CONCEPTS OF THE ENTITY THEORY

Thesis Ior the Degree of M. A.
MICHIGAN STATE UNIVERSITY

Stanley W. Gustafson
1958

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LIBRARY

Michigan Stain
University

 

CONCEPTS OF THE ENTITY THEORY

By

Stanley w. Gustafson

AN ABSTRACT

Submitted to the College of Business and Public Service
of Michigan State University of Agriculture and
Applied Science in partial fulfillment of
the requirements for the degree of

MASTER OF ARTS
Department of Accounting

1958

Approved ézgéééghm6*'

a

 

STANLEY w. GUSTAFSON ABSTRACT

There are presently many views of the business entity
theory. Many of the concepts are conflicting even though
they concern the same basic thought. This thesis will
attempt to determine what these differences are and where
they are in disagreement.

The paper was approached by studying the entity
theory of corporate enterprise as presented by writers in
fields of law, accounting, and by analyzing the position of
stockholders, creditors, and government within the frame-
work of an entity.

Three theories pertaining to the granting of auth-
ority to the corporation are recognized in law. They can
be reduced to two general views. The association theorists
hold that the stockholders associated together transfer to
the corporation the rights necessary to carry on the busi-
ness. This is basically a proprietary theory approach to
corporate organization. The fiction theorists hold that
the state gives the necessary authority to the corporation
as an impersonal being to carry on business activity. In
so doing the state does not recognize what already exists,
as proprietary theorists hold, but, following the entity
theory, the state created a new being separate and distinct
from its stockholders and other interested parties.

In the field of governmental taxation the entity

theorists claim there is no double tax because the income

STANLEY w. GUSTAFSON ABSTRACT
tax is levied on the corporation as a separate and distinct
being from the stockholders and other interested parties.

Management also plays an important role in the con-
cept of corporate entity theory. Although the typical
management team is looked upon as performing the management
function with authority delegated by the stockholders.

Some writers consider management as an entity in itself
rather than an employee of the stockholders: The part
owners previously played in the corporation has been taken
over by management. Therefore, the divorce of ownership
and control seems to indicate the entity theory or a
managerial approach to corporate enterprise theory.

The accountant, like the economist, is also divided
as to which of the two theories to follow. We shall here
be concerned with the various concepts of authors toward
the entity theory. The entity theory is a managerial
approach and the formula A = L + P is appropriate because
it demonstrates the oneness of the unit and shows the
obligation to all the claimants together. This is distin-
guished from the proprietary approach in that the proprie-
tary equation A - L = P demonstrates the stockholders as
the residual owners.

There are many conflicting ideas among authors in
various fields regarding the proprietary and entity

theories. If a more uniform approach to the ownership

STANLEY W. GUSTAFSON ABSTRACT
problem of the corporation would be adopted many of the

existing problems would automatically be resolved.

CONCEPTS OF THE ENTITY THEORY

by
Stanley w. Gustafson

A THESIS

Submitted to the College of Business and Public Service
of Michigan State University of Agriculture and
Applied Science in partial fulfillment of
the requirements for the degree of

MASTER OF ARTS

Department of Accounting

1958

ACKNOWLEDGMENTS

The writer wishes to express his sincere appreciation
to Professor B. C. Lemke for his suggestions and interest
in this paper. It was in his Theory Seminars that the
author's interest in theoretical accounting viewpoints were
cultivated.

Grateful acknowledgment is also due to Dr. R. F.
Salmonson whose suggestions and conferences proved inval-
uable in the development of this work.

The writer is also very much indebted to Professor
James Don Edwards for his constant support through graduate
school without which it is very doubtful that the present

writer could have continued his education.

DEDICATION

This work is dedicated to my wife, Joyce,
my family, Deborah, Cynthia, and Andrew, and
my parents, Palmer and Erma Gustafson, whose
constant support and encouragement, were re-

sponsible for any accomplishments that may

have been achieved.

TABLE OF CONTENTS

CHAPTER
I. PURPOSE, SCOPE, AND DEFINITIONS. . . .
Purpose.
Scope
Definitions . . . . . . . . . .
The entity theory via the accounting
equation.
The nature and definition of a theory.
II. LEGAL VIEWS OF THE ENTITY. . . .
The fiction theory of the entity .
The concession theory of the entity . .
The realistic theory of the entity.
The result of three views of the same
basic legal concept . . . . . . .
The accounting vs the legal entity. .
III. THE ENTITY THEORY AND ECONOMICS.
IV. ACCOUNTING VIEWS OF THE ENTITY .
The two theories of the accounting entity
Authorities who oppose the entity concept
A comparison of the two concepts of the
entity . . .
The personal entity . . . . .

The effect of separate personalities

PAGE

\ommw

IO

11

12
13
16

21

24

25
25
26

CHAPTER PAGE
The impersonal accounting entity. . . 29

Description of the impersonal entity . 30

V. RAMIFICATIONS OF THE ACCOUNTING ENTITY . . 35
General. . . . . . . . . . . . 35

The entity and net income. . . . . . 36

The source of profits . . . . . . 42

The definition of expense, costs,
and losses. . . . . . . . . . AA
Depreciation taken . . . . . . . A5
The distinction between operating and
non-operating items. . . . . . . A6
The entity's View of income to the
stockholders . . . . . . . . . A7

The net income of the entity carried

to retained income . . . . . . . 48
Income taxes . . . . . . . . . 50
Interest charged . . . . . . . . 53

The entity and valuation of assets. . . 57
Current assets. . . . . . . . . 57
Fixed assets . . . . . . . . . 58

The entity and the retained income account 64
The entity and dealings in its own stock. 69
The entity and financial statements . . 7A

The balance sheet. . . . . . . . 79

Consolidated financial statements . . 82

Vi

CHAPTER PAGE
'VI. OTHER VIEWS OF THE ENTITY. . . . . . . 89
Stockholders . . . . . . . . . . 89

Managers . . . . . . . . . . . 91

Creditors' view of the entity . . . . 93

VII. CONCLUSIONS . . . . . .‘ . . . . . 98.
Summation . . . . . . . . . . . 98
Speculation . . . . . . . . . . lOl

SELECTED BIBLIOGRAPHY . . . . . . . . . . . 104

TABLE

II.
III.
IV.
V.
VI.

LIST OF TABLES .

A Comparison of the Two Theories of
Accounting. . . . . . .
Entity Theory-~Statement of Income

Proprietory Theory--Statement of Income.

The Entity Theory-éBalance Sheet
Proprietary Theory-ABalance Sheet.

Recent Modification-~Balance Sheet .

PAGE

32
8O
81
83
84
85

CHAPTER I

PURPOSE, SCOPE, AND DEFINITIONS

Purpose
Accounting is the

". .art of recording, classifying,

."1 The

and summarizing . . . transactions and events
obvious question that immediately becomes material is
'"recording, classifying, and summarizing transactions for
whom"?

Traditionally there have been two so called'"theories"
of accounting. These two theories are based on two differ-
ent approaches that may be taken in viewing accounting
questions and propositions.2 One of these theories is
referred to as the'"proprietary theory"and the other is
generally called the "entity theory;" The differences

between the two theories are based for the most part on

(1) the nature of the business enterprise, (2) the

 

1Accounting Research Bulletin No. 58.

2. Recently a third theory has been suggested-4"The
Fund Theory of Accounting;" See William J. Vatter, The Fund
Theory of Accounting and Its Implications for Financial
ReportsTTChicago, IllinoiSIF The University of Chicago
Press, 1947), p. l.

 

 

viewpoint to be taken of the fundamental accounting
structure, and (3) relative emphasis to be placed on legal,
economic, and accounting structure.3

The purpose of this paper is to examine the "entity
theory" as it pertains to accountancy. In order to achieve
this goal it has been decided to explore the views of an
entity as followed by legal and accounting interests. It
is also purposed to include the views of other interested
groups such as, the stockholders, management, creditors,
et al.

After examining the entity theory consideration will
be given to some of the more important and controversial
ramifications of the theory. The conclusion will include
a review of the relative merits of the entity concept and

conclusions will be drawn based upon the material covered.

Scope

The research for this paper was done within the con-
fines of the Michigan State University Library, the Michigan
State Library, and the Lansing Public Library. It has
included opinions of Accounting, Legal, and Economic authors
writing in Journals, periodicals, books and case studies.

A good deal of the opinion of the present writer was obtained

 

3G. H. Newlove and S. Paul Garner Advanced Accounting
(Boston: D. 0. Heath and Company, 19515, p. 20. ‘

3

through various classes in accounting with special emphasis
upon the Accounting Theory Seminars offered at Michigan

State University.

Definitions

 

The term "concepts" shall refer to ideas, thoughts
and considerations of the entity as expressed by numerous
authors. It will be used to label these author's con-
ceptions of the entity. The simple definition of an entity
such as is found in Webster's dictionary will not suffice.
"En‘ti-ty--A being; esp., a thing which has reality and
distinctness of being either in fact or for thoughts; as,
to view the state as an entity."4 Naturally accounting
has special connotations ascribed to the word entity which
are not considered by an ordinary dictionary. But even
here the entity seems to have many definitions depending
on which entity you are speaking. For the purpose of this
paper the accounting equation will be used in the discussion
of the entity theory. The difference of opinion as to what

constitutes an entity in theory will be discussed.

The Entity Theory Via the Accounting Equation

 

There are two generally accepted methods of stating

the accounting equation. The reason for the difference in

 

4Merriam-Webster, Webster's New Collegiate Dictionary
(Springfield, Mass.: C. Merriam Company, 1953), p. 275.

 

stating the seemingly identical equation in two different
ways has been traditionally given as one of viewpoint. It
is this viewpoint that interests us here. The first point
of view is that A - L = P.5 The second point of View says
that the equation should read A = L + P or A = E.6

The former equation is viewed as the proprietorship
equation and the latter two equations are viewed as the
entity equations. Algebraically these formulas are iden-
tical. If we accept this statement then we are in a
dilemma. How can two formulas containing the same terms
and differing only in signs possibly result in two differ—
ent theories if the results are the same? Obviously they
are not the same, because, if they were we could not
possibly have two different theories.

It has been stated that the difference was one of
viewpoint. The point is this, the determination of profit
under proprietary theory involves the measurement of
proprietor net worth at two points in time; that is, the
change in investment oftflxaproprietor over time is estab-
lished by the measurement of net worth at the beginning

and the close of the period.7 However, corporate

 

5Terms for these symbols are as follows: A = Assets,
L = Liabilities, P = Proprietorship.

6The'"E" in this last method of stating the accounting
equation respresents the word "equities."

7Vatter, op. cit., p. 4.

proprietorship arises from numerous investments made at
various times. -The trouble arises because the prices paid
for corporate stocks on the investment market reflect
anticipations toward future activities of the corporation.8
Obviously it is nigh impossible for the accountant to apply
the proprietary theory to the corporation because he would
be required to reflect all the changes that occur in the
valuation of proprietorship.

This provides the necessary impetus for a different
theory of accounting. The entity theory takes up the gap
by imagining a separate entity entrusted with the powers
of the proprietor. This set of circumstances helps explain
why the two accounting equations reflect a difference in
viewpoint. The proprietary equation as stated, A — L = P,
suggests that the emphasis be placed on the determination
of the proprietor's interest since the usual treatment in
solving an equation is to solve for the right side of the
equal sign. The entity equation, A = L + P, suggests that
the emphasis be placed upon the combination of both the
creditors and the proprietors.

It has also been suggested that the system of double
entry suggests that the entity is automatically designed.

Double entry is based upon the concept of duality

of a single business property. This duality is
created through the separation of business properties

 

81bid., p. 5.

from their actual owners by placing these in the
possession of a fictious business entity which holds
and operates such properties under an assumed trust
arrangement between the business entity and the legal
owners. . . . Because of this separation of the prop-
erties from the legal owners, and because of the
varying legal status of these owners, it becomes nec-
essary for the fictitious business entity to account
for both the kinds of goods or things making up the
property in its possession and for thg kinds of owner-
ship claims attaching to those goods.

W. A. Paton and A. C. Littleton provide the definition
which will be used in understanding the entity theory.

The business undertaking is generally conceived of as
an entity or institution in its own right, separate and
distinct from the parties who furnish the funds, and

it has become almost axiomatic that the business
accounts and statements are those of the entity rather
than those oftflmaproprietor, partners, investors, or
other parties or groups concerned.

In way of contrast a definition of the proprietary
theory stated by Nelson B. Seidman is offered, ”the pro—
prietary concept views the corporation as having an agency

relationship With its stockholders."11

The Nature and Definition of a Theory

 

It may be said that the business of accounting theory
is to examine beliefs and customs critically, to clarify

and extend the best from experience, and to direct attention

 

9Warner H. Hord, "A Neglected Area of Accounting
Valuation," The Accounting Review, XVII (October, 1942),337.

 

13W. A. Paton and A. C; Littleton, An Introduction to
Corporate Accounting Standards (Columbus, Ohio: American
Accounting Association, 1940), p. 8.

 

 

llNelson B. Seidman, "The Determination of Stockholder
Income," The Accounting Review, XXXI (January, 1956), 64.

 

7
to the genesis and outcome of accounting work.12 Theory's
explanation may be an account definition that will help
us to know why a certain transaction fact must fall in one
category rather than another. Practice is fact and action:
theory consists of explanations and reasons.13

The following are some of the features or criteria

of good accounting theory:lLL

1. Theory should possess the attributes of clarity,
orderliness, purpose, and pattern.

2. Theory should be in harmony with observable and
acceptable (perhaps objective) factors and con-
ditions.

3. Theory should reflect impartiality and should
exclude individual bias.

4. Theory should reflect consistency in thinking.

5. Theory should contain some perspective for pur-
poses of formation.

It is clear that accounting theory cannot Justifiably

be said to consist of scientific explanations. There are

 

12A. C. Littleton, Structure of Accounting Theory,
American Accounting Association, Monograph No. 5 (Menasha,
Wisconsin: George Banta Publishing Company, 1953), p. 132.

 

 

13Ibid., p. 132.

lLAW. A. Paton, Recent Developments in Accounting
Theory and Practice (Cambridge, Mass.: Harvard University
Graduate School oT_Business Administration, Bureau of
Business Research, 1940), p. 1.

 

 

 

8
no immutable laws of accountancy comparable to the immutable
laws of Nature; there are no laboratory tests and controlled
experiments to yield data which may be set up as mathemat-
ical formulas to express existing relationships. Yet we
must grant that knowledge is involved in accountancy and
that significant relationships exist between the ideas

1
which constitute accounting knowledge. 5
In regard to the term "accounting theory" the
following definition is offered:
Accounting theory is a body of Accounting thoughts
which are logical and coherent and concerned with
the truth about basic economic facts. It accom-
plishes an understanding of the nature and purpose
of the phenomena involved and their effect and
functions.1
Thus the stage is laid for an investigation into

various concepts of the entity and a few of the ramifi-

cations of the accounting entity concept.

 

15Littleton, op. cit., p. 135.

l6Roland W. Funk, "Recent Developments in Accounting
Theory and Practice," The Accounting Review, XXV (July,

1950), 293.

 

CHAPTER II
LEGAL VIEWS.OF THE ENTITY

'The Fiction Theory of the Entity

 

There are three different theories of the separate

and distinct legal entity: the "fiction theory," the

and the "realistic theory."1 .The

"concession theory,"

theory of the fictitious legal person apparently originated

2

with Pope Innocent IV in the thirteenth century. The

doctrine was stated as the reason why corporate bodies or
"universitas" could not be punished or excommunicated-~they
had neither a soul nor a body and had being only in

H3

"abstracto. A leading proponent of this view was the

’ German law scholar, Savigny, who wrote in the early nine-
teenth century and adopted the theory based on his study

of early Roman law.“

 

1Robert T. Sprouse, "Legal Concepts of the Corporation,"
The Accounting Review, XXXIII (January, 1958), 38.

 

2Ibid., p. 38.

w

3John Dewey, Philosophy and Civilization (New York:
Minton, Balch, and Company, 193I5, pp. I52-159.

 

 

“A complete discussion of the Savigny theory may be
found in Frederick Hallis, Corporate Personality: A Stud
in Jurisprudence (London: Oxford University Press, 1930),
Part I, Chapter I.

 

 

13

The Concession Theory of the Entity

 

The "concession" theory states that a corporation can-
not arise out of a mere agreement between the members but
can exist only as a creature of the state, the result of
the gift of the franchise by the state. The concession
theory has also been expounded in Judical decisions. For
example, in a United States Supreme Court case, on the
grounds that the corporation might be incriminated, an
individual who was an officer of a corporation refused to
produce documentary evidence, consisting of correspondence,
records, and accounts of the corporation, which had been
subpoenaed by a grand Jury. Associate Justice Henry
Billings Brown delivered the opinion of the court:

. .the corporation is a creature of the State.
It is presumed to be incorporated for the benefit
of the public. It receives certain special privi-
leges and franchises, and holds them subject to
the laws of the state and the limitations of its
charter. Its powers are limited by law. It can
make no contract not authorized by its charter.
Its rights to act as a corporation are only preserved
to it so long as it obeys the laws of its creation.
There is a reserved right in the legislature to
investigate its contracts and find out whether it
has exceeded its powers. It would be a strange
anomaly to hold that a state, having chartered a
corporation to make use of certain franchises,
could not in the exercise of its sovereignty inquire
how these franchises have been employed, and whether
they had been abused, and demand the production of
the corporate books and papers for that purpose.

The "concession theory and fiction theory" are thus very
closely related. However, it is unfortunate that the courts

do not agree.

 

5Ha1e v. Henkel, 201, U.S., 74-75 (1936).

11

The Realistic Theory of the Entity

 

A third group argues that the corporate entity is
separate and distinct from the corporation stockholders and
officers but further insists that it is not artifical, but
natural, not fictitious, but real. It is maintained that
the corporation has a will of its own and a volition
identifiable from the individual volitions of the stock-
holders.6 It is believed that the real entity comes into
existence when the group comes into existence, and it does
not depend upon the state to create it even though its
legal status must necessarily depend upon recognition by
the state.7 The leading proponent of this View was another
German scholar of the law, Otto van Gierke, who lived near
the end of the nineteenth century.8 An example of the dis-
agreement of the courts can be found in a 1943 case heard
before the Supreme Court of Minnesota. The case involved
two Minnesota newspaper publishing companies. One had
transferred all of its assets to the other and the actual
printing of the old company's paper was transferred to the
purchasing publisher. Two employees brought suit for

severence pay based on the premise that the sale of the

 

6Sprouse, op. cit., p. 39.

7Ibid., p. 39.

8Otto Friedrich van Gierke, Political Theories pf the
Middle A'e, trans. Frederic William7Maitland (Cambridge:
Harvard niversity Press, 1900).

 

l2
assets constituted a dismissal. The defendant newspaper
defended on the ground that they continued in existence as
the holder of one-third of the stock of the purchasing com-
pany. The court deciding in favor of the employees, said:

Defendants position becomes untenable when we con-
sider that it and the new Star-Journal and Tribune
Company are distinct and separate entities. The
nature of a corporation is such that it is a entity
separate and distinct from the body of its stock-
holders. . . . It is not a fiction of the law but a
real legal unit possessing individuality and endowed
by the law with many of the attributes of persons.

. . . The transfer of interest was as complete and
effective as it would have been if the Tribune Com—
pany had received no stock in the Star-Journal
Company.

The Result of Three Views of the Same Basic Legal Concept
These three theories-~the fiction theory, the conces—

sion theory, and the reality theory--may be considered

together because they are in agreement as to the separate

0 It has been

and distinct nature of the legal entity.1
said that legal precedent may be found to support all sides
of a legal controversy. The propriety theory of accounting
requires that the corporation be viewed as an association
of individual owners; the entity theory of accounting is
based upon the notion that the existence of the corporation

is quite separate and distinct from the stockholders. These

 

9Mathews 23.2}: v. Minnesota Tribune Co., 10 NW (2d)
232 (1943)-

loSprouse, op. cit., p. 40.

13
two concepts of the corporation are diametrically opposed,
yet, each has found clear support in the law. Contrary
to what seems to be popular belief, reference to the experi-
ence of law is not apt to facilitate the evaluation of
accounting proposals the foundation for which rests upon
a particular concept of the corporation.11 The obvious
conclusion is that proposals of accounting theory must be

supported by something other than legal precedent.

The Accgupting Entity vs The Legal Entity

 

One of the important implications of the two theories
under discussion is concerned with the problem of whether
the accounts of all forms of business organization are to
be kept on a consistent basis. Are the same concepts of
capital, profit, cost, expense, periodic income, and loss
to be maintained in spite of legal authority to the con-
trary?

Accountants have upon many occasions commented upon
the good and bad influences of the law in its relationship
to accounting practices and procedures, but there seems to
12

be no great tendency to disregard legal points of View.

Nevertheless the fact remains that there is a definite

 

f

llIbid., pp.48—49.

l2Newlove and Garner, op. cit., p. 23.

l4
distinction between an accounting and a legal entity. The
purpose of accounting is different from that of law. H.

McCredie writing in The Accountipg_Review has recently said,

 

The separation into entities must be for the purpose
of accounting and thus the entities are accounting
entities. Difference in entities may be relevant for
other purpose, e.g. legal or economic, but may not

be relevant in accounting. This is seen when legal
entities and accounting entities are compared. A
child, that is a person under 21 years, can be a
different legal entity from an adult, yet for pur-
poses of accounting the age of the person concerned
is irrelevant. In like manner the mental capacity

or sex may determine a legal entity but in accounting
be immaterial.l '

Attempts to develop coordinated and integrated struc-
tures of accounting theory have been a step in the direction
of consistency.lLL

It is felt that accounting has a body of principles
and enough sound theory to stand by itself. This view has
been repeated on occasions. Walter G. Kell has said,

“Legal sanction is not necessary for accounting purposes.
The concept of an accounting entity should be determined

15

entirely upon accounting reasons."

 

l3H. McCredie, "The Theory and Practice of Accounting,"
The Accounting Review, April, 1957, p. 216.

14
See page 39 of this paper.

 

15Waiter G. Kell, Should the Accountin Entity be
Personified?," The Accounting Review, XXVIII January,

1953): 41-

 

15

The logic behind this statement is sound. The only
unfortunate consideration is the lack of authority to
effect this proposition. Until this question can be re-
solved between accountants and courts of law the legal

entity will prevail no matter what are its limitations or

inconsistencies.

CHAPTER III

THE ENTITY THEORY AND ECONOMICS

The theory of the business entity has had little sup-
port from the field of economics. The reason that so little
attention has been paid to this legal and accounting theory
is found in the purpose of the study of economics. In

their Principles pf Accounting, Kohler and Morrison state:

 

The economist has the social point of view. He
analyzes the individual transactions of particular
enterprises but does so principally in order to
determine the fundamental principles of markets,
prices, production, consumption, and distribution,
and their social consequences.

On the other hand, the accountant, employed by
the management of a business or its creditors,
analyzes business transactions with the express
object of interpreting their effect on the partic-
ular business enterprise.

Thus it is evident that the theory of the entity per
se has been given little attention by the economist while
at the same time it has received much attention from the
accountant and the law.

An expanded point of view between accounting and
economics is the topic of much discussion currently and the

foreseeable future could see this circumstance greatly

 

1Eric L. Kohler and Paul L. Morrison, Principles 93
Accounting (New York: The McGraw-Hill Book Company, Inc.,
1931), p. 10.

 

 

17
changed. The accountant has seemed to broaden his horizon
and is more likely today to regard his work more from the
social viewpoint than he did in the past.2 W. A. Paton
has provided a broader concept of accounting which defines
the primary function of accounting:

In a broad sense accounting has one primary function:
facilitating the administration of economic activity.
This function has two closely related phases: (1)
measuring and arraying economic data; (2) communi-
cating the results of this process to interested
parties.3

In the same way the broadening of the field of econ—
omics has included developments which do not have the social
viewpoint but which are oriented to the individual and the
individual business enterprise.

Of all the arguments which accountants and economists
have entered probably the one which has remained without
solution is the determination of income. Since it is the
income statement which seems to be the primary aim of the
entity concept it might be well to point out some of the
differences here. Robert B. Bangs has singled out some of
the differences.

In the main the differences between the net income

boundary lines drawn by accountants and economists
may be said to result from:

1. Differences regarding the functional relation-
ship between the recognition of gross revenues.

 

2Morton Becker (ed.), Handbook pf Modern Accounting
Theory (New York: Prentice-Hall, Inc., 1955), p. 44.

 

 

3W. A. Paton, Essentials pf Accounting (New York:
The Macmillan Company, 1949), p. l.

 

 

18

2. Differences as to the relative importance to
be assigned to original and replacement costs.

3. Differences in the treatment of capital gains
and losses.

4. Differences in point of view as to the proper
horizon of expectations which should be reflected in
current income figures. If these differences are
borne in mind adjustments of any of the main income
concepts of economics or accounting to the remaining
ones presents no insoluble problem. It is important,
however, to see clearly each step in passing from
the income concept of modern economic theory to those
recognized in accounting practices. When the precise
nature of the required adjustments is made plain to
both economists and accountants, economic analysis
and accounting practifie should gain equally in clarity
and logical alliance.

John B. Canning attempting to achieve the same sort
of analysis has the following things to say about accounting
theories and economics;

The economist is concerned with the incomes of persons,
of groups of persons, of society in general. The
accountant is concerned with income as it emerges in
enterprise relations; he undertakes to show to whom
the beneficial interest in income runs, but he is not
concerned with the use to which the beneficiary turns
his income. The ultimate concern of the economist

is with the subjective appreciation of income; objec-
tive valuations of income are to him indexes of that
appreciation. The accountant is not, as an accountant,
concerned with subjective appreciations at all; his
care is devoted to determining a proper dollar measure.
Nor has the accountant anything to do with the problem
of distribution. To be sure, he endeavors to express
correctly the amounts paid to each person and the
reasons for the payment; but whether a particular pay-
ment is an element of what the economist calls rent,

or interest, or wages, or profits, is a proper matter
of indifference to him. He has concluded when he cor-
rectly describes the class of enterprise operation or
transaction that has given rise to the payment. The

 

“Robert B. Bangs, "The Definition and Measurement of
Income," The Accounting Review, XV (September, 1940), 371.

 

l9

great preponderance of enterprise income, nowadays,
inures in the first instance to corporations. The
accounting for income of corporations differs in no
essential way, so far as accounting for the income
of enterprises in which the proprietor is a natural
person or persons. The economist, on the other
hand, is not ultimately concerned with the incomes
of corporations at all; he is interested in the
matter of what natural persons benefit by these
incomes (and who is injured by them), as well as
the question of when the benefits become available
to natural persons.

With social income, as the economist conceives it,
the accountant has nothing to do. Whether the income
arising out of enterprise affairs is associated wholly
with a concomitant beneficial service rendered to
society or is totally divorced from such a service,
is not for him to inquire into. Whether a profit is a
wholly speculative one gained at the expense of another,
losing speculator, or is a profit arising from the sale
of goods that allow a large consumer's surplus to all
purchasers, is no concern to the accountant.

The accountant pays little attention to what the
economists call "real income" and "final objective
income," in contradistinction to money income. Indeed,
in what accountants explicitly refer to as income or
expense, they pay no attention to changes in purchasing
power at all; their income is dollar income. The amount
of this dollar income, as will readily be seen, is not
affected by changes in the purchasing power of money,
but as we shall see, the influence is due to the
methods of valuation employed and not to a conscious
attempt to set up a "purchasing-power accountancy;"

Much of the trouble between accountants and economists
has been the failure of each to properly agree on the term

‘"income,"

however, strangely enough this shortcoming is not
only a difficulty between the two but also a difficulty

within the professions themselves. As has already been

 

v

5John B. Canning, The Economics of Accountancy (New

*

York: The Ronald Press Company, 1929), p. 91.

 

 

20
stated, accountants using the entity concept view "net
income" differently than do those accountants who hold the
proprietary concept. Obviously then it will take an
agreement within the profession of accountancy as to what
is net income before any agreement between accounting and
economics may be reached, if an agreement is necessary at
all. Since the accountant and economist seem to have dif-
ferent goals it is questionable if agreement is useful for
any other purpose than understanding.

The entity theory as has been portrayed seems to
have little to do with the economic theories usually pre-
sented and hence economic theory will receive little future

reference in this work.

CHAPTER IV
ACCOUNTING VIEWS OF THE ENTITY

The Two Theories of the Accounting Entity

 

There are two common methods of viewing the funda-
mental accounting structure. One is the "entity theory”
and the other is often called the "proprietary theory."
The difference between the two is a difference in viewpoint.

In the entity theory the proprietor, regardless of
how closely he may be identified with the business, regards
himself as a person separate and distinct from the business.

In the proprietary theory this is not true. It
becomes necessary, therefore, to adopt another explanation
of the proprietor's account. This is done by assuming that
bookkeeping represents an accounting for his own property.

In one case the central figure is the entity, and in
the other the central figure is the proprietor.

The ancient writers used the entity convention in the
same way as the moderns. Paciolo's explanation quoted by
Peragallo,l mentions that

a branch of a store is in effect the debtor of the
proprietor, so that the latter may debit the store

 

lEdward Pera allo, Origin and Evolution p£_Double
Entry Bookkeeping New York: American Institute PuElishing
C00, InCo, 5 p0 99'

 

22

for all he takes out of it, just as he would do in
the case of a debtor who contracted a debt and sub-
sequently paid it.

A. C. Littleton has stated the essentials of the
entity convention in the following words:2

Thus to the reporting (record-keeping) person the
account with a “proprietor was not different in
principle from an account with a lender; in fact, a
lender often took the form of a proprietor to avoid
the appearance of being a lender. To the active
manager (in contrast to the silent partner) of the
trading ventures so common in the fifteenth century,
there were two elements present: (a) kinds of prop-
erty for which he was accountable and (b) sources of
property to which he was accountable; profit was but
an additional "indebtedness" to the sources of the
property in use.

Porter and Fiske3 define profit from the entity view-
point as "a proprietary claim to an excess of values
received over values given up in exchange." Their use of
the word "claim" in this connection clearly intimates the

adoption of the entity viewpoint.

4

MacFarland and Ayars take a more definite stand,

saying that: '"The concept of an enterprise as a unit or
undertaking for which financial records should be classified
and kept, summarized, and interpreted is absolutely essen-

tial in accounting."

 

fiw —v

 

2A. c. Littleton, Accountin Evolution to 1900 (New
York: American Institute Pu EIIs HIngCoT , Inc., I933),p. 194.

3G. H. Porter and W. P. Fiske, Accounting_(New York.
Henry Holt & Company, 1939), p. 37.

 

4G. A. MacFarland and R. D. Ayars, AccounpinggFunda-
mentals (New York: McGraw-Hill Book Company, Inc., 1936),
p. l.

 

23
In discussing the two theories, Husband and Thomas5
assert:

Accountants may be divided into two groups: (1)
those who claim that the proprietor owns all of the
assets but owes certain amounts to creditors, and
(2) those who hold that both liabilities and pro-
prietorship are merely claims against the assets.
The former point of view, which is the older of the
wo, is held by the greater number.

W. A. Paton mentions,

Another important result of using the enterprise as
the focus of attention has been the development of
the going concern assumption, with derivative
stressing of the interpretation of business operation
as a continuing stream of activity. The increasing
consideration being given to income measurement and
reporting is presumably a manifestation of the influ-
ence gf the business-enterprise, managerial point of
View.

F. Sewell Bray supports this view ten years later by
saying:

. we cannot begin to shape accounts until we have
conceived either the unit of organized activity, or
the transactor whose history and condition we wish
to measure and portray in financial terms. Plainly
we must look at the transactions which take place
under one roof, whatever that roof may be. I there-
fore regard the entity notion of theory as primary.
.7It may be a firm, a person, or an isolationist;

 

5G. R. Husband and D. E. Thomas, Principles 9;
Accounting (New York: McGraw-Hill Book Company, Inc.,

1936), p.

 

 

6G. 0. May, Sir Laurence Halsey, and W. A. Paton,
Dickinson Lectures in Accounting (Cambridge, Mass.: Harvard
University”Press, 1933), p. 90.

 

 

7F. Sewell Bray, Four Essays ip Accounting Theory
(New York: Oxford University Press, 1953), p. 4.

 

24

Authorities Who Oppose the Entity Concept

 

8 took a decided

A recognized early authority, Sprague
stand against the entity theory While recognizing certain
of its advantages, he failed to see that "it justifies the
inclusion of proprietorship among the liabilities;" He
thought that the entity did'"not stand in the same relation
to its proprietors or its capitalists as to its 'other'
liabilities. It would seem more appropriate to say that it
is 'owned by' than 'owes' the proprietors."

Elsewhere9 he said:

Thus the right-hand side of the balance sheet is
entirely composed of claims against or rights over
the left-hand side. "Is it not then true" it will be
askt sic,”that the right-hand side is entirely com-
posed o liabilities?" The answer to this is that
the rights of others, or the liabilities, differ
materially from the rights of the proprietor.

Henry Rand Hatfield has consistently used the pro-
prietary rather than the entity approach in his writings.

Legal dislike of the overextension of the entity con-
cept is reflected by such comments as this one of Judge
Oliver B. Dickinson.10

The relation of corporation and shareholder is not

the relation of debtor and creditor and creditor

otherwise, perhaps, than in a secondary and remote
sense.

 

8Charles E. Sprague, The Philoso h of Accounts (New
York: The Ronald Press Company, 1913), p "49.

9ibid., p. 46.
loQuoted by Robert H. Montgomery in "Dealings in

Treasury Stock," The Journal of Accountancy, August, 1938,
p. 112.

 

 

25
Canningll discussed the entity theory as follows:
The accounts, it is said, constitute an accounting by
this entity to all who have commercial and financial
relations with it. Some writers even profess that,
in the case of corporate enterprise, the entity may
be more than a figure of speech. This they do by
making the blunder of identifying the shareholders
as the proprietor and making the corporation corres-
pond to the entity.
With this somewhat vague and obscure point we procede
with the two different views of the accounting entity, the

personal entity and the impersonal entity.

A Comparison of the Two Concepts of the Entity
The personal entipy. The entity convention has pre-

 

determined the design of the accounting mechanism, especially
in the area of what net profit is. The actual origin of the
entity theory seems to have its beginning with the double
entry system of bookkeeping. The origin of double entry
bookkeeping is not definitely known. Some are of the

opinion that double entry bookkeeping may have originated

from the relationship between the Roman slave and his master.
12

II

Peragallo suggests no more than that double entry: ' may

have been present in embryonic form in the Roman bookkeeping

 

system."
11 .
Canning, op. cit., p. 55.
12

Peragallo, op. cit., p. 3.

26
Whether this is true is immaterial. As an explanation
it is completely logical and satisfactory in that the entity

is best described by using the slave illustration. A story

 

told by A. C. Littleton in Accountipg_Evolution pp 1292
explains that it was beneath the dignity of a Roman patri-
cian to engage in trade. Buying, selling, and other prac-
tical matters of business were considered unfitting for
the free citizen, who found it necessary to engage in
business by proxy. Since many of the Roman slaves were
well educated and very able, many‘citizens advanced money
to them which the slaves in turn would loan at interest.
The slave himself could own no property,therefore, property
merely changed hands but not ownership.

When the business transactions were at all complex,
it was necessary for the slave to keep records. This re-
lationship of master and slave to keep records introduced
a certain pattern of accounting which has persisted to

the present day.

The effect of separate personalities. Because the
slave was a person separate and distinct from the master,
the record he kept was his own personal record. It reflected
the slave's viewpoint toward the business in general.
Despite the personal viewpoint of his record keeping, the
slave was owned and controlled by the master.

These two characteristics of (1) ownership and con-

trol, and (2) separate personality and viewpoint, represent

27

so logical and satisfying an explanation of the accounting
mechanism as to justify the adoption of the entity conven-
tion regardless of positive historical proof.

It is convenient to think that the slave had no power
of initiative, no opportunity to exercise independent busi-
ness judgment; that he merely followed directions.

Because the slave was a human being with a personality
and a viewpoint of his own, he could not fail to regard his
master as a person separate and distinct from himself. His
records, therefore, were the kind of records any man might
make in dealing with another.

When the master advanced him a certain sum of money,
it was natural for the slave to adopt a record keeping view-
point that he personally owed that amount to his master.
When the master demanded the return of the money, it was
equally as natural for the slave to consider that he was
'"paying the money back."

Any increase in the amount of funds held by him repre-
sented an increase in the amount of his debt to his master,
any decrease represented a decrease in the amount of his
debt to the master.

The relationship between a Roman slave and his master
suggests that charge and discharge concept upon which all
double entry accounting rests. The slave is charged with
certain funds advanced to him by his master and also with

any increase of those funds due to prudent investment. He

28
is discharged of his responsibilities by repaying funds to
his master. The slave neither benefits nor suffers because
of increases or decreases in the funds transferred to him.

In this master-slave relationship are two basic
accounting concepts: (1) that of keeping records in terms
of money rather than physical things, and (2) that of an
entity as separate and distinct from proprietorship. This
is in essence is the personal viewpoint of the entity. Our
modern day corporation can be looked upon as having the
same basic structure as the Roman slave in relation to its

stockholders or its master.

The impersonal accounting:entity. The only thing
lacking in our conceiving our modern day corporation as a
personal entity is its complete lack of personal attributes.
Chief Justice Marshall defined the corporation as,

. an artificial being, invisible, intangible,

and existing only in contemplation of law. Being

the mere creature of law, it possesses only those

properties which the charter of its creation con-

fers upon it either expressly or as incidental to

its very existence.
Sole proprietorships and partnerships may also be regarded
in the same manner. Accounting records have been written
from the viewpoint of an entity until now it has become an
accounting convention. The value of this concept cannot

be emphasized enough. Professor William A. Paton as

 

13Dartmouth College Case, 4 Wheaton, 518 (1819)

Dickinson Lecturer at Harvard University in 1940 said,
"I have always been a supporter of the business—entity con—
cept of accounting and have no desire to 'change my tune'

at this late date."lu

In particular, this conception has
been useful as a means of fostering the development of the
managerial point of view, and thus encouraging progress in
the field of cost accounting. In this area there has been
a truly remarkable advance, and it is difficult to see how
the narrow limits of proprietary theory can be reconciled
to the broader field of enterprise accounting.

Of all the names that have been applied to this im-

personal, artificial, intangible being, the word "entity"

seems to be most appropriate. Such substitutes as ”economic

.II II

unit, "accounting unit," "enterprise, and "the business,
have been used.

'"The business" seems to be the one most often applied.
A person commonly speaks of his business as being something
separate and distinct from himself. If he is engaged in
more than one business he speaks of each as though it were
a separate entity.

The term "accounting entity" would probably be most
desirable because it clearly indicates that the artificial
person is conceived in relation to accounting records.

"Entity" is preferred to "unit" because the word

”unit" is commonly employed in other meanings in such

phrases as "unit costs“ or "a unit of production."

 

w vv V

14W. A. Paton, Dickinson Lectures in Accounting (Cam-
bridge, Mass. : Harvard University Press "I943), prl.

 

 

33

Description of the impersonal entity. The entity has

 

been described as being as soulless and automatic as a slot
machine. Its activities are in response to the demands of
proprietorship either direct or through appointed managers.
lkiandof itself the entity makes no profits, suffers no
losses, is incapable of enjoyment, sorrow, greed, or other
human emotions which influence those who direct it.

There are various types of business entities, for
example, an association or club differs materially from a
bank or a steel corporation. However, there is no accounting
difference between them. The only prerequisite for an
entity is a double-entry set of books. If a social club
maintains no double entry record then no accounting entity
exists although the association may be conceived as some
other sort of entity.

In business organizations having departments or
plants each possessing its own set of double entry records
then each is a separate accounting entity.

Some authorities are willing to accept the entity
convention for corporations but not partnerships; or accept
the entity convention for large or moderate-sized business
units but not for small ones, or where the management and
proprietorship are so merged that it seems ridiculous to
think of the business as having an artificial personality.

W. A. Paton has pointed out that: '"A blind insistence

on the independence of the business entity in such situations

31
is bound to lead to unreasonable conclusions."15 Elsewhere
he insisted that: '"To conceive of the business of the pop
vendor at a football game as having any distinct existence,
to take an extreme example, would obviously be quite
fantastic.“l6

His objection to the entity convention here may be
due to an assumption that the pop vendor must himself recog-
nize the entity convention. This, of course, is not true.
The entity exists only in relation to double entry book-
keeping(as has been said elsewhere) and most students learn
the rules and practices of bookkeeping without ever having
considered the artificial person whose viewpoint determines
the accounting equation.

This is the impersonal entity as it now is recognized
by accounting authors.

Table I will show a comparison of the Entity and
Proprietary theories of accounting. The material displayed
was taken from the advanced accounting text of G. H. Newlove
and S. P. Garner who explain that the chart was adopted in
part from A. C. Littleton, Stephen Gilman, and G. R.

Husband.

 

 

15W. A. Paton, Accountfgg Theor (New York: The
Ronald Press Company,'l9227, p. 476.

l6I-bi-d-., p. 477.

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nSHQV mnmzzo on» mo unoEuno>cH

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lands on» p50 wcfiznano EH o>auom
Amanawdeefi one 2888 89:
mpgoaoaa Ham mo HmpOp Bun one

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undue mafipqsooom

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humans mo Goapmaom

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omomnsm hpdfiaam

n3 _ .mnOHuonooe enema mnoH

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no ma nonoem hufiofioofinom .ooneH
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:onoonH pen: ooHHeo on on unnoe<

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nH panmmn mnoanenono neon

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we .ooneunOQEH peonw no nfi eonnom

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non no mneoxe ne on ono nnopofinn
Iona no nonoHnQonn enpnxwhpfipno

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one npomne one pmnfiewe nEHeHo one

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neMOmnH mnemneoon nofiuonapnao oz

anocee nuance

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nfl momeononfl .mH pen» .mpemme
pen nH noneonona one enamonm

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oepenenon one oenamoo mannenm
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nonpefiuneneMMHo Hnmoneo

anoone aneuoannonm

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on me mpfiofioofinen
mo oonepnoneH .OH

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eonnon no oonepnoneH .m

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moneaaaneaa no onenez .s

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noozpon nonponapmam .0

4
3 ii I
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one mueOo no nonpenoomnn Aev

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Inen .nonfle> noonn ooneaem Aev

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noenonxo no nonueaom .HH

CHAPTER V
RAMIFICATIONS OF THE ACCOUNTING ENTITY

General

There are many items, classifications, and analyses
of transactions which are common to both the proprietary
and entity concepts of accounting. For example, it is
common for even the proprietary theoriests to limit their
accounting function to only the business transactions of
the proprietor. This would suggest that there is an ele-
ment of the entity theory within the proprietary concept.
It is also equally as common for the entity theorist to
speak of the stockholders as "proprietors" and to compute
their "net worth" in the entity. This would suggest an
element of the proprietary theory within the entity con-
cept. Yet it is also common for both theorists to claim
that they follow one or the other of the concepts reli-
giously. Unfortunately, this is not true.

Were it true, accounting would have clear-cut prob-
lems. But the situation today suggests that bits of each
theory are found interwoven within each other. Because of
this fact the areas of greatest controversy between the two
concepts have been chosen for investigation. In this
section on ramifications net income, retained income, and

items relating to both shall be discussed.

36

Liabilities, assets, and the proprietors section in
the balance sheet are topics that will receive attention
from both points of view. The emphasis will be placed on
the entity concept. A chart has been provided comparing
the two theories and the main distinctions are displayed
there.1 Thus the internal differences of these broad
classes will be the aim of our investigation.

Since the corporation has been visualized as having
perpetual life it is evident that the earning of income is
more important than the stating of the value of assets on
a particular date. This paper shall, therefore, begin with
the subject of net income in the discussion of the ramifi-

cations of the entity theory.

The Entity and Net Income
It has been suggested that either the proprietarycn°
the entity theory of accounting ”provides a satisfying
explanation of profit if adopted consistently.“2
Much disagreement exists today with respect to income
expenses, losses, and surplus because of a shifting of view-

point between the entity and the proprietary theory. Appar-

ently much of this is caused by the attempt to follow the

 

vvwv v fi

1
See page 32 of this paper.

2Stephen Gilman, Accounting Concepts pf Profit (New
York: The Ronald Press C61, 1939), p. 598.

 

37
law in respect to accounting for the single proprietorship,
partnership, and the corporation. However, the dilemma is

3

certainly not anything new. Gilman wrote in 1939,

It is believed that much present day altercation

and disagreement with respect to income, cests,

expenses, losses, and surplus are traceable to an

unconscious swaying between these viewpoints.
Speculating upon the reasons for such a misfortune in the
same area was George R. Husband“ who wrote,

It is somewhat ironic that the lawyers, who have done

more than anyone else to publicize and popularize

the entity convention, do not themselves apply it

consistently to all forms of proprietorship, nor in

fact are they always consistant in applying it to

the corporation.

No matter how much disagreement there is among accoun-

tants or what the reasons are for that disagreement the
fact remains that a net income figure must be arrived at.
The problem then is simply one of "how do we get it?" It
is at this point that a further complication sets in: the
traditional accounting period! Without an accounting period
the calculation of profits would be made easy since no
real profit could be recognized until the business entity
had terminated. This statement is not without support.
5

Kester said, "Profits are accurately and definitely

 

fifi fivw vvfi

3Ibid., p. 598.

4George R Husband, "The Corporate-Entity Fiction and
Accoznting Theory," The Accounting Review, September, 1938,
p. 2 10 fi fi V V—'

5Roy B. Kester, Advanced Accounting_(New York: The
Ronald Press Company, 1933), p. 494."

 

38
determinable only when a business ceases and is liquidated.
Profits of a going concern are always estimates;" Canning6
repeats this stand from the viewpoint of both accounting
and economics while listing four points of which we quote
number four: '"All measures of income for periods less
than the total lapse of time during a relationship or less
than the duration of an enterprise are approximate indexes
only;"

This will lead us to two of our present day conventions;
the going concern convention and the accounting period
convention, both of which concern the accounting entity and
net income. Actually it could be said that the corporate
entity is responsible for these conventions because of
its perpetual life feature. Since the corporation seems
to be the most likely prospect to which the entity theory
is applied this paper shall discuss net income in respect
to that form of business enterprise.

In June 1936 the Executive Committee of the American
Accounting Association issued a "Tentative Statement of
Accounting Principles Affecting Corporate Reports." This
was followed, in 1941, by a revision entitled, "Accounting

Principles Underlying Corporate Financial Statements,‘ and

in 1948, by a second revision entitled "Accounting Concepts

 

6
Canning, op. cit., pp.l23-124.

39

and Standards Underlying Corporation Financial Statements.“7

In 1955, the committee was assigned the task of revising
the 1948 Statement. In October 1957 the latest revision

was published in that month's issue of The Accoupting

 

Review. The Association sought to gain consistency in ac-
counting reporting for the corporate form of business.
Since this statement was revised and issued in 1957 it is
just now coming under attack by accounting authors in

articles appearing in The Accpunting Review.8 The attempt

 

to issue this form of statement is nevertheless an aid to
the adoption of a consistent method of accounting for net
income. The only thing that is now lacking is an attempt
to adopt either the entity or the proprietary point of view.
Until the committee does this there will be no agreement
and criticisms will continue to appear.

The entity concept views the net income of any form
of business as an increase in the liability (non-legal)

that the entity owes to the corporate stockholders.

 

7Committee on Accounting Concepts and Standards,
'"Accounting and Reporting Standards for Corporate Financial
Statements 1957 Revision," The Accounting Review, XXXII
(October, 1957), 540. " I V

 

8See George J. Staubus, "Comments on 'Accounting and
Reporting Standards for Corporate Finantial Statement--l 57
Revision';" The Accounting Review, XXXIII (January, 1958?,
11; Arthur CT—Eelley,i“Commefits on the 1957 Revision of
Corporate Accounting and Reporting Standards," The Accounting
Review, XXXIII (April, 1958), 214; and Eldon S.—HEndriksen,
j"The Treatment of Income Taxes by the 1957 AAA Statement,"
The Accounting Review, XXXIII (April, 1958), 216.

 

 

 

40

Perhaps it might be better to say that the entity, as
an entity does not make either a profit or a loss. This
should help clear the path for accountants by eliminating
the necessity for arguing that corporate income and stock-
holder income are,or are not the same.

The opposite viewpoint is taken in the 1957 revision
of Corporate Standard of Reporting as stated by the Com-
mittee on Concepts and Standards. They seem to view the
entity as making an income of its own by stating,

The realized net income of an enterprise measures
its effectiveness as an operating unit and is the
change in its net assets arising out of (a) the
excess or deficiency of revenue compared with re-
lated expired cost and (b) other gains or losses
to the enterprise from sales, exchanges, or other
conversions of assets. Interest charges,income
taxes, and true profit-sharing distributions are
not determinants of enterprise net income.

In determining net income to shareholders, how-
ever, interest charges, income taxes, profit-sharing
distributions, and credits or charges arising from
such events as forgiveness of indgbtedness and con-
tributions are properly included.

Since the term "net income to shareholders" is used to
describe the increase of indebtedness owed by the entity to
the stockholder we will for the purpose of this paper recog-
nize the use of the term as suggested by the Committee. The
view as stated constitutes a definite shifting of viewpoint
between the entity and proprietary theories.

Actually there is much disagreement as to the words

”income,"'"earnings,"'"revenue,"'"profits," and'"gains:"

 

9Committee on Accounting Concepts and Standards,
op. cit., p. 540.

41
It is believed that W. A. Paton's concept of revenue is the
one which has the outstanding merit of common acceptance:LO

Paton says,

The most conservative criterion of income is the
receipt of cash. Cash--meaning thereby any generally
recognized medium of exchange--can be used to purchase
any desired commodity or service whatsoever, provided
the same is available on the market, to retire obli-
gations, to pay taxes, to pay dividends, to liquidate
terminable proprietary investment, etc. Cash is the
asset excellent. The receipt of cash for product, con-
sequentIy,’furnishes the ultimate test of revenue
realization. From this standpoint the cash sale and
the collection of cash following the so-called credit
sale constitute the principal income transactions,

the important occasions for entries in the revenue
account.

This concept indicated the desirability of applying

the word "income" to gross sales less appropriate deductions

therefrom. In another work Paton says,

Net business income or net revenue may be defined
as the amount by which the equities of the pro-
prietors and all others entitled to participate in
income are Enhanced as a result of successful
operation.1

A vivid description of net income is given by A. C.

Littleton quoted from an early issue of the Harvard Business

 

Review. He says,

Net income then is shaped, as it were, by the inter-
action of the blades of a pair of shears--revenue as
one, cost as the other. It is obvious that both
blades are necessary to produce the result, but their

 

Vfiv

lOGilman, op. cit., p. 605.
llPaton, Accounting Theory, op, cit., p. 444.

l2Paton, Essentials pf Accounting, pp. cit., p. 82.

42
action is not necessarily equal. One blade may rest
passively on the table while the other blade moves
actively up and down under the power of the operator‘s
fingers. The passive blade represents revenue-~the
element under little direct managerial control; the
active blade represents costs--the element under con-
siderable managerial control in the process of pro-
ducing net income.13

In the various explanations, certain elements are
usually present. Foremost is the general insistence that
income should be realized before it properly can be recog-
nized by the accountant. With few exceptions, it should be
the result of completed transactions with outsiders.14

From the standpoint of the Income Statement the fol-
lowing items are the point of most controversy between the
two theories of accounting.

1. The source of profits.

. The definition of expenses, costs,‘and losses.

Depreciation taken.

-I:'UU ID

The distinction between operating and non-
operating items.

The following paragraphs shall attempt to explain

these items from the entity concept.

 

Tpeppource of profits. The entity views profits as
coming from operating revenue only. A distinction is made

between those increments which are the result of

 

V -v

13A. C. Littleton, "Business Profits as a Legal Basis
fgr Dividends," Harvard Business Review, XVI, No. l (1937),
5 . "' I II '—“""_
14

 

Gilman, op. cit., p. 608.

extraordinary transactions.

Normally the accountant has three alternatives when
he is confronted with an item of revenue. He may credit
it to the sales account, other income, or directly to the
retained income account. The first question is whether
the increment of income is applicable to the current
accounting period. If it is applicable then the decision
is whether to credit it to Sales or Other Income. The
second question is whether the item falls in one of the
following categories:

1. Operating recurring losses or gains

2. Operating non-recurring losses or gains

3. Non-operating recurring losses or gains

4. Non-operating non-recurring losses or gains

If it is decided that any item of income or expense
falls in one of these categories then it will be properly
included in this period's profit and loss computation. But
if it is decided that the item should not be shown as a loss
or gain of the current period, it has been customary to
debit or credit it directly to the retained income. Log-
ically this is an excellent method of correcting errors of
prior periods. If fits the entity concept and the mechanics
of bookkeeping to perfection. The unfortunate result is its
effect on the Retained Income Account based on the View
taken of Retained Income by the accountant. This topic
does not concern the computation of profit or net income,

however, and will be explored later in this paper.

44
Suffice it to say at this point that the procedure
just outlined for determination of items to be included in
the computation of net income is based on the concept of
the accounting entity. The only prerequisite at this point
is that the item must be an operating increment based upon
the skillful operations of the corporation during the

current accounting period.

Tpefldefinitipn of expensesgpeosts, and losses. Another

Wfi‘

 

point of controversy is the problem of distinguishing beteeen
expenses, losses, and costs. In the 1957 revision of Stan—
dards for Reporting on Corporate Financial Statements the
Committee on Concepts and Standards separated expenses from
losses and vice versa thus providing for a clear under-
standing and definition of expense and loss. The new
separation would be outlined as follows:
A. Expired costs
1. Expenses
2. Losses
Expired costs are defined as those costs which will
benefit no future period. Expenses are looked upon as being
recurring operating costs which enhance the revenue stream.
Losses are non-recurring cost which do not enhance the
revenue stream. The only word which remains undefined is
the word'"cost;"
Unfortunately definitions of the word cost are as

various as there are accountants to think them up. For the

a

\II

purposes of this discussion a definition provided by Paton
and Littleton will be used. '"Broadly defined, cost is the
amount of bargained-price of goods or services received or
of securities issued in transactions between independent
parties."15 Expired costs then fall in line to represent
those costs which are assigned to this period's revenue
and the remaining assets represent the remaining costs.
This unfortunately would be criticised on the basis that
cash could never be a cost, however, if we approach the
view from the entity concept this does not seem so imposs-
ible. The entity could receive cash only by exchanging an
asset for it or by incurring a liability and since it must
account to its proprietors for any increase in assets, cash

could be considered a cost waiting to be expired.

Depreciation taken. The basic concept of depreci-

 

ation from the entity point of view visualizes depreciation
as a cost-spreading technique which is essential in the
determination of periodic reported net income. The pro-
prietary concept since it places emphasis upon the balance
sheet attempts to relate depreciation to the net worth of
the proprietor.

There is some conflict between two vieWpoints if the

depreciation taken is thought of in any other terms than

 

15Paton and Littleton, An Introduction pp Cprpcrate

m

Accounting Standards, 9p. cit., p[ 24.

 

 

46
historical-cost-of-depreciated-assets dollars. The latter
definition is held by only a comparatively few proprietary
theorists.l6 The entity view maintains that the cost of
the asset be spread over the number of accounting periods
that the asset is expected to service. This method is
logical from the standpoint of the entity theory since it

is of no concern to the entity where its capital is obtained.

The dips pine t ion be tween ’oper a t ing and nonfppe-rat‘ing
322mg, A considerable amount of literature is available
on operating and non-operating gains and losses. The point
of greatest controversy among accountants and a number of
lay groups including the government, is whether to include
both in the income statement. In the entity theory the
road is very clear. There should be no such argument. All
items which are the result of skillful operation of the
business should appear on the income statement. All items
which do not reflect the skillful action of corporate
management should not appear.

This would suggest that any operating item would
appear as a matter of necessity since the current operation
of the business is involved. The non—operating item would
appear on the income statement only if it concerned the
action of management and would appear elsewhere if it was

an unusual item which did not reflect management's current

lllllll

 

16Newlove and Garner, op. cit., p. 25.

47
operating results. The only problem that exists here is
the determination between that which is usual and that

which is unusual.17

The entityjs View of income to the stockholderp, In

 

the earliest discussion of the slave approach to under-
standing the entity in relation to the stockholders it was
said that the slave ”accounts” to the proprietors for every
increase and decrease in the assets of the business. Accoun-
tants have generally followed this approach in their
thinking about the entity. The question which arises is
again one of viewpoint. How does the accountant view income
earned by the entity? Is it to be considered capital or
is it to be considered income held for the stockholders?
The following quote from G. R. Husband seems to state
the present thinking of accountants:
Paton and Littleton state the earnings of the enter-
prise constitute earnings to the stockholders at the
moment of their realization. Earnings retained in
the business out of such income are thus part of
the stockholders' capital investment. No dividend--
cash or stock--is therefore interpreted as income:
cash dividends are merely a withdrawal of capital
from the business; stock dividends are merely formal
notice that previous income which was capitalized is
converted to stock form.
He continues, commenting upon the accountant's position with

respect to these views by saying,

It is to be noted that as a general matter the
accountant treats cash dividends in a manner consistent

 

17Ibid., p. 432.

A8
with the separate entity theory. The treatment
which is generally accorded stock dividends, on
the other hand, is more in ling with the aggregation
of individuals point of View.1
The entity looks upon its stockholders as creditors,
therefore, accounting should reflect this point of view in
its reporting for the entity. This willhmean that all dis-
tribution of entity income is a distribution of capital to
the shareholder.
In order to be absolutely consistent the accountant
must then consider either a cash dividend or a stock divi—
dend as being a distribution of capital to the entity share-
holder. This position is not now accepted by the profession
although it has been suggested many times. G. R. Husband,
in the work just cited, echoed this opinion saying,
A distribution of assets which reduces the corporate
entity's equity in itself (a cash dividend) or the
transferring of part of the corporate entity's equity
in itself to the stockholders (a stock dividend)
transfers to the stockholders something which was not
theirs previously and therefore constitutes income
to the stockholders.1
From the pure entity theory any distribution to the

shareholder should be treated as a distribution of capital.

The logic of this rule in entity theory is well seated.

The net income of the entity carried to retained income.
The area which lies between (1) net profit before other in-

. come and charges, and (2) net profit for the period carried to

 

18Husband, op. cit., p. 555. 19Ibid.

49
retained income, has clearly been noted as a perennial battle
ground of accounting. Disagreement as to what kinds of
items should or should not be included there-in results
from certain divergent viewpoints which may never be recon-
oiled.20

This statement appeared in an accounting book written
almost twenty years ago. The prediction that this state-
ment made is still valid today. While criticizing The 1957
Revision of Corporate Accounting and Reporting Standards,
Arthur C. Kelley says,21

there is one conclusion that is most surprising

and disappointing, and could only cause confusion
in the minds of the readers of corporate accounting
statements. This is the statement with regard to
Part IV, Income Determination, as follows: "Interest
charges, income taxes, and true profit sharing dis-
tributions are not determinants of enterprise net
income;"

He continues,
Even if this distinction were logical, which is not
the case, what on earth would be the usefulness to
the readers of financial statements?

The thinking of accountants seems to be divided
between two views. There are those who favor surplus
entries for certain losses, gains, or adjustments which the

other group considers to be essential elements in the com-

putation of net profit.

 

20Gilman, op. cit., p. 584.

21Kelley, op. cit., p. 214.

50

The two most common items located between the entity's
net income and the Retained Income Account are interest and
income taxes. It is difficult to establish exactly how the
entity should view these items. Should they be considered
expenses of the entity or should they be simply reductions
of the entity's liability to its proprietors? According to
the Committee on Concepts and Standards of the American
Accounting Association these items should be excluded from
the determination of the enterprise net income but included
in the determination of stockholder income. Apparently the
Committee has taken the stand that interest and income

taxes are not expenses to the entity.

Income tapes. Arguments against the inclusion of

wfiv

 

income taxes in the expense category and in favor of
treating them.as distributions of income can be classified
as one of three types: (1) it is argued that income taxes
are not like other expenses as they are not payable if
there is no income and no measurable amount-of goods and
services are received and consumed in the realization of
income, (2) it is argued that the government is a "partner"
or "beneficiary" with special interests in the business,
and (3) the assumption is made that the incidence of the
tax is on the stockholders and therefore it is a kind of

withholding tax paid to the government for the stockholders?2

 

a wwww

2
Hendriksen, op. cit., p. 217.

51
Authors have held for some time that there is no
such device as double taxation in the corporate form of
business. The entity is taxed as a separate person.
Naturally, the proprietary theorists hold to the contrary.
Whether there is a double tax or not appears to simply
be a matter of viewpoint. In defense of the entity concept
of taxes we cite G. R. Husband who says,'"It is a common—
place that amounts which private individuals pay out of
their income to other individuals are taxable to both."23
Commenting on the proprietary view of taxes Husband states,
Profit in the long run can fall neither below the
minimum nor rise above the maximum necessary to
attract capital in given risk situations. "Normal
Profits" will prevail. It must be believed that
corporate shareholders, will be influenced by
profits after taxes. Thus the corporation will
collect its taxes paid by increasing the price or
paying lower wages.
From this point of view the corporation acts only
as a collection agency and to this extent even from
the association of individfials view there is no
double taxation existing.2
Since no double taxation seems to exist it is cer-
tainly logical to say that the income tax levied against
a corporation is definitely an expense and, therefore,
should be included as a deduction to arrive at net income

before the "other charges" section of the income statement.

In arguing against treatment of income taxes as a profit

 

23Husband, op. cit., p. 555.

24Tbid., p. 556.

52
distribution Robert Sprouse says,
In measuring the income of a corporation, income
taxes must be deducted. The state and federal govern-
ments are not corporate investors. Accordingly, the
number of dollars which could be distributed to cor-
porate equityholders without imparing their cumulative
investment is clearly adversely affected by the im-
position of income taxes.
W. A. Paton supports the same view by stating,
Taxes are a somewhat anomalous element in business
finance. Taxes are coerced; their amount is largely
outside the control of management; they do not follow
price trends closely; they can hardly be said to
measure the value of services received and utilized
in production. Taxes, therefore, are not strictly
congruous with ordinary expenses. However, taxes
are clearly a deduction from or charge against 6
revenues in the process of determining net income.2
Both of these views reflect proprietary thinking even
though they are made under the disguise of accounting for
the corporate entity. The one statement that seems to
refute their arguments is that "if there are no profits
there are no income taxes." Therefore, income taxes as
viewed by the entity must be a distribution of profits and,
therefore, deductible after net income and not in arriving
at it.
It cannot be decided here which of the viewpoints
will prevail. The Committee on Concepts and Standards has
taken the lead and it will take time to decide whether

accountants will accept the Committee‘s decision in order

 

W

25Robert T. Sprouse, "The Significance of the Concept
of the Corporation in Accounting Analysis," The Accountipg
Review, XXXII (July, 1957), 372.

26Paton, Essentials pvaccounting, op. cit., p. 99.

 

53

to provide more consistent accounting financial statements.
It should be added that this expression is in no way de-
fending the committee's position concerning accounting
theory. The writer will agree that the present tentative
standards for corporate reporting is a regression instead
of a step forward, however, it is also well established
that consistency is more important than error. Consequently
for the sake of consistency the profession of accounting
might do itself a service if the statement could be adopted
until it can be improved. Most of the concepts contained
in the statement are agreeable to accountants, therefore,
in the best interests of the profession the controversial
areas should be temporarily set aside. As soon as consis-
tency is then obtained the arguments may continue. This
would provide the profession with a statement to correct.
Presently, there is no such statement universally and
consistently applied and, therefore, no such statement to

correct.

Interest charges. The other item which usually

 

appears between the income statement and the surplus state-
ment is interest expense. (Interest income also appears

but there seems to be little controversy regarding this
method of classification.) It is probable that the majority
of accountants consider interest payments as an item of
non-operating expense and would in the classification of

the income statement include it under the capiton of "Other

54
Charges." The Executive Committee of the American Accounting

27'"theamount of interest

Association has disagreed saying,
incurred on borrowed money, including debt discount and
expense properly amortized during the year" should be in—
cluded in the operations section of the income statement.
However, the Committee on Concepts and Standards of the
American Accounting Association recently states that inter-
est charges are not to be recognized as expired costs and
would now seem to refute this former stand taken by the
Association.28
Sanders, Hatfield, and Moore mention the matter of

interest under the general heading of'"non-operating
section" in the following words:

It is desirable to show the division of earnings of

the business as an economic enterprise between those

who furnish capital on loan at fixed interest rates

and the stockholders who take the residuary gain or

loss. Interest will thus be a separate charge

against earnings.2

W. A. Paton states,
Interest charges--a return on creditor capital should

be treated as a contractual distribution of income
rather than as operating expense. Otherwise the fact

 

v—‘fi —v

27Executive Committee of the American Accounting

Association,‘ ‘A Tentative Statement of Accounting Principles
Affecting Corporate Reporting," The Accounting Review, XI

(June, 1936), 189.

28
p. 540.

 

Committee on Concepts and Standards, 0 . cit.,‘

'A Statement of Accounting_Principles New York: American
Institute ”of Accountants, 19387, p 3

 

 

29T. H. Sanders, H. R. Hatfieldg and v. A. Moore,

55

of the concern's earning power as an economical
entity, aside from specific capital structure, is
obscured, and comparisons between different enter-
prises and between periods 38 the same enterprise
tend to be improperly made.

Arthur C. Kelley taking the opposite viewpoint says,
Interest charges likewise are costs of borrowing
funds needed by the enterprise and it is hard to
see any useful purpose accomplished by considering
interest charges as distribution of income to the
creditors, as some economists view them, instead of
as cost in determining net income, which is the
universal business concept.

Roy B. Kester agrees with Paton that for purposes of
intercompany comparisons interest should be treated as a
distribution of profits but from the strictly theoretical
standpoint he believes that, "these items [interest income
and expense, cash discount items, bad debts, collection
losses, et cetera] are as much elements of normal operation

as the selling and administrative item.“32

The classic argument against considering interest as
a distribution of income finds its support intne lack of
profits that the entity may experience. The question arises
as to what is the nature of interest payments made to bond-

holders during a period of no income? If there is an earned

 

—v V v vi Vi

30W. A. Paton, Advanced Accounting (New York: The
Macmillan Company, 1941), p. 22.

 

31Kelley, op. cit., p. 215.
32Kester, op. cit., p. 73.

56
surplus then it is possible to consider interest as being
a distribution of prior period's income. But what if there
is no retained income? Commenting upon this possible situation
R. T. Sprouse mentions, "It cannot be a return of the bond—
holders' investment because their investment equity is not
reduced by these payments; it is the investment of the com-
mon shareholders which is diminished.“33
Also an advocate of the deduction of interest in
determining net income Sprouse defends his position by
saying,
Interest charges represent a valid economic cost of
the use of the capital supplied by bondholders to
the incorporated social institution. In determining
the dollar amount which could have been distributed
to society, perhaps in the form of lower prices or
improved product, without impairing the cumulative
number of dollars invested in the corporate insti-
tution, interest charges must be dedficted on an
equal footing with wages and rents.3
Clearly from the entity‘s point of view, since we have
defined it as being an entity separate and distinct, it
should consider interest charges as payments to capital
providers and thus payable out of any income that is pro-
duced as a result of the entity‘s caiital and not as a
charge necessary to earn that profit or income.
However, from the viewpoint of the accountant this
whole area between the income statement and earned surplus

or retained earnings seems to depend entirely upon the

definition of cost.

 

33Sprouse, op. cit., p. 373. 3L‘Ibid.

57

If cost is defined as cost to the stockholders (or
the proprietary theory) then these items should be consid-
ered as deductions in arriving at net income. If cost is
defined as cost to the business (or the entity theory)
then these items should be considered as distributions of
income. From the entity viewpoint it is assumed that there
are three factors of all production: resources, labor,
and capital. It might seem strange that only capital is
considered to receive a distribution of income. However,

wages paid to labor or prices paid for resources are con-

 

sidered costs in producing income and not distribution pi
income. This treatment is given to wages and rents because
the entity is interested in accountibility to its capital
providers. This, of course, has the unfortunate ring of

requiring two different definitions of the term'"cost;"

The Entity and the Valuation of Assets

 

Current assets. Current assets have been defined as

 

those assets which will expire within one accounting period.
Consequently neither the entity or the proprietary theorist
have much difficulty in establishing a value for these
classifications. -Most generally the current asset fairly
represents the current market price because of its rela-
tivelysnort life. The main complication is the valuing of
inventory, receivables, or marketable securities; items
which could conceivable distort the balance sheet if the

entity was in a period of rapidly rising or falling prices.

58
Normally very little difficulty is encountered

valuing current assets and consequently we shall spend very
little time exploring the area. Any current asset reflected
in the profit and loss statement, or income statement if
you prefer, as an expired cost will be wholely eliminated
in this accounting period and, therefore, it is expected
that either the entity or the proprietary theorist would
agree that the valuation of this classification would
closely represent the current market value of the particular

asset.

Fixedassets. In business entities, as contrasted

 

with some governmental or charitable institutions, the cost
of fixed assets must be allocated to those accounting
periods benefiting from their use. This view has been ex-
pressed by eminent authorities so often that it is not nec-
essary to support it at any great length. Perry Mason,

whose Princhlesqu PubliciUpilpr,Dgpreciation is generally

 

 

recognized as authoritive, says:

The asset account may well be thought of as a deferred
charge to operations or a prepaid operating expense,
similar in a great many respects to prepaid rent or
insurance-~charged to the operations of the period

in which the service is rendered.

Sanders, Hatfield, and Moore assert that fixed assets,

 

VV v

 

35Perry Mason, Principles 2: Public—Utility De reci-
ation (Chicago: American Accdunting Associfition, I937),

57713

59
'"are really in the nature of a deferred charge against the
future income they will help to produce."36
The concept of fixed asset cost as equivalent to a
deferred charge is helpful in that it tends to simplify
problems of valuation. Obviously, no theoretical advantage
can be gained by valuing a deferred charge at any other
figure than actual cost, if such a cost is obtainable.
Attempts have been made to exclude land from this
deferred charge concept. It is commonly held that land
does not depreciate. Generally this is true, however, in
the best interest of consistency it is well to think of
land as representing a deferred charge over an indeter-
minable or perpetual term. It is true that land is
ordinarily not subject to wear and tear or that type of
depreciation which results solely from the passage of time.
The convention that fixed asset value is in the
nature of a deferred charge, and that such a deferred
charge should be established at cost whenever cost prac-
ticably can be determined, represents the simple theory
underlying valuation and depreciation by the business entity.
In practice this reasonably simple concept can be
greatly modified by various complicating factors. Important
problems of fixed asset valuation arise when purchases are

made with securities, when one asset is exchanged for

 

36Sanders, Hatfield, and Moore, op. cit., p. 59.

60
another asset, when assets must be reconstructed or reno-
vated, or when fixed assets are donated.

When fixed assets are acquired in exchange for the
purchaser‘s own securities, the initial value of such assets
is measured by the offsetting liability created by the
issuance of such securities. From the entity viewpoint, no
other basis of fixed asset valuation is logical despite the
fact that the property for which a million dollars par value
of common stock is exchanged could have been bought for
$500,000.00 cash. Such knowledge has upset those accoun-
tants who have placed great emphasis upon the balance
sheet values. To the entity, however, the creation of a
million dollars in liabilities, even though it is a capital
stock liability, is equivalent for record purposes to the
disbursement of a million dollars in cash. The million
dollar valuation of the fixed asset is not only logical
but, from the standpoint of the entity, imperative. The
fact that the practical conservative accountant would dis-
agree violently with this concept is, of course, important
from all points of view except that of developing a logical
pattern of accounting theory.

The exchange of one asset for another involves a prob-
lem which is substantially the same as the valuation problem
of trade-ins so often noted in the purchase of office equip-
ment, automobiles, or household devices.

From the income tax viewpoint, subject to certain

exceptions, no profit or loss arises from exchanges of

61

like for like.37 From the accounting point of view, auth-

orities are not in agreement. The Accountants' Handbook

 

mentions the following:
An exchange of a farm for an apartment building, for
example, is equivalent to the sale of a farm and the
purchase of the city property with the proceeds.
From a commercial point of view the book value of
the farm in such case should be closed out and the
fair market value of the other property [what it
would have cost on a cash or equivalent basigé sub-
stituted, the difference being gain or loss.

Roy B. Kester takes the opposite point of view stating
that, "the trading of a fixed asset for another fixed asset
is not ordinarily to be considered a profit-making ex-
change.“39 He explains the common practice of applying the
'"profit" resulting from an exchange as a credit against
the newly acquired fixed asset on the theory that the item
is of the nature of a "discount from the stated price;" He
adds, however, that if a newly acquired fixed asset has a
definite list price or if the price would not have been
lower on a cash or other outright purchase basis, an
accounting profit has been made. Illustrating this point

by the exchange of an old truck for a new one, the profit,

he asserts,

 

v fivv

37Prentice-Hall, Federal Income Tax Course (New York:
PrenticeéHall, Inc, 19577, p, 1401, I

38Accountants'_Handbook (New York: The Ronald Press
Company, 1934), p. 489.

 

 

39Kester, op. cit., p. 493.

62
is explainable either as the result of a good

bargain or because the old truck had been depre-

ciated too rapidly, some portion of its reserve

ipppugp peégg-ifiafiéy a reserve of profits at the

Problems arise when a fixed asset is partially or
entirely constructed by the employees of a company. The
actual direct labor and material costs are, of course,
transferred to and became a part of the fixed asset val-
uation. The difficulty of valuation has to do with the
allocation of overhead expense to the construction work.
The problem of equitable overhead distribution is a dif—
ficult one.

Too great a proportion of overhead transferred to
the construction work may reduce the balance assignable to
regular manufacturing so greatly as to affect manufacturing
costs and hence affect inventory values and both gross and
net profits. Many authorities content that no overhead
expense should be applied to construction work unless there
has been an actual increase in the overhead expense due
directly to the work.

These authorities would add to such asset accounts
only the overhead that can be attributed directly to the
work done on the plant or equipment. However, this is
the practical approach rather than the theoretical approach.

The entity theorist is more concerned with spreading the

cost of fixed assets over the number of periods to which

 

vfiv vvw *v V

“01bid., p. 335.

63
that asset contributes its service. The only practical
matters which prevent this theoretical approach are the
unwillingness of corporation managers to maintain the
records necessary to make such an allocation and the recog-
nition that this practice might easily open the door to
undetectible schemes of manipulating profit and loss state-
ments.

Occasionally fixed assets are donated to an enter-
prise. Often such a donation is made by a group of business
men seeking to attract new industries to a town. Sometimes
the donation is conditional, but if an outright donation
is made, it is common practice to have the property ap-
praised, the offsetting credit not being considered a profit
but rather as a type of capital surplus. The amount of
profit actually made is not determinable and will not be
determinable except through depreciation or until the
donated property is sold. The valuation established for
such donated property is, therefore, only a symbol for
record keeping purposes and the credit representing an
indeterminate amount of unrealized income is correspondingly
a symbol.

Thus it may be said that the valuation established
for the entity has a definite significance as a symbol
of chargeability and as a deferred charge to future income
but otherwise has 1itt1e or no meaning. The fact that '"cost"

is used as the basis of accountibility should not be strange

64
in light of our earlier discussion of the entity from the
standpoint of the slave. Actually it would be of no con-
cern to the entity if a fixed asset were valued at any price
since it simply increases its liability to the equityholders.
However, from the standpoint of the entity and the depre-
ciation charge it makes to its income statement, it is more
logical to use cost rather than market or replacement values
because the increased depreciation charged to income would
nullify any apparent advantage gained through increasing the
value of the assets. The reason is evident since the entity,
because of its perpetual life feature, places more impor-
tance upon the income statement than the balance sheet.

The whole question of the valuation of assets through
the accounting entity theory is determined by the necessity
of recording in accounting periods. The proprietary
theorists maintain that it is necessary to increase the
value of fixed assets in order to preserve the capital of
the proprietor. The entity theorist is not concerned with
preserving the capital of its proprietors since he places
no emphasis upon any individual capital provider. If he
did it would be necessary to increase the individual book-

value of each share of stock.

The Entity and the Retained Income Account
Consistency in maintaining the entity viewpoint for-
'mds the use of many convenient terms for expressing the

proprietor‘s accounts in the balance sheet. It is very

65
difficult to coin a particular phase which will envelope
all forms of business enterprise in regard to presenting
the proprietor's interest in the business. Many attempts
have been made. Such terms as "Net Worth,"'"Capital Stock
and Surplus," "Capital," "Capital and Surplus," "Owner's
Equity," "Equities," or "Liabilities and Net Worth," have
been used at various times during the long existence of
accounting statements.

The law again enters the picture at this stage with
its various requirements as to how items, particularly with
respect to corporations, shall be shown on financial state—
ments. Through its requirements in the disclosing of
capital stock transactions as to par value, paid in surplus,
earned surplus, surplus reserves, et cetera, the accountant
has encountered much grief. Nevertheless in all of this
discussion on terminology, and what term constitutes what,
the Important issue is usually forgotten. The business
entity is primarily concerned with its own retained income
account. It is difficult sometimes to realize how any re-
tained income account can exist which has any bearing upon
the stockholder. Certainly the earned retained income
account has no relation to the stockholder in any fashion if
viewed strictly from the entity point of view--except as it
reflects the increase in liability to the stockholders.

It is recognized only that a retained income account

which reflects income retained for the use of the entity

66
should exist. This represents the entity‘s equity in itself.
G. H. Husband voiced this opinion indirectly by stating,

Consistent with the entity theory, it is usually con-
tended that the income of a corporation does not con-
stitute income to its stockholders; yet, when this

same income is credited to surplus, it is added to the
stockholder's interest as portrayed by the capital-
stock account to secure the stockholder's total equity.
But how can that which is not the stockholder's equity
as incomi Justly become the stockholder‘s equity as
surplus? l

The fact that the entity is conceived as a unit in and
of iself also makes it necessary to decide which items are
to be included in the retained income account. Obviously,
if an item does not appear in the income statement it must
appear somewhere else. The logical answer is the retained
income account. However, considerable discussion has re-
volved around the relation between the income statement,
which displays this period's earnings, and the retained in-
come account, which displays the amounts of prior periods'
earnings retained in the business. The greatest disagree-
ment comes into focus when the earnings of prior periods
must be corrected.

Basically this is merely an extension of the proprie-
tary and entity viewpoints. The proprietary theorists would
be those in favor of carrying the adjustments to this period's
income statement, while the entity theorists would insist

upon leaving the income statement for a reflection of cur—

rent operating income.

 

fi Vi

MlHquand,'"The Entity Concept in Accounting," 923
Cit.’ p- 555'

W

67

The argument seems to be one against deception. The
entity would favor making these adjustmens to retained in-
come as is previously stated. If we take an example it is
clear why some authors have considered this method deceptive.
Assume that a corporation has sales for three years at the
$50,000.00 level and expenses for these same period of
$40,000.00. In the third year a fixed asset is sold at a
$6,000.00 loss. This loss would be divided into two amounts,
$2,000.00 would appear in the income statement of the third
period, while $4,000.00 would be debited directly to re-
tained income. After this adjustment the income statements

of the three years would appear as follows:

CORPORATION X

lst Year 2nd Year 3rd Year
Net sales $50,000.00 $50,000.00 $50,000.00
Expired costs 40,000300 40,000300 42,000.00

 

 

 

Net Income for the

Perios $10,000 .00 :10 E000 .00 g 8,000 .00

Assuming that there were no dividends paid nor any
other entries to retained income, the balance of the re-
tained income account at the end of the third year will be
$24,000.00 while the aggregate of the reported annual profits
is $28,000.00. This, it is claimed, is deceptive.

The proprietary theorists would include the $6,000.00
loss in the third period as a deduction from the income
statement of the third period. Using the same example the

income statement would appear as follows:

68
CORPORATION Y

 

 

 

lst Year 2nd Year 3rd Year

Net sales $50,003.33 $50,000.33 $53,000.00

Expired costs 40,000.33 40,000.00 46,000.00
Net Profit for

Period $l3,330.33 $10,000.33 $g4,000.00

 

 

 

 

 

 

At the end of the third year the retained income ofthe company

will agree with the aggregate of the reported annual profits.
This entire argument has been resolved by suggesting

that the income statements for the three years be recast.

The objection to this method is that the income statements

of the first two years are closed and done with and it is

a question as to the usefulness of recasting the statements,

especially if one considers the expense of determining an
a .

3

l‘\

allocation against each of the prior periods affected.
The question seems to now be one of materiality and this
is exactly where the issue stands today.

The problem remains as to which method is more nearly
correct from the entity point of View. The writer's opinion
is that since the income statement is a device for matching
current cost and current revenue that the entity would ex-
clude those unusual items which would distort the current
operating method. However, it is an established fact that

most income statements contain both an operating and non-

 

42Victor H. Stempf, "A Critique of the Tentative
Statement of Accounting Principles," The Accounting Review,
XIII (March, 1938), 60.

 

69
operating section. This is certa nly not the purpose of
the entity concept. The non-operating item is properly
recognized by entity theory as being a deduction from the
liability owed to the proprietors. If the income statement
has a separate section devoted to the disclosure of the
increase of indebtedness to the proprietors then there is
no objection to this procedure. The only objection from
the standpoint of the entity is that the resulting figure

.Hnet

after the non—operating section cannot be labeled as
income" because it contains items which were not due to
operations. Beyond this there should be no objection

theoretically since it is merely a method of disclosing

information.

The Entity and Dealings in Its Own Stock

 

Interesting and controversial accounting problems
arise when a corporation deals in its own stock

Generally a corporation legally cannot purchase its
own shares of stock if it does not have a retained income.
The reason generally given is that the retirement of one or
more stockholder's investment would be to the neglect of
the creditors who rely upon a certain amount of permanate
capital. Consequently a fiction developed in the accounting
world that a reacquired share of stock, or treasury stock,
is a deduction from earned surplus. This is, of course,
not true from an accounting standpoint-—certainly not from

the entity standpoint.

73

Considering the problem strictly from the entity view-
point an interesting line of argument results.

The entity convention does not distinguish between the
liability of an entity for borrowings and the liability of
an entity for proprietorship investment. Both are liabi-
lities. Accordingly, one method of exploring this problem
is to assume the existence of a sole proprietorship which
borrows $1,000.00 from each of three persons.

The liability side of the entity balance sheet might,

therefore, appear somewhat as follows:

 

Owed to James Brown. . . . . . $1,000.00
Owed to Al Petersen. . . . . . $1,000.00
Owed to Jack Cory . . . . $1,000.00
Owed to Proprietor Jim Delaney . 15,000.00

Total liabilities . . . $8,000.00

In this illustration it is assumed that Jim Delaney
is the proprietor. If the indebtedness to Brown, Petersen,
and Cory is evidenced by three ten-year promissory notes
bearing an interest rate of six per cent, then the entity
will owe each of these creditors $60.00 a year for interest
and at the end of a ten-year period will owe each of them
$1,000.00.

Immediately after making his loan James Brown changes
his mind and sells his note to the entity for $1,300.00.
Instead of cancelling the note the entity resells it to
Ron Patten for $1,133.30. At the time the money is received
from Ron Patten, $1,300.03 of it is recorded as a liability

to him, while $100.33 of it is treated as a deferred credit

71
to be amortized against interest expense. In other words,
from the entity point of View it is a deferred credit to
the proprietor‘s account, and offset to the interest expense
which will be debited annually to the proprietor's account.
Such a premium is, of course, common in connection with
bond issues but there is no reason for not using a similar
account in connection with a note issue. The entity must
pay Ron Patten $60.03 a year interest, which is credited
to Cash and debited to Expense. Each year $12u2m)must be
transferred to Interest Expense from Premium on Notes
Payable.

If it is assumed that these notes mature in one
hundred years instead of in ten years, the same original
entries will be made but instead of amortizing the premium
at $13.30 a year, it will be amortized at $1.30 a year.

If the maturity of the notes is one thousand years instead
of one hundred years, then the premium on noted payable
will be amortized at the rate of ten cents per year. If
the liability represented by this note is perpetual, then
the premium on notes payable will never be amortized but
will continue to stand as a perpetually deferred credit

to the proprietor‘s account.

According to the entity convention the proprietor's
investment is a liability of the entity. Accordingly, the
investment by the stockholders in a corporation must be con—

sidered a liability of the entity to those stockholders

72
regardless of legal contradictions. The illustration,
therefore, may be changed to show James Brown, Al Petersen,
Jack Cory, each investing $1,000.00 in the corporation, a
$5,000.000 interest in which is owned by Jim Delaney, the
four of them being the only stockholders. Disregarding
the legal prohibitions, assume that James Brown sells his
stock certificate to the entity for $1,000.00. This stock
certificate then represents treasury stock and is resold
to Ron Patten for $1,100.00. Of this $1,100.00, $1,000.00
represents a liability of the entity to Ron Patten. $100.00
may be considered a premium on capital stock, also a liabi-
lity. This $100.00 credit item may be considered as a
deferred credit applicable against dividends, but since
the liability represented by the capital stock is a per-
petual liability, this deferred credit item of $100.00 will
stand forever on the accounting records and will not be
amortized against Ron Patten's dividends.

This particular analogy appears to have some analy-
tical value to those who, having once adopted the entity
convention, are prepared to use it in any kind of an
accounting problem. This analogy and argument logically
suggest that the ”profit" resulting from the sale of treas-
ury stock at an amount greater than its cost to the entity
is in the nature of a perpetually deferred credit to income
and hence to proprietorship, and is not an item of income

which will ever come into being until the termination of

73
the corporation itself. Christening such a perpetually
deferred credit aS'"capital surplus" is merely a matter
of terminology and its inclusion under that title as one
of the proprietorship items seems entirely logical and
correct.

Based upon different reasoning the majority of auth-
orities seem to have come to the same conclusion.

Raymond Marple says: '"Where treasury shares are
reissued for more than cost to the corporation, there
arises an element of capital surplus."43

The Committee on Definition of Earned Surplus of the
American Institute of Accountants says that: '"Capital
surplus comprises paid-in surplus and revaluation surplus."
In describing items properly to be included in paid-in
surplus, the committee mentions "profits on resales of
treasury stock;"uu

The Committee on Accounting Procedure of the American
Institute of Certified Public Accountants (name changed
only recently) in Bulletin 43, said,

Apparently there is general agreement that the dif-
ference between the purchase price and the stated
value of a corporation‘s common stock purchased and

retired should be reflected in capital surplus.
Your committee believes that while the net asset

 

 

43Ra ond P. Marple, Capital Surplus and Corporate
Net Worth {New York: The Ronald Press Company, 1936f, p. 74.

uuAccounting Terminolo (New York: American Institute
Publishing Company, Inc., 19%1), p. 119.

 

74

value of the shares of common stock outstanding in

the hands of the public may be increased or decreased
by such purchase and retirement, such transactions
relate to the capital of the corporation and do not
give rise to corporate profits or losses. Your
committee can see no essential difference between (a)
the purchase and retirement of.a corporation's own
common stock and the subsequent issue of common shares,
and (szthe purchase and resale of its own common
stock. ‘

Thus it may be supposed that the majority of opinion
seems to favor the entity theory in dealings of the cor-

porate entity in its own stock.

The Entity and Financial Statements

 

The various classifications of accounts under the
entity concept are clearly illustrated in its financial
statements. A reflection upon the thinkihg of those people
preparing the financial statements for the entity are
readily discernible when one.views the reports produced
by the entity.

-As has been stated many times in this paper the income
statement is, from the standpoint of the entity, probably
the most important statement. We shall consider it first.

There have been two age old arguments concerning the
presentation of an income statement. One group (mainly
proprietary theoristS) holds that the income statement
should be all inclusive.. The other group {mainly entity

theorists) hold that the income statement should reflect

 

45Committee on Accounting Procedure, Pestatement and
Pevision Accounting Research Bulletins (New York: American
Institute of Accounts, 1953),.p. 14.

 

 

75
only the "current operating performance" of the business.
During recent years one of the most debated subjects con-
concerning classification has been that revolving around
the question of the proper treatment of extraordinary gains
or losses recognized during the period. The proprietary
theorists favor the all—inclusive income statement and
advocate the inclusion in the income statement of all items
of profit or loss recognized during the period whether or
not they are related to that period‘s operations. The
entity theorists, on the other hand, favor the current
operating performance type of income statement and maintain
that the income statement should include items which con-
tributed to ordinary operations for the period covered, and
should exclude extraordinary items of material amount which
are not related to operations for the period.

The Committee on Accounting Procedure of the American
Institute of Accountants stated in 1947 in Accounting
Research Bulletin 32, and repeated in 1953 that,

. . there should be a general presumption that all
items of profit and loss recognized during the period
are to be used in determining the figure reported as
net income. . . . Thus, only extraordinary items such
as the following may be excluded from the determination
of net income for the year, and they should be excluded
when their inclusion would impair the significance of
net income so that misleading inferences might be
drawn therefrom:

(a) Material charges or credits (other than ordinary
adjustments of a recurring nature) specifically related
to operations of prior years, such as the elimination
of unused reserves provided in prior years and adjust-
ments of income taxes for prior years;

(b) Material charges or credits resulting from un-
usual sales of assets not acquired for resale and not

76
of the type in which the company generally deals;

(0) Material losses of a type not usually insured
against such as those resulting from wars, riots,
earthquakes and similar calamities or catastrophes
except where such losses are a current hazard of the
business;

d The write-off of a material amount of intangibles;

e The write-off of material amounts of unamortized
bond discount or premium and bond issue expenses at the
time of tflg retirement or refunding of a debt before
maturity.

In a later section the committee expressed a strong
preference for reflecting these items in the surplus state-
ment rather than the income statement. This would seem to
support the entity concept of income. However, in view of
the revised Regulation S-X issued by the Securities and
Exchange Commission in December, 1950, which required that
these extraordinary items be reflected on the income state—
ment as an addition to, or deduction from, net income or
loss, the Committee also considered the all-inclusive
income statement as acceptable providing care is taken that
the figure of net income is clearly and unequivocally
designaged so as not to be confused with the final figure
in the income statement.47

Under the procedure recommended by the Institute (or
entity concept), the surplus statement, or "statement of

retained income," as it is moreoften called, might contain

the following items:

 

46Ibid., p. 63.

m

47Ibid., p. 64.

77

BALANCE AT THE BEGINNING OF THE YEAR $5,000,000.00

ADDITIONS:
Net income for the year, from income

statement 200 000.00

Total $‘5‘,‘2’0"0‘,L0'00'.'0‘0
DEDUCTIONS:

Dividends on common stock 300,000.00

Loss on sale of land and buildings 75,000.00

Loss on retirement of bonds before maturity 60,000.00
Transfer to Reserve for future decline of
inventory prices 100 000. 00

Total Deductions 535,000 0.00
BALANCE AT END OF THE YEAR $W

The statement above includes two extraordinary items
of material amount, the loss on the sale of land and
buildings, and the loss on retirement of bonds. The current
operating performance type of income statement would not
include these two items; instead they would be shown in the
retained income statement, as illustrated above.

The requirement of the Securities and Exchange Com-
mission arising out of the December 1950 revision of Regu—
lation S—X, although now acceptable, still does not repre-
sent the type of presentation preferred by the Institute or
the entity theory. It should be pointed out, however, that
there is no disagreement concerning certain items custom-
arily shown in the retained income statement. Both agree
that dividends, appropriations to retained income reserves
and reductions of retained income reserves should be properly
shown in the retained income statement. Reserves for retire—
ment of preferred stock, reserves for contingencies, reserves

.for future decline of inventory prices, reserves for plant

78
expansion, reserves for replacement of fixed assets at higher
price levels, and redemption of bonds are examples of re-
serves which are generally accepted as being retained income
reserves by both the entity and proprietary concepts.

Under the classification suggestion by the Securities
and Exchange Commission (and the proprietary concept) the
two extraordinary items shown in the preceding illustration
would be excluded from the retained income statement,

leaving the items shown in the illustration below:

BALANCE AT BEGINNING OF THE YEAR $5,000,000.00
ADDITIONS: ‘
Net income less special items, from the

income statement 6g,000.00
Total $ : : '

DEDUCTIONS:
Dividends on common stock $300,000.00
Transfer to reserve for future
decline of inventory prices 100,000.00

 

 

Total deductions V4003000500
BALANCE AT END OF YEAR $4,662,000500

It is noted here that the reserve for future decline
of inventory prices remains in the retained income statement.
This is not a (profit or) loss given recognition during the
period, but instead is an appropriation of retained income.
The two unusual losses would be shown in the income state-

ment, after net income as follows:

NET INCOME FOR THE YEAR $200,000.00
SPECIAL ITEMS:
Loss on sale of land and

buildings $75,000.00
Loss on retirement of bonds
before maturity 60,000.00 135,000.00

 

 

.35.;5153990-90

 

 

79

These diverse viewpoints clearly indicate that the
disagreement between the entity and proprietary theory still
exist and as yet have not been settled. However, there
seems to be a growing tendency for acceptance of the inclu-
sion of extraordinary items in a special section of the
income statement.

Table II illustrates an income statement which is
conceived within the entity theory. Table III, page 81,
illustrates the income statement which would not be
acceptable to the entity but is very popular from the stand-
point of many accountants. It is commonly known as the
'"all inclusive" income statement. It reflects a consid-

erable amount of proprietary thinking.

 

The balance sheet. As has been suggested many times
previously the income statement is of more concern to the
entity theorist than is the balance sheet. However, it
must certainly be realized that while this may be true the
importance of the balance sheet must not be underemphasized.
The income statement accumulates the totals of the expired
costs of the entity while the balance sheet is the state-
ment which displays the remaining costs of the entity which
carry over to future periods.

The classification of balance sheet accounts in the
entity's statement differs very little from that of the
proprietary theory. However, it is suggested here that the

proprietary theorists do not follow the proprietary equation

80

TABLE II

ENTI TY THEORY
STATEMENT OF INCOME

FOR THE YEAR ENDED DECEMBER 31, 1958

GROSS SALES (less returns & allowances)
Less: Cost of Goods Sold

Net Entity Revenue
Selling, General, & Administrative Expenses
NET INCOME TO THE ENTITY

Non—Entity Revenues:

Interest Income $1,000.00
Unusual items non-recurring 500.00
Divident income 500.00

 

Non-Entity Expenditures:
Interest Expense $2,000.00
Unusual Items non-recurring 1,500.00

 

NET INCOME BEFORE INCOME TAXES
FEDERAL INCOME TAXES
NET INCOME TO RETAINED INCOME

$499,000.00

- 299;. 000 .00

 

$200,000.00

 

$50,000.00
$150,000.00

002,00O.000fi;

 

$152,000.00

3, 1500.00

 

$148,500.00

77,500.00
$771,900.00

TABLE III
PROPRIETARY THEORY

STATEMENT OF INCOME

FOR THE YEAR ENDED DECEMBER 31, 1958

INCOME:

Gross sales less returns & allowances

Income from dividents

Interest Income

Other Income-~unusual-recurring and
non-recurring

Total Income

EXPENSES:

Cost of Goods Sold

Selling Expenses

General & Administrative

Interest Expenses

Other Expenses-~unusua1 recurring &
non-recurring

Federal Income Taxes

Total Expenses

NET INCOME

$499,000.00
500.00
1,000.00

500.00

 

$501,000.00

$299,000.00
25,000.00
25,000.00
2,000.00

1,500.00
f77;5oo.00

$430,000.00
$ Tl)000300

 

 

81

82
A - L = P. If they do then it is necessary to deduct the
liabilities outstanding from the assets of the business in
order to arrive at the value of the proprietary account.

The practice of showing net assets and finally listing
investments of the stockholders in the form of a vertical
statement has been prevelant for a number of years. This
would certainly express the proprietary theory even though
the general form of the equation is lost.

Strangely enough the most recent change in financial
statements seems to fit neither the entity or the proprie-
tary theory of accounting theory. This is the statement
which follows the practice of deducting current liabilities
from current assets in order to arrive at a figure for
working capital.

Examples of these balance sheets appear as Tables IV,

V, and VI, on the following pages.

Consolidated financialfistatements. To date the entity

 

convention offers about the only satisfactory theoretical

foundation on which to build multi-company reports. Accoun-

tants attempt to treat a group of closely allied corporations

as a distinct economic or accounting entity despite the

legal lines of separation among the constitutent companies.
There are three important aspects of consolidated

financial statements: (1) the functions performed by con-

solidated reports, (2) the circumstances under which they

83

TABLE IV
THE ENTITY THEORY

BALANCE SHEET
DECEMBER 31, 1958

Assets Equities
Current Assets $ 500,000.00 Current $ 200,000.00
Liabilities

Long Term
Investments 1,000,000.00 Long Term Debt 3,000,000.00

Fixed Assets 5,000,000.00 Preferred Stock 1,000,000.00
Common Stock 2,000,000.00
Deferred Charges fifile,000.00 Retained Income - 310,000.00

 

 

$6,510,000,00 $6,510%900,00

 

 

 

 

This balance sheet of the entity correctly portrays
the form of the equation A = L + P. It is expected that
in order to be consistent the entity theorist would naturally
draft such a statement if he wished to explain the assets
and equities in their relative positions within the entity

theory of accountibility.

TABLE 'v
PROPRIETARY THEORY

BALANCE SHEET
DECEMBER 31, 1958

 

 

NET ASSETS
Current Assets $500,000.00
Less Current Liabilities 200,000.00
NET CURRENT ASSETS 300,000.00
Long Term Investments 1,000,000.00
Fixed Assets 5,000,000.00
Deferred Charges 10,000,00
6,310,000.00
Less Long Term Debt 3!000,000100

 

$3,310,000.00

INVESTMENTS 0F STOCKHOLDERS

. Preferred Stock $1,000,000.00
Common Stock 2,000,000.00
Retained Income ,310,000.00

 

NET STOCKHOLDER INVESTMENT $3,310,000.00

84

TABLE VI
RECENT MODIFICATION

BALANCE SHEET
DECEMBER 31, 1958

ASSETS

Current Assets
Less Current Liabilities

NET CURRENT ASSETS
Long Term Investments
Fixed Assets
Deferred Charges

Total Assets Less Current Liabilities

INVESTMENT EQUITIES

Lang Term Debt
Preferred Stock
Common Stock
Retained Income

Total Investors' Equities

85

$ 500,000.00
“209,000.00

 

300,000.00

1,000,000.00
5,000,000.00
10,000,09

 

$6.. 3194109 20.0

 

 

$3,000,000.00
1,000,000.00
2,000,000.00
310,000.00

 

$6,310,000.00

86
should be presented, and (3) the standards and principles
which underlie their presentation.

Many unsettled questions concerning the ability of a
corporate entity owning or controlling another corporation
remain unsettled both at law and in business practice.
Because of this a statement concerning the legal or business
status of a holding company will not be attempted.

Consolidated statements seem to have gained their
impetus in the last half century from Federal Revenue Acts.
However, the United States Steel Company, chartered in New
Jersey in 1901, presented consolidated statements from its
inception. Since then, consolidated financial statements
have been a familiar feature of corporate reports.48

The presentation of consolidated statements is in
order whenever there exists an economic or business
entity composed of two or more legal units. Con-
versely, consolidated statements will not be prepared
when an economic entity does not exist.u9
This statement by Professor Moonitz reflects the general
accounting thinking toward the preparation Of consolidated
statements.

The question which concerns most accountants is,

"What constitutes a consolidated accounting entity?" Many

suggestions have been offered. Professor Moonitz lists

five:50

 

jaw a

48Maurice Moonitz, The Entit§ Theor Of Consolidated

Statements (Brooklyn, New Yor : T e oundaETOh Press; 1951),
P.‘7}
ugIbi‘d‘. 50mid. , p, EOff,

 

 

87

1. Percentage of Stock Ownership

2 Controlling Influence

3 Similarity of Operations

4. National Concentration

5 Consistency of Treatment

These five points, although a definite help, have
provided no absolute standard for establishing an economic
or accounting entity. The accountant must exercise judg-
ment.51

From the standpoint of the entity theory it is quite
possible to conceive of a hybred entity consisting of many
separate entities. Therefore, it is supposed that the same
accounting doctrines, conventions, and principles will
apply to the consolidated entity.

The leading principle in the technique of preparing
consolidated statements is the elimination of all eVidences
Of intercompany relationships. The Objective attained by
elimination is the rejection of amounts and accounts re-
flecting transactions among the constituent units and the
retention of only those data pertainent to the showing of
the affiliation as an economic or business entity. In
essence this requires a shift in viewpoint from that Of a
legal abstraction--the business corporation-~to that Of an

accounting abstraction--the effective business unit.52

 

v v vii

5 5

1 2
Ibid., p. 39 Ibid., p. 84.

88

It has been the contention of authorities that the
entity concept provides a coherent theoretical basis for
rationalizing some of the practices already prevalent and
competent to solve new problems as they arise.53

Typically the use of these consolidated reports is
confined to the use of dominant stockholders, present and
prospective, and to the managerial group which wields
control. Others may conceivably receive some value from

these reports but the exact amount is doubtful.

 

5311010. , p. 83.

CHAPTER VI
OTHER VIEWS OF THE ENTITY

Stockholders:

 

In one sense the corporation is a sort of partnership
Of many people, who put their money into the venture and get
back salable interests in it; but the investor does not own
the corporation's property, nor is he responsible for its
debts. If a person becomes a stockholder he receives
'"shares" of stock.in the corporation, is technically re-
garded as one of the owners of the business, and is entitled
to such dividends, voting rights in selecting management,
and other privileges as the law and the corporation's
financial progress may make possible.

The typical stockholder is a stranger to the business
of his corporation. The very essence of the corporate form
Of government--like a republic of checks and balance of
power-~provides for delegation of authority. When authority
is left exclusively to others it is to be supposed, from
the very nature of things, that the inactive will drift
more and more into a lack of knowledge as to what is going
on.

Justice Holmes formerly of the United States Supreme

Court said:

90
A standing criticism of the use Of the corporation
in business is that it causes such business to be
owned by people who do not know anything about it.
Argument has not been supposed to be necessary in
order to show that the divorce between the power
of control and knowledge is an evil.1
The main fact seems to be this: The stockholder does
not apparently consider himself other than a mere investor.2
Stockholders of all classes have become apathetic
and indifferent with respect to their legal rights. When-
ever they believe themselves mistreated as stockholders or
suspect that the affairs of the company are being mis-
managed, they usually sell out as best they may. Seldom
do they protest, or institute legal proceedings. They do
not attend meetings, frequently fail to send back prepared
proxies, and make it generally difficult for the management
to secure approval of amendments involving new financing,
enlargement of purposes, sale of assets, merger, or other
deals, sometimes involving the factor Of time, with bankers,
underwriters, or others. As a result corporations take
advantage of inCorporating under states with liberal charter-
granting provisions, cutting down the stockholder‘s legal
rights, and participation in the company's affairs. Stock—

holders are deprived of voting rights by the common use of

voting trusts and of issuance of voteless stock.

.....

 

lLiggett Company v Boldridge, et al., 1928, U. 3.
Supreme Court, No. 34, October Term, 1928.

2Of course, a different situation may be present in
a small closely held corporation where management and the
stockholders are one and the same.

91

However, at least one governmental agency is inter-
ested in preventing the dissipation of the shareholder's
voting privilege. Under the Public Utility Holding Company
Act of 1935 (sec. 7 [0]), the Securities and Exchange Com-
mission may not authorize the sales of a security of a
registered utility without preference over and having at
least equal voting rights with any outstanding security of
the declarant.3 In another federal law, Sec. 216 (12) of
Chapter X, of the Federal Bankruptcy Act requires that
reorganization plans must include provisions prohibiting
the reorganized company from issuing voteless stock.4

It may be said that the stockholder definitely con-

ceives of the corporation as being an entity separate and

distinct from himself.

Management:

 

Since a corporation is not an individual and since
the stockholders have no inherent right to participate‘
directly in the management Of corporate business, it is
clear that all business must be conducted through the
medium of paid management employed and supervised by the

board Of directors. Stockholders participate in management

 

vV a v fififi

3H. G. Guthman and H. E. Dougall, Corporate Financial
Policy (New York: Prentice-Hall, Inc., 1948), p. 61. 7

1:
Ibid.

 

92
only by the indirect and rather remote control they exercise
through their privilege of electing directors of their
choice. In large corporations even this right is of limited
value, since existing directors control the machinery by
which proxies are Obtained, thus making it a simple matter
for directors to perpetuate themselves in office or to
select their successors.

Unusual matters, such as voluntary liquidation,
merger, consolidation, or amendments to the charter, must
be referred to the stockholders for their approval. Ordin-
arily, by reason Of by-law, charter, or statutory provision,
a quorum at a stockholders' meeting consists of a majority
of stock, and a majority of shares present in favor of a
proposition is sufficient to carry the proposal, except
in those unusual cases where statute requires a larger
portion to approve certain courses of conduct. It is quite
customary for a board of directors at an annual meeting to
request the stockholders to approve of such action as they
have taken during the year immediately prior to the time
of the annual meeting.

Management has an apparent free reign to conduct the
business as it sees fit. A stockholder is not burdened by
any fiduciary relation to the corporation. He is free to
contract with it as though he were a stranger and to vote
for his own personal interests, but the majority, acting
through their chosen directors, may not Operate the corpor-

ation for their personal profit at the expense of the

93
minority interests. They are obligated to operate it for

the best interests of the corporation as a whole.

The management of a corporate entity is under a number
of pressures from various sections of our economy. Subject
to all these pressures, management has come less and less
to consider itself responsible to the owners and more and
more to accept responsibility for the corporation as a
whole. It does not oppose the demands of the other parties
in the interest of the owner, but on the contrary, attempts
to satisfy them all, and management strives to provide
dividends for stockholders, high wages fOr employees,
friendly relations with government and the public. In a
sense such a point Of view might be interpreted as enlight-
ened self-interest of management, enlightened stockholder
interest, but typically it goes beyond that in the interest
of permanence.5

Thus it would seem that the management group also
hasendorsed the entity concept of recognizing the business

as a unit separate and distinct existing in its own right.

Creditors'View of the Entity

 

Limited liability is a characteristic Of the corporate
form of business. This means simply that the individual

fully paid-up stockholder in a corporation may lose all Of

 

r "rfi fwfifi Vfi

5Oswald w. Knauth, "Group Interest and Managerial
Enterprise," The Journal gf Industrial Economics, I, NO. 2

(April, 1953)789.

 

94
his original investment but that he is responsible for no
further capital contribution.

This is a most important characteristic from.the
creditors' viewpoint, since the creditor must look to the
corporate entity for a payment Of his claim and cannot, as
in the other two forms of organization, makeup any defi-
ciency direthrom the proprietors.6 A

This limited liability feature generally prevents the
stockholder from withdrawing his investment and emphasizes
the importance of distinguishing between capital which is
not available for dividends and retained income which is
available. Many legal accounting troubles have arisen as a
result of this necessity.

Creditors must be protected against over-optimistic
calculation of corporate profits and their distribution.
The natural desire of corporation directors to be "on the
safe side" in the computation Of profits and declaring of
dividends has greatly emphasized the importance of the doc—
trine of conservatism and accordingly has profoundly influ-
enced accounting practice.

In order to decide how the creditor looks at the

entity it will be necessary to establish what it is that

 

—v w v Vfi Vfi

6It is recognized that there are certain forms of
partnerships which provide for limited liability to some
of the partners, however, it remains necessary for at least
one of the partners to be a "general" partner and the
creditors have recourse against this partner in case a def-
iciency exists.

95

persuades the owner of goods, wares, or money to exchange
them for a promise of a future payment. The two primary
factors that induce one to become a creditor are the desire
to lend or sell at a profit, and confidence in the debtor's
ability to meet his promise Of future payment.7

The creditor's confidence in receiving payment in the

________.— —~7 ._____.

 

,

future is based upon the history, reputation, and character

we.—

r

Of tha,entity,supported by adequate accounting reports.
Accounting reports are the creditors' principal tool,
althOugh not his only one. From the creditors' point of
view reporting by the entity represents the most important
consideration given the creditor.

It is difficult to generalize which reports would
be of most interest to creditors since there are different
types of creditors whose interests vary with the kind of
credit being granted. Creditors may be classified into
three general types: (1) the Trade Creditor, (2) the Bank
Creditor, and (3) the Security Holder.

Trade creditors sell their goods or services on a
day-to-day or month-to-month basis. Because Of this, they
are more interested in the immediate financial position of
the entity. They will base their judgment of the credit
position on the probable flow of cash through the entities'

business, the working capital and short range debt position

 

w fiw va fi

7Milton J. Drake, "Reports for Creditors," The
Accounting Review, XXV (January, 1950), 58.

 

96
of the debtor, and they will give only secondary consid-
eration to long term indebtedness and earning capacity.

The trade creditor's risk is relatively small and can be
controlled by refusing to deliver new goods.

Bank creditors are usually in much the same position
as trade creditors. The extension of credit by banks may
run up to a year in the typical seasonal or temporary
financing and, therefore, the interest of the banks is
somewhat longer. Accordingly, their risk is greater and
they have an interest in more information regarding the
entity's position. The working capital protection indi—
cated in the accounting reports is of greater importance
to the bank than the trade creditor, as to the entity's
earning capacity. These considerations regarding bank
creditors do not apply to the bank creditor who loans funds
of over a year up to ten years in duration since they fall
within the third classification which is the security
holder.

The security holder is in a much different position
than either of the forementioned short term creditors.

The extension of credit runs over a long period and the

risk is much higher. Because of this the long term security
holder is in a position that is not easily changed. The
proceeds of his loan are usually used to expand operations--
either by adding_to plant and equipment, or to permanent

working capital. For this reason security holders do not

97
depend for repayment upon asset turnover. Their primary
protection is the earning capacity of the entity. For
this reason they are deeply interested in the reports
which reflect possibilities for future sales and the
mortality figures for the particular line Of business that
the entity uses for its main source of revenue.

Many of the problems between the entity and the
creditors are the result of legal requirements. The law
is concerned with contractual relations between individuals
while accounting is concerned with accountability to its
proprietors. The law takes the viewpoint of solvency
while the accountant takes the viewpoint of the going con-
cern. It would seem that from the standpoint of the creditor,
who loans or extends credit for a short term, that the legal
requirement would be the most protective. The long-term
creditor would be better protected by the accountant's
viewpoint of the going concern since he is interested in
the long range earning power. However, it has been said
that the short run is always of prime consideration since
it is the short term entity which develops into the long
term entity. The truth in this statement is certainly open
to no discussion. Thus it would seem that once again it is

the law which determines the viewpoint taken of the entity.

CHAPTER VII

CONCLUSIONS

Summation

 

Entity theory stems from the double entry method of
recording financial transactions. The theory has been
perpetuated by the large formation Of corporations. The
assets and debts are those of the corporate entity, and the
entity reports to its constituents (stockholders, bond-
holders, employees, and the general public) in much the
same way as a trustee reports to his cestuis. The corpor-
ation'"accounts for" resources entrusted to it through its
financial reports, in terms of costs and revenues, financing
transactions, and the disposition of earnings. Although the
'"equities" of the various parties at interest are main-
tained, there is no attempt to measure net worth, in the
sense of a proprietor's interest. The right side of the

balance sheet thus represents accountabilities (not values,

 

 

or even precise computations) for legal or equitable inter-
ests. The left side Of the balance sheet represents assets
in terms of cgats, not values, because it is cost to which
the accountabilities must be related. Income as measured
by the matching of revenues with cost expirations is cor-

porate income, and the disposition of income is a corporate

99
affair, subject only to the maintenance of legal and
equitable interest of which the common stock is only one.
The whole idea of "net worth" is really abandoned, and the
accounting equation is simply the accountability pattern,
Assets equals Equities.

Under entity theory, the recognition of revenue is
based upon legal and equitable concepts. The test of
revenue is the acquisition of new assets by completing
transactions with customers. These transactions arise from
rendering the service or delivering the commodity which
the corporation is set up to provide. Revenue is not an
accreation to proprietorship, for proprietorship has no
position in the theory. Revenue is the gross "proceeds"

.___LIN______‘*__wMM*_*m_,
(in cash or enforceable claims to cash) from the sales of

r——_____

 

 

product or service represent

ing the main line Of corporate

 

“N__.

activity.

In the shift from proprietary to entity theory, the
concept of expense also changed. The proprietary notion
of expense was that of outlays made by the proprietor. In'
terms of accrual accounting this was cost'"incurred" by
giving up assets or by incurring debt, as well as through
cash disbursement; but the notion of expense was still
that of a reduction of net worth. Even though it might be
recorded under several classifications, expense was "outgo"
under proprietary theory in almost the same sense as in
personal accounting, and it, therefore, carried a flavor of

undesirable though necessary sacrifice.

100

Under entity theory, however, expense is the cost

.— .—-—-—-——-—J v—-

assigned to the production of revenue. The business unit

(entity) is one part of the vast machinery of production
and distribution of goods and services. As a part of the
business system, the firm is a device for conversion of

goods and services into new and different forms. Expense

M,

is simply the financial measure (cost) of the product Of

__,.,_.—..——- —- —— __.__ __ _

the firm. Thus manufacturing, selling, and even over-all

.‘M '—

 

administration costs are but financial expressions of the
service delivered to customers in the market. Services

acquired by the firm, but not yet delivered to customers

I!

are assets. Assets are thus "postponed costs, so long

as they remain available for conversion and delivery. In

 

this latter Sense even cash and receivables are“ 'services"
available for future conversion and delivery. The nature

of an asset is thus not directly related to physical exis—
tence of property or its value in exchange. An asset is the
cost applicable to services available for future conversion
and delivery to the market.

The reporting of operations under entity theory puts

..._,

emphasis upon corpgrate_in09me, measured by matching cost—
expirations with revenue for the period. Corporate income
accrues not to stockholders or owners, but to the corpor-
ation. Corporate income is thus freed from the proprietary
connotation of profit related to increased net worth.
Entity theory tends to recognize financing trans-

actions and income distributions as distinct from either

lOl
proprietary or income-determining transactions. Thus,
although it is not generally agreed in practice, it would
seem that under entity theory interest charges are dis—
tributions of income, not expense. Similarly dividends
(in the ordinary sense) would be regarded as income dis-
tributions rather than proprietary withdrawals of capital.
Taxes on net income also would seem to fall in the category
Of distributions of income rather than determinants of
'"profit;" The underlying basis for these conclusions is
the concept that the corporation is an entity separate
from any of the parties at interest; and that it--not the
stockholders-«is the center and objective of accounting.
The financial statements are the reports of the management,
about the corporation. These reports are directed to all
interested parties, without preference or prejudice, and
no attempt is made to meet the specific needs or concerns

of particular groups in those reports.

Speculation

 

Perhaps it might be fitting to speculate as to the
future of the entity as a basis for accounting theory. It
was suggested, in an accounting theory seminar (which the
writer had the privilege of attending) that the corporation
was a natural step in the evolution Of business enterprise.
This statement seems to gain in support when one notices
the increase in the organization of corporations every

year. If this be true then it can be expected that more

102
consideration will be extended to the entity theory.

It will be necessary for courts of law to further
deprive stockholders of their rights and privileges as
owners before many accountants will be willing to recognize
the entity as being a person separate and distinct. This
trend seems to have taken place over the last half century.
It is the opinion of the writer that the entity concept is
a natural evolution of a social type theory of enterprise.
The entity as an institution being created for the purpose
of benefiting society rather than the relinquishing of
rights to a small select group of stockholders. The writer
having very little training in political science is never-
theless willing to predict that the granting of imunity
given by the state in the formation Of a corporation will
not go unregulated. Stricter controls will be effected and
accountants will be forced to adopt their conventions and
principles to fit a social type institution. Social
accounting is a subject of many current articles written
in the professional publications which make up a part
of current accounting theoretical thinking.l Apparently

accountants have already recognized that the future of

 

v—fifi—v—v V V fiwfifi

1Two of the more current social accounting articles
are: J. P. P0W€lSOD,'"Social Accounting," The Accounting_
Review, xxx (October, 1955), 651; and E. L.'E5hfer, “Aspects
of NaEional Income," The Accounting Review, XXVIII (April,
1953). 178. ' ' ’ ' ‘

 

 

103
accounting will be based on providing information to
society as a whole. The entity will expand to include
the whole of the country. The present stockholders will
be recognized as the bondholders are presently. Their
interest will be reduced to a minimum of return on their
capital investment. The regulatory agencies Of the Federal
and State governments will establish accounting doctrines.
Therefore, it is a necessity that accounting theory keep
pace with the changing economic structure and develop
principles which will be in accord with current economic
realities. The proprietary theory of accounting was un-
doubtably the first-Of recognized accounting procedure
and is being replaced piece by piece with the entity theory.
The entity theory will be replaced piece by piece by some

further type Of_social-ac00unting theory.

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Montgomery, Robert H. "Dealings in Treasury Stock, " The
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Powelson, J. P. '"Social A counting,"

XXX (October, 1955), 651.

The Accounting Review,

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Seidman, Nelson B. "The Determination of Stockholder
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Sprouse, Robert T. "Legal Concepts of the Corporation'
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. '"The Significance of the Concept of the Corpor-
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Staubus, George J. '"Comments on 'Accounting and Reporting
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Stempf, Victor H. '"A Critique of the Tentative Statement
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109
Legal Cases
Dartmouth College Case. 4 Wheaton, 518 (1819).
Hale v Henkel, 201, U. 5. 74-75 (1906).

Liggett Company v Boldridge, et a1. U. S. Supreme Court,
No. 34, October Term (1928).

Mathews et'al. v Minnesota Tribune Co. 10 N. W. (2d)
232 (19A3).

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