparre rll in size with other entitina.

Not income is also affected by the price-level

changes. If costs arisin in past periods are matched

against revenue of the current period, the not income

angears higer~TC during periods of increasing price

levels than it would during a period of stable or

decrreasitn prices. For examples inventories used or

sold during a period may have been acquired in prior

periods at lower prices. For another example, depre-

ciation is based on costs of fixed assets acquired in

prior periods--perhaps forty or fifty years before

the current period.

Arthur L. Thomas has made the following obser-

vetton concernin(: the price-lcevl probtom: "It is

difficult to see howr a rate of return can mean much

when It is calculated in terms of a mixed aggreg~ate of

unlike historical costs--some current, some stale,

some oriiginating~ so far backe in time as virtually to

be from another economy" (51, p. 576).

- ;I

P'ricJ-level chlanges may be thloubght of usj general

price-ievel changes andQ specific price-level changes.

As all prices do not move togtaher, prices of specific

items Pay be called specific Pricer levels. Tno general

prica lovel is an average of specific prices. it is

obvious that specific price changus are not necessarily

consistent with general price-level changes; thecy may

even bJ in the oppousite dirootion.7

Thiis implies that ant adljustmuent for general

price levels may not result in comparablity between

accounting6 periods. An ardjustment for a gecneral price-

level chan :o werl~l result in com~parability only if each

sipecific item in the accounting: satemenPits involved a

specific 2rice-level change equal to th~e general Zrice-

level change.


Comparability of accountinR statements between

enterprises is often referred to as the problems of

uniformity. Just as there are two principal reasons

for lack of comparability between accounting statements

of various years for a particular enterprise, there are

also a few principal reasons for lack of comparison

between entities.

Alternative meathods

The problem of alternative methods arises here

also. A company miay be able to choose fromn several

- 72

available methods of handling any particular problem

of recording anld reporting: financial data. Cven entities

within a givan industry do not necessarily choose the

samue methods. A lack of comparability results.

Somne writers are severely critical of manage-

ment's use of alternatives. (Accounting methods are

often the choice of moana::ement. Important exceptions

are public utilities and other reg~ulated entities.)

5tevzn S. Anreder is an exaample of suich writers. In

an article in narron's, Anrader says:

There are many acknowledg-ed alternatives b~y which
earnings can legally be exa. ~orate or rninirmized. .
Accounting varies fromu industry to Industry. In
fact, evarn amongl co-epanies in ths same, field
practices are so diverse as to mako comparisons
of Jaralnas less than meaningfull (52. p. 3).

Lui a en

Another reason for the lack of uniformity

between companies is the need for and dependence upon

judgment. Judgment varies from entity to entity.

)loonitz suggests that less reliance may be placed upon

judgmenart in the future, but it is neededl at theo present:

As the basic analytical framowuork of accounting
becuomes morle firmly estab~lishedr and. ore~ widely
accepted, specific rules can be set according to
sumal principal of~ opti,.riation,, that 1.., ',y a
balancing of conflicting forces, suchi as the cost
of diata accumiulation, thei uncuraicy of Cthe results,
the benefits to be derived fromn the resultant data,
and thes like. Ultilrately the opitimal solution may
even be determninable by analytical means. Nean-
kn~ile, jud6onont mlust to ro~lldc up~on, to derformn the
function of more formal analysis (31, p. 36).

-73 -

Price-level changes

The price level is nloo involved~ in compagrisons

botwuouni entities. This includes both the problem of

the general price level and theo problem of specific

price lovels.

A comparison of accounting statements may

involve the accounting statements For different entities

for just one year. (A comparison between entities

should include the statements for several years. As

thle problem of conparison wsithrin an enterprise has

just been considered, it will not be reconsidered

here.) Price-levol changes are a problem largely

because various entities acquired their assets at

various points in time at various price levels. This

results in loss of comparability in both the balance

sheet and the income statement as the assets themselves

appear in the balance shoot and expired assets appear

as expenses in the income statement.


Assuming a well-organized enterprise, it would

seem that management (internal users of accounting

statements) should receive or be in a position to acquire

any type of information they desire as long as it is

possible and economically feasible. They also should

have the opportunity to discuss the statements with

those who prepare them.


This may not always be the case. Managers may

not understand accounting well enough to know what con-

cepts underlie the preparation of accounting statements

and the resultingi inherent limitations of the state-

moints. As a result, m~lanager may think accounting

statements provide more Information than thry actually

do provide or that they are more accurate than is

actually thle case.

On the other hand, suppose mnanagers do have a

thorough knowloede of accounting. They recog~niro the

limitations which exist. This means they must make

certain adjustments and allowances on their own. This

imnplies a lesser degree of reliance upon accounting

statements than would be the case if accounting state-

ments provided more accurate and complete information.

Managers are interested in comparison--both

comparison of the entity rhich they manage with other

entities and comparison of the current period with

previous periods. Such comparisons are essential to

the matnagemnent areas of planning, controlling, and

evaluating. The problems of alternative meathodss and

price-level changes and the limitations caused by

concepts such as realization are drawbacks to manage-


Investors and Irospective Investors

Investors and prospective investors are faced

with dociatons concerning buying, holding, or sailing

- 75 -

stocks. If published financial statements accurately

presentedl financial position and results of nporations,

than these statements would be very uiseful to investors

and prospective investors in mak-ing decisions.

Many investors and prospective investors do

not make their decisions on the basis of published

finanicipt statements. This could be due to one or

mnore of several factors:

1, P~ublished financial statements may not give

aradeuate information to fonn the basis for a


2. nther sources of information may ho more help-


j. Investors and prospective investors may not

have sufficient knowlcede of accounting to use

the published financial statements.

Each of these three possibilities probably has

some validity. Published financial statements do not

give full anid completely accurate information about

the entity. This is partly due to the use of the

accounting concepts which are used in statement prepa-

ration and which have already been discussed. Trhe

limitation on statement usefulness caused by lack of

comparability between accounting periods and account-

ing entities has also been discussed. The published

financial statements may be so condensed that they

fail to give enough information.

- 76 -

The annual report may be the only contact mnost

investors have with a cooasany, Since the published

financial statements are prepared largely for Investors

and prospective investors, the statements may be some-

what biased. This is possible even when they are

certified by independent certified public accountants.

This is possible due to the alternative accountinC moth-

ods, the possibility of manipulating profits to some

extont, variations in presentation in the published

financial statements, and failure to emphasize unfavor-

able events and contingent events as much as the favor-

able ones.

The annual reports of large corporations

usually include the financial statements, a message

from the president or chairman of the board of directors,

and other information concerning factors such as pro-

ducts, growth, and plans for the future. These annual

reports tend to present a rosy outlook, it is hi.?hly

possible that, instead of trying to present all relevant

information as accurately and completely as is possible

and practical, annual reports may attempt to conceal


Published financial statements may be of rather

limited use even to those who are familiar with account-

ing because they may intentionally withhold information

or present information in an ambiguous way. William

HI. Dinsmore emphasis this in a recent article in

- 77 -

Harper's Mla:arzine. Hie blelievesi that corporate reports--

"one of the florssiet anid least informative art fonns

of our time" (59, p. 133)--go unread by most of the

praesent 17,000,000 stock~holders. This is because the

report provides such little information. "After~ revi-

sions through countless drafts by accountants, audCitors,

treasurers, bankrer-diirectors, lawryers, union negoti-

ators, engineers, scientists, and purchasing agents,

the typical corporate message enlds up freightedl wit~h

vague genieralizations, cliches, half-truths, total

omissions, unsubstaniated claims, and downright dis-

tortions" (53r p. 136), Dinsmore believes the corporate

report has lagged far behind the time. Thers are

millions of small investors now wrho want a report they

can read and use.

Joel Dean lists the follownrn possible reasons

that manage~ment may desire to limit the amount of pro-

fit re~orted:

1. To discourage potential comoetitors.

2. To woo theJ voting public and restrain the zeal
of antitrusters.

9. To restrain wag~e demands of organized labor.

4. To maintain customer good will.

5. To keep control undiluted.

6. To maintain pleasant working conditions (54.
p. 29).

Another criticism of published financial state-

m~ents is that they provide investors with very little

- 78 -

information concerning the future. Perhaps it is best

not to publish plans because this information would

become available to competitors. However, the sugges-

tion is someotimes mnade to include manay-emoent's plans

in the published financial statements. Nolrton B3ackeor

makes such a Juggestion which he recognizes to be a

significant departure from current practice. His

suggestion is basedl on three propositions:

1. Decisions are made on future expectations;

2. ilanning is a funldamental management respon-

3, stockholders are entitled to a knowloede of
managerment's profit plan and an explanation
of the causes for subsequent variations (55,
pp. 59-;0).

Though there seems to be no general agreement

as to the p~urposes financial statements serve for

investors, llobert L. Quickens and John U. Blackburn

suggest these two to sum up the goals of external

rreor ting:

a, To provide the best possible basis for the
stockholder to project the earnings end finan-
0181 conidition of a corporation.

b. To provide the best possible basis for evalu-
ating the performance of management (561 p. 914).

Whether management attempts to limit or conceal

information or not, it is obvious that puiblishedl annual

reports could provide better information to guide

investors and prospective investors in making decisions.

- 79 -

The second possibility suggested above as to

why investors and prospective investors do not use

published financial statements in making decisions is

that other sources of information may be moro helpful.

This could involve a secondary use of the published

financial statements. Investors and prospective inves-

tors may acquire information from those who have care-

fully studied financial statements. The primary user

of the statements then would be the investment experts

such as investment brokers, financial periodicals and

news reports, and investment managers For institutional

investors. If investors rely on secondary sources of

information, this could indicate that either they do

not possess sufficient knowledgee of accounting to use

the statements or they do not have the time (or do not

consider it worthwhile to use their time) to study

statements themselvos.

Another source of information which investors

and prospective investors may consider more useful

than published finanolal statements is the "hot tip"

source. The hot tip is information concerning: whether

or not to buy, hold, or sell stock. It does not come

directly or indirectly from the published statements

and is supposedly not available to the general

public. If the hot tip is reliable it usually comes

from a source of information on the inside of an

entity. Such information usually leaks out against

- 80

the wishes of mannagcment as a whole. Such information

may or may not be reliable, andi th- use of surch infor-

mation is not at reflection upon the published Financial


Still another source of information used by

investors andl prosp7ctive investors as a basis for

~nlootatou is tlhe reoordl of divideln-ls paid by Fntities,.

It has already beesn pointed out that investors arer

int r.-st 4 in one or nore factors such as dividlendls,

apprciation, saf-ty, and diiv rsity. If the, investor

is !srimarily inlterested in dividends, than thre dividend

recordl is aspooially signifioant. Entities are prevented

by' law fro1i PanJIG dividends out of capital unless so

Ifesignated. Th, in~vestor may be alssured that the entity

has ernmd at least asl much income as the dividend p~ay-

mo~nt; indicates. Dividend records are not intendedl to

toll the whiole :itory. Dividends paid in one period may

excood thes earnlings for that periodl, as they may be paid

from the earningsr of yrior periods. The dividlendi policy

of an entity is affected by its reported meanings. In-

vestors and prospective investors would be wise to con-

sider thel pulblished financial statements alongS with thle

dividend records even though their primary interest

may be in dLividends.

Another source of information ofton used by

investors and prospective investors is the daily report

of activities anld prices on the stock mlarkets. This5

- 81

information is certainly more current than annual reports

can be. observation of prices on the stock market over

a period of time reveals trends which are useful in

making decisions, especially to investors interested

largely in appreciation.

Reaction to stock-market prices may be based

on decisions already made. That is, a decision may

have been made to hold stocks for a long period of

time. Day-to-day activities may be of interest to such

investors, but they will probably not be the basis for

a decision.

Such investors, interested in the long run

rather than day-to-day activities, may compose a fairly

large group. A majority of stockholders are women. It

is likely that many of these women have inherited stock

from their deceased husbands and depend upon dividends

from such stock as a portion of their income. Stock-

holders in thiis category are interested primarily in

the long run.

On the other hand, an investor may have decided

to markmize his income in the short run. Thus, he will

buy, sell, or hold at least partly on the basis of

daily stock-market activities. The use of stock-market

activities in making decisions is not necessarily an

indication that published financial statements fall

short of their objectives. Instead, different objectives

are fulfilled. Financial statements affect the market

- 82 -

prices of stocks, espeolally in the long run. Charles

T. Horngren has said that the long-run stock prices

are probably influenced by earnings per share more than

by any other single factor (57. P. 566).

It is apparent, then, thlat there are sources

of information which are more useful to investors and

potential investors than are published financial state-

mints. This is partly because other sources of infor-

mnation may provide a different type of information and

meet different objectives. It is also because state-

ment users do not have an adequate knowledge of accounting

or because published financial statements do not present

relevant data as wonl as they could.

The third possibility suggested above as to

why investors and prospective investors do not use

published financial Jstaements in making decisions is

that they may not possess sufficient knowledge of

accounting. Such investors must rely on other sources

of information. It is perhaps worse for one who is not

informed in accounting to attempt to use financial

statements than to rely entirely on other sources of


Accounting statements could be more useful to

investors if they were propared in suchr a way that they

could be understood and used by those who aro not

experts in accounting. Arthur M. Cannon has said

I want the expert accountant to make his own
decisions as to the impact of various forces and

-83 -

factors. .. I do not want to have to hire
another export to interpret the accountants'
statements for mue. ... It is the accountant's
task to interpret business operations for the
benefit of those who have a legitimnate interest
in them (that is practically everybody), in
financial terms that practically everybody can
understand (581 pp. 32-33).

Other External Users

Oxternal users of accounting statements other

than investors and potential investors include creditors

and prospective creditors, social control agenotes,

employees, labor unions, and the general public. These

statement users masy be handicapped by the shortcomings

of acoounting statements and the problems involved in

their use which hanve already been discussed in connection

with investors. Most of these statement users do have

an advantageu over investors in that most of thema do

not hvav to rely entirely on the published financial

statements. Creditors, potential creditors, and social

control agencies may usually aske for additional infor-

.r~ation as needed. Labor unions have many other factors

to consider other than accounting statements.

These statement users would find inproved

accounting statements useful, Their need is not as

great as the need of investors for improved accounting


This chapter is the first in a series of four

chapters which discuss various measurement bases used

ii nccountin Thre moasuremesnt bajis discussed in the

pres-nt c'inpt'.r is h1 torloni~ co t, th, rrhich~

ir ,r -lent' i .y uv in the ;ri aratiol jr naccounting

S: -vral concepts related to the~ historien1 canoe a~t havei 1 onr di .cu> d~r. ThL\.i concepts also

ulnder'y~ ncouiatin_ .;trrten ats -: t;hey are: curre.ntly

:ro prod. 'nx realiaattin conc~et ij Zarticularly

r lot d in tlir iistorien1? cost basisj for meanuremeont.

7ic hirtu ricPI C volojrrrnt anid the pr Gent status of

this ccncro t iieU L en discuss cd.

Accounting,; s.totements are used b several

Crou, i: rirtna;a yment, invest~oru and pros~pective investors,

creditors end prospective creditors, social control

F~rnel C, an~d labor unionsu. ChiortoominGs of accounting

staltom nts haer been pointed out irn sterns of those wh~lo

usr tl? statements. A dual goal of accounting is sug-

Lested by the discussion:

1. 4ccounting stnatm--nts should be more useful

to thsse aho understand accounting.

2. Accounting statejm-nts should be useful to thlose

whoI have v cy little knowledge of accounting .

An alternative to tho second goal is that

accoun~tin; statements should be prepaeyd in such a

manner that statomont readers who havYO little or no

knowr: dge of accountin: will realize theuy are not

capab.n of ati~lizing thJ statements.


The followilng three chapters offer alternatives

to the historical cost measurement basis, Cachi of the

three alternatives offered is discussed and compa~red

with historical cost and the other two alternatives.




Historical cost, the measurement basis commonly

used in accounting today, has certain advantanges and

disadlvantages which have been discussed in the preceding

chapter. Alternatives to the historical cost concept

are discussed in this and the following two chapters.

These alternatives are current cost, net realizable

value, and discounted cash flow.

The current cost concept is the topic of the

present chapter. Current cost is the term chosen to

include many variations of market value and replcac-

ment cost. Several of those variations are discussed

and classified into two types:

1. Variations which separate income into

a. Holding gains and losses, and

b. Uporarting: income, and

2, Variations which recognize income on a pro-

duction basis.

T~he second type might also distingulish hloldling gains

and losses from other income. These two types of

- 8 -

- 87 -

concepts will be comparred on the basis of usefni~ness,

objectivity, and feasthtlity.

Thei current cost concept will be compared with

historical cost on the basis of the criteria suggested

in Chapter II: relevance (usefulness), objectivity,

and feasibility. Quanitifiability will not be discussed

as this is a characteristic of both measurement methods.


A major difference between economic concepts

of income and accounting concepts of income is a matter

of timing. When should income be recognized? Or when

should an increment in value be recognized? This is

also the major difference between various accounting


Income is sometimes thought of as an increment

in value due to above-average decision-making ability

or as a payment for risk taking. This can logically

be defined as wages instead of income; income is then

defined as an unexpected increment in value. Income

as used in this study means both unexpected increments

in value (pure profit) and increments due to above-

average decision-making ability and risk taking.

Accounting income also includes interest on capital.

Income is not necessarily recognized when it

arises, that is, when an increase in value takes place.

Uetermination of when an increment in value takes place

should be of at least some value in determining when


to recugnise suchl an incralment. OFor thris purpose, the

business process may be divioud into its components:

purchasing, production, holding, and selling. Incro-

ments in value may take pLace due to any one or all of

these activities. In current practice, no attempt is

usually made to determine when an increment takes place,

and the entire incomeo is recognieed in connection with

the selling process as was pointed out in Chapter III

in the discussion of the historical cost mecasuremeont

basis. juch income includes incoome due to above-average

decision-making ability, riske taking, pure profit, and

implicit interest.

Chai mere act of purchasing does not create a

value increment according to current accounting procedure.

The Increment dlue to production is usually measured in

terms of the historic cost of the ingredients added.

If the use of manpower, the use of mnanagemeant, and thle

use of land and capital in the form of current typesa

of capital and operating facilities are combined to

form a product or service, the booke vaine of thiat pro-

duct is the combined total of the cost of the ing~re-

dients. Tlhe measurement of the cost of the ingredients

may be difficult to determine and may require some use

of estimates. Usually, no effort is made to determine

whether or not an increase in value takes place due to

holding an asset over a period of time.

- 8)-

it is possible for incrlanents in value to tate

place in eachl of these actiVitiies: purchaSing, production,

holding, and selling. Alternatives to current practice

even suggest the recognition of such increments at the

time the activity takes place. it has been suggested

in Chapter III that profit is due to the entire business

process. Thus, the not realizable value concept would

give recognition to any increment in valuen during: an

accounting period. regardless of which activity GaVe

riso to such increments. A distinction might or might

not necessarily be made between the incremoents arising

from the various activities. This will be discussed

in more doetil in Chapter V.

Culrront cost concepts vary, but they are

desiened to measureo separately income from production

and selling or income from holding and selling. This

chapter includes a discussion of this point.

Price-level Adjustment Assumption

In this chapter on current cost it is assumed

that appropriate adjustments will be made for changes

in the general price level as well as changes in

individual prices. This is necessary in order for the

capital accounts to refloot the same amount of purchasing


The concept of purchiasing power attains its
validity frome the accounting objective to dis-
tinguish between invested capital and income.
Income results only if a person or firm is better
off at the end of a period than he or it was at

- 90

the beginning of that period. Capital must be
maintained in terms of its purchasing power for
a firm to be as voll off at the end of the
period as it was at the becinnine (59, p. 684).

The investment purchlasing; powerr of the f'irla
can be viewed from at least three different levels.
(1) Lt may be assurned that capital mnaintenance
applies to thle ability of the firmo to rpinv-rst inl
an equal quantity of investment goods in general.
(2) A second asumuiption is that the firm will
usually invest inl capital goods of the same
industry and it is this purchasing poxror that
should be maintained. (3) A third assumption is
that the firm will usually purchase Investment
goods siiailar to what it h~as acquired in the past;
each firmp has a unique invcestment and reinvestment
pattern that wouldL serve as the basis for the
computation of a firm purchasing power index
(59, p. 486).

It is this first concept of purchabing power

which is assumed in this chapter.

Variations of the Current Cost Concept

Current cost concepts are intended to measure

changes in the specific prices as contrastod with

general price-revel changes. Reflection in financial

statements of specifle prices changes is not a new idea.

The following quote is taken from W. A. Paton's Account-

inll Theory whichl was published in 1922:

It is above all important thaet the accountant's
statements present as accurately as possible a
picture of current data in terms of the actual
dollar as of the date of the statemecnts. And
this is not a maettr of penera( price novemlents---
which may be said to express the fluctuations
in the siignificance uf mnoney--but of speoifto
price and value changes (98, p. 629).

- 91 -

idvards andJ Ball's Concept

Urnc of the recent discussions of current cost

is the book, The Theory and Measurement of Rusine~ss

Incoino, by Sdg~ar ir. rEdwards and PI-rli~p d. Bell. Many

of the ideas are drawn from other sources; somea of the

theory is original.

odwards and Dell present the thesis thant "It

is in the evaluation of business decisions .. that

the demand for accounting data exists" (32, p. 3),

Their goal is to arrive at methods of measurement whlich

are useful in the evaluation of business decisions. Two

measurement concepts are eventually su~ggeted, and one

of them is chosen as the better of the two.

lidwards and Rel1 are primarily concerned with

the use of accoulnting: data by management. In general

terms, they enumeorate the uses made by mannaemelnt of

sacounting. Accounting, through comparison of actual

events with expected events, contributes:

1. to the control of current events in the pro-
duction process,

2. to the formulation of better decisions in the
future, and

3. to the modification of the decision-making
process itself (32, p. 6).

Although the emphasis of the book is upon thle

use of accounting data by management, the same data is

useful for external purposes. External users are also

interested in evaluation--the evaluation of management.

92 -

The same mneasurement concepts suggested for management

are also suggested for most external users.

darly in the development of their theory, the

authors put forth the premise that "in order to describe

completely and truthfully with present accounting

techniques the current position of a firm and its profit

as it accrues, recorded costs moust be equal to market

values" (32, p. 8), Knowledge of the current position

of the firm is necessary in the evaluation of decisions.

The problem is to find a workable measure of market value.

Wrhat is market value? Edwards and Bell suggest

more than one possible market value. Value mnay vary

as to the form of asset, date of prico, and type of

market. TFhe form of asset may be initial, present, or

ultimate. The date of price may be past, current, or

future. The type of market may be either entry or exit.

This gives a total of eighteen possible values. Table 3

is their presentation of these eighteen values of which

the six underlined concepts are the ones the authors

consider significant (32, p. 77), The authors are

responsible for the names of the concepts.

Current practice uses largely historic costs

as the basis of valuation. Profits are the difference

between current values and historic costs, and, according

to thu roalization conoupt, are not recorded until a

sale is made. ThPus, past entry values of initial inputs

dominate the accounting records.



Form and
place of Initial Present Ultimate
assets inputs form form

Past, entry historic discarded irrelevant
costs alternatives

Past, exit discarded discarded irrelevant
alternatives alternatives

Current, current present irrelevant
entry costs costs

Current, irrelevant opportunity current
exit costs values

Future, possible possible irrelevant
entry replacement replacement
costs costs

Future, irrelevant possible expected
exit selling values

The two measurement concepts presented are

realizable profit and business profit. Realizable

profit is composed of realizable operating profit and

realizable capital gains.

Realizable operating profit is thle increase

in Edwards and Bell's opportunity cost due to produc-

tion. Opportunity costs are defined by Edwards and

Bell as "values that could currently be realized if

assets (whether finished goods, semifinished goods,


or raw materials) were sold (without further processing)

outside the firm at the best prices immediately obtain-

able" (32, p. 79). Realizable operating profit is

determined by substracting the opportunity cost of

assets prior to production from the opportunity cost

after production. Realizable operating profit is the

increment in value due to production only. No profit

is attributable to a change in valuation method.

Rtealizable capital g~ai~ns are the gains due to

the increase in opportunity cost over time. Such gains

are computed by substracting the opportunity costs of

assets at the beginning of a holding period from that

at the and of the period. Edwards and Bell have divided

t~ime into holding periods and production periods for

simplicity. In actual practice, this cannot be done.

The same results can be obtained by determining the

increase in specific prices over a period of time if

no chlan~e took place in production.

Healizable profit is, then, the difference

between opportunity costs at the beginning of a period

and opportunity costs at the end of the period. Real-

izable profit is due to a change in value dure to

production and a change in value over time. "The

opportunity cost basis for record-keeping has this

unique characteristic: except for the initial acqui-

sition of inputs, all gains and losses can be attri-

buted either to changes in form or to changes in date

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