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A Study of various measurement bases and their effect on periodic income determination

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Title:
A Study of various measurement bases and their effect on periodic income determination
Added title page title:
Measurement bases and their effect on peiodic income determination
Creator:
Sanders, Howard Preston, 1938-
Place of Publication:
Gainesville, Fla.
Publisher:
University of Florida
Publication Date:
Copyright Date:
1967
Language:
English
Physical Description:
vi, 194 leaves ; 28 cm.

Subjects

Subjects / Keywords:
Accounting statements ( jstor )
Assets ( jstor )
Capital costs ( jstor )
Financial accounting ( jstor )
Historical cost ( jstor )
Investors ( jstor )
Net realizable value ( jstor )
Objectivity ( jstor )
Prices ( jstor )
Replacement value ( jstor )
Accounting thesis Ph. D ( lcsh )
Dissertations, Academic -- Accounting -- UF ( lcsh )
Income accounting ( lcsh )
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bibliography ( marcgt )
non-fiction ( marcgt )

Notes

Thesis:
Thesis - University of Florida.
Bibliography:
Bibliography: leaves 182-194.
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Also available on World Wide Web
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Manuscript copy.
General Note:
Vita.

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University of Florida
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University of Florida
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Copyright [name of dissertation author]. Permission granted to the University of Florida to digitize, archive and distribute this item for non-profit research and educational purposes. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder.
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13385461 ( OCLC )
ACX9127 ( NOTIS )

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A STUDY OF VARIOUS MEASUREMENT
BASES AND THEIR EFFECT ON PERIODIC
INCOME DETERMINATION








By
HOWARD PRESTON SANDERS


A DISSERTATION PRESENTED TO THE GRAUATE COUNCIL OF
THE UNIVERSITY OF FLORIDA
IN PARTIAL FIULILMENT OF THE REQUTIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY










UNIVERSITY OF FLORIDA
August, 1967
















AC.;;;JVLjD..~l~~;iTj


The author wishles to express his appreciation

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

gation was comnpleted. ~Apreciationl is also expressed to

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

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

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

served temporarily as chairman while the investigation

was underway.

The author wishes to express his gratitude to

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

script, proofreading, giving general assistance, and

most of all--giving constant moral support.


-ii


















TABLE OF CONTENTIS


Page

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

Chapter

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

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

II. M5ASURZENENT INV ACCUUNTING; ............... 18

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











Yage

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

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

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

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


-iv -












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

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

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

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

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

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

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

















LIST OFP TA13LSS


Table Page

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

2. A ClassificatiLon of Scales of Measurement .. 23

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

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


- vi















CHIAYPTR I


INTROD)UCTION


Accounting statements are the tangible product

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

tance within itself; the importance of accounting

statements is in the service they render to statement

users. The following paragraphs comprise a discussion

of accounting statements largely in terms of those who

read theme and the purposes for which they read them.

The mrost familiar accounting statements are the

balance sheet and the income statement. The number of

types of statements for internal users is almost end-

less. with certain practical limits, management may

prepare or have prepared any statement that may be use-

ful to them. The external users have a more limited

supply of statements, being limited largely to what is

known as the published financial statemsents. The pub-

lished rfnancial statements are the representations of

management to outsiders. The published financial

statements usually consist of the balance sheet, the

income statement, and the analysis of owners' equity

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


-1 -






-2


they may include other statements and details such as

the source and application of funds statement.

The users of accounting statements can be

divided, at least roughly, into two classes: internal

users and external users. The internal users of account-

ing statements are all those who participate in the man-

agement of the enterprise at any echelon. External

users include investors (both present and prospective),

creditors (both present and prospective), social con-

trol agencies (such as governmental units), labor

unions, employees, consumers, and the general public.


Internal Use of Accounting Statements

The internal users of accounting statements

are the various levels of management. Any given moember

of management is concerned primarily with accounting

statements dealing with his area of responsibility

and over which~ he has authority.

The chief function of management is decision

making. Managerial decisions may be divided into three

areas: planning, controlling, and evaluating. Account-

ing statements are utilized in aiding management in

recognizing the need for decisions and in guiding

management in making the decisions in all three areas.


Planning the future

The three areas of concern to management may

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

areas may begin with any one. The planning area has






-7-


been chosen because this would be the first area of

interest to the management of a newly organized or

prospective entity. After the enterprise is underway,

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

some writers express the view thiat accounting:

deals only with past events. This concept of accounting:

would exclude from the realm of accounting statements

those deaFLnd with the future, such as various types of

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

to include estimates of and prospects for the future

as well as records of the past.

After an entity is underway it is at once in

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

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

in the sense that a member of management may direct his

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

mnanagecment may focus its attention on theu plannin.: area

as a new fiscal year approaches.

Plans for the future are made after a careful

evaluation of the past. experience in the past mnay

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

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

accounting ; periods are a major source of information in

makint financial plans For subsequent periods, After

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

ation of the past as well as a consideration of thle

future.





-4-


Controlling the Present


Controlling the present implies the carrying

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

here, includes the concepts of coordinating and moti-

vating.

Management follows the activities of an entity

closely to see that there is compliance with the plans.

Timely cost accounting reports which can be compared

with the budgets are almost essential in this area,

Management may decide to alter plans even after an

accounting period has begun in order to control the

enterprise activities. Such changes may require spe-

oial studies and revised budgets. interim accounting

statements such as the balance sheet, income statement,

and source and application of funds are useful. Such

interim statements provide management with information

concerning current status before it is too late to

make changes and corrections. It is probable that

these interim statements would do nothing more than

help point out a problem. Further analysis would be

necessary to learn details.


Evalurating the Parst

Evaluation is the prooess of determining what

has been accomplished and the implications of these

past accomplishments. An effective way to determine

what has been accomplished is to compare results with






-5 -


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

other accounting statements are used by management in

evaluating thre past.

M:anagemeant is ordinarily interested in much

more detail than the external statement users. tixternal

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

is interested in the constituent elements. For this

reason, management may require detailed reports which

explain various sections of the general-purpose state-

ments or answer specific questions which arise.

Evaluation of the past is a prerequisite for

and biends into the planning area. except for the

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

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

the future, controlling the present, and evaluating: the

past are sepnents of an endless cycle of manaigerial

responsibility.


Stewardship

in a sense moanagemont uses the general-purpose

statements for external reporting in performin- its

stewa~rdship accounting: responsibility to investors and

creditors and in porformin : its public-duty responsI-

bility to the :eneral public. These evaluations of

the past are assumed to fulfill manaGement's responsi-

bility to outsiders. "bxternal reportin? has been

traditionally oriented towardl historical stewardship






-6 -


aspects, while internal reporting has been much more

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


External Use of Accounting Statements

The external users compose a more heterogeneous

group than the internal users. Mlost external users

have one thing in commson with each other; their primary

sources of information concerning the financial affairs

of an entity are the published financial statements.

The term financial statements is less broad than the

term accounting statements. Financial statements are

defined by Sprouse and Moonits as follows "Financia

statements are those which purport to show financial

position and results of operations, including support-

ing schedules, elaborations of special aspects of

business activity, rearrangements of underlying data,

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

Some external users have sources of information

in addition to the published financial statements.

Creditors and potential creditors may require of manaeB-

ment more detailed information such as plans concerning

the future. Social agencies such as governmental units

can and do require large quantities and various types

of data. Labor unions may sometimes acquire additional

data. The investors and potential investors, as a

group, have few other sources of information. They

must rely, directly or indirectly, on published finan-

cial statements. As individuals, they may have an






- 7-


inside track, but this is not considered a significant

exception.

An important purpose of accounting data is to

aid external users in making decisions. As the type

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

of user will be discussed separately.


Investors and Prospective Investors

The general-purpose statements distributed to

investors and available to prospective investors are

prepared largely from the stewardship point of view.

Management has an obligation to investors and pro-

spective investors to provide information which will

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

its stewardship responsibility. The Study Group on

Business Income says: "The annual finanotal state-

ments of corporations are primarily reports of steward-

ship, and the methods of presentation should be

determined with constant regard to that primary pur-

pose; but when corporations seek the advantage of

maarkcetability for their securities they inour an

obligation of disclosure to investors generally"

(3, P. 108).

The investor must make certain decisions con-

cerning his investment. Should he retain or terminate

his investment in a given enterprise? If he terminates

his investment, should he invest in other entities?






-a-


If he retains his investment, should he increase or

decrease it? These are some of the most important

decisions to be made.

The type of information used anrd needed by

investors is difficult to determine because investors'

motives are not easy to analyze. The investor may be

interested in dividends, appreciation, risk, and

diversity. Any given investor might assign different

w-eights to these various motives. Some investors may

be unable to analyze their motives. It is likely that

many investors have never tried to do so. Institu-

tional investors are likely to have more definite

motives than individual investors, Investors must

have rather clearly defined motives in order to use

financial statements effootively in the decision-

making process.

Once the investor has established his motives

for the investment he must determine how his invest-

ment measures up to the motives. This is best done

by comparing an investment with alternative invest-

ments. Also, a comparison of the financial statements

from year to year may indicate trends.

The potential investor faces essentially the

same decisions as a current investor. The main

difference is that comparison must be made between

the present use of money and the prospective invest-

ment as well as between alternative investments and uses.






S9 -


Creditors and P~rospective Creditors

Creditors are interested in the debtor's finan-

cial ability and willingness to repay debts. Pho

willingness factor is important but rather difficult

to evaluate. A debtors reputation and his financial

status are guides to his willingness to repay debts.

The better off financially a debtor is, the more Likely

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

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

good reputation and is financially able to doe so.

Creditors are seldom faced with the need to

makeo decisions concernin; current debts. Thnre is

usually nothing to do except wait for the maturity of

the principle, or perhaps to collect interest payments

and installments on the principle. bvon when they are

not faced with decisions, creditors are interested in

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

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

length of thle loan period.

the general-purpose financial statements are

used to help determlne a firm's financial ability to

repay deabts. Pho relationship of current assets to

ourrent liabilities is a -uide to short-run ability

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

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

ability to repay debts. The ;eneral-purpose financial






- 10


statements are intended to present this type of infor-

mation.

There are times and situations which require

decisions by creditors concerning outstanding debts.

The contract between the debtor and creditor may require

the debtor to perform specific acts. For example, he

may be required to place funds into a special sinking

fund for the retirement of the debt, The creditor wants

to know if the debtor is meeting such requirements.

There is the possibility that credit obligations

such as notes and bonds may be sold to others before

their maturity. The creditor does not necessarily have

to hold an obligation until maturity. A decision may

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

There is the possibility that legal proceedings

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

times a creditor will find it necessary to initiate

legal proceedings; even bankruptcy proceedings may be

necessary. The creditor needs to be in a position to

foresee the necessity of such proceedings.

For the prospective creditor or the creditor

who is considering making additional loans to a debtor,

decisions must be made concerning whether or not to

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

requirements are to be imposed upon the debtor. The

published financial statements of the debtor may be

helpful in making these decisions. More detail than





- 11 -


is usually included in the published financial state-

mlents is desired by the prospective creditor. Addi-

tional information may be obtained through more detailed

statoments or through personal interviews with the

debtor (or prospective debtor) or his representatives.

Information is also available from those who are already

familiar with the credit standing of the prospective

debtor.


Social Control Agencies

Social control agenotes usually prescribe their

own form of accounting statements. These statements,

usually prepared by the entities themselves or their

agents, provide the basis for various types of taxes

and controls. The social control agencies also use

accounting statements in making decisions concerning

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

of enforcing regulations,


Labor Unions

Labor unions are interested in ascertaining

the financial condition of the entities in which its

members are employed. The unions' main objectives are

to determine what benefits to ask for and to determine

a bargaining procedure.

Employees, consumers, and the Beneral public

as a group have less specific needs than other groups

of users. In general they are interested in products





* 12-


and services being sold at fair prices and factors of

production being paid fair prices.


Comparison of Internal and External Users

In the preceding paragraphs. many of the various

uses made of accounting statements by internal and

external users have been briefly summarized. For

internal users, the type of information and the quantity

of detail depends upon the level of responsibility and

authority. The lower levels require more detail than

higher levels. The published financial statements, or

"general purpose" finlancial statements, are not designed

to cover specific areas of responsibility and give the

amount of detail needed by lower levels of management.

Higher levels of management are more likely tD

find the published financial statements useful. How*

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

analysing the operations of an entity. It is likely

that top management does not desire details of every

item in the financial statements; only certain items

require more detail,

Moonitz emphasizes the different needs of

internal and external users in taking the position

that:

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





S13 -


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

Investors, creditors, and other external users

need information about the plans and accomplishments

of management in order to make the best decisions. The

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

nal users. Of course, various levels of management

need information on the effectiveness of lower levels

over which they have responsibility, Maanagement needs

information for planning, control, and evaluating.

This requires much more information than that contained

in the published financial statements.




The significance of accounting is reflected by

the use made of accounting statements and other account-

ing information by those internal and external to the

entity. These users and their general needs have been

presented.

The ways in which accounting statements are

used and the reasons for their use are not definite.

This has been the subject of some recent research, and

it is likely that even more research will be conducted

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

research utilizes the deductive approach, the empirical

approach is moare common. It is assumed in this study

that accounting statements are read and that the






,14,


readers utilize the information for the decision-making

process. "It is evident that accounting maeasuremaents

do represent information for decision-makers and since

decision-makers do read accounting reports, the Impli-

cation is strong that accounting measurements must

have speciflo behavioral implications, not mere general

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

Assuming: the basic needs of those who use

accounting information, this writer fools that the

basic problem in accounting is the method of measure-

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

know the amount of income earned over a given period

of time. Various amounts of income would be determined,

depending upon the method used to measure income as

several methods are available.

The purpose of this paper is to analyze and

compare the most prominent of the measurement methods,

or bases. The measurement bases chosen for inclusion

are historical cost, current cost, net realizable

value, and discounted cash flow.

The writer hopes that this study will provide

the reader with

1. An understanding of the maJor measurement

(valuation) bases by explaining each, explain-

ing and comparing the different interpretations

for each.






- 15 -


2. A demonstration of the likely effect of each

of the bases on the measurement of financial

position and periodic income.




This study is prepared largely from the point

of view of business enterprisses i. e., enterprises

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

no application to entities such as hospitals, charitable

organizations, and Imunicipalities, but that the emphasis

is on business enterprises.

One of the most important concepts underlying

accounting as practiced today is original cost, or

historical cost. This concept is generally accepted

in the determination of periodic income. The use of

this concept may have certain weaknesses. It may result

in asset values on the balance sheet which do not

reflect the worth of the assets. If asset value

increases or decreases are some~times not recognized,

gains or losses occur which may not appear on the

income statement. Revenue may be thought of as being

earned throughout the production and selling process

or throughout the selling and rendering of services.

Whon the historical cost concept is used, revenue is

not usually recognized in the accounting records until

a specific event such as a sale taesr place. These

weaknesses may be used as the basis for the suggestion






- 16


that there mary be alternatives to the historical cost

conncnt which would be more uiseful. The major portion

of Lbts ytudy is a diiscuusion of those alternatives.

ihe principles of monaulroitrnt and thpir imspor-

tance nnd application to accountin- aru tlscussed in

Chapter i1. rt is rmiphasizedl thant accountin: Is a

syst a of mneauriesent.

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

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

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

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

the realiztiton concent, on tlie accountin itatements

and cslaecliitl on the inconm statements, Saknesses

atree 'y referred to arn discussed in drotn in ordrlr

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

nhaster 11 is a discussion of curr nt cout.

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

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

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

in thris arra are divided into two catnrrories which are

disonrssc ds parately. one cateory includes all current

costs whiich wouid included prodluction incooe before a

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

current coStJ.

Jvst as to r. are several variations of what

thts writer refers to as current cost therz are aluo






- 17 -


several variations of not realiz~able valua, Chapter V

Is al discussion of these concepts.

The discounted cash flow concept isr discussed

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

concept of inemee

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

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

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

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

ment coie pts Jresented is compared with all of the

other three neasuronelnt concepts.

Are1 suimmary and conclutsions constituted Chlapter




Method

This study is based on library research and

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

Extensive empirical research would be necessary to

determine how accountin:: statements are actually used,

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

statement users, and the measurement methods which would

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

the writer relies upon his own assumptions and the

assumptions which have been made by other writers,
















CHAPTLR ~I


MtiASUREMElNT IN ACCOUNTING;


introduction

Measuremeont was at one time closely bound to

mnathemnatics. It is perhaps difficult to say whether

measuremnent had its beginning: in mathematics or mlathe-

matics had its beginning in measurement. shole-number

arithmetic and scales of numerosity (called numbering

in common usage) grew up together. "The numroursity

of collections of objects .. constitutes the oldest

and one of the most basic scales of mleasuroemnt"

(6, pp. 19-20).

The idea that measurement theory applies to

accounting is not new. Accounting has always been

concerned with moasurement just as it has been con-

cerned with arithmetic. There has been an increased

emphasis recently in the application of measurement

theory to the social sciences which include account-

ing.

The first part of this chapter is a discussion

of measuremeant theory. Types of scales and kinds of

measurement are included. Theu application of


- 18 -





- 19 -


measurement theory to accounting is discussed in the

second half of this chapter.


The Nature of Measurement

in common usage the terna "measurement" and

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

this paper the terms have much more narrow meoanings

than in common usage. Several definitions of measure-

ment as used here are given in the following paragraph,

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

of modern measurement theory, defines measurement as

"the assignments of numerals to objects or events

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

another authority on the subject, gives this defini-

tion: "Mleasurement of magnitudes is, in its most

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

rocal correspondence is established between all or

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

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

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

bell gives a definition very similar to that given by

Hussell. Mleasuremnent is "the assignment of numerals

to represent properties of material systems other than

number, in virtue of the laws governing these properties"

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

iharren S. Torgerson points out that, though

there are slight differences in these definitions, all

three deal with the same general problem concerning






- 20


"the process and rationale involved in the construction

of a scale or measuring device and the properties that

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

measurement usually refers to the application of a

scalo; in this paper measurement refers to the con-

struction of a scale. "Measurcomen as used here refers

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

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

(8, P. 14).

According to Targerson, an object is not

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

porties are essentially thre observable aspects or

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

The dofinitions of Russell and Campholl given above

indicate that properties are measured rather than

objects. Stevense definition indicates that objects

themselves can be measured.

Stevens considers his definition to be loss

restrictive. "Rostrictive definitions of measurement

have toppled as the practico of measurement, outrunning

legilsltion, has forced us to broaden and generalise

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

definition "liberal and open-handed" and realizes it

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

includes more clrssification as a form of measurement.






-21 -


Tylpos of Scntes

Mncaurement of properties requires the asslyn-

ment of numeorals to represent the properties. A one-

to-one relationship must exist between the quantities

of the proporties and the number system. Exie number

system used must have the following features:

1. Orrdered numbers,

2. ,rderod differences between numibers,

9. A ulniqlue origin, "zero."

These three features may be called order, distance, and

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

Vhen numbers are assigned to objects "`so that

the relations between the numbers reflect the relations

between the objects themselves with refspect to thie

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

l ished.

JO the three characteristics listed above

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

involved in the usual meaning of measurement. Pho other

two characteristics may or may not be involved in a

given mrasurrement. If a scale necessariLy involves

order but may or may not involve distant and orkgin,

there are four possible combinations of these three

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

Order is implied in the ordinal scalP "so that

the order of the numbers corresponds to the order of

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





-22 -

scale has the feature of the ordinal scale with an

added feature of a meaningful size of the distance

between pairs of numbers. AZn interval scale with a

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


TABLE 1

FOUR TYPES of SCALES


No Natural origin Natural Origin


No Distance Ordinal Ordinal Scale
Sale !ith Natural
Cri:in

Ulstance Interval Ratio
Scale Scale



stevens adds to these conventional scales a

lower scale which he calls the nominal scale (see

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

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

distinct through the label of numnerals is considered

to be the natural basis of measurement and is called

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

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

characterized by numerals--which are subject to order

rank in conformity with the numerals assigned"

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

enforces regularity of class-interval. The last

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

is not arbitrarily chosen but given somehow beyond

more convention" (10, P. 59).









TA9ZLS 2

A\ VLAjSZFIFAICAIN )F iCALIS OF MlAnSURAMANjlT*


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


Nominlal Determination P'ermutation


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


of equality


group 7
I' = f(*)
where f(x)
m~oans any
one-to-one
substitution

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

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


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



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

Temperature
(Fahrenheit
or Colsius)
Position
rimeo (calendar)
Enlergy
(potential)
Intelligence
test standardd
scores" (2)

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


Ordlinal Datormination
of greater or
Loss





Interval Determination
of tle
equality of
intervals or
of differences


Ratio Determination
of the
equality
of ratios


Simnilarity
group
I' ex
cO >0









~th nominal scale, involves thr assignment of

numaerals to thea object itself rather than to the pro-

parties of the object. This would not be considered

measurement at all by somef definitions such as the

conventional definitions rgiven by nussell and Campbell,

Thus, Steeves considers msore Olassification as measurre-

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

Stev~ens also inclCudes Ysoe eXampleS in the

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

sidered neasurement by RusselL and Campboll. rHe

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

scale, position as an oxample of the interval sealo,

andi numerosity as an example of the ratio scale.

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

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

and Targerson prasont still more variations in scales.

inch of Stevnns' scales after the first "igrows

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

property or condition, thus restricting: its application

to a smnaller but more speolfic area than that of the

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

soalJs i; based on how much information is rouresefnted

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

assigning numbers decreases av oneo goos down the scale--

either Stevons' or the coniventional scales.





- 25 -


hinds of 40asuremecnt

Andns of Informnation represented by numerals

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

attributed in a particular scale to those charactorts-

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

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

characteristics might obtain meaninR:

1. iharough Laws relating thle property to other

proporties--derived measuremecnts.

2. "y arbitrary dlefinition--flat meoasuremennt.

3. T'hrouuh natural laws relatin: various qjuantities

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

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

There is no necessary relationship between types

of scales and Kinds of leasurement. A particular scale

of measurement is not limited to any p~articular kind

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

"Theu view has been hold that the assignment of

numoerals to objects other than by the procedures

involved in fundamental or derived mreasurcment is not

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

with this and feel that a more general definition is

needled to include fiat measurements.





- 26 -


Impact of Merlsuremenlt on Ancoonlntin7


Definitions of Accounting

Accounting, by definition, is concerned with

measurement. It is generally accepted that financial

data is the subject of the measurement process.

"Accounting is a discipline concerned writh

the quantitative description and projection of the

income circulation and of wealth aggregates by means

of a mnethlod based on the followringq set of basic

assumptions: monetary values, time intervals, struc-

ture, duality, aggregation,. economic objects, inequity

of monetary claims, economic agents, entities, eco-

nomic transactions, valuation, realization, classifi-

cation, data input, duration, extension, materiality,

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

as used in this definition, implies measurement.

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

Accounting might even be considlered a theory

of measurement: "Since the main functions of account-

inE are classification and evaluation, the thought of





-27 -


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

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

Theae areo repre~sentative def~inlitions of account-

inL' idlich emphasirze the measurement aspect.


Importance of Hlensurement in Accounting

Galileo demonstrated "that qluantification is

the best and most accurate way to acquire empirical

knowledge." He indicated thu maxim in this proverb:

pleasuree all that is measurable and attempt; to mrake

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

"The basis of accounting is measurement" (12,

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

perhaps the purpose of accountingc could be better

expressed as: to measure financial data, Financial

data nay be arranged in the form of financial state-

ments. Thus, the two primary financial statements

measures financial position and the results of operations.

Other financial statements meas~ure changes in retained

earnings, the flow of working capital, and the flow

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

cial dlata such as the cost of products, variations

between the actual and standard costs of products, and

the differences in costs and revenues between alter-

natives.

Measurement is concerned with the quantitative

aspects of objcts. Byr tradition, at least, accounting

is concerned with the quantitative aspects of objects.





-=?-


Perhapls aclcouninglr -ouldl ' c no rrrne with oterc

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

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

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

fere~d by the president of a businosw corporationl may

be of more interests to the stockholders than much of

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

ried on thec books, for exaraple. Traditionallly, goodwill

carried on the corporations books is reported on the

balance sheet; a heart attack suffered by the president

is not mentioned in the financial statements. it mray

be argued that the president's heart attack will be

reflected in the finanotal statements in the future

by moans If reducedi profitability, but theJre is ai time

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

thie possibility of extending accounting: to nonquanti-

tative aspects of objects.

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

gy tradition, accounting: has confined its

quantitative measurement larg~oly to monetary terms,

Measurement of other quantitative aspects of objects,





- 29 -


such as the physical units of production during a given

moonth, is wilthin the range of accounting, but such

measurement has not gained the status of measuremjnt

in moneltaryy sterns.


13asic Structure of the Busine~s
Measurolement Process

Thle follow~ing structure of thec business measuro-

aent process has been suggested by Paul Kircher:

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

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

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

LI. Chloice of:

(a) a monsuring method:

(b) a mcasuiring unit.

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

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

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

"A central problem we face is to define the

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

cellod them) thlat accounting should seekr to measure"

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

structuro are important but not included within the

main purpose of this paper. Thet profit motive is usually





-33-


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

Entities other than business entities have other objeo-

tiveS.

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

The subgoals of business enterprise have been

given more attention in recent years than before. Sub-

goals may include importance in industry, growth, cash

flows, customer goodwill, and public service. It is

difficult to measure subcoals. "In most cases our

ability to isolate specific benefits from a general

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

generate enough information for mneaningful mneasure-

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

in this paper thait accountinY is primarily concerned

with the measurement of profit.

The selling of products andl the rendering; of

services are usually considered to be the means of

obtaining : the objectives, The financial aspects of

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

aspects to be measuredl. "Accounting: measurement is

primarily concerned within the measurement of assets and

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

there are accountants who suggest the extontion of

measurement to aspects other than financial aspects.





- 31 -


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

scope of t~.is study.

Accountants cannot always measure what they

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

enterprise is to make a profit, nocounting should

measure the amount of profit. There is no perfect way

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

problem is to substitute someuthing: that can be measured

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

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

surrogates, or substitutes. "Accouitnting data as well

as other types of business information are surrogates

whichi the decision-maker uses to carry out the decision

process" (201, p. 192).

The basic measuremn~ut Lask of accountinge is the

selectionl f a mioasuring: malthodl and a measuring unilt.

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

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

the decisions a measurer must makeo. "Tha neasurer must

develop a language which adequately commnunicates to

another person whiat the useur must Jo to utilize the

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

Az dileiana arises inl the selection of a lan-

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

this way:

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






-3?


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

Accounting expresses financial data in mnonetary

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

accounting is usually the dollar. The selection of the

dollar as the measuring unit does not solve the measur-

ing unit problems. A significant difficulty to be

solved concerns how to deal with the changing purchas-

ing power of a dollar. Are measurements to be made

in terms of dollars with no recognition made of the

changed purchasing power between two points in time?

"Measurementss of financial position and income based

on numbers of dollars without regard for any differences

in the economic significance of those dollars are cruder

economic measurements than we are capable of providing"

(22, p. 110).

Thre choice of a measuring methoed is the central

theme of this paper. "Incomne and wealth are dependent

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

Several possibilities are suggested, discussed, and

compared. "Accounting is a measurement system which

is plageod by the existence of alternative measurement

methods" (23, p. 474).

The fifth part of the structure is the act of

applying: a measurement method. This is measuremlent

according to the common use of theo word and is not

relevant to this study.





39-


The sixth component of the structure is the

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

This use actually has implications for the selection

of a measuring method and a mrasuring unit. "The

measurement procedures undlerlying any set of accounting

information are inevitably linked to the purpose for

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

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

if the primary goal of a business enterprise

is to make a profit, then accounting should make a

contribution toward this goal. Accounting should make

a contribution to whatever the goals of a business

might be. Therefore, evaluating the effectiveness of

the measurement in attaining an entity's objectives

is an integral part of the measurement process.

The Final results of the measurement process

is really tbo deciding factor in determining which

measurement method and unit is best. According to

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

'desirable' manner in response to the values of assets

and income prepared under one set of weights than

under another set of weights, then and only then we

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





Carl Derinn has set forth the following similar

li st as typical conrditions (anrd preconditions) for

accounrtin3 measuremlent:

1. S.oifying anid ordering worthy objectives;

2, Dtermnining dcoisions and information needed
to accomplish objectives;

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

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

5, DouidinL: what aspects of theo events should be
abstracted;

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

Number three is the only condition listed by

Da~vine which is essentially different from those listed

by Kiroher. Devine points out that an ethical aspoot

is involved in ordering~ individuals and that accounting

should be concerned with this othical as~ect.


bleasuremen~t and Va~lue

Measurement is a torul. which has ganined prestige

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

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

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

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

sciences.

Spouse says accountants are really talking:

about the measurement of value. "TChe relevant attri-

bute with which we are essentially concerned is that






- 5 -


of value: the measurement process in which we are

fundamentally engaged may be properly described as

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

because of the emotional effect of the use of the term

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

tunate tendonoy to arouse emotional reactions among

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

accountants may avoid using the word valuation. "Mleas-

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

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

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

Sprouse believes that accountants should

recognize valuation as the relevant attribute in report-

ing to the stockholders of a business enterprise. The

finanotal accounting process "could be improved enor-

mously by a clear-cut recognition of value as the

relevant attribute"(a22 p. 108).

R. J. Chambors has a different view of the

relationship between measurement and valuation. "It

seems .. that greater clarity of argument is possi-

ble if the distinction is made between acts of valuation

which always have reference to the future, and acts of

measurement which have reference to the past and

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

are interested in measurement--not valuation. Most

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





-36-


In common usage, measurement implies accuracy.

Results of measurement (numnerals) are often taken as

fact. A given person weighs one hundred sixty pounds.

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

These measurements may not be accurate. The given

person may weigh one hundred sixty pounds and three

ounces. The measurement couldl be even more nearly

exact, using even smaller units than ounces. There

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

plcatly accurate. In fact complete accuracy may be

impossible. Comoplete accuracy might not be recognizedi

if obtained.

The decree of accuracy to be obtained by any

measurement (accounting or other) depends upon the

purpose for which the measurement is made. If a room

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

mont should be within perhaps one-fourth inch of the

actual dimensions. If the dimensions are obtained to

determine the number of square feet per student for

testing purposes, measurements might well be rounded

off to the nearost foot.


Accur;acy in Scienocs

The physical sciences are sometimes thouGht

of as being exact. Chambers says "the presumption that

the exact sciences provide measurements which are

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






- 37 -


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

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

Chamblers applies this idea to accounting, The

current cash equivalent (hts proposed measurement) can

be found for all1 assets withi some derree of accuracy




Probability and Degree of Error

Compylete accuracy in accounting is never pos-

sible. Furthermore, it may be impractical to obtain

complete accuracy or highly accurate data even if it

were possible. Therefore, the uiser of financial data

should be aware of thle degrou of accuracy reflected in

the Financial data being utilized, Perhnaps financial

statements should indicate the probability and degree

of horror inaerent in measurement methods used and in

the results of thle measurement. "The information of

measurement is considerably enhanced if the degree of

accuracy or error of the pertinent measuremient is

known' (10, p. Y0).

Probability has been given very little con-

sideration in accounting although it is interesting

to notice that "the usual ordering of assets on the

balance sheet, by chance or otherwise, tends to follow

the level of confidence In the measurements" (17,

p. 22).

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






- 38 -


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


Scates in Accountin;:

Stevens' nominal scale would include the chart

of accounts within the range of measurement,

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

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

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

val scale. The dollar scale is a ratio scale.

"There are, however, instances of multiple

measuremnent, the dimensions of which are measured on

scales that differ froms each other; the accounting

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

The chart of accounts (nominal scale) is used in

classifying the debits and the credits of a transaction.

The time dimension Is measured by an interval scale.

The dollar amount is measured on a ratio seate,





Kindls of Monsuremeant in Accountin7

"Most of the economic and accounting measures

belong in the category of measurement by fiat, which

is reflected in a certain definitional arbitrariness

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

that neither fundamental nor derived measurement is

used to much extent in accounting:

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

Carl T. Devine feels that attempts by Torgerson,

Mattessioh, and others to find fundamental measurements

tend to be fruitless endeavors.

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

Sprouse suggests, on the other hand, that

direct measurements are of ten used in accounting.

Examples include the measurement of assets such as

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

the fact that fiat measurement is more often used.

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





-40-


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


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

The American Accounting Associationl's AZ SEtat-

ment of a ac Accounting Theory published in 1966 sug-

gested thle following four accounting standards:

1. nnlovance (Usefulness)

2. Vorifiabiflity

3. Freedow from bias

4. :cuantifiability (25, P ?).

Ilthese four accounting standards mighlt wall serve as

critorbia for the selectionl of th~e most approzriatej

meoasurement meithod.

The Harvard Business School Acco~untingr Rounrd

Table held in 1966 presented a slightly different set

of criteria for measuroments

1, objectivity

Twro rellat~ed requiromaunts:

(a) Certain standards should be used in pre-

senting financial accounting information,

and

(b) It should be feasible to verity financial

accountling information.

2. Usefulness

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





- #1


A combination of these criteria will be u~sed

in dijcussing and coamaring the various mueasureme-nt

miethuds. The combilned list follows:

1. Xulevance (Usefulness)

2. Objectivity

(e) Verifiability

(b) Freedom from bias

3. Fueasibility

4. Quantifinbility




Maspsuremeont is the assignnment of numerals to

objects or properties of objects to represent such

objects or properties. Accounting, as it relates to

quantification, is a systemn of measuremnent.

iioasurement is an internal part of the physi-

cal sciences and the soolul sciencres. The nature of

meoasurement has beern discussed in rather broad terms

in this chapter because mousurement theory applios to

such a broad area.

.Measuremeant theory has beeni related to account-

ing in the latter part of the chapter in morn specific

terms. It *as concluded that the selection of a

muesurement method is one of the mnost significant

problems of accounting.















CHIAPTER III


HI~STORICAL COSTr


Introduction

thlis chanpteor is the first inl a series of four

chapters whlich discuss major measurement methods, or

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

ment base which may be called historical cost (or

original cost;). Hlistoricnl cost is generally accepted

for use in nooounting statements. Thlis chapter is

largely a discussion and criticismo of accounting, state-

ments as they are currently prepared.

Thle chapter begins with a definlition of his-

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

some related concepts which underly the preparation

of accounting statements. As the realization concept

and the historical cost concept are closely related

the realization concept is of particular concern in

this chapter. The historical development of the reali-

zation concept is followed by a discussion of the

present status of the concept.

TLhe last part of thle chapter concerns the

effects of historical cost and related concepts.


- 62 -





especially thle realization concept, on accounting

statements. Thle use of this measurement basis is9

criticized.


Definition of Historical Cost

Accounting statomocnts are prepared in terms of

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

they are recorded at cost, a measure of the current

exchange value at that time. Historical cost is thle

cost arrived at in the transaction concerned; histori-

cal cost is transaction price. A record is made when

a transaction occurs between an enterprise and another

party. Thle dollar amount of the transaction is con-

sidered to be an objective basis for the valuation of

that which is exchangeod. This dollar amount, trans-

action price, is the historical cost of that which is

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

adjusted for such factors as depreciation) as long as

they are owned by the enterprise.

There are a few exceptions in practice to the

historical cost concept, but in general when an eniter-

prise oxpects to operate indefinitely, the original

cost concept, or historical cost concept, is adhered

to in the preparation of accounting statements. The

following quote probably represents the attitude of

accountants as exemplified in practice.

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






-41r-


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

T~his quote from the 1936 American Accounting

Assoolation Statement (A Tentative Statement of Account-

ingq Priscioles Underlying Corporate Financial State-

monts) represented the attitude of the Executive Com-

mnittee at that timae toward historical cost.

The historical cost concept is criticized with

varying degrees of severeness. As an illustration a

quote is rriven here fromn Harry 'I. Kamlph:

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



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

1. Return on total capital emnployed.

2. Return on capital equity or stockholders'
investment.

9. optimum mortgage loan financing terms.

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

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





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


Related Concepts Underlyint:
Accounting Statements

The following concepts are closely rotated to

the historical cost concept and also, like the histori-

cal cost concept, underlie the accounting statements.

Presently accepted methods of accounting include all

of these concepts.


Going Concern

There was a time when the venture was the pre-

dominant form of business enterprise, AS ventures

lasted for only a relatively short period of time, an

accounting was usually made only at the end of the

venture. The venture form of business enterprise is

almost completely gone. It has been replaced by

business enterprises which remain in existence for

long periods of time. Although thousands of enter-

prises go out of existence each year, a majority of

business enterprises, especially medium and large-sire

ones, have lives of indefinite length.

Since business enterprises usually operate for

Long periods of time and are not expected to discon-

tinue in the immediate future, they may be assumed to

have a continuous life. This "continuity concept,"

or "going concern concept," assumes that business





- 6 -


enterprises remain in oxistenoce indefinitely unless

there is evionce to the contrary.

AccountinC statements are Kenerally prepared

on this assumption. The primary imipact of this concept

is on the valuation of assets. Thiis assuaption has

implications for income moasuremnent due to thle inter-

relationship of the balance sheoet and the income state-

ment.

Accountants hanve generally felt that since

Liquidation values may be of little importance to a

going concern, this continuity of life concept is used

as julstification for another concept, the cost concept.

The following quotation from Heanry Rand HantlieLd's

Modern Accounting: points out the insignificance of

liquidation values.

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

This quote does not mention how to arrive at

the value to the holding concern. This does not

necessarily imply a historical cost basis. Reed A.

Storoy quotes LHatfield as saying the going concern is

not usually taken to its logical conclusion which would

be to value merchandise at net realizable value. A

Logical application of the going concern concept would





- 47-


be the mqasurement of firedl ;rssts at cost; because

changes in rnine from one period to another which are

not expected to be realized by the sale of the fixed

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

rent assets, especially thosea which will be conver~ted

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

to carry thle going concern assumptlion to itJ logicalI

conclusion left a gap in accounting theory- which was

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

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

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


Time Periods

Undesr the venture fore of business enterprise,

an accounoting was made upon tha completionn of thle

venture. Thie amount of business income earned can

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

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

end of the enterprise life to meaasure income.

The time-pariod convention has developed to

broea the life of an enterprise into arbitrary time

periods. This arbitrary timo period is usually a year.

The calendar year is used by many enterprises. 'This

may be a carryover from an agricultural society in






-11-i~-


which thle calendar year was the natural business year.

Many business enterprises ear now using what is

consider a natural business year for their particular

type of business.

accourntingi for a business entity bry time periods

6ives interested parties useful information about the

enterprise before its life is over, Some accuracy is

sacrificed for timeliness.


Realization

Since accounting attempts to measure income

by time periods there must be a criterion to determine

when income arises. The realization concept has

developeBd to meet this need. The? dominant Interpre-

tantion is that a changer in value has taken place with

sufficient objectivity to warrant recognition in the

accounts. A sale is usually thought of as having

sufficient objectivity and is generally the accepted

oriterton for realization. The realization concept is

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

recorded at original cost until realization is deemned

to have taken place.

The development of the realization concept

helped brinZ about the development of the historical

cost concept. "The assertion by the Court of the

realization postulate lent support to the proposition

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






-49-


and thrus contributed to the building up in accounting

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

(3. r. 27).

Like the historical cost concept. the reali-

ration concept is also based on transaction price.

No increase in the value of an asset is recorded until

another transaction occurs. TIhe realization concept

delays the recognition of revenue until a sale or some

other sufficiently objective event occurs. This means

that the usefulness of accounting may be impaired by

the time delay.

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

In emphasizing the importance of the evaluation

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

the demand for data is predicated largely upon the

existence of change and uncertainty in the economy,

accountinR data, to be most useful, should be designed

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

Like the historical cost concept, the reali-

zation concept results In some limitations in the

determination of periodic income. 'The realization

concept will be disonssed In more detail in a subsequent

section of this chapter. Enough has been said to






- 50 -


indicate that the realization concept may limit the

usefulness of accounting statements.


MLatching

While the realization concept determines the

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

ing concept determines what costs become oxponsos to be

matched against revenue. The matching concept means

that those costs which were necessary to attain the

revenue of the period should be matched with the revenue.

The expenses which apply to a given period are

those which can be matched with the revenue which is

recognized during that period. The following statement

is made in the 1957 revision of Accountinq and Heport-

in:: Standards for Corporate Financial Statemnents: "The

com~mittee advocates that costs (defined as product and

service factors given up) should be related to revenues

realized within a specific period on the basis of somae

discernible positive correlation of such costs with the

recognized revenues" (33, p. 969).

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

The matching process developed when the "in-

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

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

determination as being ebssntially a process of matching






- 51 -


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

recognition determines to a Inrgo extent the timing of

expense recognition and therefore the timing of not

income recognition, Matching is necessary to determine

the not increase in assets which Is similar to "increased

not worth" because not assets equal net worth.


Objectivity

Objectivity Is difficult to define. A key word

in the definition of objectivity is "unbiased."

Maurice Moonitz defines objectivity as "unbiased, sub-

ject to verification by another competent investigator"

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

reach approximately the sam.e conclusions.

HlaroLd iE. Arnett gives the following explanation

of objectivity:

Financial information is objective when:

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

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

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

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

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

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






- 52 -


Thcre are oegroos of objectivity. Accuracy is

significant Ln detenaning whether or not data is

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

able accuracy, it assumes a large degree of objec-

tivity" (36, p. 251).

Objectivity is considered to be an outstanding

characteristic of historical cost and the realization

concept.


Conservatism

Conservatism is sometimes expressed as: Pro-

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

in his loventory of Generally Acceptedl Accounting Prin-

ciples for businesss iEnterorises, explains theu concept

of conservatism as follows:

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

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

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

Grady notes the close relationship between the

conservatism concept and the realization concept by

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

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

Conlservatisa is actually a technique For

delaying thle recognition of revenue. Realiantion and

conservatism are related because tho realization concept






- 53 -


is a fairly conservative concept in that profits are

not anticipated very far in advance of the actual

receipt of cash, Zash receipts would usually be the

most conservative method of recogniring revenue. Theore

are exceptions to this statement such as the advance of

cash before a product is delivered or services are ren-

dered.

Historical cost is also a conservative concept.

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

tory valuation is even more conservative.


Eurmmary

Th~e concepts discussed above are considered

among thoe most basic accounting conIcepts. It is genl-

erally recognized that the use of those concepts aloni:

with other generally accepted accounting princi,,les

and procerdures results in accounting statements which

have limitations.

Thris discurssin of these basic concepts is

intended to show thiat accounting statement are know~-

ingly prepared under assumptions which will not result

in perfection. It is the purpose of a latter section

of this chapter to point out weakrnesses in accounting

statements due to the use of those concepts. It is

the purpose of subsequent chapters to discuss alterna-

tive measurement bases which insight result in better

accounting statements.






- 5L -


Historical cost may be thought of as the measure-

ment base wh~ichi is largely controlling in the preparation

of accounting statements. It is closely related to the

other concepts discussed: here, but it is especially

related to the realization concept. The realization

concept may be thought of as the application of the

historical cost concept. Because of the imsportance of

the realization concept in current-day accounting, the

following section of this chapter is devoted to this

topic.


The Realization Conqcpt

he realization concept is thle currently accepted

basij for revenue recognition. According to the soost

comnmonly accdptedl ruaning: of realization, revenue should

be recognized wihen a sale takes place. There8 are other

meanings for realization and criteria for recognition

as are indicated later in this section. This section

considers the historical development of thie concept andl

its present status.


Historical Development of the
realization Concept

Iho Study Group on Business Income points out

thrat the postulate of roalization is of quite mnodern

oriigint

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





- SS-


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

As an example, the Study Oroup quoted the

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

ine Prnotice and Procedure (1913):

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

W. A. Paton also accepted an increase in value

theory. He makes the following statement in his

Accounting Theory, published in 19221

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

In those early years of the current century,

the realization concept did not have its current status.

The events of the times probably brought about the

almost complete acceptance of the realization concept.

The sixteenthl amendtmont in 1913 may have had

a great effect on the creation and acceptance of the





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

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

thle realizatlion concept. In1 this decision, Charles

Evans, Hughos said:

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

The economic exporience of the 1930's falirly

well finalized the elimination of the increase-in-

value concept.

The realination concept had Cained acceptance

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

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

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

a salj in tha ordinary course of business is effooted,

unless the circumstances are such that the collection

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

p,. 423;,


The Present Status

Erelization is currontly the generally acoupted

criterion for revenue recognition. Recog~nition refers

to the timing of recording revenue on the books of an

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

to revenue recognition, is primarily a timing device.

"The test of realization is used to determine when to

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





-57 -


income from sale arises at the m~oment when realization

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

and revenues are matched to determine income, income is

assumed to arise when the recognition of revenue takes

place.

There are somo differences of opinion on the

exact moaning of the realization concept. The 1957

Statement by the American Accounting Association Com-

mittee on Concepts and Standards Underlying Corporate

Financial Statements defines the realization concept

as follows:

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

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

and "sufficiently definite and objective." According

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

change may have taken place prior to the time it became

sufficiently definite and objective for recognition"

(96, p. 251).

Floyd W. Windal defines realization by using

the three key ideas from the definition just quoted:

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






- 58 -


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

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

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

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

Inherent in these definitions is the criterion

that revenue must have been economically earned before

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

cally earned" means that a value increment has taken

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

nues are nffectively earned when substantially all of

these activities necessary for and associated with the

production of those revenues have been completed" (41,



Other criteria have been used in determining

when realisation takes place. Ilobert T. Sprouse and

Maurice Moonitz list tests which have been used to

determine if an item Is realised or not:

1. It had to be earned.

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

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

4. Lt had to be severed from capital.






- 59 -


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

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

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

The Amorican Accounting Association 1964 Con-

capts and Standards Research Study Committee on The

Realization Concept also presents its view of the

realization concept:

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

1. The nature of the asset received;

2. The presence of a market transaction;

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

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

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

this 1964 Concepts and Standards Research Study Com-

mittee. The conclusions of the committee cannot be

classified as Generally accepted. In this sense,

the conclusions and recommendations cannot be con-

sidered as part of the present status of the reall-

zation concept. They are included here because they

have been made, and in this sense they affect the

present status of realization.





- 60 -


t'he following two problems were discussed by

the committee:

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

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


The committee arrived at these conclusions:

''The comml~ittee unanimously recommends that the efforts

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

will, that can be supported by adequate evidence be

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

of the commaittee recommends that 'unrealized' changes

in the value of assets should not be included in the

computation of reported not income, but should be

shown on the incomeo statement below the not income

line" (42, pi. 312).

In considerinZ shen realization should be

regarded to have been achieved in a revenue trans-

action, the committee made the following docisionsr

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

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





- 61 -


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

There is often some confusion between the

terms recognitionn" and "realization." Robert T.

Sprouse has made some observations concerning this

confusion. "Prior to 1957, the term realizationn'

was widely used and I think g~enerally understood"

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

was expressed by the P'aton and Littleton monograph:

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

The definition given in the 1957 Revision

suggested that revenue is realized when it can be

recognized in the aooounts, Sprouse refers to this

as a "drastically different concept of realization.

...This concept renders realization devoid of any

special meaning; realization is made merely a synonym

for recognition" (43, p. 522).

The two terms, realization and recognition,

are often used interchangeably. As the realization

concept is presently accepted as a guide in the timing

of revenue recognition, then realization and recognition






- 2 -


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

implies thle occurrence of the other. In comrmonl usage,

the two tlrms often imply the stme thing.

Recognition of revenue on the basis of the

realization concept Goes not necessarily imply that

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

Sprouse and! Moonitz express this idea as follows:

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


Currently accepted exceptions
To the igeneral rule for realization

Althoughn in current practice realization is

usually deemed to take place at the point of sale,

there are exceptions to this general rule. For example,

in unusual circumstances realization is deemed to take

place when ph-ysical production occurs rather than when

a sale takes place. In order for realization to take

place due to physical production, "production must be

accomplished either by a binding contract For sale of

the product or by a market of a certain character"

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

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

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

coffee beans), crude oil, and securities meet these

requirements. The market price or contract price is





- 63-


used as basis for determining yrovnue. Markrtt prico

may be used although it may vary somewhat from period

to period,

A changes in value between the date of completed

production and the date of sale dloes not imply that

early recognition was incorroot. nussell Dowers makes

the followings statement concerning wheat:

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

Even incomplete physical production may be

appropriate for realization to take place. Bowers

suggests three ways in which income may be objectively

measured which are particularly applicable to incom-

pleted contracts:

1. A completed transaction between parties of
independent interest.

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

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

Shipbuilding is one example of incomplete

physical production in which it is customary to recog-

nine revenue before physical production is complete

and legal title is conveyed to the purchaser.






- 66 -


:)ther presently osaopted excrntionls to the~

reaulization rula include ropincoment costs in cost-or-

market calculations, index numbers of specific commodi-

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

Lifo, ami estinates of net realizable value of by-

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

Miase several exceptions to the realization

concept tidicate that ourreit practice covers a fairly

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

range of practice in considering incomec to be realized:

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


Suranary

Thre realization concept is a fairly recent

development inl accounting, having developed early in

the present century. At present it is a generally

accepted concept.

The usual interpretation of the realization

concept is thiat; revenue may be recognized when a sale

takes place. Realization is the usual guide, or

criterion, to revenue recognition. Here are some

exceptions to the general interpretation of the reali-

zation concept. Exceptions involve the valuation of






- 65 -


assets such as certain metals, agricultural products,

socurities, and other assets such as ships which

require an unusually long period of time for con-

struction,


affects on Accounting Statements
And Criticisms

Accounting statements are currently prepared

under the historical cost concept of measuremnent, As

has boon pointed out, the realization concept is an

important concept related to this measurement base.

The purpose of this section is to point out some of

the shortcomings which result when thle historical cost

measurement base is used.

Accountants themselves recognize shortcomings

in accounting statements. Hloward I. Ross made the

following statement in a presidential address at an

annual meeting of the Canadian Institute of Chartered

Accountants: "Thle basio problem which I would like

to concentrate on today is posed by the paradoxical

fact that accountants appear to divide their time,

perhaps almost equally, between preaching, on the one

hand, the great importance of publishing regular

financial statements and insisting, on the other hand,

that one who relies on financial statements, in almost

any of the circumstances in which one would normally

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





- 66 -


An obvious problem inherent in the use of the

historical cost concapt is that accounting data do

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

remembered that historical cost is not Intended to

measure value.) The following gquote by idwards and

Bell emphasizes this in discussing the effect of the

application of the realization concept:

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

even though a statement user may realize that

the statements were prepared under the realization

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

implications of the use of this concept. iidwards and

Hell point out the following two limitations which

result fromn thie use of the realization convention:

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

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






- 67 -


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

c. Balance sheet values are badly distorted.

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

Theicse limitations result because the retaliation

convention requires a sales transaction. The concept

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

changes in1 individual prices. Another major limitation

implicit in the use of the realization convention is

the failure to recognize changes in value as production

takeos place and as services are rendered.

The realization convention has the effect of

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

of steps the entire credit for having earned the resulting

income. Since "income accrues to an individual or a

business in something like a continuous strome,." it

may be illogical to assign all income to only one

step (48, pp. 80-81).

In defense of the sale as a test of income

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






- 63 -


business process which indicates that the task is now

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

The objectives of accounting statziments were

discussed generally in Chapter I in terms of those who

use them. In that chapter no attempt was made to

evaluate howr well accountinR s~tatments meet their

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

how wuell accounting statements prepared under the hlis-

torical cost basis of measursrnont meest the objectives.

Just as the objectives were classified by types of

users, thOse commennts concerning how well objCetives

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

lems of comparability and uniformity are discussed

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

and internal statemont users.


Comparability

Doth internal and external users of accounting

statements are interested in comparability, that is,

companrine the accounting statements of a particular

entity over a period of time. Comparison of those

statements should indicate trends.

Accounting statements for different periods

may not be comparable for two principal reasons: alter-

native methods and price-level changes.


Alternative methods

Generally accepted accounting principles include

alternative methods of handling: some problems, (However,





-69-


"generally accepted accounting principles" should be

applied consistently from year to year. ) If a method

of handling a problem is changed, the effort of this

change should be shown for thle year in wrhich the change

took place. Comparability Is lost if a change inl method

is not explained. Compa~rability is also lost between

the years before the change and years subsequent to

the change.

The possibility of using alternative methods

in accounting not only presents the problem of compara-

bility but also presents the question of howv different

managerial decisions would be if an alternative method

had been used. This Involves the problem of comparison

of actual results with ihat would have occurred under

alternative procedures. Although business games have

been used to determine the effect of alternative proco-

dures, conclusive evidence has not been found. llliam

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

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

major differences in results among the games using dif-

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

the other hand, Thomas R. Dyckmlan reached the opposite

conclusion in one study but the same conclusion in a

second study (50, P. 175).


Price-level changes

Although hiistorical cost is used in accounting

statement preparation, it is an accepted fact that the





- 70 -


price level has risen substantially during the past few

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

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

currently purchased, es~peially thP fixed assets,

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

entity may appear to own more assets than it did in

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

assets were purchased at a low price Level, it will

not comparre rll in size with other entitina.

Not income is also affected by the price-level

changes. If costs arisin in past periods are matched

against revenue of the current period, the not income

angears higer~TC during periods of increasing price

levels than it would during a period of stable or

decrreasitn prices. For examples inventories used or

sold during a period may have been acquired in prior

periods at lower prices. For another example, depre-

ciation is based on costs of fixed assets acquired in

prior periods--perhaps forty or fifty years before

the current period.

Arthur L. Thomas has made the following obser-

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

difficult to see howr a rate of return can mean much

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

unlike historical costs--some current, some stale,

some oriiginating~ so far backe in time as virtually to

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





- ;I


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

price-ievel changes andQ specific price-level changes.

As all prices do not move togtaher, prices of specific

items Pay be called specific Pricer levels. Tno general

prica lovel is an average of specific prices. it is

obvious that specific price changus are not necessarily

consistent with general price-level changes; thecy may

even bJ in the oppousite dirootion.7

Thiis implies that ant adljustmuent for general

price levels may not result in comparablity between

accounting6 periods. An ardjustment for a gecneral price-

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

sipecific item in the accounting: satemenPits involved a

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

level change.


Unliformoity

Comparability of accountinR statements between

enterprises is often referred to as the problems of

uniformity. Just as there are two principal reasons

for lack of comparability between accounting statements

of various years for a particular enterprise, there are

also a few principal reasons for lack of comparison

between entities.


Alternative meathods

The problem of alternative methods arises here

also. A company miay be able to choose fromn several






- 72


available methods of handling any particular problem

of recording anld reporting: financial data. Cven entities

within a givan industry do not necessarily choose the

samue methods. A lack of comparability results.

Somne writers are severely critical of manage-

ment's use of alternatives. (Accounting methods are

often the choice of moana::ement. Important exceptions

are public utilities and other reg~ulated entities.)

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

an article in narron's, Anrader says:

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


Lui a en

Another reason for the lack of uniformity

between companies is the need for and dependence upon

judgment. Judgment varies from entity to entity.

)loonitz suggests that less reliance may be placed upon

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

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






-73 -


Price-level changes

The price level is nloo involved~ in compagrisons

botwuouni entities. This includes both the problem of

the general price level and theo problem of specific

price lovels.

A comparison of accounting statements may

involve the accounting statements For different entities

for just one year. (A comparison between entities

should include the statements for several years. As

thle problem of conparison wsithrin an enterprise has

just been considered, it will not be reconsidered

here.) Price-levol changes are a problem largely

because various entities acquired their assets at

various points in time at various price levels. This

results in loss of comparability in both the balance

sheet and the income statement as the assets themselves

appear in the balance shoot and expired assets appear

as expenses in the income statement.


Management

Assuming a well-organized enterprise, it would

seem that management (internal users of accounting

statements) should receive or be in a position to acquire

any type of information they desire as long as it is

possible and economically feasible. They also should

have the opportunity to discuss the statements with

those who prepare them.






-74-


This may not always be the case. Managers may

not understand accounting well enough to know what con-

cepts underlie the preparation of accounting statements

and the resultingi inherent limitations of the state-

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

statements provide more Information than thry actually

do provide or that they are more accurate than is

actually thle case.

On the other hand, suppose mnanagers do have a

thorough knowloede of accounting. They recog~niro the

limitations which exist. This means they must make

certain adjustments and allowances on their own. This

imnplies a lesser degree of reliance upon accounting

statements than would be the case if accounting state-

ments provided more accurate and complete information.

Managers are interested in comparison--both

comparison of the entity rhich they manage with other

entities and comparison of the current period with

previous periods. Such comparisons are essential to

the matnagemnent areas of planning, controlling, and

evaluating. The problems of alternative meathodss and

price-level changes and the limitations caused by

concepts such as realization are drawbacks to manage-

ment.


Investors and Irospective Investors

Investors and prospective investors are faced

with dociatons concerning buying, holding, or sailing





- 75 -


stocks. If published financial statements accurately

presentedl financial position and results of nporations,

than these statements would be very uiseful to investors

and prospective investors in mak-ing decisions.

Many investors and prospective investors do

not make their decisions on the basis of published

finanicipt statements. This could be due to one or

mnore of several factors:

1, P~ublished financial statements may not give

aradeuate information to fonn the basis for a

decision.

2. nther sources of information may ho more help-

ful.~

j. Investors and prospective investors may not

have sufficient knowlcede of accounting to use

the published financial statements.

Each of these three possibilities probably has

some validity. Published financial statements do not

give full anid completely accurate information about

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

accounting concepts which are used in statement prepa-

ration and which have already been discussed. Trhe

limitation on statement usefulness caused by lack of

comparability between accounting periods and account-

ing entities has also been discussed. The published

financial statements may be so condensed that they

fail to give enough information.






- 76 -


The annual report may be the only contact mnost

investors have with a cooasany, Since the published

financial statements are prepared largely for Investors

and prospective investors, the statements may be some-

what biased. This is possible even when they are

certified by independent certified public accountants.

This is possible due to the alternative accountinC moth-

ods, the possibility of manipulating profits to some

extont, variations in presentation in the published

financial statements, and failure to emphasize unfavor-

able events and contingent events as much as the favor-

able ones.

The annual reports of large corporations

usually include the financial statements, a message

from the president or chairman of the board of directors,

and other information concerning factors such as pro-

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

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

possible that, instead of trying to present all relevant

information as accurately and completely as is possible

and practical, annual reports may attempt to conceal

information.

Published financial statements may be of rather

limited use even to those who are familiar with account-

ing because they may intentionally withhold information

or present information in an ambiguous way. William

HI. Dinsmore emphasis this in a recent article in






- 77 -


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

"one of the florssiet anid least informative art fonns

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

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

report provides such little information. "After~ revi-

sions through countless drafts by accountants, audCitors,

treasurers, bankrer-diirectors, lawryers, union negoti-

ators, engineers, scientists, and purchasing agents,

the typical corporate message enlds up freightedl wit~h

vague genieralizations, cliches, half-truths, total

omissions, unsubstaniated claims, and downright dis-

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

report has lagged far behind the time. Thers are

millions of small investors now wrho want a report they

can read and use.

Joel Dean lists the follownrn possible reasons

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

fit re~orted:

1. To discourage potential comoetitors.

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

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

4. To maintain customer good will.

5. To keep control undiluted.

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

Another criticism of published financial state-

m~ents is that they provide investors with very little






- 78 -


information concerning the future. Perhaps it is best

not to publish plans because this information would

become available to competitors. However, the sugges-

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

in the published financial statements. Nolrton B3ackeor

makes such a Juggestion which he recognizes to be a

significant departure from current practice. His

suggestion is basedl on three propositions:

1. Decisions are made on future expectations;

2. ilanning is a funldamental management respon-
siblity;

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

Though there seems to be no general agreement

as to the p~urposes financial statements serve for

investors, llobert L. Quickens and John U. Blackburn

suggest these two to sum up the goals of external

rreor ting:

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

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

Whether management attempts to limit or conceal

information or not, it is obvious that puiblishedl annual

reports could provide better information to guide

investors and prospective investors in making decisions.





- 79 -


The second possibility suggested above as to

why investors and prospective investors do not use

published financial statements in making decisions is

that other sources of information may be moro helpful.

This could involve a secondary use of the published

financial statements. Investors and prospective inves-

tors may acquire information from those who have care-

fully studied financial statements. The primary user

of the statements then would be the investment experts

such as investment brokers, financial periodicals and

news reports, and investment managers For institutional

investors. If investors rely on secondary sources of

information, this could indicate that either they do

not possess sufficient knowledgee of accounting to use

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

consider it worthwhile to use their time) to study

statements themselvos.

Another source of information which investors

and prospective investors may consider more useful

than published finanolal statements is the "hot tip"

source. The hot tip is information concerning: whether

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

directly or indirectly from the published statements

and is supposedly not available to the general

public. If the hot tip is reliable it usually comes

from a source of information on the inside of an

entity. Such information usually leaks out against






- 80


the wishes of mannagcment as a whole. Such information

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

mation is not at reflection upon the published Financial

staltements.

Still another source of information used by

investors andl prosp7ctive investors as a basis for

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

It has already beesn pointed out that investors arer

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

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

is !srimarily inlterested in dividends, than thre dividend

recordl is aspooially signifioant. Entities are prevented

by' law fro1i PanJIG dividends out of capital unless so

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

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

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

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

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

from the earningsr of yrior periods. The dividlendi policy

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

vestors and prospective investors would be wise to con-

sider thel pulblished financial statements alongS with thle

dividend records even though their primary interest

may be in dLividends.

Another source of information ofton used by

investors and prospective investors is the daily report

of activities anld prices on the stock mlarkets. This5






- 81


information is certainly more current than annual reports

can be. observation of prices on the stock market over

a period of time reveals trends which are useful in

making decisions, especially to investors interested

largely in appreciation.

Reaction to stock-market prices may be based

on decisions already made. That is, a decision may

have been made to hold stocks for a long period of

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

investors, but they will probably not be the basis for

a decision.

Such investors, interested in the long run

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

large group. A majority of stockholders are women. It

is likely that many of these women have inherited stock

from their deceased husbands and depend upon dividends

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

holders in thiis category are interested primarily in

the long run.

On the other hand, an investor may have decided

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

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

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

activities in making decisions is not necessarily an

indication that published financial statements fall

short of their objectives. Instead, different objectives

are fulfilled. Financial statements affect the market






- 82 -


prices of stocks, espeolally in the long run. Charles

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

are probably influenced by earnings per share more than

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

It is apparent, then, thlat there are sources

of information which are more useful to investors and

potential investors than are published financial state-

mints. This is partly because other sources of infor-

mnation may provide a different type of information and

meet different objectives. It is also because state-

ment users do not have an adequate knowledge of accounting

or because published financial statements do not present

relevant data as wonl as they could.

The third possibility suggested above as to

why investors and prospective investors do not use

published financial Jstaements in making decisions is

that they may not possess sufficient knowledge of

accounting. Such investors must rely on other sources

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

informed in accounting to attempt to use financial

statements than to rely entirely on other sources of

information.

Accounting statements could be more useful to

investors if they were propared in suchr a way that they

could be understood and used by those who aro not

experts in accounting. Arthur M. Cannon has said

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






-83 -


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


Other External Users

Oxternal users of accounting statements other

than investors and potential investors include creditors

and prospective creditors, social control agenotes,

employees, labor unions, and the general public. These

statement users masy be handicapped by the shortcomings

of acoounting statements and the problems involved in

their use which hanve already been discussed in connection

with investors. Most of these statement users do have

an advantageu over investors in that most of thema do

not hvav to rely entirely on the published financial

statements. Creditors, potential creditors, and social

control agencies may usually aske for additional infor-

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

to consider other than accounting statements.

These statement users would find inproved

accounting statements useful, Their need is not as

great as the need of investors for improved accounting

statements.




This chapter is the first in a series of four

chapters which discuss various measurement bases used









ii nccountin Thre moasuremesnt bajis discussed in the

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

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



S: -vral concepts related to the~ historien1

co:.it canoe a~t havei 1 onr di .cu> d~r. ThL\.i concepts also

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

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

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

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

this ccncro t iieU L en discuss cd.

Accounting,; s.totements are used b several

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

creditors end prospective creditors, social control

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

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

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

Lested by the discussion:

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

to thsse aho understand accounting.

2. Accounting statejm-nts should be useful to thlose

whoI have v cy little knowledge of accounting .

An alternative to tho second goal is that

accoun~tin; statements should be prepaeyd in such a

manner that statomont readers who havYO little or no

knowr: dge of accountin: will realize theuy are not

capab.n of ati~lizing thJ statements.






85-


The followilng three chapters offer alternatives

to the historical cost measurement basis, Cachi of the

three alternatives offered is discussed and compa~red

with historical cost and the other two alternatives.
















CHIAPTER~ IV


CURRENT COST


introduction

Historical cost, the measurement basis commonly

used in accounting today, has certain advantanges and

disadlvantages which have been discussed in the preceding

chapter. Alternatives to the historical cost concept

are discussed in this and the following two chapters.

These alternatives are current cost, net realizable

value, and discounted cash flow.

The current cost concept is the topic of the

present chapter. Current cost is the term chosen to

include many variations of market value and replcac-

ment cost. Several of those variations are discussed

and classified into two types:

1. Variations which separate income into

a. Holding gains and losses, and

b. Uporarting: income, and

2, Variations which recognize income on a pro-

duction basis.

T~he second type might also distingulish hloldling gains

and losses from other income. These two types of


- 8 -





- 87 -


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

objectivity, and feasthtlity.

Thei current cost concept will be compared with

historical cost on the basis of the criteria suggested

in Chapter II: relevance (usefulness), objectivity,

and feasibility. Quanitifiability will not be discussed

as this is a characteristic of both measurement methods.


Income

A major difference between economic concepts

of income and accounting concepts of income is a matter

of timing. When should income be recognized? Or when

should an increment in value be recognized? This is

also the major difference between various accounting

concepts.

Income is sometimes thought of as an increment

in value due to above-average decision-making ability

or as a payment for risk taking. This can logically

be defined as wages instead of income; income is then

defined as an unexpected increment in value. Income

as used in this study means both unexpected increments

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

average decision-making ability and risk taking.

Accounting income also includes interest on capital.

Income is not necessarily recognized when it

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

Uetermination of when an increment in value takes place

should be of at least some value in determining when





-Y~J-


to recugnise suchl an incralment. OFor thris purpose, the

business process may be divioud into its components:

purchasing, production, holding, and selling. Incro-

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

these activities. In current practice, no attempt is

usually made to determine when an increment takes place,

and the entire incomeo is recognieed in connection with

the selling process as was pointed out in Chapter III

in the discussion of the historical cost mecasuremeont

basis. juch income includes incoome due to above-average

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

implicit interest.

Chai mere act of purchasing does not create a

value increment according to current accounting procedure.

The Increment dlue to production is usually measured in

terms of the historic cost of the ingredients added.

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

use of land and capital in the form of current typesa

of capital and operating facilities are combined to

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

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

dients. Tlhe measurement of the cost of the ingredients

may be difficult to determine and may require some use

of estimates. Usually, no effort is made to determine

whether or not an increase in value takes place due to

holding an asset over a period of time.






- 8)-


it is possible for incrlanents in value to tate

place in eachl of these actiVitiies: purchaSing, production,

holding, and selling. Alternatives to current practice

even suggest the recognition of such increments at the

time the activity takes place. it has been suggested

in Chapter III that profit is due to the entire business

process. Thus, the not realizable value concept would

give recognition to any increment in valuen during: an

accounting period. regardless of which activity GaVe

riso to such increments. A distinction might or might

not necessarily be made between the incremoents arising

from the various activities. This will be discussed

in more doetil in Chapter V.

Culrront cost concepts vary, but they are

desiened to measureo separately income from production

and selling or income from holding and selling. This

chapter includes a discussion of this point.


Price-level Adjustment Assumption

In this chapter on current cost it is assumed

that appropriate adjustments will be made for changes

in the general price level as well as changes in

individual prices. This is necessary in order for the

capital accounts to refloot the same amount of purchasing

power.

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





- 90


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

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

It is this first concept of purchabing power

which is assumed in this chapter.


Variations of the Current Cost Concept

Current cost concepts are intended to measure

changes in the specific prices as contrastod with

general price-revel changes. Reflection in financial

statements of specifle prices changes is not a new idea.

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

inll Theory whichl was published in 1922:

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






- 91 -


idvards andJ Ball's Concept

Urnc of the recent discussions of current cost

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

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

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

theory is original.

odwards and Dell present the thesis thant "It

is in the evaluation of business decisions .. that

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

Their goal is to arrive at methods of measurement whlich

are useful in the evaluation of business decisions. Two

measurement concepts are eventually su~ggeted, and one

of them is chosen as the better of the two.

lidwards and Rel1 are primarily concerned with

the use of accoulnting: data by management. In general

terms, they enumeorate the uses made by mannaemelnt of

sacounting. Accounting, through comparison of actual

events with expected events, contributes:

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

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

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

Although the emphasis of the book is upon thle

use of accounting data by management, the same data is

useful for external purposes. External users are also

interested in evaluation--the evaluation of management.






92 -

The same mneasurement concepts suggested for management

are also suggested for most external users.

darly in the development of their theory, the

authors put forth the premise that "in order to describe

completely and truthfully with present accounting

techniques the current position of a firm and its profit

as it accrues, recorded costs moust be equal to market

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

of the firm is necessary in the evaluation of decisions.

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

Wrhat is market value? Edwards and Bell suggest

more than one possible market value. Value mnay vary

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

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

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

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

This gives a total of eighteen possible values. Table 3

is their presentation of these eighteen values of which

the six underlined concepts are the ones the authors

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

responsible for the names of the concepts.

Current practice uses largely historic costs

as the basis of valuation. Profits are the difference

between current values and historic costs, and, according

to thu roalization conoupt, are not recorded until a

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

dominate the accounting records.









TABLE 3

AN ARRAY OF VALUE, CONCPPTS


Form and
place of Initial Present Ultimate
assets inputs form form
Value
date,
market


Past, entry historic discarded irrelevant
costs alternatives

Past, exit discarded discarded irrelevant
alternatives alternatives

Current, current present irrelevant
entry costs costs

Current, irrelevant opportunity current
exit costs values

Future, possible possible irrelevant
entry replacement replacement
costs costs

Future, irrelevant possible expected
exit selling values
values



The two measurement concepts presented are

realizable profit and business profit. Realizable

profit is composed of realizable operating profit and

realizable capital gains.

Realizable operating profit is thle increase

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

tion. Opportunity costs are defined by Edwards and

Bell as "values that could currently be realized if

assets (whether finished goods, semifinished goods,





-94-


or raw materials) were sold (without further processing)

outside the firm at the best prices immediately obtain-

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

determined by substracting the opportunity cost of

assets prior to production from the opportunity cost

after production. Realizable operating profit is the

increment in value due to production only. No profit

is attributable to a change in valuation method.

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

the increase in opportunity cost over time. Such gains

are computed by substracting the opportunity costs of

assets at the beginning of a holding period from that

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

t~ime into holding periods and production periods for

simplicity. In actual practice, this cannot be done.

The same results can be obtained by determining the

increase in specific prices over a period of time if

no chlan~e took place in production.

Healizable profit is, then, the difference

between opportunity costs at the beginning of a period

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

izable profit is due to a change in value dure to

production and a change in value over time. "The

opportunity cost basis for record-keeping has this

unique characteristic: except for the initial acqui-

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

buted either to changes in form or to changes in date




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PAGE 1

A STUDY OF VARIOUS MEASUREMENT BASES AND THEIR EFFECT ON PERIODIC INCOME DETERMINATION By HOWARD PRESTON SANDERS A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL OF THE UNIVERSITY OF FLORIDA IN PAKT1AL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY UNIVERSITY OF FLORIDA August, 1967

PAGE 2

The author wishes to express his appreciation to Dr. >'. B« Stone, undur whose supervision this investigation was coiapxofc^d. Appreciation i.j also express.': ' N Dr. R. H. Biodgott, Dr. C, rf. fristoe. Dr. W. M. Howard, and Dr. D. D. Ray atfcO served on the author's committee and to Dr. L. J. oenningar and D*. .;. tfixoa who each served temporarily as chctiruian while the investigation was underway. The author wishes to express his gratitude to his wife, Shirley, who spent many hours typing the manuscript, .iroof reading, ,,iving general assistance, and most of all — giving constant moral support «

PAGE 3

TA^Lo oF CONTENTS ACKN ITS li Chapter I. nrTRODUCTIOl i Internal Use? of Accounting Statements . 2 Planning the Future Controllin . th i Present *» Evaluating the Fast • Stewardship 5 external Use of Accounting ijtateia^nts . 6 Investors and Prospective Investors . 7 Creditors and Prospective Creditors . I Social Control >v sol Labor Unions ii CoapariSM of Internal and External Us^rs 12 t'urposo A 3 Seeps • Method !7 II. MSASURBMBST IB ACCuUNTISi introduction 18 rho Mature of Mea en r— nt 1-9 fypes of Scales 2i Kinds of Measurement W lapse t of Measurement on Accounting ... 26 Definitions of Accounting 26 Importance of Measurement in Accounting 2 7 Basic Structure of the iiusin Measurement Process Measurement and fain* 3** Accuracy 36 Accuracy in Sciences 36 Probability and i) r oC -.rror ... 37 Scales in Accounting 3^ Lnds of Measurement in Accountin ; .. 3"J Criteria for Comparing Measurement Methods Uu Ul summary ^

PAGE 4

i'age III. I -JU CoSf k'Z Introduction k2 Definition of Historical Cost k3 •;.atod Concepts Underlying \ccounU n itatincnti UjJ I Lag Cuncrn U5 ftSM i'«riods k? Realization U8 •atchin^ JO objectivity 51 Conservatism 52 Summary 53 The Realization Concept 5k Historical Development of the Realization Conco/jt 5** The Present status 56 Currently accepted exceptions to the general rule for realization 62 Nummary 6U -ff.cts on Accounting statements and Criticisms 65 Co nparabixity Alternative methods 63 Prlee~l v..i changes 69 Unif ornii ty ?1 Alternative methods 71 Jul xl n t 72 Prlee~l*rel chan.°;?s 73 Management 73 Investors and Prospective )nv tors . 7k Other iixtornal Users S3 Junmary I I IV. I 86 Introduction Inco.fl 37 eric -'• v .. Adjustment Assumption ... 39 Variations of the Current Cost Concept 90 Edwards and Bell** Ceneept 91 i,;roui>c and Juonitz's Concept 99 fck r Barr nt Cost Concepts 107 The fast • .irabW of fcbo Current Cost Cone ptfl L10 Las and lasses ill lialitjr of ;aliii and losses .... 11Production income II 1 * iv -

PAGE 5

Comparison with the Historical C Concept liti Usefulness II 8 Accounting statements 119 Inv ntory valuation 121 Otta r asset valuations 122 Unrealized income 122 Dual accounting statements 123 Implications for cost accounting .. 123 ntory flow assumption 123 Absorption costin ; vs. direct costing controversy 12U objectivity 12U Feasibility 12 7 Summary 1 2 ^ V. BBT u-.; VALUii 130 Introduction i-3^ Rationale of let Realizable Value ... 130 Variations of fcfa aiizablo Value Concept 135 . rican Accounting Association 133 Jolin 3. Canning 137 Sprouse and Moon it?. 13# Actual Use of let I alizable Value .... lU.2 Contrast with the Historical Cost Con. t 1** j ctivity Ij* 1 * Usefulness 1*5 Accountin , statements 1*6 feasibility l* s Contrast with th Curr nt Cost Concept lU8 iloldiu, ains and Loaaea 1*9 tivity 1*9 Usefulness 151 Feasibility 152 Production incom. 152 Summary *$3 VI. l $ h Introduction L 5* Economic Cone a{ t 157 Subjectivity 157 rtrison with other Mea nr et la Historicrl Ccst Currnt Cost izabi Vaiu Io0 ry *•* VII. SUMMARY MB COBCLDSIOBS 1^2 1 LI v.i;y

PAGE 6

* TABL8S Table Pa^e 1. Four Types of Scales 22 2. A Classification >f Scales of Measurement ... 23 3. An Array of Value Concepts 93 k. A Comparison of Realisation and Realizable Criteria 98 ri. -

PAGE 7

CHAPTfin I INTRODUCTION Accounting statements are the tangible product of tho accounting process. The product is of no importance within itself; tho importance of accounting statements is in the service they render to statement users. The following paragraphs comprise a discussion of accounting statements largely in terms of those who read theia and the purposes for which they read them. The most familiar accounting statements are the balance sheet and the income statement. The number of types of statements for internal users is almost endless. With certain practical limits, management may prepare or have prepared any statement that may be useful to them. The external users have a more limited supply of statements, being limited largely to what is known as the published financial statements. The published financial statements are the representations of management to outsiders. The published financial statements usually oonsist of the balance sheet, the income statement, and the analysis of owners' equity (retained earnings, in the case of a corporation), but 1 -

PAGE 8

2 they may include other statements and details such as the source and application of funds statement. The users of accounting statements can be divided, at least roughly, into two classes: internal users and external users. The internal users of accounting statements are all those who participate in the management of the enterprise at any echelon. uxternal users include investors (both present and prospective), creditors (both present and prospective), social control agencies (such as governmental units), labor unions, employees, consumers, and the general public. Internal Use of Accounting statements The internal users of accounting statements are the various levels of management. Any given member of management is concerned primarily with accounting statements dealing with his area of responsibility and over which he has authority. The chief function of management is decision making. Managerial decisions may be divided into three areas: planning, controlling, and evaluating. Accounting statements are utilized in aiding management in recognizing the need for decisions and in guiding management in making the decisions in all three areas. Planning the Future The three areas of concern to management may be thought of as a cycle. A discussion of the three areas may be^in with any one. The planning area has

PAGE 9

3 been chosen because this would be the first area of interest to the emne .oment of a newly or.^anizod or •itity. After the onterpriso is underway, plannin ', is of continuous concern to nana -onion t . I express the view that accounting deals only with past events. This concept of account in would exclude from the realm of accounting statements those dealing with the future, such as various types of ts. Accounting as used in this study is Intended to incLudo estimates of and prospects for the future LI «S records of the past. After an entity is underway it is at once in the plannin » area, the controlling area, and the evaluatin •, area. Hie three areas may be thought of separately in the sense that a member of management may direct his attention toward only one area at a time. For example, •nana-v'.non t may focus its attention on the plannin: area as a new fiscal year approaches. . Lans for the future are made after a careful evaluation of the ,-a.t. wperience in the past may serve as a guide to th«.: future. I rends may be indicated, for example. iln' accounting statements for prior accountin . periods are a major >ourc of information in I financial plans for subsequent periods. After an entity bo ;ins business, plannin: requires an ('valuation of the past as veil as a consideration of the future .

PAGE 10

k Controlling the Present Controlling the present Implies the carrying out of plans made in the past. Controlling, as used here, includes the concepts of coordinating and motivating. Management follows the activities of an entity closely to see that there is compliance with the plans. Timely cost accounting reports which can be compared with the budgets are almost essential in this area. Management may decide to alter plans even after an accounting period has begun in order to control the enterprise activities. Such changes may require special studies and revised budgets. Interim accounting statements such as the balance sheet, income statement, and source and application of funds are useful. Such interim statements provide management with information concerning current status before it is too late to make changes and corrections. It is probable that these interim statements would do nothing more than help point out a problem. Further analysis would be necessary to learn details. Evaluating the Past Evaluation is tho process of determining what has been accomplished and the implications of these past accomplishments. An effective way to determine what has been accomplished is to compare rosults with

PAGE 11

3 slice t, the income statement, and other accouatin,", statements arc used by ma in evaluating the pft«t. . . > L ordinarily Infc i I In much (•tail than the external .-.t.-u rs« External usors look at the entity as a whole, while nan' is interested in the constituent elements. For this reason, eanageaent may require del >orts which explain v. ctions of the general-purpose stateor answer specific questions which arise. .-.valuation of the past is a prerequisite for and blends into the planning area. for the i ktl ty operations, no area need red the first area or the last area. Planning itur , controlling the present, and OYaluatifl past are segments of an 9 cycle of managerial jnsibility. ..ardship In a sense mana ;oraont uses the general *pur statements for oil its stewardship accounting responsibility to investors and Ltor.s and in peri iblie-dutj roaponslbility to Che .eneraL public. These evaluations of ast are assumed to fulfill nan ' r ponsi«* bility to outsiders. '" internal reporting has b traditionally on toward historical stewardship

PAGE 12

6 aspects, while internal reporting has been much more concerned with current and future events" (1, p. 521). external Use of Accounting Statements The external users compose a more heterogeneous group than the internal users. Most external users have one thing in common with each other; their primary souroes of information concerning the financial affairs of an entity are the published financial statements. The term financial statements is less broad than the term accounting statements. Financial statements are defined by Sprouse and Moonitz as follows: " Financial statements are those which purport to show financial position and results of operations, including supporting schedules, elaborations of special aspects of business activity, rearrangements of underlying data, and supplementary statements" (2, p. 8). borne external users have sources of information in addition to tho published financial statements. Creditors and potential creditors may require of management more detailed information such as plans concerning the future. Social agencies such as governmental units can and do require large quantities and various types of data. Labor unions may sometimes acquire additional data. The investors and potential investors, as a group, have few other sources of information. They must rely, directly or indirectly, on published financial statements. As individuals, they may have an

PAGE 13

inside track, but this is not considered a significant exception. An important purpose of accounting data is to aid external users in making decisions. As the type of decisions to be made varies with the user, each typo of user Mill be discussed separately. Investors and Prospective Investors The general-purpose statements distributed to investors and available to prospective investors are prepared largely from the stewardship point of view. Management has an obligation to investors and prospective investors to provide information which will serve as a basis for decisions as well as to fulfill its stewardship responsibility. The Study Group on Business Income says: "The annual financial statements of corporations are primarily reports of stewardship, and the methods of presentation should be determined with constant regard to that primary purpose; but when corporations seek the advantage of marketability for their securities they incur an obligation of disclosuro to investors generally" (3. P. 108). The Investor must make certain decisions concerning his investment. Should he retain or terminate his investment in a given enterprise? If he terminates his investment, should he invest in other entities?

PAGE 14

a If he retains his investment, should he increase or decrease it? These are some of the most important decisions to be made. The type of information used and needed by investors is difficult to determine because investors' motives are not easy to analyze. The investor may be interested in dividends, appreciation, risk, and diversity. Any given investor might assign different weights to these various motives. Some investors may be unable to analyze their motives. It is likely that many investors have never tried to do so. Institutional investors are likely to have more definite motives than individual investors. Investors must have rather clearly defined motives in order to use financial statements effectively in the decisionmaking process. Once the investor has established his motives for the investment he must determine how his investment measures up to the motives. This is best done by comparing an investment with alternative investments. Also, a comparison of the financial statements from year to year may indicate trends. The potential investor faces essentially the same decisions as a current investor. The main difference is that comparison must bo made between the present use of money and the prospective investment as well as between alternative Investments and uses.

PAGE 15

9 Creditors and Prospective Creditors I i in the debtor's financial ability and willingness to repay debts. wiliL i : factor is important but rot.' r lifficuit to L-valuat.'. A debtor's reputation and his financial sta( l s to his Vllllfl ness to repay debts. fhc better off financially a debtor is, the Ml i . i i n t ) t iy debts. It is generally assumed that a d«btor is willing to repay debts if ho h good reputfttlOfl an 1 i.-. financially a!>. liters are seldom faced with the need to make concerning current debt.. Fherfl is usually nothing to do except wait for the maturity of Li principle, or perhaps to collect interest payments and installments on the prinoJ t are not faced with decisions, creditors aro in in i ' ability to repay debts. fhis will inv short-run ability or Ion ;-run ability depcn;in ; ', <>n the the loan period. , i financia nts aroused to help det. riLn I lir i's financial ability to ( . i tionship of current assets to •n LlltJ Ll a uid<.. to short-run ability i . be debtor's •erning pes »r end th? of other lea -* i r did ... -run abiLity to repay debt.. -ncral-purpo sr f inane Lot

PAGE 16

10 statements are intended to present this type of information. There are times and situations which require deoisions by creditors concerning outstanding debts. The contract between the debtor and creditor may require the debtor to perform specific acts. For example, he may be required to place funds into a special sinking fund for the retirement of the debt. The creditor wants to know if the debtor is meeting such requirements. There is the possibility that credit obligations such as notes and bonds may be sold to others before their maturity. The creditor does not necossarily hare to hold an obligation until maturity. A decision may be made at any time to terminate a given credit position, There is the possibility that legal proceedings may be necessary to collect a debt from a debtor. Sometimes a creditor will find it necessary to initiate legal proceedings; even bankruptcy proceedings may be necessary. The creditor needs to be in a position to foresee the necessity of such proceedings. For the prospective creditor or the creditor v.hu La considering making additional loans to a debtor, decisions must be made concerning whether or not to mako a loan, what amount to loan, and what contractual requirements are to be imposed upon the debtor. The published financial statements of the debtor may be helpful in making these decisions. More detail than

PAGE 17

11 is usually Included In the published financial statements is desired by the prospective creditor. Additional information may be obtained through more detailed statements or through personal interviews with the debtor (or prospective debtor) or his representatives. Information is also available from those who are already familiar with the credit standing of the prospective debtor. Social Control Agencies Social control agencies usually prescribe their own form of accounting statements. These statements, usually prepared by the entities themselves or their agents, provide the basis for various types of taxes and controls. The social control agencies also use accounting statements in making decisions concerning types of control, types and amounts of taxes, and means of enforcing regulations. Labor Unions Labor unions are interested in ascertaining the financial condition of the entities in which its members are employed. The unions' main objectives are to determine what benefits to ask for and to determine a bargaining procedure. Employees, consumers, and the general public as a group have lass specific needs than other groups of users. In general they are interested in products

PAGE 18

12 and services being sold at fair prices and factors of production being paid fair prices. Comparison of Internal and External Users In the preceding paragraphs, many of the various uses made of accounting statements by internal and external users have been briefly summarized. For internal users, the type of information and the quantity of detail depends upon the level of responsibility and authority. The lower levels require more detail than higher levels. The published financial statements, or "general purpose" financial statements, are not designed to cover specific areas of responsibility and give the amount of detail needed by lower levels of management. Higher levels of management are more likely to find the published financial statements useful. However, this is likely to be just a starting point for analyzing the operations of an entity. It is likely that top management does not desire details of every item in the financial statements; only certain items require more detail. Moonitz emphasizes the different needs of internal and external users in taking the position that: published financial statements (usually in the form of annual report* to stockholders) should be designed to inform all important nomnana ;orial groups by presenting a report on management, not for management. ... i»e can no longer, however, operate on the assumption of a harmony of interests.

PAGE 19

13 that what io good reporting for investors is also good reporting for management, and vice-versa. . . . The investor is interested in results, not in methods of decision-making by management (U, p. 179). Investors, creditors, and other external users need information about the plans and accomplishments of management in order to make the best decisions. The needs of management, in general, differ from the external users. Of course, various levels of management need information on the effectiveness of lower levels over which they have responsibility. Management needs information for planning, control, and evaluating. This requires much more information than that contained in the published financial statements. Purpose The significance of accounting is reflected by the use made of accounting statements and other accounting information by those internal and external to the entity. These users and their general needs have been presented. The ways in which accounting statements are used and the reasons for their use are not definite. This has been the subject of some recent research, and it is likely that even more research will be conducted in this area in the near future. Although some of this research utilizes the deductive approach, the empirical approach is more common. It is assumed in this study that accounting statements are read and that the

PAGE 20

II* readers utilize the information for the decision-making process. "it is avidont that accounting measurements do represent information for decision-makers and since decision-makers do read accounting reports, the Implication is strong that accounting measurements must hare sjjeclfio behavioral implications, not mere general tendencies in the long run" (5» P. 212). Assuming the basic needs of those who use accounting information, this \*riter feols that the basic problem in accounting is the method of measurement to be used. For example, investors may wish to know the amount of income earned over a given period of time. Various amounts of Income would be determined, depending upon the method used to measure income as several methods are available. The purpose of this paper is to analyze and compare the most prominent of the measurement methods, or bases. The measurement bases chosen for inclusion are historical cost, current cost, net realizable value, and discounted cash flow. Tho writer hopes that this study will provide the reader with: 1. An understanding of the major measurement (valuation) bases by explaining each, explaining and comparing the different interpretations for eaoh.

PAGE 21

15 2. A demonstration of the likely effect of each of the bases on tho measurement of financial position and periodic income. Scopo This study is prepared largely from the point of view of business enterprises, i. «., enterprises organized for profit. This is not to say that it has no application to entities such as hospitals, charitable organizations, and municipalities, but that the emphasis is on business enterprises. ~ne of the most important concepts underlying accounting Ml practiced today is original cost, or historical cost. This concept is generally accepted in the determination of periodic income. The use of this concept may have certain weaknesses. It may result in asset values on the balance sheet which do not reflect the worth of the assets. If asset value increases or decreases are sometimes not recognized, gains or losses occur which may not appear on the income statemont. Revenue may be thought of as being earned throughout the production and selling prooess or throughout the selling and rendering of services, u/hon the historical cost concept is used, revenue is not usually recognized in the accounting records until a specific event such as a sale takes place. These weaknesses may be used as the basis for the suggestion

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16 that • ' rnetlTC .. o !.'i historical cost >t which would bo mor>u-j-ful. Fho .-lajor portion of fchlfl study is a discussion of these alternativos. taur tit I r i . i fcanee and application to accounting are llscussed in j t« It is emphasised that account in ureaent . a discussion of th it y generally urenent concept— historical cost. ;• I • r ' Intention si t of the historical cost cone with a related eonoept, the r I, en tl ocounttn I nts and especially on the income statement . denesses air^ a i red 1 Ln I L in ord r 1 for alternativ i tent o >ne I . r IV is a discussion of current eos . Current cost la a nam ;y tiiis writer fee »n« pass sereral eonoepts which include market rain , ; unity cost, and replacement cost, ail the one its in t;ii area are dlTlded into two categories which .i disco . i BUt \TJ inciudos all current costs which wou i .1 Lnelude production Income before a ilaooi chile she other category sxoludes such ourr ;n( c I i variations of what writer refers to as ourrent eost thor rs alae

PAGE 23

L7 reflations of 1 t r ;« I . Chapter ts a lOneeptS. ioun1 e ih flov oont in Chapter VI. i'.ii ; ma/ be rtf«n ' conoralc Lneon . orison if r nted Ln that ehnpt r r n t. base (or bases) pr trior . • rhus, each of the four neesureent eono i I if the other tor oonoepts, i oenoluslons constitute Chapter V t I . Method Ll study is based on library research and logical analysis. • i.ricaL study has been utilised, hxten^iv. --viricai research would be necessary to determine how accountin statements are actually used, the r Linnc placed upon them, the chc» i \ \ I by statement users, and the measurement methods whico i hi to ssers. for lack of such research, rit r r. Li .-> upon his own assumptions and l'u .iich have been nado by other writ |

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CHiU'Tiitt II MSASURBN£ffT EH ACGO0ITIIG Introduction Measurement was at one time closely bound to mathematics. It is perhaps difficult to say whether measurement had its beginning in mathematics or mathematics had its be^innin^ in measurement. -hole-number arithmetic and scales of numerosity (called number in,", in common usa^e ) ^rew up together. "The numerosity of collections of objects . . . constitutes the oldest and one of the most basic scales of measurement" (6, pp. 19-20). The idea that measurement theory applies to accounting is not new. Accounting has always been concerned with measurement just as it has been concerned with arithmetic. There has been an increased emphasis recently in the application of measurement theory to the social sciences which include accounting. The first part of this chapter is a discussion of measurement theory. Types of scales and kinds of measurement are included. The application of , ,

PAGE 25

19 measurement theory to accounting is discussed in the second half of this chapter. The Mature of Measurement In common usage the terms "measurement" and "measure" have a multitude of meanings. As used in this paper the terms have much more narrow meanings than in common usage. Several definitions of measurement as used here are civon in the following paragraph. . itovens, one of the leaders in the field of modern measurement theory, defines measurement as "the assignment of numerals to objects or events according to rule--any rule" (6, p. 19). B« Uussell, another authority on the subject, /ives this definition: "Measurement of magnitudes is, in its most general sense, any method by which a unique and reciprocal correspondence is established between all or some of the magnitudes of a kind and all or some of the numbers, integral, rational, or real as the case may be" (7, p. 176, quoted in 8, p. 13). N. R. Gampbell gives a definition very similar to that t;iven by Uussell. Measurement is "the assignment of numerals to represent properties of material systems other than number, in virtue of the laws governing these properties' (9, quoted in d, p. 13) . nrren S. Tor^erson points out that, thou there are slight differences in these definitions, all three deal with the same general problem concernin

PAGE 26

20 "the process and rationale involved in the construction of i scale or measuring device and the properties that can be ascribed to it" (8, p. 13). In common usage measurement usually refers to the application of a scale; in this pap«-.-r measurement refers to the con struction of a scale. ".Measurement as used here refers to the process by which tho yardstick is doveloped, and not to its use once it has been established ..." (G, p. it). According to Tor^erson, an object is not measured; properties of an object are measured. ( " ^roportii.s are •essentially t?7C cliservablc aspects ->r characteristics of the empirical world" [S t p. 9j . ) The definitions of Sussell and Campbell (;i.vcn above indicate that properties are measured rather than objects. Stevens' definition indicates that objects themselves can be measured. itevons considers his definition to be less restrictive. "-icatric blT* definitions of measurement have toppled as the practice of measurement, outrunning legislation, has forced us to broaden and generalise our conceptions" (6, p. 18). Stevens considers his definition "liberal and open-handed" and realizes it is unacceptable to some (6, p. IB). His definition includes more classification as a form of measurement.

PAGE 27

Type.--, of icfllos I Las reqa Li kn I .itnrnt of numerals to represent the proper! L . >net >-on r Latlonsbip must exist between the quantiti of the pro rtl on I khl number system. foe number system ui 'd must have tha fellowin features! 1. Ordered numbers, 2. Tdorod differences between numbers, 3. origin, 'zero." These thr f -atures may be called order, distance, and origin | , pp. l^-i;3). i numbers are assigned to objects "so that i tlona between the numbers reflect the relations n the obj cts themselves with respect to rtjr" (tf)» a seal.; of aeaaarenent baa been established. )f the fehrea characteristics li3ted a :, Listener , and origin), only order is necessarily involved in the usual Mania >f mi »t. rha two characteristics may or may not be involved in a .iv>n m.asur-n.nl. If a sea. necessarily Invo . r bat nay or nay not involv distance | In, i ubinations of thos I charact'-ris t ics as presented in Table 1 (8 a p. i.6). rder is J I rlinai .seal-"so tnat rder >f she naasbera sai i to 1 i order of magnitude of the instances" (ti, p. 16). i val

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22 scale has the feature of the ordinal scale with an added feature of a meaningful size of the distance between pairs of numbers. An interval scale with a natural origin is colled a ratio scale (8 ( p. 16). TABLE l FOUR TYi-! I If -v No Natural Jri in Natural irigin le i ii stance -j c e ordinal .Scale Lit rval Scale Ordinal Scale . itb Natural r 1 in Ratio Scale Stevens adds to these conventional scales a lower scale which ho calls the nominal scale (see ,t> v ns' table on the following page— Table 2) (it, k >, 25). "An array of categories or classes made distinct through the label of numerals is considered to be the natural basis of measurement and is called the nominal scale.'' (10, p. 58). The ordinal scale is next in hierarchy. It 'consists of classescharacterized by numerals— which are subject to order rank in conformity with the numerals assigned" (10, p. 5y ) . Iho next seal,, the interval scale, enforces regularity of class-interval. rhe last scale, the ratio scaie, requires a zero-point that is not arbitrarily etiosen but civen somehow beyond m.iri' eon v. 'i Lion" (10, P. 5'J i .

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-3 IEMT* ttesic empirical Mathematical Typical Operations tructur; -.sample: Determination of equality rainatlon of greater or Interval determination of the lalltjr if intervals or of differences .iatio determine tion of the equality of ratios Permutation -roup c' = f(x) where f(x) raoans any one-to-one substitution Isotonic group x 1 f(x) ..here t{x) means any increasing monotonic function Linear or affine group 1 * m t b ft > Q Similarity X* » ex C > "Numbering" of football. plftjr«rs Assignment of type or model numbers to cLassos Hardness of hi rals it i >t numbers trades of leather, Ltuaber ( wool, etc. Intelligence test raw scores .. rature ( Fahrenheit position (calendar ) n rgy (potential ) Intelligence i. scores" (?/ Numerosity Lea ( •, lensltj, i.ork, time interval, 3tc. Temperature inc or Kelvin) Lou;'nc if ( I ones ) Brightness (brils) * Measurement is the assignment of numerals to events or objects according to rule. The rules for four kinds of scales are tabulated above. The basic operations n;dod to croata ivon scale are all those listed in the second column, down to and Including the operation listed op >osit<: MM ocalo. Phc third column gives th > th •— tlOftl transformations that leave the scale form Invariant. Any numeral I on a scale can be replaced by another numeral x' t where x' is the function of x listed in column 3.

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21/ seals involve the assignment of nu » ra] fco ' . at 11 f rather than to the proklea of tide object. This would not be considered measurement et all by somr definitions such as the conventional definitions ."ivun by Russell and Campbell. Thus, StOYOns considers B»rs classification a? rneo ment while some authorities would not (8, p, '.,; . t v ia also lnaludi samples in the otlier sc?Tas Mhlo l '/ not, by definition, be considered nt by Russell and Campbell. Bs inclu'i:; street numbers as an example of the ordinal scale, position as an s sample of the Interval soale, and nume realty as an example of the ratio scale. leea not recognise an ordinal ^caie rlth a na . Vutherltle i other than Stevens and T.irRcrson present Still noro variations in .scales. taoh of 3 to Yens' scales aft>r the first "grows out of the preceding on: by introducing an additional property or condition, fehua ra itrictin;"; it^application to a .smaller but more specific area than that of the i't o (10, p. 5n ) . The classification of icalea i >i how much information is represented by L.. ...-,. , . Th'? amount of freedom in assigning numbers decreases a i ens ,cos down the scab)Slther StoTens* or bhs conventional scales.

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25 . irul -» of I asjf. .< nl • l | "amounts to a ration of the sorts at Moaning attributed in jnrtLcuiar scale to those characteristic, of >h1. r, distance, and origin that ar | nt d >, 21). rorgoraon iv wnys in which t.i Steristioa aight obtain meaning: i. through Lava rolatin r rty to other i r I i ,--.' r I v ieaaure*eats« 2. y arbitrary defiaition — fiat a 3. Through natural laws re lo ting various quantities of aha construct to each ether — fun la.iien tai r i : \ i, pp. 2i-22) . fhere is no necessary relationship beta R i o f s c i Lads of mmri ten t • »ar t ieular aoal a r hi nt is not limited to any particular kinl af i asm i nt ( d, p. 22 ) . v i w has | i tha t I Lga sen t >f rals to objects other than by tha ,>rec i involv.-d in f unda-iu nta L ai is not aeasaresMat at ail" (6, p. 22). 3t i r with this and fool tlia t * toi i in it ton is I i 1 1 i ic l y fiat laurea its.

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G ln.p:u. L 1 .'-I.-;, sty . . , .__ \r_ nil in Definitions of Accounting Accounting, by definition, is concerned with measurement. It is generally accepted that financial data is the subject of the measurement process. 'Accounting is a discipline concerned with the quantitative description and projection of the income circulation and of wealth aggregates by means of a method based on the following set of basic assumptions: monetary values, time intervals, structure, duality, a : -gr ga tion, economic objects, inequity of monetary claims, economic agents, entities, economic transactions, valuation, realization, classification, data input, duration, extension, materiality, and allocation" (10, p. 19). quantitative description, as used in this definition, implies measurement. Accounting is tho art of measuring and communicating financial inf orraation. This statement is not shocking or even surprising, yet the acknowledgement that accounting is.; concerned ivith measurement is the first necessary step towards aited revolution in acconn fclltg* Thlt revolution is not restricted to accounting; it has already taken place in other disci;, i ino whore measurement is crucial. For example, the classical concepts of MtrarMMilt in phy.iic.-. and psjehology have already undergone drastic changes. It it tian for restrictive definitions of measurement in accounting to topplo (11, p. 501). Accounting might even be consil, r J a theory of measurement: "iinco th main functions of accountin;, are classification and evaluation, the thought of

PAGE 33

7 •inter i I Li ft ry of et I nu nt is not farf • < ehe.d and souui 1 : plaaalble" ( . . roaeatatlva dofinltlana of accountO ! l.o 'Ue MCaiiUl ' ,.'i:Ct. Importance of Hoi wt ftt in Accountin g ^ai.ileo deinonstrnti d "that quantification is the best and most accurate uay to aeqttlr* empirical knowlfidpe." Me indicated tho maxim in this proverb: "Measure all that is measurable and attaapt to make measurable that which la not yet so" (10, pp. jjU^»j5 } . "The basis of Eccountinp is racasur> -iPiit" (i2, p. ix). The purpose of accounting is to measure, ;r pa rha pi tha purpose of accountin; could b* beti expressed as: to measure financial data. Financial data nay be arranged in the form of financial statements. Thus, the two primary financial tat I ncnts measure financial position and the results of operation; other financial statements measure changes in retained earnings, the flow of working capital, and the flow of cash. Accounting may also be used to measure financial data such as the cost of products, variations otual and standard costs of products, and the dlffaraaaaa in costs and rov>_nues between alternatives. • troment la concern:" J. with the quantitative ita af >bj 'ct radltlan, at Leo.it, accountin,: is concerned ttlth the quantitative aapaata of objects.

PAGE 34

a _ Btin I aid l e ' ; th »tli >r * '• .ind contingencies which do not Iwi ton aantltatlve aspects of objects, I heart attack suffered by the president of a business corporation nay be of more interest to the stockholders than much of the data that is reported — the amount of goodwill carried on the books, fey . Traditionally, goodwill oarrled <>n the corporation's books la reported on the balance shfcBtj a heart attack suffered by The president is not BJOittieaee! in the financial statements. It tnay bo argued that the r said nt's heart Bttaoic Will he reflected in th financial statements in the future by moans of redtteed profitability t but ther is I time Las;, there are those who argue, or at. t, the possibility of extending accounting to nonquantitativo aspects of objects. The requirement that eeaaureatent be "in terms of on v • ', Leminatlng the notionof • ptifieant nanner" and "events, " fhen an evont impact may be highly significant for t'-i financial (or ether) velfars ?f an jntity, the i , ., |.q r iesrd it or not in tUtttlng rooorda tde an the basis if ihetfc r it can >re* >d in terms of money; aonaequently tveata )" trivial nature are reoorded vhl i loatentous occurrence:whieh arr; quantifiable but to which a dollar value sennet ho attaohod**e # g #tf doubling share af aarket, number of lost sales*«er nonquantifiable events, such as the choice of a ne*t resident, are effectively ignored (13, p. ?.'•)). By tradition, accounting has confined it* quantitative lUTOU t 1 \y to monetary tor Measurement of other quantitative aspects of objects.

PAGE 35

29 such . ./sicai units of production durin,; a r ;iven month, is within the range of accounting, but such measurement; b*a not gained the status of measurement in monetary terms. Basic structure of the ijusiness ni*i following structure of the business inuasuruprocess has be.;n suggested by i'aui Kircher: 1. D B termination of the objectives of the business ontity--tha purpose which is to be served in a particular situation. 2. Determination of the types of factors which «.ii .Lit si.-rv . to attain the objective. 3. Selection of the key aspects of the factors— the aspect:; v.'hich are to be measured. k. Choice of: (a) a measuring method; (b, 1 a measuring unit. 5. Application of the measuring unit to the object to bo measured-the central action of uwusur. r fit. 6. Analysis of the measurtment— rfclating it to tli r MMItr«NStl (otiiur in time or in iiind I . 7. Evaluating the effectiveness of the measurement by de tcr.nining the extent to k'hich it assisted in the attainment of the objective (lU, p. 68). "A central problem we face is to define the prop«rtl*a of e. business (or 'attributes,' as some have cellod them) that accounting should seek to measure'' (15, p« 257). Tn© first three components of the structure ar. important but not included within the main purpose of this paper. The profit motive is usually

PAGE 36

30 U ' to be the primary purpose of business enterprise. Entities other thRn business entities have other objectives The main purpose of business firms is to increase the economic resources under their control through their activities. , v. n though business firms have many other objectives, their success or failure is primarily evaluated on the basis of the increase or decrease in the economic resources over which they have control (16, p. 151>. ihe subduals of business enterprise have been ^iven more attention in recent years than before. Subgoals may include importance in industry, growth, cash flows, easterner goodwill, and public service. It is difficult to measure subgoals. "in most cases our ability to isolate? specific benefits from a general system is inadequate and we are simply not ablo to generate enough information for meaningful measurements" (I7» P« 2k), Therefore, the assumption is made in this paper that accounting is primarily concerned with the measurement of profit. The selling of products and the rendering of services c\ro usually considered to bo the means of obtaining the objectives. The financial aspeots of rendering services and selling products are the key aspects to b=» measured. "Accounting measurement is primarily concerned with the measurement of assets and income " (Li, p. 1.51 ) . As has already been suggested, there are accountants who suggest the extontion of measurement to aspects other than financial aspects.

PAGE 37

31 . . d i.ljctr. ;»ion vf 1,1 is point la n t < vlthln the scope of odj . juntants cannot always measure what they want to ukasurt', U ' | al of a business enteral-!:.*is to ir.a,vo a profit, t.ccoiintin,, should measure the amount of profit. There is no perfect way to BOOOUro profit* "lha accountant ' l approach to this problem is, to substitute BOttO thing that can bo measured for the khlnga HO would Lilto to measure if we were more competent" (19, p. 9'-*). This is rtforrod to as usin,; surrogates, or substitutes. "icuotintindata as I as other types of business information are surrogates which the dool slon-aoiror us-^s to carry out the decision process' (20, p. 192). Tho basic Oioosiiroaoat task of accounting is the selection of a OOOOttrlng MOttkOd and a iioasurin.: unit. The raiasurin.i unit is the lan^ua go in Mhloh the results •nay be expressed. file choice of a language is one of the decisions a noasurer must maixo. "Tho lOOavror oust 1. -v. Ljj a ian.'ua ;j which adequate -y OOOflROliOOtOfl to rson what the -isor .nust Jo to utilize the i. if or. nation coatained in tho leastirein^nt" (21, p. >.5). A dilemma ii >s in the selection of a language. C. nest Churcnman has expressed the dilemma this way: The clearer a lan;;ua^e the more confusing it is to most people. Preciselanguages narrow thi class of users but increase the decree of f of InaoiOIlt that any user can attain. Ihe proper balance between

PAGE 38

JZ m -i. La the linguistic decision problem of measurement (21, p. H7 ) . Accounting; expresses financial data in monetary terms. Thus, in the United .itates, the language of accounting is usually the dollar. The stUction of the dollar as the measuring unit does not solvethe measuring unit problem. A significant difficulty to be solved concerns how to deal with the changing purchasing power of a dollar. Are measurements to be made in terms of dollars with no recognition made of the changed purchasing; power between two points in time? rl -ieasuroments of financial position and income based on numbers of dollars without regard for any differences in the economic significance of those dollars are cruder economic measurements than we are capable of providing " (22, p. 110). The choice of a measuring method is the central theme of this paper. "income and wealth are dependent upon the choice of measurement rules" (16, p. 221). Several possibilities are suggested, discussed, and compared. "Accounting is a measurement system which is plagued by the existence of alternative measurement methods" (23, p. W). The fifth part of the structure is the act of applying a measurement method. This is measurement according to the common use of the uord and is not relevant to this study.

PAGE 39

J3 The sixth component of the structure is the u.io, or application, of the ro.sults of tlv^ measuromont. i ii ; us3 actually has implications for tho selection of a measuring method and a rnoasurinf; unit. " fhe measurement procedures underlying any set of accounting information are inevitably linked to tho purpose for which that information is provided" (22, p. 101). In advocating measurement procedures in accounting, it is mandatory at tho outset to specify tho purpose for which the measurements are intended. The attribute to be measured and the unit of maasure en t to bo utilized then must be demonstrably consistent with that purpose (22, p. 102). tf the primary ^oal of a business enterprise is to make a profit, then accounting should make a contribution toward this ^oal . Accounting should make a contribution to whatever the goals of a business Might be. Therefore, evaluating the effectiveness of the measurement in attaining an entity's objectives is an integral part of the measurement process. The final results of the measurement process is really tho deciding factor in determining which measurement method and unit is best. According to Ijiri, "if people are likely to behave in a more 'desirable' manner in response to tho values of assets and income prepared under one set of weights than under another set of weights, then and only then we can say that one set of weights is better than another" (13, p. 161).

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Jk Carl • it forth the following si illar typical oendltions (and preconditions) for accounting measurement: i. Specifying and ordering worthy oljecti 2, Determining decisions and information needed to accomplish objectives; 3. Identifying and ordering individuals with Legitimate claim, to information; k. Jj-cidin;', which •vents arc relevant to achieving these objectives; 5. Da elding what aspects of tho events should be abstracted; 6. Adopting a set of feasible measurement scales and rules that will yi.2ii an advance in objectives (17, P. 17). dumber three is the only condition listed by .ijvitic Which is essentially different from those listed by Kircher. Uevine points out that an ethical aspect is involved in ordering individuals and that accounting should be; concerned with this sthleal aspect. Measurement and Value Measurement is a term uhlan has gained prestige in tae fiexd of accounting in recent years. As measure, went implies (or represents) accuracy, it possibly is used as a status symbol. i'erhaps the use of measurement in the physical sciences is imitated by the, social sciences. ..rouse says accountants are really talking about the measurement of value. "The relevant attribute with which we are essentially concerned is that

PAGE 41

• 35 of value ; the -nea suremen t process in which we are fundamentally .-ngagod naay bo properly described as valuation " (22, p. 107). The term measurement is used because of the emotional effect of the us; of the term value, "The torms value and valuation have an unfortunate tendency to arouse emotional reactions anions . . ."(22, p, 107). By usin tlxj word measurement , accountants may avoid using the word valuation . '' Meas urement , on the other hand, is an innocuous term as well as a prestigious one; it is not branded with the emotional stigma attached to valuation " (22, pp. 107-8), Sprouse believes that accountants should recornizo valuation as the relevant attribute in reporting to the stockholders of a business enterprise. The financial accounting process "could be improved enormously by a clear-cut recognition of value as the relevant attribute "( 22, p. 108). R. J. Chambers has a different view of the relationship between measurement and valuation, "It seems . . . that greater clarity of argument is possible if the distinction is made between acts of valuation which always havo reference to the future, and acts of measurement which have reference to the past and present" (2U, p. 32). Chambers believes accountants are interested in measure iunt — not valuation. Most accountants, as Sprouse, do not make such a distinction.

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36 ^ccur?cy in common usage, measurement Implies accuracy. Rosalia of measurement (numerals) are often taken as fact. A ; ivi>n person weighs one hundred sixty pounds, A room is fifteen feet uide and twenty-four feet Long. Measurements may not bo accurate. The given person may weigh one hundred sixty pounds and three ounces. The measurement could b s STea rore nearly exact, using even smaller units than ounces. There are degrees of accuracy; it is not essential to be completely accurate. In fact complete accuracy may bo impossible. Couiplete accuracy might not be recognized if obtained. The degree of accuracy to be obtained by any measurement (accounting or other) defends uoon the purpose for which the measurement is made. If a room is being measured for wall-to-wall carpet, the measurement should be within perhaps one-fourth inch of the actual dimensions. If the dimensions are obtained to I t line the number of square feet per student for testing ^urj.osej, measurements might well be rounded off to tlfcS nearest foot. Accuracy in Sciences The physical sciences are sometimes thought of as boin,'^ exact. Chambers says "the presumption that xact sciences provide measurements which are paragons of accuracy Is false" (24, p. k5) . -ven in

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37 the e.iact >ci "ic.'s, *{ c of accuracy taught is I I '• >.:•('• ] |" [2k, p. t>j)« Chamber I applies this idoa to accounting. The current aaab oqulval. -tit (hi >ropO araaMHlt) can j found f i ith some d< r of accuracy (2», p. *6). Probability and Decree of sirror Complete accuracy in accounting is never possible, Furthermore, it may be impractical to obtain complete accuracy or highly accurate data even if it were possible. Therefore, the user of financial data should be aware of the degree of accuracy reflected in the financial data being utilized. Perhaps financial statements should indicate the probability and decree ef -Tror inherent in measurement »nethods used and in the results of the measurement. "The information of ..irement is considerably enhanced if the decree of accuracy or error of the partinaat ineasuraraent is kaawn ' U°« P< 80 ) . Probability has been given very little consideration in accounting although it La interesting to notice that " the usual ordering of assets on the balance sheet, by chanc ; or otherwise, tends to follow tha Level of confidence in the measurements" (17, p. 22). Th«i accountant's attempts to disci, eve precision are crude indeed, but, worse, it is possible that he omit>; iin.-ortant information simply

PAGE 44

y> because his methods of convoying precision are so crude. A littlo-explored alternative estimates ability numbers for both the amount to bo paid and the possibility of having to pay at all and derives an expected value for the unfavorable prospect (17, p. 22). >caua in Accounting Stevens' nominal scale would include the chart of accounts within the ran^e of measurement. ith the rejection of -Stevens' approach, the designation of measurement would be unduly tJoni?! to those systems. "Unduly," because these systems still extract si^nif icant information for comparison in research and practical decision raakin , information that often can efficiently b2 transmitted by numerals only (10, p. 63), The nominal scale although basic to the accounting process is neither tb.o only nor the most important scale pertaining to our discipline. The .-valuation process--th^ core if theoretical accojntancy--utilizes the ratio scale; statement analysts ; jri>nai'ily work with ordinal scales; and c?rt3in aspects of cost accounting can be considered as applying the interval -scaU(10, p. 68). standard costing is an example of the use of the interval scale. Iha dollar scaU is a ratio scale. Thei i , ij.c ver, instances of mvilti. L6 measurement, the dimensions of which are measure! on scales that differ fre.icpoh oth;r; Um accotmti.i transaction is one of theio cas>?^ ..." (10, p. 7 1 -' ) • iii.c't.wt of accounts (nominal scale) is used in classifying the debits and the credits of a transaction, kJjM distension Is measured by an interval scale. The dollar amount is measured on a ratio scalo.

PAGE 45

39 Kinds of Measurement in Ac count in t "Most of t'l 1 WllOWln and accounting men^ur j belong in the category of Measurement by fiat, which is reflected in a certain definitional arbitrariness of our discipline" (10, p. 79). Mattossich emphasizes that neither fundamental nor derived measurement is :i.-;ed to much extent in accounting: There neither exists at present the possibility t; infer accounting values through "natural laws" (i.e., by fundamental measurement) nor throngta a combination of two or nora fundamental measures that result in derived measurement. Most of the 'conotnlc an) aouauntin : urasuraa bul »ng in the category of measurement by fiat, which is raflaotad in a certain definitional arbitrariness of our discipline (10, p. 79). Carl T. Devine feels that attempts by Torjerson, Mattessioh, and others to find fundamental measurements tend to be fruitless endeavors. Measurement is a process that requires extremely of abstraction. In this s?as'j all measurement is fiat measurement, for some identify ll I •• vr v.crty wist be isolated and related to objectives (17, p. 1*0. s ; >rouse suggests, on the other hand, that direct measurements are often used in accountin . Examples include the measurement of assets such as receivables and payables (22, p. 111). He recognizes the fact that fiat measurement is more often used. The value of an asset can be measured dire ctly only if inferoation i:i available cone rnln amounts of future cash floii's, timing of such cash flows, and the appropriate rate of discourt. In addition, if the future cash flows are measured in dollars, Lt ;r it must be assumed that the purch.-' power of the dollar is constant or information concerning future prico-L i required.

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1*0 In th no of sufficiently information about these factors, direct nuaaureiaent of the ralU« of an a.;.~,:t i.. nat faasibltj Indirect neusureraent procedures, such as the use of acquisition cost and th< .-. , n t co '. , , j. ill). Criteria for woraparln;, Mens jrouicnt .letho.:.. American Accounting Association * a A ^tn te nant of Basic AcaourUn-; Theory published in 1966 suggested fefe« following four accounting standards: 1. Roll. -vane ; ( Usof ulnuss } 2. v or if lability 3. Freedoa froa bias k, iiiantif iabiiity (25. p. 7). [base four accounting standards might vail sorvo as criteria for feha selection of the most appropriate measurement method. the ilarvard Business Jchool Accounting Uound Table bald in iybU presented a slightly different sot of criteria for measurement: i. Jbj activity Two related requirements: (a; Certain standards should be used in presenting financial accounting information, and (b) It should be feasible to verify financial accounting information. 2. Usefulness 3. feasibility (25, pp. 18-19).

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kl combination of tlMSi c; I i. be u^eu in di ,;ui , . c rlnj tb« \ . . method;., ibineu list follows: 1. KoLo vancc (Usefulness) 2. Lj.ctivity \erif inbiiity (b) Froodow from hi 3. feasibility if. iuantifiability un | j i -j •• ,ureiaont is th^ u L . 1 1 of nu.iierai s to ibj ts or properties of objects to r>, r> at such objects li<_,. Accounting, as it relates to quantifier Uiwn, is a systom >£ maa >ur J.>iont . uiJ.nodt i:. 3o Lltl rt of MM physic<>i sciences and Sho ^uoiul sciences. The natuxc of i'i.'^i.i-.i-nt baa b*«n di 1 >::r broad terms in this Obapl i I • i56 laoasureraont theory i to iujn a broad area. .'ieasuro iient theory hu | ] . it t< r:o)untin^ in the li
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CIIAPTi.u III HIST^KICAL COST Introduction This chapter is the fir^fc in a series of four c:ii> . i oil discuss major laoasureiaunt methods, or bases. The present chapter is a study of a measurement base Kbicu uiay be called historical cost (or original eost)« Historical cost is generally accepted for use in accounting statements. This chapter is largely a discussion and criticism of accountin,, state* ments as they are currently prepared. The Chapter b. ( ;ins with a definition of historical cost. This is followed by a discussion of some related concepts which underly the preparation of accountin,', statements. As the realization concept and the historical cost concept are closely related the realization ooncept i^ of particular concern in this chapter. The historical development of the realization concept is followed by a discussion of the present status of the concept. The last part of the chapter concerns the offects of historical cost and related concepts, 42

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ky especially tin. realization concept, on accounting statements. I no uoo o£ thlfl measurement basis is criticized. Definition of Historical Cost Accounting statements are prepared in terms of historical, or original, cost. When assets are acquired they are rocorded at cost, a measure of the current exchange value at that time. Historical cost is tne cost arrivod at in the transaction concerned; historical cost is transaction price. A record is made when a transaction occurs between an enterprise and another party. Th« dollar amount of the transaction is considered to be an objective basis for the valuation of that which is exchanged. This dollar amount, transaction price, is the historical cost of that which is recorajd. Assets remain on the books at cost (or cost adjusted for such factor:, as depreciation) as long as they are owned by the entorpri.x. There are a few exceptions in practice to the historical cost concept, but in general when an enterprise expects to operate indefinitely, the original cost concept, or historical cost concept, is adhered to in the preparation of accounting statements. The following quote probably represents the attitudes of accountants aj» exemplified in practico. Accounting is . . . not essentially a process of valuation, but the allocation of historical

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kh costs and rov-?nu to the cnrmnt and succeeding fiscal periods. ... If values other than • ortized costs are to be quoted they should bo expressed . . . only as collateral notations for information purposes. . . . There seems to be no sound reason for repeated adjustments of asset values for the ordinary changes in price levels commonly experienced from one generation to another, . . . I history of cost an I cost amortization is a consistent record of actual occurrences . . . and constitutes an essential starting point in financial interpretations (27, pp. 61-62). This quote from the lyjb American Accounting Association Statement ( A Tentative Statement of Account ing Pri n ciples Un d erlying Corporate Finan cial State ments ) represented the attitude of the Executive Committee at that time toward historical cost. The historical cost concept is criticized with varying decrees of sevor«ness. As an illustration a quote is "iven here from Harry M. Kamph: Conventional balance sheets and operating statements have become so distorted that they are of little or no guidance for decisionmaking purposes. I i iout taking into consideration current value.;, d find it impossible to reach valid conclusions or develop fully revealing information on such important matters as: 1. Return on total capital employ?!. 1. Return on capital equity or stockholders' investment. 3. Optimu •rtgftff* loan f inane in, terms. k. Necessary coverage under firBad comprehensive insurance policies and proof of loss. 5. evaluation of specific segments of an operation or an ontir:; business for purposes of purchase, sale or merger.

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U5 Costs and profits measured in terms of current values rather than often misleading book or original values (28, p. 17). Related Concepts Underlying Accounting Statements The following concepts are closely related to the historical cost concept and also, like the historical cost concept, underlie the accounting statements. Presently accepted methods of accounting include all of these concepts. Going Concern There was a time when the venture was the predominant form of business enterprise , As ventures lasted for only a relatively short period of time, an accounting was usually made only at the end of tu venture, The venture form of business enterprise is almost completely gone. It has been replaced by business enterprises which remain in existence for long periods of time. Although thousands of enterprises go out of existence each year, a majority of business enterprises, especially medium and large-size ones, have lives of indefinite length. >ince business enterprises usually operate for long periods of time and are not expected to discontinue in the immediate future, they may be assumed to have a continuous life. This "continuity concept," or ",;oin ; concern concept,' 1 assumes that business

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k6 enterprises remain in existence indefinitely unless tfhare is •Idmtec to the contrary. \ccountin . statements are generally prepared on this as^unption. Fho primary impact of this concept is on tho valuation of assets. Thlfl assumption has implications for income moasur *ment lu3 to the interrelationship of the balance sheet and tin; income statement. Accountants iiave generally feit that since liquidation values may be of little importance to a going concern, this continuity of life concept is used as justification for another concept, the cost concept. The f ollowing quotation from tlenry Hand Hatfield's Modern Accounting points out the insignificance of liquidation values. thm proper value is that which they have to the holding concern, and not that which they Right have to other persons, whether these persons are ordinary cus turners, or those who might bid on the assets at a liquidation sale. The value is that which they ha n ..• to Hm company as thon existing and not to a company in the hands of a roc^iv r, or one closing up its accounts and ~oing out of business (29, p. 8l). This quote does not mention how to arrive at the value to the holding concern. This does not necessarily imply a historical cost basis. Reed K. jtorey quotes Hatfield as saying the going concern is not usually taKcn to its logical conclusion which would be to value merchandise at net realizable value. A logical application of the going concern concept would

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k? I b teasaronent of fix at c.ist beoanSS changes in raltte from ano pert > ! I » mother which are not expected to be realise*! by the Ml* of the f i I asset ar« not as relevant as o La value of carrent assets, especially those which tfili be converted into cash in the n A ar future. ; -*ys, "The failure to carry the going cone ; .ion to its xOfiicai conclusion left a gap in Recounting theory vhich was filled by the realisation concept" (30, p. C37). It is the realization convention which requires valuation of all unr^alisiid (i. e., unsold) assets at cost, whether they bo fi I 1 or unsold inventories. The area of complementarity between the realization and going concern conventions lies in the area of fixed asset?, whereas the area of basic conflict lies in the aroa of current assets. . . . In tnii^ area the realization convention is clearly dominant in modern accounting (30, pp. 23738 Time Periods p the venture fora of business enterprise, an accountin • was undo upon the completion of the venture. Ehc MOS I Lneone earned can best be determined at that time, .lion there is continuity of life, it is not feasible to wait until the end of the enterprise life to measure inco . The tim j-.y^riol coiTjntion has developed to bnsak th'.life of en enterprise into arbitrary time periods. this arbitrary time period is usually a year. the calendar rear Is used by i
PAGE 54

kS which the calendar year ma the mtura ;s year. Many business Jit.r^ri.'' ; art now using what is considered a natural business year for their particular typo of business. accounting for a business entity \>y tinu> -riods glr«a interested parties Useful information about ' enterprise before its life i,i ov^r. ioraa accuracy is sacrificed for timeliness. Realization Since accounting attempts to measure income by time periods there must be a criterion to determine when income arises. The realization concept has developed to meet this need. The dominant interpretation is that a change in value has taken place with sufficient objectivity to warrant recognition in the accounts. A sale is usually thought of as having sufficient objectivity and is generally td. »cc.ted criterion for realization. The realization concept is related to the original cost one . t in that assets are recorded at original cost until realization is ',. r.?d to have taken place. The development of the realization cone t ad brtn^ about feha L v Lopment of the historical cost cone, -t. ill assertion by the Court of ti: realization postulate lent support fe« edition that, until realized, uouid be carri'J at cost.

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• k9 and thus oontributod to the buildin/r up in accountin • literature of a so-caiied 'traditional cost principle'" (3. P. 27). Like the historical cost concept, the realization concupt is also based on transaction price. Mo increase in the value of an a.ssct is recorded until another transaction occurs. The realization cone, t delays the recognition of revenue until a sale or some other sufficiently objective event occurs. This means that the usefulness of accounting may be impaired by the time delay. No doubt, everyone would like timely reports that arc also conclusive, but for the most part the two conditions (timeliness and conclusiveness) are in conflict. In most cases accountants have chosen to be more conclusive rather than more timely in their recognition of changes that have occurred, thereby exposing themselves to the charge that their reports (issued at frequent intervals) are less useful than they could be (H. pp. 33-3**). In emphasizing the importance of the evaluation of past decisions, ivdwards and Boll point out that ''if the demand fer data is predicated largely upon the existence of change and uncertainty in the economy, accountin , data, to be most useful, should be designed to report changes as they occur" (32, pp. 5-6). Like the historical cost concept, the realization conoept results in some limitations in the determination of periodic income. Hie realization concept will be discussed in more detail in a subsequent section of this chapter. nou h has been said to

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50 indicate that the realization concept may limit the usefulness of accounting statements. Matching While tho realization concept determines the period in which revenue is to be recognized, tho matching concept determines what costs become expenses to be matched against revenue. The matching concept moans that those costs which were necessary to attain the revenue of the period should be matched with the revenue, The expenses which apply to a given period are those which can be matched with the revenue which is recognized during that period. The following statement is made in the 1957 revision of Accounting and Report ing standards for Corporate Financial statements ; " fhe committee advocates that costs (defined as product and service factors given up) should be related to revenues realized within a specific period on the basis of some discernible positive correlation of such costs with the recognized revenues" (33, p. 369). In all significant cases where there is uncertainty, revenue is the controlling classification. It becomes the guide to action, the focal point which mau.es matching effectual in areas of uncertainty {3h, p. 733). 'Hatching process developed when the "increased net worth" concept ,;ave way to tho "realization" test of income. "It became common to speak of income determination as being essentially a process of matching

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31 costs and revenues" (3. p. 28). The tiuing of revenue nition d«1 to a lar ;>; extent the timing of expens recognition and therefore the timin g of net income recognition. Matching is nocessary to determine tho net increase in assets which is similar to "increased net worth" because not assets equal net worth. Objectivity Objectivity is difficult to define. A key word in the definition of objectivity i:i "unbiased." •iaurice ;ioonitz defines objectivity as "unbiased, suDj-ct to v.r if ication by another competent investigator'' (31| P« k2) . This implies that many individuals would reach approximately the sa;.ic conclusions. Harold &« Arnett gives the following explanation of objectivity: Kinanciai information is objective when: 1. It is fr-^e from personal opinion and bias, which further requires a. that there actually be an exchange of some thin,; for something, both having "value," and (1) this exchange be the result of an arm's length transaction between independent parties, (2) this exchange be capable of being accurately measurable in dollar^, (3) that one of the negotiating parties in the exchange be the unit for which the accounting is being done. 2. It is substantiated or capable of being substantiated by an independent investigator (35. P. 65).

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52 There or of objectivity. Accuracy is 1 'ior.nt in determining Whether or not data is objective. "If an item can be raoasured with reasonnccuracy, it assumes a large decree of objectivity" (3^. ?. 251). objectivity is considered to be an outstanding characteristic of historical cost and the realization concept. Conservati B I Conservatism is sometimes axpressed as: Provide for all losses; anticipate no profits. Paul 3rady, in hi -i Inventory of '.Jonerally Accepted Accounting Prin ci^l js for .-usinoss Enterprises , e Tola ins the cone • I of conservatism as follows: From the viewpoint of generally acoeptod accounting principles, the concept of conservatism comprehends the t i 1 Ldeftl that I Sales, revenue and income are not to be anticipated. Recognition ordinarily requires consummation ie and delivery, and I liabilities or losses should be recorded regardless of whether the definite amounts are determinable (37t P. 3& ) • Gtrady notes the close relationship between the conservatism concept and the realization concept by saying that the abov> ideas "often have been dealt with separate concept of 'realization'" (37. p. 36). Conservatism is a-tunlly a technique for delaying the r •••gfl i. tion of revenue. Realization and conservatism arc related because the realization concept

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53 i fairly v., nr*tlr« concept in that profits are not anticipated very far in advance of tho actual r I ipt of cash. 'Ja • ' r. I Lpta Aouid usually bo i.. M -t consrvativo method of rocognizing rcvor.u?. There are excoptioni; to this statement such ay the advance of cash h'.'l'ire l t .roduot i :. : .ivjred or .-orvic »fl are rondercd. Historical cost is also a conservative concept. The lower-of-cost-or-market valuation method of inventory valuation is even more conservative. ary The concepts discus. i among tho most basic accc-.. i me«pts« It i :(-iali ; i I i. theuse of these •OBOAJ ts aiun,; v.ith ether L .onc rally accented accounting principles and pro* • _>ults in accounting statements which have limitations. Pais discussion jf these basic concepts is intended to I accou.itir..., statements ari knowingly prepared under assumptions which will not result in perfection. It is the purpose of a latter section of thij oa-tJter to point out weaknesses in accounting lltlMMIlll lu. to the •« of th»s« concepts. It is t i >urpests of subsequent chapters to discuss I r I »tivo measurement bases vhio! tl I result in better accountin

PAGE 60

s* Historical cost may bo thought of as urement | -h ij i.ir.eiy controlling in th preparation of accounting statements. It is closely related to the othor concepts discussed here, but it la especially related to the realization concapt. Fha realization concept may be thought of as the application of th« historical cost concept. Because of the importance of the realization concept in current-day accounting, the following section of this chapter is devoted to this tu,;ic. The idealization Concept rh« realization concept i .-. the currently accepted basis for revenue recognition. According to the most commonly accepted meaning of realization, revenue should be recognized *iion a sale takes place. Tiu*re •>!"• other meanings for realization anc, criteria for recognition as are indicated later in this section. This section considers the historical development of the concept and its present stat.i:. Historical Development of the Ileal izatioa Concept iliu Study . rou.j on liusiness Income points out that the postulate ,f realization is of quite modern < i in: A review of accounting, legal, and .-conomic literature suggests that the realization postulate 0< .ted prior to the First Aorld *ar. In 1913 leading authorities in all these fields in

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'Jr• t ; .r» and Am-iri , i to I the "increase in net worth" concept of income (except i:» fcb i oa«« .>f "ptrMBMt" >nt#rprtMc) ( though the way in which it could best bo implemented was not settled, and unrealized appreciation vas not perhaps deemed to be a part of "income from operation-:" (3, ?Pt 23-2*). As an example, the Study Jroup quoted the folio it by \. L« Dickinson in his Account ing .'rnctici: and rocoduro (1913)t In the widest possible view, profits may b:stated as the realized increment in value of the whole amount invested in an undertaking; and, coiiv-'rssly, loss is t!i3 realized decrement in such value. Inasmuch, however, as the ultimate realization of the original investment is from the nature of things deferred for a long period of years, durir rtlal realizations ara continually taking pj.ace, it becomes necessary to fall back on fclfl it l of value at certain definite periods, and to consider as profit or los.i fen ti t i.nor tase or fi-.-croase between any two such periods (3# p. 2J*). W. A, i'aton also accepted an increase in value theory. de makes the following statement in his Accounting Theory , published in 1922: rho liberal view that, ideally, all bona fide Value char-go:; in either direction, : 'i ver cause, should be reflected in the accounts has «ithout arguu. ::\t . ... rir logical position is the proper one for the professional accountant, at least as a starting point ( JB , P. vii). In those early years of the current century, the realization concept did not have its current status, The events of the times probably brought about the almost complete acceptance of the realization concept. The sixteenth amendment in 1913 "»ay have had a great effect on the creation and acceptance of the

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G reai.i. soneapc (3, p. Z6) t Bw Laiufaaark easa of Si n ' -'.'..ib •• in 1920 a] 1 contribution to '. 1 all sat ion concoct, In this doolslon, Che p] Fvans ;.iid ! It is of tho saaaataa of Lnoaaw that it should be roalized. . . . Income necessarily implies separation and raallsatlan* . , . The Inoi i. tho value of lands due to growth prosperity of the ' ' f la not income until it is renin ( isner v. Macombor, 2.5 U. 3. 138, 195 fl920].). The economic exparionco of the 193^'s fairly well finalized the elimination of tho increase-invalue cone >pt« The realization concept bad gainad acceptance by 15 naad by the fir: t of si:-, rulei ei prlneipltti l la] '. I by « Iti-te of Accountants that ;-( ar: "Profit is daoncd to be realized when a sal « in the ordinary course of business is uffoctod, unit., t .:: rcuinsfcancos are aaeb I'nat the collection of the sale price is not reasonably o. >i .39, P. 129 )• The Present Status RaallaattlaJI is currently the generally accepted criterion for revc.m r^co, .nition. Uuco.;nition refers to the timing of recording revenue on the books of an enterprise. The realization concept, used as a guide to revenue recognition, lb primarily a timing device. "The test of real i/.a tion is used to determine when to recognize f particular ito.ir' (36, p. 2^1). "The entire

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57 income from ;nlc arises at the moment when realisation is decmod to take place" (3, pp. .19-20). Uecause costs and revenue:-, are matched to determine income, income is assumed to arise when the recognition of revenue takes place. There are some differences of opinion on the exact moaning of the realization concept. The 1957 Statement by the American Accounting Association Committee on Concepts and Standards Underlying Corporate Financial Statements defines the realization concept as follows: The essential meaning of realization is that a change in an asset or liability has become sufficiently definite and objective to warrant rocognition in the accounts. This recognition may rest on an exchango transaction between independent parties, or on established trade practices, or on terms of a contract performance of which is considered to be virtually certain. It may depend on the stability of a banking system, the enforceability of commercial agree-oents, or the ability of a highly organized market to facilitate the conversion of an asset into another form (27. P. 3) . The key words in this definition are "change" and "sufficiently definite and objective." According to Floyd :.. ..indal, this definition implies that "the change may have taken place prior to the time it became sufficiently definite and objective for recognition" (36, p. 251). Floyd . indal defines realization by using the throe key ideas from the definition just quoted: The realization of income takes place— that is, income comes into 2xistcnce--v.hen certain criteria have been fulfilled in connection with

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, on' Utor •• eluded arc Inc. ;.sod by gifts or additional cvner investment . Among '..". attl: IlM g*ln or increase must be confirmed by »«• event or transaction such as the receipt of cash Of pr» PT ty, relief from liability, or a change in the nature of legal rights. 2. The gain or increase must be subject to objective mensuromrnt . 3. ' I -' n or increase muit be definite and irrevocable {kO t p. 36). Inherent in these definitions is tht> criterion that revenue must have been economically earned before or at the point it is recognized {kl t p. k'J ) . "Economically earned" means that a val.u-3 increment has taken place due to the 0] rt ti< as of an entsrprit.t, "P.?v nues pre effectively earn — r ;ub.,tan tit I iy all of these activities necessary for and associated vith the production <.f tl.:;e revmucs have been comj.let d" (kl 9 P. **), tl-er criteria have been used in determining vhon realisation tal.os ;>lac<>. llobert T. J^rouso and Maurice .'oonitz list tests which have be.en ••4 to determine if an item is realized or not; l a It had to be aarntJ. 2. It had to be the result of a conversion brought about in a transaction between the enterprise and someone external to it. 3. It had to be the result of a legal sale or i lilar process (related to 2, above). U. It had to be severed from capital.

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59 5. It had to bo in distributable* form (related to U, above). 6. It had to be evidenced by liquid assets (related to 5, above). 7. Its effects on the enterprise had to be the subject of accurate measurement or of estimates with a high degree of reliability (2, pp. U-15). The American Accounting Association 196U Concepts and standards Research Study Committee on The Realization Concept also presents its view of the realization concept: w.hen should realization be considered to have been achieved in a revenue transaction/ Three factors have generally been considerod sufficient in answering this question: 1. Tha nature of the asset received; 2. The presence of a market transaction; 3. The extent to which services have been performed (42, p. 31k). It is difficult to be precise about what is the current prevailing practice, but it appears that presently accepted tests for realization require receipt of a current (or liquid) asset capable of objective measurement in a market transaction for services rendered (U2, p. 3* 1 *). The 1957 statement has been amended by the work of this 196U Concepts and Standards Research Study Committee. The conclusions of the committee cannot be classified as generally accepted. In this sense, MM conclusions and recommendations cannot be considered as part of the present status of the realization concept. They are included here because they have been made, and in this sense they affect the present status of realization.

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60 following two problems wore discussed by the com.aittce : 1. Transactions associated with tho exchange of ,",oods and services between the accountin entity and some independent, external jroup. The i^ arj referred to . . . as revenue trans actions , 2. Changes in the value of resources during the time they are held by the firm. Those are referred to ... as holdinp; .a ins and losses (1*2, p. 313). The committee arrived at those conclusions: 'The committee unanimously recommends that tho effects of changes in value of all assets, other than goodwill, that can be supported by adequate evidence be recorded in the accounts" (1*2, p. 312). "A majority of the committee recommends that 'unrealised' changes in the value of assets should not be included in the computation of reported n«t income, but should be shown on the income statement below the net income line" (U-Z, p. 312). Xn considering Mhen realisation should be regarded to have been achieved in a revenue transaction, the committee made the following decisions: 1. Xature of Asset Uoceived--'lhe committee recommends continued adherence to a policy of requiring objective evidence of tho valuation of the a^st t received before rt. cognizing realized revenue. . . . The committee would stress measurabiiity, and not liquidity, as the essential attribute required for recognition of realized revenue. 2. Presence of a Market Transaction — There is general acceptance of the view that a market transaction is necessary for revenue to be realized. rho committee concurs in this requirement.

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6l 3. iixtent of service I'erf orraed-traditionally t in establishing a realization test, accountants have considered the decree to which the seller has furnished the services being purchased. The commit tee is suggesting that another factor is more relevant, namely, whether the seller has performed an action which is the crucial ovent in the process of earning revenue. This crucial ov«nt may be something distinct from the rendering of services to the customer (42, pp. 315-16). There is often some confusion between the terms "recognition" and "realization," Hobort T, Sprouse has made some observations concerning this confusion, i'rior to 1957, the term 'realization' was widely used and 1 think generally understood" (43. P. 522), The general meaning of realization was expressed by the x'aton and Littleton monograph: Uevenue is realized, according to the dominant view, when it is evidenced by cash receipts or receivables, or other new liquid assets. Implicit here are two tests: (1) conversion through legal sale or similar process; (2) validation through the acquisition of liquid assets (44, p. 49 ) , The definition given in the 1957 Revision suggested that revenue is realized when it can be recognized in the accounts, Sprouse refers to this as a "drastically different concept of realization. . . . This concept renders realization devoid of any special meaning; realization is made merely a synonym for recognition " (43, p. 522). 1 he two terms, realization and recognition, are often used interchangeably. As the realization concept is presently accepted as a :uide in the timing of revenue recognition, then realization and recognition

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62 take plttQ -' time. The occurr \nc »f one implies the occurrence of the other. In common usage, the two t»nta oftm Inplj the sane thing. ignition of revenue on the basis of realization concept c'oey net nocus.-j^rily imcJ y that it is the only "correct" method of recognizing, revenue. Sprouse air! Moonitz express this idea as follows: Reliance on "realization" for the recognition of profit does not inn] y that profit arises only at the moment of sale. Instead it implies something that may or may not be true in t ;dvcn set of circumstances, namely, that satisfactory results emerge if profit is consistently recognized only at time of sale (2, p. 11). Curre ntly accepted exceptions To the g>-narsl rule for raalization >U tnc.^h in current practice realization is usually deemed to take place at ths point of sale, there are exceptions to this general rule. for example, in unusual circumstances realization is deemed to take place when physical production occurs rather than when a sale takes place. In order for realization to take place due to physical production, "production must be accomplished either by a binding contract for sale of the product or by a market of a certain character" (**.5, p. 9** ) . Certain metals (such as frold, silver, and copper), farm products (such as cotton, wheat, corn, oats, rye, soy beans, barley, raw sugar, and coffee beans), crude oil, and securi tie-; luct these requirements. The market price or contract price is

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63 u ; > I a ; basis for det^rm^ ling rov •!!•«». Irv-'-'nt >r\co may b^ u.j »d although it may vary somewhat fro-n period t) period. A •hAltgt la V'tltn botwoon the date of completed production and the dat-? of sale does not im-vly that early roco^nition was incorroot. Russell Bowers makes the f ol loving statement concerning whoat: • quoted price used in tir; inventory Might differ fr?m the price of sale, but this c;ain or loss need not b-* looked u->on as an error in making the previous estimate of value. It is properly assimed to the period between the date of completed physical production and date of sale and should bo attributed to speculation rather than to wheat growing. Any gain or loss could of course bo analyzed into interest, storage service, and market fluctuation l*3« p. ^5). liven incomplete physical production may be appropriate for realization to take place. Bowers suggests three ways in which income may be objectively measured which are particularly applicable to incompleted contracts: 1. A completed transaction between parties of independent interest. 2. Apportionment between fiscal periods on an objectively determinable basis, the total for the various periods being determined by a completed contract. 3. Ueference to price in a market of a certain recognized character (U.5, p. 105). Shipbuilding is one example of incomplete physical production in which it i customary to recognize revenue beforo physical production is complete and legal title is conveyed to the purchaser.

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6h Other 4 jr j . ' ' • i th> realisation o i I Its in t -orMarket calculations, index numbers of specific commodities or groups af slallar aoaaaodltloa in dollar-value *lfe, ' '. ' ia of not real 1 sal te ef bjrprodweta >eda and aqulpaeat, lions to the realization oeaeept Lndleata that current practice sere r a a fairly wide range, Carman ?. Hough haa *ed the wide ran,:;, of practice in considering income to be realised I J. what time, or in what stage of a transaction should income bo considered as having been realized/ Khila It is ;',enerally understood that incoaa should be recognized when services are rendered or ^oods delivered, in practice the time of taking it up ranges all the way from the time of production, as in the case of aoaM minin | n t ^rprises, to the tin.. the cash is received, as is sometimes done in the case of installment sales (U6, p. 39). ouramary The realization concept is a fairly recent development in accounting, having dev La d < rly in the present century. At present it is a generally aeeepted eeaoept, Hie usual interpretation of the realization concept is that revenue ;uay be recognized when a sale takes place. Realization is the usual guide, or criterion, to revenue recognition. lliere are some exceptions to the general interpretation of the realization cone • jt. .\ceptions involve the valuation of

PAGE 71

G5 assots such as certain metals, agricultural products, securities, and other assots .such as ships rhlch require an unusually long period of time for construction. effects on Accounting Statements And Criticisms Accounting statements are currently prepared under the historical cost concept of measurement. As has boon pointed out, the realisation concept is an important concept related to this measurement base. The purpose of this section is to point out some of the shortcomings which result when the historical cost measurement base is used. Accountants themselves recognize shortcomings in accounting statements. Howard I. Ross made the following statement in a presidential address at an annual meeting of the Canadian Institute of Chartered Accountants: "The basic problem which I would like to concentrate on today is posed by the paradoxical fact that accountants appear to divide their time, perhaps almost equally, between preaching, on the one hand, the great importance of publishing regular financial statements and insisting, on the other hand, that one who relies on financial statements, in almost any of the circumstances in which one would normally turn to them, is likely to be mislead" (U7, p. OH),

PAGE 72

65 An obvious probLe n inherent It t. oi ..f {.:» historical cost coocapt is that accounting data do not reflect values (except by chance). (It should be re.nombered that historical co.it is not intended to measure value.) The following quote by .idxardj and L!ell emphasizes this in * ifact of the application of tha realization cone !: | Instead of ft sensing the identity of cost anJ value, accountants have adopted the convention of recognizing profit only upon sal?; n? protsnse is made of measuring profit as it accrues either in -.reduction or as a result of simply holding assets as their prices rise. Reporting assets at historic cost r*pres«ftts a consistent application of this convention; a record at market value would involve a recognition of gain prior to sole. tuose who use accounting data are fairly warned by this convention that the inter/pre tation of a firm's position or operation on the basis of market value is not the responsibility of the accountant as record-keeper. The accountant shares the interr tKtiva responsibility with other Members of iwanegsnont, however (32, p. LQ)« nven though a statement user may realize that I wore prepared under the realization concept, it is likely that he may not realize the full implications of the use of this concept. iidwards and Hell point out the following two limitations which result fro.?i the use of the realization convention: l . Within the frame-work of present account L r-ctices, no capital gains or losses are r corded as they arise, i.e., as individual rices Chan.; :; Bhifl limitation in turn has three main implications: a. The capital gains (losses) for any one period are incomplete; i.e., they are not recognized until the assets are sold or used in the production of roods which are sold, and profit is therefore under stated (overstated ) ;

PAGE 73

e? l. ,,o..iw aapltal gain a i: ) »f foi periods are recognized as capital ^ains c{ khi • perl hion have risen in price over an extended period of time are ^old in this period, thus overstating ( under stating ) profit; c. ilalanccsheet values arc badly distorted. 2. Capital, ^ains and losses which are realized fchrougb iio«; oi a;i Oaaet whose price haii changed and the subsequent sale of the product for which the assoc vaa good no Lneluded as part of normal operating profit although the profit results activities rather tl : n activili ai r ; ti ifficulty stems from ping reeerdo at original parehaae east with the result, for example, that one of the expense deductions froa ape rating revenue is depreciation based on the historic cost valua of the fixed asset (;;_, pp. 10-11 j. te limitations result because the realise tion convention r-quiros a sales transaction. The concept does not reoognisa holding alaa i nd losses,, i. ., changes in individual prices. Another major limitation implicit in the us« of the realization convention is the failure to reeegttise changes in value as production takes place and as services are rendered. realization convention has the effect of assigning to just one atop-the sale«M»la a whole series of steps the entire credit for having earned the resulting income. .Since 'income accrues to an individual or a business in BO— thing like a continuous itroam," it may be iiiogioal to assi ; ;n all incoros to only step (43, pp. bO-dl). in defease of ch~ .sale as a test of income realized, 'it i.-> th^.la^t vital stop in the longer

PAGE 74

6 I businoss >roe«si *vhioh indicates that th i tdj \. la now completed and tii-^ Lioo U fully earned" [k& t p. til). The objictivia of accounting statements were discu i rally in Chapter I in terms of those who use them. In that chapter no attempt was made to evaluate how well accountisi;; s fca toments meet their objectiv . l c •.Hints will tio-.v be made concarnin , how well accounting statements prepared under the historical cost basis of measurement meet the object!* Just as WW ohjeotiYJ.; were classified by types ef users, those cour.ujnts conc^min;; how well objectives are met will be by type of user e.ic.-pt that the problems of c j.tparabiiity and uniformity are discussed first as tli i.io two probl oms ore faced by both external and internal statement users. Comparability Both internal and external users of account Lu statements are interested in comparability, that is, co,a,)arin,; the accounting statements of a particular entity over a period of time. Comparison of th statements should indicate trends. Accounting statements for different poriods may not he comparable for two principal reasons: alternative methods and price-level changes. Alternative .uetlods nerally accepted accounting principles include alternative methods of handling some problems. (however,

PAGE 75

(9 "generally i> . • ^counting erinci ould ho i. I con i t illy from year to year, ) If a method of handling i Ohaaged, the effect of thi change should be sliov.n for tho year in which the change took place. Comparability ii lo.it if a change in method is not l i 'ined, Comparability is also lost between the year, b. (or tk c:i.;. lad j i : ubsoquent to the chan, The possibility of using alternative •thoda in accounting not only present:, ti i probl«a of comparability but also presents the qusstion of hov different . tkci^ioni 'vould be if an siternativo method fbit involves the problem of comparison of actual results with i r hat »ould have occurred under alternative .roc . .es have n j', ed to determine tho effect of alternative procedures, conclusive evidence has not bean found. allliam '. runs, Jr., after using business ^ames, decided that "for most of the decisions and results, there were no najor differences in results amon*'. tiia ^ames usin difit inventory valuation methods" (49, p. 3^9). n the other hand, Thomas il. Dyckman reached tho opposite conclusion in one study but the same conclusion in a I study (50, p. 1 75) . . rice-level changes Although historical cost is used in accountin . statement preparation, it is an accepted fact that the

PAGE 76

70 •>ric> Level &aa risen al tantlally luring th« mat few e f i-i. . S o prlee-level change-, nay caw c an entity to ap;ioar to be growing faster than it i . tie a . g«ta currently purchased, sapeolall/ the fixed assets, usually cost more than they did in the past. Thus, an entity nar &pp«ar to »va nere assets than it did in the paat< n the etb r haiMtj If neat of an entity's asset. | ••rchesed at a low pries Lerel, it \*ill not coraparr veil in size with other entitle a « Vet incone is also affected by the price-level changes. If costs arising in past oeriods are matched 8 "ain-t revenue of the current >erio', the net incone r daring p »rieda of increasing price levels than it v.'ouid daring a psrled of stabla cr deer rices. For a UipJ , inventories u:^ed or sold during a period may have been acquired in orior periods at lower prices. For another example, depreciation is basod on costs of fixed assets acquired in prior periods— perhaps forty or fifty years before the current period. Arthur L. Thomas has made the following observation concerning the price-level trebl : "It is difficult t) aee hen' a rat-: »f r turn can mean when it 5. • calculated la tenis of a nixed aggregate of unlike historical costs— some current, some stale, liorno originating so far back in tine a;, virtually to bo from another economy" (51, p« 576).

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71 rle«*l«Y«l ahangaa .. *y b« ~..>.i...c .. ;i g«n*rftl prlo««l*T«l Chang* a . ..te ..rii.j-j.jv L Oh . As aii prlaaa viu .u,, ,.. ba . . .-, pacjo of .>p~cilic „ | bo caiiou ^.^ciiic ,>ric; LOT . I riural pricj ;t.v,l is an avaraga of sp-cific prices, it is oovious that ->peciiic prion Ohangaa arc not necesiarily consistent with geriJiv^. prlo««l«T«l e.u tl , kh*y Bay uvon bo In 'cue opposite direction. • ..i . Lapllaa that an adjustment for ganaral pric taj not result in comparability between noeaantlng parloda* an adjaatatent for a gannrai ,.riee. .v^.. i Mild iJ.uit In comparabili If ono.y if each apaalfl* ^.l-.u in the accounting aUu.jL.itj involved a ; ... rlon«*l«T«l ehi ual to kh< , ral pricewml Uniformity Co.iiparabiiity of accounting statements between enterprises is often referred to as the problem of unifor.nity. Just as there are two principal reasons for lack of comparability between accounting statements of various years for a particular enterprise, there are also a ft-* pilncipai reasons for lack of comparison between entities. ulornative me thuds . jf alternative BMthoda aris^o hare also. A company iuay be able to cnuos.. from several

PAGE 78

72 available methods of handling any particular problem of recording and reporting financial data. oven entities within a ^ivon industry do not necessarily choose the same methods. A lack of comparability results. jome writers ara severely critical of manageaeat'a u >f :utni.Uivoj. (Accounting Methods are often the chuicj of .aana g j'jont . Important exceptions are public utilities and other regulated entities. ) Steven S a An r odor is an axaaf>l« of such writers. In an article in Barron' s , Anreder say : There are many aaknovledged alt rnatives by v.hich u-uings can legally be exaggerated >r nlni iaed. . . Accounting varies frea industry to industry. In fact, Bt i aoapanies in th field practices are so diverse as to make comparisons of aarni i than neaningfal (J>?, J udgment Another reason for the lack of uniformity betwoen companies is the need for and dependence upon judgment. Judgment varies from entity to entity. .*looriitz suggests that less reliance may be placed upon judgment in the future, but it is needed at the present: As the basic analytical framework of accounting beooaea ,.iuru firetfj ridelj accepted, specific rules can be sot according to soi.io prinoij ' , balancing of conflicting forces, such as the cost *. B H u . [ , . accuracy of Its, the benefits to bo derived fran the resultant data, and < Like, 01 tiif.ii fceljr • ' '• ' my even be determinable by analytical means. Meani .Ai.. , jul aent ausl be roll the function of more formal analysis ( 31 . p. 36).

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7? .rice-level changes The price level is aluo involved in comparisons ' L',i 8 . ITiis includt's both the problem of literal price levol and the problem of specific rice lev A comparison of accounting statements may involve the accounting statements for different entities for just one year. (A comparison between entities ild include the statement:, for several years* As i roblera of comparison within an enterprise has just boon considered, it will not be reconsidered hero. ) Pr lee-level changes are a problem largely because various entities acquirod their assets at various points in time at various prloe levels. This results in loss of compar ability in both the balance sheet and the income statement as the assets themselves er in the balance sheet and expired assets appear as Ln the income statement. Management Assuming a well-organized enterprise, it would seem that management (internal users of accounting statements) should receive or be in a position to acquire any type of information they desire as long as it is possible and economically feasible. They also should have the opportunity to discuss the statements with those who prepare them.

PAGE 80

7k This may not always be the case. Managers may not understand accounting well '-n^ti a to know what conurtcJorli^ the preparation of accounting statements and tha resulting inherent limitations of the statemunts. As a result, managers may think accounting statements provide more information than thoj actually do provide »r that thoy ar Bora accurate than is actually the case. On the oth«r hand, suppose wu l > have a thorough knov;lodge of accounting. fhey reoognlsa tho limitations which exist. This means they .oust Mkk« oortain adjustments antl allovances ns cone Tni ng buying, holding, or sellin

PAGE 81

75 stock:. If published financial statements accurately -itioiand results of operations, than Ml . ^t, lt'.: would bo vory usaful to investors Li li I tori ir mat: in dc-cl:;ions. :/ investors and prospective investors do not iaak^ their decisions on the basin of published rinicl. it* tea tits. This could I ' I <• one or • r of suvorr>l factors: 1. Published finencial statement-nay not -iv<; quata information te form the basis for a •-: I i <>• r touroaa of information may bo mor
PAGE 82

76 f!iw* annual report may be th.3 only contact most investors have with a company. Sinc^ the publi,i! financial statements are prepared largely for investors and prospective investors, the statements may be somewhat biased. Thi s is possible even when they are certified by independent certified public accountants. This is possible due to the alternative accounting methods, the possibility of manipulating profits to some extent, variations in presentation in the published financial statements, and failure to emphasize unfavorable events and contingent events as much as the favorable ones. The annual reports of large corporations usually include th« financial statements, a mes from the president or chairman of the board of directors, and other information concerning factors such as products, growth, and plans for the future. These annual reports tend to present a rosy outlook. It is hi,;hly possible that, instead of trying to present all relevant information as accurately and completely as is possible and practical, annual reports may attempt to conceal information. Published financial statements may be of rather limited use even to thoso who are familiar with accounting bocause they may intentionally withhold information or present information in an ambiguous way. ..illiain li. dinsmoro emphasizes this in a recent article in

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77 Harper's Ma^a/. Lm. '...* !) LlOTOfl that corporate reports— »f fch ' (lossiust and L«ast inf ormf tivo art fonni: of our time' 1,^3. p« -133) — go unroad by most of the nt 17,000,000 stockholders. Ms is because the r p«rt irOTldOl such llttlo information. "Aftor revisions through OOUlltlesa drafts by accountants, auditors, tronaorors, banker-directors, lawyorn, union mgotirs, mnginmrntB, scientists, and purchasing agents, the typical corporate; mossa.-c ends up freighted with vague caneralixutiotr,, cJiche.i, half-truths, total MlooioitO, unvubstaniatod claims, and downri.ht distortions" {53* P. 13*0 • Dinsroore believes the corporate report has lagged far behind the time. '.• r are millions of s^all investors now who want a report they can read ftad 1 Joel Joan list; the following possible reasons that MUMgoaoat may desire to limit the amount of profit report id : 1. To discourage potential competitors. 2. To woo the voting public and restrain the zeal of antitrusters. 3. To restrain wage demands of organized labor. U. To maintain customer good will. 5. To keep control undiluted. 6. To maintain pleasant working conditions (54, p. 29). Another criticism of ,-ublished financial statements is that they providu investors with very little

PAGE 84

78 information concerning the future. Perhaps it is best not to publish plans because this information would become available to competitors. However, the suggestion is sometimes made to include management's plans in the published financial statements. Morton liacker makes such a suggestion which he recognizes to be a significant departure from current practice. His suggestion is based on three propositions: 1. Decisions are macit. on future expectations; Z. « ianning is a fundamental management responsibility; 3. Stockholders are entitled to a knowledge of management's profit plan and an explanation of the causes for subsequent variations (55, PP. 59-ouj. Though there seems to be no general agreement as to the purposes financial statements serve for investor^, Robert l., uicitens and John u. Blackburn suggest these two to sum up the goals of external reporting : a. To provide the best possible basis for the stockholder to project the earnings and financial condition ol a corporation. b. io provide the best possible basis for evaluating the performance of management. (56, p, 31**) Whether management attempts to limit or conceal information or not, it is obvious that published annual reports could provide better information to guide investors and prospective investors in making decisions.

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79 The second possibility suggested above as to why investors and prospective investors do not use published financial statements in making decisions is that other sources of information nay be moro helpful. This coui d involve a secondary use of the published financial statements. Investors and prospective investors may acquire information from those who have carefully studied financial statements. The primary user of the statements then would be the investment experts . uch as investment brokers, financial periodicals and news reports, and investment ma n a; •-•..' r -j for institutional investors. If investors rely on secondary sources of information, this could indicate that either they do not possess sufficient knowledge of accounting to use tc-'toments or they do not have the time (or do not consider it worthwhile to use their time) to study statements thom:.«iivas. Another source of information which investors and t >rosp t )Ctive investors may consider more useful than publishod financial statements is the "hot tip" source, The hot tip is information concerning whether or not to buy, hold, or sell stock. It do j s not come directly or indirectly from the published statements and is supposedly not available to the general public. If the hot tip is reliable it usually comes from a source of information on the inside of an ontity. Such information usually leaks out against

PAGE 86

so the wishes of >nanagcment as a whole. Such information may or amy not be reliable* and th • i of such inf oris, is not reflection vi >on the pabllsho 1 financial ;t?.te-n?nts. Still another source of information ssed by iiv.tor l otive Investors aa a basis for ieelsloaa is the record >f lividenis paid by ontiti. It has air tady b m point d out that investor* st 1 in one or ier factor:; such as dividends, elation, safety^ an:l diversity* If the investor I ri'-iariiy interested in dividends, then the dividend reoord is lapeelally significant. Bntltiea ore prevented by 1" fro : paying dividends out of capital unless so dated, Th-3 Investor raay be assured that the entity rned at least as much incoia as the divides I ,ay>. Dividend records are not I to tell the whole story. dividends paid in one period may uings for thai. lerlod, as they may bo paid from the earnings of prior periods. The dividend policy of an entity is affected by its reported earnings. Investors and prospective investors would bo wise to consider I dished financial statements alon <, with the dividend reoerda even though tuuir primary interest may bo in dividends. Another source of information ofton used by I v i ,,,• respective Investors La the dni^y report of activities and prices on the stock markets. This

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bl information is certainly more current than annual reports can be, •-'bsorvation of prices on the stock market over rlod of time reveals trends which are useful in making decisions, especially to investors interested largely in appreciation. Reaction to stock-market prices may be based on decisions already made. That is, a decision may have been made to hold stocks for a long period of time. Day-to-day activities may be of interest to such investors, but they will probably not be tho basis for a decision. Such investors, interested in the long run rather than day-to-day activities, may compose a fairly lar.^e ,;roup. A majority of stockholders are women. It is likely that many of these woman have inherited stock from their deceased husbands and depend upon dividends from such stock as a portion of their income. Stockholders in this category are interested primarily in tlM Lonft run. n the other hand, an investor may have decided to maximise his income in the short run. Chus, ha will buy, sell, or hold at least partly on the basis of daily stock-market activities. The use of stock-market activities in making decisions is not necessarily an indication that published financial statements fall short of their objectives. Instead, different objectives are fulfilled. Financial statements affect the market

PAGE 88

32 ricoy of stocks, u socially in the long run. CharL l T. Horngron h3s said that the long-run stock pricas nr .robably influenced by earnings >er share :noro than by any other single factor {57, p. 56k), It la apparent, then, that there are sources of information which are more useful to investors and potential inv^tors than are published financial statements. This is partly because other sources of information may provide a different type of information and *«t different objectives. It is also because statement users do not have an adequate knowledge of accounting or because published financial statements do not present relevant data as well as they could. The third possibility suggested above as to why investors and prospective investors do not use published financial statements in making decisions is that they may not possess sufficient knowledge of accountin . uch investors must rely on other sources of information. It is perhaps worse for one who is not informed in accounting to attempt to use financial statements than to rely entirely on other sources of information . Accounting statements could bo more useful to investors if they were prepared in such a way that they could be understood and used by those who are not experts in accounting. Arthur l« Gannon has said: I want the expert accountant to make his own decisions as to the impact of various forces and

PAGE 89

factors. ... I do not vant to have to hire another expert to interpret the accountants' I tatoia'.nt* for ue . . .. It is the accountant's task to interpret business operations for the .it of those who have a ii-itinato in t. < in thom (that is practically everybody), in financial tunns that practically everybody can understand (5tf, PP. U2-33). other Bxt«mal tfi r iixtornal j^or^ of accounting statements other than investors and potential investors include creditors and prospective creditors, social control a.^enai •., employees, labor unions, and th? goneral public. These statement users may oa handicapped by the shortco.ui... of accounting; statement:: and the problems involved in their use which have already boon discussed in connection with investors. Most of those statement users do have an advantage ovr investors in that most of them do rut h.v/.to rely intirely on the published financial .» tat.)iii'ntii. Creditors, potential creditors, and social control ftgenoi«a >.iay usually ask for additional inforlod. Labor unions have many other factors to consider other than accounting statenifiii; Atenient users would find inprov.vl accounting itatomencs useful. Their need is not as laed of investors for improved accounting statements. .jummary This chapter is the first in a series of four chapters which discuss various measurement bases used

PAGE 90

In AM i it LsOtt i in the present C ' • I , • c.>nc pi : i;l , ., i a • I I ••Lag I oncepts related I i. '-rical . oej .;a also SCOU :lin fcal . uL:; .::;; they ai*o cnrr.nUy red. The realisation cone-. I . i kleularly related ' '' historii t basis for measurement. t IS Of a dlseass Aeeoantli . , vera! (.rmi. : at. Investors and prospective investors, crccU ' rs am • cti si L to rs a .. ociai controx i n< I , and label unions. Shorteeaxlngs of accounting statements he -\ .ointcd out la terms ef these A dual goal of accounting is suggested by thi dibcu. c . 5 ion: i. ^ccountin statements shoal. i b. .aore useful to those uho understand accountiii . 2. Aaeountlag statements should bs useful to tnoso i. Wav f ry Llttl know i. »f accountiii.. \n tlternatl* and goal is that accountin ; statements should bo prepared in such a ana r that states at read i tribe n.iv little or no Icaon '• tea it la L] r ilia* tu.-y aro not • f itlllslag th stat aaata •

PAGE 91

3 fhe following; tlii-c clic.aor.-, offer alternatives to the historical coi>t measurement basis. ?.ch of the three alternatives offers L cussed and compared with historical cost and the ofchor two alternatives.

PAGE 92

CHAPTEH IV CURKiiNT COST Introduction Historical cost, the measurement basis commonly usoa in accounting; today, has certain advantages and disadvantages which have been discussed in the preceding chapter. Alternatives to the historical cost concept are discussed in this and the following two chapters. These alternatives are current cost, net realizaoic value, and discounted cash flow. The current cost concept is the to,.ic of the present chapter. Current cost is the toriii ouoson to include many variations of market value and replacement cost. .-ievcrai of those variations are discussed and classified into two types: 1. Variations which separate income into a. Holding gains and losses, find b. Operating income, and U. Variations which recognize income on a production basis, ihe second ty I ftlflO li stinguish holding gains and losses from othor income. These two types of „.

PAGE 93

•? concepts will bo oomi>ar^<1 on the host? of usefulness, objectivity, and f «a sibll ity. current cost concept will be romwrpd with hist^rici'l cost on the basis of the criteria suggested in Chapter 11: relevance (usefulness), objectivity, and feasibility. ^uantif iability will not be discussed as this is a characteristic of both measurement methods, income A major difference between economic concepts of income and accounting concepts of income is a matter of timing. when should income be recognized'/ Or when snouid an increment in value be recognized/ This is also the major difference between various accounting concepts. Income is sometimes thou lit of as an increment in value due to above-average decision-making ability or as a payment for risk taking. This can logically be defined as wages instead of income; income is tnen defined as an unexpected increment in value. income as used in this stuay means both unexpected increments in value ( pure profit) and increments due to aboveaverage uecision-maKing ability and risk taking. Accounting income also includes interest on capital. income is not necessarily recognized when it arises, tnat is, when an increase in value takes place. Determination of when an increment in value takes place should be of at least some value in determining when

PAGE 94

86 to racu^ni.i,i: such an increiuent. *oi this purpose, the L.Ubiiife.st> ^ioco»a ..tuy be divided into its components: purchasing, pioauction, holding, and selling, increments in value may take place aue to any one or all of these activities. Ln current practice, no attempt is usually made to determine when an increment takes place, and the entire income la recognised in connection with the selling process as was pointed out in Chapter III in the dls0ussion of the historical cost .•aauraamnt basis. Such income includes income due to above-average decision-uiaking ability, risk taking, pure profit, and implicit interest. Die nere act of purchasing does not croat a value increment according to current accounting procedure, The increm ;nt iuo to production is usually measured in terms of the historic cost of the Lngradlaata added. Jf the use of manpower, the use of nana^iiurit, ani tno U53 of land and capital in the form of current ty. of capital and ooaratin g facilities are combined to form a product or service, the boox value of that product is the combined total of the cost of the ingredients. The measurement of the cost of the ingredients may be difficult to determine and may require some use of estimates. Usually, no effort is made to determine whether :>r not an increase in value takes place due to holding an asset over a period of time.

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09 lent a iii value to ta'c pL.ic . activities: purchasing, production, holding, and selling. Alt r>ti/ )a to cuirsnt pffmetise even suggest the r^co^ni tion of S«eh increments at the time the activity taxes place. It has been suggested in Chapter III that profit is due to the ontire business ,jroce:,s. Ihus, the net raali/.aM. vc.luc tonsept v.ould give recognition to any increment in value during an nccourtin., niriod, regardless of which nctivity >-ave rise to such increments. A distinction Bight or mi lit not necessarily be made betwoen the increments arising from Use various activities. This will be discussed in raore detail in Chapter V. Current cost concepts vary, but they *f>S designed to Measure separately incomo from production and soliin." or income from holding and soiling. This chapter includes a discussion of this point, I'rice-lovol Adjustment Assumption in this chapter on current cost it is assumed that appropriate adjustments will be made for changes in the cenerai price level as well as changes in individual prices. Ihis is necessary in order for the capital accounts to reflect the same amount of purchasing power. The concept of purchasing power attains its validity from the accounting objective to di-.~ viu uish between invested capital and income. Income results only if a person or firm is better off at the end of a period than he or it »as at

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90 the beginning of that period. Capital must bo maintained in terms of its purchasing power for a firm to be as wall off at the end of the period as it was at the beginning (59, p. U3U). The inrestoent purchasing power of the firm oan ba viewed from at least three different IsvjIs, (1) It may bo assumed that capital maintenance lies to tne ability of tha firia to relttYSSt in an equal quantity of investment goods in general. (2) I geoonrf assumption is that ths firm v/ill usual xy invest in capital goods of the same industry and it i ri this purchasing pover that should be Maintained. \Ji A third assumption is that the firm will usually purchase investment < .-ods similar to what it has acquire I in the past; each firm has a unique investment and reinvestment pattern that would serve as the basis for the computation of a firm purchasing power index (59. P. U36). It is this first concept of purchasing power 'hich is assumed in this chapter. Variations of the Current Cost Concept Current cost concepts are intended to measure changes in the specific prices as contrasted with general price-ievel changes. Etsf lection in financial statements of specific price changes is not a new idea, the following quote is taken from *, A. ia ton's Accounting Theory which was published in 1922: It is above all important that the accountant's statements present a& ficcurateiy sa possible a picture of current data in terms oC the actual dollar as of the date of the statements. And this is not a matter Of general price lOYOSMRts — which nay be said to express the fluctuations in the significance »f .ioney--but of specif lo pries an.J value changes (90, p« S29)«

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91 trda and "jii's iJoncun ting, through comparison of actual events uith expected events, contributes: 1. to the control of current events in the production process, 2. to the formulation of better decisions in the future, and 3. to the mn-Uf Ication of the decision-making process itself (32, p. h). Although the emphasis of the book is upon the use of accounting data by management, the same data is useful for external purposes. external users are also interested in evaluation— tho evaluation of management.

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n The same measurement concepts suggested for management are also .juries ted for most external users. Barljr in the development of their theory, the authors put forth the premise that "in order to describe completely and truthfully with present accounting techniques the current position of a firm and its profit as it accrues, recorded costs must be equal to market values" (32, p. H), Knowledge of the current position of the firm is necessary in tho evaluation of decisions. The problem is to find a workable measure of market value, What is market value V Edwards and Bell suggest more than one possible market value. Valuo may vary as to the form of asset, date of price, and type of market. fhe form of asset may be initial, present, or ultimate. The date of price may be past, current, or future. ("ho type of market may be either entry or exit. This gives a total of eighteen possible values. Table 3 is their presentation of those eighteen values of which the six underlined concepts are the ones the authors consider significant (32, p. 77) . The authors are responsible for the names of thi; concepts. Current practice uses largely historic costs as the ba^ib of valuation. i'rofits are the difference be two en current valuos and historic costs, and, according to the realisation concept, are not recorded until a sale is made. Thus, past ontry values of initial inputs doniin^tt. Liu accounting records.

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93 TABU 3 AN ARRAY OF VALUE CONCEPTS N. Form and N. place of N.a s s e t s Value n^ date, N. market ^v

PAGE 100

$h or raw materials) were sold (without further processing) outside the firm at the best prices immediately obtainable" (32, p. 79). Realizable operating profit is determined by substracting the opportunity cost of assets prior to production from the opportunity cost after production. Realizable operating profit is the increment in value due to production only. No profit is attributable to a change in valuntion method. . izabio capital gains are the gains due to the increase in opportunity cost over time. iuch s ains aro computed by substracting the opportunity costs of assets at the beginning of a holding period from that at the end of the period. iidwards and liell havo divided time into holding periods and production periods for simplicity. in actual practice, this cannot bo done. fli .; ,;ame results can be obtained by determining the increase in specific prices over a period of time if no change took place in production. Realizable profit is, then, the difference between opportunity costs at the beginning of a period and opportunity costs at the end of the period. Realizable profit is duo to a change in value due to production and a change in value ovor time. "The opportunity cost basis for record-keeping has this unique characteristic: except for the initial acquisition of inputs, all gains and losses can be attributed either to changes in form or to changes in date

PAGE 101

95 and none can bo attributed to changes in tho method of valuation itself" (32, p. 88). The usn of opportunity cost in the realisable profit concept Invjlvas r\n oddity 'hen work-in-process is concerned. Work-in-., :>roco ss is usually considered •orth at loast the total of the inputs. But this is not necessarily true. Moonitz say^ that it is not usually true: In the H •, vprk in oroc33s and f ini ••'led fjoods are assumed to bo worth more than raw materials by the amount of labor and othor productive costs added; this it a rational attitude if the inventories will be disposed of in the normal course of business of a going concern. As others have pointed out, however, the immediate market (liquidation) value of wurk in process is usually low compared with the market value of the materials before processing (31, p. kO ) . Moonitz illustrates this with an example of printed pages of a book. The vork-in-process (printed pages before they are bound together into a book) ere worth less than the paper used. The printed page:are almost worthless to anyone other than the firm reducing the book. It would seem that .Moonitz would not agree with the use of Sdwards and Bell'* opportunity cost ftfl a logical and useful basis for measurement of work-in-process. Opportunity cost may be as /*roet as net realizable value, especially in the case of fini^hod /'nods. rtunity cos'; seldom exceeds net realizable value. Such a situation would usually indicate that the firm

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96 should sell the ^.oods immediately instead of carrying such goods through anticipated channels. ..dv.ards and Bell classify realizable profit as a short-run concept of profit: if this gain, which includes both operating profit and capital gains, exceeds interest on the opportunity cost of the firm's assets at the beginning of the period, the owners were wise to permit the business to operate during the period rather than discontinuing it at the beginning of the period. The existonce of a gain informs the owners and others that the shortrun cost of operating the business has been covered (32, p. 9& ) . This short-run concept, operating profit, indicates whether the firm should use the particular asset or set of assets rather than liquidate. The authors believe it indicates very little about whether or not the production process is worth extending beyond the life of the particular asset or assets (32, pp. 100-1). The second measurement concept suggested by lidwards and Bell is called business profit. Business profit is composed of current operating profit and realizable cost savings. Current operating profit, ono of the components of business profit, is computed by substracting current cost before some production takes place from current value after tne production takes place. Current value and current cost are two of the oighteen value concepts listed in fable 3. Current cost is an entry value; current value is an exit value. Current cost is defined as "the cost currently of acquiring the inputs which

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97 the firm used to produce Um assets bein valued" (32, p. 70). Current values are defined as "values actually r alised durin the current prrio.l for voods i rvices sold" (32, p. 79). Realisable cost savin a are feha Lneraaaaa in current costs over time. realizable cost savings for 1 are. confuted by substractin Um current innin of a period fr^n th« ciirr nt costs at the; end of the period. ness profit includes, then, r profits on a production basis and realizable profit on a time ; , . a] Lz J La used by ti authors to refer )fits measured by an external transaction such as a sale. erds and Hell break down the realization , .. j two parts: production basis and ti basis. Table U indicates the differences in the makeup of accoutitin _>rofit and the authors' business profit and r profit. The table indicates that business profit Is auc'i n ;aror to accountin profit than realizable profit is. The Jiff Tcnc. . t acoounti i iroflt and business profit is the way in which es-s in value (sp< alfle prises) over I ; Ls is not meant to imply that the dif ferric • is small or insignificant.) business profit concept abandons the realization principle on a time basis. hen the realization

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98 principle is abandoned in both of its dimensions, we have a concept of profit based on opportunity cost, a concept we have termed realizable profit" (32, p. 27k), TABLE k A COMPARISON OF REALIZATION AND H^ALIZABLii CRT >;ntry values (realization princi . L : production basis) Ixit values (realizable principle : production basis ) Historic values (realization principle : time basis) Current values (realizable principle : time basis) acoountin;; profit business profit historic values realizable profit Edwards and Bell consider business profit their lonrj-run concept of profit as opposed to realizable orofit, their short-run concept. They feel that business profit is not only more useful to internal users but also more useful to external users than realizable profit. However, since each profit concept serves a different purpose, the ideal situation would be the incorporation of both concepts in the accounting record;,. The acoounts could bo made flexible enough to accomplish this. If the accounting records are to include only one of these two concepts, tidwards

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99 and Bell would choose business profit as boing the more useful of the two. A separate adju? tment for increases in the general price lovol is assumed in both the realizable profit and the business profit concepts. Sprouse and Moonitz's Concept In Accounting Research Study Number 3 entitled "A Tentative Set of Broad Accounting Principles for Business enterprises," Robert T. Sprouse and Maurice Moonitz emphasize a current cost concept. They list three exchange prices which may be used for pricing (valuing) assets. a. A past exchange price, e.g., acquisition cost or other initial basis. .hon this basin is used, profit or loss, if any, on the asset boing priced will not be recognized untiL sale or other transfer out of the business entity. b. A current exchange price, e.g., replacement cost. When this basis is used, profit or loss on the asset being priced will be recognized in two stages. The first stage will recognize part of the gain or loss in the period or rlods fro-n time of acquisition to time of usage or other disposition; the second stage will recognize the remainder of the gain or loss at the time of sale or other transfer out of the entity, measured by the difference between sale (transfer) price and replacement cost. This method is still a cost method; an asset priced on this basis is being treated as a cost factor awaiting disposition. c. A future exchange price, e.g., anticipated seLling .:rio-> . h Mi this basis is used, profit or loss, if any, has already been recognized in the accounts. \ny asset priced on this basis is, therefore, being treated as though it were -i receivable , in that .sale or other transfer out of the business (including conversion into

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100 ca?h) will result in no gain or loss, e c««pt for any interest (discount) arising from the sage of tirna (2, pp. 23-24). The 9«o«nd , trr«nt exshan -» p**ico or eea«nt cost, is feb.6 prli ioh is of articular concern in this chapter. And it is the price which Sprouse and Moonitz fe«l is of most significance. The third price, future exchange price, is the preferred method of measurement for most assets according to the authors. Because of the lack of objectivity of future exchan -e prices, the authors fool that a current exchange price may be better for the measurement of assets such as inventories, plant and equipment, and land. Sprouse and Moonitz believe "measurement of inventories at not realizable value is the preferred method whennv^r ctM measurement is objectively determinable" (2, p« 23). Replacement cost is the next best valuation for inventories, and it is the best one to use when net realizable value cannot be objectively determined. .icemo-nt cost is not a self-explanatory tsr'n. The term "replacement cost" has many meanings: The term has been used to mean the anticipated cost of replacing an asset when it will be retired, the current cost of replacement of a precisely . L .illar asset or bulldiiy; in the same location, the cost to obtain an asset that will provide the same service.; ^>s the existing asset, the current value of the service provided by the existing asset or to be provided throughout the ramaining life of the asset, and the original cost adjusted by jecific cost indexes (5')t p. U-'?).

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101 Considering inventories first, rau materials and other inventory items which require no processing seem least troublesome. Replacement cost would seem to be the cost of buying these items in the usual quantities from the usual vendors at current prices rather than the prices which were actually paid sometime in the past. Referring to Table 3, this would be what hidwards and Bell call current costs. The meaning of the term replacement cost is not quite as clear when work-in-process or finished floods are involved. Do Sprouse and Moonitz mean the current cost of the initial inputs or the cost of replacement of the inventory item by purchase of the item in its present form? The former possibility would be the sana as Edwards and Bell*s current costs while the latter possibility would bt the same as their present costs. In general present costs would be larger than current costs. Present costs would ordinarily include not only the initial costs of the inputs but also the value of the utility added to the inputs by the production process. If present costs are used in pricing work-inprocess and finished goods, this would usually result in recognizing some profit due to production before an actual sale or delivery takes place. Sprouse and Moonitz do not seem to be recommending this. They indicate several times that the use of a current

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102 replacement cost would recognize only holding gains and losses until actual sale. This indicates that their current replacement cost would be the same as lidwards and Bell's current cost concept and not their present cost concept. Sprouse and Moonitz's discussion of the measurement of assets indicates that their current replacement cost does not recognize revenue due to production. The explanation of replacement cost already quoted does not make this clear. It merely states that part of the rain or loss on an asset is recognized in one stage and part in another. The explanation does not label or explain what K*in or loss is recognized in each stage. In a later passage in which the authors aro pointing out the advantages of the current replacement cost concept, they say: "The use of current (replacement) cost has the further advantage of introducing a clear-cut distinction in the accounts between profit from holding an item through a price rise or fall, and profit from 'operating margins,* that is, the difference between sales price and current (replacement) cost of the goods sold" (2, p. 29). This clearly indicates that the use of current replacement costs would result in the recognition of holding gains and losses in one stage and normal operating profit (increase in value due to production) in another sta^e.

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103 In setting out what they intended to say about .ition, the authors said, "We propose to use a classification ti.at distinguish*! among (a) the amount attributable to chanj-.fcs in tVie dollar (price-level changes/, (bj the amount attributable to the acquisition of goods and service;; prior to their utilization, and (c) the amount attributable to sales in a current market" (d t p. 17 )• This obviously postpones recognition of changes in utility due to the production process until final sale. oo far, it seems quite clear what Sprouse and ••alt a .Bean by current replacement cost. It seams to mean the same thing as adwards and Bell's current costs concept* that is, the current entry cost of initial Inputs. However, a later comment by 'Sprouse and Moonitz confuses the concept. In comparing their concept with current procedure, they say, "By the use of current replacement cost, a change in 'utility* is recognized la the period when the change takes place" (2, p. 31). Hie word "utility" is perhaps a poor term. Up to thi^ point in their discussion, the authors had indicated that the use of a current replacement cost would give rise to a holding gain or lossj that is, the change in the specific price of the asset would be recognized. A change in the specific price of an asset .nay be thought of as a change in the utility of that asset. 1'his concept would consider utility as

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10U Lntlre 1 I itlre t) the utility of sth 11 Ln utility" a different cone tfulof an asset, an.! that is the purpose of most business enterprises — to Ln utility. A ucinunr r or at . utilitj Lnputa • n . Mho] and re t;_ : i rlngin i in tin so . If and Moeaitz are usin . utiLity in this latter, str« c osteon, an J , they are contradictir. what they have already said and art. res aiendin the recognition of j v ,.,_ on s production basi: . this writer b« Lievea the authors in I • » an in of utility t.nd ;.-v 1 Lj) as la poorly chosen term, Sprous: and Moonitz nak< another ciai.u for I ir current cost concept which is not quite what it ay : use of current (replae< tent) cost as the oasis for inventory measurement eliminates the need for any ;l«n as to the flc% of actual cost incurred. The current cost of inv .1, :ri i sane whether tij • related underlyin r ocrds and tax returns are based on an assumption of a lastla, first-out f > . jf actual costs incurred, a first-in, first-out flow, a weighted arerage, or clfic Identification (2, p. 29), first lenteno Lmply there i nc imp t ion, 1 11 eond 1 mtenc te at all booai . , an • • I ' I Per . mis. Hi.

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J05 n l be made and the records must be kept at least for tax returns. i.von if the tax problom is ipnorod, an assumption still seems necessary to show the realized i n .

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106 The elimination of net realizable value as a possible valuation concept leaves a choice between past cost and current cost. Sprouse and Moonitz chouse current costs: In the external reports, plant and equipment should be restated in terms of current replacement costs whenever some significant event occurs, such as a reorganization of the business entity or its merger with another entity or when it becomes a subsidiary of a parent company. riven in the absence of a significant event, the accounts could be restated at periodic intervals, perhaps every five years (2, p. 3** ) . Such use of current replacement costs would {^ive rise to holding sain s and losses. Accounting Us search Study Number 3 is not intended to be a detailed set of rules. This is especially noticeable in the discussion concerning plant and equipment. Their discussion is obviously a general one. Questions such as how to arrive at current replacement costs are not discussed. The authors merely mention the possibility of using index numbers and leave further discussion for others. In another source jorouse emphasizes the need for current values. He believes that "if financial reports are to provide relevant information concernin . a corporation whose shares of stock and other securities are continuously changing hands and whose economic life is viewed as indefinite, attention must be focused upon the objective (that is, impartial) measurement of wealth and changes in wealth at the time such changes occur " (60, p. 6HU ).

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107 "Tho failure to rej>ort a measurable gain merely because it has not yet been transformed into cash is not impartial; it represents conscious bias in favor of prospective creditors and investors" (60, p. 692). Sprouse feels that accounting should provides information which is relevant for making decisions. Here again, > >rojso is recommending the use of current market values and replacement costs. Other Current Cost Concepts Accretion .-The accretion concept may be thought of as a current cost concept. The accretion concept defines income as "an increase in economic power which can be measured with reasonable objectivity" (61, p. Ik), udward Phillips gives the following list of income concepts to show how the accretion concept compares with other concepts as to objectivity: 1. l J sychic income 2. bconoutic present value income 3. Accretion income U. Accrual accounting income 5. Cash basis accounting income 'Accretion recognizes income if the increase in value is reasonably measurable; &,";,, reflected in increased market value" (6l, p. 17). Phillips believes conceptual reasonableness is sacrificed for objectivity as you go down the list.

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ioh "The case for the accretion concept rosts on the proposition that nar'cet values are sufficiently more objective than computed :>ro»«nt values to justify their use l«splt« the loss of conceptual soundness and that the further gain in objectivity does not justify waitin for 'realization' as presently defined" (6l, p. 17). "economic prosont value income'' is similar, if not the same as discounted cash flow. Under the accretion concept, expenses as well as revenues are recogniaed when "reasonably measurable." This, not the matching concept, determines timing of expensos and rsvenuss. Horn g ren's proposal .--Charles T. Horngren proposes a current oost concept which includes a liberal recognition test and a strict realization test. The rules for realization include recognition as the first of three rules: 1. Uecognltlon — Sufficiently definite, verifiable evidence to permit objective measurement of a valu? increase. 2 » Market transaction — An event "originated by tho voluntary interaction between the accountin", unit and some other unit" (62, quoted from 63, P. U). gods or g e rv i c o s rendered --The "removal of restrictions against assets" (62, quoted frri 61*, p. 32). Fhus, revenue may be recognized without realization taking place. Revenue recognized would include "(a) holding gains related to assets still on hand

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109 plus (b) pains attributable to current exchange transactions" (62, p. 326). fhus, tiorngren's concept of r>co~nltijn wojld not include an increase in valu-j duo to ,>to iuc ti?n. Valuations used in determining the nmiiant of rerouue to be recognized would probably *>•-> thj currant cojt of iiiiuts. Hornpron's concept is a coinoro->ii se >lan aimed at reconciling the two extreme sides to income reporting : The trouble is that practicing accountants sometimes adhere too stubbornly to original expectations as being overriding, while their critics lean toward measuring happenln«^s as early as jossible without worrying about (a) some loss of objectivity, or (b) how the decision finally turns out as a whole, la light of original expectations, and (c) the financial and tax implications of their not income measure (62, p. 328). riorngren recommends this combination of recognition and realization. This would Involve the use of two income concepts presented simultaneously. AAA Committee .--in 1^04 the American Accounting Association Committee on Concepts and Standards-inventory Measurement recommended replacement cost for the valuation of inventory items. This recommendation was in the form of "supplementary Statement No. 2" to the 1937 revision of 'Accounting and Reporting Standards for Corporate Financial Statements" (65). Their replacement cost concept for inventories would separate holding gains and losses from operating

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110 revenues and expenses. Replacement cost would involve for a manufacturer the "current (replacement) cost of each element of the total cost of the inventory units" {65, p. 710). The committee did not apree on who the r or not holding gains and losses should be considered as realized. Three Members of the committee (Firmin, Hepworth, and Wixon ) believe that replacement cost evidence is "sufficiently definite and objective" to regard holding ;;ains and losses as realized. The other three members (llorngren, Mautz, and /.latkovich) believe that both holding gains and losses should be regarded as unrealized until the goods to which they relate are sold (65» p. 709). The Most Hesirable of fcfca Current Cost Concepts The previous section is large Ly composed of a discussion of various current cost concepts. This is not intended as a complete list of concepts because the possible variations are great. These concepts discussed are thought to be representative. These concepts may be classified as to those which soparato increase in value into operating income and holding gains and those which recognize increases in value due to production.

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Ill Holding f.ains and losses Some of the current cost concopts discussed in Um previous section report holding gains and losses Such holding gains and losses are recognized as th<*y arise. 411 other increases in ralue are not recognized until a sale (or other currently accepted hasis for recognition) takes olace. This amounts to roeo ni/.in., increases in the value of inputs as such increases in value take place due to the holding activity of the enterprise, but it does not recognize inorease s in value due to any other of the business activities until the final sale takes plac». The reporting of holding gains and losses separately from revenues and expenses due to regular operations can be useful in evaluating business performance. Supposedly, all revenues and expenses othor than holding gains and losses are due to the operations of the business. On the other hand, holding gainand losses may not bo as simple. They cannot be assumed to always be purely a matter of luck as there may be plannin g involved. Management may foresee a rise in the price of certain inventory items and purchase quantities large enough to create a holding gain. r, as a result of poor planning, management may have overstocked certain inventory items while facing foreseeable price declines of those particular items. Such gains and losses are duo to the actions or lack of

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1J2 actions of mana(;yn;cnt; they are not just a matter of luck. Holding gains and losses may result from decisions \>y BWn»g «.nt. hi re arn definite advantages of separating holding gains Md iOS9»S fron operating income. If they arc not removed, then income int>y inc3u3>. I aalltT of gains and losses As has previously been pointed out, this chapter assumes adjustments for changes in the general

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il3 price level. Changes In the general price level result from changes in individual prices. If all individual prices change at the same rate, an adjustment for changes in the general price level would be the only adjustment needed. Current cost concepts which result in the separation of holding gains and losses from operating income would be unnecessary because such gains and losses would not exist. Since specific prices do not vary at the same rate, then holding gains and losses do exist. on the average, as many specific prices will be below the general price level as will be above it. Therefore, for the entire group of goods used in computing the general price-level change, the total holding losses will equal the holding gains. For an economy as a whole, holding losses will be equal to holding gains. Although all holding gains and losses cannot be attributable to luck and all other gains and losses attributable to the effectiveness of management, this writer feels there is much value in such a separation. This gives a starting point for an analysis of how profit came about. Holding gains and losses are a matter of luck to the extent that price changes cannot be predicted; other income is usually due to the effectiveness of management. Holding gains and losses are attributable to the correct periods, and this is an aid in evaluating results.

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11U Production Incom e i curr nc cost concepts would result in the lition of production income — that increas • in utility reduction— before an actual sal' takes place. rhe accretion concept and the realizable profit (opportunity costs) eonoept diioussod previously i v.i d s . i'iiproduction process adds utility to a product, production is here used to refer to all. activities fco cr at ;oods and services, other than holding activities, and not just to the physical combination of materials or working with materials. If the production process is successful, a product is produced which has economic value greater than the inputs. Reed K, Storey has the folio-wing to say about iet ion : i I is true in both manufacturing and .a? rcliandialog business. Both kinds of enterprise create utility since man cannot create material ;oods. can merely rearrange and move joods so as to make then nor' > rrieeable* Fhls la rrlee rforaed by botli traders and manufacturers (67, p. 14-50). Current cost concepts which reeoil ltd th. nition of th iin:r * nt in vaLue attributable to production seem to be fewer in number than thos^ ear rent cost concepts which eaptmalae the recognition of holding r ains and losses. Edwards and Bell present two curr.-nt cost conc.pty but leleet th an anion

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115 ins end losses. Their opportunity cost, or realizable profit, concept is considered i ful of the two Co Li conclusion is that a current cost concept which emphasizes the distinction b aerating profits and holding aim; ami. Loss< s but loo.i not rocof;niz: production income unti. fcb tii of salt would Liber b t easily measured concept or would be the most useful current coit concept. The prevalence of such cone pts in accountin , literature would imiicatthis. Bdvards and Bell reached the conclusion that it : b ;ost ! sirabl . I why would this be ti-u .y would this typo of curr.nt cost cone »t be nost Aeslrable? Criteria St Lii nd of Chapter II will be used hr r . . n x >ossibility is that this oenoept in m r feasible because it is closer to current practice than a cone pt which would r esogn isa production income. This would cr:at< s loss radical change and would rsicr to understand. Another possibility is that a current co.»t cone l pises r-rw notion ine to a njt realisable value concept that fcha n t r aiizva,u seaaept might b r saepted rath r than tii s n r reat cost eeneept. a comparison of realisabl vu.u concepts with current cost concepts is iric in tho foiloiw r.

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16 ui^i another possibility involves objectivity, fhe dif fax -^iic e betvaan the t.> o af aurrant seat ooncopt.. l1 jJ In fcbls chapter is in the raeagnl tion of production laeoaM prior to aala, '!v.ii, fcha difference LaVolTtta fcha valuation of in van tori. >.: . Obtaining .msure.iioilt of ;>u input.i > < • •• '. I ' i i ^ i van tori a.--, Ij Lively co bf lOra objective than obtaining aeasuroment 3f an inventory lean jusc as Lt 1». Tn ^enural, there is a ready r for inputs; naasnramant ii readily avail. . irttlj th>:r^ ii ftlaa a ready narkat for tho final produotj a;-,airi, measurement is readily available, tiut in betrfean the two points--durin,f produc tion--a market for the product, in whatever form it iiappens to have, may not exist. The current cost of the inputs i;»a> be easier to determine (feasibility) and more objectively dataradnad, >^a of a current cost concept which rs< tils* a increments of value :u i to pradnatlan daaa not necess&iily proclude the computation I ins and lasses. Juch computation would require aa measure of ro t >li cement cost of inputs as veil as a measure ei fch* value of items in their prevent, form. , this type of aurraitt aoat concept could have the advaatAgaa -f both typ-'is. Ihc difficulty and MptMl of finding bok iraa af value could moan that a I >n af holding Gains ua from production incacua on inventory items still on hand may be highly impractical .

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117 Omitting Increments In value due to production on inventory items still on hand often proves to be feasible. For example, if approximately the same amount of inventory at the same stages of production is on hand at the end of each period, then net income is the same for any given period whether inventory valuation includes the increment in value due to production or not. There will be a misstatement of value on the balance sheets, but tne error is approximately the same on the beginning balance sheet as on the last, and the relevance (usefulness) of the statements is not materially affected. If there is very little work-in-process or finished c.oods at the ends of the accounting periods, then omission of production income on such inventory items is of little significance. i'erhaps it is for these practical reasons that writers advocate current cost concepts which emphasize holding gains and losses and not increments in value due to production. Current cost concepts which emphasise holding gains and losses do have the advantage of greater objectivity and feasibility than other current cost concepts. on the other hand, current cost concepts which measure income on a production basis have greater relevance because they result in a closer approximation to value and because holding gains and losses may be measured by these concepts also.

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113 Comparison with the H is t orica l Cost Concept The preceding section has been a discussion jf th b current cost conoept — or variations of the current coat concept. The preceding chapter was a di>cuj;i'jri of tho historical cost measurement basis with emphasis on th p current realization concept. t"he • r tit section will be a discussion of the implications of the current cost concept. These implications are brought out by comparing the current historical cost concept with the current cost concepts. Usefulness Une of the criteria suggested at the end of Chapter II to be used in comparing measurement methods was usefulness, or relevance. Is historical cost or current cost more relevant to those who use accounting data? In Chapter I, it was assumed that all users of financial data wished to know financial position and results of operations. To the extent that uconomic value (the present value oi future net cash flows) is an accurate (or more nearly accurate) indicator of financial position and income, then current cost is more relevant than historical cost. Economic utility, or expected service potential, is perhaps the ideal measurement of any asset. Valuation would then be the expected future inflowing streams of cash. Market value

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119 (an indication of current cost) may be thought of as a measure of these expected future receipts because market values represent the expectation which people have of future receipts. K. J. Chambers, an advocate of current information, sees no usefulness in historical cost: U'e therefore regard it as beyond question that tho only information which is useful at o point of time, is information relating to the financial position at that time. The conventional balance sheet is no more useful than last year's news with this year's date; M -d (68 a p. ''71). Accounting statements Statement readers arcaccustomed to the financial statements currently prepared under the realization concept. Shortcomings of these financial statements were pointed out in Chapter III. Despite these shortcoming, it is possible that many people can bettor understand the statements as they are currently prepared than if statements were prepared under a current cost concept. I his would bo especially true if certain complications in the accounting statements are found to be desirable or necessary. For example, gains and losses might be separated into real and fictional elements due to changes in the general price level. Also, it l| it be desirable to separate realized from unrealized profits and losses. The small businessman and the small inviotor might find current cost statements confusing as indicated in the following quote:

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120 Accounts are kept, profits are computed, and policy decisions are made by several hundred thousand individual businessmen and their bookkeepers and clerks. Most of them would have grave difficulty in applying or even comprehending the principles of measuring cost expirations in tt • of hypothetical purchasing power. The economic data available to them are certain to be inadequate and their interpretations of several do&en tables of price-index numbers are likely to be divers-; to say the least. Depreciation calculations contain enough elements of variation now; price-index adjustments would so magnify the inconsistencies as to render the computations meaningless (3, p. 71, quoted from 69). Although tireer and Wilcox were talking here of general price-level adjustments, they would probably be just as concerned about ^enerai and specific pricelovei adjustments. Complications in the accounting statements in order to reflect current cost rather than historical cost would perhaps offset to some extent the increased usefulness which might be brought about by the use of current cost. on the other hand, accounting statements fail to tell the complete truth. As was pointed out in Chapter III, accounting statements ?nay be misleading. This has been pointed out by able accountants such as Henry If, Sweeney in his Stabilized Accounting and Kenneth MacNcal in his Truth in Accountin g. If the actual situation is complicated, it cannot bo made less complicated by preparing uncomplicated statements. Cf the actual situation is complicated and if the current cost concept reflects tho actual situation much bettor than the use of the

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L21 realization concept, then tho curront cost concept should be used even if tho resulting accounting statenents aro more complicated. Accounting statements usually present financial data of a complex business enterprise. ff accounting statements were to be presented in terms simple enough for anyone to understand them, they might mislead a person into thinking that the financial affairs reflected in the statements were also simple. At the end of the previous chapter it was suggested that accounting statements should either be simple enough to be understood by a person with very little knoi^ledge of accounting or be «o complicated and technical that tho reader would realize his inability to • statements. This discussion indicates th
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122 decrements in value. As has previously been pointed out, there vould bo no effect upon net income if be inning ail ending inventories undur current cost differed from their corrospondin.; invi-atoriei under historical cost by the same amount. In all cases, however, the balance sheet reflects more accurate valuations under current costs. other asset valuations The application of thn current cost concept to other assets results in the recognition of holding gains and iosaos and not production income. Current cost concepts do not vary greatly except in tho valuations of inventories. Fho BOO of a current cost concent for tho valuation of assets means tliat vaiu;s are more neaningful. Jf assets are valued at current costs, than the asset expirations reflected in the income stateoat 'H'j;tiura more accurately the valuo of survl r anderod. Unrealized income The u:n of aurront aosta rooulta in the reco-nition of rOTOmiO boforo lIMll related income is realized :>en.;o that "realized" is usually used. Jo.uo current cost aonoopta •Uggoat a distinction bo made •ill ttnroallaod incoaie. Juuii a distinction vould eid in bri ' . . • t m the use

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'23 of the historical cost concept »nd the use of current cost. Dual accounting statements The suggestion is often made that dual accounting statements be prepared. ime set of statements would be prepared under traditional accounting and the other set under another method— in this case, current cost. This use of dual statements would emphasize the difference between the two concepts. Implications for cost accounting Inventory flow assumption The accounting profession has faced the problems of inventory flow assumptions for several years without definite solutions. A variety of methods such as Lifo, Fifo, and average cost are considered acceptable. A change in revenue recognition concepts could affect inventory flow assumptions. Current cost concepts could eliminate the need for any assumption about inventory flow, but this would not be possible if a distinction is made between realized and unrealized revenue. If such a distinction is made an inventory flow assumption is as applicable as ever.

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121* Absoi v . -'ir ct eos ting ooatron rsy Ll l • ' • . that Income Ltn ;;a'ic; — not with combination of saios, 1 uc i. , i.,,,;.. s la inv . lil.i'i . | .-..inflict f; full cor., tine and direet coatin^ ho _ in soneepts of r«Temt< recognition would aft ,i'sy. Tlie adoption of a cost i ;ures the value of an item in its :> . , Ha direct costing conrjy alto ither. On the ether liana, the adoption cost concept uuch as replacement cost whleh adjusts only £jT the currmt co.= t of ;: juld hav. ne ff-ct on the controversy at ail. Objectivity thod may be, unless the results are use of verif iaoiiity and freedom fro I bias), th -.y ar.. not ace ptabi in account, Lfl . UsefuLn.'is and objectivity are often bh«U 'it of as oppositcjs. If on. 1 iv n Mr Lght t '•• • >tlicr must b iv a L< ss. This is not n c< ssariiy true, for objectivity may contribute to usefulness . eaui P rti i this idea: if b Ln 'obj ctiv :• ' la to conviuc financial ..tat.iinl i I r. that statements are free of ulterior motives or wlilm" (70, p« 1 • -'i I '• the stat i ut r

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123 can attach to statements, the more useful they may become to him. The characteristic of ohjectivi ty may make accounting data more usoful, but it does not follow that the greater the objectivity, the greater the usefulness. For example, accounting statements orepared on the cash basis may be more objective than accounting statements preoared on an accrual basis, but accrual basis accounting statements are usually more useful. Accounting statements prepared under either basis aro considered sufficiently objective. Likewise, historical cost is more objective than current cost. But does current cost have sufficient objectivity? Accountants have traditionally usud acquisition cost because of the difficulty of measuring objectively oconomic value. Also, historical cost is an objective measure of economic value on the date of acquisition. In other words, when assets are intelligently acquired, their expected services must be equal to or greater than those available under acquisition alternatives. Therefore, historical costs are a measure of expected service potential, at date of acquisition (65, n, 703). William A. t'aton has said that cost and value are "not opposin/j and mutually exclusive terms" (71» p. 193). Cost and value are assumed to be the same on the date an asset is acquired.

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126 In fact cost is significant primarily because it approximates fair value at date of acquisition , •lost is not of basic importance because it represents an amount paid; it is important as a measure of the value of what is acquired (71, p. 193). Subjective cost . —In contrast to the usual point of view, R. H. Homburger points out that actual costs are subjective: The amount of the cost of an asset to any particular business is dependent not only on the time and place of acquisition, but on the judgment, hopes, fears, and preferences of the buyer as well as of the seller. &hile cost, as a measurement, is subjective with regard to those factors, it is also objective to the degree and extent that cost reflects an existing market price. This has led to the unavoidable question whether a measure based on current market value would not be preferable to cost, if substantial differences exist between the two (72, pp. 96-97). Horaburger describes accounting measurement as social In nature, and therefore it contains a subjective element. According to this view, market values may be as objective as historical cost. If this is true, objectivity may be retained while increasing the usefulness of accounting statements. Lower of cost or narkot . — The lower of cost or market rule is an accepted rule of accounting for the valuation of certain assets. Market value is considered objeotive enough for measurement purposes when market value i:> less than cost. Many accountants see an unsupported lack of consistency here. ShouLd losses be reco;mizod when market values drop below costs while gains are not recognized when market values

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127 rise above costs? i'aton says th~< ; is no less and no mor >i 1 If leant, fco >• >arties conc'.'rn.Ml wh n such va!:. abov r oorded cost than wh~n it Is lower'' (71, p. l')7 ) , Mowevor, faton looks at th' oractioai tho issue and considers the problems of det rminin vaiu , eialljr of specialized assets. For this ;sts that departure from cost should b considered "only where such a substantial and > rsistin ; clian ;e has occurred as to render accounting on the old basis inadequate and invalid in vi^w of the roco ii d urposes of accounting" (71, p. 198). The question of the objectivity of current cost is still unsettled; many writers believe it is sufficiently objective:. Current costs of inventories may usually be more objectively determined than current costs of other assets. The question of the objectivity of current costs is on. of the bigg«st drawbacks to the use of current costs. Feasibility Feasibility i i that t.i information is worth more than it cost. Current cost information does cost more than historical cost information; it is usually in addition to historical cost information. Feasibility would depend upon which curr nt cost variation is ob>osen ( as sonwould tM uor difficult

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128 to utilize than other;;. :>oine variations such as adwards arid Doll's business profit would seem to be feasible . they are not too difficult to implement. Summary The current cost concepts discussed in this chapter have boon classified according to whother they emphasize holding ;^ains and losses or whether they emphasize the recognition of production income as production takes place. Of the many variations of current cost which have been suggested by various writers, those uhich emphasize holding fains and losses predominate accounting, literature. Of the two types of current cost concepts, the type «hich e^pha^izes holding gains and losses is more objective and foasible than the other type. Also, the separation of holding fains and Lease* from other i.itoi!,. result fl in useful financial data as it gives Indication as to whether the incoims is duo to trial effort or ,'just chance or the passage of Lime. of current cost concept which recognizes income as production takes plaoo may be more aseful than the ether k/pe in that it is eleser to economic income (increase in value), bu<; this refinement of accounting i-^ sjldom considered worthwhile.

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12f . Ljiicai eos,t has been compared with current cu„x on the basis of relevance, objectivity, and feasibiiivy. Current cost is more relevant to the usual of >n«f innt und moat e.xtornal users because it raiUi-t., in financial .statements which more neariy reflect financial position and results of operations than does historical cost. On the other hand, the difficulty reailui ; u,hi. ..<>v I in using current cost staten.en 1 1 might diminish their usefulness . Historical cost is certainly more objective than current cost. However, the variations of current cost aug^cjtail by some writers possess sufficient objectivity. Historical cost is easier to obtain than current cost, Dut some of the variations which have i>oen suggested would make the use of current cost feasible.

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OBAPTBR V NtiT RKALIZABLU VALUii Introduction Chapter IV was a discussion of the use of currant cost as an alternative to the historical cost concept. The present chapter is a discussion of another possible al ternative--net realizable value. There are variations of the net realizable value concept; several are discussed in this chapter. The net realizable value concept is compared with the realization concept and is also compared with the current cost concepts. Rationale of Net Realizable Value ^Jet realizable value is usually intended to ••SttJr* expoctod sailing price discounted at a rate of interest and less cost to complete and sale. fhero are other possible variations. Theoretically, the concept result J in the measurement of value increments as they occur. In order for the conc«,.»t \.o bo practical, it i,; desirable to know hoiv, why, and when value incryoccur, Sevoral theories of income were mentioned in Chapter IV. Incorao may be duo to risk taking or i'JO -

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Ill unusual mana;cirial ski Li, but payments for risk taking and unusual managerial skills (above average .luciaonMklng ability) may bo considered as earned by the factors of production, if payments are not mad t.> tli appro jria to factors of production—owners and management—for these functions of risk taking and unusual mana^^rla 1 skill, then the residue af t. r all factors of production are paid will include Lncrsm^nts in va Lai !<» to these functions. All such residue is considered to be income in this study. This will differ from the concept of pure economic profit (due entirely to chance). t'ure income, or profit, i*, also included in the concept of profit used hero. Accounting profit also includes interest on oapital invested by the owners. This portion of profit is particularly ...uphasized in the net realizable vaiu.; concept. in some variations of net realizable value the expected sales prices, and sometimes expected expenditures, are discounted back to the present to arriv • at th present value by use of some rat. of interest. From the present time until the time of sale the value of the ass <-t rnfually increases until, at the time of sale, the value is the sal? price. !he Ineraasc in value jv r time frona the first valuation i, lue to interest. Ln economic theory, this int rest is attributable to a particular factor of productioncapital .

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132 If riccountin.. refit is defined to include value increment:? due to risk taking, unusual managerial skill, :)«ro profit, and the use of capital, then the next question is "When does profit arise'/" In Chapter IV it was pointed out that profit is attributable to all of the processes of business: buying, holding, manufacturing, and selling. This significant problem in income determination hinges on revenue measurement and the matching of costs with revenues. The basic problem is measurement. The historical co^t concept, the current cost concept's, and tho net realizable value concepts are all concerned with the measurement of revenue. The historical cost concept makuj no attempt to distinguish between the value increment arising during the various phases of business activity. Current costs and net realizable value, on the other hand, do make such an attempt. Molding gains and losses may be composed of interest as a payment for the use of capital and income as a payment for risk taking as well as pure profit (due entirely to chance). To the extent that management is able to plan for holding gains and losses then they are a payment for unusual management skills. Operating income due to buying, manufacturing, and selling, is attributable largely to unusual management skill.

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133 Going Concern . --rho net realizable value concept utilizes the ,'-oing concern concept. According to Canning* going concern value reeans "the valuation should be dependent solely upon the contemplated use of the valued thin/ 7 , in the operations of the enterprise" (73. p. 21a). Instead of basing valuations on prices that now exist the net realizable value concept bases valuations on prices that are expected to be received when the goods are sold less expenses expected to bo incurred and less an appropriate amount for interest. Referring to inventory items. Canning says: "The present worth of the amount of money that can be ot for them in the conditions in which the enterprise is placed, less the present worth of the future outlays and expenses properly referable to such a dollarvolume of trade expresses not merely the chief but the only significance this existing stock of goods can have" (73, P. 219). The usual situation is that a going concern will plan toward the completion of goods. The situation may arise where the market value of a good in process is greater than the net realizable value. If this situation is expected to continue, an entity may chango its plans and begin selling the product when it reaches this certain stage of production. In general, such a situation is likely to be a temporary

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131* one, and an entity is unlikely to be in a position to change its production and selling plans temporarily in order to make a short-run gain. For this reason, then, a firm is more interested in the amount for which its finished goods will sell than the market value of a good at any given point in time. The main problem is in the difficulty of measurement. Market value may be more easily measured than veiling prioe at some date in the future. when expected sale price is reduced by the cost of completion and discounted at some rate of interest to arrive at not realizable value, it is likely that market value is more easily determined, especially for raw materials and goods in process. As goods approach the time of sale, net realizable value becomes easier to measure. 'mother application of going concern is also expressed by accountants. The view is taken that if an entity is expected to continue operations indefinitely, then net realizable value is not applicable. Gains and profits should be postponed until they can be expressed more objectively in subsequent periods. Gilman says : "Acceptance of the accounting period convention, and its subordinate convention of the going business, introduced a new accounting concept, namely, that inventorying at realizable values was not appropriate for periodical reports, there being at the end of each period a fictitious rather than

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135 an actual termination of the business unaccompanied by substantial change of proprietorship" (7U, p. 96). Ihose who use the going concern concept as an argument against not realizable value may have a different concept of net realizable value than those who use the going concern concept as an argument for net realizable value. This first j;roup may think of net realizable value as the not amount realizable upon a forced or immediate liquidation. V ariations of the Net Realizable Valu* Conc»pt in general, net realizable value may be thought of as the expected selling price less expected expenses of completing and selling. There are many possible variations of this concept. American Accounting Association rhe Anorican Aocountin* Association, in its Supplementary Statement No. 2 to its 1 ( )57 itatenent, Lvos several possible variations of the net realizable value concept. Net realizable value "assumes that all income or loss arises exclusively through the acquisition (purchasing or producing) activities of the business entity" (65, p. 706). The value of inventory is a measurement of expected revonue l;ss expected costs of completion and disposal. All profit is attributabla to the buying or producing activity, and no profit is attributable to the other activities.

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136 A slightly different concept is called "net realisable value loss normal operating income on activities not performed," A normal operating income is determined. The normal operating income on activities not performed may bo found by multiplying a compound fraction titles the cost of completion and disposal. The numerator of the fraction is the normal operating income, and the denominator of the fraction i-, total costs including materials, conversion, selling, and administration. This is one possible method of computing "normal operating income on activities not performed." The main problam is to find a realistic method. A disadvantage of this method is that tl&fj income attributable to each activity is not noc a isarily proportional to costs incurred in that activity, "Any method of allocation has limited significance in the absence of arm's length market tests at intermediate stages during the holding or converting process" (65. P. ?07). jtill another version of net realizable value is called "net realizable value less normal operating incoma." This variation may be similar to historical cost, Mowever, if replacement cost and selling prices move together, this variation gives results similar to the use of a current cost conoept which recognizes holding gains and losses.

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137 Th" '.u.mcritary tatemont No. ?. suggests the f ruplttciim ,)nt costs rather than net realizable value because of the difficulty of measuring the latter: Many subjective estimates are required in its implementation : expected revenue, expected e.xp B , and allocation of margin;; acquisition and distribution functions. Furthermore, if Bailing ,)ric.i fluctuate in harmony with replacement costs, the replacement cost method ..^ne rally vill yield a reliable approximation of net realizable value less normal -•rating income. Therefore, replacement cost can generally meet conceptual and x>ractical criteria more easily than can some version of net realizable value (65, p. 708). John B. Canning John B. Canning suggests that cost, market, and net soiling value be exhibited simultaneously as each of them has a ; cci.l significance (73, p. 221). Although Canning recognizes several ways of determining the value of finished goods the method he suggests allows for selling and general expenses as well as a normal profit: The one suggested here is to multiply each unit selling price by a fixed constant, k. This constant is determined as follows. (1) standard ratios to sales (preferably averages of the concern's own experience) should be found for loss on bad debts, selling, expensos, and general >enses including costs of collection (but not inl nit paid or other distribution items like income taxes). (2) Some normal industrial rate of return converted to an average rate on the concern's own inventories should bo found. Hie constant which is to be multiplied into each selling price then becomes one minus the sum of the rate allowances for subsequent exponses and for a normal profit on the inventory (73, p. 222).

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13 For raw materials and unfinished »0 , ->st to Ooap] kto mst '50 estimated SJtd MSOd in computing •>nt value. As the actual sals is further in the future than ir, th ^ oaso of finishod [OOd ., irrora in computing value ar* Likoly kO bo r>ater. This aothod is what fcho aM Cossnittoo called "not realizable value Loss normal operating inc Herli 11 profits, but ftt loa ;t normal profits, »ostponed until th ti w of sale. Sprouse and MoonitS Sprouse and Moonitz define SSSOti as follows: "Assets represent expected future economic benefits, rights to which have been acquired by the enterprise as a result of some current or past transaction" (2, p, 20). The value of an asset depends on the future economic benefits which are OXpoOtodl In other words, the problem of measuring (prioingj valuing) an asset is the problem of measuring the future services, and involves at least throe st» • : 1, A determination if future services do in fact exist. for exaaplo, building is oapaM of providing space for manufacturing activities. 2, An OStinato of the quantity of services. "'or example, a building i :-. estimated to be useable for 20 more years, or for half of its estimated total life. 3, The choice of a method or basil or formula valuing the quantity of services arrived at under sboTO (2, p. 23),

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139 At this point, the authors list the three exchange prices which have already been quoted: A past exchange price, a current exchange .jrice, or a future exchange price. This third choice is repeated here as it is of primary importance in this chapter: A future exchange price, e.g., anticipated sailing price. When this basis is used, profit or loss, if any, has already been recognized in the accounts, Any asset priced on this basis it, therefore, being treated as though it were a receivable, in that sale or other transfer out of the business (including conversion into cash) will result in no gain or loss, except for any interest (discount) arising from the passage of time (2, p. 2k), This future exchange price seems to be the most theoretically correct method of measuring future benefits. There are ofton practical disadvantages such as lack of objective, verifiable data. For this reason Sprouse and Moonitz do not recommend the use of net realizable value for the measurement of all assets. Net realizable value could be applied to receivable:;. The time until collection is usually so short that discounting is not of much value. The application of their net realizable value concept to inventories is more meaningful. The authors feel that this concept should be applied "whenever the ultimate proceeds from sale can be established" (2, p. 27). "As a specific case in point, inventories which are readily salable at known prices with no^li(•,ible costs of disposal, or with known or readily predictable costs of disposal, should be measured at

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1*0 not realizable vaUn (i.e., anticipated sales proceeds less costs of completion and disposal)" (2 , p. 27), Sprouso and Moonitz's net realizable value coioipt would result in the recognition of revenue when an increase in value takes placs — whather the increase i3 due to an increase in the spsoific price level (holding gain) or due to an increase in value as a result of production. The authors say it this way: "This procedure will have the result of assigning most if not all of the change in resources and the related profit or loss to the period of production (or other activity) when the actual effort was made" (2, P. 27). Although the concept is not always applicable, ".noasurement of inventories at net realizable value is the preferred method whenever the measurement is objectively determinable" (2, p. 28). ISm authors do not believe their net realizable value concept is applicable to plant and equipment: They do not represent potential revenue, as do tho inventories, and therefore are not amenable to treatment as though they were receivables. As a consequence "net realizable value" has no relevance, except as a measure of scrap or secondhand value (2, p. 33). mil and Moonitz do not go into enough detail to explain fully hov thall* concepts would be applied. For example, they note the desirability of separating gains (losses) due to changes in the specif ic

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141 price levels from revenue due to the production of goods or the rendering of services. Such a separation la automatic in their current cost concept. It is not automatic in their net realizable value concept. The separation would be possible to obtain by measuring the net realizable value at different points in time. The change in net realizable value from the time inputs are acquired until they are placed into production would be a measure of gain or loss due to changes in the specific price levels. The change in net realizable value due to production would be a measure of profit due to production. 3prouse and Moonitz do not mention such a separation at all. Perhaps this is a detail they feel is not essential to their study. This net realizable value concept is based on the assumption "that profit is attributable to tho whole process of business activity, not just to the moment of sale" (2, p. 10). This idea is not intended to be an original one with oprouse and Moonitz. They quote the idea from accounting leaders of the past and present. One such quote is from George 0. May: "Manifestly, when a laborious process of manufacture and sale culminates in the delivery of the product at a profit, that profit is not attributable, except conventionally, to the moment when the salo or delivery occured!" {75, p. 30, quoted in 2, pp. 10-11).

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1U2 Another such quote is from V'illiam A. Patont "If there is a major point upon which there is general agreement in accounting, it is that revenue results from the over-all process of production ..." (76, P. 39, quoted in 2, p. 11). The preceding varietions of net realizable value emphasize the wide range of differences in the concoft. I arhaps profit is attributable to the entire process of business activity, but these variations range from a concept which results in no normal income realisation until the time of sale, through concepts which result in som» income realization throughout the business processes, to a concept which results in the realization of all income imnediately upon the initial purchase, X)M most logical variation of net realizable value soeais to this writer to bo discounted estimated sales price less discounted estimated future expenditures required for completion and disposal and less profit allocated to incompleted activities. Actual Use of Net Realizable Value The concept of net realizable value is not just theoretical at present; it is actually applied in soita situations. The use of net realizable value is an exception to the realization concept, but some applications of net realizable value are accepted

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11*3 accounting thoory according to both Accounting Research Bulletin No. U3 and Accounting Research Study No. 3. The following quote is from Accounting «e .ecrch Study No. 3: It is generally recognised that incnnc accrues only at the time of sale, and that gains may not 1 M anticipated by reflecting assets at their current sales pric?. For certain articles, hovovor, exceptions are permissible. Inventories of gold and silver, when there is an effective Governmentcontrolled market at a fixed monetary value, are ordinarily reflected at selling prices, A similar treatment is not uncommon for inventories representing Agricultural, mineral, and other products, units of which are interchangeable and have an immediate mr-rketability at quoted prices and fer which appropriate costs may bo difficult to obtain. I.ti . i iota inventories are stated at sales prices, they should of course be roducod by expenditures to be incurred in disposal, and the use of such basis should be fully disclosed in the financial statements (2, p. ?,U ) . According to currently accepted accounting iu'Ccdirn, '^lic i llccrtion of revenue to accounting periotli. in terms of production rather than sal g I not an entirely unreasonable procedure if production is tho main end of the enterprise, subsequent sale being merely a routine incident, to be taken for granted (3^. P. ^55). There are also r.itvations in which neither the current cost concept rmr the historical eost concept app-.ii:.;. In -juch cases net res!i rable value may be Vkm j-o, Lcil ueas.iri.ient cmc\>t. "*y products which do not have a rv>ady markot aftir ...•>.-' ration from the Bain prod.jot without furth.r ,-rK X for which rlo.il <; > ;t cannot b-*» d'jtormin'id are examples.

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Ikk ConL-d.,t ..ith the historical Co:>t Concept .:.V/i by blstorleal oj: i concept i considered to be morn objective thai) act realisable value in :;i>rt Cv-xsv.-.., : .j 1 ,)f the current realisation ceneept lapllea bbat aeseta ire carried at co,t ar adjusted e >s ; until a jai.j takes .... 1 . . . I ., usually tbjeotlTely daterained ao it results froaj a nar'.cet transaction 'iCh an onti;y external tj the enterprise. 3isdlarly« a sale gives an objective basis Tor revenue recognitions , a aarfcet brensactlon with an sntity »xternal to tbe anterpri ,• baizes place. realisable value, on bns . »t 1 »r band,, 3.02s not result "rora an arm's length Market transaction involving the snterprlss itself, Ratber a .ut realisable vaiuo ij based an braasaotioaa involving tbe anterprise which ar.i expected to occur in bba future. Transactions Mbiob bava already ocourroJ will, in general, result in valuations which era nore abjective kban valuations biased on future transactions. Profit v»ithout a sale . --The reali2.ati.ju concept I v! bajis for recognizing revenue, for
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Iks Oilman presonts a few possibilities. "Recognition of income on tho basis of production could hardly fail to result in a most fantastic situation in the case of a new company organized to produce cash registers in competition with the National Cash Register Company, or adding machines in competition with Burroughs, or automobiles in competition with ford" (7U, p, 122). In a few cases, net realizable value may be more objectively determined than cost. This is why net realizable value is sometimes used for valuation purposes. Usefulness £1 though net realizable value is not as objective as valuations usod with the realization concept, this writer believes the use of the net realizable value concept could often result in accounting figures r to V*lu«. Some degree of objectivity mi^h*well be sacrificed in order to more pearly approximate realizable value xvould not be useful unless it could b<; measured with fair degree of accuracy. If net realisable value La completely subjective, most of It* usefulness for external acrumtln" statements is lost. NLifc realizable vnlir ir here • • [ ^d as ft more usoful M >t than original cost when original cost does not olosoly ros ft rnbl« value and net

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lur, realizable value can be determined with only a small probable decree of error. Accounting statements For the assets to which net realizable value is applicable, a more useful valuation may be shown in the accounting statements than the valuation used with the realization concept--histoi ical cost. This statement assumes a net realizable value with a reasonable degree of accuracy. The use of the net realizable value concept on the income statement would have significantly different results from the use of the realization concept. Pome revision of the income statement would be needed to reflect this concept. For example, an income statement might show the present value of estimated future receipts. Current expenditures and the present value of expected future expenditures would bo substracted from the revenue to arrive at net income. If it is desirable to divide net income between that which is realized and that which has not boon realized, other changes in tho incomo statement would be required. i ho impact of tho net realizable voluo nnncept upon the balance sheet would also be ;Ti'at. It is likely that fower complications would arise*, howover. Net realizable value does not soom appropriate for all assets. This measurement basis soon:; appropriate for inventories, accounts roceivablo, and other

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1U7 current assets. Net realizable value 1« ( in effect, used i'oc tne valuation of aocounts receivable when an allowance for doubtful .icojj.iI, -, •Ubstr*Ct#..jc;cted co L»o oniLictjJ, There is no allowance for discounting ftt some rate of iiivoi'o.it ! .. i i-j of iiii'.i-j si»'-,aif ioaiio . fhe concept is .Less cv^^jdju co ec.ior OOOOto such as plant, equipment, and in ta.i,>bi.j OSOOto* fnese are asr;eo:> used in the operations of the ii.i.jfpri ;j and ire .ic* x.iuonded to bo -,oid. IOSM of BOO variations of not roallftoblo value seems a^iicaui a ~o these assets. in this writer's opinion, tne use of net realisable VOluoa *liic.i .ire reasonably accurate* in the aco'jj.ui,j{statements, especially the income statement, would result in statement j w.tieh are Boro useful than those statements wnich are prepared under the realization concept, fhe increased usefulness lvsuits from the oioser approximation to vaiuo, liie disadvantages are much trie same as those discussed in the previous chapter dealing with current cost. The main problem would probably be the lack of understanding on the part of statement readers. An approach to solving this problem would be the publication of dual statements— one prepared on the basis of the realization concept and the other on the basis of net realizable value.

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lua ability The feasibility of net reallsab] vaiu as compared with historical cost depends upon how difficult it is to determln I I * ftliaabl vaiue and hov ug fui it would b . Che unavjilublj conclusion is that feasibiiit I ->:i th Olreumstaneas. If H t real isable value can be determined with a hifth degree of accuracy and without ,r -at cost, it is likely that the iacr need usefulness would outweigh the additional cost. Contrast With the Current Cost Concept In contrasting the net realizable value cone t with the current cost conc-.pt, it may be inappropriate to maice general statements about which is more useful and which is more objective. Beeans of t.i possible variations of each concept, it is not possible to say that one is mor. objective and the other more useful. As has been pointed out in Chapter IV, variations of current cost fall into two major classes. Since these two general concepts of current cost ar> so different, it is best to compare net realizable vaiue with each one separately. Fhe comparison is limited to those assets to which n t reallsabl value i dicable, such as inventories, accounts re ivnbl., investments, and other current assets.

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Ik9 Holding Gains and Losses Net realizable value is first compared with the ciirront cost concept which emphasizes the holding gains and losses. Comparison is difficult because of the possible varietions of each. Objectivity Current cost concepts which emphasize holding gains and losses give rise to substantially objective valuations. The current prices of inputs into a manufacturing process or merchandise held for sale by a merchandising enterprise may bo determined by consulting a vendor's current price list or a current invoice or by telephoning the vendor. There is usually an active market for such inputs or such merchandise, so the current price may be considered objective. The net realizable value of inventories is loss objective than the current cost of inventories. This seems to be true of the several variations of net realizable value. This is largely because the two major components of net realizable value— soiling price and expenses to be incurred--will be definitely determined in the future. nven though they may be predicted with a high degree of accuracy, they are by definition less objective than valuations which currently exist. The nearer inventory items are to actual sale, the more objective is net realizable value.

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150 Mtrrent cost, of accounts reeeirab . I ul than the curr i Lories. Ciut Lrab ,, ti.. current cost of account., re ivable th curr nt cost of m . -rchandi i-vic fro. a which Ui> accounts r. c .ivable r .u I .. uch a valuation would h*. an ob.j ctiv on -, but it Is not a very practical on;?, ay the tall L usually considered an objective basis for the real ization of i.ncotrvond valuation is increased by the amount of allowance for doubtful account I LnL ni I to r fi..ct the net value, and thus tho market value, of total accounts receivable . This market value would hav a little or no relation to thfl rcpiac cost concept of current cost while net realizable value is applicable. current cost of investment* is an objective valuation if the trading of the security is active. If I | v is little or no trading activity, then the current •e t, if one could bo determined, would probably not be obj ctiv . objectivity of nv-t realizable value of i,jv tta D • » >on the type of inv st;n nt. t I r .took held as a Ion -t n; lnv-stnant is difficult to nr and not objeotiv •-. r alizable value of bonds is more objectively letarla I. i'he presence: of, or lack of, a Ma r ket valuof

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151 investment is controlling in determining waion concept-net realizable value or current cost— ij more objective. Usefulness If an accurate determination can be made of net realizable value, then net realizable value is a more useful concept to use in the financial statements. Valuations arrived at by both concepts could be shown in the balance sheet by giving additional information in parentheses or in the footnotes. The choice of methods is more important in the income statement. The use of this current cost concept results in the reporting of holding gains and losses along with income traditionally realized. Edwards and iHell refer to this as eliminating the realization concept on a time basis but holding to it on a production basis. On the other hand, the use of net realizable value results in the reporting of all increases in value during a period of time as income of that period. Income under either concept might be divided into realized and unrealized elements. Income is realized when it passes the point of sale. Net realizable value is more useful than current cost if net realizable value can be determined with a reasonable degree of accuracy for it is theoretically a better expression of value than current cost.

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152 a ibi.ity Current cost is usually . ic . tir to dlt rain than n i r aii^ab. .. i ... r f«* Is BO] ible. Lisabl ralae may result in a valuati in which ilo i . Lam tea valu . Production Income I t realizable value is now compared with the j,. cond major class of current costs which measures all increases in market value— not just the increases duo to holding ;ains and losses. It is difficult to determine which is ior objective for this would depend on the variation of each concept. Hie two concepts tind toward the same valuation. Market vaiu? of an asset is a sort of an average jstimate of net raj.iz.able vain by ail those who buy and sell that particular asset in the market. A market may not exist for goods in process; an objective basis for the valuation of the asset in a certain forn may not be present. Net realizable value rnay thus be more objective and more useful than this current cost concept in certain situations. En i rai, comparison of the usefulness, obj.ctivity, and feasibility of net realisable vam and this current cost concept depends upon the variation of each. So one in< rai ssaeept cannot bo said to be bettor than the oth r.

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153 Summary Met realisable value is another alternative to the historical cost concept. There are many variations of net realizable value. One common variation is expected selling price lc .,<-, costs of completion and sale. Another common variation i:> the same eicu,)t that both the selling price and future cost are discounted back to the present at some appropriate rate of interest. The concept chosen as most logical is discounted estimated sales price less discounted estimated future expenditure :j required for co.n^lotion and less profit allocated to incompleted activities. The effect of the use of net realizable value is that increments in value for all reasons are recognized in the period in which they occur. The results are similar to those obtained under the variations of current cost which recognize production income. >Jet realisable value is a very useful concept when it can be determined with a reasonable degree of accuracy. Unfortunately, net realizable value cannot be measured with the desired degree of accuracy in many cases. Furthermore, the not realizable value concept is not applicable to all assets, e.g., fixed assets and some intangible assets. Net realizable value is much less objective than historical cost and somewhat less objective than current cost.

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CHAPTbR VI DISCOUNTED CASH FLOW I ntroduction The past three chapters have been discussions of three alternative measurement methods. This chapter is a discussion of a fourth alternative--diseounted cash fiov:. At the present time, it is unlikely that the discounted cash flow measurement basis will be adopted for general use. Although it is perhaps the most ideal method, it is the most difficult to apply. Assets may be thought of as service potentials. The value of an asset may be expressed as the value of its service potential; an asset may bo measured by measuring its service potentials. The discounted cash flow concept (sometimes called the discounted future receipts concept or discounted services concept) is designed to measure the service potentials of either individual assets or assets as a group. Net realizable value is a similar concept and could be used to moan the same thing. As used in this study, net realizable value refers to assets such as inventories which are expected to bo sold. Net realizable value is applicable to very few assets as was 15U -

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155 discussed in Chapter V. Hie discounted cash flow concept would apply to all assets. Discounted cash flow may be referred to as "net present value of expected future cash flows" and "net present value of expected future cash flows with adjustments for risk" (11, pp. 50^-06). "Discounted*' means reduced by some rate of interest because of the time factor. The concept refers to a net valuation-reduced by future expenditures also discounted back to the present. Although the concept mi^ht be applied to certain individual assets, it is probably more appropriately applied to the enterprise as a whole. individual assets may have service potential only when used along with other assets in an enterprise, or they may have greater service potential when used with other assets. Average service potential of a .^i?en asset to an average enterprise is possible, but it may have little significance for a given enterprise. Discounted cash flow usually measures the earning capacity of a Kiven enterprise. Heed K. Storey, in an article entitled "Cash Movements and Periodic Income Determination 1 presents six statements concerning the nature of periodic income and its determination which are particularly relevant to the discounted cash flow concept. Mr. Storey draws upon an article by Edward G. Nelson, "The Relation

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156 between the Balance Sheet and the Prof it-and-Loss Statement , " vhich appears on pages 1 32-Ul of the April , 19^~» Tine Accountin g Ilevtew. The six statements are listed here: l a Over the life of a business, revenue is equal to the cash receipts from operations, and expense is equal to the cash disbursements from operations; tho profit (positive or negative) is therefore equal to the difference between cash receipts and cash disbursements resulting from operations. 2, For any period less than the life of the enterprise, revenue is equal to the cash that will bfl received (pa>-t, present, or future) es a result of the operations of the period, and r>x^f>n^(f la equal to the cash that will be disbursed (past, present, or future) as a rp'iilt of the operations of the period. 3. Periodic income determination is essential^' a process of asset valuation because the value placed on net assets at the beginning and end of an accounting period determines the profit allocated to that period, or conversely the part of the total profit allocated to periods determines the value of the assets. fe. The rate of profit (whether it is assumed to be equal in ail periods or not) is a rate of rowth of capital value because it measures the proportion by which a given asset or group of assets increases in value during the period due to operations, jj. The value of an asset determined by the invested capital method (adding outlays and allocated profit) equals its value determined by the .resent value of net revenues method (discounting net revenues by the same profit-rates used in allocating profits under the invested capital method). 6. Income and asset valuation depend on the expected amount and time distribution of cash movements which take place primarily in tho future and are therefore subjective in nature (67, !>. ^52). This step-by-step development is an aid in understanding the nature of discounted cash flows.

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157 Economic Concept There are many different economic theories of income. One cannot accurately speak of "the'' economic theory of income, but one can generalize and speak of an economic theory of income which is perhaps more prevalent than other theories. J. H. Hicks is usually given credit for putting into words the concept of income as the amount that can be spent during a period of time and yet leave the entity as well off at the end of the period as it was at the beginning of the period: The purpose of income calculations in practical affair., is to give people an indication of the amount which they can consume without impoverishing them i^Lvps. Folin ring Wit this 14«a, it would seem that we ought to define a man's income as the maximum value which he can consume during • weak, and still expect to be as well off at the end of the ao he was at the bCfinalftg (77, p. 172). For purposes of this study, discounted cash flow i s ijquated to oconoraio tWOWK « subjectivity Discounted cash flow appears too difficult to measure and too subjective to be used in the valuation of all assets. Arthur L. Thomas says the discounted service aporoach 'cannot, even in theory, give a precise val'ie to i ndividual assets. It may, though, be able to give a fairly precise value to companies as a whole, or to entire economies" (78, p. 68). The value of this concept in accounting may be in the valuation

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isa of entire enterprises. For example, this concept might be useful in buying or selling an entire enterprise. uith current methods of prediction and measurement, it seems that the discounted cash flow concept is not a likely candidate for a measurement base. Perhaps new techniques in the future will make the concept more applicable. Comparison with other Measurement Bases The three measurement bases already discussed are now compared with the discounted cash flow concept. This is not to discover the best base; it is to compare each base with a aieasurement of economic income. Historical Cost The current use of the historical cost concept in recognizing revenue would have the same results as this economic theory only in isolated circumstances. For example, the two concepts could result in the same amount of revenue if there are no price-lovel changes during feh« ooriod and there are comparable inventories at the beginning and end of the period. The use of the historical cost concept is not intended to measure revenue from an oconomic point of view. lho accountant is not necessarily interested in the same measure of revenue in whioh the economist is interested. Both the economic concept and the accounting concept involve increments in value. The

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159 main difference is in the timing of the recognition of such increments. There are also some differences in emphasis. For example, the accountant Is usually interested in the inoo'oe of >^cific entities while the economist usually is not. "This specific interest of the accountant makes him more conservative than the economist faced with the same problem— for example, the accountant typically hesitates to recognize a favorable change 'too early' because it may never be 'realized,' and the party to whom the benefit flows may prematurely demand his share or act on the presumption that it is his" (31. P. 12). Current Co^t The economic concept includes in income increase, in wealth over time. *5uch increases in value art? included In income vhether they ere converted into a liquid form or not. The currently used realization concept is further from this economic concept than tho current cost concepts. A sale or deliverj' is the usual criterion for recognizing revenue at present. Increases in value, especially those increases in value duo to the production of goods, are not recognised under the realization concept until the sale or del ivory takes place. rhit> could be far remove] ia time from the

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ir.n actual iicrerse In value. Thi 3 incroasa in v*iue r^f^r 8 t > both value inore^onti due to prod\ic t.ion and balding gains and losses. current cost concepts are more similar to the eoonomio concept than is the realization concept. The first group of current cost concept 1 ? (emphasizing holding gains and losses) comes closer to the economic concept than the realization concept but not as close as the second grouo of concepts (emphasizing production income). The second group of concepts might have practically the same results as the economic concept. Dif f eronc*.s between the concepts would be duo to difference:; In the wny they are implemented. Net Realisable falv* TTie economic concept described in the preceding paragraphs is similar to the net realizable value concept. The differenc La in the assets to which the concepts apply. JJet realizable value is bost applied to certain current assets. The economic concept, expre'i t*d h* ro as discounted cash flow, applies to the valuation of all assets and therefore to the increase in value, income. Summary The three major measurement bases in accounting for financial data are historical cost, current cost, and net realizable value. A fourth base, which is not

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161 likely to be acceptable for use in accounting in the foreseeable future, is discounted cash flow. This is intended to be an expression of the economic concept for asset valuation and income measurement. Discounted cash flow is most applicable to asset groups such as an ontire enterprise. This economic concept cannot be applied with the same degree of objectivity as the other measurement bases suggested in the preceding chapters. If discounted cash flow could be implemented, it would be the ideal measurement method.

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CHAifaR VII SUMMARY AND CONCLUSIONS Accounting is the measuring of financial data. Finanoial data is measured in order to meet the needs of management as well as persons and entities outside the accounting entity — external users. These external users include investors, creditors, social control agencies, labor unions, employees, consumers, and the general public. Management uses the information provided by systems of accounting to aid in making decisions in three areas: planning, controlling, and evaluating. Accounting also serves to make management aware of the need for decisions; this is essential in order for the "management by exception rule 1 ' to apply. These three areas of managerial interest imply that management is interested in what has happened in the past (evaluation), what is happening at the present (control), as well as what is expected to happen in the future (planning). Accounting serves management's needs in all three areas; accounting is not confined to recording the past. -.valuation of past events is largely to aid in controlling and planning. 162 -

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163 The primary accounting statements consisting of the balance sheet, the income statement, and the capital statement are used by management, but management's needs extend beyond these statements. Management needs much more detailed information than is ordinarily provided in these primary statements. Also, management requires information much more frequently than is provided by these primary statements. Management may use these primary statements as a starting point in reviewing the results of financial affairs. From the primary statements they may go to other accounting records and statements for more details on specific points and for more frequent information. The external users as a group have diversified interest in the measurement of financial data of an entity. The published financial statements are the main source of information to these users, although some users obtain additional information. Creditors may receive information according to the contract between the entity and the creditor as well as additional information concerning collateral and earning power. Potential creditors may also ask for information more detailed than that appearing on the financial statements. Governmental agencies have the authority to require specific types of information. These are typical examples of external users receiving information in addition to that presented in the financial statements.

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16U Investors and prospective investors compose the largest group of users of accounting statements. Investors are interested in some combination of dividends, appreciation, risk, and diversity. It is not known exactly how investors use accounting statements and to what extent financial statements affect their decisions. It is assumed that investors use accounting statements to determine financial position and results of operations. internal users (management) and external users have different needs. Although high levels of management may use the primary accounting statements as a starting point, they desire much more detailed and more frequently provided information on specific Items. At lower levels of management even more detail and more frequently provided data are desirable. The lower levels of management may have no need for the primary accounting statements. •xternal users, faced with decisions which differ from management's decisions, need essentially different information. fheso external users are more interested in results of management's efforts than in the detailed information needed for managerial decisions in various areas of an organization. Kxternal users, especially creditors, desire a report on management. They are more interested in plans for the future than in the process of managerial planning. The

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165 published financial statements are intended to meet the needs of most external users while they serve the needs of management to only a small extent. Although the type and detail of financial data desired by external and internal users are not the same, both groups of users are interested in an appropriate measurement of financial data. The purpose >f this paper is to analyse and compare the most prominent of the laeasuro.uent methods which have been suggested in the accounting literature. The measurement methods, or bases, chosen for inclusion are historical cost, current cost, not realizable value, and discounted c?sh flow. Accounting has always been a system of measuring financial data. The idea that measurement theory applies to accounting is not new, but recent years have witnessed an increased emphasis on the application of measurement theory in accounting. Measurement may be defined as the assignment of numerals to represent properties of objects or ovents according to rule. Measurement is sometimes dofinod more broadly to include the assignment of numerals to objects or events themselves, This broader definition includes ;;aro classification within the sphere of measurement. A one-to-one relationship must exist between the quantities of the properties or the objects and the

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numb used in teastir b . Should posses ; :ces un Lqus A if K asd to of objects in . ' i ray relations between rs indicate relations between the objects or proper tl >f fch »bJeots. According to Stevens the lowest seal:, called ieal , Lav asslf ioation and Lees net necessarily involve order, distance, or uri in. 4any experts would not consider this as a sea to at ail. >i Laal seal:, feb a ct -cat.-, implies order and includes the features >f Lbno.unai SOOle, Che next scale, the interval scale, has the features of the ordinal, scale with an added feature of a meaningful size of tin. distance between pair* of numb. rs. An interval soale with a natural ori CJ in is called a ratio sea , the highest type of soale. liach scale after the first grows out of the preceding scale. The application of .-ach scale is restricted to a more specific area than the preceding one. i sr « tir e kinds of measurement . ( [hey iiavr ao relatleaship with the types of scale.) These arc fundamental Measurement (which has i anin| three natural Laws relating various quantities of the construct to each other), derived aeasureaeat (which has meanin , through laws relating the property to other properties),

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167 and fiat measuremen t (which has meaning by arbitrary definition). Measurement theory is essential to accounting because the purpose of accounting is to measure. .Measurement is concerned with the quantitative aspects of objects. Accounting is also concerned with quantification. Perhaps accounting should also be concerned with nonquantitative aspects of objects, and perhaps in the future this will be a significant feature of accounting. This paper discusses accounting from a quantitative aspect only. Accounting is sometimes defined even more narrowly to include quantitative measurement in financial terms only. in order for measurement in accounting to take place, several decisions must be made. The objectives of the entity is the first factor to determine. The profit motive i.s usually assumed to be the primary motive of business entities. Other objectives do exist, but they are usually subgoals. Before measurement may take place, the types of factors which may serve to attain the objectives or objectives must be determined. The selling of products and the rendering of services are usually considered to be the means of obtaining the objectives. Accounting attempts to measure only the financial and some other ouantitative aspects of the selling of products and rendering of services.

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i6;j Accounting cannot usually iaoi.;urc incoa; directly. The formulation of rules has been found necessary in order to determine "accounting income. " Inconia as determined by the application of accounting rules my be considered a surrogate, or substitute, for real income. A measuring method and a measuring unit must bo selected before income and the subgoals may be measured. This is the basic measurement task of accounting, the choice of a measurement method is the central theme of this paper. The measurement unit is the language of the measurement method. Accounting expresses financial data In monetary terms, but this involves the problem of the changing purchasing power of the dollar. Are measurements to be made in terms of dollars with no recognition made of the changed purchasing power between two points in timey After these decisions concerning objectives and methods have been made, the measurement process itself may take place. Analysis of the results and the use of mea*urem«nt follows the measurement process. The measurement methods and units should be determined in li ht of the use expected to be made of the results. Since the primary f-oal of a cusiness enterprise is to make a profit, accounting should not only measure the attainment of the goal but should actually make a contribution toward reaching that goal.

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169 The goal of acco'intin^ should be to measure The rules applied in accounting arrive at a substitute for value and increases in value. Substitutes and estimates fail to measuro actual valuo, o amounts reflected in financial statements amy imply accuracy which does not exist. Cornpleto accuracy is usually unnecessary, the degree of accuracy depending upon th*; purpose for which the measurement is being made. The user of accounting data should be made aware of the degree of accuracy reflected in the data. Perhaps financial statements should indicate the probability and degree of error inherent in measurement methods used and the results of the measurement. Accounting measurement utilizes all four types of scales of measurement. The classification used in the chart of accounts i3 an example of the nominal scale. Ordinal scales are used in statement analysis. The time dimension is an examplo of the use of Mm interval scale. The use of dollars is an example of the ratio scale. The kind of measurement used in accounting is usually fiat. Most measurement methods such as historical oost and current cost are examples of measurement by fiat. Net realizable values and discounted cash flows aoproach fundamental measurements. Four criteria are chosen to bo used in discussing and comparing these four measurement methods. These criteria are relevance (usefulness), objectivity (verif lability and freedom from bias), feasibility, and quantif iabili ty .

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170 Iliu first MtmrMMt Method i. historical cost (Chapter 111) which is generally accepted for u;t in accounting statements. Historical cost (so fti Mod original cost and transaction price ) la RSI objective basis far taut Kfeioh is exchanged. Bm use of this neasurrfoient method in the accounting rjcordi istpllsfl that accounting is the a i vocation o£ historical cost.:, sad revenues to fcne fiscal periods. There are several concepts so closely related to historical cost that they are almost inseparable. One of these is the going concert) concept. IUij.Lii3.ss enterprises are assumed to hava a continuous life, and the accounting records are based on this assumption. This means that liquidation value may be of little value, ana this is often interpreted as support for the historical cost concept. An in terpr* tation .-.hich i less acceptable in current practice is that net realizable values and discounted cash flows would hi. S natural consequence of the going concern concept. Another concept related to the historical cost concept is the time period concept. The use of the time period makes it necessary to determine iflOSSM and asset measurements before the enUr^rioO life i~ ever. Hules must oe made t« cu.aatd the results of operations. tteali nation is the co;ic »t BSad to determine wliat revenue is to be r«)Co»ia<.oil aur*. I ;i time period. fhe dominant in tor pro tation of tho realization

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171 •MM«pt i fchat ohan^o In I n ' Lte* Wl flolent objectivity fee mrrnnt recognition in the accounts. A tela li U ' fc] V of a uffloient objectivity and i generally '' — • <-.ed eri.1 for ro,-i l tion« Ha seta reaaln in *;h^ bo oka at bi ; t ->r.lcal cost until realisation li Aoeaad to hav; taken place. Hie related oonc^;-t of notching Is u=;ed to determine Khat expense a r.h mid lodneted fro-: the roeeajnised rsvenuo, Thoso eeata %'hich wrr^ — ry to attain the revenue of the period should bt SMtefeed with tho revjnm. Another concept directly related to the historical cost concept is objectivity. Objectivity implies rarlf lability and freedon from blast objectivity is one of the nost i.-.iportarit advantages of historical coat. The conservatism concept la also related to historical cost. Historical oost L the <->;t rsonserratiVS concept of thoso di sen.sod here. Of the ooncc;;ti discussed hers, thn >:!•-> -no. t alaaely related to historical cost is the realization concept. Suggestions have been cade to use l top liberal realization concept than is currently accepted. in cun-Mit practice there ar: several exceptions to the general rule that a sals la 1 I far realization. Tn sooo situations jc'i a-. shipbuilding realisation .nay occur during production. Completed ; rcHiiction

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172 is required in some situations such as mining of metals and producing agricultural products. The use of historical cost along with the closely related realization concept results in some shortcomings in the financial statements. A reader is likely to be mislead if he assumes that financial statements reflect values. In order not to be mislead, the reader must realize what measurement method is used and the implications of its use. Under the historical cost concept, capital gains and losses are not recorded as they arise. Also, when capital assets are consumed, capital gains and losses become part of normal profit. Another major limitation implicit in the use of historical cost is the failure to recognize changes in value as production takes place and as services are rendered. file use of historical cost may make difficult the comparing of the accounting statements of a particular entity over a period of time. One reason for lack of comparability is the use of alternative methods which arc permissible with the historical cost measurement method. Another major reason for lack of comparability is price-level change. General and specific price levels do change from period to period and thus distort the financial picture based on historical cost. The use of historical cost also results in lack of uniformity between enterprises. The problems of alternative methods and price levels are again involved.

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" ' : not b.' . by fina i lents produo L„torical >OSl C 'i n tfa -y hav • an ^lforcation ' i r i ooount in. ->) feat eonoepl i under 11 the >r ,^aration of accounting sta' Lnh rent limitation f to itat u . fv i! | f i do understand accountin .;, kt) y M t ir > >.n ad J . .. tu financia I at and ther for Information they need. Investors and prospective investors also need re Levant information in tin financial statcim nts a.s they must i n r Lj >n such statements oven mor< than mana ;eaeat. Fhere ar thr< reasons any investors may not Tvly on published financial statements. iirst, t, | may not {Its ad> a.!'. ir.f ormaticn to for a decision. IT, rjay b« intentionally biased in addition to shortcon. already atloaod. toother criticism of published financial, statements is that they provide inv stors with very little information concrnin , th: futur . rhe seoond possibility as to why Investors and pro olive investors Jo not use published financial statements in making decisions is that sta r sourc'b of information nay be Ml l ^ fut. coniary sources such as investment brokers, financial periodicals and news reports, and Investment nana ;• rs for

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1 < i titutional inv stars ther sou, include , LI Tide nd r cor I , and da I y I >okmarket activities. Tl r tfa ;-rc not ;rii/ imply a lack ol >• i icial stat teats, i . ay j roTlde lifferent typ of inforn and it»i t :iff r nt Object!* iiity as to whj Lnrestora and prospect It investors do not use published financial bat it-, in makin d ci ions is that they nay not tuffioient knovl I , • ef account in .. A poasible solution ivouid b; to prepare statements in such a way that th:y coui . er stood and used by those who have some ^n^ ,f financial data but who are not experts in accounting. rs of financial statements other tian wana nt and inv ;tor ; , n, rally have 1 | ,i d for the Statements b^cauv they nay aae other sources of information. However, they nay be mislead if they rely entirely on the published financial statements. An alternative to the historical coat aeaear< nt method is current co^t (Chapter IV) which is a tor>n chos-n to include »iany variations of market value and replacement cost. variations of current oo^t seam to fall into one of two types: those which separate uii anJ La f r n eperating incoin an J reoognii L a a erne on a production basis. Ih ^ '.i ) ty i might also distinguish holding ^ains and losses from other Lneome.

PAGE 181

V!5 ZnooiM . ms.'I la this ^ludy inean^. both unexpected J.rcre'i! nts in value ( pur.; pi'ofit) and increments due to aboTe-iiVor.'icfi deci >ion -Making ability and risk vuking. anting income also includes interest on cubital. Jncrorsrr) * in value for any of tats* reasons . r aay bo con iidorod income whether rfco^niied or not. Enoom is not ne-cesse.rily ncoyiiied when incroMntl ir vrlue takj i.'Uce, but doter.nina tion of when incrc:riroiuct ion, holding, and selling, each of which ;uay rive rise t :> value incmraentj. Alternatives to the historical cost irjeasuremen $ method suggest the recognition r >!» of these lncro-nentrf aj they tcke place. Current cost concepts are intended to .ncasure c'^n;es in ttM specific prices as contrasted with general priC'j-1 ev* 1 clian^js, (It, is assumed that appropriate i-";u |1 •-•it-ill be roads for o:?j-i ,:, i.i Mm g*n«ral pric? l11.) Ihl increment measured depends upon the part\o, , . : .• '-'urrent cost concept uatd. and Bell reuoiunend two current co^t concepts — roalUclie profit and business profit. Healizab.le profit io coLaposed of realizable operating profit and realizable oapital gain3. Realizable »p*r*ti«l profit is the increase in opportunity cost duti to pr«duntion Mid Ll Una ttl increment in value duo to production. ( Pro hit ti<"i here implies all business activities

PAGE 182

1/6 other than wording. ) .{cai.j.zatjly; oapita^. gain fl avc the gains due co tnc inor -.. la in opportunity cost over time and baa a baa increment in value due to holding. ^dvards and Jaii'i business profit concept is composed of current operating profit and raaliaabla coat savings. Current operating profit is the difference between current cost before production and current value after production. {jurrent cost is the cost of acquiring inputs at tne present time, and current value is the value actually realised for goods or services sold. I realizable cost savings is the increase in current ojst over time. litis concept results in the recognition of increments in value due to holding wnile the remaining increments are net recognized until the tlaa of sale, edwards and Ball would choose business profit as being the more useful of the t*o concepts. Spraaaa and .-ioonitz suggest a current cost concept which they call replacement cost. .lithough they do not make it ciear how replacement cost should be determined, tne> ,e^m to be suggesting the use of what nd wards and i>ell calx current cost. Ihis implies that holding gain a and losses would bu recognized as incurred but that the recognition of other increments in value would be postponed until the time of sale. Other current cost concepts fall into one of the two categories. lao accretion concept is an example of those which emphasize production income while

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177 Horngren's concept (see oa»»e 108) is an exafoU of those concepts which emphasize holding ?ains and losses. The separation of increments in valne 1ui to holding activities from other business aatlvitlai is a good starting joint in anaiyr.in^ operating r*»r.iUs. Although it raav not always be possible to determine the cause of holding gains and losses, they ara at Least aligned to the period in which th*y aroT> and ar« not included with other incomo. Current cost concents emphasising holding gains and losses have the advsntacp of b^in" closer ta current practice than the other type of concepts. Th« currant, cost of inputs can be determined without much cost and difficulty (feasibility) and objectively determined. Current cost concepts which aaphaalza pradnetlsa income are recommended less often than concepts emphasizing holding gains and losses. Concepts ewhadring production income are more theoretically dsslral I because they approximate value more closely. Also, this concept may be useH to determine both roduction incoane and holding g»ins end Laasas« but thp difficulty and expense may make this method l^s-: practical than V <~ other type of conceit . Historical cost and current cost have b compared on tho basis of u efoln° is, objectivity, and fea .ibility. To the extent that economic value is an accurate indicator of financial ->o^.ltion and inco.ne.

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178 then current co.it is more useful (relevant) than historic cost. the necessity of chan ;in g from the use of historic cost to current cost in the financial statements woul'J somewhat limit the usefulness of the statements until readers became accustomed to the new measurement method. Complications in the accounti.i statements in order to reflect current cost rather than historical cost would perhaps offset to some extent thu increased usefulness of current cost. One useful aspect of current cost concepts which recognise production income is that th, direct costing controversy would be eliminated. The other current cost concept would have no effect on the controversy. fulness and objectivity are not necessarily in conflict as objectivity may contribute to usefulness. The more significance the reader can attach to financial statements, the more useful they may become to him, and objectivity may make the statements mor oi nificant. ) Corical coat is definitely more objretiv than currnt cost, but Le current cost liave sufficient objectivity/ in many ecsea current cost does hav. sufficient objectivity. Nh.cn current co^t can bo detemin«d with sufficient objectivity to be included in the financial statements thn its us Be ms to i»

PAGE 185

J 79 Although there are several variations of net reali/.ablo value (Chapter V), the concept generally implies recognition of value increases or decreases as they occur. One variation is expected revenue loss expected costs of completion and disposal. All profit is attributable to the buying or producing activity, and no profit is attributable to the other activities. Another variation is identical to that suggested in the preceding paragraph except for a reduction by a normal income on activities not performed. Still another variation postpones all operating incoae until the time of sale. These variations may or may not use a rate of discount to compute the present value of future revenues and expenses. The most logical variation of net realizable value seems to be discounted estimated sale.-, price less discounted estimated future expenditures required for completion and less profit allocated to incompleted activities. This variation would assign value increments to the activities performed. The determination of holding gains and losses from other income is possible, but it is not usually built into this measurement method. The net realisable value concept seems to a,;. 1/ to only inventories, accounts receivable, and other current assets. The net realizable value concept is compared with historical cost on the basis of objectivity,

PAGE 186

i8fl ci ,efulne.->s, and feasibility. Historical cost is generally itioro objective than net roaliiabij value. \'e t realisable value has an advanta;;*) over historical cost because it is a closer approximation to valua, Met realizable valua is ;ug. o.;ted as a nur.i useful iaoa ;jr-ment conoopt than historical cost when historical cost does not closely r*S**bl« value and net reali /.abi j value can be determined with only a snail probable decree of error. If net realisable value can B* determined with a high degree of accuracy and without great co.it, then the use of tho cone spt would bo feasible. Not realizable value is compared with current co,t on the basis of the same criteria. Tho current cj,t concepts which emphasize holding gains and losses are generally more objective than net realizable value. i of usefulness, objectivity, and feasibility la of little value.

PAGE 187

181 Laaoun . f i >w (Ch.iptjr vt) i; the fourth and 1 B 1 itMSttT 'l ' i Iho I d ' may b . fco Individual aaaeta or [ta applloatlon to ;roupa of a • tor root leal i. it la difficult to break down rtn n\ r >rl.'a cosh fiow between the various ass'ts. This flow concept is similar to n t r alizabLo value except that It applies to ail ass fcs. Discounted ca.sh Plow i; a good m .i.in.~ i conoinio income ami can tli. r for • bo considered the ideal m -asur merit method. If discounted oaah fLows could bv a I nail) d for an aaterprlae then it would :.\ e most useful. r. ur n at thod. dowev-r, dl counted ca.sh flows appear too difficult to m asur and too subjective to be U8«d in th" valuation of all aaaet . f the four Laau discounted cash flows is t: i.: a f of economic value. • t. r allaabl< valve La th »ai but appllea to only a Limited number of assets. The curr a1 cost concept which measures production inc. closer to being Ideal than th oth: r current cost conc pt. Th curr nt cost concept which
PAGE 188

8IBLI> 1. Davidson, Sidney; ^reen, David, Jr.; Ilorngren, Charles T.j and Sorter, ( }eoY:-;e H . (ed. ). An Income Approach to Accounting Theory , pcriewood Cliffs: Prentice -Ha 11 , Inc., 196U. 2. Sprouse, Robert T. , and Moonitz, Maurice. A Tenta t ive Set of Broad A ccounting Principles for Business Enterprise . New York: American Institute of Certified Public Accountants, 1962. 3. Study Group on Business Income. Changing Concepts ?X T B"^ H e:i ;s Income « iVclited by Robert K. Jaedicke, Yuji"ljiri, and Oswald Nielsen. American Accounting Association, 1966. 6. Stevens, S. S. "Measurement, Psychophysics, and Utility," Measurement, Definitions and Theories . iditod by C. west Churchman and itiilburn Ratoosh. Vow York: John Wiley & Sons, Inc., 1959. 7. Russell, B. Principles of Mathematics , Second Kdition. New York: Norton, 193^. !. Tor^erson, Warren 5, Theory and "let-hods of :>callnft . New York: John Wiley & Sons, Inc., 1962. 9. Campbell, N. H. "Symposium: Measurement and Its stance for Philosophy, " '/roc, ^risfc. ioc . .iuppl. London: Harrison, 193<3. 10. Mattessich, Richard. Accounting and Analytical Me th ods . Homewood, Illinois: Richard D. Irwin, "inc., 196^. 11. Bierman, Harold, Jr. "Measurement and Accounting," The Accounting Review . Vol. 38, No. 3 (July, 1963). PP. 5^1-7. 182

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183 12. Jaedicke, Robert K., Ijiri, Yuji, and Nielsen, Oswald. (ed.). Research In Accounting Measurement . American Accounting Association, 1966. 13. Churchill, Neil C, and Stedry, Andrew C. "Some Developments in Management Science and Information Systems with He spec t to Measurement in Accounting, " Re search in Accounting Measurement . BdltW by Robert tv. Jaedicke, Yuji Ijiri, and Oswald Nielsen. American Accounting Association, 1966. lU. tvircher, Paul. "Measurements and Managerial Decisions," Measurements; Definitions a nd Theories . edited by C. West Churchman and Philburn Ratoosh. New York: John rfiley A Sons, Inc., 1959. 15. Anthony, Robert N. "Synthesis: Research in Accounting Measurement," Research in Accounting Measurement . .dited by Robert K. Jaedicke, Yuji Ijiri, and Oswald Nielsen. American Accounting Association, 1966. 16. Gordon, Myron J. f Horwita, Bertrand N., and Meyers, Philip T. , "Accounting Measurements and Normal Growth of the Firm," Research in Accounting Measurement , edited by Robert K. Jaedicke, Yuji Ijiri, and Oswald Nielsen. American Accounting Association, 19&6. 17. Devine, Carl Thomas. "Some Conceptual Problems in \ccounting Measurements," Research in Accounting Measurement . edited by Robert K. Jaedicke, Yuji Ijiri, and jswald Nielsen. American Accounting Association, 1966. 18. Ijiri, Yuji. "Physical Measures and MultiDiraensional Accounting," Research in Accounting Measurement . edited by Robert li. Jaedicke, Yuji Ijiri, and Oswald Nielsen. American Accounting Association, 1966. 19. Johnson, Charles i. "Management's Role in External Accounting Measurements, ' Research in Accounting Measurement , idited by Robert K. Jaedicke, Yuji Ijiri, and Oswald Nielsen. American Accounting Association, 1966.

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V6U 20. Ijiri, Yuji; Jaedici.e, BotM rt K.; and Knight, Kenneth .i. "The Effects of Account! Ai tenia tive »a on Management iiucisions," He .search in Accounting Measurement , edited by Robert K. Jaedicke, Yuji Ijiri, and Oswald "Jiaisen. American Accounting Association, 19-66. 21. Churchman, C. West. '' rfhy .Measure V" Measurements ; iter initions and Theories . edited by C. West Churchumn e>.nd Thilburn Ratoosh. New York: John tfiley & ions, Inc., 1959. 22. Sprouse, Robert "f. ''The Measurement of Financial Position and Income: Purpose and i rocodure, ' Research in Accounting ••fe&vure '<• r»f. riited by Robert K. Jaedicke, Yuji Ijiri, and Oswald .Nielsen. American Accounting Association, 1966. 23. Ijiri, Yuji, and Jaedicke, Robert K« "Reliability and Objectivity of Accounting i-'easureRMmts« |jhg Ac counti ng RevifcV , Vol. kl , No. J (July, 1^66), pp. k7b-i>j. 2b. Chambers, U. J. "Measurement in Accounting," Journal of Accounting Research , Vol. 3. # No. 1 (Spring, 196.5). K£ 32-62. 25. American Accounting Association Committee to i re^are a itacniimnt of ttasio Accounting The o ry . A statement of Ltaaic Accounting iheory . American Accounting Association, 1966. 26. Harvard business School Accounting Round Table. The .itiubuixuiont of i'roperty. Mant, and iauXvgtmnt in Financia 1 stat ements . Uoston: Harvard University, 196^. 27. American Accounting Association. Accounting and Reporting Standards for Corporate Financial Statement:; and .'receding Statements and »Ui> i >leiuonoM t j-95/ Revision . Oolu»i»ms, ibio: American Accounting Association, 1957. 28. Kamph, Harry N. "Current Values— An Imperative in Today's Financial Reporting," N. A. A . Hul l/; tin . Vol. kZ 9 Sec. 1 (Aug., 196l ), PP. 17-2U.

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185 29. Hatfield, Henry Rand. Modern Accounting . Mew York: D. Apploton-Contury Co., 1909. 30. Storey, Hoed K. "Revenue Realization, Going Concern and Measurement of Income, '' The Accounting Review . Vol. 3 1 *, No. 2 (Apr., 1959). pp. 232-33. 31. Moonitz, Maurice. The Basic Postulates of Accounting . Sew York : American Institute of Certified Public Accountants, 1961. 32. Edwards, udgar o. # and Bell, Philip tf. The Theory and Measurement of Business Income . Berkeley and Los Angeles: University of California Press, 196l. 33. American Accounting Association 1965 Concepts and Standards Research Study Committee — line Matching Concept, "The Matching Concept," The Accounting Review . Vol. 40, No. 2 (Apr., 1965), pp. 268-72 . 3^. Arnett, Harold E. Recognition as a Function of Measurement in the Realization Concept," The Accounting Review . Vol. 38, No. U (Oct., 1963), pp. 733-^1 . 35. Arnett, Harold B. "What Does •objectivity' Mean to Aocountants v" The Journal of Acc ountancy , Vol. Ill, No. 5 (May, I96I), pp. 63-68. 36. Windal, Floyd W. "The Accounting Concept of Realization," The Accounting Review . Vol. 36, No. 2 (Apr., 1961), pp. 2U9-53. 37. Grady, Paul. Inventory of Generally Accepted Acc ounting ^rincip lo s f o r Business .-ntorprises . Accounting Research study No. 7. American Institute of Certified Public Accountants, New York: 1965. 33. Paton, W. A. Accounting Theory . Mew York: The Ronald -r« la Co. , 19*22, 39. American Accounting Association Committee on Concopts and Standards--General, 1963. "Report of the Committee on Concepts and Standards--General, " The Ace oun ting Review . Vol. 39, No. > (Apr., 1964), p P . U'*5-31.

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188 63. Sorter, B< fl u r-o'.'rM'pri «•-• of the Accounting Universe: The Accounting: Rul er , of ''election , Unpublished lti. IJ. dissertation. University of Chicago, 1963. 6k. Vatter, William J, The Fund Theory of Accounting and Its .Implications for Financial 'leports . Chicago: University of Chicago i'ress, 19U7. 65. American Accounting Association Committee on Con0«pta Mid Standards— Inventory Measurement. 'A Discussion of Various Approaches to Inventory Measurement, Supplementary State1 • »" The Accounting .^vj.-i, Vol. 39, Ho. 3 (July, 19^*0. pp. 7°0-lU. 66. iliilips, <'. iidward, "The Revolution in Accounting Theory," r he A c c oun ti ng; Rovl ey , Vol. 38, No. h (Oct., 19^3), pp. 696-7 67. Storey, Reod K« "Cash Movements and I eriodic Incortia Determination," The Accounting Review . Vol. 35, #« 3 {July, 1.96O), 68. Chambers, R. J. "Measurement and Objectivity in Accounting," The Accounting Review, Vol. 39, No. 2 {Apr., 196^), p.>. ?6lf-7V. 69. reer, Howard C, and Wilcox, tidward B. "The Case Against i'rice-1-evel Adjustments in Income Determination," Illinois Certified Public Accountant . Vol. 13, No. 1 ( ?ept. , 1950), ! j7 1.-1^. 70. Fertig, i'aul t« "Current Values and Index Numbers: The Problem of Objectivity,' Hoc --arch in Ac count! .-> L ^ y t 1 a jure >\ ' n t . .dlted by Robert K. Jaedicke, Yuji Ijiri, and Oswald A'ieison. American Accounting Association, I.966. 71. 1'aton, William A, Cost and Value in Accounti , The Journal o f Accountancy . Vol. Si, So. 3 ( iarch, 19^6), pp. 192-99. 7 1, Uo.nburger, R. H, 'Measurement in Accounting, " fit; ncoountia; Review . Vol. 36, No. 1 (Jan., 19SI), up. 9«*-99. 73. Canning, John U. The Economics of Accountancy . New York: Ronald I'ross Co., 19-9. 7k. Gilman, StcplMMI* Accounting Concepts of I'rofit . fork: Ronald toss Co., 1939.

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189 75* May, George 0. Financial Accounting . New York: The Macmillan Company, 1951. ?6. I'aton, William A. "'Deferred Income 1 — a Misnomer, The Journal of Accountancy . Vol. 112, No. 3 (Sept., 1961), pp. 38-U0. 77. Hicks, J. R. Value and Capital . Oxford: Clarendon iTsss, 1950. 74, No. 2 (Apr., 1959). pp. 207-lU. American Institute of Accountant:; Committee on Auditing rocedure. Statement on Auditing : roc e dure . New York: American Institute of Certified i*ublic Accountants. Anderson, Corliss D. "What the Analyst Wants In Corporate He ;->orts, " Investor Relations: The Company and Its Owners . Kdited by Jerome a. blood. (New York : Aine r i c an Management Association, Inc., 1963), . 141-56. Anderson, William T. Data from Financial Statements Are Used in Reaching Decisions, ' The Journal of Accountancy , Vol. 113, No. 5 (May, 1962), p. 89. Anton, Elector R. "Some Aspects of Measurement and Accounting, " Journal of Accounting Research . Vol. 2, No. 1 (Spring, I96U), PP. 1-9. Bedford, Norton M. 'The Need for an Extension of the Accrual Concept," The Journal of Accountancy . Vol. Ill), No. 5 (May, 1965), PP. ?9-33. Devis, Herman W. "Progress and I'overty in Accounting Thought, The Journal of Accountancy . Vol. 122, No. 1 (July, 1966), pp. 3U-U0.

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190 Burke, dv/ard J. "Objectivity and Accounting," fhe Acc o u nting Review . Voi . 39, No. 4 (Oct., iy~64), pp. 837-49 . Carson, A. ;i. Cash Movement: ilie Heart of Income Measurement,' The A ccounting Review . Vol. 4o, No. {A rxl*" i9»5), pp. 334-37. Cook, Franklin H, "The Sale as a Test of Income Realization," The Accounting Review , Vol. 14, Ho. 4 (Uec, 1939), PP. 355-67. Corbin, Donald A. Comments on the Accretion Concept of Income, ' The Accounting Review , Voi. 33, wo. 4 (Oct., 1963), p. 744. Cruse, Hex B, , Jr., and Summers, Edward L. ' economic ;, 'iccountim: I ractice and Accounting Reseaixh ^tudy No. 3# " The Accounting He view, Voi. 4u, No. 1 (Jan. , 1965), pp. 92-80, Defliese, Philip L, "A Practitionor ' s View of the Realization Concept,' The Accounting Review, Vol. 40, No. 3 (July, 1965), Deinzer, Harvey r. ' >xpL ana t ion Strains in Financial Accounting, The Accoun ting .Ley, Vol. Ul, No. 1 Tjan., 19^6)", ,21-31. Dyckman, Thomas R. On the Investment Decision,' Tti e Accounting Review . Voi. 39, No. 2 TTpr., 1964), pp. 285-95 . ..ntlioven, Adolf J. H. economic Development and Accountancy, The J ournal of Accountancy , Vox. 120, no. 2 l~uig., 1965)» PP. 39-35. experience With Heturn on Capital to Appraise Management Performance, Accounting ractice Report Number 14, N. A . A . Bullet in. Vol. 43, No. 6, Sec. 3 (Feb., 1962). Fess, i'hilip .i. , and Kerrara, ..'illia.n L. "The ieriod Cost Concept for Income Measurement-Can It Be Defended/" The Accounting Review . Vol. 36, No. 4 (Oct., 1961), pp. 598-60?. Foullce, Hoy A, rractical Financial Statement Analysis . New York: Mcuraw-Hill Book Co., Inc., 196I.

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BIOGRAPHICAL SKETCH Howard i're:;ton Sanders was born February 15, 193B, at Colbert, Georgia. In 1955 be was graduated fro:n Comer High school, Comer, Georgia, and in 1957 from TruettMcConnell College, Cleveland, *eorgia. In June, 1959, he received the degree of Bachelor of Business Administration from the University of eorgia. From 1959 until 1962 Hr. Sanders was employed as an accountant by John C. taridge, C. P« A., ^lberton, eorgia. He received a U. , A. certificate from the State of eorgia in iy6l. He enrolled in the Graduate School of the University of Florida in 1962 and received the degree of Master of Arts in December, 1963. Ho has pursued his work toward the degree of Doctor of lliilosophy since that time. Howard Preston Sanders is married to the former Shirley Helen Vandiver and is the father of two children. He is a member of the Georgia Society of Certified Public Accountants, the American Institute of Certified Public Accountants, the American Accounting Association, Beta Al,jha 'si, Beta Gamma Sigma, and Phi ka^pa Phi.

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This dissertation was prepared under the direction of the chairman of the candidate's supervisory committee and has been approved by all members of that committee. It was submittod to the Dean of the College of Business Administration and to the Graduate Council, and was approved as partial fulfillment of the requirements for the decree of Doctor of Philosophy. August, 1967 Oean, College of. Business Administration Dean, graduate School Supervisory Committee: Chairman . ;<>?.