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7

Measuring Profit in an Age of

Inflation: Alternative Accounting

Models

The central problem of accounting for business enterprises and thefocus of most controversies surrounding accounting policy is the

measurement of

-

profit. Inflation only exacerbates the problem.Curiously, accountants rarely use the term profit without a modifier,such as "net profit" or "operating profit." The subject is made riioreconfusing by the superabundance of terms that are synonymous oralmost synonymous with profit, such as earnings and income, terms thatalso often have modifiers attached to them. The FASB's recent effortsin its Concepts Statement No. 5 on Recognition and Measurement tostandardize the terminology in this area deserves support as far as it

goes, and we shall use its terms. But because they are based on the

use ofa historical cost accounting model, when we depart from themodel, we shall have to introduce one or two additional terms.

A Variety ofIncome Concepts7n its treatment of this subject, the Board focuses on the concepts of

earnings and comprehensive income, a term introduced by the Board inits Concepts Statement No., 3 on elements. Neither of thesetwo'concepts is identical with the present_ generally accepted conce t ofnet income. The best wav, to understand t e re a onships among these

three terms is, to look

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Making Accounting Policy

Present

EarningsComprehen

siveRevenues 100 100 100

Ex enses80 80 80

Gain from unusual (3) (3) (3)Income from

Extraordinar loss -6 -6 -6

Net income 13

Earnings 15 -

Comprehensive 14

Figure 7-1 Net income,-earnings and comprehensive income:the relationships

at Figure 7-1, which brings together two illustrations of the

Board from SFAC No. 5.

As can be seen from Figure 7-1, the difference between

net income as presently understood and earnings is not a

fundamental one. The difference is the inclusion in net

income and the exclusion from earnings of the cumulative

effect of certain accounting adjustments relating to past

periods. The only example given by the Board of such anadjustment is one ari_ sing from a change in an accounting

principle,'. for example, a change in the method of pricing

inventory or of accounting for longterm-construction

contracts. In other respects, net income and earnings are

synonymous.

The difference 'vetween earnings and comprehensiveincome goes somewhat deeper. Neither the Board nor

anybody else has ever satisfactorily defined earnings. The

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nearest the Board gets to a definition in SFAC No. 5 is the

following:

Earnings focuses on what the entity has received or

reasonably expects to receive for its eutput (revenues) and

what it sacrifices

Alternative Accounting Models 139

lo p~ r

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owners's equity in an acounting model based on currentprices but not in one based on historical cost..

But it is not the choice of attribute that determines the

nature of comprehensive income; rather it is: one's view of

the nature of comprehensive income that leads to thechoice_ of one attrih,ite rather than another. Although the

concept of income admits a great number of variants, those

variants generally fall intr. two broad categories, which may

be called, respectively,

140 Making Accounting Policy

"activity profit" and "change in owners' equity." The first corresponds tuaccounting income or earn;-igs as presently measured. The secondcorrP

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This way of putting the matter makes jt ej~r that the "results of certainspecified operations" form la subset of_the_causes of net increase lnowners' equity. And the-emphasis on the result of activities leads to thechoice of historical cost as the attribute of assets and liabilities to bemeasured, with the resulting recognition of gains and losses only when atransaction is deemed to be complete. The view of income as the change inowners' ^__^,ui!y, on the other hand, leads to the choice of a currentprice attribute, with the resulting recognition of unrealized value


;.banges as a component of income." More will be said about

this later.

Thus, while the choice of attribute to be measured deter-

mines the resulting income number, the choice of attribute is

itself determined by the view that is taken of the nature of in-come. Is it the result of certain activities or is it an overall (a

"comprehensive") change in well-offness? It might have been

thought that when the FASB introduced the term comprehensive

income in Concepts Statement No. 3, it had in mind the broader

view of income; but its later pronouncement in SFAC No. 5

considerably restricts the term. The term itself does not

exclude other views of income, although it ill befits incomemeasured in accordance with present GAAP, for that stops well

short of being comprehensive.

A truly comprehensive concept of income for a period mustinclude all chanzes in owners' eguitv from nonowner sourcesthat are associated with the period and that can be measuredre i5611-y, regardless of the restrictions on recognition

imposed by our present GAAP. Obvious candidates forinclusion are holding gains and losses on assets and liebilides,whether realized or not. Such an income concept, as was

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stated previously, points to current cost as the attribute to bemeasured. And because we cannot, without causing confusion,call the related income concept simply comprehensive income(since the FASB has preempted that term to mea-ii somethingelse), we shall use the term "current cost comprehensiveincome." That is the measure of net income that is associatedwith a current cost accounting model. This will be discussed rter below.

Components of Income

Financial analysts are well aware that knowing about thecomponent parts of an enterprise's income for a period maybe more important than knowing the aggregate figure shown

on "the bottom line," for it is:knowledge about the compositionof

*For those who prefer an entity view rather than a proprietary view of income, the same

choices of attribute-are equally appropriate.

_


the aggregate that makes judgment about the "quality of earnings"

possible. That expression generally refers to the durability and stability of

earnings. One company may have $1 million of income, all derived from

continuing and recurrent operations; another may have the same

aggregate income derived from a one-time gain on redemption of debt.

Most investors would attach more value to the first in~ome number than

to the second. The disaggregation of income into its component parts is a

matter of some importance, as this example shows.

Although some generalizations can be made about the disaggregation

of income, the separate components that it is useful to recognize will differ

for different kinds of entt )rises. The FASB, in defining the elements of

financial statements in SFAC No. 3, distinguishes between revenues and

expenses on the one hand and gains and losses on the other. The

difference is that revenues and expense are inmases and decreases in net

assets from an entity's "ongoing rnajor or centra.l_pQerations,"5 whereas

gains an`d Iosse nse E-6;ripheral or i_na~ntai transactions and from allother transactions and othex_e_v_ents anTcircumstances affecting_the

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en_tityAurin_g a period," except those that resul't_Fo_m transactions withowners. What are major or central operations for one kind of enterprise

are peripheral or incidental for another, and for some it may be difficult to

know where to draw the line. For most businesses, gains and losses on the

sale of company automobiles are incidental; for a car rental company they

are central, or arguably so. Transactions in marketable securities areincidental for a manufacturing business and central for an investment

banker. Thus, what are revenues to one company are gains to another.

A few generalizations can be offered that, if followed, would help the

users of financial reports to gauge the "quality of earnings" bette-. Besides

the distinction between the results of central and incidental activities,

other distinctions are, in fact, already required by existing accounting

standards. Thus, SFAS No. 14 requires reporting of results by segments of

the business of public companies. Prior period adjustments are covered by

SFAS No. 16, though quite unsatisfactorily; these are discussed further

below. Separate reporting of the results of discontinued operations and of

the gain or loss on disposal of such


operations is covered by APB Opinion 30. Each of these sepa-

rately report-d items is recognized as a component of income.

nther comp_,nents that could usefully be recognized-the list is

by no mea. 1s exhaustive-are the following:

Items that are unusual or that occur infrequently, but that do

not qualify as "extraordinary items."

Items that are discretionary, for example, large charitable con-tributions.

Items that can be estimated with only little reliability.

The results of transactions in investments in other enterprises

Unrealized changes in the value of assets and liabilities, whenthese are recognized by the accounting model in use.

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Items relating to the payment ur recovery of taxes.

Regrettably, existing accounting standards require that "all

items of profit and loss recognized during a period . . . shall be

included in the determination of net income for that period"

except for the correction of errors in the financial statements

of a prior period and certain income tax adjustments."

"Errors," as the term is used here, does not include revisions

of estimates made in an earlier period that were found to be

erroneous in the light of subsequent events. The definition of

comprehensive income in SFr,C No. 3 makes it include "all

changes in equity during., aperiod except those resulting from

investments by owners and distributions to owners" (italicsadded). Although an all-inclusive statement of equity changes

wo,.:Id include changes in estimates made for prior periods,

there is no need for comprehensive income to do so, and the

definition quoted above is just as consistent with their

exclusion as with their inclusion. Without doubt, a more useful

figure would result from their exclusion. When government

statistics report a revision of a previous announcement of,say, the gross national product (GNP) of a prior period, the

revision is not added in with the GNP of the current period,

and it would be thought strange if it were handled in that way.

Revisions of estim~tes ought not to be included in

comprehensive income, though of course they have to be

includedin changes in equity. Although recognized in the

current period, they are corrections nf.a prior period's results,arid GAAP should require th


Most of the components of comprehensive income mentioned above

would be no different in name under, say, a current cost accountingmodel from the components of accounting net income that would be

separately reported under present GAAP, but their measurement wouldbe different. Using a current cost model, the major part of income from

continuing central operations would consist of current operating profit

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(the excess of sales revenue over the~current cost of resources used up)

measured at the date of sale. If prices had changed between the time thc

resources were acquir?d and the time they were used, their current cost

would be different from their historical cost, current operating profit

would be different from GAAP operating profit, and recognized holding

gains would be different in amount from the realized gains recognizedunder GAAP.

One negative guide might be added here on the subject of component

recognition. Management intention should play little or no part in

deciding what components of comprehensive income to recognize.

Accounting measurement should help management to form intentions

and plan actions, and they cannot do that if management intention

influences a measurement. For example, it may be argued that the

diminution in value of a long-term bond held as an asset during a periodof rising interest rates should not be recognized because the enterprise

intends to ho!d ihe bond to maturity, when it will be redeemed at par.

But such a procedure involves a sacrifice of information that should enter

into management's decision whether to hold the bond or not. The

decision should be a result, not a datum, of the accounting process. Ofcourse, the advice to disregard management intention is advice to

disregard manage ment's needs. ecision us~fulness ust'be the

foremost criterion for,judging epara e components of comprehensive

income should be recognized, as for so many other accountingjudgments.,

Income an.: Capital Maintenance

The indissoluble linkbetween the measurement of resources

and changes in them, on the one hand, an the measurement


of income, on the other, is simply another way of expressing theconnection between income and capital maintenance. The most quoteddefinition of income is that given by the economist J. R. Hicks-it is theamount that an individual can consume during a _period that leaves himar her as well off at t__bn~ d oE the ;period a_s at the be~innin~. Thisdefinition makes it clear chat the measurement of income involves a

comparison of two states of well-offness, one at the beginning and one atthe end of the period. Even if well-offness is measured in money rather

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than in psychic terms, there are, unfortunatelV, a great many ways to doit, each corresponding to a different concept of capital maintenance.

A Hicksian view of well-offness is essentially forward looking. It

depends on an individual's expectations about the future, in terms of

either the net cash flows to be received (or the purchasing power of those

cash flows) or their discounted , capitalized) value. Because this view of

"being as well of " at two dates depends so heavily on how an uncertain

future is seen, it has never had much impact on accountants' practices in

measuring income." Nevertheless, it is important to understand it in order

to understand how far from the theoretical ideal our actual practices are.

If the Hicksian concept of income is applied to an enterprise rather thanto an individual, the notion of "the amount that ca-, be consumed" isusually replaced by "the amount that can be distributed to the owners."However, what is meant by "being as well off" is much more complex herethan when applied to, an indhidual, and the problems of comparing well-offne5s are aggravated, in the presence of uncertainty, by the different at-

titudes that persons have to risk bearing and to the rate at which theythink the future should be discounted. ir.:tracta are these problems thatsome theorists are ieady to abandon the concept of income altogether. .

Financial Capital Maintenance

);or those who are willing to settle for somethir; less than theoreticalperfection, the income concept can be made usable by introducing somesimplifications-drastic ones, o be sure,


though they do not have to be as dras: ^ as those that GAAP forces on us."As well off," instead of being defined in terms of future flows of cash or ofpurchasing power, or in terms of the capitalized values of such futureflows, can be defined in terms of the worth of an enterprise's net assets.

This is the financial capital maintenance concept, the most widely held but

by no means the only view of wbat should be meant by "maintainingcapital intact." If net assets include goodwill, then the worth of enterprise

net asse..s will be equal to the market value of the enterprise. But then

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t.11 ihe!vroblem~ of evaluating an uncertain future again have to befaced. They can be evaded on y y excluding intangibles and by confiningthe valuation process to net tangible assets. I` that is done, to maintaincap= ital intact it will be enough to maintain the value of the enterprise'snet tangible assets. But before a value can be placed on the assets, achoice has to be made among the attributes that could be measured. Arethe assets to be measured at their historical (acquisition) cost, at somevariant of their current realizable value . or at their current cost? Or cansome other valuation rule be devised that will have more logical supportthan any of these? This question will be answered positively, at a laterpoint in this chapter,- when the concept of "value to the business" isexamined. This is a modification of current cost, as we shall see, and inmost situations current cost is an acceptable surrogate for it.

?Nhatever attribute is chosen for measurement, a unit of money (e.g., a

dollar, pound, or franc) will be the measurement unit. But throughoutmuch of the modern era; this measurement unit has been anything butstable. Between 1926 and 1933 the U.S. consumer price index (all urbanconsumers) fell by 27%. From 1967 to 1978 it doubled. From 1979 to'1983it increased by a further 37%. During an inflationary period'-such as wehave recently lived through, maintaining capital intact in money terms bymaintaining a constant number of dollars would fall far short ofmaintaining capital in real terms, that is, in terms of the purchasing powerof that capital. Thus, financial capital maintenance involves a choice not

only of the attribute to be used in measuring wealt' : but also of the unit ofmeasurement, nominal or real, that i= to be used.


Financial Capital Maintenance and the Choice of an AccountingModel

The financial capital maintenance concept takes intc account allchanges during a period in the net assets of an E iterprise (excluc~i ngng

those resulting from transactlons with owners). All such changes shouldenter into the measure of enterprise performance. Whatever the merits ofour present historical costbased s5stt n, it cannot be said to take into

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account all changes in net asset~ Where there are unrealized changes inthe value of resources between the date of acquisition and the accounting,

date, the historical cost of those resources can give only a most imperfectmeasure of,financial capital at the accounting date. For that and oLherreasons, many think the time has come to adopt a different accountingmodel encompassing an income concept more consistent with the notionof financial capital maintenance than is our present GAAP income. Weshall take up this matter in the next chapter.

It cannot be gainsaid that the historical cost model has shown aremarkable capacity to withstand attack. Critics, both academic and anumber of practical accountants, have for years tried to change it, sofar'with only modest success. There has, to be sure, been- change. Somerecent standards have shown more readiness ':0 recognize current valuesthan formerly; and an important place was found for current cost figures,

coupled with general price-level adjustments, in the supplementary infor-mation called for by SFAS No. 338 to reflect certain effects of

an 'ng prices. But historical cost, though eroded at many points, is s

e basis of GAAP accounting.

Several alternative accounting models have been waiting in the wings,so to speak, some of them for 50 years; waiting for dissatisfaction withhistorical cost-based accounting to mount to a level at which change

could be resisted no longer. In periods of high inflation, pressure forchange is high. When inflation abates, dissatisfaction with historical costabates also. The case for abandonment, or at least for more modificationof the historical cost model, can be made independently of the existenceof inflation; but it is greatly strengthened when inflationary conditionsare present. '

148 Making Accounting Policil

The essential characteristic of historical cost accounting(HCA) is that once recorded, the book va: ie of assets is not

changed, however much t!-^_ v 7`-2 m the c-,u yside marketchanges, except to recognize accounting depre, ation, whichis a process of allocating asset costs over the per:A of their

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us: fu! lives. Because some assets are originally recorded ata figure that is not a historical cost, the FASB has suggested"that "historical exchange price" would be a bettei descriptionof this attribute, and that "transaction-based system" wouldbe a better description of the present accounting model than"historical cost system." However, we shall retain the morefamiliar terminology.

HCA has been much modified over the years, for already

GAAP countenances many departures from historical cost. To

give just a few examples, the "cost or market" rule for inven-

tories and' some marketable securities, the use of current ex-

change rates for currency translation in SFAS No. 52, and al- .

loKarues for uncollectable amounts (even below the cost ofgoods sold) when accounting for receivables are all departures

from ' the rule that assets are carried at historical cost. In

Briiain, revaluations of fixed assets are not uncommon,

although they are not normally permitted by GAAP in the

United States.l But the alternatives to HCA that we shall be

considering here call for , even more radical modifications of it

than that.Incidentally, although most of the discussion here is con- I

ducted in terms of accounting for assets, ;what is said willapply , equally to the treatment of liabilities. The historicalcost of assets becomes historical proceeds when talkine aboutliabilities' and similar substitutions can be made in the case ofthe other accounting models to be discussed. The treatment ofliabilities , in a current cost model will be discussed later.

Periods of complete monetary stability have been rarethrough ! history, and except for a brief period of falling pricesin the early' 1930s, since 1914 we have seen prices risingconsistentlysometimes slowly, sometimes rapidly. All the timethese changes ' in the general level of prices have beenoccurring, the relative i prices of commodities and serviceswithin the general market basket have been varying. We canthus distinguish general price changes (as measured by ageneral price index) from specWt price changes (as measured

by changes in the price of a single c~~~r~erti~ a

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commodity or by an index of the prices of a group of related items, e.g.,machinery). Clearly the movements ofa general price index will depend

on the selection of goods and services to be included in the index.

Different accounting, models have been derived to recognize these two

kinds of price chan;;es, separately and together. Each model represents a

particular combination of choice of attribute `O I` measured and rc1tv1~~ of

.7n. east, r:i"tg unit.

The choice of measuring unit is relatively simple, for it lies betweennominal dollars (or pounds or francs, etc.) and constant dollars (or pounds

or francs, etc.). Nominal dollars are the dollars we receive aw~' pay outevery day, and the goods and services that each dQll~.r_~nmmands varywith what the dollar is spent on. Constant dollars are units of constantpurchasing power. They exist only as a concept. Each constant dollar willcommand the same fraction of a particular basket of goods at any date,regardless of changes in the prices of the goods in the basket.

The choice of attribute is less simple. Five attributes of assets -were

defined in Table 6-1 on pp. 128-29: historical cost, current cost, current exit

(i.e., sale) value, expecte exit value, and ^resent value of expected cashflows. It is unnecessary to consider eacHof ese u y, or the practical choice

lies between historical cost and current cost (or rather current cost modified

in a way to be discussed later)- Accounting models based on exit values do

have their proponents, almost exclusively a:nont academic accountants; but

they have gained few adherents in the world of practice, and we shall not

consider them further.

The concept of current cost is an important one, and it calls for a fuller

definition than that given in Table 6-1. The definition that was given inSFAS No. 33 (paragraphs 99f) is more illuminating: ll

Current cost. Current cost is equal to }hC cun ent reola -ment cost of the

asset owned, adjusted for the value of any operating ador disadvantages

ta~es or disadvantages of the asset owned. Current cost differs from

current replacement cost in that current cost measure

ment focuses on the cost of the service otential mbodied in the

asset owne _ y the enterprise whereas current replacement cost

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150 Making Accountir,g Policy

may be a measurement of a different asset, availablefor use in place of the asset owned. Current cost will be

less than current replacement costif tlie servicepotential of the asset owned is less than the servicepotential of the asset that would replace it. That maybe the case, for example, when the asset owned has ahigher operating cost or produces an output of lowerquality. Similarly, current cost may be less than currentreproduction cost if identical used assets are notavailable for purchase and if acquisition of a new, but

otherwise identical, asset would not be worthwhile be-cause that asset is obsolete for the purposes of theenterprise concerned.

It -hould be noted that any technological inferiority ofthe asset owned in comparison with the asset that would

replace it (if a replacement were made) depresses itscurrent cost. The criti~~ L- cism sometimes aimed at current

cost that it does not take obJ-.--,----.-_ solescence into

account is notjustified. However, it ma ., , unfortunate y,irue t at when the conce t is applied in ractice, the

deduction that s auld.,be made to reflecLIhe_ulfgriority ofexisting assets compared with potential replacementsis

often overloo e~

We nw have a choice between two attributes,historical cost and current cost, and between two units

of measurement, nominal dollars and constant dollars.We can arrange these in a 2 x 2 matrix 12 to give fouraccounting models, as follows:

Attr ibuteUnit

Nominal

OfMeasurenient

Consta

Historical Historical Constant

cost power(HCA) accountingCurrent Current'cost Current cost

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accountin purchasin. (CCA) accounting

Historical Cost Accounting

HCA, the result of using nominal dollars to measure theattribute historical cost, needs no further explanation here.HCA

em to be s.yown as such. The FASB, however, takes adifferent view.


is the GAAP accounting we are familiar with. It has already been noted

that HCA departs al several points from strict adherence to historical cost,

but those departures are modifications of the model, not an abandonment

of it.

Constant Purchasing Power Accounting

Constant purchasing power accounting (CPPA) calls for moreexplanation because, although it has been around for more than 50 years,it was rarely seen in the English-speaking world outside textbooks andaccounting periodicals before 1979, when the FASB introduced it into SPASNo. 33. CPPA retains historical cost (and historical proceeds, in the case ofliabilities) as the attribute to be measured, but the measurement is donein terms of units of constant purchasing power. A base year has to beselected, and if prices are rising in subsequent years, nominal dollars inthose years will represent diminishing numbers of .1 constant dollars," thatis, units of base year purchasing power. As a simple example, suppose,

that a company's sales revenue a $1 million in the year 19x0, and itincreases by 15% per annum in each of the next five years. During thesame period, the general level of prices increases by 10% per annum.

Then the sales figures in nominal dollars and constant 19x0 dollars willloot, like this:

Sales

Nominal

Revenues

19x0

19x0 1000 1000

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19x1 7150 104519x2 1322 1093190 1521 114319x4 1749 119519x5 2011 1249

Mue numbers in the second money column for 197x1 on are equal ta the

nominal_ dollars of revenue of each year divided (in this


case, since prices rise steadily by 10% each year) by 1. 1, (1.1) z,(1.1)1,

(1.1)',and (1.1)5,respectively. They show the number of dollars that would

have been needed in 19x0 to buy what the actual revenue will buy in the

year in which it is earned." They represent the real increase in revenue.

If the rate of increase in selling prices in this enterprise were exactly thesame as the rate of increase in prices in general (10%), the stabilized" s:rieswould represent the votunie of sales, increasing at roughly 4'/z% a year. It isunlikely, of course, that the rate of inc-.-ease in the firm's specific prices andin the general price level would coincide, or even that the firm's variousspecific prices (assuming it sold more than one pro:' ict) would all movetogether.

The following very simple illustration will bring out two key features ofCPPA. A company's balance sheet at the beginning of the period under

review looks like this:

$

Cash 300 Bonds 500

Equipment (at cost) 1200 Common stock 1000

$1500 $1500

During the period, the general price level increases by 10%. The companyhas no operations and, for the sake of simplicity, depreciation and bondinterest will be ignored. At the end of the period, then, its HCA balancesheet will look exactly the same as it did at the beginning of the period. ItsCPPA balance sheet, expressed in end-of-period dollars, will look like this:

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$ 5

Cash. 300 Bonds 50Q

Equipment 1320 Common stock 1100

{$1200 x ($1000 x

Retained earnings 2C.

$1620 $162D


Where did the CPPA retained earnings of $20 come from? T7he answer is

that it represents the purchasi:.g.,power gain on the comp any_'s net

monetary items lU% of $200). Monetary items are those with values fixed interms of nominal dollars, regardless of what happens to the price level.Neither the cash balance nor the bondholders' claims grew when prices

rose. In this case, the stockholders gained more at the expense of thebondholders than they lost by holding cash while its purchasire, -nowerevaporated. The nonmonetary item, equipment, :. deemed to represent thesame amount of purchasing power throughout the period, so its cost is re-expressed in end-of-pezod dollars at $1200 x 110/?;00, or $1320. Commonstock is rec-arded as a nonmonetary item and is adjusted similarly. Notet3Zat the equipment is not revalued under this system. It continues to be

carried at historical cost, but in the end-of-period Q'PA c~ance_ ,$heet,that~ cost is re-expressed in Predated-end-:dFe^od dollars. With thissystem, net income is HCA net in.=re adjusted principally in three respects.

3~The cost of goods sold is adjusted so that each of its compo-_/nents

(opening inventory, purchases, and dosing inventory) is expressed in

dollars of equal purchasing power, as of whatever _ date is chosen for

stabilization purposes.

?Depreciation expense on fixed assets is recalculated in dollars as of thestabilization date, just like the fixed assets thenu; ~selves.

The net stabilized income includes any purchasing power gain or is

reduced by any purchasing power loss on net monetary items.

The capital maintenance concept implied by CPPA is the : -intenance of

financial-capital .in_real l.terms, that is, in terms ~ ; Of its generalized

_purchasin_g-power. However, because CPPA , ; ~s historical cost as the

attribute to be measured, ,it_meg- ': swes very imperfectly the amountby,which an enterprise or its ~ mm;Txxs are better or worse off at the end

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of a period compared ' the beginning, so that an appearance of maintaining

real " capital may be no more than that--an appearance. More

be said about this later w eTi we compare the capital and ~w_-menumbers generated by the various models ~hown in the


Current Cost Account=-ig

Current cost accounting (CCA) replaces :he historical costof assets in the balance sheet with their curr nt costs (asdefined earlier) at the balance sheet date. Strictly, thehistorical proceeds of liabilities should be replaced;, similarly,with the proceeds that the same obligations would currt!ntlyyield. Discussions of CCA have usually confined theirattention to the assets Ade of the balance sheet, but the

treatment of liabilities will be taken up later. It is easy tounderstand how the current cost of an asset can diverge fromthe asset's historical cost, for that will happen whenever theprice of that specific asset changes after it his been acquired.It is less obvious why the historical proceeds and the currentproceeds of a liability might diverge, but it will be easier tounderstand the divergence if one remembers that the currentvalue of a bond tends to move inversely with changes in themarket rate of interest. Because the coupon rate of .intereston the bond does not change with the market rate, a rise inthe market rate will depress the price of the bond, and viceversa when the market rate falls. The price of the bond canbe taken to represent the proceeds that the bond, if issuedcurrently, would produce. Current proceeds will differ fromhistorical proceeds, therefore, whenever the price of thebond diverges from the price at which it was issued.

CCA, in its pare form, is concerned with changes inspecific prices only. It does not recognize or make anyadjustmeWts'for changes in the value of money. CCAaccounts are kept in nominal dollars, and changes in the

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current cost of assets between their.,acquisxtionand theirdisposal or use are~ecognized as holding gains or losses.

The disposition of those holding gains or losses is a matterfor debate, to be taken up shortly. HCA also recognizesholding gains and losses, but only when they are realized bysale. CCA recognizes them when they occur, as far aspossible. Thus, if an asset rises in value (as measured by itscurrent cost) during an accounting period, and is disposedof at that enhanced value early in the subsequentaccounting period, CCA would show the holding gain in the --first period, while HCA would show it in the ~econdl Thisassumes, of course, that the enhanced value could-b6-

determined reliably


at the end of the first period, even though no sale had yet

taken place.

Since, in its pure farm, CCA/Ies~not' oncern itself with

changes in the value of money, no distmction is made, when

measuring I:olding ga+ins or losses, between real and

nominal gains. A real gain on an asset is established if the

proceeds from the asset exceed its cost in units o; purchasing

power. It will be convenient to refer to real gains, so defined,

as "holding gains net of inflation." If an asset that cost $100

is sold for $120 while prices in general have risen by 9% simethe asset was bought, the holding gain net of inflation is $11,

since $109 would have been ne^ied to recover the

purchasing power invested in the asset. The real grin is the

excess of the sale proceeds over what is needed,_to recover

the o_ri inal real cost. ,

The cost of operations charged in the income statementunder CCA is the current cost of operations, and this is the

second important respect in which CCA differs from HCA.

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Under HCA, the cost of goods sold is computed at the

historical cost of inventory used up, but one of the great

deficiencies of FICA is that there is no unique way of

computing that figure. A different cost of goods sold figure

corresponds to each of the possible cost flow assumptions-FIFO, LIFO, or average cost. CCA, on the other hand,

computes the current cost of goods sold, determined at the

date of sale, and thus no cost flow assumption need be

made. One of li&i s cost flotiv assumptions, LIFO, does give a

cost of sales figure tnat approximates to current cost, but it

does this at the expense of the balance sheet, which is left

c,zth inventory in it at prices that may be far from cuzrent_.CCA, on the other hand, shows inventory in the balance sheet

at current cost as well as a current cost figure in the income

statement. It is able to do this because it is willing to

recognize an unrealized holding gain on the inventory. LIFO,

being one form of HCA, does not recognize unrealized holding

gains.

The treatment of depreciation under CCA is basically thesame as the treatment of ccst of goods sold. As depreciable

assets are carried at current cost in the balance sheet,

depreciation expense is computed as a proportionate part of

that cost. The excess of current cost depreciation over

historical cost dyret-iamon is the realized portion of the gain

that accrues from holding


depreciable assets while their current cost is rising. ;1s long as current costs

continue to rise, current cost depredation ex- . pense will rise each year. But

accumulated past write-offs lag beltind. They need to be supplemented by a

"catch up" charge. As for unrealized holding gains, these are the excess ofthe depreciated current cost of equipment over its depreciated histor~* al

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cost. Each year, it is the increase in this excess, if any, that ould be

recognized and reported as the unreal:z~_-_-i holding in for the year.

simple example should make this matter dear. Suppose that a pi ce ofequipment is acquired for $1000 at the beginning of year `I. Its expe-ledlife is 10 years, and the depreciat;on rate is 10%'0 (scrap value will beignored). By the end of the year, an equivalent asset would cost $1500new. A year later, it would cost $2000.

For year 1, depreciation expense is $100 under HCA and $150 underCCA.* The unrealized holding gain under CCA is $450, this being thedifference between the HCA book value of $900 (i.e., $1000-$100) and theCCA book value of $1J350 (i.e., 1500-$150). Of course, FICA does notrecognize any, gain from holding the asset, in this or any other year,unless and until the asset is sold.

For year 2, HCA depreciation expense is again $100. CCA depreciation,at 10% of the further enhanced current crr-=t, $2000, would be $200. Butadding this to the $150 depreciation expense for year 1 gives anaccumuiated depreciation :igt:re at the end of year 2 of $350, whereas theamount needed to give a CCA book value of $1600 (80% of $2000) is$400. A "catch-up" charge of $50 has to be made in year 2, making thedepreciation expense for that year $250. A similar catch-up charge willhave to be made each year if the curTent cost of the asset (new)

continues to rise.

The unrealized holding gain under CCA for year 2 is $350. . At the end of

that year, the CCA boc;k value ($1600) exceeds

'Strictly, unless the increase in current cost occurred soon after the

beginning of the year, CCA depreciation calculated month by month

would amount to less than $150. For the sake of simplicity, however, we

shall use that figure. The same point arises in year 2

Alternative Accounting hlcrfels 157

the FICA book value ($800) by $800. Bulk$450 of this gain was recognized

in yea: 1, leaving $350 to be recognized in year 2.

Capital Maintenance Under CCA

Those accountants and economists who advocate the use of C CA in itspure form (i.e., without any recognition of change:5 in the purchasingpower of money) see the purpose of income measurement as being the

maintenance of an entity's productive capacity, not the maintenance of

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theproprietors' financial capital. Consistent with that view, currentoperating profit, that is, the excess of revenue earned over the cmrentcosts of assets used up, is all that is available for distribution to theowners. The holding gains that accrue during a period of inflation must, beretained, in the business and added to capital, for only then will enough

capital be available, at the enhanced prices, to re- .

place assets that are used up. If those holding gains were dis-tributed, the size of the business would have to shrink. J This entityapproach to income measurement and capital maintenance is morelikely to appeal to managers than to stockholders. From astockhold.ers' or proprietary viewpoint, if more capital is needed to

maintain a given volume of assets at higher prices than wasformerly needed at lower prices, the increased capital requirement,

aftertaking account of any change +n the price !evel, is justas much new investment as it it were necessitated by sometechnological advance in the assets used. If a hotel replaced 100black and white television sets with 100 color sets, no one wouldquestion that the 'enhanced cost represented new investment. Thesame is true if, in the absence of technological change, the real costof an asset that has to be replaced (i.e., the cost net of inflation)increases.

The television set example also points up the difficulty of defining

productive capacity and of saying what is meant by, maintaining it.

The concept's meaning is reasonably clear in a single-product

situation (a steel mill, e.g., producing a. single kind of steel plate);but in multiproduct situations,-with chan--.s in both quality and

product mix from time to time, productive capacity is not a useful

measure for the purpose. of defining


capital maintenance. In the discussion that follows, a proprie-ta.y view of capital maintenance will -)e taken. Capital will besaid to be maintaineu wnen the purc' asing power of the pro-prietors' financial capital is held cons' int. That corresponds toa reasonable and useful view of "being as well off" at one dateas at another. It also points clearly to an accounting modelthat combines CCA and CPPA. We shall call it current cost

constant purchasing power accounting (CCCPPA).

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Current Cost Constant Purchasing rower

Accounting

As might be expected, the CCCPPA model carries assetsand liabilities at current cost, as does CCA, but it differs

from CCA a: one important respect. On nonmonetary assets,holding gains are recognized only to the extent that they arereal holding gains, that is, only to the extent that the value ofan asset exceed-s what is necessary to maintain thepurchasing power (not iust the nominal dollars) invested inthe asset at the balance sheet date (or date of sale of theasset, if it has been disposed of). In the case of holdinglosses, real losses will' exceed nominal losses il the_general.-price level- has, risen. during the holding period. Holding

gains net of inflation are smaller than nominal gains if pricesin general have been rising, and hoiding losses net of in-flation are laraer than nominal losses.

On net monetary assets or liabilities, purchasing pow,er

gains and losses are recognized just as they are by CPPA. In

their treatment of monetary items, the two models do not

differ.

Although the treatment of monetary and nonmonetaryitems by CCCPPA might appear to differ, it is actually quiteconsistent for the two types of item. On nonmonetary items,CCCPPA recognizes holding gains or losses, net of inflation. Apurchasing power gain or loss on monetary items is a holdinggain or loss net of inflation. There is no gross holding gain orloss on monetary items, for the nominal dollars that theyrepresent do not change when the price level changes. But

when the price level rises, they lose purchasing power. So,when the price level rises, there a a zero gross holding gain,minus a purchasing E~er-Ioss (to the owner) in the case ofcash or plus a pur-


chasing power gain (to the debtor) in the case of liabilities, Thus, holding

gains or losses - tet of inflation are basically the same as for nc~-:=-.-`.2^., items; we simply give them different names.

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As has already been xplained, the conce tp of capital maintenance i-mglied..by CC;- PPA is the maintenance of the proprietors' financialcapital in real terms. The income measure that corresponds to this concept

of capital maintenance is one that includes purchasing power gains and

losses on monetary items and holding gains net of inflation in income. The

rationale for this treatment is that only income so measured corresponds to_

"better-offiriess" in real- te_rms, _-W increase in command over goods and

ser'vices by _'the proprietors of the enterprise. A simple, ilTustration willexplain this important conclusion.

An enterprise holds cash of $100 and a marketable noncash asset thatcost $400 at the beginning of a period. It has no liabilities. During the

period, the specific price of the asset increased by 25% while the generalprice level increased by 10l0. No transactions occur during the period, andthe asset is nondepreciable. At the end of the period, therefore, theenterprise holds $100 in cash and another asset worth $500-its total fi-nancial capital, in nominal dollars, is $600. Its capital at the begiruung was$500 in nominal dollars. To maintain capital, in real terms it should havegrown by 10% to $550. It did better than that by $50. That $50 is what wecall current cost comprehensive income; and that is Yvhat an incomestatement would show if it included the holding gain (net of inflation) dn theasset and the purchasing power loss on the cash, thus:

Holding gain on asset ($500-400) $100Less: inflation effect (10% of $400) 40Holding gain (net of inflation) 60

Less: Purchasin ower loss on10% of $100 - 10

Current cost comprehensive income

The balance sheet of this enterprise at the end of the period expressed in

end-of-year dollars under CCCPPA would appear as follows:

160 Making Accourrting Policy

Cash $100 Capital $550Noncash Retained 50at current 500

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$600 $600

It is worth pausing to ask what the same simple situation wouldlook like u accounted for by HCA, CPPA, and CCA. HCA wouldshow income of zero. Capital would be shown as being main-tained at $500. CI'PA would show a loss of $10--the purchasingpower loss from holding cash. Under CPPA this loss is not offsetby a holding gain on the other asset, for Cl'PA retains thehistorical cost basis of measurement, merely re-expressing it inconstant dollars. CCA, like HCA, would also show income ofzero, for although the holding gain of $100 on the noncashasset would be recognized, it would be added to owners' equityand would not be included in income for the period. Capitalwould appear at $600. Neither HCA nor CCA would take any

account of the decline in the purchasing power of the dollar.Only CCCPPA, which shows income of $50 and capital of $550in units of end-of-period purchasing power, reflects themaintenance of capital in purchasing power terms and the in-crease in command over goods and services of $50. The enter-prise's net assets are worth $100 more at the end of the periodthan at 'he beginning in nominal dollars, but $30 aa this in-crease is attributable to inflation and only the other $50 isavailable for real consumption.

4f course, in a more realistic situation, there would be op-erations that would generate income also. Current operatingprofit (COP) under HCA is arrived at by charging against rev-enue the historical cost of assets usedYup. That is, on assetsused up, any holding gains that may have accrued are includedin COP. With both CCA and CCCPPA, they are kept out of LOP. InCCA they a:e added to capital, whereas in CCCPI'A they areincluded" in income.

Dichotornization of Income

There is no universal agreement about the usefi_tlnesS of di-chotomizing income into operating profit and holding gains,

Alternative Accounting b4odels 161.

regardless of whether a historical cost or a current exchange price modelis being used. Moreover, it has been argued' that the senantion is us ;allymeaningless, because assets cannot be used without being l eld, andtherefore holding gains and losses are inseparable fro- i operating profits

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and losses. It may be noted that, although assets cannot be used withoutbeing held, some can be used without being owned, through the device ofleasing, and the separation of holding gains and losses may contribute toa decision whether to own or lease. But regarding inventory, as distinctfrom fixed assets, ?t is true thit operations and holding usually cannot beseparated except for inventories that are held for speculative as distinctfrom trading purposes. And unless the two functions can be separated, it isnot feasible for the business to try to maximize operating profit or holdinggains separately. It may he argued that it is then not useful to separatee1hem in the financial statements.

Whatever view is taken of this question, it is important to recognizethat the merits of a current price model do not depend on the separationof operating profits and holding gains. Prakash and Sunder make this pointquite clearly:

Neither the dYfinition nor the implementation of current value accounting !

requires hat income be dichotomized. Conversely, dichotomy oWcome is

not unique to current valuation; historical cost income can also be broken

down into two components-current operating profit and "; calized holding

gain." Thus, the dichotomization of income into COP and HG a pot a

valuation issue.'6

And they further recognize that even if the dichotomy is implemented, theuser of the financial statements can ignore it and can concentrate on theaggregate of operating and holding gains_ But the dichotomy is not free ofcost to the preparer of financial statements and should not be made if it isnot useful. Of course, although the dichotomy is not essential to thedetermination of current cost comprehensive income (induding holdinggains;, it does affect its disaggregation into components.

Value to the Business

Reference was made earlier to a modification of current cost in somesituations, as the attribute of assets and liabilities to be


measured. That modification substitutes a lower value, called

the "recoverable amount," for the current cost of an asset in

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situations in which the asset, if lost or destroyed, would not

be replaced. Current cost or lower recoverable amount is

known as "value to the business" or "deprival value."

Paragraph 99(h) of SFAS No. 33 explained why:

i ,'rli;C to tii0-c bus : i:if SS.Vai:.I2 to the &usiness be definedas the lower of (1) current cost and (2) recoverable amount,

where recoverable amount is measured at the higher of net

~ealizable value and net present value of future cash flows.

The rationale for measurement at value to the business is

that the measurement of an asset should depend on the

circumstances of the enterprise. Current cost is the

appropriate measure if purchase of the asset would beworthwhile in current circumstances, i.e., if the value of the

earning power of the asset is at least equal to current cost.

In some cases, however, current purchase of the asset

would not be worthwhile and current cost would then

overstate the worth of the asset. If the asset is about to be

sold, its worth to the business is limited to net realizable

value. If the asset is not about to be sold, (but would not-bereplaced), value in use would be an appropriate measure of

the asset. Value to the business is often called "deprival

value" because it can be assessed by assuming that the

enterprise has-been deprived of the use of an asset. and

asking Fiow -m_ucFi the enterprise-would need to be. paici_to

compensate it for tlie loss7 -Current cost sets the upper limit

for measurement of the asset. The maximum loss incurredby the enterprise, following deprival, would be limited to the

current cost of the asset as long as replacement was

possible. The assumption of deprival should not be

interpreted literally; it is no more than a helpful analytical

device. (As the above discussion indicates, the terms "value

to the business," "deprival value," and "current cost or

lower recoverable amount" all have tfte same meaning.)

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As the foregoing definition makes clear, value to the busi-

ness is generally equal to the cost of replacing an asset if the

business were deprived of its use (its current cost), but if

the,,; asset is worth less to the business than it would cost to

replace it, then replacement will not take place. In that case,the asset's value to the business is its sale value or its value

in ase (the discounted value of its expected cash flows),,

whicheve- is the higher. Although it has been convenient to

talk here ab:-ut cump-i


rent cost models, it would have been more correct (but clumsier) to re: erto them as value-to-the-business models.

Summary

Most of the-problems with which accounting policy is concerned relate

to the way a_ccountants d_ zFn_e and measure profits, the most widelyused measure of performance both of enterprises and ~.eir managers.

Terminology is unfortunately confusing in this area, and it was convenient

to adopt the tAS13's usage,:''- and eo_"mprehensive income, for the

purposes of our discussion. Har.lings is measured in accordance with

GA

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accounting (CCCPPA), which measures the attribute current cost in units ofconstant purchasing power. Different concepts of capital maintenancecorrespond to these different accounting models, but only CCCPPAprovides a measure of income that seems truly to represent an incrementover and above a maintained level of real well-offness_

Further Readings

It is impossible to separate references that are appropriate for this

chapter and for the next except quite arbitrarily. Readers should

therefore consult the list of references at the end of Chapter 8.

8Measuring Profit in

an Age of Inflation: The

Need for Change

In the last chapter, we er.amined several accounting models, each giving

a different view of what is meant by maintaining capital intact and

income. If alternatives to historical cost accounting are desired, they are

ready to hand. The preferred alternative, without much doubt, is current

cost constant purchasing power accounting. But before we leave this

central topic of income measurement, it is worth asking why alternatives

are needed. What major deficiencies are alleged to be inherent in the

FICA model, in the income numbers, and in the depiction of financial

position that it generates?

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Deficiencies of Historical Cost Accounting in an Era ofChanging Prices

All of the deficiencies spring from a single defect, but it is so

fundamental that its consequences take many forms. The historical cost

model that is u'lsed to measure accounting income lacks generality. Itshould be seen as a special case of the current cost model. The

special case is one in which input prices are all frozen at the date that

resources are acquired. It is appropriate onry if pnces in fact, do notchange between the date that resources are acquired and the date they

are used or the accounting date, if that comes first. The general current

cost model r~~values inputs if prices change after resources are,

acquired. ?n

165


the special case, revaluation is unnecessary, because prices

are deemed not to change. The special case has

unfortunately not been generally recognized as such.Consequently, it is used in circumstances that it does not fit.

Several more specific deficiencies result from this

fundamental defect. One is that the model is incomplete.

Because its input prices are frozen, it is forced to exclude

highly relevant information about changes in the value, of

resources that rnay hzvt supervened between their

acquisition and use or between their acquisition and the

accounting date if they are still then held. Exceptions are

made for the recognition of cost-based depreciation of long-

lived assets an or_losses_(o t gains) in the value of inventory

and of marketable securities. Other unrealized gains and

losses are ignored. It is in this sense that the model isincomplete; and because it is incomplete it cannot be

representationally faithful. It does not faithfully represent the

resources held by an enterprise at the balance sheet date,

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for the values at which they are carried ;do not relate to that

date but to the date on which they were acquired. And it

does not faithfully represent the enterprise performance

during the accounting period, for often some part. of the

gains and losses realized by using or disposing of resourceswill have accrued in an earlier period and to that extent are

therefore properly attributable to that period rather than the

period in which they are realized and reported. In addition,

there must be doubt about the additivity of 1-ustwical cost

inputs. When the value of money is fluctuating, what

meaning is to be attached to the aggregate of expenditures

made at different dates, in doliars of different purchasingpower?

An important consequence of the emphasis placed by the

HCA model on realization is that a"ecounting profit can easily

be manipulated. By accelerating or retarding the timing of

the realization of gains, profits can be increased or reduced.

Those who value management's ability to contrcl what profits

are reported call this "income smoothing." Even a currentcost model leaves open possibilities of income smoothing-for

example, by speeding up or holding back on discretionary

expenditures such as R&D, maintenance of buildings and

equipment, training, and advertising. But with the recognition

of all gains accruing in a

The Need for Change

period rather than gains realized in the period, the scope for incomesmoothing is much reduced. If it is ever useful to smooth income, the

process is best, left to financial, analysts and other users of. financial

reports; it is not a lob for accountants.

The FASB now seems to hold a similariv adverse view of income

smoothing, although it does not necessarily espouse the means advocatediiere to make it harder. In an address to financial analysts in September1983, Donald Kirk, the chairman of the Board, said:

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. . . the Board has rejected "smoothing" or "normalization" as part of the

concept for measuring income, thereby more sharply delineating the

boundary between accounting and financial analysis . _ . if normalization is

needed, that is the analyst's responsibility.'

The charge that historical cost figures in a balance sheet lackrepresentational faithfulness is often rebutted by pointing to the definitionof rep-esentational faith',Aness and emRhasizin&the :vords "what ii purportsto represent." 1--iisiorical costs, it is said, do not purport to be currentvalues and therefore cannot be said to lack representational faithfulness.

This argument is valid only if a balance sheet is regarded as no more than alist of ledger balances--a refined trial balance, so to speak. As soon as it isca'.led a statement of financial position, with a current or ceceitt date on it,the figures in it at once take on added significance. They are no longer mereledger balances; they now purport to represent "economic reality' at the

date of the statement in some sense other than a purely historical one. Thecharge that they lack representational faithfulness, then, has much greatervaIidity.

Proponents of historical cost accounting attach great importance to itssupposed "objectivity." This, it is said, results from the fad that historicalcost numbers are clerived from actual transactions that have been enteredinto by the enterprise itself rather than some mes rom ransactions that areein~ enereinto by others in the marketplace. The objectivity that is

~_aIIiea is largely spurious, for it is lost as soon as resources bave to becarried over from one accounting period, to another


and costs have to be allocated to reflect these interperiod resource

transfers. Only rarely is it possible to find a uniquely right way to make

these allocations, which thus have to be d 11IdLlCr of opinion. The

multifarious ways of computing depreciation expense or the cost ofinventory testify eloquently to this fact.

Another very important deficiency of FICA is that it is apt to result ininvalid comparisons--it does not always make similar situations look alikeand it does not always make different situations look different. This p )intis best explained by means of an illustration (Table 8-1). Wt shall use oneadapted from Edwards and Be11.2

The illustration shows the results of five periods of trading as accountedfor by three different inventory methods-FIFO, LIFO, and current cost., Thenumber of units sold and the selling price per unit vary from period toperiod but of course are the same for all three inventory costing methods.

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Similarly, the numbers of units purchased, the purchase price, and thenumber of units in inventory vary from period to period, but thesenumbers are also independent of the inventory method used. The profitsor losses are, of course, not independent of the inventory method.and,except for period 1, when the initial inventory valuation is assumed to bethe same for all methods, the profits and losses vary not only from periodto period but also from inventory methe.i to inventory method. With one

important e;:cepLion, no two of these figures are alike.

The FIFO and LIFO profit figures are straightforward, for once thepurchase prices are known and the convention for costing inventory hasbeen selected, the cost of goods sold, and the trading profits or losses canbe computed. Not so for the current cost method, however, for now it isnecessary to have information about purchase prices at the dates whensales take place and at the terminal accounting dates. However, if pur-

chases and sales take place evenly throughout each period, the currentcost of sales can be arrived at more simply by using the weighted averagepurchase price of actual purchases.

In the illustration, as all purchases in each period are made at a single

price, it is assumed that buying prices did not vary during a period -nd the

actual cost of purchases can also be used as their current cost at the date

of sale. The excess of sales ffo( ')we'-t(~~Y

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revenue over this current cost is the current operating profit (COP).

The holding gains or losses shown under current cost are all those that

accrued during the period, whether they were realized during the same

period or not. Only if it is desired to separate them into realized and

unrealized gains (losses) is it necessary to make a cost flow assumption.

The total holding gains (losses) that accrue dul-Ing a period, for example,

$29 in period 4, are equal to the sum of the following:

The initial inventory (units) times the change in current cost during the

period [8 units x ($20 - $17) _ $24], and

The change in inventory (units) times the difference between the

weighted average purchase price and.the current cost at the end of the

period [(10-8) units x ($20-$17.50) _ $5].

We now get to the point of the illustration, which can be seen bycomparing the results of period 2 and period 5. In those two periods, thenumbers of units sold and the selling prices are the same. The numbers ofunits bought and the purchase prices are the same. The numbers of unitsheld in inventory at the beginning of-each period are the same, and they arealso the same at the end of each period. In other words, all of the realevents and transactions pertaining to both periods are the same. And theonly one of the three accounting methods that makes these like things ioekalike is current cost accounting, for only that method shows the sameresults (a loss) for the two periods.

The case against HCA is a formidalvle one. The information it providesabout the financial position of an enterprise is not relevant to the situation

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of the enterprise at the accounting date. The information it provides aboutincome does not faithfully represent "better-offness," and what it disclosesabout financial position does not faithfully represent the position as it existsat ;he accounting date. HCA results in invalid and misleading comparisons.Insofar as it is riddled with arbitrary allocations, its numbers are incapable ofbeing verified by reference to events and conditions outside the enterprise.In sum, its results are woefully lacking in the qualitative characteristics that,in an earlier chapter, were seen to be the criteria by which accountinginformation should be judged.

The Need for Change 171

Determining Value to the Business

The adoption of value to the business (current cost or lower recoverableamount) in place of historical cost as the attribute to be used for measuringassets and, if relevant, liabilities also would greatly increase the relevanceof the information conveyed in financial reports, and it would increase itsrepresentational faithfulness. It is important that these improvements be

secured without unduly increasing the subjectivity that already surroundshistorical cost measurements. The vaiue of an itenn to the business must becapable of being determined reliably; if this cannot ,be done, a surrogate forit must be found. The reliable measurement of an asset's value to thebusiness (and therefore of any holding gains and losses associated with it)will be easiest when two conditions are satisfied:

1. The asset can be bought or sold in its present condition at a

determinable price.

2. Evidence of that fact can be inferred from a number of transactions of akind that the enterprise might enter into, whether it actually does so or

not.

Generally, value lo the business is equal to current cost. Even if the

above two conditions are not satisfied, reasonable estimates of currentcost may be made. Guidance on this matter was given by the FASB in SFA_S

No. 33.-' In that context, it was meant for use in prepai-ing the

supplementary- information required of large companies by that statement,

but it is just as relevant to the preparation of primary financial statements.

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The current cost of inventory is the current cost of purchasing it or of

manufacturing it (including an allocation of overhead expense). For

purchased inventory, current invoice prices or current price lists can usually

be referred to. For manufactured inventory, standard manufacturing costs

that reflect current costs can be used. Even where such direct pricing meth-

ods are available, many businesses, when implementing Statement 33,have regrettably fallen back on indexation, that is, they have applied a

specific index number (either obtained trom an external source or

generated internally) to the historical cost of the inventory in question.

Although not ideal, this is usually an acceptable alternative to direct pricing.

172 Making Account ing Pol i cy

Determining fhe current cost of long-lived assets presents asomewhat greater difficulty, because usually the assets now in use wereacquired longer ago than is typical] - the case with inventory, anc~tReassets in use, if re placed ct r_rently, would be replaced by differentassets. In the words of 5tatement 33'-337-the cu rren t cos

oproperty, plant and equipment owned by an enterprise is

the current cost of acquiring the same service poten~ : . 1 1 (indicated by

operating costs and physical output capacity) as embodied by the asset

owned; the sources of information used to :neasure current cost should

reflect whatever method of acquisition would currently be appropriate in

the circumstances of the enterprise."' Thus, if a used asset of like age

and conditior to the asset in use can be priced, that will set the currentcost. If a new asset has to be used as the basis for pricing the old asset,

adjustments have to be made for the differences in life expectancy,

productive capacity, quality of service, and operating cost between the

new asset and the old.

As an alternative to pricing the used asset by reference to a new one,it may be necessary to resort to "functional pricing." This meanscomputing the cost per unit of service of whatever asset would replace

the present_ one, and multiplying that figure by the service potential (inunits) o_f t P old asset. Yet another alternative, already referred to inconnection with inventory, is indexation. The book value of the asset in

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use is multiplied by a specific index, number ~pplicable to assets of thattype (e.g., machine tools) to give the current cost of the used asset. Therepresentational faithfulness of such a figure may be questioned; but ifthere has been a material degree of inflation since the present asset wasacquired, a current cost figure arrived at by indexation would probablybe much closer to economic reality under current conditions than anunadjusted historical cost figure would be.

In circumstances where the asset in use would not be re- - placed if for

any reason it were taken out of service, its value to the business is not its

current cost but a lower "recoverable amount." This recoverable amount is

its value if sold or its value if used, whichever is the higher. Its value if sold

is its realizable value, net of selling costs. Its value in use is "the net

present value of future cash flows (including the ultimate proceeds of


disposal) expected to be derived from the use of [the] asset

by the enterprise."S This is arrived at by discounting expected

cash flows from the asset at an appropriate iscount rate. Value

in use is probably the most subjective of the measurements

used in CCA.

Assets for Which Current Cost Cannot Be

Ascertained

If it is feasible to replace an asset, that a---;et will have a re-placement cost, and normally its replacement cost will be

dose to its current cost. The more difficult it is to replace anasset (e.g., becaus:: it is obsolete and is no longer be" ngmade, or because, like a work of art, it is unique), the lessappropriate the repiacement cost is as a starting point fordetermining current cost. For this or other reasons, currentcost may not be determinable. "Lower recoverable amount"-the higher of net realizable value or net present value offuture cash flows-must then take over as a measure of va!seto the business. There is no need to strain unduly to arrive at

current cost in circumstances that make that conceptmeaningless.

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Although assets have been discussed here as though each

one ,vas a discrete item used in isolation, we, know that

assets are often used in groups, that they complement each

other, and that looking ai an entezpiise as a whole, its value is

not equal to the sum of the values of its parts The fact is thata balance sheet is not a valuation statement in the sense that

it shows the value of an enterprise -as a whole. The values

that it does disclose are inputs for stockholders, analysts, and

others to use in arriving at their own valuations; and CCA

inputs will be more useful for that purpose than HCA inputs.

Problems of aggregation and disaggregation are present in

different forms in all accounting models. No model: has amonopoly of them.

The "Relief'4'alue" of Debt

There has been little discuss" -)n in the literature of "value

to :he business" in relation to lia`_-iiities, but the idea of

deprival


value can be applied just as well to liabilities as to assets. 1nstead of

asking how much cash (or its equivalent ) an enterprise would need to

compensate it for the loss of an asset, we may now ask how much an

enterprise would pay to be relieved of a liability. That amount is its

"value to the business."'

Relief value, the burden of a liability to the enterprise, is the mirrorimage of the "value to the business" of owning an asset. And just as"value to the business' is the lower of current cost or recoverableamount (which is the higher of net realizable v ue or net present valueof future cash flows), so "relief value" is the hi h e r o f the amount thatcould be raised currently by an issue of a precisely imilar debt securityor the cost of disc argin~t_he liability y t e mosteconomical means

TTe.,Ty repur

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ase in the market, exercise of call privileges or provision of a fund to

service the liability on its due dates). Relief value might be called

current receipt or discharge cost, whichever is the higher.

Value to the business of an asset is normally equal to its currentcost because if an enterprise were deprived of an asset, it wouldnormally replace it (or its services). Similarly, th~ relief value of aliability will normally be equal to the current receipt, because if theliability were eliminated (with the elimination of equivalent assets) thefirm would normally replace it. Only if the liability can be eliminatedwithout replacement will the cost of discharging it be a relevantmeasure of relief value.7

The market value of debt falls during periods of inflation if the

amount of inflation is not fully anticipated when the coupon rate of

interest on the debt is fixed. If the coupon rate of interest could float

upwards with a rising rate of inflation (or downwards with a falling

rate), the real rate of interest-received by the lender would be stable

~and so would the price of the debt. A fall in the price of debt

securities, to the extent that it is not caused by a_ change in the

creditworthiness of the borrower, indicates that the inflation was not

fully anticipated when the coupon rate of interest was 'set. The result

to the holders of equity is a holding gain; and the real holding gain is

greater than the nominal holding gain, because the diminished marketprice of the debt is mea5ureci in depreciated dollars, so the gain in

constant dollars is larger than in nominal dollars.


To illustrate this reasoning, assume that a company issued debt with aface value of $1,000 on January 1, lyxl. It will be redeemed at par 10 years

later. The debt carries a coupon of IO%;- this being the rate set by the

market in anticipation of a 5':d rate of inflation. By the end of the year,inflation has reached lOC i and the market rate of interest has gone to 15%.

The rate is expected to stay there, and the debt falls in price to $761.42,this being the sum of the present value of $100 a year for nine :ears at15lo and the present value of $1000 discounted at 15% for nine years.

In a current cost accounting system, the total gain on the debt in thisillustration, after taking into account the interest expense, is $238.58, madeup as follows:

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Nominal holding gain on debt

($1000-$761.42) $238.58

$1000 l110-100`` 100.00

Real gain on debt 338.58

Interest expense 100.00Net gain on debt $238.58

If in the following year there is no further change in the rate of inflationor in the exuected rate, the debt will increase in price to $775.63 because itis one year closer to redemption. This increase in value of $14.21 is anadditional interest expense, and the total interest expense, $114.21, is infact "current cost" interest, being.l5% of $761.42. In the second year, thereis a further purchasing power gain on the debt of $76.14 (10% on the value

of the liability at the beginning of the year) because of the continuinginflation. There is no further holding gain. The cost of the debt in this secondyear is therefore $38.07, thus:

Interest expense ($100+ 14.21) $114.21

$761.42 (110-100 1 76:I4

Net cost of debt $38.07

176, Making Accounting Policy

' Strictly, the interest expense, like other expenses, should be expressedin en, -of-year dollars or average-of-year dollars. That uuju,a.:it::nt has

`)een ignored in this illustration.

The Virtues of Current Cost Comprehensive

Income

The obverse of the deficiencies of HCA income that were discussedearlier are the virtues of comprehensive income computed on the basis of

current cost. CCCPPA income better reflects enterprise performance of aperiod because it does not leave out unrealized gains and losses thataccrued in that period, and it does not include gains and losses (realized

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currently) that accrued in an earlier period. It is representationally faithfulin that it articulates with a statement of financial position that displaysvalues derived from current transactions, not past transactions. Theperformance associated with a period is unaffected to a great extent bythe accidental timing of purchase and sale transactions. And it makespossible comparisons that are independent of an arbitrary choice of costallocation convention. When resources are carried over from oneaccounting period to another, they are valued at a current price, so thattemporal allocations of historical cost become unnecessary. Othervaluation problenus have to be `raced, to be sure, but arbitrary allocationsbetween one period and another play no part in them.

What about the usefulness of CCCPPA income measurement for makingdecisions? It should be apparent that the further back in.. the pastresources now held were acquired, the less trustworthy their acquisition

cost will be as a guide to the probable future cash flows thoseresources ,may be expected to gererate, through either sale or use. Andinsofar as performance measurement is the basis for decisions, -CCCPPAcomprehensive income, a more complete measure of performance thanFICA earnings, is likely to lead to better decisions. For example, if thedecision were whether to reward the more successful of two investmentmanagers, when both had equal realized gains on their portfolios for theyear but one had substantial unrealized (and therefore now unrecognized)gains at the end of the year

The iJeed for Change 177

whereas the other did not, most people would think that the

performance of the second investment manager was superior.

CCCPPA comprehensive income would reflect rh~t fnrt: HCA

income would not.

Two Common Misunderstandings About

Deparfures from Historical Cost

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Accounting models _ ot based on historical cost are apt tocome under attack because they make extensive use ofvalues' derived from what are called "hypotheticaltransactions"--what an asset would have cost at an accountingdate, not what it did cost when it was acquired at an earlierdate. Of course, the transactions from which current cost dataare derived are usually not really hypothetical transactions butactual transactions currently being entered into, sometimes bythe enterprise itself (if a purchase transaction entered into ator near the accounting date is used to price other units of likeinventory bought at earlier dates) or by other enterprises. Butin any case, GAAP accounting itself has not scorned to usehypothetical transactions for reporting purposes where it wasuseful to do so. The 'lower of cost or market" rule for inventoryvaluation uses a hypothetical replacemen' price wheninventory or marketable seturides arc written down belowcost. The use of the current exchange rate for foreigncurrency translation does not depend on actual transactionsentered into by the enterprise at the balance sheet date. If anote is exchanged for property, goods, or services, APBOpinion No. 21, Interest on Receivables and Payacles, requires that theface value of the property or "an amount that reasonablyapproximates the market value of the note" be used inrecording the transactions. FASB Statement No. 13, Accounting

for Leases, is full of hypothetical transactions. Accounting fornonmonetary transactions under APB Opinion No. 29 makesextensive use of hypothetical transactions. Fully dilutedearnings per share is as hypothetical a figure as one can imag-ine. It is hardly an exaggeration to say thak: the increasing so-phisticatirn of accounting during the last half-century hascome about thrrugh a growing awareness that financialreporting must


recognize hypothetical transactions as well as actual transac-

tions entered into by an enterprise if it is to give a fsir presen-tation of that enterprise's financial position and performance.

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A second widespread misunderstanding about the possibleconsequences of departing from historical cost as the basis ofincome measurement is the fear that by including valuechanges in current cost comprehensive inSome, companiesand their stockholders may be,misled about how much can bedistributed as dividends. That fear is groundless. Even presentaccounting principles give no assurance that "earnings" canbe distributed. An enterprise may well be profitable and yet beshort of liquid resources; and that is likely to be especially trueif historical cost depreciation lags far behind the inflation-enchanced cost of replacing assets. The link between"earnings" and dividends is necessarily a loose one, whateveraccounting methods are being used. But in any case, inpresenting the various components of current costcomprehensive income, it should be possible, if not alwayseasy, to distinguish between realized and unrealized (butrealizable) components. Current cost comprehensive income isnot i;ealized income; but neither is GAAP net income, if by thatis meant income that is readily available for distribution in theform of liquid assets.

An Illustration

Let us now try to draw some of the threads together bymeans of an illustration. To keep it really simple, we shallconcentrate on four purchase and sale transactions. Theexistence of depreciable assets as well as any differencebetween real and nominal values (i.e., changes in thepurchasing power of money) will also be ignored.

Assume that in 19x0, two identical parcels of goods are

purchased, each for $10. One parcel (No. 1) is sold in 19xI

for $16, the other (No. 2) is still in inventory at the end ofthat year. At the end of 190, these parcels would hav~ cost

$12 each, and at the date of sale in 19x1, current cost

was',~14. In 19x1, tvo further identical parcels are bought

for $13 each. One of cnese ("Jo. 3) is sold for $16 (its

current cost at that date is $14), while ~he other-(No. 4) is

unsold at the end of the year. Current cos' at

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The Need for Change ' 174 -

end of 19x1 is $15. These transactions can now be

summazizvcd as follows (CC = current cost):

Parcel Purchase

CC

12/31/

CC

at

CC

12131

Sale

$No_ 1, bought 10 12 14 16o. 2 bou ht 10 12 15

NP-3, bou ht 13 14 16No. 4, bought 13 15

46 24 28 30 32

An HCA income statement for 19x1 would show ?'ealized

earnings of $9, thus:

Sales revenue (Nos. 1 $32

HC of goods sold .23

HCA income 9

A CC`PPA income _tatement* for 'yxl would show compre-hensi.e :r:come of $12, made up of a current operatingprofit of 54 and holding gains (realized and unrealized) of $8,thus:

Sales revenue (as above) $32

CC of goods sold (Nos. 1 and 28Current operatin profit 4Holdin ains accrued and

realized Nos. 1 and 3 3Holdin ains accrued but

not realized (Nos. 2 and 4) 5 8CCCPPA income 12

'For the sske of consistency, the accounting model used hereis called CCCPPA, ever, though it is assumed that nopurchasing power changes occurred.

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It should not be difficult to see haw HCA and CCCPPA income are related

to each other. The linkage is as follows:

HCA income, 29x1 $9

Less: Holding gains accrued

19x0, realized 19x1 (No. 1) 2

Add: Holding gains accrued but

and 4) 5

CCCPP.4 income, 19x1 12

The important difference, as can be seen, is that FICA income attributes to19x1 the result of events that took place in 19x0. CCCPPA gives 19x1credit only for the result of events that occurrred in 19x1. However, itcannot be claimed that, in a more realistic situation, it would give 19x1credit for all the results of 19x1 events. To do that, it would be necessaryto capture the probable impact on future prospects that will result from19x1 activities. No accounting model now being contemplated is willing tolook that far into the future.

Summary

The deficiencies of historical cost accounting (HCA) are fun' damental.

It ignores changes in relative prices unless they are reflected in

transactions, and it ignores chan es in the,general purchasing power

money-entire y. Con

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