A METHOD FOR REPORTING ALL ASSETS AND THE RESULTING ACCOUNTING AND ECONOMIC IMPLICATIONS Thesis for ”:9 Degree of DH. D. WCHIGAN STATE UNIVERSITY Roger Herbert Hermanson 1963 THESIS This is to certify that the thesis entitled A I‘I'E‘IHOD FOR REPORTING ALL ASSETS AND THE RESULTING ACCOUNTING AND ECONOMIC IMPLICATIONS presented by ROGER HERBERT HERMANSON has been accepted towards fulfillment of the requirements for Ph D degree in BUSINESS ADIflNISTRATI ON - —_ ACCOUNTING 0-169 LIBRARY Michigan State Universit Y {4 v—w ABSTRACT " A METHOD FOR REPORTING ALL ASSETS AND THE RESULTING ACCOUNTING AND ECONOMIC IMPLICATIONS by Roger H. Hermanson Professors Robert T. Sprouse and Maurice Moonitz, ixi'their recent monograph -- A Tentative Set of Broad Ac— counting Principles for Business Entergises (New York: American Institute of Certified Public Accountants, 1962) , recommended a substantial change in accounting theory. In- <:luded in their recommendations was that all assets and asset Changes should be reported for a particular entity. Human resources are includable as assets under the concept of assets they have used. No method for recording and report- ing the value of human resources, however, has been given by Professors Sprouse and Moonitz. The purpose of this study was to search for a method of accomplishing this task and to investigate the implica- tions of reporting human resources as assets. The method chosen for determining the value of human resources involves a capitalization of superior or inferior earnings on non—human resources. The capitalization rate is Roger H. Hermanson the average rate of earnings on non—human resources con- trolled by all corporations in the economy. Although only the most recent year's performance is used in the computa— tion, investors would be informed of prior year's valuations so that trends could be identified. The method chosen for reporting the value of human resources involves a change in financial statement construc- ticui. The use of two separate position statements is recom— mended. Under the plan, the balance sheet becomes an append- age to the accounting income statement. Its function would Ina to serve as a resting place for charges and credits await- ing assignment to the income stream. A separate statement, called the statement of financial condition, would be pre- pared to show the worth of the entity to the absentee stock- holder from the going-concern point of view. Since deferred charges are not resources in their present form they would be excluded from the statement, as would be the portion of retained earnings pertaining to these charges. The value of human resources and the equity change resulting from their recognition would, however, be included. The study also shows how two successive statements of financial condition could be used to report entity eco- nomic income (in the Hicksian sense). This aspect does not, Roger H. Hermanson ‘however, form part of the basic proposal for a change in accounting theory. Specific benefits from generally adopting the pro- ‘posal are discussed. They include--increased comparability and completeness of financial statements leading to a more efficient allocation of funds in the economy, a rejuvena- tion of the position statements, a closer tie-in between financial statements, and an aid to the analysis of firms for internal purposes. There are at least two other contributions which the study makes. One of these is a more precise definition and interpretation of assets. Another rather incidental contribution is a closer relationship between "related" disciplines. By showing the economic implications and especially how accounting state- ments can be used to arrive at economic income, these two disciplines are drawn closer together. Accounting and fi- nance are brought closer together by showing that the account— ing "model" (for evaluating firms in the economy) is analo— gous to a capital expenditure decision model (for evaluating capital projects in finance). Accounting and management are drawn closer together by including human resources in the Roger H. Hermanson statements, thereby making the accounting representation of the firm conform more closely to the management concept. The study should be viewed as an extention of the recommendations made by Professors Moonitz and Sprouse. It accepts their recommendations with only slight revision, and then proposes further changes to accounting theory. It is hoped this study will make a contribution to the long—term ‘betterment of accounting as a discipline and as a profession. Copyright by ROGER HERBERT HERMANSON 196A A METHOD FOR REPORTING ALL ASSETS AND THE RESULTING ACCOUNTING AND ECONOMIC IMPLICATIONS BY ROGER.HERBERT HERMANSON A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1963 1‘ ‘11 (‘0 (,. ACKNOWLEDGEMENTS The author expresses his sincere thanks to Dr. James Don Edwards, the chairman of his guidance committee and Chairman of the Department of Accounting and Financial Administration, for his continuous aid and encouragement throughout the preparation of this dissertation. Gratitude is also expressed to Drs. Bernhard C. Lemke and Claude McMillan,Jr. for serving as members of the committee. Sincere thanks are also due to Dr. Roland F. Salmonson for his valuable advice and suggestions. Credit must be given to the faculty members of the Department of Accounting and Financial Administration and of the Department of Economics for any significance this thesis may have. This work is dedicated to my wife, Dianne. Without her encouragement and aid, this dissertation may never have existed. ii TABLE OF CONTENTS Chapter Page I. INTRODUCTION . . . . . . . . . . . . . . . . 1 Nature of the Problem 1 Reasons for Searching for an Answer 3 Closer Tie-in Between Financial Statements 4 Rejuvenation of the Position Statement(s) 5 More Efficient Allocation of Funds 8 Aid in Financial Analysis for Internal Purposes 10 Implementation of Economic Theory 11 Approach to the Problem 13 II. THE NATURE OF ASSETS . . . . . . . . . . . . 16 General 16 The Accountants' Generally Used Definitions of Assets 18 Assets as Things of Value Owned 18 Assets as Deferred Charges 21 General Comments 23 The Economists' Concept of Assets 26 A Synthesis of Views 28 The Definition of Assets To Be Used in the Thesis 32 III. COMPUTATION AND ENTRIES TO RECORD UNIDENTIFIED ASSETS . . . . . . . . . . . . 35 General 35 The Mechanical Process 41 Computation of Amounts 41 Proposed Journal Entries 44 iii Chapter Discussion Why Only Deviations from Normal Are Given Recognition Comparable Valuations for Identified Assets Comparable Computations of Net Income Support of the Net Income Base Selected The Nature of Unidentified Assets and Negative Assets Segregation of the Equity Changes 13]. PRESENTATION OF DATA IN THE POSITION STATEMENTS . . . . . . . . . . . . . . . . General The Mechanics of Presenting Unidentified Resources Discussion Why Deferred Charges Are Not Listed on the Statement of Financial Condition Why Past Valuations Assigned to Unidentified Assets Are Given on the Statement of Financial Condition The Effect of the Proposal on the Amount Which Is Available for Dividends Why Professor Paton Did Not Choose To Use This Concept in His Accounting Model V. THE ANTICIPATED BENEFITS FROM ADOPTING THE PROPOSAL . . . . . . . . . . . . . . . . General More Efficient Allocation of Funds A Capital Expenditure Model for a Firm Comparison of the Two Models Other Benefits iv Page 46 46 47 51 54 57 62 64 64 7O 80 80 82 84 86 92 92 93 95 104 112 Chapter' Page Closer Tie—in Between Financial Statements 112 Rejuvenation of the Position Statement(s) 115 Aid in Financial Analysis for Internal Purposes 122 ‘VIQ ECONOMIC IMPLICATIONS . . . . . . . . . . . . . 127 General 127 A Comparison of Accounting and Economic Concepts of Income 138 The Reporting of "Economic" Income 142 The Mechanics of Computation 142 A Discussion of the Method 147 Other Economic Implications 152 HOW the Proposal Affects the Allocation of Resources 152 The National Income Accounting Implications of the Proposal 155 The welfare Implications of the . Proposal 157’ The Increase in "Knowledge" Resulting from the Proposal 163 Some Concluding Remarks 164 VII. SUMMARY AND CONCLUSIONS . . . . . . o . . . . . 166 A Review of the Argument 166 The Benefits Which WOuld Result from an Adoption of the Proposal 174 Other Contributions of the Thesis 178 An Extension of the Moonitz and Sprouse Contribution 178 A More Precise Definition of Assets . 178 A Closer Relationship Between "Related" Disciplines 179 General Comments 183 BIBLIOGRAPHY..................... 195 Y, LIST OF TABLES Table Page 1. .Assumed Data . . . . . . . . . . . . . . . . . 42 2. Computation of the Value of the Unidentified Resources to Each of the Firms in the Economy . . . . . . . . . . . . . . . . . . . 43 3. The Balance Sheet . . . . . . . . . . . . . . . 71 4. The Statement of Financial Condition . . . . . 75 5. The "W" Corporation -- Comparative Statements of Financial Condition . . . . . . . . . . . 143 6. Computation of Economic Income by the Net WOrth Technique . . . . . . . . . . . . . . . 145 7. An Alternative Format for Computing Economic Income by the Net Wbrth Technique . . . . . . 146 8. Computation of Incremental Rates of Return . . 189 9. Computation of Net Profit Assuming a 10% Cost of Capital . . . . . . . . . . . . . . . . . 191 10. Computation of Net Profit Assuming an 8% Cost of Capital . . . . . . . . . . . . . . . . . 191 11. Assumed Data Concerning Available Projects . . 192 12. Comparison of the Results of Using the Two Different Rules . . . . . . . . . . . . . . 193 vi LIST OF ILLUSTRATIONS Graph Page 1. The Monopsonistic Case . . . . . . . . . . . 160 2. Correction of the Monopsonistic Case Through Minimum wage Legislation . . . . . 162 vii LIST OF APPENDICES .Appendix Page A. Sources in Which No Specific Definition of Assets was Located . . . 184 B. Listing of Sources Containing Various Definitions of Assets . . . . . . . . . 186 C. Rules To Follow Under Each of the Two Types of Budgets . . . . . . . . . . . 189 viii CHAPTE R I INTRODUCTION Nature of the Problem In 1961, Maurice Moonitz, Director of Accounting Research for the American Institute of Certified Public .Accountants, authored a monograph entitled, The Basic Postulates of Accounting.1 The next year, 1962, Professor Moonitz and Robert T. Sprouse co-authored a monograph en- titled, A Tentative Set of Broad Accounting Principles for Business Enterprises.2 Moonitz and Sprouse in the ”Princi- ples" monograph stated that: . . . The principle task of accounting is to measure the history of the resources held by economic entities, to measure all of the resources and all of the Changes. .'. .3 They went on to state: Maurice Moonitz, The Basic Postulates of Account- ing (New York, N. Y.: American Institute of Certified Public Accountants, 1961). Robert T. Sprouse and Maurice Moonitz, A Tenta- tive Set of Broad Accounting Principles for Business Enter— prises (New York, N. Y.: American Institute of Certified Public Accountants, 1962). 3Ibido : ppo 1.1-1.2. In accordance with the emphasis in the postulates study, this study of broad principles takes the posi- tion that ideally all assets (and liabilities) should be recognized, as well as all changes that can be ob- jectively determined. . . .4 A few paragraphs later they stated: All assets of the enterprise, whether obtained by investments of owners or of creditors, or by other means, should be recorded in the accounts and reported in the financial statements. The existence of an asset is independent of the means by which it was acquired.5 In October, 1962, Professor Moonitz spoke to a group composed of faculty and graduate students on the campus of Michigan State University, East Lansing, Michigan. He dis- cussed the monographs in detail. Later that evening the same group met informally at the home of Professor Herbert E. Miller to further discuss the topic. The author mentioned to Professor Moonitz the fact that many resources which conceivably could be included as assets to a given firm are not now recorded. Professor Moonitz agreed that, while the monographs state all assets should be recorded, more investigation is needed to show ways in which the idea might be implemented. The author suggested the best method for recording these resources 41bid., p. 53. 51bid., p. 55. Inight be to capitalize superior or inferior earning power (as compared with other firms in the economy). Professor Dmoonitz agreed that this may be the best way of accomplish- ing this task and inferred further investigation of this matter might be a worthwhile dissertation topic. The main purpose of this dissertation is to devise a logically defensible and meaningful method of recording all assets of a firm somewhere in its financial statements. If this were the only accomplishment of the thesis, the effort involved would not have been wasted. The author, however, intends to go beyond the initial task by inves- tigating the benefits which may derive from the recording of all assets and thinks that by doing so he may contrib- ute some significant ideas to making financial statements more useful. Reasons for Searching for an Answer The question might be raised -- Why record all assets? The value of quantifying data was recognized by Moonitz when he stated: Quantitative data are helpful in making rational economic decisions, i.e., in making choices among alter- natives so that actions are correctly related to con- sequences.6 6Moonitz, op. cit., p. 21. The recent emphasis in our schools of business lipon the use of quantitative methods in decision-making is a result of the realization that explicit reasoning leads to better decisions than does implicit reasoning. The anticipated specific benefits that may derive by adopting the proposal for quantifying the value of all assets are many. Each of them is briefly summarized below. Closer Tie-in Between Financial Statements The need for a close relationship between the financial statementsums'pointed out by Moonitz as follows: The fact that accounting statements articulate with each other distinguishes them from most other types of statistical exhibits. Accounting statements constitute a design that is readily apprehended; they depend on each other in a systematic manner.7 The proposal contained in this dissertation will provide for a much closer relationship than now exists be- tween these statements. In fact, the relationship will be so close that one will be able to approximately determine a given year's income by looking only at the statement of financial condition prepared at the end of that specific year. The author refers to the statement of financial 7Ibid., p. 27. (mandition rather than to the balance sheet because he in- tends to differentiate between the two and assign different ‘usages to each. It is believed that this close unity of financial statements will indicate to the statement reader that all the assets have been recorded, at least in total. Rejuvenation of the Position Statement(s) In recent years the conventional balance sheet, which at one time purported to be a statement of finan- cial condition, has been looked upon as nothing more than a post—closing trial balance. The proposals made by .Moonitz and Sprouse, if adopted, would serve to greatly increase the usefulness of the conventional balance sheet. Moonitz and Sprouse recommended the following method of correcting valuations for assets which now usually ap- pear on the books: We observe that it is technically feasible to re- flect changes in some assets in a more timely fashion, and thereby give more current information in the bal- ance sheet. In this connection we prOpose to use a classification that distinguishes amoung (a) the amount attributable to changes in the dollar (price-level changes), (b) the amount attributable to the acquisi— tiOI1 of goods and services prior to their utilization, and (c) the amount attributable to sales in a current market. The horizon of accounting for the results of operations can be expanded in this manner beyond the limits now imposed. At the same time it will continue to be based on objective, verifiable evidence. Its usefulness to management, to investors, and to others can accordingly be greatly increased.8 Arthur M. Cannon, a member of the AICPA committee on accounting principles would even go further. His sug- gestions on the valuation of assets might also contribute to the rejuvenation for certain purposes. He stated: I am particularly pleased with the proposal to price inventories at current values, realizable value when readily available and otherwise replacement cost. I would go further in the same direction in the areas of fixed assets, though I recognize the distinction between current assets as those held for relatively prompt liquidation and fixed assets as those held for productive use over a long period. Since I am famil- iar with real estate, I would not find it difficult to accept a current value principle for valuation of land and buildings based on expert and independent appraisal reviewed by the accountant. That kind of evidence is just as good and, in some cases, better than evidence we are using already in other areas. ,I am sure that persons familiar with machinery and equipment would find it equally easy to accept the notion of reappraisal thereof to current value from time to time.9 The proposals of these men are significant ones. Until all assets are recorded, however, the position state- ment(s) will remain subordinate to the income statement. 8Sprouse and Moonitz, op. cit., p. 17. 91bid.. p. 63. The importance of rejuvenation of’ the position :statement(s) has been given recognition by the American .Institute of Certified Public Accountants as is evidenced 'by the following: . . . With the increasing importance of the income statement there has been a tendency to regard the bal- ance sheet as the connecting link between successive income statements; however, this concept should not obscure the fact that the balance sheet has significant uses of its own.10 Moonitz and Sprouse also commented on this problem by stating: Both experience and abstract analysis tell us in unmistakable terms that any attempt in accounting to emphasize either the balance sheet or the income state- ment to the virtual exclusion of the other is bound to give disappointing results. Neither lives in isolation from the other. Both must be considered in an inte- grated attack on the problems of financial reporting.1l- It is hoped that the ideas contained in this disser- tation might aid in the task of making the income statement and position statement(s) of more equal value to readers of financial statements. 10Restatement and Revision of Accounting Research Bulletins (New York, N. Y.: American Institute of Certi— fied Public Accountants, 1953), p. 7. l . . Sprouse and Moonitz. o ..c1t., p. 5. More Efficient Allocation of Funds In some of the more recent literature on capital expenditure decision-making for the individual firm, one of the most important concepts is that the company should receive feedback information so that estimates of net 'benefits to be derived from future projects will be more realistic. For certain uncompleted projects management may even choose to halt work after an analysis of the feed- back-information. There is an analogy to be drawn here when one looks at investment decisions as faced by potential in- vestors in our economy. Investors should be encouraged to make funds available to those firms which can earn the highest rate of return. This would encourage an optimum allocation of resources within the economy, as well as help to enable investors to earn a high rate of return on their investments. In order to determine how firms have performed in the past in relation to other firms in the economy, it is presently necessary to rely quite heavily on investment counsellors and on others who make this analysis a full-time pursuit. Much of their advice seems to be contradictory and the scope of the inter-firm com- parisons made by these experts may be too limited. One of the expected benefits of the proposal con- tnained herein is that a potential investor by looking only art the financial statements of one firm can tell whether it earned a higher than average rate of return on its identi- fied assets. While it is realized by the author that past or present returns are not necessarily indicative of future returns, it is argued that the public has a right to know how well the firms have performed in the past. If an in- vestor then chooses to ignore the past and bet on the future of a particular firm he may still do so. It is thought the proposal, by informing the public as to the relative performances of firms in the past, may also affect the cost of capital to the firms. Firms that have done well in the past may find their cost of capital falling, while those who have performed poorly may find their cost of capital increasing. While this undoubtedly occurs under present methods of financial reporting, the author would argue that his proposal may help to speed the action. Analysts would still be free, however, to attempt to convince the public it should ignore past per- formance and make funds readily available to certain firms because of their future potential. 10 Aid in Financial Anaylsis for Internal Purposes Persons engaged in financial analysis have long argued the accountant does not give information that is relevant for many decisions the firm must make. Leonard Spacek told of the opinion of a man he calls "one of the foremost financial men of our country" concerning the usefulness of financial statements for management decision-making. He quoted the man as saying: Now yesterday's witness . . . suggested that some- how these (accounting) systems have one more important use -- that they are valuable for managerial decision making. This isn't so. I cannot think of a single major decision that we make by going back to the books of account. . . .12 The improvements in the valuation of assets recom- mended by Moonitz and Sprouse should satisfy many of these objections, assuming their proposals are adopted. It is hoped the recording of unidentified assets, as proposed in this dissertation, will also make a contribution to the usefulness of financial statements for internal (to the firm) purposes. 2 Leonard Spacek, "The Need for an Accounting Court," The Accounting Review, XXXIII (July, 1958). pp. 369- 37o. 11 Implementation of Economic Theory Robert K. Mautz, in an address before the Eighth Annual Institute on Accounting held in Denver, Colorado, in October of 1961, had this to say: I think the profession must, from time to time, take a good look at what it is doing and question whether substantial improvement is not possible. Improvement comes from serious introspection. Only by seeking out our weaknesses and searching for a remedy, can we attain real progress. Financial state- ment presentation is, in my judgment, one of those weaknesses.13 He went on to state: . . . We have not yet begun to realize the full po- tential of accounting or of financial statements. There is no valid reason why we should not report much more information than we do in a considerably greater variety of ways. And although conservatism is undoubtedly a virtue of peculiar importance to accountants, progress demands a certain amount of innovation, even from conservative accountants.l4 Speaking of the need for more innovation he com- mented: . . . we cannot but be impressed by the magnitude and complexity of our task -- to present to those who have a right to [it] pertinent, financial information about business enterprises in such a way that it will meet their needs and assist them as fully as possible to 13Proceedings of the Eighth Annual Institute of Accounting (Boulder, Colo.: University of Colorado, 1961), p. 31. Ibido I p. 370 12 discharge their responsibilities. Business grows ever more complex; the interests in business have many and diverse needs; adequate reporting is thus a challeng- ing task indeed. Secondly, we must be impressed also by the relatively unexplored opportunities that lie before us. There are many possibilities for service that we have not yet even attempted, much less ex- hausted; there is much room for research and innova— tion.15 Professor Mautz made another statement which is pertinent to this dissertation when he stated: ... . we are not concerned with all possible kinds of economic information -- at least, not as public account- ants. It may be that some great day in the furture, accountants may truly measure and communicate all eco- nomic data, but frankly, I don't expect to see it. . . .16 It is believed the accountant will be called on in the future to communicate an increasing amount of economic information to the individual firms and to the public. The ‘wide gulf which now exists between the economic and account— ing concepts of business income may have been substantially narrowed by the Moonitz - Sprouse recommendations on the valuation of assets. It appears that the methods of valu- ation they have proposed are much closer to the economic concept than is the historical-cost method now used in ac- counting practice in the United States. If the gulf is to 15Ibid., p. 38. 16Ibid., p. 33. 13 be completely eliminated, changes may be necessary in the thinking of both groups. The author hopes he might further contribute in some way to needed changes on the accounting side of the prob- lem. In this way, he might help accounting practice to take a step in the direction of that "great day in the future" of which Professor Mautz spoke but does not ex- pect to see. Approach to the Problem Source data for this study includes literature from accounting periodicals, textbooks, and publications of ac- counting professional organizations. Appropriate litera- ture from the fields of economics and finance has. also been investigated. It is important to understand the scope of the study. It shall ppp_be the purpose of this dissertation to evaluate and pass judgment on the Moonitz - Sprouse monographs. ‘While the nature of assets and their valuation must be fur- ther dealt with, even though the Moonitz - Sprouse mono— graphs discussed these topics, the central task of the dis: sertation is to devise a meaningful and logically consistent way of recording usually unrecorded assets. This disserta~ tion should, therefore, be viewed as an appendage to the 14 work contained in the above-mentioned monographs. The scope of the dissertation is limited to a dis— cussion of the nature of assets, how generally unrecorded assets might be recorded, and a discussion of the expected benefits to be derived from doing this. Following this introductory chapter, there are six additional chapters. Chapter 11 reviews the literature on definitions of assets and settles on a definition the author will be committed to for the remainder of the thesis. His interpretation.of the definition is as crucial to the proposal itself as is the definition chosen. Chapters III and IV contain the basic proposal of the dissertation. The proposal itself entails a priori reasoning and is intended to be an extension of accounting theory. Problems concerned with the application of the method selected are discussed. An investigation and analysis of some of the antic- ipated benefits from adopting the proposal is the subject matter of Chapter V. A model is described for making cap- ital expenditure decisions for an individual firm. An analogy is drawn from this model for the situation facing the public in allocating funds to firms within the economy as a whole. The chapter also includes a discussion of how 15 some of the other benefits might derive. The discussion of the relevance of the proposal to an implementation of economic theory is reserved for Chapter VI. The special attention the author wishes to give to this topic is the reason why he has dedicated an entire chapter to it. Chapter VII summarizes the entire study. It re- states time argument contained in the preceding chapters and emphasizes the most important benefits which would result from an adoption of the proposal. Other contri— butions of the thesis are also discussed. The author sincerely hopes this study will con- tribute significantly to the formulation of a more mean- ingful body of accounting theory. CHAPTER II THE NATURE OF ASSETS General It was quite surprising, in gathering and reviewing definitions of assets, to note the lack of preciseness in most of the attempts. Still more surprising was the fact that many books on accounting, although discussing assets at great length, either felt it unnecessary to define the term or felt un— able to do so. A partial list of these books, with the author and date of publication of each is given in Appen- dix A.1 In 1929, Professor John B. Canning wrote about his efforts in searching the accounting literature for adequate definitions of assets. He became so disappointed with the definitions existing in the literature that he decided the 2 effort was not worth the scissor-work. He then constructed a definition by observing how various items were treated by 1The books appearing in Appendix A have not been included in the bibliOgraphy. 2John B. Canning, The Economics of Accountangy (New York, N. Y.: The Ronald Press Company, 1929), p. 13. 16 17 practicing accountants of the day. -The definition he formulated was as follows: . . . "An asset is any future service in money or apy giture service convertible into money (except those services arising from contracts the two sides of which are proportionately unperformed) the beneficial inter— est in which is legally or equitably secured to some person or set of persons. Such a service is an asset only to that person or set of persons to whom it runs."3 He concluded that not all items with the charac— teristics of assets are commonly included on the balance sheet, and that some items do appear which are not really assets.4 This conclusion is also one of the major points made in this thesis. It shall be the purpose of the next section to review the nature of commonly used definitions existing in the accounting literature since only then can recommenda- tions be made for an improved definition. The succeeding section is devoted to an analysis of the economic concept of assets to determine if it can contribute to the improve- ment. Finally, a synthesized concept is presented. 3Ibid., p. 22. 41bid., p. 45. 18 The Accountants' Commonly Used Definitions of Assets The author chooses to divide the commonly used definitions into two categories. Under the first cate— gory assets are viewed as "things of value owned,‘ while under the second category assets are viewed as "deferred charges" awaiting assignment to the income stream. Assets as Things of Value Owned webster's New Collegiate Dictionary was probably not the source for many of the authors in this group although it defines an asset as "any thing of value owned.”5 Most of the definitions that were substantially similar to the dictionary definition were contained either in textbooks for beginning students in accounting or in books written for non—accounting students. It is interest- ing to note that definitions of this nature were found in books written over a fifty—year time period. Certain other sources believed it necessary to immediately add a phrase to indicate that amounts owning to the entity should also be included as assets.7 It 5webster's New Collegiate Dictionary (Springfield, Mass.: GTC Merriam Co., 1949), p. 53. 6For a listing of sources see Appendix B. 7For a listing of sources see Appendix B. 19 seems this phrase, however, does not substantially alter the initial definition since accounts receivable and other claims could be viewed as "things" of value owned. There was another group of sources which did not specifically mention that assets must be owned.8 They referred to assets as being property of value to the business. Even though they did not specifically mention ownership as being required, it is believed that ownership was implied. Many of these sources gave one sentence defini- tions of assets and did not choose to interpret or qualify the definitions further at that point in their writing. A possible reason for this method of presentation is the authors believed that, because they were writing for persons not familiar with the field of accounting, a technically precise understanding of the term need not be conveyed. There were some authors, however, who chose to define the term through interpretation of it. Those sources which contained "interpretative" definitions went beyondaisimple one sentence definition to immediately explain For a listing of sources see Appendix B. 20 precisely what was meant. For example, one author after defining the term went on to say that the asset need not be legally owned by the enterprise, but need only be under the control of the enterprise.9 This was his way of indicating that such things as machinery purchased under a conditional sales contract, or real estate subject to a trust deed should be included as assets. He would not, however, include consigned goods as assets since the consignee only controls the property through delegated authority. Other authors also contrasted legal and constructive ownership.10 They argued constructive ownership is all that is required to record an asset. For instance, Arnold W. Johnson stated that in purchases on the installment plan the reservation of title by the seller is merely a protection device and therefore constructive ownership rests with the buyer.11 The actual source of many of these writers may have been the works of Professor William A. Paton. His writings 9Myron M. Strain, Industrial Balance Sheets (New York, N.Y.: Harper & Brothers Publishers, 1929), p. 2. O . . . 1 For a listing of sources see Appendix B. 1 1Arnold W. Johnson, Elementary Accounting (New York, N.Y.: Rinehart & Company, Inc., 1946), p. 9. 21 have been commonly referred to by many "students" of account- ing. In 1922, Paton and Stevenson defined assets as ". . . any consideration . . . owned by a specific business enter- prise and of value to that enterprise."12 In 1949, Paton's definition of assets was substantially the same. -Assets as Deferred Charges In 1957, Professors Paton and Littleton co—authored a monograph for the American Accounting Association. They described assets as ". . . factors acquired for production which have not yet reached the point in the business process where they may be appropriately treated as 'cost of sales' or 'expenses.'"14 It is not certain that this represents a change in Paton's concept of assets, but he has certainly described them from a different viewpoint. One writer specifically mentioned this shift in view- point as to the nature of assets by stating, "New this idea 12William A. Paton and Russell A. Stevenson, Princi- ples of Accountipg_(New York, N.Y.: The Macmillan Company, 1922), p. 18. 13William A. Paton, Essentials of Accounting (New York, N.Y.: The Macmillan Company, 1949), p. 15. 14William A. Paton and A. C. Littleton, An Intro- duction to Corporate Accounting Standards (Ann Arbor, Mich.: American Accounting Association, 1957), p. 25. 22 of assets as "deferred charges" is much nearer to the one which I am proposing. It is based on a "going—concern” view of costs-a1ready-incurred-thus—relieving—the-business—of- some-future—costs-against-future-revenue, rather than the "winding up" view of realizable values for some material assets and "fixed-capital sunk" view for some other material 5 assets."1 The Committee on Terminology of the American Insti- tute of Accountants, as it was known in 1953, chose to define assets from the "deferred charge" point of view. It gave the following all-inclusive definition: Something represented by a debit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of ac- counting (provided such debit balance is not in effect a negative balance applicable to a liability), on the basis that it represents either a property right or value ac- quired, or an expenditure made which has created a property right or is properly applicable to the future. Thus, plant, accounts receivable, inventory, and a deferred charge are all assets in balance-sheet classification.16 The Committee also admitted that deferred charges really are not assets in the popular sense, but because they Harry Norris, Accounting Theory (London, Eng.: Sir Isaac Pitman and Sons Ltd., 1946). p. 47. 6American Institute of Certified Public Accountants, Accounting Terminology;BulletinstNo. 1, Review and Résumé (New Ybrk, N.Y.: American Institute of Certified Public Accountants, 1953), p. 13. 23 may be carried forward as proper charges against future in— come, they are assets in a balance—sheet classification. The Committee on Terminology of the Institute blamed the difficulty in arriving at a proper definition of assets partially on the double-entry bookkeeping system and admitted that defining assets as those items on the balance sheet with debit balances may not be an adequate statement of assets. Professor Canning commented on the weakness of defi- nitions of assets which include all items with debit balances by stathrL "Perhaps the most difficult task of all will be to show the nature of those items often listed under the general caption of assets in the accountant's reports that are not generally considered by accountants to be assets at all."18 General Comments The definitions contained in this section are thought by some to be quite inadequate attempts. Probably the most vocal of the critics of the so-called ”simple" definitions was Professor Canning. He attributed the lack of an adequate definition of assets (as of 1929) to the incompetence of . . . l9 . . writers in the area of accounting. It is almost certain l7lélégl pp. 11-12. 18Canning, op. cit., p. 12. l91bid., pp. 8-9. 24 that if Professor Canning were to perform an investigation of the literature existing in 1963, he would again be dis- appointed with most of the attempts to define assets. It does seem that the possible uses which can be made of ac- counting statements are somewhat limited by the use of these "simplified" and divergent definitions. One might tend to think there has been an improving evolutionary trend in the concept of assets. However, it instead appears that such things as the sophistication of the expected reader and opinions as to the function of the balance sheet have greatly influenced the definitions given by each of the many writers. Mr. Leo A. Schmidt, writing in 1937, came to the aid of these writers by claiming the simpler definitions are only meant to be working definitions and need to be further refined by "scientific" thinking before the term can really be understood.20 Until a technically precise definition is agreed upon, the users of the financial statements are bound to remain confused. The "deferred charge" definition in treating assets as unexpired costs conflicts with the com- monly held view that assets are things of value, while the 20Leo A. Schmidt, Theory and Mechanics of Accounting (New York, N.Y.: Prentice-Hall, Inc., 1937), p. 10. 25 "things of value owned" definition excludes resources which are controlled (but not owned) by the entity and which, therefore, have economic value to it. One of the main reasons for the divergent views of assets, within the commonly stem from the fact that the been asked to serve both as as a statement of financial follows in Chapters III and situation. Professor Charles E. originally written in 1907, used definitions, then, seems to conventional balance sheet has a post-closing trial balance and condition. The proposal which IV will attempt to remedy this Sprague, in his ”classic" book pointed out the various ways in which assets may be considered. In his words: . . . the assets comprising the debit side of a balance sheet may be considered in one or more of the following ways: 1. As things possessed, directly or indirectly, or physical assets. 2. As rights over things and persons, for use, for services, or for exchange. 3. As incomplete contracts, whereof our part has been performed in whole or in part; or contrac- tual assets. 4. As the result of services previously given, or 9.83.- 5. As the present worth of expected services to be received. 6. As investment in the hands of another who uses it as capital.21 21 Charles E. Sprague, The Philosophy of Accounts (New York, N.Y.: The Ronald Press Company, 1922), pp. 47-48. 26 His categories are quite inclusive with the possible exception that he did not specifically include the "deferred charge" concept. The probable reason for not including that concept is Professor Sprague viewed the balance sheet as the most significant of the financial statements. The "deferred charge" concept, in contrast, implies that the income state— Inent is to be emphasized. Professor Sprague included the economic concept, however, which is discussed in the next section. The Economists' Concept of Assets Professor Canning was careful to point out that an asset is a future service (rather than a source), in money or convertible into money, the beneficial interest in which is legally or equitably secured to the entity. Another writer, Edward G. Nelson, writing in 1942, chose to alter Professor Canning's definition by stating that the service or services need not be legally or equitably secured to the entity to be an asset to it.22 The major point which Mr. Nelson made, however, was concerned with the difference between assets and agents. He stated: 22Edward G. Nelson, "The Relation Between the Balance Sheet and the Profit-and-Loss Statement," The Accounting Re— view, XVII (April, 1942), p. 136. 27 The elements of all assets are not listed on all balance sheets. Some are implied. If the enterprise is a "going concern," it may be reasonable to expect future labor services, for example. However only the relatively minor item, Prepaid wages, is generally exhibited. The rest is left to the imagination. Buildings, Machinery, Equipment, and Inventories are commonly listed as assets. These instruments are, in themselves, useless. A building cannot provide shelter for very long without a janitor. Someone must press the button to provide a pleasant atmosphere for customers. When the instruments are listed as assets, the future services associated with their use are implied. Labor, power, heat, light, repairs, and maintenance must be had or the instruments are useless and the proprietor has no assets. we must distinguish between the agent and the asset. The former is merely an instrument which will render a service. The latter is the future service or services. A delivery truck, for example, is an agent. Future transportation is the asset. . . .23 His argument is in line with the economic view of assets. It seems clear from the above that economists equate assets with services. It is also a fact that economists . . 4 equate "factors of production" With resources.2 To show that economists equate factors of production with services as well, Kenneth Boulding stated: The prices which form the subject matter of the theory of functional distribution are the prices of 23Ibid., pp. 136-137. 24See A. C. Pigou, The Economics of welfare (London, Eng.: Macmillan and Co., Limited, 1952), p. 134; or Abba P. Ierner, The Economics of Control (New York, N.Y.: The Mac- millan Company, 1959), p. 324. 28 services of property, not of the property itself from which the services are derived. These services are usually called the "factors of production" although this term is sometimes carelessly used to mean the property from which the service is derived.25 From an economist's point of View it would seem, therefore, that assets, resources, expected future services, and factors of production are identical concepts. A Synthesis of Viewg It is evident from the study of balance sheets, accounting textbooks, and other accounting literature that the accountant uses a different concept of resources (and, therefore, of assets) than does the economist. The account- ing usage seems to conform to one of the definitions given by The American College Dictionary to the effect that re— sOurces represent money, or any property which can be con- Verted into money. There is little doubt that by listing such things as; buildings and equipment on balance sheets as assets, the a~<2countant has the "agent” concept in mind. The system of afl:taching values to agents is so traditional in accounting \ Kenneth E. Boulding, Economic Analysis (New York, IN.Y.: Harper and Brothers Publishers, 1941), p. 219. 26 . . . The American College Dictionary (New York, N.Y.: Random House, 1958), p. 1033. .- o a 29 that any attempt to change this method of grouping and re- porting the value of future services would detract from, rather than add to, the proposal of this thesis. A synthesis of the two concepts is possible, how- ever. The method of grouping values and labeling them ac— cording to the agent which will provide the future services can be retained from accounting. The amount of valuation to place on total assets could be determined by taking the economic concept of expected future services into account. The economic concept can also be used to identify assets which have not been recorded by the accountant. It 118 ‘already evident that the economic "factor of production," lalmor, has not been given asset recognition by accountants. That some businessmen realize this error is evidenced by Stirtements such as the one made by Kenneth Stiles, Vice President of General Dynamics Corporation, to the effect that nth? resources, I am thinking not just in terms of equipment and materials but also of our most valuable assets, the Skill and brainpower of our people."27 Probably as a result of an increasing interest by Kenneth Stiles, "What's wrong with Financial Reporting - Accounting for Research and Development," The mml of Accountancy, CXII (August, 1961), p. 31. 30 accountants in the area of economics, some of the more re- cent attempts to define assets have incorporated economic terminology. The definition given by the Committee on Con— cepts and Standards Underlying Corporate Financial Statements of the American Accounting Association, for instance, de- fined assets as "economic resources devoted to business purposes within a specific entity; they are aggregates of service - potentials available for or beneficial to expected . ,, 2 ope rations . The most notable recent attempt to incorporate the economic concept of assets was made by Professors Moonitz and Sprouse. They stated that " assets represent expected future economic benefits, rights to which have been acquired by the enterprise as a result of some current or past trans- aCtion." 9 From the wording of this definition it, at first, seems that they intend the asset to be the future service rather than the agent which will provide the future services. They later stated, however, that "the apparent ability to 28American Accounting Association, Accounting and BEEQrting Standards for Corporate Financial Statements COlumbus, Ohio: American Accounting Association,l95TL 29 . . . Robert T. Sprouse and Maurice Moonitz, A Tentative §2£_9f Broad Accounting Principles for Business Entepprises (New York, N.Y.: American Institute of Certified Public Accountants, 1962), p. 8. p. 3. 31 render future economic benefits is the attribute which makes resources valuable; that which is incapable of rendering future benefits under any set of assumptions has no value . "30 . . . and is therefore not an asset. A further clarification of their concept can be obtained from another comment they Inade to the effect that: . . . the asset status of a resource is usually tem- porary. Most assets are capable of providing only a limited quantity of economic services. When those serv- ices have been dissipated or the time has elapsed, the asset status expires.31 From this latter statement it seems apparent that Moonitz and Sprouse are using the term, resources, to de- S<2:I:'ibe agents which render future services or benefits. To the extent that this interpretation is correct, Moonitz and SProuse have chosen to retain the traditional accounting Ineathod of grouping values by agents rather than by services. :[tl is evident, however, from reading the remainder of their Inuld be made that it is constructively owned), nor is it di- re{Itly usable or convertible for the payment of entity debts.34 \ 33’William A. Paton, Accounting Theory (Chicago, Ill.: AcCounting Studies Press, Ltd. , 1962) , p. 138. (This work was was originally written in 1922 as a doctoral dissertation at e University of Michigan.) 34An analogous category to that of "Unidentified As— sets" is one entitled "Unidentified Negative Assets." The aliter category will be used, in the proposal which follows, . 0 record the negative worth of such factors as a relatively inefficient and untrained sales force. 34 Neither of the above categories are intended to in- Since cflude items commonly referred to as deferred charges. these items are not resources in their present form (but only charges awaiting assignment to the income stream), they are 35 :not considered to be assets under the definition selected. In the next two chapters, the main proposal of this tihesis is given and defended. The proposal not only con- cnerns itself with how unidentified assets might be recorded, IDLIt also with a differentiation between the balance sheet and 'tlie statement of financial condition. It will then become Incxre obvious to the reader why the above categories have been 8elected. . The reader may be comforted in knowing that these 5Ltems will still be accorded a place in the balance sheet. CHAPTER III COMPUTATION AND ENTRIES TO RECORD UNIDENTIFIED ASSETS General The recording of unidentified assets is analogous to the problem of estimating the amount of goodwill. which exists as an economic fact for an entity but is not recog— nized in its books of account. A differentiation is made between "goodwill" and "unidentified assets" later in this Chapter. However, much of the literature on goodwill was found to be applicable to the problem dealt with in this thes-sis. Instances in which some attempt must usually be made to place a value on previously unpurchased goodwill include the transferring of an entire business from one owner to an- c>ther, the transferring of a share in a business from one interest to another, and the assessing of an estate duty tax on capital.1 It may be helpful to know how the amount of goodwill is estimated in instances such as these. \ Kenneth S. Most, "Valuation of Commercial Good— will," The Accountant, CXXXVIII (March 1, 1958), p. 248. 35 36 One source2 listed six methods. They include valu- ation by an arbitrary assessment, an assessment based on turnover (gross fees), totaling the net income for a certain number of years in the past, totaling the super—profits for a certain number of years in the past, capitalizing expected future net income, and an annuity method. Another author3 mentioned two additional methods; the use of a sliding-scale Valuation of super-profits, and valuing goodwill as the dif— ference between the average value of tangible assets and the Capitalized value of the yield. There seem to be disadvantages to the use of each of the methods. An arbitrary assessment of the amount would lack in uniformity of application among firms. The optimist Would place a higher value on goodwill than would the Pessimist. Those methods which value goodwill at some number of years' purchase of annual net income, super-profits, or \ 2R. K. Yorston, E. B. Smyth, and S. R. Brown, Ag— ched Accounting (Sydney, Austral.: The Law Book Co. of Australasia Pty. Ltd., 1950) , p. 65. The original contrib- utor of the methods could not be located by the author of this thesis. The summary contained in this source, however, seems to be quite useful. 3Arthur J. Little, "Valuation of Goodwill," The SEépadian Chartered Accountant, LXXIV (February, 1959), I3. 110. 37 gross fees seem to beg the logic of the problem. For in- stance, it is not of much satisfaction to be told that, traditionally, goodwill is worth from one to five years' purchase of past net income in a trading business, and from one to four years' purchase of net income in a manufactur— ing concern.4 Two firms may have equal net income totals but different amounts of investment in tangible assets, yet, under these methods, the goodwill of the two would be the same. Methods which require a prediction of future net income are subject to a wide range of errors. It is likely that "even with the exercise of the greatest care and skill maintainable future profits must necessarily be an estimate, subject . . . to a material margin of error, since no one can foretell the future." The sliding—scale method uses different multipliers for different layers of super-profit.6 The advocates of this system believe that the greater the super-profit the more likely is the business to attract competition. There- fore, the upper layers of super-profit are valued at a lower ¥ 4H. E. Seed, Goodwill as a Business Asset (London, Eng.: Gee and Co., Limited, 1937), p. 147. 51bid° 1 ppo 149-150. 6.133.;‘gnw 1 pc 1519 38 rate than are lower levels. Since one of the intentions of the proposal presented in this thesis is to affect the flow of capital, it does not seem desirable to minimize the value of unidentified assets before the capital has been reallocated. The method which establishes the value as the dif- ference between the average value of tangible assets and the capitalized value of the yield seems to be managable (assum- ing past yields, rather than future ones, are selected as a basis for capitalization). The problem still remains, how- ever, of selecting a capitalization rate and of determining the number of prior years' income performance to be used in the computation. Another conceivable method of valuation would be to take the market value of shares of stock times the number of shares outstanding as the total value of the entity rather than capitalizing net income. The major difficulty with this procedure is that the market quotations apply to purchases at the margin rather than to the price which would be paid either for the total entity or the controlling interest in . 7 . . the entity. Commenting on the use of this method Couchman ‘ 7Charles B. Couchman, "Limitations of the Present Balance Sheet," The Journal of Accountancy, XLVI (October, 1928), p. 267. 39 stated, "Such a procedure would, among other things, be a reversal of the order of cause and effect. . . . Under the present conditions governing bids and offers of stock on the market, a limited group might raise or lower the price of stock of a particular corporation to almost any degree de- sired, regardless of the fact that the actual values in the 8 corporation remained constant during the period. . . In 1912, George May was called to testify in the matter of the estate of E. P. Hatch on the computation of goodwill. He chose to use past earnings as an indication of future earnings. In his words: The value of the goodwill was a very difficult prob- lem indeed. In the first place, I adopted the method that has been used in numerous cases which have come to my notice in the sale of goodwill, of determining the value solely on the basis of the earning capacity or of the past earnings. . . . I worked out the value of the goodwill . . . on the basis of deducting from the earn— ings interest on the investment [in] tangible assets, and then capitalizing the excess on the basis of five years' profits. . . .9 The method used by Mr. May is quite similar to the one‘which will be suggested in this thesis. 8Ibid., pp. 266-267. 9 George 0. May, Twenty-five Years of Accounting Resppnsibility (New YOrk, N.Y.: American Institute Pub- liShing Company, Inc., 1936), p. 237. 40 As evidenced by the methods cited above, it can be seen that no method of recording goodwill is both absolutely correct in theory and practicable. Some compromise will have to be made. Future net income streams, while theoretically correct to use, are subject to wide ranges of error. The use of past earnings as a basis for capitalization is man- ageable but not theoretically correct. As Mr. Stodder once wrote, ”I do not know of any combination of formulae which would . . . produce an exact answer; there is only reasonable knowledge and judgment."10 Hewever inaccurate is the method selected to record the value of unidentified assets, the effort will provide more accurate statements than does the present practice of leaving them off the position statement entirely. As Profes- sor Emeritus A. C. Littleton once stated, "A good approxima- tion is more truthful than the omission of a fact."11 It is possible that if a method for the calculation of unidentified assets could be agreed upon by members of the accounting profession, the practice of valuing them ¥ 10John w. Stodder, "Some Methods of Valuation of a GOing Concern," The Illinois Certified Public Accountant, .XXI (Summer, 1959), p. 17. ll . . A. C. Littleton, Structures of Accounting Theory (Urbana, 111.: American Accounting Association, 1953), P. 10. 41 annually and including the amount in the statement of financial condition might become general. The proposal is presented in two major parts. The first is the method for calculating the amount of unidenti- fied assets or unidentified negative assets and the entries to record them. The remainder of this chapter is concerned with this problem. The second part of the proposal is con- cerned with the presentation of the data in the financial statements and is dealt with in the next chapter. The Mechanical Process Computation of Amounts For the sake of simplicity, it will be assumed that there are only four firms in the total business sector of the economy of a given nation. They are all corporations with a separation of ownership and management.12 Table 1 gives the average value of identified assets and the net income of each of the firms for the previous year. 12 . . . . This is a necessary condition for some later arguments on the nature of unidentified assets. Manage- merm will be considered a resource under the control of the owners . 42 TABLE l.-—Assumed data (Dollar Signs Omitted) Firm W X Y ZN Total Average Value of Identified Assets1 100,000 50,000 200,000 150,000 500,000 Net Income 11 After Taxes 15,000 5,000 25,000 5,000 50,000 Rate of Net Income on Average Identified Assets 15% 10% 12.5% 3.3% 10% i - The average value of identified assets ideally would represent the arithmetic average of the daily value of identified assets which were under the control of the entity throughout the year. From a practical vieWpoint a monthly, quarterly, or annual average may have to suffice. ii - Net income after taxes was selected since the point of view adopted in this proposal is that of the absentee owner. It can be seen from Table 1 that the rate of net income on identified assets for the total economy is 10% for the given year. The rates for the individual firms vary from 3.3% for Firm Z, to 15% for Firm W. Table 2 shows the computation of the amounts at which the unidentified factors should be recognized. 43 TABLE 2.—-Computation of the value of the unidentified resources to each of the firms in the economy (Dollar Signs Omitted) Firm _E_ .Ié. _X_ _E_ Average Value of Identified Assets 100,000 50,000 200,000 150,000 Nbrmal Net Income (at 10%) 10,000 5,000 20,000 15,000 Actual Net Income 15,000 5,000 25,000 5,000 Divergence from Normal 5,000 —0- 5,000 (10,000) Unidentified Assets (Capitalized at 10%) 50,000 -0- 50,000 Unidentified Negative Assets (Capitalized at 10%) 100,000 Since the tangible or identified assets laying idle “muld earn nothing, the differences in rates of earning can be ultimately traced to the efforts of human resources. From Thble 2 it can be seen that the human resources working with the identified assets in Firms W and Y were more efficient than average and therefore deserve to be capitalized and shown as assets on the books of these companies. The human nesources in Firm X were only average in efficiency and, therefore, do not warrant capitalization into the records. 44 The inferior performance of Firm Z must mean that the human resources manipulating the other resources in that firm are performing submarginally as a group and, therefore, have a relatively negative economic effect. For valuation purposes the effect of unidentified assets has been converted into an equivalence of identified assets. Thus, based on its identified assets, it would be expected that Firm W would earn $10,000 for the year. The actual earnings for Firm W, however, were $15,000. To earn this amount with assets which were only normally productive, it would be expected that total assets should have been $150,000. Since identified assets were $100,000, there must have been $50,000 worth of other assets at work during that year. These are recognized as unidentified assets. For Firm Z, it is as if it only had $50,000 of identified assets being manipulated in a way which resulted in average productivity. Proposed Journal Entries The journal entries to record unidentified assets and.negative assets on the books of the various firms are as follows: 45 Firms W and Y 12/31/__ Unidentified Assets 50,000 Equity Increase — Superior Earning Power on Identified Assets 50,000 To record the existence of unidentified assets. Superior earnings on identi- fied assets were capitalized at the normal earnings rate in the economy of 10%. (5,000) (10%) Firm X No entry Firm Z 12/31/___ Equity Decrease -; Inferior Earning Power on Identified Assets 100,000 Unidentified Negative Assets . 100,000 To record the existence of unidentified negative assets. Inferior earnings on identified assets were capitalized at the normal earnings rate in the economy of 10%. (10,000) (10%) At the end of each accounting year a fresh computation is made concerning the existence of unidentified assets or :negative assets. The conCept is one of pgp_va1uation so that bcmh categories should not exist on the financial statements Of a given firm for the same year. If a firm switches from a 46 position of recording unidentified assets one year to record- ing unidentified negative assets the next year (or vice versa), it is necessary that the entry made for the previous year be reversed. Discussion Why Only Deviations from Nermal Are Given Recognition Professor Paton, in discussing the existence of ‘Lllilpurchased goodwill, mentioned a method of valuation which is quite similar to the one given above. He stated, "It Eslfixauld be emphasized that none of these rights, conditions (DWK‘ favorable circumstances can reasonably be said to con- 1:--3l=‘.':i.bute to goodwill or any other value except as they give the particular business an advantage over the basic repre- S3Sadrltative concern."13 At another point he referred to good- “Vhi~ll as being "the capitalized value of the excess income ‘Vflblich.a particular enterprise is able to earn over the income :E? a representative competitor -= a "normal" buSiness . . . ‘t:]b1£: rate used in capitalizing being the rate by the \ £§L 13William A. Paton, Accounting Theopy (Chicago, Ill.: WQQounting Studies Press, Ltd., 1962) , p. 316. (This work $8 originally written in 1922 as a doctoral dissertation at 1: 1b1€3* University of Michigan.) 47 representative firm." Mr. Leake also emphasized that only the divergences from normal should be capitalized. His argument was that ‘there were always opportunities free for the employment of cnapital at normal rates of interest.15 It seems logical to easssert, then, that the only positive (or negative) valuation 1:11at should be placed on human factors is the amount above (<5: below) normal by which they affect the productivity of no n—human resources . Comparable Valuations for Identified Assets It is important to the proposal that identified assets among the various firms be valued on a comparable I 13Eisis. The presently used method of valuing assets on a historical—cost basis results in non-comparability of values. IEP<>r instance, one firm might be carrying fixed assets at ‘tLTIe cost to it in 1930, while another firm may be carrying $3imilar assets at the price it paid in 1960. The valuation methods recommended by Professors 1°onitz and Sprouse eliminate this problem. For money or \ 14Ibid., p. 313. 15 . . P. D. Leake, "CommerClal Goodw111,” The Account— Ea \\\$ZEE;J LXVII (Nbvember 11, 1922), p. 700. 48 claims to money they recommended valuation at their dis- counted future exchange prices.16 Presumably this would also represent their current market value assuming the dis— count rate used is the going rate in the economy for the degree of risk involved. For other assets they generally recommended that current market prices be used where they exist and are determinable.l7 Where this is not possible, they recommended the use of index numbers or independent appraisals. 18 For specific items, however, their thinking deviates from current market prices in several instances. For in- Ventories they recommended valuation at net realizable value where determinable.19 If for some reason this cannot be I determined they recommended the use of current replacement 20 Q‘Dst. The use of either of these methods eliminates non- Qc>mparability resulting from such alternative practices as One firm using LIFO while another uses FIFO. \ 16Robert T. Sprouse and Maurice Moonitz, A Tenta- \e Set of Broad Accounting Princgsles for Business Enter- ‘Kisgg (New York, N.Y.: American Institute of Certified DIlhlic Accountants , 1962) I P- 24- 17Ibid., p. 26. lalhidy, p- 27- 19Ibid, 20Ibid., p. 29. 49 They believe that "in the external reports, plant and equipment should be restated in terms of current re— placement costs whenever some significant event occurs, such as a reorganization of the business entity or its merger with another entity or when it becomes a subsidiary of a parent company."21 They also stated that in any event the accounts saliould be restated at certain intervals of perhaps five years. According to Moonitz and Sprouse, land should also be restated in current terms whenever a significant event <3'<:o::urs or at reasonable intervals of perhaps five years. The author of this thesis chooses to value identified a~38ets by the general method which Moonitz and Sprouse first mentioned. He would recommend the use of current market Values, or the best approximation of current market values, as a basis of valuation for all identified assets. To the extent that this is accomplished properly, the valuations of identified assets would be on a completely comparable basis.2 zkli‘thur M. Cannon concurred with the selected basis of valua- t ion when he commented, "I would not find it difficult to 6‘chpt a current value principle for valuation of land and \ 21Ibid., p. 34. 22Ibid., p. 36. 23This is true only if economy-wide market prices Q {‘Q assumed. 50 buildings based on expert and independent appraisal re- viewed by the accountant." Why has the author chosen market values? The main is that it makes valuations of reason, as was stated above, ixientified assets among firms more comparable. There is a cuonflict here, however, which must be mentioned. Market xraalue is equivalent to the economic concept of opportunity 1c:<>st. The market value shows the cost to the user of not £3£elling the asset. It also is an indication of the maximum "7Eilue of future services which the asset could render to an alternative user should he gain control of the asset. One might then argue that, since the absentee stockholder's JE><>int of view has been selected in this thesis, should not 1ill‘ie assets be carried at the value of future services pg lflLégp. This objection is valid. However, to the extent that 1:11e identified assets are more productive to the present L1Sier than they are to alternative users and have indicated t:l‘iis fact by causing the firm to earn a higher rate of return 1::rlan normal, this difference has been capitalized and in- Qluded in unidentified assets. \ 24Arthur M. Cannon, "Comments of Arthur M. Cannon," QL“11- Sprouse and Moonitz, op. cit., p. 63. 51 Comparable Computations of Net Income If market values are used for identified assets, many of the difficulties of non-comparability involving the For instance, «determinations of net income may be eliminated. jgf depreciation were to be regarded as the difference between ‘tlae market value of the asset at the beginning of the period aarid at the end of the period, the alternative methods of sum-of—the-digits, and £31:raight—1ine, declining—balance, <>1zher methods could not be used for financial reporting pur- .E><>ses. As mentioned previously, differences in inventory \failuation which ultimately affect net income also would be e liminated. The nasty problems concerning the elimination of O . a Gaxtraneous" losses and gains would also be aVOided because 1:hese changes are recognized when they occur, rather than ‘Ndnen the assets are disposed of. It is recommended that Ea$11 gains and losses be recognized in the income statement 1because they are the result of some decision made by a human resource in the entity. In computing accounting net income, however, dif- Items generally in- ferences among firms may still exist. (:33ledab1e in the category of "deferred charges," which have 52 no market value (and therefore are not identified assets), may be treated differently by the various firms. One firm may capitalize research and development costs as a deferred charge, while others may “expense" these costs immediately -- even when the economic facts are similar. The chief threat to comparability of data, then, under the system presented in this thesis, is the fact [that some firms will treat cer- tain expenditures as deferred charges while others will lug-u treat similar expenditures as expenses of the period. The effect of this would be that differences in the amounts of unidentified assets shown on the, statements of financial con- 11t actually setting up a court, much "red-tape" would be it seems that the auditor, if eliminated. In either case, given a code to follow, could ensure that the net income he ‘p’éis reviewing would be computed in a manner comparable to t11‘1at of all other firms. Arthur Cannon has stated that "the very significance Q’f what is reported rests on an assumption of consistency Eilid comparability, just as the significance of any statis— 1:ical data rests on the comparison with some standard, not on t "29 ‘~;EEE absolute data. 26Leonard Spacek, "The Challenge to Public Accountingfl EEIEE; Harvard Business Review, XXXVI (May-June, 1958), P. 116. 27Ibid., p. 117. 28Spacek, "The Need for an Accounting Court," pp. 5§£§L3;., p. 376. 29Arthur M. Cannon, "What's wrong with Financial Re- Eb‘=>::ting -- The Investor's View"(A S osiumL The Journal of YmP r a particular entity. Each of these methods used the in- <2J:ding unidentified assets would be lacking. 55 Ruling out any method which required the prophesiz- ing of future net income left the author with only past "objectively" verifiable net income figures to work with. Professor Moonitz agreed that an objectively verifiable method is desirable when he wrote, "Changes in assets and liabilities, and the related effects . . . should not be given formal recognition in the accounts earlier than the point of time at which they can be measured in objective I“ . terms." Leonard Spacek also supported this idea when he Wrote that "when the public accountant fails . . . to report the facts objectively, the accounting statements may become t001s of propaganda for the use of anyone who is able to i ITlfluence them. " 31 Left with past "objective" net income figures with ““hich to work in attempting to arrive at a valuation for 1:“:"'1'?l:i.dentified assets, it was decided that only the income figure for the current year should be used in the computa- It is believed that the best evidence available \t iOn itself. 3' f the present existence of unidentified resources is the \ 0 . Maurice Moonitz, The BaSic Postulates of Account- W (New York, N. Y.: American Institute of Certified Public z\Qcountants, 1961), p. 14. lSpacek, "The Challenge to Public Accounting," pp. Q - &-, p. 115. ”,3- on' " .4"- r‘ ' .o.c .,.. IA"! \u an! .v'v . I‘v. V'- ‘ . \y.‘ I . o“' .0. “'5 . , II.‘ 1... N 56 fact that a given firm earned a higher than normal rate of income for the most recent year. If the results of several years were included in the computation, there is a possibility that unidentified resources affecting income results of several prior years would be included although no longer of any economic consequence to the firm. In an attempt, there- fore, to provide the best evidence of the current existence of unidentified resources only the current year's income I... I Performance was used in the computation. It is not inferred that the absentee stockholder (or Prospective stockholder) should refrain from examining past Performance or estimating (at least implicitly) the future net income of a given firm. These would provide further in— formation as to the worth of the entity. The author chooses, I1<>V\7ever, not to incorporate these into his computation of u n identified assets. The method selected indicates that the amount in- Q J~"~-1ded under the caption "Unidentified Assets" includes the va- lIle of those unidentified resources which had economic S ignificance to the entity during the most recent year. The inference is that this amount is the best "objective" evi- a3lice that these same resources are more than likely to Q0 htinue to have economic significance in the immediate 57 future. Professor Paton once wrote, "An assumption that the current favorable situation will be maintained from two to . . "32 five years is common. Professor Canning supported the indirect method of vealuation used in this thesis by stating, "Some valuations IDEE found for some types of assets." . . . . r“" xniist of neceSSity be indirect in the sense that no separable ! i realized income . . . in terms of money receipts, can ever :3 I 33 t The method selected for valuing unidentified assets is indirect and is called the residual method by persons erlgaged in real estate appraising. As one writer stated, "UPkue residual techniques used in capitalization processes £13362 mathematical methods for revealing unknown factors of "34 "'53LLue by means of the use or consideration of known factors. The Nature of Unidentified Assets and Negative Assets The conceptualization of unidentified resources in 1::blis thesis is different than the usual meanings given to ‘1‘\§‘_» 2Paton, op. cit., p. 324. TE? 33John B. Canning, The Economics of Accountangy (New (DJik, N.Y.: The Ronald Press Company, 1929), pp. 206—207. fiL 34Clifford W. Hollebaugh, "Income Approach to Value," “In Encyclopedia of Real Estate Appraising, Edith J. Fried- «e111 (ed.), (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 95 9), p. 79. 0.. ~I‘ UV ' Q 9 0 ‘~. 58 goodwill. In order to illustrate this point a brief review of various meanings attached to goodwill is necessary. Eric Kohler defined goodwill as the present value of the expected future income in excess of a normal return on the investment in tangible assets. This definition de- fines goodwill by telling how it should ideally be valued. Another source mentioned three different kinds of goodwill. The first, commercial goodwill, includes favor— able attitudes or reactions of customers toward certain The second, industrial goodwill, aSpects of the firm. represents the willingness of employees to work for the Present employer instead of competing employers. The last, financial goodwill, represents the favorable attitudes of anestors and credit institutions toward a particular firm. Economists have traditionally viewed goodwill as an external economy resulting from the reputation or public esteem which an enterprise holds in the eyes of the public. \ 5 . . . Y 3 Eric L. Kohler, A Dictionary for Accountants (New Qrk, N.Y.: Prentice-Hall, Inc., 1952), p. 238. Handbook 36William A. Paton (ed.), Accountants' 1934), é2nd ed.; New York, N. Y.: The Ronald Press Company. ‘ 801. 37C. J. Foreman, "Economics and Profits of Good— » ~ 2 ill," The American Economic Review, XIII (June, 1923) , p O 9 59 Jurists have seemed unable to agree as to the nature of goodwill.38 Some have interpreted it as an advantage of the productive process while others have viewed it as wholly an element of demand. One writer stated, however, that "all the legal definitions indicate very clearly that the thought F in the mind of the court was the essential identity of good- E will with reputation, commercial standing, location and all other favorable conditions leading customers to deal with a business. " Sprague while writing on the causes of differences between book value and market value of shares of stocks, attributed the divergence to the fact that in some cases aseets are not handled with the success which will earn the a:‘7erage rate of return, while for other firms the management may be so successful that its earning power is greater than the average . 4O \ 38Ibid. 39 u . . - Herbert C. Freeman, Some Cons1derations Involved :l‘lj- the Valuation of Goodwill," The Journal of Accountancy, M11 (October, 1921), p. 252. 40Charles E. Sprague, The Philosophy of Accounpg JC: New York, N.Y.: The Ronald Press Company, 1922) , p. 41. a t . is important to realize that if a historical-cost valu- 1 tion were used for identified assets, some of the amount a h?luded as unidentified assets would actually represent J Listments of these values to a more realistic current l. {h v “A ‘hch 60 Professor Paton also wrote about causes of the vari- ous rates of return. He stated: . . . The amount of capital invested in any case is only one of the elements determining the amount of peri- Managerial ability, methods and pro- odic net revenue. trade-name —- these and cesses, territorial location, numerous other factors may contribute to financial suc— cess. Further, purely external and fortuitous circum- stances over which the particular management has no control whatever may be the dominant conditions, for a time at least, in the determination of profit and loss. Factors, conditions, and circumstances which Paton believes contribute to goodwill include special skill and lclucnvledge, high managerial ability, exceptional selling (ziisnacity, personal credit, social and business connections, EJEBrueral reputation, attractive personality, patents, trade— ‘Tiéixflcs, copyrights, trade-names, established clientele, loca- -t:jLE34313. As Little [Little, op. cit., p. 111] has stated, jil‘53 tessential to arrive at a realistic value of the tangibles, 1;13?' formal appraisal if necessary, before the amount attrib- table to goodwill, if any, can be determined." p. 313. II It 41 . . Paton, Accounting Theory, 9p. c1t., 43Ibid., pp. 486—487. 61 The concept of unidentified assets in this thesis includes many of these descriptions of goodwill. Unidenti- fied assets are all those resources under the control of a firmwhich have a positive economic significance to a given firm (in comparison to other firms), but are not expressible separately in terms of their market value (either because they have none or they are not owned by the firm). The unidentified assets are conceptualized as human resources Ehich still have economic significance to the firm as a £esult of some past action or decision. A very broad inter- For instance, besides the obvious Pretation is intended. 6elements which would be included such as a trained sales force and efficient factory laborers, it is contended that the effect of patents, trade-marks, favorable location, and s imilar items are also properly included as human resources. The reason for their inclusion is because these favorable Q0nditions are the direct result of a decision or action taken by a human resource. Even the fortuitous external Q:Lli‘cumstances of which Professor Paton writes can be ulti- mately traced to a decision to enter, or remain in, the H lucky" industry at some time in the past. The presumption implicit in the reasoning is that a management which has b 3611 more than normally successful in the past (in hiring I j 62 a trained sales force, acquiring favorable patents, or be— ing in the right industry at the right time) will more than likely be able to continue this performance in the future. The term, unidentified assets, is really not very ciistinct from some of the broad meanings given to goodwill. {Iflue conceptual difference is mainly one of grouping. While <2<>nventional accounting chooses to record only purchased gg<>odwill and to list patents, organization expense, and EBiJnilar items separately; a proposal of this thesis is to <2Cuubine these items and to include all generally unrecorded assets with them -- even when they have not been purchased. To say that the proposal is to record "unpurchased goodwill" ‘Mkblild be quite accurate, assuming a broad definition were aSsigned to goodwill. The term, unidentified negative as- Eifiets, is conceptually similar to unrecorded negative goodwill. 351: results from having relatively ineffective human resources InEinipulating the identified assets of the firm. Segregation of the Equity Changes George Walker, in 1938, speculated as to what ac- Q0unt might be credited if non-purchased goodwill were to be I 44 - reco nized on the books of account. He believed \ g It; 44George T. Walker, "Goodwill on Financial State- Gautlts," The Accounting Review, XIII (June, 1938), p. 182. '--v o'. o I .nah “mg I... Q Q. .- n ‘5 ..' “VIN S‘ch A O .HUE t...‘ . I~-~ -“ RI v... “mo?"- “-1! 63 goodwill to be .a fixed asset. Since a committee of the American Institute of Accountants had previously defined a revaluation surplus as - the appreciation recognized as arising from the appraisal of fixed assets, he believed that the "revaluation surplus account" should be credited. Another writer, in 1928, had stated that practically all textbooks and published courses in accounting existing at that time advocated a credit to some account such as, .1 " surplus - appraisal valuation." The account titles chosen in this thesis, "Equity Increase - Superior Earning Power on Identified Assets" and " Ecluity Decrease — Inferior Earning Power on Identified ASsets," were chosen to conform to the idea that the recog- 1'1-5---1?—:'Lon of these assets should be shown separately in the e<311ity section, and also to avoid the use of the word "Sur- JE>:IJJS" which has fallen into disfavor in accounting usage. This chapter has dealt with the computation of ‘EiJ‘NDunts and the entries required to recognize the value of Lltlidentified assets in the financial records. The next chap— 1t1EEJ? is concerned with the second, and possibly more signifi- <2=Ei1Tt, part of the proposal - the reporting of financial i . . r1formation 1n the external statements. \ 4 . . Th 5George E. Bennett, "Treatment of Apprec1ation,” \Q\Journa1 of Accountancy, XLV (June, 1928) . PP. 430-431. CHAPTER IV PRESENTATION OF DATA IN THE POSITION STATEMENTS General Before getting into the mechanics of reporting the presence of unidentified resources in the position state— ments it is necessary to discuss a problem which exists in current reporting practice. There has been a tendency in recent years to empha— size the income statement to the extent that the balance sheet has lost its significance as a statement of financial condition. Some persons have rebelled against this trend as is evidenced by statements such as, "I might comment that the tendency of accountants to strongly emphasize the income statement and de-emphasize the balance sheet is not, in my judgment, entirely shared by investment analysts. we find the financial position of great importance."1 The opinion that the conventional balance sheet does 1Arthur M. Cannon, "What's wrong with Financial Raporting -- The Investor's View" (A Symposium), The Journal Of Accountancy, CXII (August, 1961), p. 32. 64 65 not report financial condition2 is held by many. Stewart wrote, "In describing the balance sheet, some venturesome souls use ‘Statement of Financial Position' and other mean- ingful phrases which might suggest its purpose; but others still adhere to the technical term 'balance sheet' which is ideal to cover an increasing awareness of its limitations."3 Professor Paton also wrote, "The balance sheet, as a true statement of financial condition, should not be taken too seriously; it has very definite limitations under the most favorable circumstances." Couchman wrote of some of the various changes that have been suggested for improving the usefulness of the balance sheet as a statement of financial condition When he stated: Much criticism of balance-sheets as now generally prepared by public accountants has been voiced . . . . Some feel that the fixed assets should be valued on a 2In this dissertation financial condition and financial position are used interchangeably. 3W. J. Stewart, "Problem of Valuation in Annual Flnancial Statements and the Relationship of the Auditor's Report," The Australian Accountant, XXX (August, 1960), P- 396. 4William A. Paton, Accounting_Theory (Chicago, Ill.: Accounting Studies Press, Ltd., 1962), p. 486. (This work was originally written in 1922 as a doctoral dissertation at the University of Michigan.) 66 sound reproductive basis rather than at depreciated cost; others that the valuation should be based on the efficiency of the plant as a whole; still others that the valuation in the balance-sheet should bear a direct relation to the earnings; and yet another group is de- manding that the price offered for the capital stock on the stock market should be the determining factor of the worth of the business and should be reflected in the the financial statements. . . .5 It might be well, before attempting to resolve the dilemma, to find out exactly what "financial condition or position" will be taken to mean in this thesis. .A Dic- tionary for Accountants is of little aid since it defines financial position or condition as ”the assets and liabili- ties of an organization as displayed on a balance sheet, following customary practices in its preparation."6 Strict use of the meaning of the term would indicate that the balance sheet and the statement of financial condition are one and the same. The accountant's opinion paragraph would then say in effect, "The accompanying balance sheet . . . fairly presents the balance sheet of the Blank Company." One of the most useful sources in gaining an under- standing of the term mentioned three different points of ‘ 5Charles B. Couchman, "Limitations of the Present Balance Sheet," The Journal of Accountangyj XLVI (October, 1928), p. 254. Eric L. Kohler, A Dictionary for Accountants (New York, N.Y.: Prentice-Hall, Inc., 1952), P- 208- 67 View which could be taken. The three viewpoints were that of the financial manager, the general management, and the absentee owner. Professor Kollaritsch stated that, to financial management, the term "financial position" is synonymous with the firm's debt-paying ability as a going concern.7 This includes the ability to meet all cash obli- gations which arise. He recommended that for financial management purposes assets must be listed according to their availability as to time and amount. It would seem, however, that, to meet the needs of financial management, a funds statement and a cash forecast would be more useful than some radical modification of the balance sheet.8 From the general management point of view, Kollaritsch stated that "no one concept of financial position can be developed . . . due to the many specialized interests within this group, nor could all the necessary information possibly be recorded in one balance sheet."9 7Felix P. Kollaritsch, "Can the Balance Sheet Re— Veal Financial Position?,” The Accounting Review, XXXV (July, 1960), p. 487. In support of this contention see: Gordon Donald- SCNI, ”New Framework for Corporate Debt Policy," The Harvard fhlsiness Review, XL (March-April, 1962), pp. 117-131. 9Kollaritsch, op. cit., p. 487. 68 Since the absentee owner's point of view has been adopted in this thesis, that is the meaning of financial position or condition that shall be used. Kollaritsch stated, "To summarize the absentee owner's concept of financial posi— tion, it can be generalized that the worth of the enterprise should be shown on any financial statement prepared for them, and that the concept of unity should be accepted for valuation purposes with the inclusion of certain intangible assets not shown on the balance sheet at the present time."10 He gave further evidence of his views by commenting as follows: If the worth of the owner's investment is to be shown on a balance sheet, it must be decided which assets are to be included. The tangible assets are obviously important and are already included in the balance sheet, but many times the intangible assets have been omitted, particularly the group classified under goodwill. For example, a well-trained, loyal labor force should be included as an intangible asset, as should a good mana- gerial staff, or a certain advantageous arrangement of machinery. So far, these intangibles have been included only under the term "goodwill," and since goodwill is only added to the balance sheet under certain circum- stances, the result is generally an understatement of values.11 Kollaritsch also mentioned that the absentee owner's Point of View would be appropriate for a creditor with a Suhstantial interest in the company.12 His point was that \ lolQ;§,, p. 486. llIbid.,po485. 12Ibid.,.p.484. 69 such a creditor needs to be concerned with more than merely the cash position. He needs to be concerned that the firm can survive in the long—run as well as the short-run. One of the most crucial points to this thesis made by Kollaritsch was that the basic weakness of the balance sheet as a statement of financial condition is that certain intangibles are excluded. P. D. Leake supported this View by stating: It should be particularly noted that although the value of goodwill forms part of the present value of every profit-seeking undertaking expected to yield future super-profit, yet such value only takes recorded and visible form, and becomes a practical financial question, if and when the goodwill of the undertaking has been purchased. . . . It is probable, therefore, that the bulk of the value actually existing in the form of goodwill is not recorded in any financial books or accounts. . . .14 Professor Paton commenting on this point stated: Until some scheme is found by which these impon- derables of the business enterprise may be assayed and given definite statistical expression, the accountant must continue to prepare the balance sheet as he has been doing. At present there seems to be no way of measuring such factors in terms of the dollar; hence, 13The concepts given by many other writers on the meaning of financial position or condition can be assigned to one of the points of view discussed by Professor Kollaritsch. Therefore, nothing new would be added by mentioning their views. 14 n . . f P. D. Leake, CommerCial GoodW1ll," éggt, LXVII (November 11, 1922), p. 700. The Account- 70 they cannot be recognized as specific economic assets. But let us, accordingly, admit the serious limitations of the conventional balance sheet as a statement of financial condition.15 It cannot be denied that the balance sheet as cur- rently prepared has an important function. It serves as a resting place for charges and credits awaiting eventual as- signment to the income stream. Likewise, there is a need for a statement which will show the financial condition of the firm. It is quite apparent that the conventional balance sheet does not serve this need. The proposal which follows is intended to solve the dilemma by serving both needs. The Mechanics of Presenting Unidentified Resources Table 3 contains a summary of the balance sheets of each of the four firms which are assumed to comprise the total business sector of the economy of a given nation. They are the same firms which were assumed in the previous chap- ter, Firms W; X, Y and Z. The balance sheets, of course, would be presented individually by each of the firms and would be prepared in accordance with acceptable format. The oversimplified format chosen for Table 3 is intended to focus 15Paton, op. cit., p. 487. I .i 71 .000 .0000 .. N 83m ooo .oomw .. M. gnaw oco .omm u N 83h COD 6ch - 3 8.2m 830:0“ mm 00.3 '2 4m quEoooQ @095 no?» or: HOW muommses poGUGoUH mo 00.38.? owm~o>m 9:. 683 no>o mwgcnmo pocwmuou on. powumfio mfion ohm 083M omofi 085 meme mm coquESmmm ova. .. a 000.020 000.0000 000.000 000.0000 Amoou50mon powmficopwcs Ho 9390 Ho “one tauwdvm .muogogxoobm pom moflfifimwd H.308 000.0 000.00 000.0 800.02 000.00 - 000.000 000.000 000.00 000.0000 000.0s 0 000.000 ooo.o~ mowhmgu. «5.33 -oQ ow uooflnsm .. momamsu poHHOHoQ. 88.0w mosh mmcfizmm Umamuom xooum £05800 gals. .muogogxooum ooo.om 009mm 000.00 0 $32305 30.0 000.00 000.00 000.00 0 25.90 ooo.mm oooda mm ooo.m ooo.m m 0006 m oosm>o< 5 oozooom “Com 0390mm mpoom ofinmtfwm smoq 039an mucdoooses 00.032534 ooo.m Good Im: .Hm umnEoooQ mo m4 Hmmmm QUZANAANM ZOHH 05H. 000.0» a 000.mmmm 000.00% 000.005 .30qu was 000 .00 a 000.mm~m 000.00% 000.020 30.090. 00333.34 H.308 H308 800.00: 000.00 - 000.00 333. 00:30:53 Go nogonm mcwcpmm nowuomom u tnfidwm cw mmmonofi 800.03 000.00 - 000.00 30.220 800.00: 000.00 - 000.00 03$... 00.0.8on 883 0303:3033 00.0mm .... mwnw usumm confided 000 00~ 000 000 000 0N 000 m0 Mogm GOEAIImIMHMOH 000.003 000.m0~w 000.0mm 000.02% . muommxw 0330.083 .m .0 00305305 H.308 000.m03 000.00 a 000.00% 000.3 a 00333.34 1308 000.m~ 000.mN 000.m 000.2 954 . 000.0 8:93.. E 000.00 000.0,: 000.00 000.00 $535 83890 seam 000.00 000.00 000.0 000.00 esoasssem 000.mm 000.0m odnmtwdnm mpcom 000.0N 000.0: 000.0 000.2 oEmZooom 000.mm 000.0H 000.m 000.0 Ending 500% mucdooors 000.0: a 000.00. a 000.m a 000.0. a oHnm>mnH 000.2 a 000.0H w 0004 a 000.m a £000 mecsoooaw muomm< $32305 a % .le fl Isl/u .W le le led. Shh Eng” l0“ .2” nonEoooQ Ho m< ZOHHHQZOU A use 8263.807- .0. ”04030.0 Shah 77 The major difference between the balance sheet and the statement of financial condition is that the latter does not show the deferred charges or the portion of retained earnings which pertains to them, but does include the value of unidentified assets (or negative assets) and the resulting change in equity. The value of unidentified assets as computed in each of the five previous years has also been reported so that the reader of the statement might be better able to form an opinion as to the trend and consistency of the effectiveness of the unidentified resources. For instance, from Table 4 it might be inferred that the unidentified resources handling the identified assets in Firm W are becoming relatively more and more efficient. For Firm X the trend seems to be a down- ward one, which may indicate the firm will soon be operating at a. subnormal level of performance. The performance of the unidentified resources in Firm Y seems to have been con- sistently superior to that of the other firms. Firm Z seems to be under the influence of some relatively ineffective unidentified resources. Some fairly radical changes could be expected in the values shown from year to year since the concept is a rela- tive one. The only resources given value are those which 78 are more efficient than the average. This means that if the absolute performance of a certain group of human re- sources in one firm remains constant, while the human resources in other firms become more effective, the valua- tion given the unidentified assets in the initial firm can change radically. One problem which can arise in the mechanics of preparing the statements is that, given the method of com- putation, any firm showing a net loss for the year would show total assets at a negative amount. The reason for this is that the amount of unidentified negative assets would be larger than the amount of positive identified assets. The author chooses, however, to set a lower limit of zero on the value of total assets since he believes a negative figure to be conceptually misleading in this situ- ation. The statement of financial condition is designed to show the worth of the entity as a going concern from the absentee stockholder's point of View. Since the absentee stockholder has limited liability, and can only lose what he has invested, his share of the worth would be not less than zero. (The only exception being in certain cases where stock was originally issued at a discount.) 79 The argument could also be made that, if the loss sitnaation could not be corrected, the going-concern view- poiJnt itself would become irrelevant. A ”winding-up" View might then be called for. Instead of a statement of finan- Ciill condition in this situation, a statement of affairs would be appropriate. Another problem which arises in the mechanics of Preparing the statements is the fact that individual firms Iwusthnow the rate of earnings in the economy before each Can compute the amount of unidentified positive or negative iassets it is to report. It, at first, appears that there Inust be a lag between the time when the income statement and ‘balance sheet can be prepared, and when the statement of financial condition can be prepared. There are ways, how- eVer, to minimize or eliminate this time lag. One way would be to require firms to teletype information concerning the rate of earnings and the average value of identified assets to a central information agency as soon as the figures are determined. A random sampling of firms may be enough to establish the rate in the economy. When one realizes how accurately computers can predict the outcome of national elections on the basis of a very small percentage of returns, it is not difficult to envision the same type of system be- ing sufficient for the problem at hand. 80 Discussion Why Deferred Charges Are Not Listed on the Statement of Financial Condition When Moonitz and Sprouse discussed the valuation whixih should be placed on "intangibles" such as patents, C0pyrights, research and development costs, and the like, they stated that "these items are notoriously difficult to evaluate and therefore should probably be carried at acqui— sitzion cost in the absence of compelling evidence that their Value is markedly different."20 While the carrying of these intangibles at cost may be acceptable for balance sheet purposes, so that the cost canbe spread over the useful life of the intangible; the anthor maintains that, on the statement of financial condi- tion, carrying intangibles at cost is not acceptable. In this thesis, all "intangible" factors causing a firm to earn a higher than average rate of return have been lumped into One category called "unidentified assets." All of these factors are traced back to actions or decisions made by ¥ 20Robert T. Sprouse and Maurice Moonitz, A Tenta-‘ Live Set of Broad AccountinggPrinciples for Business Enter- prises (New YOrk, N.Y.: American Institute of Certified Public Accountants, 1962), p. 36. 81 hunuan resources. It is argued that, for purposes of deter- mirning the worth of a firm to an absentee stockholder, a valjiation of unidentified assets based on a capitalization prcuzess involving earnings is more appropriate than is a lierting of the amounts which management has decided to spend 131 attempting to increase future earnings. The purpose is tOmeasure the effectiveness of human resources in compari- scni to those of other firms in the recent past as best evi- dence of the market value of these resources. The resources Sliven up in the creation of "deferred charges" are no longer 1linder the control of the firm and, therefore, a partial listing of the amount of resources which have left the firm in.their behalf is of little significance as an indication of'financial condition. Any positive effect that these EXpenditures have had in the past in causing a particular firm to earn a higher than average rate of return are in- cluded in the valuation given to human resources in the above statements of financial condition. Professor Paton once wrote, "Much stress . . . has been laid upon the conception of goodwill as the value of all income—producing factors which are independent of and in addition to the ordinary purchased assets."21 This is the 21Paton, Accounting Theory, op. cit., p. 317. 82 concept which has been adopted in the statement of financial condition. Since this statement should ideally approach the market value of the firm as a going concern, and since "de- ferred charges" commonly have no market value, it is believed that the market value of the human resources can best be given value by the process described in this thesis. When the decision was made to not include a listing of the deferred charges in the statement of financial con- dition, it was obvious that the amount of retained earnings pertaining to the deferred charges must also be deducted. One author came to this same conclusion (although his pur— pose was different) by stating, "It might be desirable for credit or other purposes to show the financial condition of an enterprise on the basis of tangible assets alone. If so, goodwill or the intangibles might appear on the balance sheet as deductions from the proprietary equity."22 Why Past Valuations Assigned to Unidentified Assets Are Given on the Statement of Financial Condition The amount shown in the main body of the statement of financial condition for unidentified positive (or negative) 2 . . . George T. walker, "GoodWill on FinanCial State- ments," The AccountingyReview, XIII (June, 1938), p. 174. 83 assets represents a capitalization of the superior (or in- ferior) earning power based on the evidence of only the most recent year. The amounts computed for previous years, how— ever, also have significance to an understanding of the value of these resources. Professor Canning agreed that these previous amounts have significance when he wrote: . . . it would be a very simple matter to attach to the . . . statements a schedule or table of the book value of assets at the end of each of, say, the last five periods together with the enterprise earnings . . . , and the percentage relation between earnings and book value of assets, would inevitably make the segregation of high profit earners from steady losers that single-year statements fail to make. Such a state- ment involves no responsibility for predicting future rates; it does suggest the need for wariness to the general reader.23 The reporting of unidentified assets (meaning either positive or negative) for the five previous years, as shown on the statement of financial condition in this thesis, provides the absentee stockholder with a knowledge of how well the firm in which he is interested has compared in performance to the average of all other firms in the economy during that period. That future performance is related to past perform- ance was stressed by Barlow when he stated, "In estimating 23 . . John B. Canning, The Economics of Accountancy (New York, N.Y.: The Ronald Press Company, 1929), pp. 246- 247. 84 future performance the common technique is to rely upon the recent past record and presume that the future, within fairly broad limits, will be governed by the past . . . the estimate for a particular company tends to be tied to its own strengths and weaknesses as portrayed by past performance."24 It is believed that, if provided with the individual valuations of the past five years, the reader could judge for himself the significance of the trend in estimating the valuations which will occur in the future. If the amount to be reported in the main body of the report had been computed by using the earnings rates of several past years the trend would have been more difficult to determine. The Effect of the Proposal on the Amount Which Is Available for Dividends One might wonder about the effect of the changes made in the equity section of both statements on the legality of dividend payments. Even though retained earnings in the balance sheet has been divided into two parts (one free from deferred charges, and the other subject to deferred charges), there is no intent to prevent either of the parts from being 4 . . . . Leonard E. Barlow, ”Earnings Ratios in Valuing Companies," The Canadian Chartered Accountant, LXXV (Octo- ber, 1959), p. 3190 85 available for dividends. The legality of dividends is determined outside the accounting system. The attitude of the legal authorities has been that directors should be able to pay dividends as long as they do not reduce the capital margin established for the protection of creditors.25 Since all of the retained earnings apply to the stockholders' interests, it is all considered legally available for divi- dend purposes. Neither is it intended that the recording of an equity increase (or decrease) from the recognition of su- perior (or inferior) earning power in the statement of fi- nancial condition should, in any way, affect the legality of dividends. For instance, the account "Increase in Equity- Superior Earning Power on Identified Assets" should not repé resent distributable earnings. The account represents the economic value of human resources which are essential to the continued operation of the firm at the reported level of income. While the worth of the enterprise is affected by changes in this account, payments of dividends based on the valuation would be analogous to paying dividends out of the capital investment. 25 . A. C. Littleton, Essays on Accountangy (Urbana, 111.: The University of Illinois Press, 1961), p. 267. 86 In order to determine the legality of dividend pay- ments under current legal interpretation, it would still be necessary to use the balance sheet rather than the statement of financial condition. Why Professor Paton Did NOt Choose To Use This Concept in His Accounting Model Professor W. A. Paton, in 1922, considered the idea of recording unidentified assets in the financial statements. He realized there were unrecorded resources under the con— trol of the various firms which caused them to earn differ— ent rates of return on their tangible assets. He decided, however, to not attempt to recognize these in the formal 'statements. It should prove worthwhile to investigate and evaluate his reasons for arriving at this decision. Paton's main objection was as follows: Goodwill, as has been indicated, expresses the value of an excess earning power. It represents the capitali— zation of the peculiar rights and advantages enjoyed by the supramarginal enterprise. Evidently, then, if good- will were completely recognized as an asset in the accounts of all businesses . . . all unusual rates of return would be thereby annihilated . . . as far as net income rates were concerned all particularly successful businesses would be reduced essentially to the normal or representative level.26 6Paton, Accounting Theory, 0 . cit., pp. 318—319. 87 He went on to state that the investor should be shown the actual rate of net income realized on the objec- tive economic resources possessed by the firm. His conclu- sion was that any accounting procedure which equalized the rates realized by different competing enterprises, would be quite unreasonable.27 This objection has been met squarely in this thesis. The investor is informed on the balance sheet as to the rate of earnings on identified assets. The rate reported by the various firms would not be uniform as Paton feared. The reason his objection does not apply to the method proposed in this thesis is that he would calculate a rate of return after the unidentified assets have been capitalized, and the proposal only calculates a rate of return on assets before the capitalization has taken place. While it at first seems that one must choose between reporting different rates of return and recording all assets, this is not so. The method of reporting used in this thesis is similar to "having your cake and eating it too." Differ- ent rates of return are shown for the various firms on their identified assets in the balance sheet while all assets are recorded in the statement of financial condition. 27Ibid., p. 318. 88 The second objection that Professor Paton presented against the recognition of non-purchased "goodwill" really only applies to situations where there is no separation between ownership and management. In his words: . . . To recognize goodwill in this sense as a definite asset would mean . . . the accruing of the services and conditions furnished by the owners themselves as a property value on the books of their own enterprise. But, as has been urged repeatedly . . . the owners do not buy their own functions and services as they do other valuable considerations; hence to include the estimated value of such factors as properties would involve an absurd shifting of vieWpoint.28 Other writers have also expressed this point of view. For instance, Charles Sprague once stated, "The balance sheet has limitations. The personality of the proprietor, his skill, his experience, though important elements of his - . . 29 capital, can never be brought into his balance sheet-" This line of argument is irrelevant to the use made of the method by the author. In this thesis the point of view of the absentee stockholder has been selected. Therefore, the viewPoints of the single proprietor, partner, and owner- 28Ibid., p. 319. 29Charles E. Sprague, The Philosgphy of Accounts (New York, N.Y.: The Ronald Press Company, 1922), p. 36. 89 manager of a corporation have been ruled out.3 Does the assumption of a separation of ownership and management exclude a significant share of the business sec- tor of the United States? It seems doubtful that anyone would deny that a predominant portion of the business sector of the economy is made up of corporations, or that closely held corporations are the exception rather than the rule. Leonard Spacek has stated that "the great change in owner- ship of corporate securities in the last 25 years compels the profession to recognize its responsibility to produce meaningful [reports] . . . Whereas, a generation or two ago corporate ownership was concentrated in the hands of a relatively few, today we have mass ownership of corporate securities."31 Possibly it is time, then, to take the ab- sentee owner's point of view and to treat management (as well as the other human resources) as resources under the control of the firm. 30It. could be argued, however, that the method is appropriate even from the point of View of the owner-manager of a corporation since the person in that position really wears "two hats." As a human resource, he is selling his labor to the legal "being" called the corporation; and, as an investor, he is free to sell his shares and invest in a different entity. 31 .. ' Leonard Spacek, The Need for an Accounting Court," The Accounting Review, XXXIII (July, 1958), p. 371. 90 The final reason why Paton did not believe that unpurchased "goodwill" should be capitalized and reported as an asset was because the firm did not pay a price for it. In his words: . . . an enterprise, which is especially endowed . . . and because of these exceptional advantages earns a very high rate of return, is not justified in capitalizing a part of such income despite the fact that it might be possible to sell the business on a favorable basis be— cause of these factors. But an enterprise which actually buys out the old business and voluntarily pays a price in excess of the sum of the values of the ordinary assets has thereby made a definite investment in goodwill -- has purchased goodwill -- and hence can properly recognize this asset in its accounts. . . .32 It seems that, while Professor Paton admits an asset exists, he is claiming it should not be recorded because no price was paid for it. Certainly, one would not contend that the process of paying for an asset creates that asset. The payment given for the purchase of goodwill represents only additional evidence that it exists. If one is willing to admit the asset exists, before formal recognition is given by payment, why not record the existence of the asset at the best estimate of its value? It would seem that this situation is quite analogous to the recording of donated assets at a fair value. Paton, himself, stated: 2 . . 3 Paton, Accounting Theory, 0 . c1t., p. 322. 91 An asset may occasionally be acquired by gift, acci- dent, "strategy," etc. In such a case the accountant would usually admit that, if the asset were one which had a determinate purchase and sale value, the fair mar- ket value of the asset so acquired should be set up in the accounts; for otherwise the existence of a definite property would be concealed so far as the accounts were concerned. . . .33 While the unidentified assets may not have a “deter- minate purchase and sale value,l attempting to place a reasonable value on them is certainly preferable to excluding them entirely from the statements. In a speech at the Ameri- can Accounting Association Convention held at Michigan State University, East Lansing, Michigan, in August of 1962, Pro- fessor Paton stated that if the accountant is not in the business of determining values he may as well "close up shop." The author would construe this statement to include the value of human resources under the control of the firm which are generally not recorded because of the difficulties of valuation. The expected benefits of recording all assets and reporting them as outlined above are the subject of the next two chapters. 33Ibid., p. 490. CHAPTER V THE ANTICIPATED BENEFITS FROM ADOPTING THE PROPOSAL General Chapter I listed five specific benefits that are expected to derive from an adoption of the proposal which was presented in the prior two chapters. All those except the one concerning the implementation of economic theory are covered in this chapter. The order in which the benefits are discussed is intended to emphasize the considerations which are not as evident as are some of the others. For instance, special attention is given to an analogy which can be drawn between the decisions facing the absentee stockholder in evaluating firms in which to invest in the economy, and those facing management personnel in allocating capital to its most effi— cient use within the firm. The reason for the dispropor- tionate amount of space devoted to this topic is the unique— ness of the argument that funds would be allocated more efficiently rather than its importance over the other bene- fits. The grouping of the remainder of the benefits under the heading "Other Benefits" does not necessarily mean they 92 93 are less important. It merely results from the opinion that they are more obvious and, therefore, need not be stressed to the same extent as the above-mentioned one. More Efficient Allocation of Funds In an attempt to show that the model presented in this thesis will cause a more efficient allocation of funds in the economy, an analogy will be drawn to a model which is used internally by firms in making capital budgeting deci- sions. Mason Haire wrote of this technique of comparison as follows: . . . This use of models appears in a variety of forms. Sometimes it is a mathematical model with a relatively explicit definition of variables, and immense power to be gained from the generative capacity of the logical structure. At the other extreme are models which might be called "mere" analogy -- models in which a well- known physical structure, mechanical process, or bio- logical organism is used as an example in the hope that it will be an aid to insight into a complex phenomenon. Between these two is a more legitimate use of analogi- cal reasoning. There are cases in which one takes a model already developed in another science and hypothe- sizes that its characteristics fit [the problem at hand]. . . .1 The author is convinced that the model below, for making capital expenditure decisions, results in an optimum 1Mason Haire (ed.), Modern Organization Theory (New York, N.Y.: John Wiley and Sons, Inc., 1959), pp. 13-14. 94 allocation of funds within the firm. If he can successfully show that the model described below is analogous to his own model for making investment decisions among alternative firms, he will have gained the support of its soundness for his own model. In order to prove that the two models are analogous, the differences between them must be shown to be based on sound reasoning. Similarities, differences, and the reasons for the differences are, therefore, pointed out. The capital expenditure model presented below will be assumed to be that for a multi—division, large firm. This assumption is not essential, but it tends to liken the com- parison to that of an investor facing a complex economy made up of many firms. The model is intended to incorporate the thinking of many of the writers in the field of capital expenditure decision-making. A by-product of this section may be that it helps bring about a closer understanding of some of the differ- ences existing between viewpoints of the accounting and finance disciplines. The author has heard persons engaged in teaching finance express the view that the accountant is too concerned with earnings and not enough with cash flows. Similarly, accountants sometimes feel that the "finance" approach to problems too often ignores the earnings data nu. ...- Au v.- o.. CO] ‘vw 5n.\ (I) _; In 95 and erroneously concentrates almost entirely on cash flows. By discussing the reasons for the different emphasis placed on these aspects, it is possible that finance and accounting in general can be drawn closer together. A Capital Expenditure Model for a Firm2 It will be shown why the model described in this section is considered by the author to be both theoretically correct and practically applicable. Alternative methods and their weaknesses are also briefly mentioned. It is necessary to give the assumptions and defini- tions which make the model more desirable than its alternatives. There are two explicit assumptions which are made. The first is that money has time value. For example, a dol- lar today is worth more than a dollar tomorrow. The second is that management is attempting to maximize the present value of future cash flows to the present stockholders of the firm at any point in time. 2The author is especially indebted to Dr. Robert W. Johnson, Professor of Finance at Michigan State University for many of the ideas included in the model. While other sources were helpful also, none of them have been directly quoted or paraphrased to the extent that specific references are necessary. However, several of the general sources are included in the bibliography. -Avl. "up. - .gn .ol'd u "'A . H ‘I‘h s‘: 5" ‘. 96 Two terms which need to be defined are incremental investment and annual cash benefits. The incremental in- vestment shall be taken to mean the additional cash invest— ment (net after taxes) necessitated by investing in a given project. Examples of "additions to" incremental investment include net invoice price, freight-in, increase in working capital, training expense, installation expense, and added taxes on the sale of old equipment. Examples of "deductions from" incremental investment include amounts realized from the scrap sale of old equipment, tax savings resulting from losses realized on the sale of the old equipment, and ini- tial working capital decreases. Such costs of old machines being replaced should not be included as costs of the new investment since they represent "water over the dam." Cur- rent liquidation values of facilities that are being modern- ized should also be ignored unless going out of business is an alternative that is being seriously considered. To charge projects with "opportunity costs" of this nature, which may not be feasible alternatives, merely decreases the computed rate of return to the point where some desirable projects will appear to have a yield below the cost of capital. 97 Annual cash benefits shall be taken to mean the additional cash receipts (net after taxes) realized by in- vesting in a given project. Examples of ”additions to" net annual cash benefits include cash savings by reducing ex- penses, cash increases by increasing sales or other income categories, and terminal values (to be considered in the last year of the useful life of the project). Examples of "deductions from" net annual cash benefits include the in- crease in taxes resulting from the operations of the new project, increases in general overhead cash outflows result- ing from acceptance of the project, and opportunity costs of foregone receipts which would have resulted from an alterna- tive use of the facilities used by a given project (i.e., Because the firm went ahead with project Y it had to confis- cate the space formerly used by activity X in producing Z amount of net annual cash benefits. Activity X had to be discontinued, therefore the annual opportunity cost is the amount 2.). To consider possible, but improbable, foregone receipts as reductions of net cash benefits is uncalled for. Only opportunity costs which would have been realized should be included in the computation. Now that the assumptions and definitidhs upon which the model is based have been presented, the model itself can 98 be described. The proposed model is based on a "rate of return" method. The mathematical expression of the model is as follows: Present Value (of net : _§l + A2 + + An annual cash benefits) l+r (l+r)2 °°° (1+r)n Where: A1 = the net annual cash benefits in year 1. An = the net annual cash benefits in the last year of the project. r = the yield of the project. The present value of the net annual cash benefits is set equal to the amount of incremental investment. The un- known to solve for is r" and is called the yield.3 Once the yield has been computed, it can be compared with the company- wide cost of capital to determine if the project meets the minimum return necessary. A firm may be using either a "financing budget" or a "rationing budget" for governing the amount it will spend on 3Sometimes, when solving for "r,' multiple yields or imaginary roots are obtained. In these special cases the "present value" method should be used. The formula is the same. However, under this method the cash outflows and cash benefits are brought back to their present value by dis- counting each stream at the cost of the capital rate. If the net present value is greater than zero, the project is acceptable from a present value point of view. 4Instead of using the mathematical formula to solve r," a present value table can be used. for 99 capital projects. Those using a "financing budget" are willing to go ahead with all projects having a higher rate of return than the cost of capital, even if it means that new funds must be obtained from outside the firm. Those using a "rationing budget" set aside only a certain amount of funds for capital expenditures for any given year. There- fore, they will invest in all projects having a higher rate of return than the cost of capital, up to the maximum amount they have set aside for that year. A discussion on how the use of these two types of budgets affects the projects which should be selected is crucial to the understanding of the capital expenditure model being described. H0wever, since this understanding is not necessary in order to contrast the model with the one proposed in Chapters III and IV for in— forming absentee stockholders of rates of return, the dis— cussion is relegated to the appendix. (See Appendix C.) There is no attempt to incorporate risk into the Calculation of the basic rate of return. The consideration of risk is left to management to determine independently. Since the willingness to take risks varies with different groups of managements this treatment seems justified. The computation of the "cost of capital" shall not be