Title Page
 Table of Contents
 Capital maintenance
 The market for used plant...
 Edwards and Bell
 Exit values: R. J. Chambers
 Value to the owner
 Historical cost
 Biographical sketch

Title: Modern accounting approaches to capital maintenance and valuation
Full Citation
Permanent Link: http://ufdc.ufl.edu/UF00098649/00001
 Material Information
Title: Modern accounting approaches to capital maintenance and valuation
Physical Description: viii, 154 leaves : ; 28 cm.
Language: English
Creator: O'Doherty, Brian Anthony, 1948-
Copyright Date: 1978
Subject: Capital -- Accounting   ( lcsh )
Cost accounting   ( lcsh )
Accounting thesis Ph. D   ( lcsh )
Dissertations, Academic -- Accounting -- UF   ( lcsh )
Genre: bibliography   ( marcgt )
non-fiction   ( marcgt )
Statement of Responsibility: by Brian Anthony O'Doherty.
Thesis: Thesis--University of Florida.
Bibliography: Bibliography: leaves 149-153.
General Note: Typescript.
General Note: Vita.
 Record Information
Bibliographic ID: UF00098649
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 - 000074787
oclc - 04718020
notis - AAJ0061


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Table of Contents
    Title Page
        Page i
        Page ii
        Page iii
    Table of Contents
        Page iv
        Page v
        Page vi
        Page vii
        Page viii
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    Capital maintenance
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    The market for used plant assets
        Page 49
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    Edwards and Bell
        Page 55
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    Exit values: R. J. Chambers
        Page 94
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    Value to the owner
        Page 113
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    Historical cost
        Page 126
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        Page 128
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    Biographical sketch
        Page 154
        Page 155
        Page 156
Full Text







To my parents


I would like to thank mv dissertation committee:

Dr. E. Dan Smith, my chairman, Dr. Williard E. Stone,

and Dr. C. W. Fristoe for their help and encouragement

in this work. Dr. Smith, helped me clarify my ideas on

many difficult points.

I would like to take this opportunity to acknowledge

the support Dr. Williard E. Stone and Dr. S. C. Yu have

given me over my entire graduate career at the University

of Florida.


ACKNOWLEDGMENTS ...................................... iii

ABSTRACT.............................................. vi


INTRODUCTION...... ............................ ........... 1

1 CAPITAL MAINTENANCE .............................. 11

The Pure Theory of Capital Maintenance:
Informed Conduct............................ 11
Some Problems with a Market Based Approach
to Capital Maintenance. ..................... 20
Accounting Approaches to Capital Maintenance.. 24
Chambers' Approach to Capital Maintenance..... 26
Edwards and Bell on Capital Maintenance........ 34
The CRVA Approach to Capital Maintenance...... 38
Absolute Capital Maintenance: Historical Cost. 45
Notes ......................................... 48

2 THE MARKET FOR USED PLANT ASSETS................. 49

The Exit Versus Entry Debate ................... 52
Value in Use Versus Value in Exchange......... 53

3 EDWARDS AND BELL.................................. 55

Reasons for Switch from Historical Cost....... 55
Edwards and Bell's Accounting Framework ....... 57
Decision Making Benefits for E&B's Scheme..... 65
Edwards and Bell and the Valuation Issue...... 71
Holding Versus Operating Activities........... 90

4 EXIT VALUES: R. J. CHAMBERS ...................... 94

A New Basis for Valuation...................... 94
Decision Specific Arguments for Current
Cash Equivalent............................. 96
Criticisms of Current Cash Equivalent.......... 99
The McKeown Test of Current Cash Equivalents..105
The Effect of Current Cash Equivalent on
Income. .................................... 109


5 VALUE TO THE OWNER .............................. 113

Ma's Criticisms .............................. 118
Chambers' Criticisms ......................... 122

6 HISTORICAL COST............................. .... 126

Cost Versus Value: the debate till 1940....... 126
Public Utility Accounting and the Value
Debate .................................... 130
Postwar Inflation and Historical Cost......... 131
The Accounting Profession and Historical
Cost in the Postwar Inflationary Era...... 133
The SEC and Current Values................... 135
Ijiri: a Modern Day Apologist for Historical
Cost ...................................... 136
Notes.......................................... 139

CONCLUSION..... ........ ............................... 140

REFERENCES..... ........ ............................... 149

BIOGRAPHICAL SKETCH ................................... 154

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



Brian Anthony O'Doherty

June 1978

Chairman: E. Dan Smith
Major Department: Accounting

The stimulus for this study was the belief that a

thorough analysis of capital maintenance would offer val-

uable insights into the asset valuation problem. Capital

maintenance was approached through the works of F. A. Hayek.

We saw that a pure theory of capital maintenance entailed

that capital be a subjective assessment of management. Two

of the key characteristics of a suitable surrogate of

subjectively valued capital are that it continuously cap-

tures expectations concerning the future, and that it

measures the value of the asset in use. Hayek was quite

sympathetic to the accountant's and tax official's expedient

of emplcving historical cost to measure value, but he

indicated that this expedient would be very poor under

certain conditions--when there was an unexpected change in


As a prelude to part II of the study, where we examined

several modern approaches to asset valuation, we examined

the conditions necessary for the very existence of a used

asset market. We saw here that in what we called our

"hard cases" that a used market for assets didn't exist.

Our hard cases represent an extremely important segment of

U.S. industry: the market for highly firm-specific plant

assets. A good example of such assets would be the plant

assets of firms in the photographic industry.

In part II we examined the approaches to asset val-

uation of Edwards and Bell, R. J. Chambers, the "Value to

the Owner" School, and historical cost. We saw that

Edwards and Bell employed market entry values (replacement

cost) to value capital, but rather than proceed directly

to a used entry value they choose instead to use the new

asset entry value adjusted for estimated wear and tear.

Edwards and Bell choose to adjust a new asset value because

of their concern that in many cases a used asset value

would be a scrap value. Edwards and Bell are perhaps at

their weakest when they attempt to value assets that are

no longer produced. Here they are forced to talk about

index numbers and appraisals. Another theorist, F. K.

Wright, has developed the notion of "equivalent services"

which gives satisfactory results in the case where the as-

set in use is partially obsolete. But even his ideas suf-

fer if the new asset renders services which are qualitatively

different from the services of the outmoded asset.

Chambers, on the other hand, employs a used market

price, the resale (or exit) price. While his system works

well for assets with a strong used market it deteriorates

into a scrap value measure where the market is thin. Thus

Chambers' scheme presents in many important cases a value

which has no relation to value in use. The value to the

owner valuation procedure consists of six decision rules

that specify whether present value, replacement cost, or

net realizable value ought to be used in a particular

instance. We feel that the value to the owner valuation

system best presents the value of the asset in use. We

examined historical cost in a historical context so that

we could determine why historical cost has been so exten-

sively used for such a long time. We discovered that the

reason for historical cost's popularity was not due to its

inherent benefits but rather due to the practical dif-

ficulties in determining value: and our analysis of market

values patently showed that market values are in many cases

extremely difficult to determine--if not impossible.

Finally the work of Yuji Ijiri was examined because Ijiri

is regarded by many as the leading modern apologist for

historical cost. We discovered that Ijiri predicates his

regard for historical cost on its ability to offer a unique,

certain measure of completed transactions and so be useful

in custodial situations and for settling disputes. We

agree with Ijiri, but we believe E&B's system can offer

these benefits and more.



The purpose of this dissertation is to examine some

of the major theoretical models currently orooosed in

accounting. Our specific ooint of attack is to see how

these models approach the capital maintenance problem and

the asset valuation problem. Our underlying objective is

to shed some light on the choice between these models.

The dissertation is divided into two arts; oart I deals

with the capital maintenance problem and part II with the

asset valuation problem. In the remainder. of this intro-

duction we will discuss each of the six chapters of the

dissertation in turn. Part I is ccmorised of chapters 1

and 2 and nart II the remaining four.

Chanter 1. In chapter 1 we develop Havek's notion

of capital maintenance which we use as our theoretical

standard. We discover that Hayek's standard rests on a

subjective view of capital by which we mean that the

correctness of the capital measure cannot be ascertained

until future events unfold. 'e further see that the dis-

tinction between a subjective and absolute (cr objective)

view of capital depends upon whether events can be clas-

sified as being foreseeable or not. Havek himself sua-

cests that in most instances the expedient of maintaining

intact an absolute amount of monev capital is satisfactory.

After we develop the necessary background we examine

how four leading accounting models approach the mainte-

nance question: Edwards and Bell's (1965) replacement

cost model: Chambers' (1966) exit value model; the current

replacement value school's model, and the historical cost

model. We see that with the exception of the current

replacement value school's model all emnlov an absolute

notion of capital maintenance. The distinction between

an absolute notion of capital maintenance and one that

is not turns on whether the underlying concent of capital

is adjusted for changes in expectations.

Chapter 2. Chapter 2 is a prelude to the detailed

analysis of the various accounting models in nart II.

In chapter 2 we discuss the possibility of anoroximatinc

Hayek's subjective valuation ideal. ie see that this

question turns on whether a used asset market exists.

You may ask, why a used market? 7e deal with a used

asset market and not a new asset market because we are

basically interested in the "value-in-use" of an asset.

By focusing on a used market we avoid the pitfalls of

comparing assets which, despite their similar functions,

cannot be regarded as direct facsimiles in all respects

but degree of use. The new asset may incorporate an

important technological improvement which adds greatly

to its usefulness and usually to its value. Where the

new asset was a direct facsimile in all respects but decree

of use the market estimate of wear and tear will cenerallv

be inferior to the estimate made by the firm usina the

asset. The market estimate is an average of all types of

different usace patterns whereas the firm in question

knows exactly how it used this particular asset. In the

direct facsimile case the only reason for emnloving a

used market value instead of adiustina the neo, asset value

for the appropriate degree of wear and tear would be the

desire for some decree of cb-ectivitv.

For certain classes of assets no used market may

exist whatsoever. We refer to this situation as our

"hard cases" case. In order for any market to exist vcu

need a demand for and a supply of the aood or service

required. In our "hard cases" case demand is nonexistent

or so weak that no market price will be forthcoming. This

situation can exist in a hich technology olicooolistic

market such as exists in the photographic industry. Here

the factors which cause the market structure in the first

place preclude (or all but preclude) the existence of a

used market for the industry's specialized olant assets.

Chaoter 3. In chapter 3 we deal with Edw'ards and

Bell's (1965) accounting scheme oavincr particular attention

to their valuation system. We start out by examining why

they decided to develop an alternative accounting model

to historical cost in the first place. Edwards and Bell

explain that thev wanted to provide a framework where

actual events could be compared to expected events so that

management could learn from its errors. In particular

they wanted to integrate significant economic chances into

the accounting system (such as specific rice chances)

that are onitted under historical cost.

Edwards and Bell develop an accounting framework to

accomplish their objectives that is auite complex. Two of

its more interesting features are that it uses replacement

costs (entry values) as its valuation base and that it

divides income into two components. The first component

is called operating income and represents the results of

the firm's normal operating activities, while the second

component measures the gains or losses due to simply

holding assets over time.

After we present their accounting system we examine

the topic we are chiefly concerned with, their valuation

scheme. Edwards and Bell advocate replacement cost, as

was previously noted, but instead of acinc to the used

replacement market they recommend adjusting the rice of

an identical new asset for estimated wear and tear. Their

aversion to a used market value seems to be linked with

their general rejection of market resale values. we also

examine how Edwards and Bell deal with the "thin market"

case, the case -here the market is very weak or nonexistent.

In this situation Edwards and Bell recommend that replace-

ment cost be estimated by index numbers or acpraisals. we

conclude our analysis by looking further at their holding

cain versus oneratinc cain dichotoyv.

Chapter 4. In chapter 4 we discuss the accounting

model formulated by R. J. Chambers (1966) paving particu-

lar attention to his valuation ideas. Chambers is unique

among leading accounting theorists in that he has developed

a wholly new basis for valuation--adaptability. Adapt-

ability is the organizations' ability to change in the

face of varying external conditions. A larae measure of

an organization's ability to adaot depends unon its

knowing about its internal state of affairs.

Chambers' ideas have not been well received bv ac-

countants; the reason has not been so much a dissatisfaction

with his adaptability idea per se, but rather with his val-

uation system which he argues follows from his adaptability-

thesis. ;n order to measure adaptability Chambers recom-

mends that firms value their assets at their current resale

prices (current cash eTuivalents) since a firm must know

how much cash it would receive by selling its assets if the

need arose. In other words, a firm needs cash in order to

adapt to chancina conditions in its environment.

A major problem with an exit value based accounting

system is that very often the exit value deteriorates into

a scrap value. This is particularly ant to happen where

the market is very thin, and as Folomons (1971) notes, it

makes little sense to value an asset at its scran value

when it is obviously worth so much more to the firm as

part of its productive process. rqe have here the familiar

discarit- between value in use and value in exchange.

Our analysis in chapter 2 where we talk about the

conditions necessary for the existence of a market largely

supports Solomons' misaivinos about exit values oarticu-

larlv where the market is weak. :There the market is not

weak we find that there is cerhans a case for exit values;

M!cKeown (1971) has shown that in at least one instance

reasonable exit values exist for a comoanv's assets.

McKeown's test is rather a special case but it does ooint in

the direction to where exit values may be crofitablv used.

Chapter 5. In chapter 5 we discuss the "value to

the owner" (VO) aoDroach to accounting= valuation. This

is an ancroach that is derived from the pragmatic rules

formulated by Bonbright (1937) for determining indemnity

values in insurance croceedinos. Bonbrioht's rules briefly

stated are that a person is indemnified (made whole acain)

if he can replace his lost asset. This sets the uoper

limit to the asset's value. At the other end of the scale

the minimum that we could cive hin would be what he would

receive if he could sell his asset.

We can express the value to the owner rule (VO) for-

mallv in terms of the relationship between replacement cost

(PC), net realizable value (NRV), and the present value of

future cash receipts (PV). The rule says that the value t-

the owner is the lower of replacement cost and netback,

where netback is defined as the higher of net realizable

value and present value. The most likely relationship for

olant assets -ould be where 17 > DC > ?;n, that is -'here

the value of the asset in use, PV, is greater than either

RC or NRV, while RC is greater than the exit (or liquidation)

value--NRV. The most likely relationship for inventories

would be where NRV > PV RC, or perhaps even better where

NRV = PV > RC. Here the sale price of the inventory asset

would be very nearly equal to the present value of the

future cash receipts and both of these values would be

greater than the purchase price.

The value to the owner rule has not been without crit-

icism, the main criticism being that it relys too heavily

upon present values which are subjective. As we shall see

in chapter 5 only in one of a possible six cases is an

asset valued at its present value, and in this situation

a subjective measure is what is wanted. Chambers (1971)

criticizes the value to the owner rule on the grounds that

it is irrelevant; firms seldom are deprived of their assets.

Chambers' criticism could be applied against practically

all market based valuations because none involve actual

transactions except at the time of purchase and disposal.

As we hinted at earlier the value to the owner rule is a

pragmatic set of decision rules that arrive at a common

sense value in most cases.

Chapter 6. In chapter 6 we conclude our analysis of

various accounting valuation models by examining the model

which is currently in use--historical cost. Our analysis

follows the development of historical cost from the early

days of the twentieth century when accountancy as a

profession was in its infancy to the present time. The

first period from 1900 to 1940 sees American industry

grow from small closely held companies to mature widely

held corporations; another trend during this period was

the increasing regulation of business by the government.

In the early days of the century there was no firm commit-

ment to historical cost, rather some accounting leaders

advocated the use of value where it seemed appropriate.

George O. May (1943) says that this early favorable atti-

tude toward value was later changed not primarily because

of the inflation of 1919 nor because of the depression of

the early thirties but because basically market values

were difficult to determine and harder still to interpret.

His attitude is instructive in that it tends to support

our thesis that the main obstacle to the inclusion of val-

ues into accounting is the difficulty of arriving at the

appropriate numbers in the first place.

After the Second World War American industry (and

industry everywhere) experienced a period of rapid and

continual inflation, a phenomenon that has continued to

the present day. With the onset of this steady inflation

theorists and practitioners alike started looking for ways

to meet the problem. The first suggestion was to adjust

historical cost data by an index representing the change

in the general price level. Although this idea was long

contemplated by the accounting profession they only started

to seriously act upon it in the early 1970's but by then

theorists and the SEC were demanding a full-fledged value

based accounting system.

In the last part of chapter 6 we present the argu-

ments for historical cost of Yuji Ijiri, considered by

many to be the leading modern apologist for historical

cost accounting. Ijiri claims that historical cost is

much more practical than market measures because it is

concerned with unique, completed transactions. Historical

cost also does not suffer from multiplicity and stability

problems as do market measures and it is additive where

market measures are not. This practicality and certainty

make historical cost uniquely suited to fulfil the custo-

dial function of business. Ijiri believes that historical

cost accounting provides an extremely valuable service to

the community in that it helps resolve conflicts. He

calls this activity equity accounting.

P -,- T


The Pure Theory of Capital Maintenance: Informed Conduct

Capital maintenance is in its most fundamental sense

a maxim for reasonable behavior; as Hayek (1935) puts it,

we wish to maintain capital intact not because it is an end

in and of itself but because of consequencess which are

known to follow from a failure to do so" (p. 248). The

consequences to which Hayek alludes are the unintentional

impingements upon future income flows (as income is derived

from a capital base). If we fail to maintain our stock of

capital then our future ability to receive income is


The future income flows to which we refer can take on

any conceivable time-shaoe. It is easy to imagine a pro-

ducer desiring a time-shape that allowed more consumption

now rather than later or vice versa. But, again following

Hayek, for expositional purposes we will chose as a standard

a constant permanent stream. It is the standard against

which all others can be compared. One reason for our want-

ing the stream to be constant, and not erratic, is that

while a producer may wish to enjoy a special, irregular,

stream, the worker cannot. The worker receives his wage

because he cooperates with capital and, since he does not

own the capital, he cannot express a ?reference about what

the future time shane of income should be. And thus we

"have to assume that he 'aants an income streak which does

at least not decrease" (1935, p. 250). Besides beinc

constant the income stream in our normall" case is to be

received in oerpetuitv. This assumoticn is nurely a

convenience; any arbitrary shorter time period could be

chosen but while the argument would not chance in Principle

it would be much more clumsy to work with. It should be

noted that we refer above to a constant flow of income.

The constancy is in terms of a civen flow. Havek's capital

maintenance scheme allows for the constant flow to suddenly"

(and unexpectedly) change up or down to a different level,

but no particular level of inflows is resumed permanent.

The difficulty with the notion of maintaiinin a con-

stant amount of income can be well demonstrated bv what we

shall call the "cosmic cataclysm" case. Just suppose there

is a city with say a very orosnerous mort, the north beino

the basis for the city's wealth. Suddenly, and most iroor-

tantly, unexpectedly, the port is rendered useless, cerhaos

because some cosmic event has permanently shifted the tide.

How are we to regard the city's future income nrosnects ncow

that its capital base has been destroyed? TF we defined

income as a constant perpetual amount of money, then the

unfortunate inhabitants of the cidtv icht never acain have

any--the meager receipts generated in the future, 'rom

whatever sources, would be swallowed-up in replacing the

lost capital base. The city would have to maintain a

constant capital base in order to enjoy a constant amount

of income. The city's populace could go on living, albeit

more poorly, for perhaps hundreds of years, and yet, be-

cause of the maintenance of capital charge never again

enjoy an income flow. Strictly speaking the city's popu-

lace should not consume anything, but rather channel all

future receipts into building up a capital fund to the

point where the fund generates a return (an amount) equal

to their previous return from the port. Such a view makes

nonsense of our everyday notion of income as the basis for

consumption (and living) and cannot be seriously entertained.

Hayek (1935, 1969) also dealt with the case of an

unexpected decline in capital. He suggested that a capi-

talist who faced such a situation has three options. The

first option is to, as it were, ignore the decline in

receipts incident to the capital decline and to consume as

much as before if there are enough receipts. He would

reduce the depreciation allowance (the capital maintenance

allowance) so as to "finance" the present consumption.

This reaction would have the effect, he says, of building

up a sinking fund that will return a stream smaller than

the one previously enjoyed. The second option available

to the capitalist is to reduce consumption, as soon as the

decline in receipts is seen, to the level "at which it

could be permanently maintained" (1935, p. 261). The third

option available to the capitalist is to take the same

action as did the city in our "cataclysm" example which is

to continue to take the same depreciation allowances as

before the change, reducing consumption "to what remains

beyond this, if anything does remain. In this way it would

be possible in many cases to recover the full capital val-

ue originally invested" (1935, p. 261). But Hayek contin-

ues, could this be properly regarded as maintaining capi-

tal constant?

It would mean that the owner would have
to reduce consumption for a period below
the level at which it could be permanently
maintained in order to increase it later
above that level. It seems that this would
have to be regarded in every sense as new
savings savings it is true to make up for
a loss, but for a loss which has already
occurred. This loss was irrevocably incured
when the investment was made in ignorance
of the impending change. (1935, p. 261)

Hayek's analysis is not quite as dramatically drawn as

is our "cataclysm" example but the implications are the

same. The third option, the "cataclysm" reaction could

lead, if taken to the extreme, to starvation. It could

literally take a lifetime of doing without any income mere-

ly to replace capital lost. The first option, that of

consuming as much after the capital loss as before, could

lead, if the loss was large enough, to the situation where

all the capital was "eaten-up" leaving none for future

income generation. This would be a live today, starve

tomorrow situation. Options one and three in situations

where the capital loss was larce enough, would lead to

absurd results. Only option two does not offend against

reason in the capital loss situation.

Hayek's analysis can be applied also to the capital

gains case, the case where future receipts unexpectedly

rise. Here the capitalist has some options as well. He

can consume the extra receipts as they arise taking only

the same depreciation allowance as before. This is option

three. Under option one the capitalist would consume only

the same as he always did allowing the extra receipts to

accumulate, the sinking fund thus accumulated would return

more than he experienced before the unexpected capital gain.

This leaves option two, that of consuming only so much of

the additional receipts such that from now on the capital-

ist could enjoy a higher constant return on his capital base

The capital gains case is not as dramatic as the cap-

ital loss situation. The consequences of consuming all to-

day are not nearly so dire as the opposite situation of con-

suming nothing today so that you can rebuild your lost cap-

ital. But Hayek is not interested in building up a theory

of morally proper behavior, rather his ideas are designed to

guide behavior. It is certainly possible to consume all of

the extra receipts as they flow in; such an action is not

generally considered unreasonable, nor imprudent. But at

least Hayek's concept of income would signal the fortunate

recipient of the capital gain that the extra consumption

is not a permanent thing. The gain is due to completely

unexpected events which cannot be counted upon to occur

again; indeed it is just as likely that the next unexpected

event be a capital loss.

The key notion underlying Hayek's income concept is

the possibility of discriminating between foreseen and un-

foreseen events, or those that are planned and unplanned.

His definition of income is just a way of expressing this

basic reality. This is Hayek's pure theory of capital

maintenance (or income, for they come to the same thing).

It is a theory of informed conduct, no more, no less.

Besides incorporating the distinction between foreseen

and unforeseen events into his capital maintenance system

Hayek also framed his system in terms of value--he rejected

any physical notion of capital. Hayek's position contrasted

with that of A. C. Pigou (1935, 1969) who advocated a phys-

ical notion of capital. Pigou pioneered the analytical

development of capital theory and his ideas vacillated over

time but by 1935 Pigou had incorporated into his theory the

distinction between foreseen and unforeseen events: he ex-

cluded from capital maintenance events that sprang "from

the act of God or the King's enemies" (1935, p. 240). Pigou

had also by this time softened his ideas on the exact phys-

ical reproduction of discarded assets. He explains that if

you discard an asset capital maintenance does not imply that

you must reproduce the identical asset; rather, you take

the quantity of resources that "would suffice in actual

conditions of technique to reproduce the discarded element"

(1935, p. 239) and produce whatever asset that now gives

you the best return.

Pigou's attempt to retain his physical concept of

capital by employing a modified notion of reproduction is

not without its difficulties. Perhaps it is impossible

nowdays to reproduce the outmoded asset: technological

change having advanced too far?

Pigou's next statement of his physical notion of

capital comes in a 1941 article where he says:

Capital consists at any moment of a definite
inventory of physical things. What these are
depends in part on how the general interplay
of demand and supply has worked in the past.
But, at any given moment they are constituted
by an unambiguous physical collection. In
order that capital may be kept intact, if any
object embraced in this collection becomes
worn out or is thrown out (scrapped), it
must be replaced by 'equivalent' objects.
(1969, p. 123)

In this new definition Pigou does not elaborate on what

he means by "equivalent" objects but at least he allows

for expected obsolescence as he allows for the replacement

of scrapped assets. Yet on the very next page, in stressing

once again the importance of physical maintenance, he

directly contradicts his above definition. He says that

capital maintenance is only concerned with actual physical

changes and is not concerned with mere changes in value

due to obsolescence:

I accept too the view that, if maintaining capital
intact has to be defined in such a way that capital
need not be maintained intact even though every item
in its physical inventory is unaltered, the concept
is worthless. . we should try to define it
in such a way that, when the physical inventory of
goods in the capital stock is unaltered, capital is
maintained intact. (1969, p. 124. Emphasis Pigou's)

Both Hayek (1969) and Hicks (1969) grasp upon Pigou's appar-

ent rejection of obsolescence as a factor in capital main-

tenance and rightfully criticize his theory on this ground.

Perhaps they should have, in fairness, pointed out that

Pigou was somewhat ambivalent on the question of obsoles-

cence but they chose not to. Picou's difficulty with de-

veloping a completely unambiguous theory of capital mainte-

nance based upon a physical notion of capital is instructive

and we shall deal with this question again in part II where

we investigate the approaches to capital valuation of var-

ious accounting theorists.

Pigou's above mentioned difficulty in developing a

physical notion of capital and capital maintenance is a

little easier to understand if we remember that he was

mainly interested in developing a practical theory of capi-

tal accounting for use in aggregate economic accounts.

Hayek, on the other hand, did not really attempt to develop

a practical standard of capital maintenance, and this may

be partly explained because he saw (correctly) that capital

values depend upon individual expectations. He believed

that there could be no objective standard of foresight be-

cause, "what is to be understood as maintaining capital

intact on the part of the individual entrepreneur or capi-

talist, is purely subjective, because it depends on the

extent to which the individual capitalist foresees the fu-

ture" (1935, p. 264). Hayek's use of "objective" is some-

what different than the use accountants' these days make

of the term; when accountants use the term "objective"

they mean that the number can be verified by an impartial

third party--a market value is therefore objective in the

accounting sense.

One reason for Hayek's failure to develop a practical

standard based upon market values may have been that the

accountants at the time that he wrote, in the mid- and late-

1930's, employed a system of accounting based on historical

cost. The annual depreciation charge based on a straight

percentage of the original cost less estimated salvage was

the practitioner's capital maintenance allowance. In com-

menting on these practical policies, Hayek (1969) said:

I personally have come to the conclusion that
while the ordinary practice of trying to keep
the money value of capital constant is in most
circumstances a fairly good approximation to
the real purpose of capital accounting, this
is not true in all circumstances. (p. 130.
Emphasis added)

He went on to say that if this was an essentially negative

conclusion, it was not therefore any less useful: "if the

usefulness of the practices aiming at 'maintaining capital

intact' have definite limitations, the important thing is

that these limitations be recognized" (Hayek, 1969, pp. 130-

131). In the final comment of his article in which he

touched upon the practical issue of capital maintenance

Hayek throws out a challenge to accountants and tax of-

ficials to formulate practices that approximate the more

theoretical theory he developed, saying:

The problem which the accountant and the income
tax inspector face is not what constitutes in
any real sense 'maintaining capital intact' in
these cases--although they may have to interpret
legal provisions which use such or similar
phrases--but what are the most appropriate prac-
tices which will achieve the same end, which in
the more ordinary situations is adequately
achieved by.keeping the money value of capital
constant. (Hayek, 1969, p. 131)

This dissertation is in fact an acceptance of this chal-

lenge. We plan to examine modern accounting approaches to

income theory and capital maintenance in the light of

Hayek's theory, keeping in mind all the while its practical


Some Problems with a Market Based Approach
to Capital Maintenance

One way to improve upon income theory and the mainte-

nance of capital is to incorporate some form of market val-

uation into asset measurement in place of historical cost.

This is so because market values capture all the infor-

mation known to the market. The current market price of an

asset in use includes the effects of events unforeseen at

the time that the asset was purchased. Thus if we employ

market values we can attempt to isolate capital gains from

income gains and so measure an asset's worth more appropri-

ately--in terms of its future earning potential. I am going

to argue that the market prices that we are mainly inter-

ested in are used asset prices since we are concerned with

assets actually in use, not with hypothetical or potential

assets. If prices changed only at the end of an asset's

physical life then most of our difficulties would be

eliminated. The first problem we encounter in attempting

to apply Hayek's income concept is that in many important

cases used asset markets do not exist. This is particularly

true of firm-specific plant assets such as custom-made

machinery and large, technically advanced, immobile assets.

We shall discuss the whole question of the existence of

used asset markets in some detail in chapter 2.

Even if we have used asset values there is still the

problem of isolating market declines due to unexpected

events and market declines due to depreciation. This prob-

lem has been discussed by J. R. Hicks (1969) and an account-

ing theorist, R. J. Chambers (1966). Following Hicks, if we

let Co be the value of capital stock at the beginning of the

year, and Cl the value of these same goods at the end of the

year, then to determine depreciation by Co Cl is inter-

nally inconsistent. This inconsistency arises because the

value of C1 takes into account all the events of the year

just passed, including unexpected events, which change C1

to other then it would have been had only depreciation af-

fected the beginning of year balance, Co. Consistency re-

quires that Co be adjusted so that the events of the year

just passed be incorporated into it too. Hick's expressed

this new definition thus:

Let us then define the depreciation of the
original stock of capital as the difference
between the total value of the goods comorisina
that original stock as it is at the end of the
year (Cl) and the value (Co') which would have
been put upon the initial stock at the beginning
of the year if the events of the year had been
correctly foreseen, including amonc those events
the capital value C1 at the end of the year.
(1969, p. 136. Emphasis Hicks')

Hicks felt that this method of estimating depreciation

would be no harder to apply in a practical sense than any

other method suggested for dealing with depreciation. It

must be admitted that present day accounting methods are

also estimates. But here the similarity ends. Hicks'

method would require that each producer subjectively esti-

mate the effects of the year's events on Co; this is a great

deal more subjective than the present-day approach of ap-

plying one of several depreciation formulas to the beginning

book-value of the asset in question.

Chambers' approach to the depreciation problem requires,

"An active secondhand market that will readily supply a

resale price" (1966, o. 239). He starts his analysis by

letting x. represent the unit resale price at to of good X

and xl' represent the unit resale price at tl of X', the

same cood as X but in a different condition (it is one year

older at 1l). Chambers divides changes in value into two

classes, those due to specific asset price changes and those

due to wear and tear (depreciation). He says that if there

has been no change in specific prices for a period then

the change in the measurement of current cash equivalent

(resale price) of the good is given by xo xl' and that

this is a measure of depreciation (1966, p. 239). If the

price of X changes during the period he says that the mea-

sure xo xl' is a mixture of both a change in its specific

price and a change due to depreciation. Chambers goes on

to say that one is able to isolate the effects of depre-

ciation and unexpected events,l "only if it is possible to

obtain at any time the present price of a good in the same

condition as it was at the beginning of a period. It is

not impossible to conceive such a price being available,

but it is quite unlikely that such a price could be found

in practice due to the difficulty of specifying the meaning

of 'condition'" (1966, p. 242). Because of this difficulty

Chambers avoids any attempt to separate specific price

changes from changes due to depreciation. Thus Chambers

also avoids any attempt to isolate declines in value due to

wear and tear and declines in value due to obsolescence.

He acknowledges the differences (1966, pp. 208-09, p. 242)

between these two factors but says that it is not possible

to separate them by reference to the market changes

themselves. Chambers is rather quick to eliminate the pos-

sibility of subdividing income into causal parts, a part

due to normal, or expected operations and a part due to

unexpected events. The reason that Chambers is rather

quick to eliminate the possibility of subdividing income,

which we shall investigate later when we discuss Chambers'

accounting system in more detail, is that he places no

great significance on income, seeing it merely as "the

result of a calculation, an inference" (1965, p. 740).

Chambers is much more concerned with presenting a statement

of financial condition.

Accounting Approaches to Capital Maintenance

We are now in a position to see how modern accounting

theorists have dealt with the capital maintenance problem.

In this chapter we shall deal explicitly with the capital

maintenance problem only, leaving our detailed analysis of

the other aspects of their different accounting proposals

to part II. We are treating the capital maintenance prob-

lem separately because not only does it allow us to concen-

trate on this important issue but also because it separates

the discussion of the capital maintenance problem from dis-

cussion of the asset valuation problem. Shwayder (1969,

p. 304) suggests that these two problems be separated,

saying that if we can isolate and obtain agreement in one

area we may perhaps simplify the remaining area of dis-


Four approaches to capital maintenance will be dis-

cussed: the historical cost approach; Chambers' approach;

Edwards and Bell's (E&B's) approach, and the approach

advocated by proponents of Current Replacement Value

Accounting (CRVA).

At this point we shall introduce a simple numerical

example that will form the basis for our comparison of the

various approaches to capital maintenance. Our standard

example besides presenting some basic facts will illustrate

Hayek's pure theory of capital maintenance.

Assume we have a firm with two assets and no liabili-

ties. It starts out its life at to with $2,000 worth of

cash and a machine worth $2,000 (market value). Thus at to

the firm's net assets (assets minus liabilities) are equal

to $4,000 and the total equities are also $4,000.

Balance Sheet at to

Cash $2,000 Capital Stock $4,000
Machine 2,000
$4,000 $4,000

Let us further assume that the machine is expected to last

for 10 years and have no salvage value. The only revenue

that the firm receives is from renting-out the services of

the machine for $500 cash per annum. There are no expenses

except for the depreciation on the machine and at the end

of the year any income is distributed as a cash dividend.

Now immediately after the machine is purchased some

unforeseeable event occurs causing the market value of the

machine to rise to $3,000 (it will still be useful for 10

years but the rental revenue will we assume rises to $750

per annum). Under Hayek's pure capital maintenance theory

the asset account would be increased by $1,000 as soon as

the unforeseen event occurred and a capital adjustment ac-

count would be similarly increased. The capital adjustment

account would be credited directly; the increase would not

flow through an income summary account.

Balance Sheet immediately after adjustment

Cash $2,000 Capital Stock $4,000
Machine 3,000 Capital Adjustment 1,000
$5,000 $5,000

Income for the year under Hayek's theoretical scheme would

be $450: $750 revenue less the depreciation expense of $300

(one tenth of the adjusted asset balance of $3,000). Thus

at tl, after all transactions but before the dividend was

distributed, the balance sheet would be:

Balance Sheet at ti, before distributions

Cash $2,750 Capital Stock $4,000
Machine $3,000 Capital Adjustment 1,000
Less 300 2,700 Retained Earnings 450
$5,450 $5,450

After the $450 dividend distribution the balance sheet

would be:

Balance Sheet at t after distributions

Cash $2,300 Capital Stock $4,000
Machine $3,000 Capital Adjustment 1,000
Less 300 2,700 _
$5,000 $5,000

Chambers' Approach to Capital Maintenance

Chambers defines income simply as the change in capi-

tal between two points in time. His definition of capital

is "that part of assets of an entity over which its com-

mand is unrestricted by liabilities. The measurement of

the capital of an entity at a point of time is, thus, the

current cash equivalent of all its assets less the current

cash equivalent of its liabilities" (1966, p. 114).

Chambers uses the expression current cash equivalent in

preference to resale price or exit price.

It is useful to illustrate Chambers' approach to capi-

tal maintenance by way of our standard example introduced

in the preceding section of this chapter. At to the firm

begins its operations with two assets. We will assume that

the current cash equivalent of the machine is $2,000 at to.

Balance Sheet at to

Cash $2,000 Capital Stock $4,000
Machine $2,000
$4,000 $4,000

Under Chambers' scheme specific price changes are only

entered into his system at the end of the year. Thus the

$1,000 unforeseen price rise is ignored at to. At the end

of the period (at tl) the new current cash equivalent of

the machine is entered as the balance of the machine ac-

count. Let us assume that at ti the new current cash

equivalent is $2,700 ($3,000 less $300 depreciation) in

line with our standard example. This means that the

machine account must be increased by $700. Chambers treats

this appreciation as an income gain:

Machine Retained Earnings
Balance, to 2,000
Appreciation 700 700 Appreciation
Balance, t1 2,700:

It should be noted at this time that we are assuming

away all problems concerning the existence or strength of

markets by assuming that markets are perfect. A perfect

market is one where market participants have perfect knowl-

edge of all relevant information. Thus all market partici-

pants will share identical knowledge about any good and so

hold the same views about that good. The result of this

common knowledge will be that only one price for the good

will prevail throughout the market. Another feature of a

perfect market is that there are no constaints on the free

movement of goods into and out of the market. In other

words there are no market "frictions" such as brokerage

fees or transportation costs. This second feature of

perfect markets is important because it allows only one

price to exist for any good. If we take the case of a

used plant asset, there will not be a market for selling

the used asset and a separate market for buying the used

asset. There will be only one used market and so the

selling price (exit price) will always equal the buying

price (replacement cost).

In all the numerical examples in this chapter we will

see that the market price rises by $1,000 during the first

year. This occurs despite the fact that we are dealing

with Chambers' exit market or E&B's replacement market.

Such uniformity is a result of the perfect market assumption;

we will see that when we study imperfect (realistic)

markets in part II that we get markedly different results.

As was indicated earlier, in the section where we

discussed problems in apolying market values to capital

maintenance, Chambers regards the entire decline in market

resale price as depreciation. In our example there is no

decline in rice; instead a rise is experienced, giving us

an appreciation of $700 instead of depreciation. This

strange result occurs because Chambers makes no effort to

distinguish price declines from declines in value due to

use. He doesn't try to distinguish between these two causes

because he feels that it is virtually impossible to do it

in a practical sense. Nor would he theoretically want to

distinguish between the two causes. By the end of the vear

the firm has earned its $750 rental so that its cash in-

creases by $750 and retained earnings also rises by $750.

The balance sheet at tl, before distributions, is now:

Balance Sheet at t], before distributions

Cash $2,750 Capital Stock $4,000
Machine 2,000 Retained Earnings 1,450
Plus 700 2,700
55,450 $5,450

Chambers defines chances in the specific prices of assets as

income chances, thus the entire $1,450 in retained earnings

is income. We have assumed that all this will be distrib-

uted. The balance sheet at tl, after distributions is now:

Balance Sheet at t after distributions

Cash $1,300 Capital Stock $4,000
Machine 2,000
Plus 700 2,700
$4,000 $4,000

Thus capital is maintained under Charmers' system if the

amount of money represented by the beginning capital

balance is keOt intact. If all the income for a period

is distributed in the period in which it is earned then

the $4,000 capital balance will be kept constant from

period to period.

It is clear that Charmers has an absolute capital

maintenance system which gives quite different results

from Hayek-'s pure capital maintenance system in situations

where there are substantial capital (unforeseen) cains or

losses. Absolute capital maintenance refers to the case

where the initial capital "value" is maintained indefinitely

despite unforeseen changes in the specific price of assets.

Thus Chambers must maintain $4,000 every period before he

can say he has earned any income. We will leave aside in

this chapter any consideration of the affects of chances

in the general level of prices. In our example Chambers

arrives at a figure of $1,450 for income after aoolying his

notion of capital maintenance, but Havek arrives at an

income figure of only $450.

Chambers' notion of income is different from Havek's.

Chambers sees income as the end product of a set of pro-

cedures, not as a cuide for reasonable consumption. Although

our examoie is rather simple, it shows that Chambers was

only able to distribute the $1,450 income because of the

large cash balance on hand. If the firm experienced a

similar $1,000 unexpected capital aain in vear two it would

still be able to distribute the entire year's income as a

dividend. The balance in the cash account at the end of

year two (before distributions) would be $2,300: the

beginning balance of $1,300 plus the new, higher rental

revenue of $1,000 (the $1,000 capital gain is in fact the

present worth of the unexpected higher annual rentals;

again for convenience we'll assume that the rental receipts

rise $250). Thus at the end of year two the entire income

($1,000 capital gain plus $1,000 rental revenue) could be

distributed as a dividend, leaving an ending cash balance

of $300. But if the firm experienced a third capital gain

in year three the beginning cash balance of $300 would not

be enough to cover the capital gain of $1,000. It would

be possible for Chambers to distribute the entire capital

gain if we were to broaden our example to include borrowing

If borrowing were possible the owner would borrow the

$1,000 capital gain. He could then repay the loan over,

say, the next 4 years because we have assumed that receipts

rise $250 per year for 4 years. However he would be

forced to also pay an annual interest charge (let us say

$100: 10 percent of $1,000). A result of the borrowing

would be that future income flows would be slightly more

irregular as income would be reduced in the years when

interest was due.

A key notion behind Hayek's pure theory of capital is

the presumption that events can be classified into those

that can be foreseen and those that are unforeseen. It is

this quality that distinguishes income chances from capital

changes. To be consistent with his approach of treating

all cains and losses as income changes Chambers must reject

the dichotomy that events can be divided into those that

are foreseeable and those that are not. By and large

Chambers dces reject this dichotomy, mainly vb regarding

almost all events that affect a firm as expected. The

only unexpected events he calls windfalls: "One's assets

and residual equity [owners equity] may be increased by

the receipt of legacies or gifts, and may be decreased by

accidental loss or destruction of assets. To such

involuntary effects we apply the term windfalls" (1966,

o. 117. Emphasis added). He says further that: "We regard

windfall gains and losses as gross increases and cross

decreases respectively in the measure of residual equity

due to fortuitous events, the incidence of which in time

or magnitude could not have been evaluated in advance"

(p. 119). Thus unexpected events are the result of gifts

or accidents. Perhaps it would be better to refer to wind-

falls as unplanned, rather than unexpected, for in the case

of accidents, though they be unwelcome, they surely are

expected as it is possible to insure against the possi-

bilitv of their occurrence.

Despite the fact that windfalls are unexpected

Chambers still treats them as income although he does dif-

ferentiate them from ordinary business income. He says

that: "One's attitude towards windfall gains and losses

will differ from one's attitude towards discretionary

income and expenditure. A man may feel free to dissipate

a windfall cain in a manner cuite different from the

careful manner in which he plans to lay out his regular

income" (1966, p. 117). The only time that Chambers

sucgests that income has an informative role is in his

discussion of windfalls; although this discussion is not

extensive, it does show that he is not oblivious to this

informational role of income.

All other chances in resources, besides windfalls,

are referred to as discretionary income and costs.

Chambers defines them as "gross increases and cross

decreases respectively in the measure of residual equity,

the incidences of which are capable of beina expected

in advance" (1966, p. 119. Emphasis added). These other

chances include the lion's share of events which affect

the firm including chances in specific prices of assets.

Thus to repeat our previous observation excluding windfalls:

Chambers is, on the whole, consistent in treating the

entire chance in capital as an income chance--a change

which is expected.

Chambers formulated the rather oracmatic rule that

all rice chances be regarded as expected because he felt

that it was icmossible to verify after the fact whether a

price chance was foreseen or not. He saw that we would

have to rely on the word of the producers themselves. We

could make the procedure verifiable if producers were

required to state beforehand how they expected the prices

of their assets to change, we could then divide the

changes, after the fact, into those that were expected

and those that were not. But while this procedure would

solve the verifiability problem it would leave the deter-

mination of income completely to the subjective estimates

of the producers. A hundred different producers faced

with a similar situation would, most likely, come up with

a hundred different estimates of future changes in prices

and thus a hundred different income figures. Worse still,

there would be no objective way of determining at the

beginning of the period who had the best estimate. Thus

each estimate would have to be regarded as reasonable when

it came time to determine the unexpected price changes.

Thus in conclusion we feel that Chambers has formu-

lated a capital maintenance rule that is internally

consistent and deals with present prices rather than

guessing at subjective values: all qualities which are

to be desired. Chambers' accounting system cannot be

rejected because of any great defects with his capital

maintenance policy. Whether his system is acceptable or

not depends on other factors, such as his valuation


Edwards and Bell on Capital Maintenance

Edwards and Bell (E&B) employ a concept of capital

maintenance quite similar to Chambers in that it ignores

unexpected price changes. Income is the excess of the

ending balance of capital (assets minus liabilities)

over the beginning capital balance. Edwards and Bell

define income, which they call business profit, as the

excess that remains when the current cost of net assets

is maintained (1965, p. 95). The first, and major, dif-

ference between E&B's income concept and Chambers' concept

is that rather than use resale prices to value capital

they use replacement prices (entry prices). Another dif-

ference concerns their respective approaches to deprecia-

tion. Chambers regards the decline in market value as

depreciation when prices are stable, but E&B calculate

depreciation on the average market value of the asset in

question. The technique is much the same as used under

historical cost--some appropriate rate is applied to this

average balance.

Again we will illustrate E&B's approach to capital

maintenance with the aid of our standard example. At to

the machine is worth $2,000, and as we have perfect markets

this is also the replacement cost of the asset. Thus the

balance sheet at to is:

Balance Sheet at to

Cash $2,000 Capital Stock $4,000
Machine $2,000
$4,000 $4,000

Edwards and Bell incorporated price changes into their sys-

tem as a year-end adjustment. Thus at tI E&B would increase

the asset account by $1,000 and increase the retained

earnings account by $1,000. Edwards and Bell use a more

complicated procedure than this hut the ultimate effect

is the same; the capital oain is considered part of income.

Machine Retained Earninas

Balance t 2,000
Appreciation i,000 1,000 Aopreciation
Balance tl 3,000

At the end of the vear the $750 rent revenue will have

been earned (and received). Edwards and Bell calculate

depreciation on the average of the beginning and ending

balance in the machine account. The depreciation charge

would be one-tenth of $2,500 (the average of $2,000 and

$3,000) or $250. Thus at the end of year the machine

account would be reduced by $250, brincina it to $2,750.

The balance sheet, before distributions, would now be:

Balance Sheet at t before distributions

Cash $2,750 Capital Stock $4,000
Machine 2,750 Retained Earninas 1,500
$5,500 $5,500

The entire $1,500 would be distributed as dividends since

it is all regarded as income. Thus after distribution we

would have a capital balance of $4,000. Acain we have

a procedure that maintains a constant, or absolute, amount

of capital. The $4,000 would have to be maintained from

period to period before income could be said to exist.

Like Chambers E&B don't try to distinguish between

expected and unexpected gains and losses. This is some-

what unusual because the fundamental ournose for their

accounting scheme is to aid in the evaluation of excecta-

tions. Accounting's task is the recording of "actual

objective events as they occur" (Edwards, 1975, n. 238).

Management coanares these objective events with a statement

of expectations and so evaluates the expectations. Part of

the process of evaluation entails isolating the unexpected

errors. Thus E&B could incorporate these after-the-fact

errors into their accounting structure if they so desired;

but they choose not to incorporate them.

Edwards and Bell do isolate -rice chances from opera-

tina income, however, referring to these price chances

as holding gains and losses. But while the dichotomy is

designed to aid the ultimate evaluation of expectations,

holding aains and losses are still regarded as income.

This dichotomy will be discussed in detail in chapter 3.

Edwards and Bell's maintenance procedure, like

Chambers', is objective in that no subjective elements

are directly incorporated into it (we will talk about the

subjectiveness of their valuation scheme later). Also like

Chambers' scheme, it is consistent with a maintenance

procedure that ignores the distinction between expected

and unexpected events.

The CRVA Approach to Capital Maintenance

Capital is maintained under the CRVA system only if

the productive capacity of beginning capital is maintained

intact. Productive capacity is defined as replacement

cost. So far this is the same notion of capital mainte-

nance as employed by E&B. Current Peolacement Value

Accounting differs from E&B's scheme in that, while a

capital cain or loss was considered an income adjustment

for E&B, it is not for CRVA. A capital gain under CRVA

increases an asset account and increases a capital adjust-

ment account, but does not increase income. Accounting

bodies in many countries of the world advocate CRVA: the

Dutch, Australians and the European Economic Community

have implemented or proposed a CRVA system. Jan Klaassen

(1976), a Dutch academician, says that under the CRVA

capital maintenance rule: "The write uc of a phvsical asset

is a capital adjustment and not a Dart of profit, since

this revaluation is needed to ensure the replacement of

the assets (to be) consumed in the sold products" (p. 6).

Likewise R. L. Mathews (1974), an Australian academic

accountant, takes a similar view. Mathews wants unexpected

asset price chances to be entered directly in an owners

equity account rather than be flowed through the income

statement. He feels that these unexpected price changes

are more akin to capital contributions and withdrawals,

and thus they should not be treated as distributable

earnings. As 'Mathews puts it:

In the current value system that will be de-
scribed, the value of residual equity may
change as a result of factors other than income
flows associated with the productive activities
of the business, for example because of capital
gains or losses, specific and possibly, under
one variant of the system, general price level
changes. But these, like proprietorship capi-
tal contributions and withdrawals, are treated
as capital adjustments or restatements of cap-
ital, rather than as positive or negative
contributions to distributable income. (p. 51)

The balance sheet of our standard case would be the

same as usual at to with the machine valued at replacement

cost which we have assumed to be $2,000.

Balance Sheet at to

Cash $2,000 Capital Stock $4,000
Machine 2,000
$4,000 $4,000

The capital gain experienced immediately after the begin-

ning of the year would be now treated as a capital adjust-

ment and not as an income adjustment as was the case under

Chambers and E&B. The machine account would be increased

by $1,000 and a capital adjustment account would also be

increased by a $1,000, viz:

Machine Capital Adjustment Account

Balance to 2,000 1,000 Appreciation
Appreciation 1,000

At the end of the year (at tl) after all transactions have

occurred but before distributions the accounts would be thus:

Cash Canital Stock

Balance to 2,000 Balance to 4,000
Rent 750


Balance to 2,000 Depreciation 300
Appreciation 1,000

Capital Adjustment

1,000 Appreciation

Retained Earnincs

Depreciation 300 750 Rent Revenues


The rent revenue would again be $750 and we will assume

that depreciation is estimated at $300. Only $450 can be

distributed as this is the income under CRVA. This would

leave total assets of $5,000 (cash of $2,300 and the machine

at $2,700). Thus we see in this simple example that we get

the same capital maintenance rule as we got under Hayek's

pure case. The CRVA theorists don't discuss whether they

regard price increases as expected or not, but they do

talk about whether price increases are distributable or not.

This notion of distributability is one of the key ideas

underlying the CRVA system. Income is the amount that can

be distributed as dividends. The CRVA conception of income

approaches Hayek's notion that income is a signal that

informs the producer as tc what proportion of total receipts

he can or cannot consume. It is a rule that prevents

producers from unintentionally impinaina on their ability

to consume in the future. The Dutch school of theoretical

accounting acknowledges this informational aspect of

income. Van Seventer (1975), alluding to Limperg, the

father of Dutch accounting, says:

The question that lies at the heart of the
problem of income accounting involves the
measurement of the size of the income flow.
Limperg sees this as a primary informational
requirement because the measurement of the
income indicates how much can be consumed
without encroaching upon the income source.
(p. 72. Emphasis added)

The signalling function of income whereby imorudent consurn-

tion is avoided is not ruled out under E&B's scheme as in-

formation concerning holding gains and losses is.accumulated

separately from gains and losses from ordinary operations.

Even under Chambers' accounting scheme holding cains and

losses are accumulated but as depreciation allowances

making them less accessible than under E&B's scheme.

The argument for treating a capital gain as a capital

adjustment rather than an income adjustment is not symmet-

ricallv held for the capital loss case. Where an asset

suffers a capital loss this loss is first charged against

previous capital gains, but when the capital gains have been

offset by capital losses any further losses are considered

an income charge. Thus, the absolute minimum capital that

is maintained under the Dutch CRVA system is the original

purchase price. As van Seventer (1975) further explains:

A fall of value below this minimum requires a
contraction of consumption until the original
investment is reconstituted out of subsequent
transaction profits. Such reconstitution can-
not be accomplished by a subsequent recovery
in the value of capital assets. A rise in the
asset valuation is, once again, an undistribu-
table capital increase, inextricably linked
with the productive capacity, and it is irrel-
evant from which price level the rise obtains.
Any value decrease not offset by a previous
increase acquires the character of an opera-
tional loss, and the historical capital value
can be reestablished only by transactions in-
come, not by holding "gains." (p. 76)

The Dutch theorists refer to this as the double min-

imum theory. There are two minimum amounts of capital that

must be maintained: one for the capital gain case and an-

other for the capital loss situation. In the capitall gain

case the minimum is the beginning of the period replacement

cost of assets, whereas under the capital loss case it is

the original purchase price (historical cost) of the assets.

The capital loss minimum can equal the capital gain minimum

but can never be larger and generally will be smaller. We

will illustrate the capital loss situation by using our

standard example. At tI the machine account and capital

adjustment account stand as follows:


Balance t9 2,000
Appreciation 1,000 300 Depreciation (Wear and tear)
Balance tj 2,700

Capital Adjustment Account

Appreciation 1,000

Now assume that immediately after the start of the second

year the firm experiences an unexpected price decline of

$1,500. This would mean that the asset account would be

decreased by $1,500, the $1,000 credit balance in the cap-

ital adjustment account would be offset and retained earn-

ings would be reduced by $500. Thus after the capital loss

the machine, capital adjustment, and retained earnings

accounts would show:


Balance tl 2,700 ; 1,500 Price decline at tl

Capital Adjustment Account

Price decline tl 1,000 1 1,000 Appreciation to

Retained Earnings

Price decline tI 500

The double standard implied by the theorem has been a

controversial aspect of Dutch CRVA. The double minimum

standard was proposed by Limperg and according to van

Seventer the only justification Limperg offered for it was

that a capital loss is just as real as an unprofitable

operation. Limperg's "justification" has no logical basis.

One could as easily argue that a capital gain was just as

real as a profitable operation and so advocate that the

capital gain too be treated as an income gain. But the

use of an historical cost standard is not consonant with

the rest of Limperg's ideas and van Seventer says: "Why it

should be allowed to substitute for the originally developed

maintenance concept remains an unanswered question" (p. 77).

Current Replacement Value Accounting and the Continuity

Under Hayek's capital maintenance scheme there is the

presumption that so long as the capitalist maintains a

given capital fund then he can expect to earn a given

return on this fund. A necessary condition for the mainte-

nance of the income return is thus the maintenance of the

fund. The Dutch CRVA theorists regard continuance of the

income flow as perhaps the main idea behind their accounting

scheme. Rosenfield (1975) criticizes the CRVA approach to

accounting because he believes their ideas concerning

continuity are faulty.

Rosenfield says that CRVA theorists link continuity to

survival; he then proceeds to attack this association. It

is not difficult to show that survival is a broader concept

than capital maintenance; survival entails meeting the

obligations of creditors and the expectations of owners,

things which are not necessarily implied by the simpler

notion of capital maintenance. Rosenfield based his

attack on an isolated quote by Barton (1975a) who is not

generally regarded as a CRVA advocate. And while it is

true that Barton mentions the words survival and productive

capacity within one sentence, the discovery of this quo-

tation does not necessarily mean that all, or even most,

CRVA theorists would support the view that continuity is

synonymous with survival. Rosenfield has set up a straw-

man: it is easy to demolish a straw-man, but such arguing

is hardly convincing.

To sum up, the main difference between the CRVA

approach to capital maintenance and the approaches of

Chambers and E&B is that CRVA focuses on the distributa-

bility of income. Distributability is closely linked

with Havek's informational function of income. It should

be noted, however, that the same information is available

under E&B's capital maintenance scheme, but it is not

presented in the same manner as under CRVA. Whether this

is a real difference depends upon how financial statement

users treat the income information. Current Replacement

Value Accounting is also internally inconsistent in that

it treats capital losses differently from capital gains.

Absolute Capital Maintenance: Historical Cost

Under the historical cost accounting system, which

was until quite recently used almost exclusively, all asset

"values" (or measures) are based upon their original

purchase price. As these assets are used-up in the process

of production they are charged against the period's

revenues; the difference between the revenues and expenses

being considered income. Some of these assets, such as

inventories, are used-up (sold) relatively quickly; others,

like machinery and buildings, may last for many years

while some, like land, are not used-up at all. Capital

maintenance under the historical cost system means that in-

come is not earned for a period until the historical cost

of assets used-up in the productive process is recovered.

Thus, if we assume that there were no capital contributions

or withdrawals, income is only earned after the beginning

of the period's assets, valued at historical cost, are kept

constant. Or more accurately, since assets may come into

the firm from debt sources as well as from revenue sources,

income is only earned after the beginning balance of net

assets (assets minus liabilities) is maintained. In terms

of our standard example we would have the same $2,000

machine and $2,000's worth of cash at to. There would be

no entry to adjust the accounts when the price of the asset

rose to $3,000. .The firm would still recognize the $750

cash inflow as rent revenue but depreciation would now be

based on the asset's original cost ($2,000) and not on its

adjusted cost of $3,000. Assuming that the straight-line

depreciation method is used (with no salvage and a 10 year

life) we would have a depreciation charge of $200. Thus

the accounts at tl, before distributions, would now be:

Cash Retained Earnings

Balance to 2,000 Depreciation 200 750 Rent
Rent 750 550

Machine Capital Stock

Balance t- 2,000 200 Depreciation 4,000 Balance to


As can be seen from the balance in the retained earnings

account, income for the period is $550. This could be

distributed leaving cash of $2,200, which together with the

$1,800 balance in the machine account leaves $4,000 as the

capital maintained.

Under the historical cost maintenance scheme an

absolute amount is maintained--the original cost of net

assets which in this case is $4,000. Actually we are

maintaining the same absolute amount of capital, $4,000,

as is maintained under both Chambers' and E&B's accounting

schemes. But the difference between the historical cost

maintenance scheme and that of Chambers and E&B is that

under the historical cost scheme there is a smaller

depreciation charge associated with a higher operating

income as opposed to the oneshot capital gain and smaller

operating income of Chambers and E&B.

Thus, in regard to capital maintenance, there is

little difference between the market based measures of

Chambers, E&B and historical cost. The main differences

in their respective operating income and net income figures

are due to the different asset values that they maintain.

Thus any conclusive evaluation of these different schemes

must be in terms of asset valuation.



1. It should be noted that not all price changes are to
be regarded as unexpected. It is quite reasonable for
some price chances to be expected. The effects of the
expected price chances will obviously be taken into
account at the time they are first seen, but the chance
itself will occur in the future.


It is our objective in this chapter to closely ex-

amine the market for used assets paying particular at-

tention to the question of whether or not a used asset

market even exists under certain circumstances. Basically

the existence of a market depends upon the supply of and

demand for a good or service. The characteristics of sup-

ply and demand are traditionally stated in terms of their

similarity to the characteristics defining perfect compe-

tition. And according to the generally accepted view,

perfect competition presupposes:

1. A homogeneous commodity supplied and
demanded by a large number of persons, none
of whom can influence price perceptibly by
his actions alone.

2. Free entry into and out of the market
and the absence of other restraints on the
movement of prices and resources.

3. Perfect knowledge of all relevant infor-
mation by the market participants.

These conditions are approximated in the real world by the

market for grain. Here we have a fairly standard, or homo-

geneous product, and there are a large number of farmers

supplying grain and millers demanding grain. The competi-

tive process itself means that information is quickly and

efficiently disseminated throughout the market. If, for

instance, a better strain of rain is developed, information

about it will be quickly transmitted via the centralized

commodities market. Similarly, chances in demand and suo-

ply are registered on the trading floor of the commodities

exchange immediately as they become known. The nature of

the commodity, grain, facilitates the existence of a

centralized, very efficient trading area, the commodities

exchange, and the outstanding characteristic of this

centralized exchange is the way information can be rapidly

disseminated throughout the market.

Imperfect competition, on the other hand, is charac-

terized by conditions that are in several important resoect-

the exact opposite to the situation described above for

grain.' We have a market with few sellers; in the limit

we have a monopoly situation, but, more usually, an

oligopoly. The other determining feature of imperfect

competition is that entry into the market is very difficult.

Usually entry would necessitate that you make an enormous

capital investment, not only in terms of physical capital

but also in terms of managerial expertise. Besides the

initial capital outlay barrier, the producers already in

the market would attempt to destroy your entry bid by

engaging in some form of price-cuttinc, so forcing you to

absorb early operating losses as well.

As far as the final output is concerned, while the

products may not be exact duplicates as in the perfectly

competitive case they may be close substitutes. The

differences between the products are due to laroelv

artificial distinctions, for instance, consider the market

for soap. Here the distinctions between one soan and the

next are more due to skillful advertising than to any

essential technical differences in the soaos themselves.

It is true, though, that in some olicooclistic markets,

for instance, the photogranhy market, the final products

are not entirely similar. The differences between the

various photographic products often are due mainly to

the priviledges granted by the patent laws.

Plant Assets of Cliconolistic Producers

We are interested in oliaonolistic markets not because

we want to analyze their final products but because we wish

to examine their plant assets. Part of the reason for the

very existence of the imoerfectlv coroetitive market in

the first place is due to the barriers to entry of new

competitors. And, as mentioned above, the main barriers

are the enormous capital investment in plant and expertise

required. It is these highly technical plant assets that

we are really interested in.

Let's again take as an example the ohctoaraphic

industry. Manv of the key plant assets of Polaroid or

Kodak would be either self-manufactured or purchased cn

a special-order basis. Thus the demand for these assets

would be perhaps limited to one or two buyers, and this

is for the assets as new assets. It is doubtful that these

specialized plant assets, when sunerseded by new equipment,

would have any used market value whatsoever, exceotinc for,

possibly, a scrap market value.

The noint we wish to make here is that there may

exist no used market, or at the very most an extremely

weak used market for firm-soecific plant assets. Only

where the alant assets are general-use and mobile will

there even be the possibility of a used market.

The Exit Versus Entry Debate

Where a used asset market exists, and this will be the

case for any nonspecific, mobile, generally used assets,

there must exist both a selling market and a buvino market.

The existence of one implies the existence of the other.

In a perfect market setting the selling or exit price will

equal the buving or entry price. In this setting no broker

is necessary, and the goods sold must be so easily trans-

ferred that transportation and removal costs are zero.

To the extent that the used asset market differs from

a perfect market, the exit and entry prices will differ too.

A broker becomes necessary and transportation become

important. But even where these costs are considerable the

essential differences between the exit and entry market are

clear and predictable. There is no reason in orinciole why

the entry price for the used asset could not be determined

from the exit rice: all that would be needed would be the

average brokerage fees and removal costs.

Value in Use Versus Value in Exchance

Imolicit in the discussion in chanter one and the

discussion of asset values in this chapter is the notion

that the value of an asset ultimately depends uoon the

future income flows receiptss less maintenance charrce)

that come from the asset. The flows, beinc future events,

are necessarily subjective, but deDendinc on the market-

ability of the asset we can attain some coalescing of

subjective valuations. If the asset has a wide usefulness

and is readily severable from the firm, then besides

having a value in use, it will also have a value in


-The similarity between the value in use and the value

in exchange becomes rather ill-defined as the market

becomes weaker (thinner). In the circumstances that we

mentioned above, that is in the market for used highly

technical plant assets, the market is very thin indeed.

In these circumstances the exit value reduces to a scran

value and so no one would want to buy the asset. Needless

to say the scrap value of a highly specific olant asset

has little to do with its value in use.




Reasons for Switch from Historical Cost

Edwards and Bell's (E&B) (1965) ideas on what account-

ing should be spring largely from their background as

economists; they see accounting data as information needed

by managers in their task of allocating resources so as to

maximize some goal--usually profits. Since allocative de-

cisions, and for that matter decisions of all kinds, are

based upon expectations of the future, they reason that if

management "can increase the relative accuracy of its

expectations and the ability of the firm to act upon those

expectations [then they should be able to] increase the

profitability of the firm" (p. 2). The mechanism for in-

creasing the relative accuracy of expectations lies in the

comparison of these expectations with the actual events of

a period. E&B see accounting's function as the measurement

of actual events:

The effective isolation of errors in expectations
requires, of course, that the accounting data
developed be directly comparable with the set of
expectations originally specified. This means
clearly that, insofar as possible, accounting
data must measure the actual events of a partic-
ular period, no more and no less. Events of
earlier periods must not be confused with events
of the current period; nor must any events of the
current period be omitted. We shall find this

criterion useful in evaluating the existing set
of accounting principles. (1965, pp. 4-5)

Edwards and Bell's dissatisfaction with historical

cost is based squarely on the fact that, in their opinion,

historical cost does not measure the actual events of a

period. They maintain, and we agree with their conclusions

in this regard, that historical cost accounting would only

"yield accurate and truthful results under very special

circumstances" (p. 6). These circumstances would prevail

only in a stationary state. Functionally, at least from

the accounting standpoint, stationarity, implies: (1) a

stable monetary unit, or in other words that the purchasing

power of money be stable (2) that cost and market value are

identical and that (3) the future be known with certainty.

E&B suggest that rather than directly employing these

heroic assumptions accountants instead have adopted certain

conventions which "purposely restrict and circumscribe the

scope and validity of accounting data as they are currently

developed" (p. 9). These conventions are (1) the money

convention, (2) the realization convention, and (3) the

fiscal-period convention. The money convention restricts

accounting to only those variables that can be measured in

money. The realization convention means that profit is

recognized primarily at the point of sale with no effort

generally being spent trying to measure profit as it accrues

in production or as it results from holding assets. The

fiscal period convention is adopted to recognize the

tentativeness of so much of accounting, as is seen in

arbitrary depreciation allocations and bad debt estimations.

Edwards and Bell next ask hew far these conventions

are from reality (p. 11)? Their answer is largely in terms

of studies that indicate just how unstable prices have been,

both in general and in particular. They conclude that

attempts to modify historical cost which rely entirely on

adjusting for changes in the general rice level are defec-

tive because they ignore the effects that chances in specific

prices have upon the firm.

Edwards and Bell's Accounting Framework

At the heart of E&B's accounting framework is the

desire to approximate economic income as closely as possi-

ble while at the same time keeping the scheme thoroughly

objective. Like most accounting theorists who grapple with

the notion of income, E&B define economic income in terms

of maintenance of capital. They say, "It is the amount

that could be paid out as dividends in any period without

impairing subjective value" (1965, p. 38). Economic income,

as anticipated at the beginning of the year (called antici-

pated subjective profit by E&B), is the difference between

the subjective value of the firm at the end of the year

less the subjective value of the firm at the beginning of

the year all measured at the beginning of the year. If we

let Vo represent the value of the firm at the beginning of

the year and V1 the value of the firm at the end of the

year, all measured at the beginning of the year, then, Sa,

the anticipated subjective profit is defined as:

Sa = V1 Vo

We can find the past subjective profit for the year just

ended by subtracting Vo from the value of the firm at the

end of the year as measured at the end of the year, Vl',

thus past subjective profit, Sp, is defined as:

Sp = V1' Vo

The difference between Vl' and V1 reflects changes in

expectations. But this difference, Sp Sa, cannot be

used to formulate V1' itself for the procedure whereby

p Sa is calculated already assumes we know Vi'. Edwards

and Bell thus reject subjective income because it negates

the very purpose of their accounting scheme: the improvement

of expectations through the analysis of errors in past

expectations. In place of subjective income E&B suggest

an objective measure of income which they call realizable

profit. Realizable profit is based upon market values and

is the amount that a firm could pay out as dividends at the

end of a period without impairing the market value of its

assets. Realizable profit, based as it is on market values,

is objective and thus enables deviations from expectations

to be logically analyzed.

Realizable Profit. Edwards and Bell divide market val-

ues into two groups: entry values and exit values. Entry

values are the prices that must be paid to acquire assets

for the firm whereas exit values represent what the firm's

assets would bring if the firm sold them. Since the firm

only sells a small percentage of its assets, exit values

represent opportunity values rather than consummated sale

prices for most assets. They state that: "The use of entry

values as a basis of asset valuation implies that all as-

sets should be valued at an entry basis until they actually

leave the firm as a result of sale" (1965, p. 79). In this

case no operating profit would be realized until the sale

is consummated. This approach follows the conventional

accounting philosophy of regarding the point of sale as

the critical point in a firm's operations. The use of exit

values, on the other hand, implies that operating profit

is recognized "as soon as the exit value of assets at one

stage of production exceeds the sum of the exit values of

all inputs (whether raw material inputs or intermediate

products) used in moving the asset from the preceding stage

of production" (1965, pp. 79-80). If all stages of pro-

duction are completed before the good passes to the custom-

er then no operating profit will be related to the final

sale of the good. The sale will merely represent an ex-

change of assets of equal value.

Edwards and Bell advocate that entry values be generally

used to value a firm's assets but they do discuss the case

where exit values would be appropriate. Edwards and Bell

say that exit values are associated with a performance meas-

ure (realizable profit) that only tells you whether the firm

has successfully covered "the short-run cost of operating the

business" (1965, p. 98). Entry values, on the other hand,

are associated with a performance measure (current operating

profit) which "indicates that the firm is making a positive

long-run contribution to the economy" (E&B, 1965, p. 98).

Edwards and Bell are interested in developing an accounting

scheme that is useful for evaluating the firm as a going

concern; they therefore recommend that replacement costs be

used to value the firm's assets.

Current operating profit is predicated on the assumption

that the firm is going to continue on in its present line of

business. Where there has been a decision to abandon the

firm's assets a reversion to realizable profit is called for.

The decision to abandon the firm's assets would be forth-

coming if the operating revenue of the firm were less than

the current cost of generating that revenue; that is where

the current operating profit was negative. In these circum-

stances, E&B say, "one must turn to opportunity costs to de-

termine whether there is any short-run future for the pro-

duction process being used" (1965, p. 103). Thus E&B allow

for exit values where exit values are most appropriate: where

the firm's current productive process needs to be abandoned.

Edward and Bell's use of the term operating profit

stems from the distinction that they draw between production

activities and holding activities. Production means the

various activities involved in transforming one asset into

another given that the transformation may only be spatial,

whereas holding activities refer to the changes in value

that occur purely due to the passing of time leavinga aside

certain "aging" activities associated with wine and cheese

etc.). Edwards and Bell divide the fiscal interval into

two components: production moments and holding moments.

They regard, for purposes of arg-nent, the production moment

as an instantaneous event so that aains due to production

can be distinguished from holding cains.

We are now able to define E&B's realizable oDerating

profit since we have introduced their notions of realiza-

tion and operation. Edwards and Bell define it "as the

excess of the opportunity cost of the firm's total assets

at the end of the production moment over the opportunity

cost of the firm's total assets at the beminninc of the

production moment" (1965, p. 82). Any chance in total as-

sets that can be attributable only to the effects of rice

chances is considered a realizable capital cain (or holding


Business profit. Edwards and Bell consider their

concept of business profit to be "the accounting view of

business operation" (1965, n. 88). Whereas realizable

profit avoided any reference to a noint of realization,

business profit does not avoid reference. Under the busi-

ness profit framework gains from production are not recoc-

nized until the point of sale. The emphasis is not on

potential gains but rather on definite events which signal

that a gain has been made. However under the business

orofit framework holding cains are still recognized at the

time they occur; they are therefore potential, or real-

izable, gains.

Present costs versus current costs. Edwards and Bell

eliminate exit values as the preferred valuation base be-

cause, as they say:

We believe that the primary function of accounting
processes . is to provide data to aid in the
evaluation of the existing mode of production.
The decision which is being evaluated on the basis
of accounting data is the decision which was actu-
ally made with respect to the composition of as-
sets, not the possible alternatives relating to
abandonment . of those assets. (1965, p. 275)

In the case of firm-specific assets exit values, which im-

ply that the production process is to be abandoned, will

have little or no relationship to value in use. Thus exit

values cannot answer E&B's most important question: how

have we used our existing productive assets? But after

E&B have chosen entry value over exit value they must still

consider which of two forms of entry value to choose.

The choice is between present cost and current cost.

The present cost of an asset is the cost of currently ac-

quiring the asset being valued, whereas the current cost

is the cost of currently acquiring the incuts which the

firm used to produce the asset being valued. Edwards and

Bell (1965) reject present cost because:

If the production process which created the
asset is in current use by the firm, the use
of present cost would imply the abandonment
of the production facet of the realization
convention. If the asset being valued is a
good in process or a finished good, for exam-
ple, the cost to purchase it from a competi-
tive firm would oresumablv exceed the current

cost of the asset. The valuation of the as-
set at present cost would therefore imply the
recognition of some operating profit prior to
final sale. (p. 91)

Edwards and Bell obviously have a point here regarding

inventories. If inventories were valued at present costs

the gain due to manufacture would be recognized at the time

of manufacture and not at the point of sale. Where the

present cost is lower than the current cost we have the

agelong accounting dilemma of whether losses should be

recognized at sale or earlier when they occur. Edwards and

Bell stick to a strict interpretation of their realization

ideal--they recommend that current costs still be used.

Edwards and Bell justify their preference for current

cost, even when present cost has fallen below it, on two

grounds. The first reason they give is that "present-cost"

is not a valid measure of the productive resources of the

economy which the firm is actually using" (1965, p. 92).

They feel, on the other hand, that current cost is a valid

measure. We disagree with their reasoning here. Where it

is cheaper to buy a good on the open market then to manu-

facture it yourself the valid measure of the resources used-

up in an economic sense is the present cost of the good.

The marginal cost of the good is the market price, this is

the maximum amount of resources that should be expended to

produce the good in question. In the case above where the

firm is using more resources than the marginal producer to

manufacture the good, it is wasting resources due, perhaps,

to inefficient production. In this case the extra resources

used should be reported as an unfavorable efficiency variance,

not as higher inventory costs.

The second reason E&B give for advocating current costs

over present costs is that the exclusive use of present

costs would circumvent the signal that the current production

process ought to be abandoned. As E&B express it, "but if

all assets were valued at present cost, this signal [that

the current production process ought to be abandoned] would

never be apparent" (1965, p. 92). Edwards and Bell's prob-

lem would be readily solved if both current cost and present

cost could be used. Current cost would be used so long as

it lay above present cost, but when present cost fell below

it, present cost would be used. If this procedure were

used the appropriate signal would not be lost. In the event

that the firm's productive process becomes more expensive

than its competitors then the firm's financial statements

should report this fact. Such reporting would enable the

analysis of deviations of actual events from expected events

which E&B consider so vital (1965, p. 55). Edwards and Bell

have strangely set up for themselves a false dilemma, there

is no logical reason why present costs and current costs

cannot be both employed. If both costs are used, then not

only is the dilemma resolved, but we would get better

reporting as well.

Decision Making Benefits Under E&B's Scheme

Edwards and Bell point out that their accounting scheme

corrects some of the major defects of historical cost. Two

major defects are the "neglect of realizable cost savings

and the confusion of realized cost savings with operating

profit" (1965, p. 222).

The omission of realizable cost savings from historical

cost data entails certain implications for the evaluation

of business decisions. The first implication is that

holding activities are not ways that management can enhance

the firm's market value. Historical cost data fails to

inform management and external interested parties of the

progress the firm made in this regard during the current


The second implication is that when holding gains are

in fact realized the gains are attributed to the period in

which the realization occurred. It is not possible to

allocate the gain over the entire span of time in which

the gains in fact occurred. You can have the case where an

asset is held say for 4 years over which time the asset's

market value may have doubled. Under historical cost all

the gain is shown as coming in the fourth year. But what

if the asset's market value tripled in the first year and

declined to its ultimate level over the next 3 years?

Under the E&B's scheme only in year one would management

be credited with making a wise holding decision, in the

next 3 years they would be shown to have lost money as a

result of the holding decision.

A third implication is that present day historical

cost statements, by omitting holding gains and losses data,

make valid across company comparisons more hazardous. An

outsider can only guess at holding activities; perhaps one

firm has some hidden potential holding gains that another

does not? Investors could make better decisions if they

knew of these hidden holding gains. Edwards and Bell's

accounting scheme would present this information.

The second major defect of present day historical cost

statements, which E&B feel is the most damaging of all, is

that holding gains are not identified as such under his-

torical cost but are "included in what is called operating

profit" (1965, p. 223).

Under the present historical cost system, since

holding gains are ignored, depreciation is based only on

the original purchase price of an asset--not on market

value. Edwards and Bell present a scenario where a firm

acquired some plant assets just before an unexpected rise

in the price of these assets. In subsequent periods, under

the historical cost system, this first firm would report

higher operating income than its competitors who purchased

the plant asset after the rise in its price. The inference

one would draw from their respective income figures would

be that the first firm was more efficient. But this would

be wrong. The first firm was only wiser (or luckier) in

the timing of its asset purchases.

Suppose that the first firm's operating efficiency

actually declined. This decline would be possibly hidden

for several years because of the offsetting lower depreci-

ation charges. The result of such hidden information could

be quite serious for external investors and for the economy

as a whole. Precisely when the first firm should be finding

it harder to acquire new capital, it may find it easier.

Should Holding Gains and Losses be Included in Income?

As we have just seen E&B regard the subdivision of in-

come into a part due to current operations and a part due to

holding activities as a vital aspect of their accounting

scheme. In chapter 1 we saw that the ultimate role of in-

come is to indicate how much of your income you can consume

without impinging on your future ability to consume. Income

was presented as a guide to reasonable behavior. We will

now analyze E&B's accounting scheme to see whether his

income figure is useful as a guide to reasonable behavior.

Let us first consider the income derived from inven-

tories. We will demonstrate the inventory case by way of an

example. Assume that we have a certain firm that buys and

sells goods: a wholesale firm, for instance. Let us also

assume that this firm must maintain a basic inventory level

of two units if it is to trade effectively. Our firm begins

business on to by buying one unit of good A for $10. It

buys a second unit of good A on t but this time it pays

$12. Assume that on t2 it sells the first unit of good A

for $15. Also assume that there were no price changes for

good A Between tI and t2. The income statement for the firm

prepared in accordance with E&B's accounting scheme would be:

Income Statement for interval to t2

Revenue. .......................... $15

less Replacement cost of good sold.... 12

Current operating profit......... 3

plus Holding gain...................... 2

Net income (or Business income).. $ 5

Remember that at t2 the firm has to replace the first unit

of good A it just sold if it is to have two units on hand--

its optimal inventory level.

The question to be asked now is, could the firm dis-

tribute the $5.net income? If we assume that the firm must

replenish its inventory out of its operating revenues, which

is normal capital maintenance practice, then the answer is

no. For if the firm distributed the entire $5 net income

this would leave only $10 cash to replenish inventory and a

new unit of good A would now cost $12. Edwards and Bell's

net income figure does not fulfil the primary role of income

in this case--that of guiding behavior. In this instance if

the entire $5 was distributed the firm would not be able to

continue operating. Thus to repeat our conclusion; in the

case of inventories E&B's income concept is likely to misin-

form statement users about the distributability of net

income. Thus, in this particular case at least, their ac-

counting scheme is not useful.

Edwards and Bell's accounting scheme definitely would

be useful in the case of investment assets. Let us demon-

strate this claim with another example. Assume that we have

two companies, company 1 and company 2. At to company 1

buys investment asset X for $10 which it holds and sells

later at tl for $20. It immediately takes the $20 and buys

investment asset Y which also stands at $20 at tl. Company 2

at to buys investment asset Y which then, like X, was selling

at $10. Company 2 does not sell Y at tl but continues to

hold it. Comparative income statements prepared under the

historical cost accounting system would be:

Historical Cost Income Statements

Company 1

Revenues (realized gain) $20

Expenses (cost of asset sold) -10

Net income $10

Company 2




Whereas the comparative income statements prepared under

E&B's scheme would be:

Replacement Cost Income Statements





(realized gain)

(cost of asset sold)


(holding gain, appreciation)


Net income

Company 1



Company 2



If the owners of company 2 rely on the historical cost in-

come statement they will not know that they could sell asset

Y for $20. It could be that they wish to maintain only a

$10 investment and earn a normal return on this $10. If

this were the case they could sell asset Y and buy, say,

investment asset Z which we will assume is selling for $10

at tl. They could then consume the $10 asset appreciation

if they so desired.

The income statement prepared under the historical cost

system is not informative in the case of investment assets,

whereas the income statements Drepared under E&B's account-

ing scheme are informative. A statement user would know

about the possibility of realizing the S10 appreciation from

E&B's replacement cost income statements-. In the case of

investment assets E&B's holding gain and loss concept is

quite useful.

In concluding this section we are prompted to make the

general statement that the usefulness of E&B's operating

gain, holding gain dichotomy depends upon the type of asset

under consideration. We have seen that in the case of

inventory assets the inclusion of holding gains in net

income could misinform statement users about the distrib-

utability of net income. We have also seen that in the

case of investment assets that the inclusion of holding

gains in net income provides valuable information to

statement users which historical cost statements omit.

Edwards and Bell and the Valuation Issue

Before we can begin to analyze E&B's approach to

valuation we need to first provide some background on

economic obsolescence. Economic obsolescence is defined

as the unexpected decline in an asset's value due to

factors such as changes in taste and new inventions. In

order to understand how value declines, one must first

understand what gives an asset value. Assets are valued

because of the services they perform; these services

ultimately represent future cash flows. The value of an

asset at any point in time is the present value of these

future cash flows discounted back to the present at some

appropriate interest rate. If these flows change, the

value of the asset changes too. In this discussion we will

assume a constant interest rate; one appropriate to the

industry to which the firm belongs.

Until now we have been talking about cash flows and

present values in a purely theoretical sense, but a market

price is a reflection of the same sort of discounting

process. Where the market is very strong the price repre-

sents the expectations of a vast number of people, or, to

put it another way, the market price is based on a broad

underlying subset of information. In our discussion we

will assume that the market is strong and reacts quickly

to new information.

If some unexpected event occurs that decreases the

future expected receipts of an asset then the present value

of the asset falls which means that the asset's market

price falls as well. This might occur, say, when a new

machine is invented that is a close substitute for the

machine now in use. The new machine produces the same

product at the same rate, is expected to last for the same

length of time, but has lower operating costs associated

with it than the old machine. Assuming a competitive

market and elastic demand, firms employing the new tech-

nologically superior asset would find it advantageous to

expand their output by lowering their prices. Such price-

cutting would continue till the firms employing the new

asset earned a normal return on their capital. The indus-

try price would thus be lower.

The upshot of all this for the firms employing the

older asset would be that they would experience lower

future cash flows, due to the lower product price, and

thus the value of their assets would consequently decline.

So long as the annual cash inflows from the old asset

exceed the related annual cash outflows then it would be

worthwhile for them to keep on using it. The old asset is

said to be partially obsolete in this case. Total obso-

lescence occurs when the cash inflows are less than cash

outflows, thus forcing immediate scrapping of the obsolete

asset. In the case of partial obsolescence the old asset

is used until it is physically worn-out; it is then re-

placed with the more efficient asset.

A good example of partial obsolescence is presented

by Green and Sorter (1959). Their example is this: A firm

owns a machine (asset A) which has a bookvalue of $5,000,

"zero resale value, and a remaining life of 5 years. It is

capable of producing 2,000 units of X each year with yearly

input of materials and labor costing $1,500" (1959, p. 436).

A new machine (asset B) enters upon the scene, it costs

$5,000 has the same service life, 5 years, and also pro-

duces 2,000 units of X each year, but its yearly input cost

is only $1,000.

Green and Sorter analyze the situation in two stages;

in the first stage they ignore the time value of money, and

in the second stage they introduce it. We will follow their

lead and ignore the time value of money until later. Green

and Sorter maintain that the introduction of the new machine

(asset B), an event unseen when asset A was acquired,

renders A partially obsolete. Arguing that:

1. If a firm owned neither asset, it would
be willing to pay more for "B" than "A,"
but not more than a differential of
$2,500 ($500 per year for 5 years).

2. As the firm already owns asset "A"
it will not be replaced because the
total savings of $2,500 are less than
the $5,000 cost of replacing. (1959, p. 436)

Green and Sorter point out that present accounting tech-

nique (in 1959) would not recognize the obsolescence (nor

does it in 1978). They propose that the carrying value of

A should be reduced to recognize its inferiority to B.

Suggesting that since asset A will necessitate that you

spend an extra $2,500 over the next 5 years then A's car-

rvina value should be reduced by $2,500. In other words,

if you now had to choose between A and B you would choose

B if both cost $5,000, but if A's price were reduced to

$2,500 then you would be indifferent between then. The

way that they would effect the reduction in A's carrying

value would be to debit prior years' income and credit the

allowance for depreciation. The reduction in carrying

value would obviously affect the depreciation charge each

year. The straight-line annual depreciation expense (uti-

lizing asset A) would now be $2,500 divided by 5 years or

$500 per year rather than the $1,000 per year ($5,000 + 5

years) that would have been taken if machine B hadn't


Green and Sorter's example can easily be refined one

step further by taking into account the time value of money,

but the principle is exactly the same. All that is changed

is that the present value of the $500 annual cost savings

(assuming a 6% interest rate) is $2,106, rather than $2,500-

the present value assuming a zero interest rate.

Up till now we have been talking about the consumer

goods producer, but the invention of a more efficient plant

asset not only affects the consumer coods producer but also

the producer of the outmoded plant asset. Whether the

plant asset producer's productive process is rendered

totally obsolete by the new invention depends upon the

demand conditions he faces. It mav be Possible for 'irms

to buy the old outmoded plant asset at such a reduced price

that they can use it and still earn a normal rate cf return.

Therefore whether the olant asset producer's productive

process is rendered totally or partially obsolete depends

uoon whether he too can cover his variable costs.

It is possible to have partial obsolescence in both

the consumer goods and producer goods industries, or par-

tial obsolescence in the former and total obsolescence in

the latter. But it is not possible to have total obsoles-

cence in the consumer goods industry and partial obsoles-

cence in the producer goods industry since there would be

no market for the outmoded olant asset if there were no

consumer market.

We have one more point to make concerning obsolescence

before we discuss E&B's valuation scheme; it concerns the

relationship between the price of a used asset and the rice

of an identical asset in a new condition. If we take the

case where the outmoded plant asset is still produced in

the face of the new invention, then the difference between

the market price of the outmoded plant asset in a new con-

dition and the market price of the outmoded plant asset in

a used condition is due only to the wear and tear attendant

upon production. Economic obsolescence affects both the

new and the used asset and one can theoretically derive the

price of the used asset from the price of an identical new

asset. This is accomplished by subtracting an allowance

for depreciation from the price of the new asset.

Edwards and Bell's Notion of Current Cost

Edwards and Bell vie- the current cost of a used fixed

asset as the price of a new asset, of the identical type to

the one possessed, reduced by an allowance for depreciation.

They thus derive the used cur-rent cost of a fixed asset by

working backwards from the price of the asset in a new

condition. As E&B explain it:

Some types of fixed assets are marketed continu-
ously as new products and are subject to little
technical chance. The current purchase rice of
such assets new, at the end of a period, rav be
obtained in the same way as the current purchase
price of raw materials, by a telephone call or
by arrangement for a year-end statement from the
selling company. And assuming the accuracy of
the depreciation method used, the current cost
of a used fixed asset can then be derived by
taking depreciation on the new (current cost
value) base. (1965, pp. 185-186)

This procedure for deriving used asset values seems muite

unexceptionable; we saw above that the market orice of a

used asset was logically related to the market price of an

identical new asset, all that was needed was an accurate

determination of depreciation. One nay wonder why E&B do

not proceed directly to the used market instead or emolov-

ina this roundabout procedure. The reason why E&B do not

advocate using the purchase price of the used asset obtain-

able from a secondhand market is that thev record such a

market price as an opportunity cost, a resale rice, which

they reject as the measure needed (oo. 286-87).

Edwards and Bell seem to miss the 'act that the price

of an asset is merely a reflection of the future cash

receipts which flow from the asset. Or, in other words,

that an asset's value is the present value of future cash

receipts. They state that (1965);

External technological change will affect the
firm's existing process of production bv alter-
inc the relationships amonc those prices which
govern the firm's behavior. As competitors
adopt newer techniques, it is to be expected
that the prices of the product sold by the firm
will fall relative to the prices of its factors
of production. (o. 285. Emphasis added)

Edwards and Bell seem to indicate here than whereas the

price of the final product falls the price of the olant

asset which produces the final product doesn't fall. They

thus ignore the relationship between future cash receipts

and asset value. Perhaps E&B meant that since the invest-

ment in fixed plant assets was already made then the cost

of the overhead factor of production was fixed relative to

the declining output price.

The error seems to have biased E&B against usino second-

hand prices to value used assets where the secondhand rice

is exactly what is wanted. Where technological progress

has caused production of a plant asset to cease E&B allow

the current cost of the used plant asset to be approximated

by appraisals, index numbers and even opportunity costs.

Edwards and Bell use opportunity costs (exit values)

when they believe that the asset is no longer useful to the

productive process of the firm. Cooortunitv cost represents

a scrap value, not a value in use. As E&B express it (1965):

Finally there is probably no great harm done if
the firm at this stage reverts to an oDoortunitv

cost basis for evaluation. . Even potential en-
trants to the industry could not be tempted to adopt
the same plan of operation as that used by the ex-
isting firm simply because the necessary assets are
not being produced. The potential entrant could
secure such assets only in the second-hand market,
and the prices prevailing there are the opportunity
costs which the existing firm would be reporting.
(pp. 286-87. Emphasis added)

Edwards and Bell are correct in supposing that the purchase

price of the secondhand asset is closely connected with the

selling price that the previous owner sold the asset for.

We have indicated before that the main differences between

the two prices lies in such factors as removal costs and

brokerage fees, and where the market is strong and the as-

set mobile these differences would not be substantial. Also

it would be an easy matter to rather accurately estimate

one price from the knowledge of the other. Thus, assuming

we had an active secondhand market, the difference between

an entry value accounting system and an exit value account-

ing system would not be very great. It would appear that

E&B had immobile assets in mind when they made the state-

ment directly quoted above. Where we had an immobile asset

with perhaps only a scrap market E&B's statement would not

be all that far from reality.

Revsine on the Present Value Model

Our analysis of E&B's valuation scheme up till now has

been based upon the presumption that the present value model

of asset valuation is valid. Some call the present value

model the rational expectations model as it presumes that

the valuing process is a logical, rational activity: an

asset (or investment) is valued because of the benefits

expected to flow from it; the discounting rccedure is

merely the vehicle for converting the future flows to a

common basis.

Revsine (1970) calls the rational expectations model

the indirect measurement hypothesis because rather than the

price of an asset at the beginning of the i th period (Pi)

being equal to the present value of future cash flows (Vi),

as is true under perfect competition (Pi = Vi), we only

have the price (Pi) approximating the present value of fu-

ture cash flows (Vi) under imperfect competition (Pi ^ Vi).

As Revsine (1970) puts it:

Even in imperfectly competitive economies asset
prices approximate the average net present value
of asset revenue generating potential. Theoreti-
cally, changes in asset revenue aeneratina poten-
tial precipitate appropriate chances in asset
price. Proponents of the indirect measurement:
hypothesis apparently would contend that lust as
market price is related to asset net present
value, so too the chance in asset market price is
related to the chance in asset net present value.
(p. 517. Emphasis Revsine's)

But, Revsine continues, "there are a oriori rounds for

questioning the validity of the posited relationship between

changes in asset prices and changes in service potential in

realistic economies" (p. 518). If Revsine's criticism is

correct it throws into doubt our whole ability to analyze

market prices in terms of the rational expectation (present

value) model.

Revsine says that rather than asset prices chancing in

direct response to changes in the net cash flows expected

to be generated by these assets there is "no necessary

relationship between movements in asset prices and move-

ments in cash flows" (1970, p. 518.Emphasis Revsine's).

Revsine sees three possible relationships between chances

n asset prices and changes in future cash flows:

A. They can chance in the same direction.

B. While the asset price chances future
cash flows can remain constant.

C. Future cash flows can chance in the opposite
direction to chances in asset prices.

He labels these three possibilities as Type A,'Type B, and

Type C asset price chances. Revsine's discussion is con-

cerned mainly with Type C price changes as they directly

contradict the rational expectations model.

Revsine's example concerns the hypothetical camma

industry which produces a consumer good called a camma.

Now the industry is perfectly competitive but at the be-

ginning of 19X0 it is cut of equilibrium, with the industry

earning an above normal rate of return. This situation

obviously induces new firms to enter the industry and the

resulting demand for plant assets in the camma industry

causes the price of these assets to rise. Revsine savs

that the final output of gamma goods won't immediately rise

because of the lead-time needed to setup production. Thus,

he says, "in this initial stage, no chance in the magnitude

of established gamma firms' cash flows occurs, but asset

prices are bid uowards" (1970. p. 519).

After the necessary lead-time the supply of final

output will increase in the gamma industry. Revsine assumes

a fixed demand schedule so that the increase in suoplv

causes the price of gammas to fall. Further, Revsine

assumes that the volume attained by new entrants is

"garnered at the expense of established camma industry

firms" (p. 519). As a final assumption Revsine'savs that

since the gamma industry is an increasing cost industry,

"the increased output will trigger increases in the price

of variable inputs used in production" (p. 519). Revsine


The net effect of these events on the estab-
lished firms in the industry will be: (1) a
rise in the market price of capital assets
used in production, and (2) a fall in expected
future cash flows associated with operating
the gamma producing equipment. Hence, a Tvpe
C price change (opposite movements in asset
prices and future flows) is the likely result
of this sequence of events. (p. 519)

Revsine even presents a short numerical example of the

type of situation he envisages. At the becinnina of 19X0

the gamma industry is in a state of temporary disequilibrium,

the asset which produces the gamma (which has a three year

life) is expected to generate annual cash flows of $110

for the next three years. Assuming a normal rate of return

of 5 percent for the gamma industry the equilibrium rice

of the asset should be $299.55, the present value of $110

for three years discounted back at 5 Dercent. However the

actual market price is only $250 due to the temporary

disequilibrium. Thus the camma industry is earning greater

than a 5 percent return and this extra return attracts new

entrants and so brings about the change of events that we

described above.

Revsine's argument is wrona from the outset. His er-

ror stems from his notion of disequilibrium. In economics

disequilibrium refers to the situation that results from a

an unexpected change in events. At one moment a firm or

industry is operating smoothly and then suddenly an unex-

pected chance shifts the underlying relationships supporting

the equilibrium. Such a change may result fror. a sudden

shift in consumer tastes or the advent of a new productive

process. Now in Revsine's example there is no unexpected

chance but the bald statement that the actual market rice

is $250 when it should be almost $300. The onlv way this

could be explained would be in terms of a temporary

irrationality on the part of the producer of the olant

assets. All that would happen in this case would be that

some of the firms in the industry who managed to purchase

such an underpriced asset would experience a windfall cain;

the value of the plant assets purchased before at the

equilibrium market price would not fall. The most likely

result would be that an arbitrager would buy up the under-

oriced assets and sell them later at a fair market value.

Thus we conclude that Revsine's argument is fallacious and

that the rational expectations model utilizing the discount-

ing procedure is a valid approach to asset valuation.

A reasonable explanation for the sudden droo in the

price of plant assets would be (assuming no droc in input

prices) a fallinc-off of demand. In this situation the

fall in asset prices (from $299.55 to S250) would be merelv

the market adjustment to the initial fall in cash flows

that are generated by the asset. The fall in cash flows

would be the simple result of the leftward shift in the

demand schedule. We have here a classic case of Revsine's

Type A asset price chance. Revsine's Tyoe C asset price

change is just contrary to economic loaic.

Current Costs When the Market is Thin

Edwards and Bell suggest that where no new fixed asset

of the same type as the firm employs is available then two

means of measuring current costs are available: "(1) ao-

praisal, and (2) the use of price index numbers for like

fixed assets to adjust the original cost base to the level

which would now have to be oaid to purchase the asset in

question" (1965, p. .186). Edwards and Bell offer little

discussion of either of these two substitute measures. All

they say about acoraisals is that they ouoht to be carried

out periodically by "independent experts" (o. 187). As for

index numbers their discussion is limited to a few obser-

vations about which government departments compile "various

price indexes" (p. 187). Because of the importance of

market price surrogates a few observations concerning index

numbers and appraisals are in order.

Indexes. The first observation is that indexes can

only exist for a class of assets. Of necessity thev must

be averages and therefore suffer from the defects of any

average--they may be unrepresentative of any given element

that makes-up the class. A more serious problem is that

the price indexes are composed of new asset prices and thus

represent "best technology" indexes. Edwards and Bell are

concerned with estimating the current costs of outmoded

assets, not the current costs of assets emolovina the latest

technology. Wright (1965) criticizes E&B's use of index

numbers where technical progress has occurred, saying:

"Where substantial obsolescence has occurred this

suggestion [of employing price index numbers] seems very

unsatisfactory. Consider, for instance, a oropeller-driven

aircraft which originally cost $2,000,000, but which would

now be replaced by a jet aircraft costing $8,000,000"

(p. 173). It's difficult to see how such an index based

on the latest technology would be of much use in determining

how much a new propeller-driven aircraft should cost, if

only it were still produced?

What E&B are looking for is probably best described as

a reproduction cost index. Quite apart from the difficulty

of deriving such an index there is the question of its

relevance. The difficulties of using a reproduction cost

index were investigated by Livingstone (1967). Livingstone

studied electric utility plant costs for the twenty vear

period 1945-1964. Using a well-known published reproduction

cost index, the Handy-Whitman Index of Public Utility

Construction Costs, he found that the reoroduction cost of

actual operating facilities approximately doubled over the

twenty year period. But Livingstone notes:

However, a replacement cost index (measuring the
cost of productive capacity rather than productive
facilities) specially computed for this purpose
showed virtually no change for the 20 years. In
other words, the greatly increased costs of repro-
duction of given facilities had been totally off-
set by technological progress and economies of
scale due to larger plant sizes. This striking
example highlights the potentially material error
involved in using reproduction cost estimates
instead of replacement cost estimates. (Largay
and Livingstone, 1976, p. 221. Emphasis in original)

Appraisals. As Wright (1965) has correctly observed

it is not much use specifying appraisal as a method of

valuation, "without also specifying the principles to be

followed in making that appraisal" (p. 173). The most

familiar type of appraisal is that done by land or property

appraisers. Largay and Livingstone (1976), wTho have devel-

oped a market value approach to accounting based on the

work of E&B, discuss the problem of appraisal with the

property appraiser in mind as model.

They discuss such problems as who should assume final

responsibility for the appraisal? The appraiser or the

certified public accountant (CPA)? They answer, and we

concur with their judgement, that the appraisal must ulti-

mately be the responsibility of the appraiser. Another

question they deal with is whether the CPA should review

the appraisal information. They point out that one impor-

tant point that the CPA should be concerned with is whether

the appraisal relates to the historical cost information

presented. Clearly the appraisal must be related to the

underlying physical assets of the firm.

Despite the fact that Largay and Livingstones' dis-

cussion of the responsibility of the appraiser and his

relationship to the CPA is very interesting we feel that

they have avoided the main issues concerning appraisals.

An appraiser can offer his services in the market because

of specific knowledge he possesses that others do not

possess (they could acquire this knowledge but only at a

considerable cost). The knowledge that is most valuable

is knowledge of the local situation, or local conditions,

and not knowledge of general principles. An outsider

could not appraise property in a new community without

first learning some specific information about the area.

But what is true of property assets is not necessarily

true of plant assets.

Is there an outside appraiser who could appraise the

specialized equipment of, say, Eastman-Kodak or Polaroid?

Their plant assets and markets are so complex that it is

likely that only a few of their own executives could

adequately appraise them. The knowledge necessary to

determine the value of specialized assets associated with

technologically advanced corporations such as Eastman-Kodak

and Polaroid is probably restricted to a handful of people

within each firm. In these circumstances we could still

have appraisals but they of necessity would be the subjec-

tive internal appraisals of management.

Equivalent Services. Edwards in a 1975 reassessment of

his and Bell's views on replacement costing confessed to

being "less than happy" (1975, p. 241) with their treatment

of the case when current costs had to be approximated be-

cause identical assets were no longer produced. Edwards

(1975) settled on another basis for appraising the current

cost of obvious replacement, which he likened to the

approach taken by the American Accounting Association's

Committee on Concepts and Standards--Long-Lived Assets

(1964). The Committee said:

Where there is no established market for assets
of like kind and condition, current cost may be
estimated by reference to the purchase price of
assets which provide equivalent service capacity.
The purchase price of such substitute assets
should be adjusted for differences in operating
characteristics such as cost, capacity, and
quality. (p. 695. Emphasis added)

We have here an attempt to derive a surrogate for a used

asset. The key is to be able to come up with a measure of

equivalent service. This may be a simple task as would be

the case, say, when a new machine is available that is

twice as productive as the old machine (keeping in mind

that the older machine is no longer produced nor available

secondhand). In this case the current cost of the old

machine would be half the cost of the new machine less an

allowance for depreciation.

Wright (1965) too grappled with the meaning of equiva-

lent service. He asked what services are equivalent to a

propeller-driven aircraft that flys 250 m.p.h. in an age

of jets? Perhaps this question is unanswerable? He said,

"Strictly speaking, in this case, no equivalent services

are available from new equipment. While this way of dealing

with the question may be correct, it is not very helpful"

(p. 177). Wright went on to suggest that we define a unit

of output which is applicable to the new equipment and the

old (for instance, passenger-niles, or ton-miles). Given

this common unit of output we then estimate the difference

in value per unit of output from the existing and new

machines. Wright continues:

Cost of equivalent output may then be defined
as the cost of producing a similar output on
a new machine, less any premium which this
output enjoys over that produced on the exist-
ing machine. This now enables us to define
cost of equivalent services as the cost of
equivalent output from a new machine, less
cost of inputs saved by not using the existing
machine. (p. 177. Emphasis Wright's)

Wright's approach while theoretically attractive is practi-

cally very weak. It is almost wholly subjective in all but

the simplest of cases. In situations where marked techno-

logical change has occurred there is the difficult problem

of trying to equate plant assets that produce products that

are aualitatively different. Returning to Wright's example,

it is not really obvious that the modern jet would be a

realistic competitor for the old outmoded propeller-driven

aircraft. If they were not realistic competitors then the

aircraft could not be considered substitutes. If this were

the case Wright would be valuing an asset with reference to

a wholly different type of asset. One might as well value

land by using the market price of automobiles.

Wright's notion of equivalent services would be more

appropriate where there were no qualitative differences

between the old and the new asset. Where the asset cer-

formed a purely mechanical function, like making moulds,

then some sort of meaningful engineering comparison could

be made.

Despite our reservations concerning Wright's index

when technological change embodies qualitative changes,

Wright's index is interesting because it is a "best technology"

index. Edwards and Bell were careful to avoid one trap when

discussing possible ways of approximating the replacement

cost of outmoded assets; the trap entails the equating of a

new, best technology asset with the old, outmoded asset. It

is faulty reasoning to say that the replacement cost of the

outmoded asset is the cost of the new, technologically

advanced asset. Capital maintenance theory says that you

should maintain the value of the assets you currently employ,

not that you should maintain some hypothetical amount, which

may be many times what you originally invested. Wright's

index is interesting because he uses the best technology as-

set to approximate the value of the old, outmoded asset.

The key to Wright's index is that he attempts to reduce

the old and the new asset to a common basis by introducing

the notion of equivalent services. In the case of aircraft

it might be passenger-miles or ton-miles. With this common

unit of service he then estimates the difference in value

per unit of service from the old and new aircraft.

Conceptually Wright's index is unexceptionable. To the

extent that you can devise a common measure of output then

you can use Wright's best technology index.

In conclusion, it seems to us that the task of de-

fining the concept of equivalent services is in many cases

fraught with difficulties. It could only be done in cases

where the output of the new and old assets were very simi-

lar and where there were no qualitative differences between

the old and new assets. Where substantial technological

progress had occurred it could be highly subjective and

perhaps even meaningless. The Committee on Long-Lived

Assets recommended that: "Whenever there is no objective

method of determining the current cost of obtaining the

same or equivalent services, depreciated acquisition cost

should continue as the basis of valuation" (1964, p. 695).

We agree with their recommendation. Historical cost would

seem preferable to an unverifiable, subjective evaluation.

Holding Versus Operating Activities

As we saw in the section on their accounting frame-

work E&B emphasize the distinction between holding activi-

ties and operating activities. Operating profit is derived

from the production process (although it is recognized only

at the point of sale) whereas capital gains occur during

the intervals between production. Theoretically holding

gains and losses are not difficult to calculate; you simply

take the difference in the price of the asset before and

after the change in prices. But E&B go one step further;

they claim that the dichotomy is useful in evaluating two

different types of decisions. Explaining that:

These two kinds of gains [holding and operating]
are often the result of auite different sets of
decisions. . The difference between forces
motivating the business firm to make profit by
one means rather than by another and the dif-
ference between the events on which the two meth-
ods of making profit require that the two kinds
of gains be carefully separated if the two types
of decisions involved are to be meaningfully
evaluated. (Drake and Dopuch, 1965, p. 195)

Edwards and Bell's dichotomy has not been universally

accepted; Drake and Dopuch (1965) challenge the contention

that E&B's mechanism for separating holding gains and

losses from operating gains and losses correctly measures

the relevant facts. They pose two situations where E&B's

mechanism does not.give unambiguous results. They show

that some of the holding activity's costs are carried across

to operating income and vice versa. The first situation

involves an inventory investment decision. Suppose a

firm has a normal inventory but because of an anticipated

price rise decides to actively speculate and so holds more

inventory than it needs to meet current needs. Drake and

Dopuch first ask how the extra costs of holding the inven-

tory, such as the extra storage, insurance and purchasing

costs, would be treated under E&B's scheme. Holding gains

and losses are calculated by simply subtracting the old

price of inventory from the new price; this procedure

thereby avoids introducing the extra holding costs (the

costs of holding the above-normal inventory) into the

holding gain and loss calculation. These extra holding

costs are lost in the normal operating costs of the business.

Secondly, Drake and Dopuch ask whether the firm should re-

port a holding gain on the normal inventory level since

this amount is not held for speculative purposes. In

fairness to E&B Drake and Dopuch do acknowledge that E&B's

method of calculating an inventory holding gain or loss

could be changed so as to accommodate their criticisms. In

order to do this E&B would have to present a statement of

normal expectations. But Drake and Dopuch question whether

internal management would report its explicit expectations

to external parties.

Drake and Dopuch's second situation where E&B's mecha-

nism does not give unambiguous results involves the de-

cision to invest in capital assets. They argue here that

the decision to invest in capital involves factors that

may effect both operating results and holding results.

The situation they present involves the decision by U.S.

Steel in 1952 to build the capital-intensive Fairless

Steel Works. This decision was predicated on U.S. Steel's

desire to gain future labor savings for they had antici-

pated rising labor rates. As it turned out they were

correct in their anticipations; their capital-intensive

plant later proved most economical. Drake and Dopuch ask

how would this decision be reflected over the life of the

asset under E&B's scheme? They suggest that initially

U.S. Steel's operating income would suffer, relative to

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