Rational Accounting Concepts (RLE Accounting)

The Writings of Willard J. Graham

Harold Langenderfer, Grover Porter

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317976158
• Edition: 1
• Topic: Business
• Subtopic: Managerial Accounting
• Index: Business

Willard J. Graham (1897-1966) was an important contributor to both accounting thought and education and he pioneered life-long education for executive business that is still emulated today. This volume collects 25 of his key writings which shed light on his contributions to management accounting and business education as well as the accounting profession.

Section III:
Financial Reporting Issues, Including Price Level Accounting, Leases, Depreciation, and Deferred Income Taxes

THE EFFECT OF CHANGING PRICE LEVELS UPON THE DETERMINATION, REPORTING, AND INTERPRETATION OF INCOME

The Accounting Review, Vol. XXIV, No. 1, January 1949, pp. 15-26

EDITORIAL COMMENT

Dr. Graham was one of the early and, perhaps, the strongest advocate of the desirability of adjusting financial statements for price level changes. This article is one of his earliest published statements regarding the effect of changing price levels upon the determination, reporting, and interpretation of income.

His strong personal convictions that “current costs, and only current costs, should enter into the determination of income” are evident in this article. These convictions probably date to the research undertaken by Dr. Graham in the early 1930’s that provided the foundation for his doctoral dissertation and his subsequent monograph on Public Utility Valuation.

Dr. Graham had the unique ability of being able to communicate complex concepts in a manner understandable alike to colleagues, students, and the average man/woman on the street. The following introductory comment excerpted from this article expresses that ability:

The other day a student was asked, “Where is the capital of the United States?” His answer was, “On loan all over Europe.” There is a better answer to this question. The capital of the United States, the capital invested in business, is being distributed to stockholders and other owners under the guise of income and it is being paid to government as taxes on income.

Other less astute accountants recommend that “the principal income statement be prepared under the now generally accepted principles of accounting, with income determined on the basis of original costs, and that supplementary statements be prepared to show the effect of profit on using current costs.” Dr. Graham, however, recommended the reverse approach because “the significant income amount is that based on current costs, therefore, the principal statement should show income on the basis of current costs.”

QUOTED HIGHLIGHTS

I have firm personal convictions that current costs, and only current costs, should enter into the determination of income.

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The validity of the principle that only current costs should enter into the determination of income is independent of the fact of price change, or the amount of the difference between original costs and current costs. Even in periods of stable prices the use of original cost is justified only by the fact that the results are substantially the same as those that would be secured by the use of current cost.

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The information presented in accounting reports must be useful for making decisions. Accounting is only a service activity, though a highly important one. Its primary function in business is to furnish information to certain persons and institutions, and the only important use of this information is to facilitate the making of decisions and the formulation of judgments. It follows that this information must constitute an appropriate basis for these decisions.

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… price profits are not a sound basis for predicting future profits; they will not recur without continued price advances and, if recognized, they will be cancelled by price losses when prices decline.

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The value of the stockholder’s investment depends primarily upon the probable future profits of the corporation – profits after full provision for recovery of the equivalent of the physical capital consumed in operations. Only profits so defined are of any significance in an attempt to forecast the probable future course of the profits of the company or of the industry. … But is the stockholder given the information that will assist him in making a decision to retain, dispose of, or increase his investment? No! The income figure reported to him does not distinguish between management profits and price profits. And price profits are not a sound basis for predicting future profits; they will not recur without continued price advances and, if recognized, they will be cancelled by price losses when prices decline.

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… accountants have been partially responsible for unstable prices and for the amplitude of cyclical fluctuations. By our accounting methods we have stubbornly implied that the dollar has a constant value when, of course, we know that its value fluctuates widely. By charging unrealistic past costs against current revenue, we have constantly overstated profits in periods of rising and high prices. We have thereby artificially stimulated the continuation and expansion of business activity at high levels and have thus been partially responsible for over-expansion, inflated stock prices, and unwarranted wage demands – some of the factors that carry business “booms” to dangerously high levels.

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A balance sheet has never been a statement of financial condition in the strict meaning of that term. It has been rather an historical summary of the effect of operations to date. The right-hand side of the statement shows the net amount of capital received, to the balance sheet date, from each of the various sources – creditors, owners, and retained income. The left side shows the net amount of that capital invested in each of the various assets at the balance sheet date.

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Utility
Referece

THE EFFECT OF CHANGING PRICE LEVELS UPON THE DETERMINATION, REPORTING, AND INTERPRETATION OF INCOME

Willard J. Graham

Reprinted from

THE ACCOUNTING REVIEW

Vol. XXIV January, 1949 No. 1

THE EFFECT OF CHANGING PRICE LEVELS UPON THE DETERMINATION, REPORTING, AND INTERPRETATION OF INCOME

WILLARD J. GRAHAM

The other day a student was asked, “Where is the capital of the United States”? His answer was, “On loan all over Europe.” There is a better answer to this question. The capital of the United States, the capital invested in business, is being distributed to stockholders and other owners under the guise of income and it is being paid to government as taxes on income.

I FEEL very strongly on this subject, “the effect of changing price levels on the determination, reporting, and interpretation of income.” I have firm personal convictions that current costs, and only current costs, should enter into the determination of income. In 1934, I wrote a monograph ¹ in which I attempted to state, from the point of view of public utility valuation, the case for the use of current costs in determining the amount of the rate base and the amount of the annual charge for depreciation. (This monograph has had remarkably little effect on the decisions of public utility commissions and courts. Ever since it was published there has been a distinct trend in the direction of the use of original costs for these purposes.) For public utilities, of course, the problem is much more critical than for unregulated business, because under rate regulation the method of computing costs determines selling prices, the rates which utilities may charge for their services.² Unregulated business, on the other hand, is in an entirely different situation. Insofar as there is any relationship between selling prices and costs, it tends to be between selling prices and current costs. For unregulated business, then, the accountant’s choice between current cost and original cost has little or no effect on selling prices. However, his choice does affect the determination, reporting, and interpretation of income, and that is the subject of this discussion.

For over a decade I have been advocating the use of current costs in the determination of income, to my classes on the campus at the University of Chicago, to down-town evening classes of business men, and to local chapters of various accounting organizations. I have seen here and there some effect of these discussions on the thinking of individuals and on the accounting practices of certain corporations. There have always been accountants and others who have held similar opinions; and within the last few years there has arisen a general and ever increasing uneasiness about current accounting practices—a feeling that accountants should “do something” about the unreality of income figures based on original costs. Up to this moment, however, in spite of dozens of speeches and articles on the subject and the conversion to the current cost point of view of many of the leaders in the accounting profession, almost nothing constructive has been done to remedy the situation.

The validity of the principle that only current costs should enter into the determination of income is independent of the fact of price change, or the amount of the difference between original costs and current costs. Even in periods of stable prices the use of original cost is justified only by the fact that the results are substantially the same as those that would be secured by the use of current cost. In such periods, the basic assumption that the dollar has a constant value is close enough to the truth that not too much damage is done to income figures by following that assumption. However, the degree of error arising from the use of original costs does depend on the amount of price change; recent price changes have increased that error to intolerable proportions.

Income, as ordinarily computed and reported, arises primarily from two related but to some extent independent sources. First, there is the margin between selling price and current cost of acquisition and selling—the cost at the time of the sale. This I shall call “management profit.” It has been defined as income after the “recovery” of physical capital—the provision for replacement, at current costs, of the equivalent of the physical capital consumed in earning the revenue.³ Second, there is the so-called “gain” or “loss” arising from the change in price between the time of acquisition and the time of sale, or between acquisition and consumption. This has been called “price profit,” or “price loss,” or “market profit” or “market loss.”⁴ Actually when such price profit is due primarily to changes in general price levels, it is not profit at all, but merely a restatement of capital in terms of different monetary units. Only when there has been a specific price change of greater or less magnitude than the change in general prices can price profit be said to exist. In any case, this so called “profit” is ordinarily absorbed in the preservation of physical capital—its current replacement or the provision for its replacement at current costs. (If a “loss,” it is “refunded” through the replacement—or provision for replacement—at prices lower than its original cost.)⁵

The effect of changing price levels upon periodic income has created a problem that accountants should solve now. If it is at all possible, action should be taken before the issuance of the 1948 annual corporate reports. The problem is so important that its solution cannot be deferred “until a stable price level would make it practicable for business as a whole to make the change at the same time.”⁶

An analysis of the reported corporate income for 1947 indicates the urgency of this problem. The total net income of all corporations in the United States was reported to be about $17.5 billion after income taxes. Of this amount, however, at least $7 billion was price profit, an estimated $5 billion in inventories, and approximately $2 billion arising from the conversion of low cost fixed assets by way of depreciation based on original costs in a period of substantially higher costs.⁷ Thus the total corporate profit in 1947, after recovery of the physical capital consumed—after provision for its replacement at current cost—was not $17.5 billion but only about $10.5 billion. Only this amount was available for payment of dividends, expansion of physical capital, and retirement of debt⁸. Furthermore, when this adjusted profit of $10.5 billion is related to total corporate net worth of at least $225 billion (adjusted to current price levels) it is seen that total corporate profit in 1947 amounted to less than 5% of the present value (current cost net of liabilities) of total corporate net worth. This is a far cry from a generally accepted notion that corporations earned $17.5 billion, which is described as about 10% on a net worth which has a cost or book value of $175 billion. It would seem that the charge so frequently heard—that corporations are making excessive profits—is hardly justified.⁹

If substantial revisions are not made in accounting practices relative to the determination of income before publication of 1948 corporate reports, the discrepancies between management profits—profits after recovery of physical capital—and reported income may be even greater in 1948 than they were in 1947, for costs are still increasing.¹⁰

Why should current costs and only current costs be used in the determination and reporting of income? The answer is very simple. The information presented in accounting reports must be useful for making decisions. Accounting is only a service activity, though a highly important one. Its primary function in business is to furnish information to certain persons and institutions, and the only important use of this information is to facilitate the making of decisions and the formulation of judgments. It follows that this information must constitute an appropriate basis for these decisions.

The final test of the soundness of any accounting principle is, in my opinion, simply this: Will the application of the principle produce...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Copyright Page
• Table of Contents
• Foreword
• Recollections and Accolades
• Introduction
• Section I: Manufacturing Accounting and Public Utility Rate Setting
• Section II: Using Cost Information in Making Management Decisions
• Section III. Financial Reporting Issues, Including Price Level Accounting, Leases, Depreciation, and Deferred Income Taxes
• Section IV: Accounting and Business Education
• Appendix