Accounting Queries (RLE Accounting)

Harold Edey

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781134677627
• Edition: 1
• Topic: Business
• Subtopic: Accounting
• Index: Business

These reprints of articles, lectures and talks cover the period 1949 – 1980. They chart the development of the academic subject of accountancy and illustrate some of the matters which were concerning the academics at the London School of Economics at a time when academic accountancy was still in its infancy.

ACCOUNTING PRINCIPLES AND BUSINESS REALITY

by

H. C. EDEY, B.COM., F.C.A.

(Professor of Accounting in the University of London)

I The Objects of Financial Accounting

1. It is perhaps not always remembered that financial accounts fulfil more than one purpose. Consider the most important part of financial accounting: that concerned with company accounts. Of the numerous reasons for preparing annual company accounts, we can distinguish four major ones:

(1) To provide a working basis for the annual share-out among shareholders.

(2) To provide a basis on which, after suitable adjustments, the annual income and profits tax assessments can be made.

(3) To provide shareholders, and others with financial claims on the company, with an indication of the business prospects of the company and the relative success of the directors.

(4) To indicate to owners what remuneration and perquisites have been enjoyed by the directors.

The fourth object differs from the other three in that no economic estimation of profit is involved, and I shall not discuss it further here.

2. The other three objects have in common the calculation or estimation of a figure called ‘profit’ The purposes served by the calculation have, however, a significant effect on the way it is approached and, I would argue, on the accounting principles that are appropriate. Whatever their ultimate rationale, the rules relating to distributable profit and to taxable profit are now more or less tightly drawn. The desire to avoid uncertainty in their application has played a great part in their development. On the other hand, the idea of profit as a guide to shareholders and other interested parties must, if it is to be of much use, be a business (or if you prefer it an economic) concept: a more flexible approach is required.

3. In my view the idea of the annual accounting report as a statistical aid to financial management has not yet been properly disentangled from the much older idea of the annual accounts as a simple check on directors’ honesty vis-à-vis their shareholders, and as a rough guide to the equitable distribution of annual dividends with an eye on the interests of various classes of shareholders and of creditors.

4. Indeed, I think that there have been occasions when changes in accounting methods intended to improve the information given to shareholders (or to management) have been prevented because auditors have taken the view that they conflict with the rules for profit calculation generally assumed to be imposed by the judicial decisions on dividend law. Whether auditors are always right on such occasions does not matter here, since the point I wish to make is that such considerations are not necessarily relevant to business needs.

5. Furthermore, I believe that tax law has an influence on company accounting practice, in that it may inhibit a change of method that would commend itself on other grounds. Accounting principles (e.g. of stock valuation) that will do for company law purposes may be unacceptable by the Revenue courts. For example, in the cases of Patrick and Broadstone Mills Ltd ([1954] i All E.R. 163 (C.A.)), andMinister of National Revenue v. Anaconda American Brass Ltd ([1956] A.C. 85 (P.C.)), the base stock and lifo methods of stock valuation were held to be invalid for income tax computations. The balance has, for the time being at least, been restored by the decision in Ostime v. Duple Motor Bodies Ltd ([1961] 2 All E.R. 167 (H.L.)), allowing valuation by direct costing. But no one knows in which direction the decision in such cases will go. Most accountants would hesitate before introducing a modification in accounting procedures if this meant that in future there was a risk that two sets of figures would be required, one for the Revenue and one for the annual report: duplication is not without cost.

6. The conventions on which financial accounts are prepared – the normal accounting principles – have grown up as the result of a historical process. They were originally needed in order to provide workable rules by which the maximum dividends appropriate to the situation could be approximately gauged. They were, I suggest, no more than a sensible, rule of thumb, way of solving a particular problem. The old auditing cases show that this is how the judges understood them. It is doubtful whether in the days when they developed they were ever intended to provide precise measures of the degree of business success. Clearly there was no intention that they should do this for shareholders, for as you know directors had, at any rate until the Royal Mail case, no compunction in reporting profit net of significant undisclosed contingency reserves, not necessarily based on any careful consideration of future known liabilities. Secret appropriations to reserve were perfectly respectable.

7. TheRoyal Mail case, the Institute’s Recommendations and the Act of 1948 may be thought to have changed all that. But is the change as big as was thought? The Recommendations and the 1948 Act have done good. But this should not obscure the fact that financial accounting statements and business reality can still be far apart. Indeed, although there is still room for improvement in financial accounts-for example, with respect to valuation methods – I think there are reasons for believing that we may be nearing the end of fruitful development in the traditional form of accounting report. In order to show what I mean I shall now turn to the question of business aims and in particular the nature of the investment process.

II The Nature of Investment

8. Business considered as an economic activity is essentially a process of investment: purchasing power is parted with in the expectation of receiving greater purchasing power in the future. On this view, we must agree, I think, that the owners of business are, so far as economic decisions are concerned, interested ultimately only in the amount of purchasing power committed to the investment, the future flow of cash receipts (dividends) they may expect to receive, and the potential liquidity in the form of available cash which the investment will give them at all future times. In short they are interested in the relation of the financial input of the investment to the financial output. Nothing else is of economic interest to them. I have been careful to avoid saying that nothing else is of interest: the adjective ‘economic’ is of great importance. Non-pecuniary considerations probably enter to a greater or a less degree into most investment decisions. But this does not concern us here; our problems are those that arise when allowance has been made for all such matters.

9. You will notice that I have spoken of dividends and of liquidity and not of profit. This is quite deliberate; much of what I have to say turns on this point, that – in the end – it is money that buys things and not figures of profit.

10. Some formulations would suggest that the economic interest of shareholders lies simply in the relation of a single expected pattern of future dividends to the resources initially at risk; but this is not enough: liquidity must be brought in too. It is because liquidity may be of importance that writers on the valuation of securities lay so much emphasis on ‘marketability’–an important determinant of the liquidity of such investments. The question may be just as important in relation to an internal management decision: Tf something goes wrong or we need more finance suddenly, how much could we realise by discontinuing this process ?’ It would, indeed, be possible to make a classification of shareholders such that the classes constituted a range, at one end of which lay shareholders whose interests were almost entirely confined to future dividends, with little concern for liquidity, and at the other end those whose sole interest lay in the liquidity they could withdraw from the investment in the near or more distant future: at one end would be the purely ‘income-conscious’ person, at the other the purely ‘capital-value conscious’ person. In between we should find the majority who are interested in varying degrees in both.

11. One can perhaps simplify the picture by regarding potential liquidity as nothing more than a possible alternative cash receipt flow. One can then think of any given investor as making his plans in terms of a standard ‘most probable’ dividend expectation – perhaps continuing for an indefinite period into the future – but with an eye on the possibility, should his general financial position require it, of stopping this flow at any point in time and accepting in lieu, a single, final cash receipt; or, where part of the investment was realised, of accepting a specially large cash receipt plus, thenceforth, a smaller flow. In its most obvious form this appears as the possibility of selling part or whole of a quoted investment, thus obtaining liquidity at the point of time of the sale and sacrificing any further dividend flow from the part sold. An owner-manager may be able to raise liquidity for personal use in this way by selling off part of his ownership claim, e.g. by selling equity shares, and he must take this possibility into account in his overall plans. When he is considering investing resources in any particular activity to be carried on as part of the business, he is faced with the same kind of pattern in his internal planning: he must (assuming, of course, that he is attempting to make a systematic appraisal) consider the possible contribution to the net cash flow yielded by the new expenditure – the dividends to the whole enterprise from this particular investment, if you like – and also the possible net realisation receipt if he decides at any time to terminate the activity and liquidate the assets he is using. If any activity is not expected to be of indefinite duration, one component of the flow of cash released by the activity will be that realised in its final winding-up. A board managing a company on behalf of shareholders is in a similar position, though one must assume in their case that in choosing between opportunities they are basing their decisions on what they consider will best suit the shareholders rather than themselves.

12. Thus, when we get down to the kernel of the matter, there is a structural similarity between the arithmetical pattern that describes the economic aspect of an investment in a security – say an ordinary share of an industrial company – and that which describes any industrial investment project, such as the outlay made by a chemical manufacturing company on a new plant. From this two things follow. First, that whatever formal calculation procedure is used in evaluating the one, will be relevant to the other. It is, for example, the view of some financial controllers, of economists and, I may say, of academic accountants, that the use of discounted net worth calculations (or their arithmetical equivalents in the form of annuity or compounding calculations) is the best approach at present available to the task of making clear the logical implications of investment: of the significance of assumptions that have to be made about future cash flows and initial sums invested. (See Appendix i for a note on the rationale of this method and an illustration.) Such methods are equally appropriate, whether one is a member of a financial committee concerned with the economic justification of a new chemical plant or a new power station, or the investment manager of a pension fund.

13. Second, the general principles guiding the preparation and presentation of the arithmetical information on which the decision is based, and the figures which are later used to check (so far as is ever possible) whether the outcome of the decision tallies with that planned, should be the same, whatever the form of the investment. These principles should be related to the criteria on which the investment decision is based. There are, of course, considerable differences ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Title Page
• Original Copyright Page
• Preface
• Table of Contents
• Published Accounts as an Aid to Investment (The Accountant, London, February 18, 1950)
• Reflections on the Accounting Provisions of the Companies Act, 1948 (Accountancy, London, September/October, 1950)
• A Note on Reserves, Provisions and Profits (Accounting Research, Vol. 2, No. 2, London, 1951)
• Income and Capital in Income Taxation-Distributions by Companies (Accounting Research, Vol. 4, No. 4, London, 1953)
• Accuracy and Inaccuracy in Profit Calculation (The Modern Law Review, Vol. 17, No. 3, London, 1954)
• Company Accounting in the Nineteenth and Twentieth Centuries (The Accountants Journal, London, April/May, 1956)
• The Valuation of Stock in Trade for Income Tax Purposes (British Tax Review, London, June, 1956)
• Memorandum of Evidence to the Jenkins Committee (Minutes of evidence taken before the Company Law Committee, third day, London, H. M. Stationery Office, 1960)
• Thinking in Figures (Travers Lecture, The Accountant, London, April 21, 1962)
• Income and the Valuation of Stock-in-Trade (British Tax Review, London, May/June, 1962)
• Business Valuation, Goodwill and the Super-Profit Method (Studies in Accounting Theory, London, 1962)
• Company Accounts in Britain: The Jenkins Report (The Accounting Review, Vol. 38, No. 2, April, 1963)
• Accounting Principles and Business Reality (Institute of Chartered Accountants, Oxford Summer Course papers, 1963)
• The Principles and Aims of Budgetary Control (Production Engineering Research Assoc. Symposium Papers, 1967)
• The Nature of Profit (Accounting and Business Research, London, Winter, 1970)
• The Drue and Fair View (Accountancy, London, August, 1971)
• Some Aspects of Inflation and Published Accounts (Omega, Vol. 2, No. 6, 1974)
• Deprival Value and Financial Accounting (Debits, Credits, Finance and Profits, London, 1974)
• Accounting Standards in the British Isles (Studies in Accounting London, 1977)
• Why All-Purpose Accounts Will Not Do (Accountancy, London, October, 1978)
• Sandilands and the Logic of Current Cost (Accounting and Business Research, London, Summer, 1979)
• The Logic of Financial Reporting (Deloitte, Haskins and Sells Lecture, Cardiff, February 28, 1980)