Studies in Accounting

William Baxter, Sidney Davidson

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781134632404
• Edition: 1
• Topic: Business
• Subtopic: Accounting
• Index: Business

This volume brings together noteworthy articles in accounting. Some of the pieces existed in journals, but many were commissioned specifically for this volume. They fill gaps in the usual text-books, gaps that are particularly glaring where concepts are at issue. Among other things the articles cover:

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• depreciation

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• dividend law

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• social accounting

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• value and income

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• inflation

Asset Valuation and Income Theory

Income Measurement in a Dynamic Economy^*

SIDNEY S. ALEXANDER

Professor of Industrial Management, Massachusetts Institute of Technology.

REVISED BY DAVID SOLOMONS

Arthur Young Professor of Accounting, University of Pennsylvania.

CONTENTS

SUMMARY

I. THE BASIC CONCEPT OF INCOME

Use of the Income Concept

The Concept of Income

Income for a Year

Profit from an Operation

II. VARIANT CONCEPTS OF INCOME

III. INCOME UNDER CONDITIONS OF CERTAINTY

The Value of an Asset

The Value of Equity

Is Our Definition Circular?

Pure Economic Income

Going Value Change as Income

IV. A CRITIQUE OF ACCOUNTING INCOME

The Exclusion of Going Value Change

Accrued Versus Realised Gains and Losses

Fluctuating Versus Stable Income

V. INCOME UNDER UNCERTAINTY

Objectivity Versus Relevance

Changes of Expectations

The Concept of Variable Income

Variable Income and Unexpected Gain

Measurement of Variable Business Income

VI. CHANGES IN PRICES

Real Income

Real Versus Money Income

Pure Profits Versus Mixed Income

Should Unexpected Gains be Counted as Income?

Conclusions

Summary

A YEAR’S income is, fundamentally, the amount of wealth that a person, real or corporate, can dispose of over the course of the year and remain as well off at the end of the year as at the beginning. The arbitrary choice of a time period of one year raises certain difficulties in income accounting because many transactions relate to several different years. The elaborate developments of the art of accounting are principally designed to handle the problems raised by the attempt to assign to each year a share in the flow of income which is associated with the activities of many years. With these difficulties connected with the attempt to decompose the income of a corporation’s entire life into the income of individual years, the present monograph has little to do.

Another set of problems, which concern the question of what is meant by “as well off at the end of the year as at the beginning,” is the principal subject of the present monograph. It is here argued that in a dynamic economy, when values are changing both because of changes in prices and changes of expectations of future earning power, there is no unique well-defined ideal concept of income against which can be compared the actual practice of income measurement. Instead, many variant concepts can be conceived, each of which has certain advantages for a particular purpose. Consequently, in any dispute over how income should best be measured, it is only rarely that the question can be settled by appeal to the fundamental income concept. More frequently, the several different methods of income measurement under consideration are all consistent with the basic concept of income, but each puts a different interpretation on the elementary notions of which the basic concept is composed. In particular, important variations in the practice of income measurement are related to different interpretations of what is meant by a person’s being as well off at the end of the income period as at the beginning.

Because different interpretations are possible, and because any concept of income can be justified only by reference to the use to which it is put, the only criterion by which a choice may be made among various methods of measuring income is the relative effectiveness of the different methods in serving the purposes for which the concept of income is to be used. But the concept is in fact used for many different purposes, so it is only natural that the measure of income best for one purpose should not be well suited to another. That means that either a compromise measure must be devised, fairly suitable to several purposes but ideal for none, or a different measure has to be constructed for each purpose. Both these lines have been followed in practice.

Choice among various concepts of income is not governed only by considerations of which measure best serves the ends in view. Another very powerful factor operating on the development of accounting methods has been the attempt to minimize the accountant’s responsibility for the human judgments which must be made in passing from a consideration of the accounts to the conduct of business affairs. This desire to avoid responsibility has led accountants to set up two requirements for sound accounting that somewhat limit the choice of methods. These are the requirements of objectivity and conservatism. To the extent that accountants have achieved objectivity and conservatism they have made the measurement of income safer but they have also made it yield a result that only partially achieves the end sought. Anyone using the accountant’s measure of income, particularly the businessman, must then make it accord with reality by himself making the subjective judgments which the accountant has avoided.

This division of function is probably well justified; the formation of the subjective judgments necessary for a final evaluation of income is more in accord with the activities and responsibilities of the businessman than with those of the accountant. It is certainly not suggested that the accountant should assume these responsibilities. But it should be recognized that income, as measured by the accountant, does fall short of the ideal appropriate to any particular purpose because the necessary subjective judgments have been left out.

The economist’s concept of income is designed primarily to fit the case where the future is known with certainty. Strict application of that concept would mean that a corporation which each year paid dividends equal to its income would always have the same level of income. Year to year variations of income are inconsistent with the economic concept of income under conditions of certainty. When the future is reasonably certain as in the case of a bond or annuity, the accountant shares the economist’s point of view, but in the measurement of business income that viewpoint is abandoned, presumably because of the uncertainties inherent in business operations. In order to make a meaningful comparison between the economist’s and the accountant’s concept of income, the economist’s concept must somehow be extended to the case of uncertainty concerning the future. This can be done by the introduction of the concept of variable income which is elaborated in Chapter V. Variable income can be taken to represent the economist’s concept of income as applied to conditions of uncertainty and it can be contrasted with income as conventionally measured by accountants.

The principal respect in which the accountant’s measure of income departs from the economist’s concept arises from the quest for objectivity. The accountant’s practice consists of matching historical costs against historical revenues. It deals therefore in recorded events, and the only difficulties are the traditional accounting problems of just how to match up those recorded events in relation to any particular time period. Changes in goodwill or going value, which are not recorded events but judgments of the future course of events, are not in general permitted to enter the income records of accountants. From the economist’s point of view, however, changes in going value should be counted in income since they do influence the amount that a person can dispose of while remaining as well off after the change as he was before. Furthermore, most of the purposes for which income is measured would be better served by the inclusion of changes in going value. Its exclusion in practice can be justified by the need for objectivity, but, it is here argued, attempts to justify the exclusion of changes of going value from income on grounds of principle are ill-founded.

A second characteristic which distinguishes the accountant’s concept of income from one more nearly in accord with the viewpoint of economic theory is that the accountant accepts the money measure of values, while economic reasoning most frequently runs in real terms, i.e., in terms of what the money can buy. It should not be thought that there is a body of economic doctrine that says it is wrong to measure income in money value when price levels are changing. But the whole orientation of economic reasoning is towards dispelling the money illusion and encouraging measurement in real terms. The most hotly contested points of dispute in the measurement of income depend fundamentally on whether income is to be measured in money terms or in real terms. In particular, the issue of whether depreciation should be charged on the basis of historical cost or of replacement cost hinges on whether income is to be measured in money or in real terms.

Since the ultimate criterion governing the definition of income is the purpose to be served, choice between the real and money measures must depend on what purpose is in view. The question of which procedure to use cannot then be settled on the basis of principle, but only on the basis of which procedure works best for the purpose in hand. One method is superior to the other if it works better, and an appeal to general principles may obscure the issues of social philosophy or practical expedience which govern the choice. Income for any purpose must be so defined as best to serve the general welfare and the interests of those concerned. When those interests are in conflict the issue must be resolved by a comparison of the merits of the various claims and interests, and not by recourse to a “true” concept of income, independent of the ends served by the use of the income measurements.

Another unsettled question is whether capital gain should be counted as income. This question can be somewhat clarified by breaking capital gain into two parts; one, like the gain in value of a bond issued at a discount and gradually approaching redemption at par, can clearly be recognised as income; another, like a change in market value of an asset, is more debatable. The second component of capital gain may be called unexpected gain. The principal argument for its exclusion from income is that an unexpected gain is not a measure of how much better off a person has become, but is merely a revision of a valuation of how well off he is and has been. Even if this argument is accepted, however, it means that at some time in the past an asset was acquired that is now recognised to be worth more than was then believed, and what is more to the point, is worth more now than it cost then. Consequently, the unexpected gain must be counted as income of some period, and the principal respect in which it differs from other types of income is in the difficulty of associating it with any particular period within the time during which the asset has been held.

The two questions, should income be reckoned in real or money terms, and should a capital gain be counted as income, are both embodied in the controversy over whether depreciation should be based on original or on replacement cost. Current accounting practice, which bases depreciation on original cost, implies that income is to be measured in money terms and capital gains on assets used in the business are to be counted as income. That is, the difference between the current year’s income as based on historical cost depreciation and as based on replacement cost depreciation can be regarded as the capital gain in money terms on that part of fixed plant and equipment which has been charged against the current year’s revenues. If the principle is to be adopted that capital gains should not be included in income, then replacement cost should be used as the basis of the depreciation charge. If a real rather than a money measure of income (even including capital gain) is to be used, then the depreciation charge should be adjusted for changes in the general price level, rather than in the replacement cost of the specific assets owned. If, however, it is desired to include capital gains in income, and to use a money measure of income, then the current practice constitutes an elegant and automatic way of distributing the money-measured capital gain on a depreciable asset over the useful life of the asset.

I The Basic Concept of Income

Use of the income concept

The determination of income is the principal task of the business accountant. The final result of his calculations is used in a variety of ways with important consequences for the individual firm, the business community and the economy as a whole. In particular, income is used as the basis of one of the principal forms of taxation. It is used in reports to stockholders or the investing public as a measure of the success of a corporation’s operations and as a criterion of the availability of dividends. It is used by rate regulating authorities in investigating whether those rates are fair and reasonable. It is used for the guidance of trustees charged with the responsibility of distributing the income from property to one person while preserving the capital for another. Probably the most important use of income is, or should be, as a guide to the management of enterprise in the conduct of its affairs.

Because of the practical importance of the measurement of income in so many everyday affairs, extensive and complicated rules for the determination of income have been developed. These rules have come from academic and practising accountants, from courts of law, from tax authorities, and in the United States from regulatory bodies such as the Interstate Commerce Commission or the public utilities commissions of the several states, and from supervisory agencies such as the Securities and Exchange Commission.¹ It should not be surprising that rules emanating from ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Copyright Page
• Table of Contents
• Introduction to the present (Third) Edition
• Introduction to the First Edition
• History
• Asset Valuation and Income Theory
• Depreciation
• Price Change
• The Accountant and the Community
• Authority
• Law
• Outside the Law
• Special Aspects
• Things to Come
• Index