[Introductory note: Robert R. Sterling is Francis
G. Winspear Distinguished Professor of Professional Accounting at
the University of Alberta. He holds the Gold Medal of the AICPA
for 1969 and 1974, the highest research prize awarded by that organization.
Professor Sterling was the first Distinguished International Lecturer
of the American Accounting Association.
*Adapted from Robert R. Sterling, Toward a Science
of Accounting (Houston: Scholars Book Co., 1980) with the kind
permission of Scholars Book Co. The author is indebted to the members
of the Accounting Workshop at the University of Alberta and Francis
G. Winspear for valuable comment on an earlier draft and to the
Winspear Foundation for financial support.]
There is no less merit in keeping what we have got, than in first
acquiring it. Chance has something to do with the one, while the
other will always be the effect of skill. -- Ovid
Keeping what we have got requires skill in any circumstances. Inflation
makes it difficult and double-digit inflation makes it doubly difficult.
In a commendable attempt to aid users by reflecting inflationary effects,
accountants have been honing their skills. Many accountants have noted
that in times of increasing prices, if historical cost income is paid
in dividends, it does not provide the firm with adequate funds to
keep what we have got -- the ability to replace physical units declines
-- and therefore historical costs produce "false profits."
The proposed solution is to use current costs. The argument is that
"true profits" are those figures that reflect an increase
in physical capital because that is the amount that can be paid in
dividends without reducing the number of physical units of the firm.
The modest goal of this article is to clarify the concept of physical
capital. Evidence of the need for clarification is provided by FASB's
indecision in FAS 33. The alternatives of (1) maintaining financial
capital versus (2) maintaining physical capital were clearly and correctly
stated in FAS 33 (¶97b) and a choice was previously made in the
Exposure Draft but FAS 33 (¶104) does not make a choice. Instead,
FAS 33 (¶124, 131) refers to the views of some Board members
and such statements in conjunction with the failure to make a choice
provide ample evidence that the Board is split on this issue.
The basic difference between financial and physical capital is that
the former seeks to measure a monetary or value attribute and the
latter a physical attribute. This is a crucial distinction: the choice
of (1) versus (2) requires that we address the fundamental question
of what attribute we should account for. Obviously the question
of the attribute that we account for goes to the very foundation of
accounting thought and practice.
A corollary of the difference in attributes is a difference in reported
income: the write up to current cost is credited to income in the
financial option but that write up is credited to equity in the physical
option. That is, both options adjust the assets to current
cost but the former takes that adjustment to income and the
latter to equity. Physical capital proponents insist
that the write up to current cost should be taken to equity, not income
for the straightforward reason that the write up does not reflect
a change in physical capacity. Thus, some Board members would take
the write ups directly to shareholders' equity, bypassing the income
statement. Financial capital proponents insist that the write up is
income for the equally straightforward reason that it is an increase
in monetary capacity. Thus, some Board members would term the write
ups "holding gains" and take them to the income statement.
Obviously the two options will result in significant differences in
It is not my purpose to review or critique FAS 33. Instead, my primary
purpose is to clarify the concept of physical capital by casting it
in a simple and easily understandable context. My secondary purpose
is to state the arguments that I use in choosing between financial
and physical capital. If I achieve the primary purpose, it should
advance accounting thought in general, as well as advancing the deliberations
of FASB, regardless of the ultimate choice. A choice, however, is
imperative both for the well being of accounting and for the well
being of FASB. For the well being of accounting, indecision results
in a proliferation of income numbers which can exist only on pain
of vast confusion. In regard to the well being of FASB, recall that
a major criticism of its predecessors, perhaps a major factor in their
demise, was the inability to make a choice when presented with alternatives.
In this article I will focus exclusively on the physical capital
version of current costing: I will not consider the financial capital
version or the more general question of current costs versus other
valuation proposals. First, the background of physical capital will
be briefly reviewed; second, the false profits criticism of historical
costs will be explained; third, the nature of the true profits produced
by physical capital-current costs will be explicated and the advantages
claimed will be stated; fourth, the tacit assumptions of physical
capital will be revealed and the consequences of their violation will
be examined. Finally, I will show that the fundamental question of
what attribute we should account for raises the equally fundamental
question of who we should account for.
The proposal to measure physical capital has been with us, in one
form or another, for a very long time. It was a major factor in the
ancient LIFO-FIFO debate. Proponents of LIFO coined the terms "false
profits" and "fool's profits" because if FIFO income
was paid in dividends, it resulted in a decline of physical capital.
Since the argument for LIFO was based on physical capital, the natural
progression was to NIFO -- next in first out -- which was permitted
in some cases. NIFO is, of course, merely another name for current
cost of inventory. Another form of the proposal arose in the equally
ancient debate over price level adjustments. Although there was fairly
widespread agreement that price level adjustments were needed, there
was disagreement about the kind of price index that should be used:
some favored a general index and others a specific index. Those who
favored a specific index argued that a general index did not reflect
the pattern of purchases of the firm being accounted for and, therefore,
it was inappropriate to use a general index. A firm specific index
was more appropriate and the natural progression was to an asset specific
index. Adjusting historical costs by an asset specific index is, of
course, merely another way of reflecting current costs.(2)
In 1961 the theory of replacement costing was presented by Edwards
and Bell. They proposed to value assets at replacement cost and to
bifurcate income into "current operating profits" -- revenues
less current costs -- and "holding gains" -- the increase
in costs. Their argument against historical cost income was that it
deferred the reporting of holding gains until they were realized instead
of reporting them when they occurred or accrued thereby reporting
false profits. The work gradually gained supporters, mainly from academe,
but it also met strong resistance, mainly from practice, primarily
because it violated the realization convention. Some of the holding
gains were write ups of assets that were unsold or unused and therefore
unrealized. There were precedents in practice for writing up assets
to current cost but the credit had been to appraisal surplus, not
Several debates ensued. Some debated the merits of replacement costing
while others debated the proper interpretation of replacement costing.
Rosenfield, for example, presented cogent criticism of replacement
costing as well as lucid expositions of the distinction between price
level adjustments and replacement costing. There were many who debated
the proper interpretation of replacement costing culminating in Revsine's
provision of a theoretical base different from Edwards and Bell but
with the same conclusions. Revsine adopted a physical measurement
system but contrary to the physical capital proponents he considered
holding gains to be income. But these were theoretical debates which
had no effect on practice. The APB had already rejected the Moonitz
and Sprouse-Moonitz research studies and therefore it appeared that
practice was safely insulated from replacement costing. The SEC broke
through that insulation in 1976 with the issuance of ASR 190 requiring
disclosure of replacement costs. This brought many practitioners into
the debate, most of whom were opposed. It also resurrected the academic
debates about the proper interpretation. One notable reaction to ASR
190 was Johnson and Bell's charge that it was a misinterpretation
of replacement costing. It was notable both because of its cogency
and because Bell was the co-author of the seminal book -- Edwards
and Bell -- and was the former professor of Sandy Burton, the architect
of ASR 190. In effect, Professor Bell graded student Burton's paper
and found it wanting. Thus, practitioners resisted ASR 190 because
it was replacement costing and academics resisted it because it was
not the proper interpretation of replacement costing.
In the debate over the proper interpretation of replacement costing
many refinements were proposed. One recurring theme was that holding
gains are not income because they are not realized. (For a recent
argument that holding gains are not income for other reasons see Samuelson.)
In effect, these proponents of replacement costing wanted to truncate
the income statement at current operating profit, eliminating the
holding gains. The elimination of holding gains allows one to avoid
violation of the realization convention or, to put it positively,
reporting only current operating profit allows one to embrace both
replacement costing and the realization convention. In addition
it is even more conservative than historical cost income because it
eliminates realized holding gains as well as unrealized holding gains.
By more than mere coincidence current operating profit is exactly
the same as "operating income" in the physical capital proposal.
Operating income is the amount that can be distributed without imparing
physical capital and therefore it is also known as "distributable
income" or, in Revsine's replacement costing terminology, "distributable
Thus, the two proposals converged. Replacement cost income less holding
gains is exactly the same as physical capital income. The confluence
of the adherents of these two proposals swells the support for reporting
operating income as well as undermining the opposition based on the
violation of the realization convention. Additional opposition was
dissipated when the idea of multi column financial statements was
introduced in the academic literature and interpreted as supplementary
statements in practice. Recognition that physical capital statements
could supplement instead of supplant historical cost statements subsumed
the proposal under the hoary concept of additional disclosure. In
short, the effect of the refinements was to add supporters from other
camps and to quiet the opposition. The trend was one of increasing
support and decreasing resistence and that trend seems to be continuing.
The present widespread support is evidenced by Standard Setters in
Australia, Canada and the U.K., all opting for current cost/physical
capital methods of reporting at least in the Exposure Draft stage.
In the U.S., as noted above, FASB is divided on this issue and has
presented a compromise. Those Board members who support physical capital
present their case in FAS 33:
Erosion of physical capital (or erosion of operating capability)
may be regarded as the failure to retain sufficient financial resources
to acquire assets needed to maintain the capacity of the enterprise
to provide a constant supply of goods and services. The concept
of physical capital erosion may be linked to a concept of distributable
income where distributable income is defined as the amount of cash
that may be distributed without reducing the operating capability
of the enterprise. (¶124.)
[C]osts must be measured at current cost in order to provide for
the maintenance of operating capability. Assume, for example, that
inventory is purchased for $1,000 and sold for $1,500 at a time
when current cost is $1,200. Although historical cost-nominal dollar
income is $500 ($1,500 less $1,000), distributions may be limited
to $300 ($1,500 less $1,200) to maintain operating capability. Costs
are measured at $1,200 in order to provide for the replacement of
inventory out of revenues. An increase of $200 ($1,200 less $1,000)
in current costs would not be regarded as part of income
under concepts that address maintenance of physical operating capability.
(¶125, emphasis supplied.)
In brief, the argument is that historical cost/nominal dollar accounting
produces false profits because of the need to replace the inventory
at its current cost and that the difference between current cost and
historical cost is not income for the same reason.
In summary, the proposal to measure physical capital has a very long
history. It has roots in practice -- LIFO and appraisal surplus --
as well as in theory -- specific price indices and replacement costing.
Support is growing, having become sufficient to be adopted or exposed
in other English speaking countries, and having become sufficient
to cause FASB to retract its choice in the exposure draft and to compromise
in FAS 33.
Given the history and the widespread support, it is most curious
that the literature on physical capital is exceptionally sparse. The
quotation from FAS 33 above is a typical statement of the case for
physical capital both in regard to content and brevity. It seems that
the widespread support for physical capital is based on the intuitive
appeal of such brief statements. Surely the fundamental nature of
the question of what attribute that we account for requires a much
more intensive and extensive analysis. The trend toward adopting physical
capital in all English speaking countries, including the promise to
review and revise FAS 33 (15) in not more than five years, makes the
provision of such an analysis especially urgent. My hope is that the
following remarks will motivate others to provide the more intensive
and extensive analysis so that physical capital will either rest on
a bedrock foundation or be abandoned if its intuitive appeal does
not withstand such analysis.
The argument that historical cost income results in false profits
can be clearly seen by considering a simple merchandising firm. Assume
that the firm starts with $100 cash on January 1 and buys 100 units
for $1.00 each on January 2. On January 31 it sells all the units
for $1.60 each and pays its income in dividends. The combined financial
statements appear in Exhibit I.
Combined Financial Statements
|| Month of
|Beginning Retained Earnings
| Cost of Goods Sold
| Net Income
|Change in Retained Earnings
|Ending Retained Earnings
Examination of Exhibit I reveals that there is absolutely nothing
false about any of the figures. It accurately reflects the easily
measurable attribute of Number of Dollars (NOD).
The NOD on hand at January 1 and February 1 was in fact $100 and that
could be readily empirically tested or, as we also say, readily audited.
The increment (net income) in NOD during January was $60 which is
also readily auditable. Since the figures conform to empirically testable
facts, they must be characterized as true and those who claim them
to be false are mistaken.
The basis of the mistaken claim that the figures are false is that
they do not reflect physical capital. Proponents of physical capital
want to measure Specific Units Purchasable (SUP), not NOD. To obtain
a direct measurement of SUP the only thing required is to divide the
February 1 NOD figures by $1.25, the current cost on that date. This
division restates the dollars as equivalent units purchasable, i.e.,
$100 would purchase 100 units on January 1 but $100 will purchase
only 80 units on February 1. Thus, there is a decline in physical
capital of 20 units. In the same fashion, the sales of $160 is divided
by $1.25 to obtain the equivalent units purchasable of 128 from which
is deducted the 100 units sold to yield the "true profit"
of 28 units. The problem is that the $60 NOD profit was paid in dividends
which is equivalent to 48 units (=$60/$1.25) resulting in the decline
of 20 units in physical capital. (Cf. FAS 33 ¶100b, 125.) Exhibit
II displays all of these SUP figures.
Measuring SUP in Units
Combined Financial Statements
|| Jan 1
|| Month of
| Feb 1
|| 100 units
|| 80 units
|Beginning Retained Earnings
| Cost of Goods Sold
| Net Income
| Less Dividends
|Change in Retained Earnings
|Ending Retained Earnings
All of the figures in Exhibit II are also true in that they conform
to empirically testable facts. (3)
Thus, both Exhibits are true. The distinction is that they measure
different attributes, not that one is true and the other false.
Of course, it cannot be denied that Exhibit I gives a false measure
of SUP. It overstates SUP profit by 20 units. As a result 20 units
of SUP capital was paid out and therefore SUP assets declined by 20
units. If this trend continues, so the argument goes, the firm will
dwindle and eventually die. If income taxes are levied on the basis
of NOD, it is possible for those taxes to be greater than SUP profit
and therefore confiscatory, i.e., a tax on SUP capital. It is on the
basis of these evils that NOD profit is said to be false.
Physical capital proponents want to avoid the aforementioned evils
by measuring SUP. They propose to measure SUP by adjusting the historical
costs to current costs in the following entry:
| Shareholders' Equity
This entry writes up the 100 units from the $1.00 per unit historical
cost to the $1.25 per unit current cost. All -- both physical and
financial capital -- current cost proponents are agreed that the asset
accounts should reflect the current cost. Hence the most general proposition
of current cost accounting is:
Proposition 1: Asset accounts should reflect the current cost, not
the historical cost, of the assets.
All physical capital proponents agree that the adjustment should
be taken to equity, not income. The argument is that the original
capital invested was 100 units and that this has not changed. It is
incidental that the 100 units was expressed as $100 originally and
is now expressed as $125. Since the only thing that has changed is
the dollar expression, since the underlying physical capital has not
changed, the adjustment cannot be considered income -- it is an equity
adjustment. Thus, the second proposition of physical capital current
Proposition 2: Differences between current costs and historic costs
are equity adjustments, not income.
After the adjustment to inventory, as given in the above entry, the
recording of cost of goods sold is straightforward:
|Cost of Goods Sold
The purpose of charging the current cost against revenues is to get
the net income to reflect the change in units. This idea may also
be stated as a general proposition:
Proposition 3: Income is the change in physical capital and is determined
by deducting current costs from revenues.
The above adjustment to inventory can be backed up to an adjustment
to cash. The $100 cash was used to purchase 100 units of inventory
Measuring SUP in Dollars
Combined Financial Statements
|| Jan 1
|| Month of
| Feb 1
|Beginning Retained Earnings
| Cost of Goods Sold
| Net Income
| Less Dividends
|Change in Retained Earnings
|Ending Retained Earnings
The January 1 figures are stated at the current cost as of February
1. (4) The Cost of
Goods Sold is also stated at the current cost resulting in a $35 SUP
net income as contrasted to the $60 NOD net income. The smaller net
income results in smaller dividends being paid and hence more cash
retained in the firm. (Cf. FAS ¶124.)
But it would now require $125 to purchase the same number of units.
Thus, the January 1 cash should be stated at $125 to reflect the fact
that it would require that amount on February 1 to purchase the 100
units. The effect of these propositions and entries is displayed in
the combined financials in Exhibit III.
These dollar figures are intended to reflect physical capital --
the objective is to measure SUP, not NOD. That this objective has
been achieved can be seen by dividing all the figures in Exhibit III
by $1.25. The quotients of such divisions are displayed in Exhibit
Measuring SUP in Units
Combined Financial Statements
|| Jan 1
|| Month of
| Feb 1
|| 100 units
|| 100 units
|Beginning Retained Earnings
|| 128 units
|Cost of Goods Sold
|Change in Retained Earnings
|Ending Retained Earnings
This is said to prove that the true profit is $35 since that is the
dollar expression of the increase in units purchasable arising from
The proponents of physical capital claim that this measure produces
a number of advantages. First, it aids dividend policy. As
we have seen, if dividends of more than $35 are paid, the physical
capital is reduced. SUP income is sometimes called "distributable
income" to indicate that it is the amount that can be distributed
in dividends without reducing physical capital. (Cf. FAS 33 ¶124.)
Second, it aids tax policy. (Cf. FAS 33 ¶94b.) If income
taxes were based on SUP income, it would prevent taxation of capital
under the guise of taxing income. For example, in the case at hand,
if an income tax rate of 60% or greater were based on NOD income,
it would reduce the specific units purchasable thereby, in fact, being
a tax on physical capital.
All proponents are agreed on the above advantages. Many go further
and argue that it also aids price policy. Some argue that selling
prices are in fact a function of current costs. FAS 33 (¶117),
for example, alludes to the possibility of selling prices being closely
related to current costs. Other argue that management should establish
a policy of setting selling prices on the basis of current costs.
The suggestion is to apply the markup rate to current cost instead
of historical cost in order to gain the same increase in physical
capital that would have been had there been no change in purchase
price. In this case the markup rate of 60% is applied to the $1.25
current cost to yield a sales price of $2.00. See Exhibit V.
Markup applied to Current Cost
Comparative Income Statements
Month of January
|| Constant Cost
|Cost of Goods Sold
If purchase prices had remained at $1.00, as in column (1), the SUP
income would have been $60 which is equivalent to 60 units as shown
in column (2). In order to obtain the same increase in units, as shown
in column (4), we must base the markup on the increased purchase price
and thereby increase the revenue to $200. To put it negatively, if
the markup of 60% is based on historical cost, the result is an increase
of 28 units, as shown in Exhibit IV, instead of the increase of 60
units originally planned. Applying the same markup rate to current
cost allows the firm to earn the same SUP income as it would have
earned had there been no increase in purchase price.
Those who make this suggestion argue that such an increase in sales
price is likely to be possible because competitors who purchase at
a later time will incur the increased cost and therefore will want
to markup on that basis. In this case competitors will purchase the
units at $1.25 each and therefore will be forced to sell at $2.00
in order to earn a 60% gross margin. Thus, in general, firms can be
competitive with the sales price based on current cost.(5)
Up to this point the discussion has focused on the advantages of
this pricing policy that would accrue to the firm. Note also
that it has advantages for the owners of the firm. The distributable
income -- dividends payable without decreasing physical capital --
would have been $60 had purchase prices remained constant. With the
selling price based on the current cost the distributable income is
$75.Thus, if the profit is in fact distributed the owners will receive
an additional $15. Since owners do not purchase the specific units
of inventory from their dividends and are likely to be interested
in their capacity to purchase consumer goods from their dividends,
the fact that $60 and $75 are equivalent in terms of SUP is not relevant
to them. Instead, the consumer price index is relevant to determining
the owners' relative well offness, but regardless of where the consumer
price index stands at the time of the receipt of dividends, $75 will
always purchase more than $60 and therefore the owners are always
better off from constant markups on increasing purchase prices. The
situation is truly Utopian: the firm is equally as much
better-off and the owners are more better-off from using
this method of accounting and the attendant pricing policy. For this
reason, many managers and owners are strong supporters of the physical
capital proposal. (6)
Another advantage to owners and others is the predictive power
of SUP profit. (Cf. FAS 33 ¶116-123.) Many proponents base their
entire argument for adopting SUP profits to predict future SUP profits.
Since SUP profit is distributable income -- the maximum amount that
can be paid in dividends without reducing physical capital -- then
dividends equal to SUP profit will allow physical capital to be maintained
at the same level and therefore allow SUP profits to continue at the
Since share prices are the discounted value of future dividends,
this aids owners in the valuation of their share prices. For example,
we noted above that dividends increased from $60 to $75 due to the
constant markup being applied to the increased current cost. This
means that share prices would increase 25% to reflect the discounted
value of the 25% increase in dividends since present SUP profits are
good predictors of future SUP profits and SUP profits can be distributed
without impairing physical capital.
One of the more straightforward arguments for the predictive power
of SUP measures was presented by Revsine and Weygandt (p. 75):
(1) "[T]he value [present price] of a firm's ownership
shares is determined by the level of its cash operating flows."
(2) "[A]t a minimum management can be assumed to be constantly
striving to maintain existing share prices." (3) "[I]n order
to maintain existing share prices management must maintain operating
flows at their current level." (4)"[M]anagement's primary
controllable variable in attempting to maintain operating flow levels
is to maintain the prevailing physical level of operations on the
assumption that the margin between input and output prices will remain
constant. " (5)[A]dopting as the objective of accounting] the
primacy of cash flow predictions... whichever inflation accounting
method generates an income figure that best reflects the maintenance
of the physical operating level of the firm ought to be preferred.
Therefore, SUP measures are preferred. Not only can they be used
to predict cash operating flows of the firm they can also be used
to predict dividends of the owners thereby meeting the objective of
providing information useful to investors for predicting, comparing
and evaluating potential cash flows.
Numerous other advantages of SUP measures are claimed. Current costs
are said to be a surrogate for net present value of future
cash flows and SUP profits a surrogate for "economic income"
(change in net present values). Since many consider net present value
to be the "ideal measure" that cannot be obtained for practical
reasons, a surrogate is almost ideal. (Cf. FAS 33 ¶ 132-133.)
Assessing managerial effectiveness is also aided by SUP measures
because management has control over the quantity of physical units
but does not have control over prices. Therefore owners can judge
the quality of managerial decision by focusing on what they can make
decisions about. For the same reason managers should be considered
stewards of the physical units and therefore SUP measures best meet
the stewardship objective. There are other advantages claimed
for SUP measures but enough has been said for the present since my
sole purpose is to indicate that the proponents believe that SUP measures
dominate other alternatives in all, or almost all, respects.
In summary, SUP measures are said to be true because they reveal
the physical capital of the firm. In addition, such measures are said
to provide advantages for formulation of dividend policy, tax policy
and price policy, as well as having predictive power, being a surrogate
for ideal measures, aiding in assessing management and providing the
best report on stewardship. For these reasons, the proposal has rather
wide appeal and support from influential groups.
Careful examination of physical capital proposals reveal three crucial,
albeit usually tacit, assumptions:
(1) The firm continues to replace identical units;
I will examine the consequences of the violation of each assumption
(2) Costs (purchase prices) continue to increase; and
(3) The firm buys and sells in different markets.
Different Units. As long as a firm replaces identical units,
we can report empirically testable SUP measures as demonstrated above.
But what happens if the firm changes the kind of units that it purchases?
Such changes do not violate the going concern assumption; indeed they
are regular occurrences in long-established firms. Macys and Gimbels,
for example, purchase and sell mini skirts one season and then purchase
and sell maxi skirts the next season. How does one employ a measure
of physical capital when the units change from minis to maxis?
To make the example concrete assume that Macys starts with $100 on
January 1, purchases 100 minis at $1.00 each on January 2, sells 100
minis at $1.60 each on January 31 when the current cost of minis is
$2.00, and replenishes its inventory on February 2 with maxis at a
cost of $1.25 each, that cost having increased from $1.20 each on
January 2. Even though the case is simple there are several different
asset and income figures that can be derived. Two of the more obvious
(1) The firm actually bought minis and therefore the measurement
ought to be based on the cost of minis. On this basis a $40.00 loss
would be reported. The $160.00 cash will purchase 80 minis at $2.00
each on February 1; the $100.00 cash will purchase 100 minis at $1.00
each on January 1; the decrease in ability to purchase minis is 20
which at $2.00 each is a $40.00 loss.
(2)The firm actually replaced with maxis and therefore the measurement
ought to be based on maxis. On this basis $55.84 profit would be reported.
The $160 cash will purchase 128 maxis at $1.25 each on February 1;
the $100 cash will purchase 83.33 maxis at $1.20 each on January 1;
the increase in ability to purchase maxis is 44.67 which at $1.25
each is a $55.84 profit.
We have a choice of reporting a substantial profit or a substantial
loss from the same set of facts. Which figure do we report? The criterion
used by physical capacity proponents is truth, but examination reveals
that the alternatives are equally true. The choice is SnUP
(for minis as the basis) versus SxUP (for maxis as the
basis), not truth versus false-hood. SnUP is true in that
100 minis were purchased on January 2 and 80 minis could have been
(but were not) purchased on February 2. SxUP is true in
that 128 maxis were purchased on February 2 and 83.33 maxis could
have been (but were not) purchased on January 2. Thus, any defense
or criticism of one applies with equal force to the other: either
both are true or both are false since both contain one factual purchase
and one counterfactual purchase. Thus, we have returned to the fundamental
question: what attribute should we account for? The only difference
is that we now face the choice of SnUP versus SxUP
instead of NOD versus SUP. I confess that I do not know the answer.
I fear that physical capital proponents also do not know the answer
because insofar as I am aware the question is never addressed.
A digression to discover how FAS 33 would answer the question will
illustrate the difficulty of the answer as well as the concealment
of the question. Based on the definition of current cost it appears
that FAS 33 would prefer option (1). It emphasizes that current cost
refers to the asset owned (¶99f) as opposed to replacement cost
which is defined as the current purchase price of "the best available
asset to undertake the function of the asset owned" (¶99c).
In this case the assets owned at time of sale were minis and maxis
are the best available asset to under-take their function. It is not
at all clear what "function" means in this context but it
does appear that "current cost" is the present purchase
price of minis ($2.00) and "replacement cost" is the present
purchase price of maxis ($1.25). That is, current cost is SxUP.
Therefore, the correct report is a $40 loss.
This would clear it up were it not for the lack of explanation as
to the reason for the distinction. It appears to be purely definitional:
the "current cost income" is a $40 loss and the "replacement
cost income" is a $55.84 profit and there is nothing to distinguish
them except the words. Mr. Walters evidently shares my confusion (FAS
33, p. 28 emphasis supplied): "In most cases, it [current cost
or distributable income] is a result of subtracting the estimated
cost of the next purchase from the revenue of the last sale."
This supports reporting a $55.84 profit by subtracting the cost of
maxis from the revenues of minis. That is, SnUP is the
correct measure. As a member of the Board Mr. Walters was a party
to the deliberations and therefore it seems likely that if the question
had been raised, he would know the answer given by the proponents
even though he disagreed. My conjecture is that the question was never
answered because it was never raised.
Thus, FAS 33 either answers the question by definition or it fails
to answer the question. If the former, it merely rephrases the question:
should we account for current cost (SxUP) or replacement
cost (SnUP)? If the latter, we return directly to the original
question of SxUP versus SnUP. Was the "current
income from continuing operations" a $40 loss or a $55.84 profit?
Should the firm pay its "distributable income" of $55-84
in dividends or should it seek additional financing of $40 to restore
its physical capital position which was diminished by a $40 loss?
Perhaps the proponents can answer, I cannot.
Extension of the time period reveals that both SnUP and
SxUP result in conceptual as well as practical problems.
If we choose SnUP we must apply it consistently in February
in order to achieve comparable figures. The conceptual problem is
apparent: maxis are being purchased and sold in February and therefore
the presumed objective is to maintain the physical capital
of maxis but we are measuring the physical capital of minis.
Of what use to either managers or owners is information about minis
when the firm is dealing in maxis? The practical problem is also apparent:
since minis are out of style, they are no longer being manufactured
in February and therefore we cannot determine their current cost.
When there is no market for minis the amount of current cost is impossible
to determine. It would be difficult, albeit possible, to determine
their reproduction cost but one wonders whether this would be cost
beneficial especially in view of the conceptual problems. Both the
conceptual and practical problems are highlighted by further extensions
of the time period. Not only could we consider such problems in March
when midis will be in style, we could also assume that Macys adopted
physical capacity measures in 1880 when bustles were in style and
confound ourselves with the 1980 conceptual and practical problems
of measuring minis, maxis and midis on the basis of bustles.
The problems of SxUP are parallel. In order to achieve
comparability we must restate the December figures on the basis of
maxis. But the firm was dealing in hot pants in December and this
raises the conceptual problem of usefulness as well as the practical
problem of determining the cost of maxis before they were being manufactured
and sold. For the same consistency-comparability reason, we would
need to restate the past figures, going back at least five years if
not all the way back to bustles, on the basis of minis in January,
maxis in February, midis in March and so forth every time the style
changed. Not only would frequent restatements be confusing, they would
also be very costly and the benefits would be minimal.
Given these considerations we must reject both SxUP and
SnUP. A third approach is to define a more abstract unit.
The argument is:
(3) The firm is actually replacing skirts with skirts and
therefore the measurement should be based on skirts. On this basis
a $35 profit would be reported. The $160 cash will purchase 128 skirts
(maxis) at $1.25 each February 1; the $100 cash will purchase 100
skirts (minis) at $1.00 each on January 1; the increase in the ability
to purchase skirts in 28 which at $1.25 each is a $35 profit.
This measures SsUP (for skirts) as opposed to the rejected
SxUP and SnUP. The criterion of truth is met
since SsUP conforms to empirically testable facts.
In essence, SsUP is an application of the solution to
the well-known problem of adding (or subtracting) apples and oranges.
The proposed solution is to call the sum (or difference) units of
"fruit" instead of "apples" and "oranges."
Here we call the difference "skirts" instead of "minis"
and "maxis." If one had 128 apples on February 1 and 100
oranges on January 1, it is reasonable to say that one is better off
by 28 pieces of fruit just as it is reasonable to say that one is
better off by 28 skirts.
Extension of this approach to more dissimilar units, however, yields
absurd results. For example, it would be absurd to say that if one
had 2 pineapples on February 1 and 100 grapes on January 1, then one
is worse off by 98 pieces of fruit. The reason we consider the result
to be absurd is that the pineapples and grapes are not sufficiently
similar to permit us to ignore the difference in, say, food value.
To put it positively, the reason we consider the difference between
apples and oranges to be reasonable is that, at least implicitly,
we equate one apple to one orange in some sense such as food
value. Since we are not willing to equate one pineapple to one grape,
we consider sums and differences of pineapples and grapes to be absurd.
The same applies to measuring the profit of Macys. It is reasonable
to say that the firm is better off by 28 skirts only if we are willing
to equate, in some sense, minis to maxis. The question is: in what
sense is one mini equal to one maxi? The fact that both are skirts
does not answer the question unless we are willing to ignore differences
in workmanship, design, quantity of material, kind of material, and
so forth. A cotton mini is not equal to a wool maxi in several senses
not the least of which is market value.
To make the point consider the extreme example of Macys deciding
to compete with Neiman-Marcus by replacing its cotton mini skirts
with ermine maxi skirts at a cost of $80 each. The $160 cash will
purchase 2 ermine maxis at $80 each on February 1; the $100 cash will
purchase 100 minis at $1.00 each on January 1; the decrease in the
ability to purchase skirts is 98 which at $80 each is a $7,840 loss.
The consequent is absurd. Just as we cannot equate pineapples to grapes
because of differences in food value we cannot equate cotton to ermine
because of differences in market value.
Once again we have come full circle to the fundamental question:
what attribute should we account for? To be able to equate different
units requires that we measure the same attribute in both to see whether
they are equal in regard to that attribute. The unanswered question
is: what attribute should we measure to determine that equality? I
confess that I do not know the answer if value measures are excluded.
I fear that physical capital proponents also do not know the answer.
Worse, I fear that they do not know the question. Instead of addressing
the question it seems that they assume, often tacitly, that the firm
replaces with identical units. (8)
In summary, adopting SUP instead of NOD does not resolve the question.
If we decide to account for specific units, we must decide which specific
units we should account for. If we assume replacement with identical
units no decision is required but if we make the more realistic assumption
of, at least eventually, replacing with different units, we must choose
the unit that we use as the numeraire. This simple case reveals three
plausible choices -- minis, maxis and skirts -- with no apparent reason
for preferring any one over the others. Extension of the time period
or extension to more dissimilar units reveals that all three result
in such severe conceptual and practical problems that all three must
Therefore, I conclude that physical capital measures are not applicable
to firms that replace different units. This excludes a large number
of firms. Car dealers replenish their inventory of luxury cars with
compact cars and appliance dealers replenish their inventory of black
and white televisions with color televisions. Toy dealers purchase
and sell hula hoops one year, while they purchase and sell skateboards
the next year. Last year's propellers are this year's jet fans in
firms that sell airplane parts, and last year's slide rules are this
year's hand-held electronic calculators in firms that sell office
and engineering supplies. Last week's fresh strawberries are this
week's fresh cherries at the grocery. And so on for a great number
of firms. In time all firms must either adapt to changing tastes and
changing technology by replacing with different units or fail to adapt
and die. Thus, physical capital measures eventually become inapplicable
to all living firms, to all going concerns.
Decreasing Costs. Arguments for measuring physical capital
are almost invariably couched in terms of increasing current costs.
In times of inflation it is rather natural to think about increasing
prices. Even in times of inflation, however, some prices decrease.
Dealers in electronic calculators provide a ready example since their
prices have decreased dramatically in the recent past.
Let us consider the case. Assume that Radio Shack purchased 100
calculators at $1.00 each on January 2 and the current cost is $0.50
each on January 31. According to Propositions 1 and 2 we need to make
the following entry:
The arguments are the same: (1) the inventory account now reflects
the current cost of the units; and (2) the adjustment is to equity,
not income since the 100 units has remained constant and the only
thing that has changed is the incidental dollar expression of these
units. Upon sale of the units the entry is:
|Cost of Goods Sold
This is in compliance with Proposition 3 that the income is the change
in physical capital and this is determined by deducting the current
costs from revenues.
The pricing policy arguments are also applicable. Radio Shack can
place itself in the same physical capital position by basing its markup
on the current cost. That is, if the current cost had remained constant,
it would have earned $60 on a 60% markup which would have allowed
it to pay the equivalent of 60 units in dividends after provision
for replacing the 100 units. Basing the markup on current costs the
firm will earn $30 which will allow it to pay the equivalent of 60
units (-$30/$0.50) in dividends after provision for replacing the
100 units. Of course, Radio Shack would prefer to sell the units at
$1.60 each instead of $0.80 each but its competitors who have purchased
later at the decreased current cost will set their prices at $0.80
and therefore it will be forced to sell at $0.80 in order to meet
Exhibit VI displays these figures.
Measuring SUP in Dollars
Combined Financial Statements
|| Jan 1
|| Month of
| Feb 1
|Beginning Retained Earnings
|Cost of Goods Sold
| Net Income
| Less Dividends
|Change in Retained Earnings
|Ending Retained Earnings
When the dollar figures in Exhibit VI are divided by the current
cost of $0.50 the quotients will reveal that the firm started with
100 units and ended with the ability to replace 100 units and therefore
physical capital has been maintained. The income statement figures
are the same as they would have been if current cost had been constant
-- their equivalent units are exactly the same as those in Exhibit
V. Thus, in regard to SUP, the firm is the same in all respects.
But something is not quite right. The firm purchased units for $100,
sold them for $80 and yet it reported a $30 profit. That is a very
curious statement. The reason it is curious is that the well-offness
of the firm and the owners have diverged. In the increasing cost case
the firm was equally as much better-off, having earned the same SUP
profit in units, and the owners were more better-off having increased
their dividends. In this decreasing cost case the firm is equally
as much better-off, having earned the same SUP profit in units, but
the owners are worse off, having suffered a decrease in dividends.
The owners' ability to purchase consumer goods has been halved --
dividends decreased from $60 to $30 -- and they would find small comfort
in the fact that their ability to purchase calculators has been maintained.
That $30 will purchase the same number of calculators now as $6P would
have purchased before is irrelevant to the owners. From the owners'
point of view, there has been a $20 loss -- a decline from $100 to
$80 -- not a $30 profit. Therefore, owners would object to receiving
a distribution of profit, a dividend, when, from their point of view,
there was no profit to distribute.
The halving of dividends and the $20 loss is likely to incur the
wrath of owners. But when assessing management they will be forced
to give them good marks because the managers have achieved the objective
of maintaining physical capital. Note the contradiction of the owners
being unhappy with the results of management's actions and yet being
required to conclude that they have been good stewards since their
only controllable variable is the number of physical units and since
they have achieved the objective of ending with the same number as
they started with.
Even the managers are unhappy with themselves since they have not
achieved the minimum objective of maintaining share prices. (See point
(2) p. 000 supra.) Since the share price is the discounted value of
the dividend, the halving of the dividend results in the halving of
the share price. In order to maintain the same dividend and the same
share prices managers should double the physical capital, not
maintain it. But the need to double physical capital means that
the SUP profit must be retained and therefore SUP profit is not
distributable income. The owners must invest an additional $20 to
permit the doubling of physical capital as well as foregoing the dividends.
That required investment is an alternative explanation of the reason
that the owners think that the firm has suffered a $20 loss instead
of earning a $30 profit.
The cruelest blow comes when we find that our efforts to convince
the IRS to base the income tax on SUP profits have been successful
and therefore they levy a 50% tax on the $30 profit. This requires
the owners to invest $45 in order to maintain share prices and dividends
and therefore causes them to complain that the tax is confiscatory,
i.e., a tax on capital, not income.
The world has gone haywire. All of those wonderful advantages of
SUP measures are now catastrophes. And the only thing that has changed
is the direction of the price movements. All of the other facts and
assumptions in this decreasing cost case are exactly the same as in
the increasing cost case. (9)
The basic problem is that SUP measures of units do not coincide with
SUP measures of dollars. When prices are increasing the physical capital
measures enhance the owners' well-offness since SUP profits in units
remain constant but SUP profits in dollars increase which permits
a dividend increase. When prices are declining the opposite happens
-- SUP profits in units remain constant but SUP profits in dollars
decrease which requires a dividend decrease.
The magnitude of the divergence increases as the price declines.
Consider the extreme case of zero current cost. Although rare, there
are actual cases of zero prices. Recall the sharp decline in prices
of hula hoops after that fad had peaked. At the end of that fad hula
hoops could not be sold at a positive price -- they were free -- and
therefore wholesalers offered them to retailers at a zero current
cost. Consider a retailer who held an inventory of hula hoops at the
time the current cost went to zero. Since the retailer had previously
paid for the inventory and since it cannot sell that inventory, a
monetary measure would show a loss equal to the historical cost of
the inventory. But a physical measure will not show a loss since the
number of units has not changed. On the contrary, it will show a SUP
profit in units since it can now acquire, say, 1,000,000 additional
units -- its specific units purchasable has increased since it requires
no dollars to purchase at a zero price. Thus, with no further action,
by the sole fact that current cost has gone to zero, the retailer
would report a SUP profit of 1,000,000 units. The SUP profit in dollars
is zero since the multiplicand of the units is zero. The adjustment
of the asset to current cost with the offset taken to shareholders'
equity means that the firm started with zero dollar capital and ended
with zero dollar capital, hence a zero loss.
Such a report is not merely curious, it is absurd. If prices are
truly of no consequence, if physical units are the only thing of interest,
then we must allow any firm that traffics, in free goods to report
an infinite SUP profit in units and a zero SUP loss in dollars. The
reason such reports are absurd is that the owners invested dollars
with the expectation of receiving a dollar return in dividends. They
are worse off, having lost their original dollar investment and having
no prospect of receiving dollar dividends. Therefore, the owners would
certainly consider such reports to be absurd.
In summary, when prices are declining SUP measures are, at worst,
contradictory in that they permit the firm to show a profit when the
owners have suffered a loss and, at best, asymmetrical in that all
the advantages when prices increase are disadvantages when prices
decrease. The reason for adopting SUP measures was to avoid the evils
of NOD profits when prices are increasing but SUP profits produce
equally as many evils when prices are decreasing. Therefore, we must
reject SUP measures when prices are decreasing for the same reasons
that we reject NOD measures when prices are increasing.
I therefore conclude that SUP measures are not applicable when prices
decline. This excludes a fair number of firms. In the recent past
we have experienced substantial, albeit short-term, price decreases
(or "rebates") in television sets, automobiles, beef, poultry,
airframes, electronics and so forth. Even if inflation continues we
can expect price declines in other goods from time to time. For this
reason we can expect SUP measures to eventually become inapplicable
to most firms.
Different Firms. Arguments for current costing are invariably
couched in terms of merchandising or manufacturing firms. The thing
that characterizes such firms is that they operate in two markets:
the market in which they purchase is different from the market in
which they sell. For example, a retailer purchases in the wholesale
market and sells in the retail market. There is another class of firms,
called "trading firms," that purchase and sell in the same
Consider a trading firm, e.g., a mutual fund, that purchased 100
shares of General Motors on January 1 for $1.00 per share and sold
them on February 1 for $1.60 per share. This firm will report a zero
SUP profit for the month. To put it in terms of the balance sheet,
the firm started with $100 which would purchase 100 shares and it
ended with $160 which will purchase 100 shares. Thus, it is equally
as well off in physical capital since 100 shares is equal to 100 shares.
To put it in income statement terms, the revenues are $160 and the
current cost of goods sold is $160 and the difference is zero.
Now compare this firm to another one that purchased 100 shares of
General Electric on January 1 for $1.00 per share and sold them on
February 1 for $0.75 per share. For the same reasons as given above,
the firm will report a zero SUP profit for the month. Thus, the same
SUP profit will be reported for both firms despite the fact that one
had a price increase and the other a price decrease. The same holds
for the gold speculator who bought for $35 and sold for $700 per ounce
and for the silver speculator who bought for $50 and sold for $10
per ounce. Both will report a zero SUP profit.
In general, any firm that buys and sells in the same market
will always report a zero SUP profit for the obvious reason
that the selling price always equals the current cost of the identical
units. (10) The consequent
of a zero profit for all trading firms, for all time periods
for all price changes is absurd. There is no point in measuring
profits if one knows a priori that its magnitude will always be zero.
There is no point in reporting profits if the receivers know beforehand
that the reported amount will always be zero.
For these reasons we must conclude that SUP measures are not applicable
to trading firms. This excludes a large number of firms and an even
larger segment of the economy. The most apparent exclusions are those
firms whose major assets are marketable securities. There are a large
number of financial institutions who would thus be excluded. In addition,
SUP measures would not be applicable to the marketable securities
held by merchandising or manufacturing firms. Thus, there would be
inconsistencies in the method of accounting for different assets in
such firms. All commodity traders -- wheat, soybeans, oil, copper,
etc. -- would also be excluded, as well as all real estate traders.
Summary. The measurement of physical capital has severely
limited applicability. The measure is applicable only when prices
are increasing, the firm replaces identical units, and the firm buys
in one market and sells in another market. If the firm buys and sells
in the same market, the measure yields the absurd result of zero profits
for all firms. If the firm replaces with different units, serious
conceptual and practical problems arise. If the prices are decreasing,
the measure results in reporting a profit for the firm when the owners
have suffered a loss. Therefore, measuring physical capital is a special
case that cannot be generally applied to the measurement of wealth
Firms vs. Owners
The previous discussion of what attribute we should account
for raises the fundamental of who we should account for: should
we account for the firm or the owners of the firm? This choice is
sometimes phrased as the entity versus the proprietorship concept.(12)
It can be more simply and starkly phrased as: whose income and wealth
should we measure?
The concepts of income and wealth must refer to something quite
specific. This is indicated in ordinary language when we speak of
the wealth and income of the nation or the wealth and income
of General Motors or the wealth and income of Sterling. Obviously,
we cannot speak meaningfully of wealth and income unless we have a
specific object for the preposition of. Until we supply the
object for that preposition, we cannot begin to measure wealth and
income. The choice revealed here is the firm versus the owner.
The firm, at least in its corporate form, is known to be a fictitious
person. We can postulate that this fictitious person's maximand is
physical capital. Since this fictitious person is not a consumer,
we can conclude that ability to command consumer goods is irrelevant.
Since it does not consume the goods that it deals in, it has no declining
marginal utility for those goods. Its utility is a linear function
of the quantity of goods. The prices of those goods are not pertinent
except insofar as the purchase prices affect the quantity that it
can command when it holds cash. It is indifferent to price changes
of goods that it holds in inventory since those changes do not affect
the quantity. Its pertinent price index is the price relative of the
good that it deals in since it is only interested in its ability to
command that particular good.
By contrast, the owner is a real person, a consumer. For any particular
good, the marginal utility declines with the quantity owned. The owner
qua consumer will get less satisfaction from owning the second calculator
than he gets from owning the first; the hundredth calculator will
provide minimal marginal utility. Thus, the owner qua consumer would
be quite happy to exchange the hundredth calculator for a pound of
meat. The consumer prefers a variety of goods. The way to obtain a
variety of goods in a market economy is via exchange. The medium of
exchange is money, and the ratio of exchange is price. Thus, prices
and price changes are of utmost importance to owners.
Just as the firm is indifferent to price changes (under the assumed
maximand), the owner is indifferent to quantity changes given constant
value. It makes no difference to the owner whether the firm owns 100
units that can be sold for $1.00 each or 2 units that can be sold
for $50.00 each since both yield $100. The value is equal, the command
over the variety of other goods is equal, and therefore the owner
is indifferent to the quantities.
If the owner qua consumer owns a good and its selling price goes
up relative to the purchase prices of other goods, the owner is better
off because he can command a greater quantity of other goods,
and vice versa if the selling price of an owned good declines. By
extension, if the firm owns goods and the owner owns the firm, then
the owner is better off when the selling prices go up relative to
the purchase prices and is worse off when the selling prices go down.
It matters not to the owner whether the firm can replace the same
quantity as long as the value is maintained. Thus, the owner prefers
a monetary measure of the firm to a physical measure of the firm because
the monetary measure better reflects his ability to command a variety
of goods. Of course, if the price level, as opposed to the
specific price, changes, then we need to adjust the monetary
measure to more accurately reflect the changes in his ability to command
the variety of goods. But since it is a variety of goods that is of
interest, it is clear that the pertinent index is not the price relative
of the assets owned by the firm but rather a general index that reflects
the owner's normal purchases, e.g., the Consumer Price Index.
In other works I have argued that we ought to account for owners'
wealth and income. For this reason, among other reasons, I concluded
that the attribute that we should measure is Command Over Goods (COG)
as opposed to SUP, NOD and other alternatives. I mean by COG that
assets be stated at their exit values (immediate selling prices) and
adjusted by the Consumer Price Index. Since the interested reader
can pursue those arguments elsewhere,(13)
I will not repeat them here. In addition, the arguments for COG go
beyond the objective of this article. My primary objective here is
to try to clearly reveal that the fundamental question of what attribute
we should account for involves the equally fundamental question of
who we should account for. My secondary objective is that casting
the choices in stark relief will allow us to clearly see that although
it is possible to account for fictitious persons with assumed maximands
of physical units, the result of such an accounting so diverges from
accounting for real persons that real persons consider such results
to be absurd. Certainly no real person would ever agree that beginning
with $100 cash and ending with $80 cash results in a $30 profit. Since
we do in fact account for real persons, I conclude that we should
reject the physical capital concept and return to the financial capital
concept. (See FASB Exposure Draft, 59 for the same conclusion for
The charge that historical cost accounting produces false profits
has been with us for a very long time. The charge has merit in the
sense that it can be demonstrated that in times of increasing prices
if historical cost income is paid in dividends the firm cannot replace
an equal number of physical units absent additional financing. The
proposed remedy is to account for physical units, to adopt maintenance
of physical capital as the basis for measures of wealth and income.
Such physical measures are said to produce true profits.
Examination reveals that the proposal is to measure a different attribute,
not that one is false and the other true. Just as the measures of
the different attributes of length and weight can both be true, the
measures of the different attributes of NOD and SUP can both be true.
Therefore the criterion of truth will not permit a choice.
An appealing argument can be made for physical measures. It appears
that it solves all, or almost all, of the problems which vex accounting.
However, the apparent solutions will not tolerate careful examination.
The proffered solution to the problem of measuring value is to avoid
the problem by measuring physical units. But this solution is applicable
only when the units are identical. When units are different, as will
be the case in the majority of instances in the long run, measurement
of physical units is at least equally as difficult as measuring value.
Thus, the proffered solution to the measurement problem is the substitution
of one set of unsolved problems for another set of equally difficult
unsolved problems. The proffered solution for accounting for merchandising
and manufacturing firms results in reporting zero profits for all
trading firms for all time periods for all price changes, which consequent
is absurd. Thus, the solution to accounting for firms of one type
causes equally difficult problems in accounting for firms of another
type. The proffered solution to the problem of accounting for increasing
prices results in contradictory measures -- reporting a profit for
the firm and a loss for the owners -- when accounting for decreasing
prices. The advantages of SUP measures when prices are increasing
become disadvantages when prices are decreasing. The evils of SUP
measures when prices are decreasing are equally as bad as the evils
of NOD measures when prices are increasing.
The consideration of trading firms and decreasing prices in merchandising
and manufacturing firms reveals that the choice of the attribute to
be accounted for involves the choice of accounting for the firm versus
the owners. Since the firm is a fictitious person, it may be acceptable
to measure physical units when accounting for firms. Such accounting
effectively disregards prices and thereby reports a constant zero
profit for trading firms regardless of price movements and a positive
profit for merchandising and manufacturing firms that increase physical
units regardless of price decreases for those units. However, owners
are real persons to whom prices are of utmost importance and therefore
price changes cannot be disregarded. Owners of trading firms enjoy
a profit or suffer a loss when prices change and owners of merchandising
and manufacturing firms suffer a loss when selling prices are less
than original purchase prices. Such profits and losses are measures
of value changes which effectively disregard physical units. The alternatives
are to account for firms or owners and the choice that we make dictates
whether we choose a physical or value attribute. I choose owners and
And many false prophets shall rise, and shall deceive many. --
Physical capital proponents have correctly identified serious deficiencies
in historical cost accounting. We are indebted to them for pointing
out those deficiencies in particular and for helping us to peer through
the monetary veil in general. However, they have not identified the
correct remedy for the deficiencies. Their proffered solution is intuitively
appealing and has attracted many disciples but they have been deceived
by a superficial analysis. Further analysis reveals that physical
capital fails when its tacit assumptions are violated and that those
assumptions will in fact be violated. Therefore at the present time
the need to beware the false prophets of physical capital is equally
as pressing as the need to beware the false profits of historical
(1) FAS 33, in
fact, compromised the two positions. In brief, it changed the name
of "holding gains" to "increase in current cost"
(135) and then employed the financial capital concept by placing
it on the income statement but employed the physical capital concept
by not adding it to income (70). The idea is to allow users
to decide whether or not it should be an addend in the calculation
of income. Both dissenters point to the proliferation of income numbers
which reflects "the range of views [of] respondents" (p.
25) and "offers a smorgasbord of data [which has] something for
everybody" (p. 28).
This outcome confirms my long held view that FASB is a legislative
body and that the function of a legislature is to record the compromises
that it can effect among its constituencies. It also confirms my view
that such compromises do not achieve their intended objective: instead
of reaching a middle ground that satisfies everyone, it reaches a
muddle that dissatisfies everyone. I fear that this describes the
compromise adopted in FAS 33: even though it reflects the range of
views of all respondents, it dissatisfies all respondents.
The process of reaching a compromise resembles "the prisoners'
dilemma" which has caused my captive students to dub it "Sterling's
prisoners' dilemma." It goes like this: No group is fully satisfied
unless its position is adopted; each group is highly dissatisfied
if an opposing position is adopted; FASB records a compromise; ergo
no group is fully satisfied; ergo all groups are dissatisfied. The
point is that compromising is not a process of achieving satisfaction,
it is a process of lessening the level of dissatisfaction. Perhaps
this explains why everyone, even supporters of FASB, are critical
of FASB. An alternative to compromise is to adopt one of the opposing
positions, to "exercise strong leadership," which fully
satisfies the proponents of that position but which fully dissatisfies
the proponents of opposing positions. It makes strong allies and dedicated
enemies. This strategy requires sufficient power to enforce the adopted
position as well as sufficient power to gain immunity from retaliation
by the constituencies either at the ballot box or in the pocket book.
FASB has not been granted that power and therefore it must compromise
and suffer criticism from all.
Accountants at some times are masters of their fates: The fault, dear
colleague, is not in our FASB, but in ourselves, we are the
(2) For inventory
the proposal was to define the index, I, as p1/p0 where p0 is the
purchase price at date of purchase (i.e., historical cost) and p1
is the purchase price at date of sale (i.e., current cost) and then
"price level adjust" the historical cost figures by multiplying
by I. Obviously Ip0 = (p1/p0 p0 = p1. Thus, this kind of price level
adjustment is merely current costing by another name.
(3) Those who object
to specific units purchasable because it refers to "hypothetical,
not actual, transactions" can achieve the same results by shifting
the accounting period ahead by one day and having the firm repurchase
the units on February 2. This allows one to interpret SUP as specific
units purchased instead of purchasable. SUP Financial
Statements from January 2 to February 2 will contain exactly the same
figures as those in Exhibit II.
Many accountants criticize physical capital and other proposals on
grounds that hypothetical transactions are ipso facto illegitimate
or false and therefore should not be reported; others on grounds that
it is impossible to measure things that didn't actually happen. A
moment's reflection will reveal the error: scientists often measure
the potential instead of the actual. There is a whole class of scientific
concepts, called "dispositional terms," that end in "ble"
such as flexible, soluble and flammable. If we prohibit such concepts
in science, then we will artificially deprive ourselves of an enormous
number of useful scientific measurements. For example, we won't be
able to say "there are x Btus in that coal pile" both because
it is potential, not actual, energy and because it is flammable
or burnable, not burned. For the same reason that we shouldn't
prohibit such concepts in science, we shouldn't prohibit them in accounting.
Thus, purchasable is both legitimate and measurable and therefore
shouldn't be prohibited on those grounds.
(4) If there is
an objection to adjusting the January I cash from $100 to $125 one
can shift the accounting period forward by one day and adjust the
January 2 inventory from $100 to $125. Some prepublication readers
objected to adjusting cash but did not object to adjusting inventory.
I do not understand the distinction: to my mind there is no difference
between writing up cash to more than was actually in the till and
writing up inventory to more than it actually cost especially when
that cash is used to purchase and to measure the cost of the inventory.
(5) Physical capital
proponents assume, either implicitly or explicitly, that the firms
can be competitive under these conditions. Specifically, the assumptions
are: (1) the same number of units will be sold at the new selling
price as at the old selling price; (2) the new selling price is based
on the application of a constant markup rate to the current cost.
Revsine (p. 71n) is one of the few who explicitly recognizes the necessity
of the assumptions: "(1) operating levels are unchanged, and
(2) input costs and output prices move in parallel fashion."
(See also p. 153 et passim for a repetition of the same points in
different words.) In order to be consistent with the proponents I
am making the same assumptions throughout this article even though
I think they are likely to be violated more often than they arc met.
(6) They are particularly
enthusiastic in price regulated industries such as public utilities.
The managers and owners of such industries want to write up the assets
to current cost because the public utility commissions allow them
to earn a "fair rate of return" and the application of that
rate to an increased asset base permits higher selling prices. Since
the write up is taken to equity instead of income, the same result
is achieved if the public utility commission figures the return on
equity rather than on assets. Since the expenses deducted are the
higher current costs, the increased revenues from the increased selling
prices do not result in increased reported profits. They can still
report an acceptable profit to the public and the public utility commissions.
In addition, they and other non-regulated firms hope to eventually
convince taxing authorities to levy the income tax (but not the property
tax) on the basis of current costs.
This would make almost everybody happy. Managers would be happy because
they could increase their reported assets without an accompanying
sacrifice and they could increase their selling prices and revenues.
Owners would be happy because they could increase their reported equity
without an accompanying reported or taxed profit and they could increase
their dividends. Both managers and owners would be happy with the
prospect of paying lower income taxes. Accounting practitioners would
be happy because they have pleased their clients. Accounting academicians
would be happy because of the rarely received support of owners, managers,
and practitioners for their theoretical proposals. Perhaps consumers
and other taxpayers would not be happy with this system, but then
you cannot please everyone.
(7) A third possible
interpretation of FAS 33 would result in reporting a zero current
cost income. The board (¶126) decided to use "current cost
or lower recoverable amount" when replacement is not "worthwhile"
which is defined as when "recoverable amounts [selling price
for inventories] are lower than current costs." Applying the
illustration presented and the example discussed to the mini-maxi
case yields the following income statement:
|Cost of Goods Sold
|Income from continuing operations
|Cost at date of sale
|Cost at date of acquisition
|Increase in current cost
I am not sure that the illustration applies to the mini-maxi case
but if it does the confusion is compounded. The above cannot be interpreted
as SUP even though the objective is to measure SUP. The reader is
invited to try to cast the above in the form of Exhibits III and IV.
To put the problem in more familiar terms, the books do not balance.
The debit to inventory (or cost of goods sold) necessary to reflect
the recoverable amount" is $60 while the credit to shareholders'
equity necessary to reflect the "increase in current cost"
is $100. The debits do not equal the credits: the February 1 balance
sheet shows total assets of $160 and total equities of $200. The limited
objective of this article as well as limited space prohibits me from
exploring the perceived ambiguities of this application despite my
itch to do so. Since I cannot see how this application measures SUP,
it is irrelevant to the main thrust of this article.
(8) There is another
dimension to the problem of identical units. The above discussion
was concerned exclusively with making comparisons over time within
the same firm. We also need to make comparisons among firms at a point
in time. We would like to be able to compare the assets and income
of Macys to those of Gimbels. If Macys used SxUP and Gimbels
uses SnUP, it prohibits such comparisons for the same reasons
that switching from SxUP and SnUP within Macys
prohibits comparisons over time. It would be very difficult to formulate
a standard which would require Macys and Gimbels to use the same unit
because of differences in the timing of purchases and sales. Extension
to firms in different industries compounds the problem. How do we
compare Macys' assets to U.S. Steel's assets when the units are so
different? I mention this problem in a footnote because it seems to
me that the objective of physical capital proponents is to account
for each firm individually without regard to comparisons to other
firms. Since I do not think that they can achieve their chosen objective
when they encounter different units over time, I have not delved into
the problem of different units among firms.
(9) The critical
assumptions are those mentioned in footnote 5 supra, namely: (1) the
same number of units will be sold at the new selling price as at the
old; (2) the same markup rate is applied to the current cost as was
applied to historical cost.
(10) To be slightly
more technical, a price greater than zero will always result in reporting
a zero SUP profit. A zero price will allow the firm to increase its
physical capital and hence report a positive SUP profit in units.
A second technical assumption is that the firm does not hold cash.
If cash is held and prices increase (decrease) SUP measures could
show a loss (profit) because the units purchasable from the cash balance
decrease (increase). (For further discussion of this point see Sterling,
Enterprise Income, pp. 199-222.) This profit or loss only arises
when a balance sheet approach is taken in the determination of income.
The procedure of taking holding gains to equity does not show the
SUP profit or loss from holding cash. A third technical assumption
is zero transaction costs. If such costs were taken into account all
such firms would always report a loss equal to the transaction costs.
readers were of the view that a zero profit for all trading firms
was so obviously absurd that I should omit this section. They implied
that the fault was in my interpretation of physical capital rather
than a logical consequence of physical capital. Perhaps my interpretation
is faulty but a reexamination failed to reveal the flaw. On the contrary,
the reexamination provided some evidence that reporting a zero profit
for one market operations is precisely what physical capital proponents
propose. Note that merchandising and manufacturing firms operate in
two markets for their inventory, but they buy and sell plant and equipment
in the same market. Thus, the treatment of plant and equipment is
an instance of a one market operation. Some physical capital proponents
are quite explicit in their view that sales of plant and equipment
do not result in a profit or loss:
During the year, plant and equipment having a net book value in
the historical cost financial statements of $1,200,000 was sold
for $2,000,000. The sale proceeds are assumed to provide an appropriate
measure of the current cost of the assets at the date of sale. The
$800,000 gain on disposal reflected in the historical cost income
statement represents the realization of an increase in the current
cost of a productive asset and is eliminated from current cost income
of the enterprise. The amount of the increase in current cost is
disclosed as part of the change in the amount required to maintain
the operating capability of the enterprise. (CICA Exposure Draft
Thus, if one purchases plant and equipment for $x and then sells
it for $y, the procedure is to consider $y to be the current cost
and then deduct the current cost from the sale proceeds, i.e., deduct
$y from $y which yields zero in all cases. If $y-$x or if $y
-$x there is a zero profit because is not germane to SUP. Since it
presented a compromise, FAS 33 is less explicit but it seems clear
that those members of the Board who are physical capital proponents
would agree with the Canadian position of reporting zero profits for
all sales of plant and equipment. (See, e.g., FAS 33 ¶55, 124
The reasoning for plant and equipment in the quotation is the same
as that used in the text for marketable securities and commodities.
If readers find zero reported profits for one market operations to
be absurd, perhaps the fault lies in the concept of maintaining physical
(12) See Lee for
an insightful discussion of how neglecting this choice has confused
the U.K. standard setting process. I suspect that an examination of
the U.S. standard setting process would reveal a similar neglect and
that much of our difficulties could be traced to that neglect. As
Lee points out, the different concepts lead to different standards
and therefore vacillation in the choice of concepts leads to vacillation
in standards and confusion of the concepts leads to confused standards.
(13) See Toward
a Science of Accounting and Theory of the Measurement of Enterprise
Income for detailed analyses or "Relevant Financial Reporting
in an Age of Price Changes" and "Decision Oriented Financial
Accounting" for overviews.
Canadian Institute of Chartered Accountants (CICA), "Current
Cost Accounting," Exposure Draft (December 1979).
Edwards, E.D. and Bell, P.W., The Theory and Measurement Of
Business Income (University of California Press, 1961).
Financial Accounting Standards Board (FASB), "Financial Reporting
and Changing Prices," Exposure Draft (December 1978).
_____, Financial Reporting and Changing Prices, Statement
of Financial Accounting Standards No. 33 (September 1979).
Johnson, L.T. and Bell. P.W., "Current Replacement Costs:
A Qualified Opinion," Journal of Accountancy (November
1976), pp. 63 -70.
Lee, T.A., "The Accounting Entity Concept, Accounting Standards,
and Inflation Accounting," Accounting and Business Research,
No. 38 (Spring 1980), pp. 176-186.
Moonitz, M., "The Basic Postulates of Accounting," American
Institute of Certified Public Accountants, Accounting Research
Study 1 (1961).
Revsine, L., Replacement Cost Accounting (Prentice-Hall,
_____ and Weygandt, J.J., "Accounting for Inflation: The Controversy,"
Journal of Accountancy (October 1974), pp. 72-78.
Rosenfeld, P. "Reporting Subjunctive Gains and Losses,"
The Accounting Review (October 1969), pp. 788-797.
_____, "The Confusion Between Price-Level and Value Accounting,"
Journal of Accountancy (October 1972), pp. 56-62.
_____, "Current Replacement Value Accounting -- A Dead End,"
Journal of Accountancy (September 1975), pp. 63-73.
Samuelson, R.A., "Should Replacement -- Cost Changes be Included
in Income?" The Accounting Review (April 1980), pp.
Securities and Exchange Commission, "Notice of Adoption of
Amendments to Regulation S-X Requiring Disclosure of Certain Replacement
Cost Data," Accounting Series Release No. 190 (1976).
Sprouse, R.T. and Moonitz, M., "A Tentative Set of Broad Accounting
Principles for Business Enterprises," American Institute of
Certified Public Accountants, Accounting Research Study 3