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ABSTRACT

RAILROAD FINANCIAL REPORTING
AND AUDITOR RESPONSIBILITY

by Phillip Andrew Jones, Sr.

The Uniform System of Accounts for Railroad Compa-
nies, prescribed by the Interstate Commerce Commission,
differs in several respects from "generally accepted account-
ing principles." The two theoretically material variances
relate to the use of flow-through accounting for federal
income taxes instead of tax allocation and the use of better-
ment or replacement accounting for track components in lieu
of depreciation accounting. The single factor that most
often creates a material dollar variance between the two
systems of financial reporting is the difference in the
treatment of federal income taxes.

Certified public accountants attest to the fairness
of presentation of published financial statements in accor-
dance with generally accepted accounting principles. They
invariably qualify their opinions on railroad annual reports
because of the material dollar variance created by confor-
mance with the Uniform System, thereby implying that the use
of the Uniform System of Accounts as the basis of reporting

does not yield fair presentation.

Phillip Andrew Jones, Sr.

This thesis evaluated the Uniform System of Accounts
in order to determine its relevance for published annual
reports. The annual reports of thirty-seven Class I rail-
roads comprised the sample which was analyzed. The question-
naire responses of twenty-four railroad companies and the
opinions of financial analysts on railroad reporting were
evaluated. Interviews with railroad industry personnel,
certified public accountants, and members of the Interstate
Commerce Commission were also relied upon. The currently
employed concept of auditor responsibility was evaluated and
conclusions were drawn as to the fairness of presentation
achieved through the application of the Uniform System.

The results of the study indicate that both the
Interstate Commerce Commission and the railroad companies
questioned are essentially satisfied with the Uniform System.
Fifty years of development have brought about a consistent
set of accounting principles. Although this prescribed
accounting is popularly known to be a "uniform system,"
alternate treatments for material items are allowed when
properly justified to the Commission. The Commission's
emphasis has evolved into one of fostering the national
transport system. The Uniform System is as much for protec-
tion of the railroads as for control over them. The rail—
roads are impressed by the progressive attitudes evidenced
by the Commission in recent years and foresee a growing

industry under continued regulation of this type.

Phillip Andrew Jones, Sr.

The financial analysts contacted View the Uniform
System as a relevant basis upon which to rest railroad
financial reporting. They recognize flow-through accounting
for federal income taxes and betterment accounting for track
components as logical and appropriate solutions to difficult
accounting problems.

If the Uniform System of Accounts provides an accep-
table basis for financial reporting, the accounting profes—
sion should recognize it as such. Currently the profession
appears to be stifled from exercising true professional
judgment in its audit engagements through a self-imposed
concept of "general acceptance." A more relevant concept of
auditor responsibility would require the auditor to evaluate
the results of the accounting principles applied by the com-
pany in order to determine their correspondence with the
underlying economic flows. This concept of responsibility
would certainly lend more professionalism to the profession.
Improved financial reporting (more comparability) would
result and railroads might no longer receive qualified audit
opinions on their annual reports.

The majority of the railroads adhere to the Uniform
System in their financial reporting while the accounting
profession prefers conformity with generally accepted
accounting principles. The profession stands at a cross—
roads; its action in this impasse situation may establish

the pattern for the future. A weak stand, or no stand, on

Phillip Andrew Jones, Sr.

the part of the profession could raise a question about the
importance of the issues in dispute and perhaps of the opin-

ion expressed by independent accountants on financial state—

ments.

RAILROAD FINANCIAL REPORTING

AND AUDITOR RESPONSIBILITY

BY

Phillip Andrew Jones, Sr.

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

1968

©Copyright by
PHILLIP ANDREW JONES, SR.

1969.

ACKNOWLEDGMENTS

I wish to eXpress my sincere appreciation to
Dr. Herbert E. Miller for his wise counsel and able guidance,
not only relating to the thesis but also to the development
of my career goals. I also wish to offer my thanks to
Dr. Roland F. Salmonson and Dr. John L. Hazard for their
suggestions and guidance in developing this thesis.

The financial support provided by the Department of
Accounting and Financial Administration during my tenure at
Michigan State University is gratefully acknowledged.

Members of the Interstate Commerce Commission must
be praised here for their cooperation and assistance.
Mr. Richard Ferris showed tremendous patience with this
researcher and demonstrated a sincere willingness to have
the goals and actions of the Commission investigated. The
certified public accounting firms of Arthur Andersen & Co.,
Haskins & Sells, Peat, Marwick, Mitchell & Co., and Price
Waterhouse & Co. showed extreme willingness to cooperate and
my sincere thanks goes to each of them.

My parents have shown me through time that the diffi—
cult is possible. My wife, June, and my children, Phillip
and Valerie, have given me the reasons to attempt this diffi-
cult venture. All have helped where they could—-parents
through encouragement, June through typing all rough drafts
of the thesis, and the children through sheer patience
exercised throughout the ordeal. My thanks to them all.

****

iii

TABLE OF CONTENTS

Chapter Page
I. NATURE AND SCOPE OF THE PROJECT . . . . . . . 1
Purpose of the Study . . . . . . . . . . 1
Statement of the Problem . . . . . . . . 2
Nature of Research Conducted . . . . . . 4
Research Methodology . . . . . . . . . . 6
Limitations of the Study . . . . . . . . 8
Results of the Study . . . . . . . . . . 8
II. THE UNIFORM SYSTEM OF ACCOUNTS FOR
RAILROAD COMPANIES . . . . . . . . . . . . 10
Introduction . . . . . . . . . . . . . . 10
Reasons for Creation and Early History . ll
Developments Affecting the Uniform
System . . . . . . . . . . . . . . . . 15
Present Justification . . . . . . . . . . 25
Degree of Uniformity Guaranteed . . . . . 36
Summary . . . . . . . . . . . . . . . . . 40
III. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
.AND THE UNIFORM.SYSTEM. . . . . . . . . . . 42
Introduction . . . . . . . . . . . . . . 42
Value of Accounting Principles . . . . . 43
Generally Accepted Accounting Princi-
ples v. the Uniform System . . . . . . 45
Accounting for Federal Income Taxes . . . 47
Betterment Accounting . . . . . . . . . . 59
Summary . . . . . . . . . . . . . . . . . 68
IV. RAILROAD FINANCIAL REPORTING . . . . . . . . 70
Introduction . . . . . . . . . . . . . 70
Financial Reporting Before 1962 . . . . 70
The Arthur Andersen & Co. Petitions . . . 74
Present Reporting . . . . . . . . . . . 78
Opinions of Financial Analysts . . . . . 95
Railroad Questionnaire . . . . . . . . . 104
System of Financial Reporting . . . . . . 109
Summary . . . . . . . . . . . . . . . . . 113

iv

Chapter

V. THE AUDITOR AND RAILROAD FINANCIAL

STATEMENTS . . . . . . . . . . .

Introduction . . . . . . . . .
History . . . . . . . . . . . .

Criticisms from‘Within the Accounting

Profession . . . . . . . . .

Criticisms from Outside the Accounting

Profession . . . . . . . . .
Relevant Auditor Responsibility
Summary 0 O O O O O O O O O O 0

VI. CONCLUSIONS AND RECOMMENDATIONS . .

[APPENDICES

Introduction . . . . . . . . .
The Study and the Conclusions .
The Impasse . . . . . . . . . .

SOURCES CONSULTED . . . . . . . . . . . . .

Page

115

115
116

125
129
132
138
140
140
142
148
161

172

10.

11.

12.

13.

14.

15.

LIST OF TABLES

Page
Responses to proposed rule making on
financial reporting . . . . . . . . . . . . . 76
Sample of 1966 annual reports—-reporting
basis by size of railroad . . . . . . . . . . 79
Sample of 1966 annual reports--distribution
by auditor . . . . . . . . . . . . . . . . . . 80
Number of firms presenting reconciliation
between bases of accounting by auditor . . . . 82
Coverage of Class I railroad sample provided
by the unaudited portion of the sample . . . . 82
Sample of 1966 annual reports—-audited v.
unaudited by size of railroad . . . . . . . . 83
Sample of 1966 annual reports--distribution
of audit opinions . . . . . . . . . . . . . . 85
Sample of 1966 annual reports—-audit opinions
by size of firm . . . . . . . . . . . . . . . 85
Sample of 1966 annual reports--reasons for
qualified opinions . . . . . . . . . . . . . . 86
Chicago, Rock Island and Pacific Railroad
Company--non-depreciab1e track components
and betterment expenditure . . . . . . . . . . 88
Correlation with betterment expenditures . . . 90
Sample of 1966 annual reports-—pension plan
accounting methods . . . . . . . . . . . . . . 91
Sample of 1966 annual reports--reconciliation
between bases of net income . . . . . . . . . 93
Questionnaire results (Questions A-l,2,3,4). . 105
Questionnaire results (Questions A-5,6,7) . . 107

vi

LIST OF APPENDICES

Appendix Page
A. Sample of Class I Railroads . . . . . . . . 161
B. Railroad Questionnaire . . . . . . . . . . . 164

vii

CHAPTER I

NATURE AND SCOPE OF THE PROJECT

Purpose of the Study

The purpose of this study was to evaluate the cur-
rent state of annual financial reports to the public by
railroad companies and the views of the accounting profes-
sion relative thereto as a guide to expected future report—
ing and auditor responsibility. The methodology, of neces-
sity, was primarily deliberative and analytical, conducted
by analysis of railroad annual reports, a surveying of rail—
roads by means of a questionnaire, interviews and correspon-
dence. The purpose for establishment, history of accomplish-
ments and current effectiveness of the Uniform System of
Accounts for Railroad Companies prescribed by the Interstate
Commerce Commission were evaluated. "Generally accepted
accounting principles" were considered, insofar as they
differ from the principles underlying the Uniform System.
It was necessary to evaluate the progress of the accounting
profession toward improved financial reporting and the
responses of the railroads and the Interstate Commerce Com-
mission to this progress. A standard for auditor responsi-
bility was developed against which to measure the accomplish-

ments of the accounting profession.

Statement of the Problem

 

Financial reporting to the public in the railroad
industry is in a state of flux. In 1962, a ruling by the
Interstate Commerce Commission allowed the railroads, for
the first time, the freedom to choose generally accepted
accounting principles for financial reporting to outsiders.
This election could be made if the railroad companies would
indicate in footnotes the extent of differences between
these financial statements and the statements submitted to
the Interstate Commerce Commission from the books and
records kept according to the prescribed uniform accounts.
Most railroad reporting, however, still reflects the account—
ing methods associated with the Uniform System of Accounts
prescribed by the Interstate Commerce Commission. Some rail-
roads have made modifications in the reported figures in
order to bring the financial statements more in line with
generally accepted accounting principles. A few have so
completely adjusted their reported figures to those prin-
ciples that the independent auditor feels justified in
rendering an unqualified opinion. It is apparent that the
two reporting systems are not interchangeable as one large
midwestern railroad changed back in 1966 from reporting
according to generally accepted accounting principles to
reporting according to the Uniform System because of the

effect on reported net income.

The first reporting standard from "generally accepted
auditing standards" requires that the independent auditor
state whether the financial statements being audited are
presented in accordance with generally accepted accounting
principles.1 The majority of auditor's reports accompanying
railroad statements are qualified reports comparing the
financial presentation to generally accepted accounting
principles while the railroads themselves often make no pre-
tense of following these principles. Two certified public
accounting firms sometimes use a three paragraph certificate
for railroad companies, the second paragraph of which may
read as follows:

The company maintains its accounts in conformity
with the Uniform System of Accounts for Railroad
Companies prescribed by the Interstate Commerce
Commission and the accompanying financial state-
ments have been prepared in accordance therewith.
As explained in Note x, the provisions of the
Uniform System of Accounts vary in certain

respects from generally accepted accounting
principles.

 

1Committee on Auditing Procedure, Auditing Standards
and Procedures, Statements on Auditing Procedure, No. 33
(New York: American Institute of Certified Public Accoun-
tants, 1963), p. 16.

2Generalized from the 1966 Annual Report of The

Atlantic Coast Line Railroad Company, p. 18. Mr. Russell D.
Tipton of Haskins & Sells, in a letter dated March 1, 1968,
states that the three-paragraph audit opinion is preferred
by his firm because the opinion "clearly indicates the basis
on which the financial statements are prepared, and directs
the reader to a note which indicates the respects in which
such basis varies from generally accepted accounting princi-
ples."

The opinion paragraph of this certificate then relates the
financial statements to generally accepted principles of
accounting. These certified public accounting firms appar—
ently feel that a detailed description of the reason for the
qualified report is relevant information to present to
stockholders.

The New YOrk Stock Exchange has twice, since 1962,
taken the position that railroads should report according to
generally accepted accounting principles in order to improve
comparability between railroad financial statements and
statements from other industries. The apparent freedom
granted by the Interstate Commerce Commission in 1962 has
not solved the problem of lack of comparability for at least
two reasons. The first is, of course, that the attainment
of absolute comparability between any two firms is difficult
to achieve. The second is that the 1962 decision provided
Options of reporting according to the Uniform System, gener-
ally accepted accounting principles, or some hybrid system

and the railroads have used all three.

Nature of Research Conducted

The bulk of the research conducted in this study
relates to attitudes and ideas. Contacts with certified
public accounting firms probed such issues as "betterment"
or "replacement" accounting acceptance, the nature of the
qualified audit opinion, the accounting professions's obli-

gation toward improvement of railroad financial reporting,

the reasons for railroad industry adherence to the Uniform
System for financial reporting, and the current and poten-
tial usefulness of the Uniform System.

From the railroad industry, through communications,
a questionnaire, and an interview, confirmation was received
as to the reason for conformance to the Uniform System, the
degree of industry satisfaction with the Uniform System, and
guides to the future with regard to greater conformance with
generally accepted accounting principles, either within or
outside of the Uniform System.

The Interstate Commerce Commission is the primary
user of the data collected through the use of the Uniform
System. Its evaluation of the system's past, present and
future usefulness was quite valuable as was its projection
of future conformity with generally accepted accounting
principles.

The Securities and Exchange Commission and the New
YOrk Stock Exchange currently accept railroad financial
statements based either upon generally accepted accounting
principles or upon the Uniform System. Both of these orga-
nizations have sanctions that could be enforced against
corporations which report in a misleading manner. A guide
to their present position and future policies was of value.

There is currently a bill pending in the House ways
and Means Committee (H.R. 12175) the stated purpose of which

is: "to prevent Federal regulatory agencies from directly

or indirectly denying regulated industries the right to
exercise business judgment in selecting their method of
depreciation or to account for depreciation on a deferred
tax accounting basis." The intent and sponsorship of this
bill might indicate congressional response to groups dis-

satisfied with regulatory accounting practices.

Research Methodology

Library search was necessary to develop the frame-
work for evaluations of the Uniform System of Accounts and
generally accepted accounting principles. Other aspects of
the project such as the history of the Arthur Andersen & Co.
petitions and a criterion against which to evaluate auditor
responsibility also required search of the literature.

The analyses of railroad financial statements and
the auditor's reports were necessary for the establishment
of current practice. A sample of Class I railroads selected
by Moody's Investors Service, Inc. on the basis of the "rela—
tive importance and size of the various companies as well
as upon the amount of investment interest" was used in this
study3 (Appendix A). Based upon a report of the Association

of American Railroads,4 this sample of thirty-nine Class I

 

3Letter, dated June 30, 1967, from Richard G.
Neumeier, Consultation Department, Moody's Investors Service,
Inc.

4Bureau of Railway Economics, Yearbook of Railroad
Facts (1967 ed.; Washington, D.C.: Association of American
Railroads, 1967).

railroads covered the majority of the industry (Appendix A).
Class I railroads represent about 99 per cent of the rail-
road industry in terms of traffic, operate 94 per cent of
rail mileage and account for 92 per cent of the workers
employed by all railroad companies.5 A Class I railroad is
defined as one which has annual operating revenues of
$5,000,000 or more.6 The financial statements and auditors'
certificates were analyzed in order to identify similarities
and differences in statement presentation among companies
and in auditor's opinions.

The interview technique was applied in this study as
follows. The issues were defined and a list of questions
prepared before the interview. The notes taken during the
interview were used to prepare a summary of the discussion.
This summary was then sent to the party interviewed for his
comments and criticisms so as to verify the perceptions
received during the interview. The same basic questions
were asked of several sources so as to be able to distill
the issues and properly interpret the responses.

Communications with selected sources were used to
supplement the interviews and to gain information from
sources where an interview would not be practical. Less
reliance can be placed on written communications, than on

interviews, because of the inherent limitations in the

 

51bid., p. 2. 61bid.

technique. However, the differences in the kinds and impor—
tance of information acquired through the several techniques

were such that both were justified in their use.

Limitations of the Study

There were at least three basic limitations to the
study. The first was a limitation inherent in the subject
matter investigated. There was very little that could be
quantified and therefore very little that could be statis-
tically evaluated. The material was judgmental and there-
fore necessitated interpretation. The second limitation
related to methodology. The interview and communication
techniques have numerous shortcomings which, hopefully, were
mitigated by asking the same questions of several different
sources and encouraging the sources to criticize the summary
of the interviews. There was also a statistical limitation
to the study. The sample of Class I railroads was not a
random sample, therefore, it was not possible to generalize
extensively. But, since the sample was selected on the
basis of the relative importance and size of the companies
as well as the amount of investor interest in the companies,

generalizations relevant to the study could still be drawn.

Results of the Study
It is hoped that this study will contribute to a
better understanding of railroad accounting, as an example

of regulatory accounting. The reasons for ”unusual"

practices were evaluated and these practices were compared
with generally accepted accounting principles in an attempt
to determine their validity for financial reporting purposes.
From this analysis, a guide to better reporting standards
for railroads may emerge.

Auditor responsibility, as usually conceived, is
detailed in publications of the American Institute of
Certified Public Accountants.7 These publications primarily
stress clarifications and improvements of current practice
but the concept of auditor responsibility they advance has
been criticized both from within and outside the profession.
A close look at these publications, an analysis of current
practice, and a review of the literature on professional
responsibility should result in the determination of guides

to effective auditor responsibility.

 

7See for example: Committee on Auditing Procedure,
Auditing Standards and Procedures.

CHAPTER II

THE UNIFORM SYSTEM OF ACCOUNTS

FOR RAILROAD COMPANIES

Introduction

The Uniform System was developed to serve primarily
a regulatory function, to act as a matrix into which account-
ing information from all of the railroads could be placed
such that valid inter—firm comparisons could be made and
equitable economic regulation could be carried out. The
system is quite detailed, especially as to classification of
accounts. There is a chart of accounts and a comprehensive
description of what should and should not be put into each
of the accounts.1 Also, there is a series of interpreta-
tions wherein the recommended accounting for special types
of unusual transactions is presented.2 These interpreta-
tions are based on circumstances referred by a railroad to

the Interstate Commerce Commission for its consideration.

 

lUniform System of Accounts for Railroad Companies,
prescribed by the Interstate Commerce Commission in accor-
dance with Section 20 of the Interstate Commerce Act, issue
of 1962, as amended to January 1, 1962 (Washington, D.C.:
Government Printing Office, 1962).

2Interpretations of the Uniform System of Accounts

for Railroad Companies, issue of 1962, effective September 1,
1962 (Washington, D.C.: Government Printing Office, 1962).

10

11

The system is therefore a guarantee of quite uniform report-
ing to the Commission. This chapter analyzes the reasons
for creation, development over time, present justification
and uniformity guaranteed by the Uniform System. Chapter III
analyzes "generally accepted accounting principles," insofar
as they differ from the principles underlying the Uniform
System, in order to act as a standard for judging the pre-
scribed accounting as a basis for financial reporting.
Reasons for Creation and
Early History

During the nineteenth century, railroads existed in
anunregulated environment. While this environment led to
bold experimentation and a rapid expansion of the industry,
it created, or accentuated, the numerous abuses which caused
adverse public opinion and a marked change in public policy.
The evils of highly speculative railroad building, of irre—
sponsible financial manipulation, of destructive competitive
warfare, of fluctuating and discriminating rate adjustments,
of the overreaching exercise of monOpoly power brought the
inevitable reaction.3

Public response to railroad abuses was first mani-
fested through state attempts to exercise control. In the

United States, the earliest prescribed instructions for

 

3For a more detailed presentation, see: I. L.
Sharfman, The Interstate Commerce Commission, Vol. 1
(New York: The Commonwealth Fund, 1931), p. 14.

12

keeping railroad accounts were issued in 1876 by the Railway
Commissioners of Massachusetts.4 An outline for a uniform
system of accounts for railroads was prepared by a special
committee of State Railroad Commissioners and railroad
accountants and adopted by all State Railroad Commissioners
in 1879.5 It was also in the late 1870's, in the so-called
Granger Cases, that the Supreme Court rejected the railroads'
contention that they were private businesses not to be sub-
jected to economic regulation.6 It definitely ruled that
the railroads were "clothed with a public interest" and that
the states therefore had the power to regulate them.7 State
regulation turned out to be ineffective because so much of
the railroad business was interstate rather than intrastate
and different states set up different rules.8 The final
blow to the possibility of effective state control came with
a Supreme Court decision in 1886 where the Court decreed

that "a statute of a State intended to regulate (transporta—

tion) from one State to another is not within the class of

 

4Eldon S. Hendriksen, Accounting Theory (Homewood,
Illinois: Richard D. Irwin, Inc., 1965), p. 33.

5Ibid., pp. 33-34.

6Three cases are: Munn v. Illinois, 94 U.S. 113
(1877); C.B. & Q. R.R. Co. v. Iowa, 94 U.S. 155 (1877); and
Peik v. C. & N.W. Ry. Co., 94 U.S. 164 (1877).

7

Munn v. Illinois, 94 U.S. 113 (1877).

8See for example: Kent T. Healy, The Economics of
Transggrtation in America (New York: The Ronald Press
Company, 1940), pp. 381-384.

l3

legislation which the States may enact, (even) in the
absence of legislation by Congress."9 This case pointed out
that federal legislation was necessary for railroad regula-
tion.

As a compromise to the Senate demand for an admini-
strative commission and the House proposal for control
through court—enforced vigorous laws, the Act to Regulate
Commerce was passed in 1887. This act created the Inter-
state Commerce Commission and President Cleveland appointed
five lawyers to comprise it.10 This was the first commis-
sion and it performed, and still performs, all three func-
tions of government: administrative, legislative and judi-
cial. Congress tends to view the commission form "as a
creature of Congress, independent of the President, impar-
tial and objective in the performance of its duties, and
eXpert in the handling of complex, difficult matters beyond
the capacity of Congress to handle effectively."ll A crea-

ture of Congress, but legally oriented by its personnel, the

Commission, as an investigating body, was authorized to

 

9Wabash Ry. Co. v. Illinois, 118 U.S. 557,558 (1886).

10John R. Turney, Development of Internal Organiza-
tion of the Interstate Commerce Commission (Washington, D.C.:
Association of Interstate Commerce Commission Practitioners,
1963), p. 7.
llMerle Fainsod, Lincoln Gorden, and Joseph C. Pala-
mountain, Jr., Government and the American Economy (3rd ed.;
New York: W. W. Norton and Company, Inc., 1959), p. 58.

14

inquire into the management of the business of all common
carriers subject to the Act and to keep itself informed as
to the manner and method in which the same is conducted.12
For this purpose the Commission could require by subpoena
the presence and testimony of witnesses and the production
of books and papers; and it was also empowered to require
annual reports from the carriers and to prescribe uniform
accounts.13

The first classification of accounts issued by the
Interstate Commerce Commission appeared in 1894.14 But, it
was not until after the Hepburn Act of 1906 that the Commis-
sion was authorized to prescribe the form and substance of
uniform accounts for railroads under its jurisdiction.15
Accordingly, a revised "Classification of Operating Expenses"
was issued in 1907 and a complete "Accounting Classifications
for Steam Railroads" became effective in 1914.16 The Hepburn

Act of 1906 conferred upon the Commission the requisite

authority for strict supervision of accounting and statistical

 

12Sharfman, p. 22.
13Ibid.
l4Hendriksen, p. 34.
15

The initial Commission appointed to its staff
Henry Carter Adams, Professor of Economics and Finance
at the University of Michigan, whose effort was outstanding
in the development of the mandatory accounting, following
the authority vested by the Hepburn Act.

l6Hendriksen, p. 34.

15

practices. The availability to the regulatory tribunal of
prompt, full and accurate financial and Operating data, as

a necessary basis for the effective enforcement of all the
provisions of the Act, was considered to be of far-reaching
importance. The Commission was enabled not only to pre—
scribe uniform accounts and to require, under oath, stan-
dardized reports, both regular and special, but it was given
the right of access to and examination of the accounts and
records of the carriers, and heavy penalities, including
imprisonment, were imposed for willful obstruction or falsi-
fication.l7 The Supreme Court in 1913 affirmed the Commis—

I I I I 18
Sion's power to prescribe uniform account1ng.

Developments Affecting the
Uniform System

Four key items stand out in the development of the
Uniform System: The Valuation Act of 1913 and similar legis-
lation, the controversy over the acceptability of deprecia-
tion accounting, the formation by the American Institute of
Accountants of a Committee on Relations with the Interstate
Commerce Commission and the immediate results, and the

acceptance of reporting according to the Uniform System by

 

l7Sharfman, p. 44.

18Kansas City So. Ry. v. United States, 231 U.S.
423,442-3 (1913).

16

the New York Stock Exchange and the Securities and Exchange
Commission.

The Valuation Act.—-By 1913, public reaction to the
"watering" of railroad stock had been worked up into enough
of a political issue by Senator LaFollette to result in the
passage of the Valuation Act.19 The Interstate Commerce
Commission had also expressed conclusions in favor of valua-
tion. The Valuation Act required the Interstate Commerce
Commission to determine and report the value of all the
property owned by every common carrier. The Commission,
through Valuation Order No. 3, was required to thereafter
keep itself informed of all extensions and improvements or
other changes in the condition and value of the property of
all common carriers, and determine the value thereof, and
from time to time revise and correct its valuations.20 The
initial, and subsequent, valuations were to be on the bases
of (1) original cost to date, (2) cost of reproduction new,
(3) cost of reproduction less depreciation, and (4) other
values and elements of value, if any.21 The initial valua-
tion took about twenty years at a cost of about $200 million.
The result is probably the largest compilation of economic

records ever made. One writer, at least, feels that these

values have not been of any great help in the rate-making

 

19Healy, p. 393. 20Turney, p. 21.

21Ibid., p. 18. 22Healy, p. 540.

17

prnocess and seriously doubts if they have been worth even a
fruaction of the expense involved.23 However, original cost
tc> date, as the result of valuations, presently serves as
thus basis of valuation for recorded railroad assets.
Depreciation accountinq.--The early concern for a
clxaar distinction between capital and revenue expenditures
byr the railroads caused considerable controversy over the
remzording of depreciation and other methods of providing for
capital maintenance. Toward the end of the nineteenth cen-
tiLry, the most commonly accepted method among railroad firms
ir1 the United States and England was the "replacement" or
"Inenewal" method whereby all replacement expenditures were
cfliarged to eXpense at the date of replacement or renewal;
true original cost of the asset was not depreciated.24 The
iJlitial invested capital was assumed to be maintained perma-
Inently by regular expenditures for repairs and renewals.
The property of a railroad company was considered so diverse
that renewals were assumed to be made continuously and in
amounts at least equal to what depreciation would have been
if it had been accrued.25 Depreciation was introduced in
1914 for equipment only and Congress authorized and directed

the Interstate Commerce Commission to deal with the whole

 

ZBIELQy. p. 541. 24Hendriksen, p. 34.

25115151.

18

question comprehensively in 1920.26

Studies and hearings
were conducted on the subject in 1924 and a decision was
rendered in 1926. This issue was reconsidered in 1929 and

a new and different decision emerged in 1931. The proposed
regulation was suspended in 1932 because of the depression.
This regulation would have ordered depreciation applied on a
straight-line basis. The order, modified to some extent,

was finally put into effect in 1943, but replacement account-
ing is still used for rails, ties, ballast and other track
materials. The courts finally accepted an accounting defi-

27 so the intentions of the

nition of depreciation in 1934,

Interstate Commerce Commission were more modern than the

court system, even though the Supreme Court, in 1913, had

called depreciation "an inevitable fact which no system of
. "28

accounts can properly ignore.

American Institute Committee.--In a letter to

 

Anthony F. Arpaia, Chairman of the Interstate Commerce

 

26George 0. May, "Improvement in Financial Account-
ing," Dickinson Lectures in Accounting (Cambridge, Massa-
chusetts: .Harvard University Press, 1943), p. 26.

27Lindheimer v. Illinois Bell Telephone Company §§_
I§1., 292 U.S. 154 (1934). Chief Justice Hughes: "Broadly
speaking, depreciation is the loss, not restored by current
maintenance, which is due to all the factors causing the
ultimate retirement of the property. These factors embrace
wear and tear, decay, inadequacy and obsolescence. Annual
depreciation is the loss which takes place in a year."

28Kansas City So. Ry. Company v. United States,
231 U.S. 423 (1913).

19

Commission, on May 17, 1956, Phillip L. West, Vice President
of the New York Stock Exchange, suggested that the Uniform
System should attempt to conform with generally accepted
accounting principles. He suggested as a means of accom—
plishing this purpose that the American Institute of Accoun—
tants establish a committee to study these differences and
recommend solutions. The Chairman of the Commission agreed
and a committee was appointed by the president of the Insti-
tute on or about June 5, 1956. This committee (Committee on
Relations with the Interstate Commerce Commission), on
March 29, 1957, made a report to Owen Clark, then Chairman
of the Commission, in which six principles of the Uniform
System were found to be at variance with generally accepted
accounting principles. These were:

1. The retained income account (formerly called
profit and loss account) of the railroads
relieves current income of items which under
generally accepted accounting principles
would be included as charges or credits in
current income.

2. Appropriations are made by railroads under
the category of "disposition of current
income" for items such as sinking funds and
other capital requirements which under gen-
erally accepted accounting principles are
not of an expense nature and would not be
chargeable to income.

3. Income taxes are dealt with on the basis of
charging railway operating expenses for essen-
tially all accruals and adjustments of income
tax, whereas other industries allocate a
portion of such taxes to other accounts and/or
to other years when there are divergencies
between the handling of major items of income
or expense for tax purposes and for financial
accounting purposes.

20

4. The acquisition adjustment account of the
railroads comprises a variety of diverse
elements. Under generally accepted princi-
ples of accounting, identification and seg—
regation of the respective elements would
be required and, as to certain elements,
the establishment of a policy for ultimate
disposition might be appropriate.

5. The railroads do not deal with long-term
debt maturing in one year and certain other
liabilities as current liabilities.

6. Voucher drafts outstanding are shown as 29
liabilities rather than reductions of cash.

The Committee also considered the issue of replacement or
betterment accounting as applied to track components and
concluded that "no substantial useful purpose would be
served by a change to depreciation accounting techniques in
the absence of evidence indicating that depreciation-mainte—
nance procedures would provide more appropriate charges to
income for the use of such property."30
During the years 1957-58, the Interstate Commerce
Commission conducted a complete study and review of its
accounting rules in order that prescribed procedures might

be more in line with the best present-day practices. Con-

siderable impetus was given to this work by the report of

 

29Letter reproduced in: Arthur Andersen & Co.,

Cases in Public Accounting Practice, Vol. 7: Interstate
Commerce Commission Jurisdiction Over Financial Statements
in Reports to Stockholders (Chicago: Arthur Andersen & Co.,
1962), pp. 22-23.

30Ibid., p. 24. There was one dissent to this
report, that of Arthur J. Abbott of Arthur Andersen & Co.,
who took exception to replacement accounting acceptance by
the Committee.

 

21

the Committee. Most of the modifications suggested by the

Committee were put into effect by the Commission effective

January 1, 1958. Major changes in the railroad rules which

were adopted were to:

1.

Require that all gains and losses recognized
during the year are to be included in net
income, except special and extraordinary
items, material in amount, which are not
identifiable with usual or typical business
operations and would impair the significance
of net income for the year and be misleading
unless such items are excluded.

Require that there be excluded from net
income the federal income tax consequence of
special and extraordinary gains or losses in
situations where such gains or losses are
excluded from net income in financial state-
ments.

Provide a separate balance sheet account to
show the important item of liability for
federal income taxes, apart from the other
taxes.

Provide a separate balance sheet account for
equipment trust notes and installments on
debt obligations, regularly employed by rail—
roads for financing acquisition of equipment
and facilities, which are to be paid within
one year.

Provide that estimated amounts payable with-
in one year covering liability on claims for
injuries to persons, loss and damage to ship-
ments in transit, and other casualty losses
shall be classified in the balance sheet
under current liabilities.

Provide that cash balance shown in financial
statements shall reflect reductions because
of bank checks and drafts, issued by the
fiscal officers and agents of the company

in payment of obligations and released to
payees but not yet paid by banks.31

 

31As reported by Herschel C. Walling, "Changes in

Railroad Accounting Rules," The Federal Accountant, June
1958, pp. 55-56.

 

22

It is important to note, however, that the Commission's
position on the area of deferred federal income tax account-
ing was not modified. The Uniform System still does not
have this provision. The Commission also made a distinction
between material and nonmaterial extraordinary items in
terms of the accounting treatment to be accorded. No change
was made regarding the use of replacement accounting for
track components. These three areas--accounting for federal
income taxes, extraordinary items, and betterment accounting--
remained as the only significant variances from generally
accepted accounting principles.

Acceptance for reportipg.--The Securities Act of
1933 provides that the financial statements required to be
made available to the public through filing with the Securi-
ties and Exchange Commission shall be certified by an inde—
pendent public or certified accountant.32 But, the Act
exempts from its provisions carrier securities whose issu-

ance is subject to regulation by the Interstate Commerce

Commission.33 Therefore, annual railroad financial reports

 

32As reported by: J. Arnold Pines, "The Securities
and Exchange Commission and Accounting Principles," Law and
Contemporary Problems: Uniformity in Financial Accounting,
XXX, No. 4, School of Law, Duke University (Autumn, 1965),

728.

33J. H. Price, Jr., Richard Walker, and Leonard
Spacek, "Accounting Uniformity in the Regulated Industries,"
Law and Contemporary Problems: Uniformity in Financial
Accounting, XXX, No. 4, School of Law, Duke University
(Autumn, 1965), 827.

 

23

to stockholders are not required to be audited. In a

sample of 37 annual reports, the following was found: 31
were audited and 6 were unaudited (2 of these 6 had received
auditor certificates for consolidated subsidiaries). That
is, 16.2 per cent of the sample was not audited-~a percent-
age that would not be descriptive of other industries.

The Securities and Exchange Commission took a posi-
tion in Accounting Series Release No. 4 (1938) that finan-
cial statements prepared in accordance with accounting prin-
ciples for which there is "substantial authoritative support"
would not be presumed to be misleading or inaccurate. Al—
though the Commission has not elaborated on the meaning of
"substantial authoritative support," at least the following
should qualify: pronouncements of the American Institute
of Certified Public Accountants; American Accounting Asso—
ciation pronouncements; uniform systems of accounts, regula-
tions and rulings of federal and state regulatory author-
ities; and uniform systems of accounts recommended by cer-
tain trade associations for members of an industry.3 For
registration under the Securities Exchange Act of 1934 and
in lieu of annual submission of 10-K annual reports, the
Commission will accept copies of the reports filed with the

regulatory agency in certain industries, including the

 

34Louis H. Rappaport, SEC Accounting Practice and
Procedure (2nd ed.; New York: The Ronald Press Company,
1963)! pp-II-7.

 

24

railroad industry.35 The major reason for "acceptance" by
the Commission of the Uniform System for railroad accounting
is a provision of the Securities Act of 1933 which prohibits
the Commission from prescribing accounting requirements in-
consistent with those prescribed by the Interstate Commerce
Commission.36
The New York Stock Exchange also makes an exception
for railroads, on the original listing application. Except
for railroad companies, corporate statements must be audited
by certified public accountants.37 The New YOrk Stock
Exchange, then, essentially accepts what the Securities and
Exchange Commission accepts. It is interesting to note that
both of these agencies have sanctions that can be used
against companies which are considered to be reporting
inaccurately or in a misleading manner. Therefore, these
agencies must consider reporting according to the Uniform
System to be neither inaccurate nor misleading, even though

the System does not conform to generally accepted accounting

principles.

 

35;p;g,, pp. XII-3, and XII-6.

36Letter dated December 12, 1967, from Lindsey J.
Millard, Associate Chief Accountant, Securities and Exchange
Commission.

37George L. Leffler (dec.), The Stock Market,
revised by Loring C. Farwell (3rd ed.; New York: The Ronald
Press Company, 1963), p. 132.

25

Present Justification38
The Interstate Commerce Commission (the first and
oldest independent federal agency) has regulatory jurisdic—
tion over four different modes with eleven different kinds
of carriers. It regulates all aspects of the transportation
business including the accounting and financial reporting
functions of the subject carriers. One of the underlying
purposes of the Commission's regulatory activities concerns
the maintenance of an efficient national transportation
system adequate to meet the ever expanding needs of the
nation's commerce, the national defense and the postal
service. Changing circumstances and economic conditions,
therefore, affect the Commission's pattern of regulation.
From the creation of the Commission in 1887 up until

the middle 1930's, its regulation for the most part was con-
fined to the railroad industry. During that period, it
might appear that the Commission gradually became more
static in its policies and approach to regulation. This may
be evidenced by the Commission's tendency to hold on to
traditional techniques and procedures whose applicability
and usefulness might be questioned because of changes in the
economic climate and other factors. Regardless of the

merits of that contention, the Commission has kept abreast

 

38This section is adapted from an interview with
Richard J. Ferris, Assistant Director, Bureau of Accounts,
Interstate Commerce Commission, January 29, 1968.

26

with the thinking and developments in the unregulated indus—
trial and commercial sectors and has been quick to incorpo-
rate in its accounting regulations those new concepts and
standards deemed to further the attainment of regulatory
objectives. At the time the motor carrier industry was
placed under regulation in 1935, the Commission undertook
a particularly comprehensive and penetrating evaluation of
its accounting regulations to determine where improvements
could be made to assure that the prescribed system would
produce financial information that fully met the needs and
purposes of carrier management and also provided the current
knowledge required for effective and meaningful regulation.
It is an interesting sidelight that when they first came
under regulation in 1935, several of the largest motor car—
riers already had modern accounting systems which had been
developed under the supervision of outside CPA firms. It
can be surmized that this situation had a substantial influ-
ence on the Commission's 1935 evaluation study. In any
event, the initially prescribed accounting regulations were
based on the most progressive and advanced concepts with the
result that conversion over to the Commission's new system
was accomplished by the major motor carrier companies with
a minimum of difficulty.

The railroad industry uses highly progressive
accounting techniques because it has perhaps the largest and

most complex accounting task of any of the nation's major

27

business enterprises. As one example of the immensity of
its problems, shipments of freight (carload, less-carload,
container, or piggyback) are transported in freight cars
from coast to coast over the connected tracks of as many as
ten or more different railroads. This generates numerous
accounting transactions among the railroads participating in
the transportation; transportation and accessorial revenues
must be divided, and various related costs allocated such as
shipment loss and damage, equipment rental and repairs
enroute, trackage allowances, switching services, etc. To
aid in handling their gigantic accounting task, the rail-
roads were the largest users of punched card equipment
before the growth in popularity of such equipment. They
also were among the first to recognize the possibilities of
the computer and the great majority of railroads are now
highly computerized. In recent years many roads have hired
CPAs to fill financial executive positions. This brings
qualified professionals into an important sector of manage-
ment responsibility. It also has helped to correct misunder-
standings and in mitigating the criticism that CPAs have
long voiced about railroad accounting.

Financial reportinq.--Financial information accumu-
lated under the Uniform System of Accounts for Railroad
Companies serves as a standard by which the results of
operations for the individual railroads can be compared and

evaluated on a common basis. The surest way to destroy

28

uniformity is to allow alternative methods of accounting for
the same transaction or event, as does "generally accepted
accounting principles." This statement is not intended to
imply that absolute uniformity is guaranteed by the Uniform
System. A carrier may, upon submission of a request, be
granted a deviation from the Uniform System if the Commis—
sion feels that such a deviation more properly presents the
financial results of the firm involved and has no negative
influence on the remainder of the transportation system.

The use of the Uniform System for rate-making pur-
poses is premised on the proposition that the Commission
should be primarily concerned with today and the problems of
today. The concern should be for rates that are equitable
for the shipper of today and railroad accounting is struc-
tured to this end. Hewever, this emphasis on rate-making
should not be taken as the only responsibility of the Com-
mission. Forty years ago, rate-making was the predominate
responsibility; however, managerial and investor responsi—
bilities are perhaps of equal if not greater importance
today. Because of the competition in the transportation
industry and the statutory restrictions placed upon the ICC
that no mode of transportation should be deprived of its
inherent advantage, the ICC must have broad concepts. Sec-
tion 20(a) of the Interstate Commerce Act repeatedly uses
the phrase "compatible with the public interest" in describ-

ing the accounting responsibilities of the Commission.

29

Under the concept that "public" includes shippers, other
modes of transportation, individual carriers, stockholders,
bond holders, etc., it is apparent that the Commission has
broad responsibility relative to railroad accounting systems
and financial reporting.

As an example of this responsibility toward the
accounting and reporting of railroads, the ICC considered
the deferred tax issue in 1958 and released its report in
February of 1959 (included as an appendix to Docket No.
34178 decided February 1, 1963). The railroads and Commis-
sion felt that the use of tax allocation would have two neg-
ative effects. The tax expense reported under this method
would reduce net income and could possibly bring about
demands for rate adjustments which would benefit future
shippers to the detriment of present shippers. Also, the
highly speculative nature of the deferred taxes payable
account made it difficult to conceive of reporting such a
nebulous liability. Accelerated depreciation and tax allo—
cation were accepted into generally accepted accounting
principles in 1958. In the ten years of experience recorded
so far, railroads have not had to pay any taxes as the
result of loss of tax benefits. The Commission, therefore,
can justify its 1959 action in that the tax benefits of
accelerated depreciation, guideline lives, and the invest-

ment credit have tended to increase and so, in the aggregate

3O

sense, have been permanent tax savings not deferrals of
benefits.

Should economic circumstances change, this decision
would most likely be reviewed. If the railroad industry
should, in the future, present a united front in favor of
tax allocation, the ICC would reconsider the issue. It
appears, though, that if the railroads continue to replace
their equipment at the present rate, there won't be a tax
reversal in the aggregate sense. The Commission presently
is requiring the railroads to provide information on the
excess depreciation claimed for tax purposes. It is be-
lieved that with such information the ICC will be in a
better position to determine whether or not the deferred tax
issue will need to be reconsidered. In any reconsideration
of tax allocation, the increased probability of higher
future tax payments would need to be weighed against the
probable effects on rates. At present a procedure is open
to the railroads should they foresee an eventuality of pay-
ing these higher taxes. An appropriation of surplus can be
made for this purpose and it serves two functions: it indi-
cates the projected eventuality in the accounts while at the
same time it indicates the contingent nature of the liabil-
ity. The railroad cannot create a balance sheet liability
for this purpose nor can it charge these questionable taxes

to income. The rationale is something like this.

31

The tax law does not imply that anything done
in 1958 has any effect on 1968. The railroads
were not required to adopt accelerated depreci-
ation for tax purposes. If they did adopt it,
they adopted it knowing the risk Of possible
future tax reversal.

The ICC rule-making procedure is initiated by changes
in economic circumstances. The Commission studies the matter
carefully and elicits the response of experts in the indus-
tries to be affected. A Proposed Rule Making is prepared
and distributed to the regulated industries, CPA firms,
shippers, and other interested parties for their responses.
The responses are carefully evaluated and a final Decision
and Order are released by the Commission. The process is
therefore not doctrinal in nature, rather it is responsive
to the wishes of the affected parties, subject to the restric-
tion that the best interests of the national transport system
must be maintained.

The Commission does not Oppose CPA audits on regu-
lated industries, however, it feels that the CPA examination
is not a substitute for the audit performed by the ICC audi-
tors. The CPA audit is concerned with the fairness Of pre—
sentation of the financial results while the ICC audit is
more specialized. The ICC feels that the Uniform System
"fairly presents" the financial results for a firm but the
transactional analysis and the statistics created from the
system are also parts of the ICC audit. The Commission

currently has about sixty field auditors, highly trained

specialists in railroad accounting. The training program

32

takes over a year and, even then, a new man is assigned to
assist only. The schedule for Class I railroads calls for
an annual Commission audit. The Commission accepts the
independent audit as added assurance as to the quality of
the accounting employed by a firm, but, because Of the
differing emphasis, feels that its audit must be retained.
The Commission's audit staff is at least as independent as

a certified public accountant's audit staff in its examina-
tion as the Commission's staff is concerned primarily with
the information necessary to report and regulate the national
transportation system and only secondarily with the individ-
ual company.

Relative to the establishment of depreciation rates,
the ICC requests that railroads complete certain forms list-
ing the assets owned, their service life, salvage value, and
actual cost. The company develops depreciation lives and
submits them to the Commission, based primarily on mortality
tables reflecting the company's experience with these assets.
It also submits its anticipated retirement date for the cur-
rent inventory taking into consideration such factors as
inadequacy, changes in the art of railroading, and more
usage Of equipment due to greater availability. The Commis-
sion has the power to make detailed analyses of the depreci-
ation rate construction and may modify the company's proposed
depreciation rates if they differ significantly from those

used by other similar carriers. It also has the power to

33

question rates after establishment and ask for the company
to submit justification data. Class I railroads are on a
five year cycle of review regarding these rates.

The current uncertainty regarding Obsolescence that
has entered the picture as a result of the development of
highly specialized cars complicates the rate setting pro-
cedure somewhat. The new aluminum covered hopper cars that
cost about $20,000 each are a case in point. In order to
evaluate railroad depreciation rates, since there was no
mortality experience, the ICC requested statements from the
car manufacturers as to the life expectancy of the cars.

The actual railroad experience with rolling stock (freight
train cars) is a life expectancy of 28-30 years and the
suppliers indicated that the same life could be expected for
the new aluminum cars. The procedure then, for new or Old
equipment, is basically that the ICC prescribes depreciation
rates but these rates are based upon data submitted by the
company involved, tempered by judgment. Depreciation rates
may vary, within limits, between companies because Of man-
agement intentions relative to replacement and differing
circumstances related to usage. TO illustrate, large Class
I railroads have between $150 million and $1 billion invested
in rolling stock representing the cost Of fleets Of from
15,000 to 200,000 freight cars. It would be difficult to
shorten the replacement interval significantly as a very

high percentage of rolling stock is financed at original

34

purchase date, the obligation extending on the average about
fifteen years. By the next five year cycle, the progressive
roads may have reduced the average life of rolling stock to
about twenty-five years.

Rate-makipg.--The Federal Power Commission has

 

developed guideline rates of return for use as a yardstick
to gauge the fairness Of the rates charged by the respective
companies engaged in the production and marketing of elec-
tric power and natural gas. This procedure is appropriate
and practical for regulated industries which are monopolies
and where the forces of competition play little if any part
in the pricing Of the products or services furnished. This
same situation applied to a large extent in the earlier
period of ICC regulation when the railroads enjoyed a vir-
tual monopoly over public transportation. But the later
growth and expansion of motor and water transportation has
brought about radical changes in the transportation picture.
Now railroads, motor carriers, air transport, pipe lines,
and water carriers compete aggressively against one another
for the available traffic.

Depending upon conditions and circumstances the ICC
may apply different levels of cost in judging the reason-
ableness Of contested rail rate proposals. In one case it
may apply short-term out-Of-pocket cost, in another, long-
term out-Of-pocket cost, and in a third, the fully distrib-

uted cost. Both long—term out-of-pocket and the fully

35

distributed cost levels include an allowance for return
which is intended as the source of funds for interest and
dividend payments and for replacement Of equipment and
facilities at a price level different from their original
acquisition cost. The allowance is computed at a rate of

4 per cent (after taxes) on the depreciated book value Of
railroad property, plus a computed amount for working cap-
ital. The 4 per cent return rate (equal to about 6-1/2 per
cent before Federal income tax) was originally selected on
the basis Of the historical earnings of the railroads over
an extended span Of time. Taken as a group, railroads have
not succeeded in earning a 4 per cent return for a number Of
years. Partially, at least, this is due to the sharp compe-
tition Offered by motor carriers and water lines.

In so-called general increase cases, i.e., where
railroads as a group apply for an increase in their freight
rates and charges (usually an across—the-board percentage
increase), the Commission's decisions include some discus-
sion on rates Of return. However, the ultimate revenue
level is generally determined on the basis of the total
revenue needs, requiring a consideration of the necessary
funds to cover interest payments and dividends for maintain-
ing credit, and funds for capital expenditures in order to
maintain an efficient national transport system. In this
connection any serious study Of the effect of flow-through

accounting must weigh and consider the part that the forces

36

Of competition have played in the railroad industry's com-
paratively low level of earnings in recent years. In marked
contrast to the upward trend of prices for almost every
product and service, railroad tranSportation rates have been
on a descending scale for the past several years. This
decrease in rates can be attributed primarily to competition
from other transportation modes. Although the decision to
retain flow—through accounting for federal income taxes was
made on the basis of the speculative nature Of the future
tax expense, a positive side-affect can be seen in railroad
financial reporting. Certainly the financial reports of
railroads would have reflected a much more dismal picture
except for flow-through accounting. Clearly their earnings
and financial status, as shown in their published financial
statements, have a profound bearing on the ability of the

railroads to Obtain vitally needed capital.

Degree of Uniformity Guaranteed

The control of railroads is about as complete
as can possibly be imposed on any private enter-
prise. The Commission's control Over literally
every phase Of rail transport is such as to
endow it with a large measure of managerial
powers. The fact that its control over the
other agencies is much less complete is because
Of the technological conditions. Had it not
been for these, it is reasonable to assume that
all regulation Of transport would have been as
extensive as that Of the railroads.39

 

39Dudley F. Pegrum, Public Regulation of Business
(Homewood, Illinois: Richard D. Irwin, Inc., 1959), P. 566.

37

The Commission may inquire into the management
Of the business Of all common carriers subject
to the provisions Of the act, and may prescribe
the accounts, records, and memoranda which shall
be kept by the carriers, which shall be open to
examination by the Commission through its author-
ized agents or examiners. Carriers are required
to file annual reports with the Commission and
such other reports as the Commission may from
time to time require. By the amendments Of
February 28, 1920 and September 18, 1940, the
Commission was directed to prescribe . . . the
classes Of property for which depreciation
charges may be included in Operating expenses
and the percentages of depreciation chargeable
for each such class Of property, with authority
to modify such classes and percentages so pre-
scribed when deemed necessary.

As the above quotations indicate, the Interstate Commerce
Commission exercises a tremendous amount of control over the
railroads and, to a lesser extent, over other carriers. The
Uniform System Of Accounts for Railroad Companies, as pre—
viously described, is the mechanism Of control over the
accounting aspect of the railroads. It guarantees uniform
treatment Of items and uniform reporting to the extent pos-
sible. There, however, cannot be absolute uniformity in
reporting among companies because the system allows for
alternative treatment in some cases. This lack of absolute
uniformity was recognized twenty-five years ago.41 George 0.

May stated that "there is today a closer approach to

 

40Moody's Investors Service, Inc., Moody's Transpor-

tation Manual (New York: Moody's Investors Service, Inc.,
September 1966), p. a68.

4J'George 0. May, "Improvement in Financial Account-
ing," p. 31.

38

uniformity in the published accounts Of the large steel
companies than in those of the large railroads, though the
former are not and the latter are subject to a uniform
classification."42 Of course, May was making these Observa-
tions before the recent updating attempts on the part Of the
Commission, attempts designed to conform the Uniform System
more closely to generally accepted accounting principles.

To take a more meaningful look at uniformity in
financial presentation, the present Uniform System must be
evaluated. The present system is not too flexible as to the
recording options available to a railroad. Depreciation
rates and lives are established individually for each rail-
road as the result Of a study by the Interstate Commerce
Commission. This allows for some difference in reporting
among railroads but a railroad must be able to justify the
rates or lives it prefers or they will not be approved by
the Commission.43 Fairly definite lines are drawn between
capital and expense items. For example, expenditures Of a
repair or replacement nature on a diesel engine valued at
50 per cent or less of the replacement cost of the diesel
are considered expense; expenditures on the diesel exceeding

50 per cent of the replacement cost are considered capital

 

421bid., p. 21.

43From an interview, October 24, 1967, with Ernest
J. Rua, Jr., Of Peat, Marwick, Mitchell & CO.

39
in nature.44 (Although this guide is purely arbitrary, it
appears intuitively preferable to having no monetary guide
at all.) Railroads have had an Option in the treatment Of
profit arising from a repurchase of their own bonds, whether
to treat this gain as income or an adjustment to retained
earnings. The concept of materiality enters the picture
here as in the case of property retirements. Retirements
could be accumulated and the total considered a surplus
charge while recurring retirements could be passed through
income.45 There are certain amendments to the Uniform Sys—
tem Of Accounts for Railroad Companies which have recently
been released by the Interstate Commerce Commission.46 "Al-
though the . . . amendments improve current regulations which
conditionally permit direct charges to retained earnings they
do not conform completely with Accounting Principles Board
Opinion 9 on reporting the results Of Operations."47 The
changes: "(a) generally require that items affecting net

income be recorded in appropriate profit and loss accounts,

and (b) eXplain, define and provide accounts and categories

 

44Ibid.

45From an interview, October 23, 1967, with Delbert
Wacker Of Arthur Andersen & CO.

46Interstate Commerce Commission, Uniform System of
Accounts for Railroad Companies, Docket NO. 32153, Service
Date September 12, 1967.

47From the minutes of the July 19-20, 1967 meeting
Of the Executive Committee Of the American Institute of
Certified Public Accountants.

40

for ordinary income, extraordinary items, prior period items
and applicable income taxes."48 The surplus charge option
will no longer be available; all elements Of revenue,
expense, profit or loss will be put through the income state—
ment. A divergence from generally accepted accounting prin-
ciples, as stated in Accounting Principles Board Opinion NO.
9,49 will be created in that prior period items will be

charged or credited to income rather than allowed to remain

as an adjustment to retained earnings.

Summary

The Uniform System of Accounts for Railroad Com-
panies was developed to serve the early twentieth century
need for control over the financial and rate practices Of
the railroads. It was a well constituted system Of accounts
and has apparently served its regulatory ends in a satisfac-
tory fashion. The New York Stock Exchange and the Securi-
ties and Exchange Commission accept financial statements
prepared on this basis in lieu Of audited statements pre-
pared in accordance with generally accepted accounting prin-

ciples. The public accounting profession, through the

 

48Editorial, The Journal of Accountancy, July 1967,

p. 3.

49Accounting Principles Board, Reporting the Results
Of Operations, Opinion NO. 9 (New York: American Institute
Of Certified Public Accountants, December 1966), pp. 115-116.

41

Committee on Relations with the Interstate Commerce Commis-

sion, has assisted in bringing about substantial changes in
the Uniform System during the past decade, however, signif—

icant variations still exist.

CHAPTER III

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

AND THE UNIFORM SYSTEM

Introduction

 

Generally accepted accounting principles are man-
made statements about what "should be" in accounting. They
are generally accepted because of practicality as well as
justifiability. General acceptance may mean imposition by a
higher authority, as in the case of the uniform systems Of
accounts prescribed by regulatory agencies.1 However,
realistic guides to action for the accounting profession
must be justified by logic, not by practice or authority
alone. The principles referred to by members Of the Amer-
ican Institute Of Certified Public Accountants in their
audit certificates have been developed over time in the
search for better financial reporting. These principles
were developed as a means to the end Of fair presentation

Of financial position and the results of operations to which

 

lPaul Grady, Inventory Of Generally Accepped Account-

ingyPrinciples for Business Enterprises, Accounting Research
Study NO. 7 (New York: American Institute Of Certified
Public Accountants, 1965), pp. 52-53.

42

43

the auditor attests. Therefore, generally accepted account-
ing principles will be utilized as a standard against which
to measure any divergence from fair presentation Of the
Uniform System basis Of reporting. The generally accepted
accounting principles which are not a part Of the Uniform
System will be detailed, evaluated, and contrasted with the
alternative principles in the Uniform System. The Opinions
expressed by three financial analysts and thirty-one audited
railroad companies will also be analyzed. Conclusions will
be drawn as to the relative acceptability of each system in
the areas Of accounting for federal income taxes and capital

asset accounting for track components.

Value Of Accounting Principles

 

The payment of federal and state income taxes,
ad valorem and franchise taxes and taxes to
local bodies, the revenue receipts Of these
governmental bodies, the payment Of dividends,
the buying and selling of securities, stock-
holder's reports, information for management,
regulatory purposes—-are some Of the areas in
which accounting has vital impact. . . .

The consequences that flow from adherence to
any system of accounting have far-reaching
effect. This is especially so in the case 3f
regulated industries such as the railroads.
The primary focus of this paper being financial reporting,

it can be seen that accounting principles Of some sort are

important. The reason for their importance is as follows.

 

2"Railroad Accounting Procedures," A Report by the
Committee on Government Operations, condensed in The Journal

 

Of Accountancy, November 1957, p. 70.

44

Accounting principles may be defined as guides to
action, second—level propositions derived from general
postulates describing the function of the discipline. In
1953, the Committee on Terminology Of the American Institute
Of Certified Public Accountants selected as its definition
Of an accounting principle: "a general law or rule adOpted
or professed as a guide to action: a settled ground or basis
Of conduct or practice. . . ."3 The essential members Of a
structure Of accounting theory were presented to the Insti-
tute by another Committee in 1958. This Committee (Special
Committee on Research Program) defined postulates, princi—
ples and rules and their interrelationships in the framework
Of accounting theory.

Postulates are few in number and are the basic
assumptions on which principles rest. They
necessarily are derived from the economic and
political environment and from the modes Of
thought and customs Of all segments Of the
business community. . . . .A fairly broad set
of co-ordinated accounting principles should

be formulated on the basis of the postulates.

. . . Rules or other guides for the application
Of accounting principles in specific situations,
then, should be developed in relation to the
postulates and principles previously expressed.4

Based upon a determination Of the Objectives Of accounting,

postulates may be developed which serve the additional

 

3Committee on Terminology, Review and Resume,
Accounting Terminology Bulletins, NO. 1 (New York: American
Institute Of Certified Public Accountants, 1953), p. 11.

4"Report to Council of the Special Committee on
Research Program," The Journal of Accountangy, December 1958,
p. 63.

45

function of setting forth the boundaries of the field Of
study.5 From these postulates, principles or second-level
generalizations can be drawn.6 The actual rules or prac—
tices can then be developed to carry out the principles.
The principles, then, are the logical basis for action and
the rules are the Operational devices needed to put the
principles into practice. Alternative practices may be
developed to discharge one particular principle but even
though the practices lead to different answers, the alterna-
tives are still correct. This is a basic statement of the
position held toward theory by the American Institute Of
Certified Public Accountants.
Generally Accepted Accounting
Principles V. The Uniform Syptem

Without a doubt the American Institute Of Certified
Public Accountants has been the most influential society in
the United States in the development of generally accepted
accounting principles. These principles and standards are
found primarily in the Accounting Research Bulletins issued

by the Committee on Accounting Procedure, the Opinions Of

 

5See: Maurice Moonitz, The Basic Postulates Of
Accounting, Accounting Research Study NO. 1 (New York:
American Institute Of Certified Public Accountants, 1961).

6See: Robert T. Sprouse and Maurice Moonitz, A
Tentative Set of Broad Accountipngrinciples for Business
Enterprises, Accounting Research Study NO. 3 (New York:
American Institute of Certified Public Accountants, 1962).

 

46

the Accounting Principles Board and the Research Studies Of
the Accounting Research Division. However, prior to 1930,
little was done to develop a formal structure for the devel—
Opment Of accounting principles and theory.7

The test Of rules and practices, as currently
evidenced by auditors' certificates, is the conformity Of
these rules and practices to generally accepted accounting
principles. The independent auditor attests to fairness of
presentation based upon the consistent application of these
principles. This set of principles could be called a
"uniform system" except that the diversity Of rules imple-
menting them leads to less than uniformity in financial
reporting. Grady states that, in theory, management is
therefore charged to choose the accounting practices and
methods of application most suitable to the needs and pur—
poses Of the entity and which, in its judgment, will most
fairly present the financial position and results of Opera-
tions Of the entity.8

In nonregulated industries, the choice of accounting
practices belongs to management; in regulated industries the
accounting rules are primarily prescribed by the regulatory

agency. The responsibility for financial reporting practices,

 

7Eldon S. Hendriksen, Accounting Theory (Homewood,
Illinois: Richard D. Irwin, Inc., 1965), p. 79.

8Grady, p. 34.

47

then, resides with the agency. Financial reports are neces-
sary for effective regulation Of an industry.

What action could be taken to assure that the

financial, statistical and other information

reported to the [Interstate Commerce] Commis-

sion not only was accurate, but that Of equal

importance, it was similar in substance and

nature for all railroads? Similarity in the

reported information was Of utmost necessity;

otherwise the operations of railroads could

not be compared either individually or by

groups, nor could the Commission readily deter-

mine the current state and condition Of the

railroad industry.9
After considerable study it was decided that the Objective
Of comparable reporting could best be Obtained under a sys-
tem Of uniform accounting which would assure that all rail-
roads used the same methods and procedures. The primary
Objective Of the Uniform System is, of necessity, uniformity
for regulatory purposes. Fairness of presentation in finan—
cial reporting was considered but this goal is not necessar—
ily compatible with uniformity for regulation.
Accountingyfor Federal Income
Taxes

It is generally recognized that the net income

reported in annual financial statements may differ from the

net income subject to federal income taxation. These

 

9Richard J. Ferris, Assistant Director, Bureau Of
Accounts, Interstate Commerce Commission, "The Uniform Sys-
tem Of Accounts: Development and Performance," a speech
before the Seventy-first Annual Meeting, Accounting Division,
Association Of American Railroads, May 31, 1966, p. 6.

48

variances may be caused by timing differences in the deduct—
ibility Of certain items between tax return and book. Exam—
ples are accelerated depreciation and guide-line lives for
taxation purposes but straight-line depreciation and longer
use-lives for book purposes. The Uniform System and gener-
ally accepted accounting principles differ as to their treat-
ment Of the tax effects Of these timing differences. The
Interstate Commerce Commission prescribes "flow-through"
accounting for such tax effects and the investment credit,
that is, no deferral of the tax effect Of the timing differ-
ence between the tax on taxable income and the tax on pre-
tax accounting income. The charge tO income is thereby
restricted in the current year to the amount Of federal
income tax indicated to be payable on the tax return. Gen—
erally accepted accounting principles prefer deferring this
difference resulting from timing because it is believed to
be only a temporary tax saving. Tax deferrals are viewed as
"privileges established by law, and if, instead Of the
deferral Of the tax, the tax is to be eliminated, this can
only be done by changing the law."10 Tax allocation is
viewed as a generally accepted accounting principle and a
qualified Opinion is given by the independent auditors to

firms not following this practice. Of 31 railroad financial

 

lOLeonard Spacek, "A Report by a Critic of His
Profession," a Speech presented at the Sixth Annual Account-
ing Forum of Hayden, Stone, Incorporated, November 10, 1967,
p. 23.

49

statements in the sample that were audited by certified
public accountants, 4 were unqualified while 27 received
qualified reports, 23 of the 27 being qualified for lack Of
tax allocation.

Position of Accounting Principles Board.--The
Accounting Principles Board sets forth three approaches to
tax allocation.11 The "deferred method" is a procedure
whereby the tax effects Of current timing differences are
deferred currently and allocated to income tax expense Of
future periods when the timing differences reverse. The
"liability method" proceeds in the same manner with the
exception that the initial computations are considered to be
tentative and are subject to future adjustments if tax rates
change or new taxes are imposed. The "net Of tax method"
considers the amount computed under either Of the preceeding
approaches as a contra-asset (or contra-liability) account
on the basis that tax deductibility or taxability are factors
in asset and liability valuation. The Board concluded that
the "deferred method" is most appropriate because it treats
income tax expense as a consistent and integral part Of the
process Of matching revenues and eXpenses in the determina-

tion of results Of Operations. This method "emphasizes the

 

llAccounting Principles Board, Accounting for Income
Taxes, Opinion NO. 11 (New York: American Institute Of
Certified Public Accountants, December 1967), pp. 162-163.

50

tax effects Of timing differences on income of the period in
which the differences originate."12

The Board then recognized and commented upon three
differing views as to the extent to which interperiod tax
allocation should be applied in practice.13 A minority
Opinion is that tax allocation is never appropriate. This
view is based upon a concept of federal income taxes as an
imposed expense, determined by appropriate laws and regula-
tions Of the governmental unit, which requires no adjustment
or allocation. The "partial allocation" approach suggests
that recurring differences between taxable income and pretax
accounting income, which give rise to an indefinite postpone-
ment Of tax payments, do not require allocation. Proponents
Of this approach point out that the application Of tax allo-
cation procedures tO tax payments or recoveries which are
postponed indefinitely involves contingencies which are at
best remote. Under the "comprehensive allocation" approach,
income tax expense encompasses any accrual, deferral or
estimation necessary to adjust the amount of income taxes
payable for the period to measure the tax effects Of those
transactions included in pretax accounting income for that
period. The Board concluded that "comprehensive allocation"
should be applied because "tax effects should be matched

with or allocated to those periods in which the initial

 

12123Q3, p. 162. l3Ibid.,E¥L 164-168.

51

differences reverse. The fact that when the initial differ-
ences reverse other initial differences may Offset any

effect on the amount of taxable income does not . . . nullify
the fact Of the reversal."14

Discussion Of Board position.--In differentiating
between the "deferred method" and the "liability method," the
Board considered only the advisability and practicality Of
modifying the deferral for changes in tax rates or tax
structure. Essentially, then, the two approaches differ
only in application. Both reflect a liability concept
toward future tax reversal. Both apply allocation on a
transaction by transaction approach.

The primary difference between "partial allocation"
and "comprehensive allocation" is a difference in the con—
cept Of liability envisioned by the supporting groups.
Partial allocation requires that a significant probability
Of aggregate reversal be in evidence before deferral is
recognized while comprehensive allocation conservatively
assumes that individual reversal is inevitable. The two
concepts Of degree Of payability and transactional alloca-
tion require serious consideration.

Interperiod tax allocation, as defined by the Board,
implies a restriction placed upon current net income and a

liability created tO represent future expected cash flows

 

14Ibid., p. 167.

52

for tax reversal on individual assets. Taxes are similar to
salaries--both require cash out-flows. Salaries are accrued
when payment has not yet been made, but the amount and tim-
ing Of the cash flow is determinable. Taxes, under compre-
hensive deferral, are accrued even though the amount and
timing are not determinable because of the possibility Of
future offsetting timing differences. This is conservative
accounting but not necessarily consistent accounting. Par-
tial allocation would permit the accrual Of taxes when the
amount and timing are determinable. This practice would be
consistent with current accrual accounting practice for
other liability items. The estimated contingent liability,
the timing of which is not determinable, could be reported
as a footnote to the financial statements--a practice which
is followed for other contingent liabilities.

It is Obvious for any single asset, if the service
life is properly estimated, that the total amount Of depre-
ciation taken will be the same regardless of the deprecia-
tion method employed. Use Of an accelerated method for tax
purposes and a straight-line method for books results in a
timing difference in the net income generated which com—
pletely reverses itself over the life of the asset. Postu-
lating an asset costing $15,000, having a five year life,
straight—line depreciation for book purposes and sum-Of-the-
years digits for tax purposes, the following example pre-
sents this complete reversal in terms of the depreciation

charges.

53

DEPRECIATION CHARGES

 

Years
1 2 3 4 5
($) ($) ($) ($) ($)
Tax Return Depreciation 5,000 4,000 3,000 2,000 1,000
Book Depreciation 3,000 3y000 3,000 3,000 3,000
2,000 1,000 ..... (1,000) (2,000)

It is on the basis of reasoning such as the above that the
Board rests its transactional allocation. If federal income
tax was assessed on income generated by individual assets,
this assumption might be justified. But as Sidney Davidson
indicates, the tax is based on taxable income Of the entity
(an ever changing, interacting bundle of assets).15 He pre-
sented a model of a static firm which used accelerated depre-
ciation for tax purposes and straight—line for its records.
This firm replaced its assets as their economic usefulness
ended. He showed that, once the system stabilized, neither
method would record more annual depreciation than the other.
During the stabilization process, more depreciation would be
taken for tax purposes than would be taken on the books. If
the firm were using comprehensive tax allocation, it would
have deferred the tax effect of the timing difference while

no reversal would ever result unless the firm began to dis—

invest. In other words, if the tax laws remain relatively

 

15Sidney Davidson, "Accelerated Depreciation and the
Allocation Of Income Taxes," The Accounting Review, XXXIII,
NO. 2 (April 1958), 177.

 

54

constant and a firm replaces its assets at the end Of their
economic life, a deferral will arise initially and will not
reverse. Davidson also postulates a growing firm and,
predictably, comprehensive tax allocation would produce a
growing deferral in this case.

The Accounting Principles Board, by attempting to
define one practice suitable for all firms, has adopted what
appears to be a questionable rule. If the Board's concern
was providing for future tax reversal, the investment policy
of the individual firm best determines the existence and
timing Of such a reversal. In other words, where firm
policies indicate that a reversal is probable, tax alloca-
tion should be employed. Where the policies Of the firm
preclude the possibility of a foreseeable reversal, tax
allocation may be irrelevant and misleading.

Interstate Commerce Commission position.--A state-
ment of policy was presented by the Interstate Commerce
Commission on February 9, 1959, relative to the tax treat—
ment to be followed if accelerated depreciation were to be
followed for tax purposes. The Commission states the reason-
ing behind its prescription of flow-through accounting for
such tax benefits:

When an available depreciation allowance produces
a reduction in Federal income taxes, no matter
how temporary the benefit may be the effect on
net income should be the same as a reduction in
taxes produced by lower tax rates. Possible

income taxes to be assessed in the future are
not an element of tax expense for the current

55

year. As to depreciable property with an
expected life Of thirty years, or even less, it
is illogical to eXpect that tax reductions re-
sulting from accelerated depreciation allowances
can be matched with tax increases Of the future.
New property units acquired in the future will
provide increased depreciation allowances to
Offset decreasing allowances for older units.
Furthermore, income tax rates and tax procedures
are subject to change from year to year, and the
computation of income taxes differs as between
carriers, and for any carrier differs as between
years, in too many respects to justify special
provision for a fluctuation in taxes resulting
only from depreciation allowances. 6

The carriers were then directed to report the annual tax
savings and the cumulative amount to date in their annual
reports to the Commission. On February 1, 1963, the Commis—

sion issued its order relative to guideline lives and the

investment credit.17 In the report, the Commission indi-

cates that most respondents to the proposed rule-making Of

November 8, 1962,18 favored flow—through in accounting for

these two tax provisions.19

They express the View that actual taxes payable
for each year, based on the effective tax regu-
lations Of the year, is the only liability to

 

16Interstate Commerce Commission, Accounting for
Federal Income Taxes, 24 F.R. 1401.

17Interstate Commerce Commission, Accounting for
Federal Income Taxes Under New Depreciation Guideline Lives
and Investment Tax Credit, Docket NO. 34178, Service Date
February 13, 1963.

1827 F.R. 10909.

19Interstate Commerce Commission, Accounting for
Federal Income Taxes Under New Depreciation Guideline Lives
and Investment Tax Credit, p. 4.

 

 

56

the Government and the true amount to be recorded
in the corporate accounts and financial state-
ments each year for tax expenses; and that when
taxes so computed are reported in the tax return
for a year no deferred—tax liability remains
unpaid for the year and no amount should be
recorded in the accounts and financial statements
for unpaid taxes or for tax-liability contingency.

In opposing tax-deferral or tax-equalization

accounting procedures the opponents declare

that the ever-changing tax system does not

lend itself to interperiod tax allocation

because Of uncertainties associated with such

allocation; and that tax reductions resulting

from tax—depreciation guideline lives and invest-

ment tax credit are just as real as though statu—

tory tax rates were decreased.2
The railroad industry overwhelmingly endorsed flow-through
accounting as, Of the respondents to the proposed rule-
making, 82 per cent of the railroads supported flow-through
while 18 per cent was Opposed.21 Division 2 of the Commis-
sion issued the February 1 report which in essence instructed
all carriers subject to the prescribed accounting rules to
apply the flow—through method in recording federal income
taxes. "Subsequent developments and happenings have tended
in our Opinion to confirm the wisdom Of the Commission's
decision in this area Of accounting."22 The reduction in
income taxes from use Of accelerated depreciation methods,

guideline lives and the investment credit, for one Class I

railroad, aggregated $87 million for the years 1962 to 1964.

 

201bid. 2lFerris, p. 28.

57

"Had the Commission selected the tax deferral or normaliza-
tion method, a total Of over $127 million would have been
removed from net income and set up as a balance sheet
reserve. (The excess over $87 million covers reduction from
accelerated amortization Of emergency facilities.) Using
the actual federal income tax liability Of $23.3 million for
1964 as generally representative, it can be seen that the
reserve Of $127 million would be equivalent to over 5 full
years' income taxes."23

Although the Commission prescribed flow—through
accounting for federal income taxes, the results would have
been similar had it prescribed partial allocation. As the
above quotation indicates, the present justification Of this
past action could be that asset turnover has kept taxes low.
But it has been predicted that, unless the railroad industry
receives some sort of special tax treatment by the 1970's,
some, at least, may demand that some form Of tax allocation
be included in the Uniform System.24 Rua and Murphy are
convinced that the long lives of the railroad assets have
prolonged the period during which flow-through accounting

has benefitted financial reporting, but the day Of reckoning

 

231bid., pp. 29-30.

24From interviews, October 24, 1967 and January 24,
1968, respectively, with Ernest J. Rua, Jr., of Peat, Marwick,
Mitchell & CO. and Howard Dudley Murphy Of Price, Waterhouse
& CO.

58

may be approaching. This conviction is based upon the fact
that the reversal for an asset which has a thirty-three year
life should occur between the tenth and eleventh year
(assuming double-declining balance depreciation for tax
purposes and straight—line for books). Rolling stock, the
chief railroad depreciable asset has an average life Of
about thirty years. Since railroads began using flow-through
accounting in 1958, the first reversals should begin to be
found on individual assets about 1969. By the 1970's, a
substantial number of assets should have experienced rever-
sals--possib1y bringing about pressure for tax allocation
procedures.

The arguments posed by Rua and Murphy may be invalid
if reference is made to the Commission's statement in Chap-
ter II and the proposition advanced herein that, so long as
assets are replaced at the end Of their useful life, deferral
is unnecessary because aggregate reversal is not possible.
In other words, if the railroads have made annual dollar
investments in new assets at least equal to the dollar value
Of those assets which became no longer subject to deprecia-
tion in that year, no aggregate reversal will Occur and tax-
able income will not exceed pretax accounting income.

Railroads are like other business firms in their
planning in that forecasts are made of future income and
future income taxes. It should be possible for them to

determine, in advance, the amount and timing of any aggregate

59

tax reversal. The Interstate Commerce Commission, as indi—
cated in Chapter II, requires that excess depreciation taken
for tax purposes be reported, in hopes that it may be able
to anticipate any future tax reversals and the effect on the
transport system.25 Its argument against tax allocation is
primarily the speculative nature of the future liability;
ten years of flow-through accounting has not shown the need
for tax allocation. Although the Commission will not permit
any form of tax allocation at the present time, it stands
ready to reevaluate its position and may permit partial
allocation based upon a liability concept should the trans-

port system find itself in need Of such an accounting method.

Betterment Accounting

 

"Betterment" or "replacement" accounting, under the
Interstate Commerce Commission's rules, means that "the
property account contains only that portion Of the track
structure which constitutes a quantity increase or quality
improvement. This is accomplished by capitalizing the first
installation and thereafter only capitalizing that portion
Of the replacement constituting the quality improvement (the

26

'betterment')." For example, assume a section Of 90 1b.

rail were to be replaced by a section of 120 lb. rail. The

 

25See Chapter II, n. 38 and following.

26"Railroad Accounting Procedures," 9- 72-

6O

labor would be charged to expense; the current cost of a
section Of 90 lb. rail would be charged to expense; the
difference between the current cost of 120 lb. rail and 90
lb. rail would be added to the property accounts. The
analogy may be drawn to the replacement Of tires, spark
plugs, and other such items on an automobile. If there is
no change in quality, betterment accounting conforms exactly
to LIFO inventory accounting. The Association Of American
Railroads justifies the use of betterment accounting through
statements made by the accounting profession, the courts,
and the Interstate Commerce Commission. The Committee on
Accounting Procedure approved the 1957 report of the Commit-
tee On Relations with the Interstate Commerce Commission in
which the following statement may be found:

. . . As to track components, however, the com-

mittee, in consideration of the long history of

the use of replacement accounting by railroads

with respect thereto, the unique nature of this

category Of railroad property, its relatively

stable physical quantity, and the mature economic

status Of the industry, has concluded, with one

member dissenting, that no substantial useful

purpose would be served by a change to deprecia-

tion accounting techniques in the absence of

evidence indicating that depreciation maintenance

procedures would provide more appropriate charges
to income for the use of such property.

 

27Report reproduced in: Arthur Andersen & Co.,
Cases in Public Accounting Practice, Vol. VII: Interstate
Commerce Commission Jurisdiction Over Financial Statements
in Reports to Stockholders (Chicago: Arthur Andersen & Co.,
1962), p. 24.

61

The justification of the courts can be found in a case heard
in 1935, in which the court said:

. . . It would be inconvenient, if not imprac-
tical in railroad accounting to charge every
item having a life Of more than one year to
capital account and allow depreciation on it as
a deductible item of expense; and in a great
business where thousands of similar replacement
or repair items are involved nothing would be
gained by such a system of accounting, since,
on the law Of averages, expenditures for such
items during a given year would substantially
balance the depreciation for that year. The
proper accounting practice, therefore, is to
allow normal expenditures for repairs and
replacements as an expense of the business and
not to allow depreciation on such items except
to the extent that it may not be covered by
expenditures for repairs and replacements. 8

The Interstate Commerce Commission justifies this treatment
for basically the same reasons used by the Committee Of the
American Institute. When the Uniform System of Accounts was
established in 1914, betterment accounting was firmly estab-
lished as the method of providing for capital maintenance.29
This method was adopted by the Commission in accordance with
its policy Of choosing, for the Uniform System, the gener-
ally accepted and most acceptable practices in use at the
time.30 Even the growth Of depreciation accounting in other

industries and the acceptance by the Commission of deprecia-

tion accounting for other property items have not threatened

 

28Southern Ry. Co. v. Commissioner of Internal
Revenue, 74 Fed. 2d 887 (4th Cir. 1935).

29Hendriksen, p. 34.

3OFerris, p. 14.

62

betterment accounting for track components. Beside the fact
that betterment accounting has a long history, there are
numerous practical difficulties that would be entailed in
changing over to depreciation accounting:

1. The use of rail first on main line and its
subsequent removal to secondary and then to
branch lines; also the serious problem Of
valuation of used rail.

2. The determination of units Of property which
is an extremely debatable subject. Ties are
seldom replaced in a continuous stretch but
usually through replacement programs of every
fourth or fifth tie. Thus attempts to specify
any continuous length of ties would probably
not give a satisfactory result while an indi-
vidual tie is too small a unit for practical-
ity. It might be conceded that 1400 feet
would be an appropriate unit for rail.

3. Ballast is seldom replaced, any annual charge
could only be an estimate of the wastage
within the given period.

4. The change would require restatement Of the
assets to a historical figure predicated on
the newly defined units of property with 31
some provision for accumulated depreciation.

These practical difficulties should not, however, prevent
change over if depreciation accounting in fact produces more
reliable results. The difficulty is that no information is
available as to the dollar differences between the two
methods. During the hearings Of the Subcommittee on Legal
and Monetary Affairs Of the Committee on Government Opera-
tions Of the House Of Representatives, the Subcommittee
Counsel, Plapinger asked the following question and received

the attendant answer from Howard D. Murphy, who was then

 

31Adapted from: "Railroad Accounting Procedures,"

p. 73.

63

Chairman Of the Committee on Relations with the Interstate
Commerce Commission:

Plapinger: "Was there any effort on the part
Of your committee to appraise the effect Of
a switch to depreciation accounting on the
income Of the railroads?"

Murphy: "There was not on the part of the com—
mittee. I tried myself to make an estimate
several times on that, and I have had to
admit defeat because of inability to answer
the first question--what are the units of
property, and what is the life of them."32

Perhaps the best argument for the adoption Of depre—
ciation accounting for track components is an argument
against the use Of betterment accounting, since the dollar
differences between the two approaches are impractical to
determine short Of full-scale change over. In fact, the
Interstate Commerce Commission itself may have stated the
case for depreciation accounting as succinctly as anyone:

As has been indicated, the carriers frequently
adjust the amount Of maintenance work done tO
the state Of their earnings. They are liberal
in such expenditures in times of prosperity, and
curtail them in times of adversity. When earn-
ings are poor, they may spend only enough on
track and equipment to keep them in reasonably
safe condition, deferring other desirable expen—
ditures until more favorable times, if they ever
arrive. If depreciation accounting were applied
to track material, the opportunity for such vari-
ations in maintenance charges would be reduced,

 

32Arthur Andersen & Co., Letter to American Institute

Of Certified Public Accountants Requesting Reconsideration Of
Its Position Regarding Replacement Accounting_in the Railroad
Industry (Chicago: Arthur Andersen & Co., September 17,
1963), p. 8.

64

and the situation as to track would be similar
to that which now exists as to equipment.
.Actual expenditures could be curtailed as much
as at present, thus conserving cash, but there
would be less opportunity for reduction in
recorded operating expense.

While the executives prize the present Oppor-
tunity to control and adjust maintenance expense
to changing financial conditions, the extension
Of depreciation charges to the track accounts
would undoubtedly result in a more accurate
statement of the actual expense which is being
incurred in the operation of the property, and
one less apt to mislead both investors and the
public generally. We believe that such a result
is greatly to be desired. The problem presented
by the recurrent peaks and valleys Of railroad
traffic ought not to be met by incomplete and
misleading statements of operating expense.

Howard Dudley Murphy presents an argument for reten-
tion of betterment accounting for track components on the
basis that better cost control is achieved through its
application than is achieved through the application Of
depreciation accounting.34 About three times as many main—
tenance dollars are spent for depreciable assets as for
betterment of track components so the distortion on asset
values in the balance sheet may not be as great as imagined.

Depreciation accounting spreads the effect Of managerial

 

33From Interstate Commerce Commission Case Number
15,100, decided July 28, 1931, pp. 438—439, as found in
.Arthur Andersen & Co., Accounting and Reportipg Problems Of
the Accounting Profession (2nd ed.; Chicago: Arthur Ander-
sen & Co., October 1962), p. 132.

34Interview, January 24, 1968, with Howard Dudley
Murphy Of Price Waterhouse & CO.

65

action over future periods while betterment accounting pre-
sents the effect in the year Of the action. NO evidence has
been presented as to the magnitude Of the difference between
the two approaches as applied to the American railroad indus-
try. For the above three reasons, betterment accounting
might be retained because Of better cost control obtainable
by management and because readers of financial statements

can better evaluate managerial policies.

If conversion from betterment accounting to depreci-
ation accounting for track components is deemed advantageous
for either balance sheet or income statement reasons, two
methods are available for the accomplishment Of this Objec-
tive. The first is to start from the time Of policy change
tO capitalize all betterment expenditures and depreciate
whatever asset balance is on the books. This method,
because of the initially understated asset balance, will
result in depreciation charges that would most likely be
substantially lower than the comparable betterment charges
that would have been made to income. This condition Of
income overstatement will continue until the original dol-
lars in the asset account have been removed. If deprecia-
tion accounting is theoretically superior to betterment
accounting, the sacrifice made in the measurement Of income
may be justified by the change to the theoretically better
method. However, as has been indicated, it is not known

whether depreciation accounting is superior as to income

66

measurement. NO comparative results are available for
American railroads.

The second method Of implementing a change to depre-
ciation accounting is a complete restatement Of the assets
and depreciation contra accounts such that a fresh start is
made. It is possible to make a change-over to depreciation
accounting for track components from betterment accounting
and in a relatively short period Of time. The Canadian
Board Of Transport Commissioners, in 1952, decided that
Canadian railroads should make this transition. However, it
took from 1952 until early 1955 to decide upon the units Of
property to be used, the method of valuing the "inventory"
and the depreciation rates to be used.35 The work on the
inventory was started by the railroads in early 1955 and the
restatement Of the property accounts was reflected in the
railroad annual reports for 1956. The Arthur Andersen & CO.
report indicates that the adoption Of depreciation account-
ing had no material effect on the net Operating results for
the year 1956 of either of the two Canadian railroads (Cana-
dian National and Canadian Pacific) which converted from

36

betterment accounting. This indicates that there is per-

haps less justification for the conversion to depreciation

 

35Arthur Andersen & Co., "The Canadian Experience

with the AdOption Of Depreciation Accounting for Railroad
Track Structure and Grading Accounts," unpublished report
(Chicago: Arthur Andersen & Co., March 7, 1966), pp. 3, 9.

36Ibid., pp. 17-18.

67

accounting for track components than there would be if mate-
rial differences had been evidenced. The annual reports of
these two major railroads disclosed the magnitude Of the
adjustments that were made to the property accounts. The
Canadian Pacific indicated that an adjustment Of $213,788,319
was made to Gross Property Investment, a 12.3 per cent in-
crease over the December 31, 1955 balance of $1,761,669,249.37
The adjustment made by the Canadian National was $173,302,045,
a 6.3 per cent increase over the December 31, 1955 balance Of

38 This does not appear to reflect the adjust-

$2,757,290.868.
ment of "grossly understated" asset balances which some argue
that betterment accounting creates.

It would be very difficult to generalize the experi-
ence of two Canadian railroads to cover the expected experi-
ence of seventy-six Class I railroads in the United States.
In other words, the issue as to whether or not depreciation
accounting should replace betterment accounting for track
components for American railroads must be decided on the
basis Of the relative merits as perceived by the railroads
involved, the Interstate Commerce Commission, and other

users of the information. It appears currently that the

practical difficulties of change-over and the speculative

 

37The 1956 Annual Report of the Canadian Pacific
Railway Company, p. 26.

38The 1956 Annual Report Of the Canadian National
Railways, p. 32.

68

nature Of any benefits to be forthcoming stand in the way Of

eliminating betterment accounting from the Uniform System.

Summary

The two material divergences from generally accepted
accounting principles, as practiced by other industries,
exhibited by the Uniform System are in the areas Of the
treatment Of federal income taxes and replacement or better-
ment accounting applied to track property. In the area Of
income tax accounting, it has been concluded that the
deferred credit approach to tax allocation is questionable.
If tax allocation is to be used at all, partial allocation
based upon a liability concept appears the more acceptable
approach. The railroads and the Interstate Commerce Commis-
sion favor flow—through accounting because of the specula-
tive nature of any future liability. As indicated earlier,
flow-through gives results similar to those Obtained under
partial allocation, when the future aggregate reversal is
considered unlikely. The conclusion of this paper is that
flow-through is preferable to predicting current income on
speculative future tax reversals, the aggregate amount and
timing Of which are unknown or nonexistent. In the area Of
betterment accounting, in View Of the weight Of years Of use
and the practical as well as monetary consequences Of change-
over to depreciation accounting, the railroads may never
conform to other industries. The only comprehensive evi-

dence Of the effect Of a change from betterment accounting

69

to depreciation accounting indicates neither a material dif-
ference in the net income generated in the year of change
nor a substantial reevaluation Of assets. It is possible to
agree with the Committee on Relations with the Interstate
Commerce Commission that, because of the long history of
railroad use of betterment accounting, the unique nature of
this category Of railroad property, its relatively stable
physical quantity, and the mature economic status of the
industry that betterment accounting is justifiable, as is

depreciation accounting, for track components.

CHAPTER IV

RAILROAD F INANC IAL REPORTING

Introduction

This chapter contains an evaluation Of the current
state Of the art Of financial reporting in the railroad
industry as it is reflected in the sample. _In order to
properly analyze the present state, a frame Of reference was
needed. Conformity with generally accepted accounting prin-
ciples was selected as the standard, since the evaluation
was made Of published financial statements most of which
were attested to by certified public accountants as to their
fairness Of presentation in accordance with such principles.
A brief look at railroad financial reporting prior to 1962,
the Arthur Andersen & CO. petitions, present financial
reporting practices and the Opinions of financial analysts
relative thereto, Opinions Of the audited railroads, and
conclusions as to the acceptability of current reporting

comprise this chapter.

Financial Reportinngefore 1962
Prior to 1961 annual reports, auditor's certificates
related the financial statements Of railroads to their con-

formance with the Uniform System. Two paragraph reports

70

71

predominated and the substance Of the second paragraph would
read substantially as follows:

In our opinion, the accompanying balance sheet
and statement of earnings reinvested in the
business present fairly the financial position
at December 31, 19XX and the results of Opera-
tions for the year then ended, in conformity
with principles Of accounting prescribed or
authorized by the Interstate Commerce Commis-
sion applied on a basis consistent with that
Of the preceding year.1

Railroads were not actually required to prepare their annual
reports to stockholders in accordance with the Uniform Sys-
tem; they apparently prepared these reports in this manner
because it was less complicated than conversion to another
system and because the Interstate Commerce Commission had
never made a formal statement to the effect that any other
system was acceptable for this purpose.

Financial statements in annual reports to

stockholders and otherwise released to the

public are regularly prepared by carriers in

conformity with rules in the uniform system of

accounts and this Commission has not had ocas-

sion in the past to issue a general rule deal-

ing with the question. . . .2
Financial statements in the stockholders' reports Of rail—

roads were based On accounting principles prescribed or

authorized by the Commission, and it appears that the

 

1Taken from the 1960 Annual Report Of the Chesapeake
and Ohio Railway Company, p. 30.

2Interstate Commerce Commission, Financial State—
ments to Be Consistent with Accounting Regulations, Notice
Of Proposed Rule Making dated September 16, 1960, Docket
NO. 33581.

72

railroads considered this mandatory; conversely, some of the
other regulated transportation companies (trucking and inter-
state bus companies, for example) deviated from the Uniform
System and reported on the basis of generally accepted
accounting principles followed by other industries.3 Al-
though there were divergences in financial reporting within
the jurisdiction Of the Interstate Commerce Commission,
within the railroad industry uniform reporting was in
evidence.

Another interesting factor about pre-l962 railroad
annual reports relates to the proportion that were audited
by certified public accountants. In a study conducted by
the staff Of Arthur Andersen & CO. Of the 1961 annual
reports Of major railroad companies, 13 Of the railroad
financial statements, included also in the sample of 37
annual reports used in this paper, did not receive an inde—
pendent audit.4 The sample Of 1966 annual reports indicates
that 6 were unaudited.5 The respective percentages, as
related to the sample Of 39 are 33.3 per cent and 15.4 per

cent. The same six that were not audited in 1966 were

 

3Arthur Andersen & Co., Cases in Public.Accounting
Practice, Vol. VII: Interstate Commerce Commission Juris-
diction Over Financial Statements in Reports to Stockholders
(Chicago: Arthur Andersen & Co., 1962), p. 1.

4Arthur Andersen & Co., Subject File NO. 2030,
Item NO. 51.

5This includes two which received audit Opinions
only on the financial statements of consolidated subsid-
iaries.

73

represented in the thirteen unaudited in 1961. The reason
for the large percentage Of unaudited railroad annual reports
is quite simple: the regulations Of the Interstate Commerce
Commission, the Securities and Exchange Commission, and the
New York Stock Exchange specifically exempt these enterprises
from this requirement. There appears to be a trend, as evi-
denced by the period from 1961 to 1966, for fewer railroads
to remain without auditors possibly because Of the tremendous
debt financing required by the industry.

As indicated in Chapter II, the 1957 report of the
Committee on Relations with the Interstate Commerce Commis-
sion proposed modifications in the Uniform System which were,
with two major exceptions, approved by the Commission and
incorporated January 1, 1958. These, and other changes over
time, have improved the financial reporting Of railroads
using the Uniform System as the basis upon which their
reporting was founded.

According to my score card, the first complete
system Of accounts, issue Of 1914, was amended

71 times. The following issue of 1943 was
amended 37 times, the issue of 1952 a total Of

11 times, the issue of 1957 a total of 10 times
and the currently effective issue Of 1962 already
has been amended 5 times. If you will add up
these figures you will find that the rules have
been amended 134 times since 1914. I will leave
you to judge whether a backward and unprogressive

agency living in the days Of the past could have
established this record.6

 

6Richard J. Ferris, Assistant Director, Bureau Of
Accounts, Interstate Commerce Commission, "The Uniform Sys-
tem Of Accounts: Development and Performance," a speech

74

Even allowing for the revisions, the Uniform System, as a

basis for financial reporting, continues to be criticized.

The Arthur Andersen & Co. Petitions

 

The following is a historical sketch Of the events
leading up to the Interstate Commerce Commission's decision
to allow carriers subject to its regulation to base their
annual reports to stockholders on generally accepted account-
ing principles.7

On May 4, 1959, Arthur Andersen & CO. submitted a
petition to the Interstate Commerce Commission requesting
that the latter render a decision as to whether or not rail—
road companies and other carriers subject to Section 20 Of
the Interstate Commerce Act (the Hepburn Act) are required
to use the prescribed accounting practices for financial
reporting to parties other than the Commission.8 On
September 16, 1960, the Commission issued a Notice of Pro-
posed Rule Making which stated:

NO carrier subject to accounting regulations
prescribed by this Commission shall distrubute

in its annual reports to stockholders or other-
wise release tO the public financial statements

 

before the Seventy-first Annual Meeting, Accounting Division,
Association Of American Railroads, May 31, 1966, pp. 49-50.

7This history may be found in Arthur Andersen & Co.,

pp. 6, 10, 50.

8Petition reproduced in ibid., pp. 41-45.

75

which are inconsistent with the corporate books
of account, maintained in conformity with the
uniform system Of accounts prescribed by the
Commission, and with reports filed with the
Commission for or on behalf of the carrier.

This rule shall not be deemed to prohibit dis-
tribution or publication of reasonable conden-
sation or rearrangement in the form Of financial
statements in annual reports to stockholders or
otherwise released to the public or Of special
statements pursuant to requirements of indentures
or mortgage to secure bonds or other similar
instruments.

The Commission, in order to be fully advised, solicited
data, views, and comments in writing from all interested
persons and indicated that oral argument or a public hearing
could be arranged if the interested persons should request
it.10 NO oral argument or public hearing was ever held even
though one was requested in a letter from The Greyhound Cor—

poration dated March 13, 196111 and in a petition by Arthur

Andersen & CO. dated November 1, 1960.12 Written views and
comments were received by the Commission from the American
Institute Of Certified Public Accountants, 16 public account—
ing firms (including five Of the "Big Eight"), one bank, the
Investment Bankers Association Of America, the New York

Stock Exchange, 22 trucking companies and associations and

from seven other transportation companies and associations

 

9Notice reproduced in ibid., pp. 48-49.

l01bid., p. 49.

11Letter reproduced in ibid., pp. 131-132.

12Petition reproduced in ibid., pp. 57-59.

76

(including one railroad).l3 The effect Of these letters to

the Commission is as presented in Table 1. It appears then

Table 1. Responses to proposed rule making on financial

 

 

 

reporting
Total In Favor Opposed
Accounting profession 17 0 l7
Institutions 3 0 3
Trucking 22 l 21
Other transportation 7 0 7

 

that 97.9 per cent of the respondents opposed the Proposed
Rule Making. The American Institute Of Certified Public
Accountants emphasized the public interest in its statement:

The managements of private enterprises have a
responsibility and the freedom to report finan-
cial information to investors and creditors in

a manner designed to best serve the needs of
such investors and creditors. There would seem
to be no good reason why the managements Of com-
panies subject to the Commission's jurisdiction
should not have the same responsibility and
freedom to make such reports as do the manage-
ments of other private enterprises.

The Commission considered it unnecessary to hold a public
hearing. On January 25, 1962, it withdrew the proposed rule

and issued its decision and order permitting carriers to

 

l3Letters reproduced in ibid., pp. 55-136.

l4Letter reproduced in ibid., pp. 55-56.

77

prepare financial statements to stockholders and others in
conformity with generally accepted accounting principles.

Many reSponses have been received from carriers
and others, including the American Institute Of
Certified Public Accountants and individual firms
of certified public accountants, who audit finan-
cial statements of carriers, expressing Opposi-
tion to the proposed rule. The substance Of these
Objections is that the Commission should not as a
matter of policy deny the carriers the right to
furnish their stockholders or to otherwise publish
financial statements based on accounting methods
for which there is substantial authoritative sup-
port under generally accepted accounting principles.

In our Opinion, the following rule is reasonable:

Carriers desiring to do so may prepare and publish

financial statements in reports to stockholders

and others, except in reports to this Commission,

based on generally accepted accounting principles

for which there is authoritative support, pro-

vided that any variance from this Commission's

prescribed accounting rules contained in such

statements is clearly disclosed in footnotes to

the statements. 5
By requiring footnote disclosure Of variances between the
two systems when generally accepted accounting principles
were used, the Commission insured that the parties desiring
financial statements prepared on the basis Of the Uniform
System could acquire that information by making the appro-
priate adjustments. At the same time, the integrity of the
Uniform System was not being threatened; the reporting
requirements to the Commission remained unchanged. The

order was not to become effective until July 1, 1962, but

certified public accounting firms changed their Opinions to

 

15Reproduced in ibid., pp. 50-54.

78

begin to compare the financial statements of railroads with
generally accepted accounting principles with the 1961

annual reports.

Present Rgporting

As indicated in Chapter I, certified public accoun-
tants are required to base their statement Of Opinion upon
fairness Of presentation in accordance with the consistent
application Of generally accepted accounting principles.16
The railroad industry is not required to apply these princi-
ples in its reporting to stockholders and in fact, is
required to use The Uniform System Of Accounts for Railroad
Companies for its bookkeeping and for reporting to the
Interstate Commerce Commission. The Securities and Exchange
Commission and the New YOrk Stock Exchange specifically
exempt railroads from following generally accepted account—
ing principles by accepting reports prepared for the Inter-
state Commerce Commission in lieu of audited annual reports.
The railroads are, therefore, in the curious situation of
having their annual reports evaluated on one basis by certi-
fied public accountants while in fact this reporting may
correspond to another basis. This "difference in perspec—
tive" is aptly illustrated in the following, which was
jprepared from the opinion certificates and footnotes to the

16See Chapter I, n. 1 and following.

79

railroad financial statements Of the thirty-one annual
reports in the sample that were audited. For eight rail-
roads the auditors' opinions indicated that the Uniform
System was the basis for financial reporting while twenty-
five Of the railroads indicated that they were using the
Uniform System as the basis Of accounting in their annual
reports. This apparent lack Of uniform perception will be
investigated more fully in Chapter V. For the moment, it
is sufficient to say that even relatively sophisticated
users of railroad annual reports might be misled by the
auditors' Opinions because the basis upon which the state—
ments are presented is not uniformly disclosed by the
auditors.

Analyzing the number Of railroads apparently follow-
ing each basis of reporting by the size Of the company

reveals the following information (Table 2). It appears to

Table 2. Sample of 1966 annual reports—-reporting basis by
size Of railroad

 

 

Total Operating Revenue (in millions)

 

 

0- $100- $200- Over
$100 $200 $300 $300 Total
Number reporting
according to GAAP 4 O 2 0 6
Number reporting
according to ICC 12 3 8 8 31
Total 16 3 10 8 37

 

80

be significant that smaller railroads have a greater ten-
dency to report according to generally accepted accounting
principles while larger ones prefer to base their reporting
on the Uniform System Of Accounts. One reason for this
situation is the negative effect on the net income Of most
of the firms that would result from conversion. The distri-
bution Of the sample by auditor is presented in Table 3. It
appears to be significant that specialization has occurred
in the auditing Of railroads. Five Of the "Big Eight"
certified public accounting firms audited the 31 railroads
in the sample with three firms accounting for 87.1 per cent

of these audited roads.

Table 3. Sample Of 1966 annual reports—-distribution by
auditor

 

 

 

Number Per Cent
Haskins & Sells 9 29.0
Peat, Marwick, Mitchell & CO. 8 25.8
Price waterhouse & CO. 10 32.3
Arthur Andersen & CO. 3 9.7
Ernst & Ernst .__l 3.2

Number audited in sample 31 100.0

81

Since the Interstate Commerce Commission requires
that the amount of deferred tax savings be disclosed in
reports to the Commission, the railroads will report this
amount and Often the cumulative amount in footnotes to the
published financial statements. It is not a requirement,
however, that a reconciliation be presented to explain the
difference between the net incomes on the basis of gener-
ally accepted accounting principles and the Uniform System
of Accounts unless the former is used as the basis for
financial statement presentation. There were 11 railroads
which reported such a reconciliation, 9 Of these did not
need to because their reporting was based upon the Uniform
System. It is apparent that the Commission's requirement of
a reconciliation when generally accepted accounting princi-
ples are applied is satisfied by scattered notes to the
financial statements. The results, by auditor and by type
Of reconciliation, are presented in Table 4. It appears to
be significant that clients Of Price Waterhouse & CO. are
more prone to disclose this reconciliation than are the
clients of other independent accountants. This may result
from more progressive management on the part Of the clients
or from successful suggestion on the part Of the auditor.

The information presented in Table 5 suggests that
a close look should be taken at the six firms in the sample

that were unaudited. These six firms, comprising only about

82

Table 4. Number Of firms presenting reconciliation between
bases Of accounting by auditor

 

 

 

Notes On the Supple-
tO Income ment to
State— State— Income
ment ment Statement Total
Haskins & Sells 0 0 l 1
Peat, Marwick, Mitchell
& CO. 0 l 0 1
Price Waterhouse & CO. 3 3 l 7
Arthur Andersen & CO. 0 0 l 1
Ernst & Ernst 0 0 0 0
NO auditor 0 0 l 1

 

Table 5. Coverage of Class I railroad sample provided by
the unaudited portion Of the sample

 

 

Number of Class I railroads

 

 

in sample 37
Number unaudited in sample 6
Per cent 16.2%

Total gperating revenues
in sample $9,284,103,000
Total Operating revenues
Of six unaudited in
sample $2,743,979.000
Per cent 29.5%

Net railway Operating income
in sample $1,008,133.000
Net railway Operating in-
come Of six unaudited

 

in sample $ 317,695,000
Per cent 31.3%
Net income in sample $ 806,471,000
Net income Of six
unaudited in sample $ 276,878,000

Per cent 34.3%

 

83

8 per cent Of the Class I railroad industry, account for
over one-third of the net income for the sample. Table 6
presents a size breakdown of audited versus unaudited rail-

roads in the sample.

Table 6. Sample Of 1966 annual reports--audited v. unaudited
by size Of railroad

 

 

Total Operating Revenue (in millions)

 

 

0- $100- $200- Over
$100 $200 $300 $300 Total
Number audited l4 3 10 4 31
Number unaudited _g_ _Q. ._Q _44 ._g
Total 16 3 10 8 37

 

The railroads that are unaudited are not evenly distributed
over the continuum from the smallest to the largest. Rather,
they are bunched at both ends. There may be some signif-
icance attached to this distribution as the small unaudited
railroads (Maine Central and Lehigh Valley) Operate primarily
in local areas servicing specialized needs while the large
unaudited railroads (Atchison, Topeka and Santa Fe, Pennsyl—
vania, Southern and Union Pacific) are Old, well-established,
massive enterprises. There are more and more railroads
becoming involved in holding company activities. Holding

company activities are subject to the regulation of the

84

Securities and Exchange Commission. Therefore, the trend
toward more complete auditing of the railroad industry
should continue. These six unaudited railroads account for
only about one—sixth (16.2%) of the 37 in the sample but
they are responsible for over one-third (34.3%) of the net
income Of the sample.*

Because certified public accountants are required tO
relate their statements of opinion to the application Of
generally accepted accounting principles, the majority (27)
Of the 31 audited annual reports received qualified Opinions.
As has previously been indicated, most (25) Of these 31
firms indicated that they were using the Uniform System of
Accounts as the basis for financial reporting, and, since it
differs from generally accepted accounting principles,
either a qualified Opinion or an adverse Opinion would be
required. The rationale for the qualified Opinion rather
than the adverse Opinion will be pursued in Chapter V.

Table 7 presents the distribution of qualified v. unqual-
ified Opinions rendered by auditor. It can be seen that
87.1 per cent Of these Opinions were qualified, a situation
that could not be found in other industries. .Analysis Of
this distribution by size Of the firm yields the results

shown in Table 8.

 

*Three Of these railroads have communicated the
intention Of presenting audited financial statements for
the year ended December 31, 1967.

85

Table 7. Sample Of 1966 annual reports--distribution Of
audit Opinions

 

 

Unqualified Qualified Total

 

Haskins & Sells l 8 9
Peat, Marwick, Mitchell & Co. 1 7 8
Price Waterhouse & CO. 2 8 10
Arthur Andersen & CO. 0 3 3
Ernst & Ernst _Q_ ._l __1

Total 4 27 31

 

Table 8. Sample of 1966 annual reports—~audit Opinions by
size Of firm

l

1 _

Total Operating Revenue (in millions)

 

0- $100- $200- Over
$100 $200 $300 $300 Total

 

Number Of unqualified

Opinions 2 0 2 O 4
Number Of qualified

Opinions 12 3 8 4 27

Total 14 3 10 4 31

 

Unqualified opinions tended to be issued to smaller rail-
roads since, Of the eight railroads with over $300 million
Of Operating revenue, four were not audited and the other
four received qualified Opinions. The primary reason for

qualified opinions was lack of tax allocation as Table 9

86

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n
A: H o H o 3ch a “drum...
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m o o H h .00 w mmoosumum3 moaum
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musmEOHm nonuo muummoum mo coflumaomumma xme mo xomq

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chAcHQO OOHMHHmOo MOM mCOmmoullmunomou Hmsscm coma mo OHQEmm .m magma

87

reveals. None Of the qualified Opinions was for the use of
betterment or replacement accounting in lieu of depreciation
accounting for track components. Arthur Andersen & CO.
qualified its Opinions on the financial statements in the
1956-61 annual reports of the Chicago and North Western
Railway Company for this reason but has discontinued this
practice. It feels that, until a definitive statement has
been made by the Accounting Principles Board or some other
body with authoritative support, it is unduly penalizing its
clients relative to other railroads should it qualify its
Opinions for this reason while other certified public
accounting firms do not.17
The impact Of betterment accounting on the net
income Of a railroad was referred to in Chapter II. The
effect of the procedure is to expense the current replace-
ment cost Of the item being replaced and the labor involved
in the replacement while leaving the cost Of the original in
the asset account. One of the issues raised was the diffi-
culty Of determining the difference between the depreciation
expense and the betterment expense for any one year, assum-
ing that depreciation accounting had been used rather than
betterment accounting. From the annual reports in the sam-
ple, thirteen presented the dollar amount of betterment ex-

penditures for 1966, a total Of $161,842,474. This

 

17From an interview, October 23, 1967, with Delbert
Wacker of Arthur Andersen & CO.

88

represents 30.5 per cent of the $530.4 million of net income
for these railroads before the deduction for betterment.
These expenditures may therefore be considered significant.
Some railroads listed the dollar amount Of non-depreciable
track prOperty in lieu Of the amount of betterment expendi-
tures but not both. Table 10 is prepared from the 1966
Annual Report Of the Chicago, Rock Island and Pacific Rail-

road Company.

Table 10. Chicago, Rock Island and Pacific Railroad
Company--non-depreciab1e track components and
betterment expenditure

 

 

 

1965 1966
Non-depreciable assets $254,892,487 $253,270,545
Replacements and betterments 13,752,637 14,159,197
Per cent Of asset 5.4%» 5.6%
Appropriate asset life* 18.5 years 18.1 years

 

*This asset life assumes that replacements and
betterments are approximately equivalent to the depreciation
that would be taken on the asset if depreciation accounting
were applied.

This was the only company in the sample that disclosed both
of these figures. The percentage figures in the table are a
bit misleading in that the dollar value for the non-deprecia-
ble track components represents the historical cost Of the
original track components plus the quality improvement over

time while the dollar value for replacements and betterments

89

is the current cost Of track components and the labor
involved. Also, betterments and replacements include main-
tenance elements as well as the depreciation element. The
betterment expense, the counterpart Of depreciation and
maintenance expenses, would indicate about an eighteen year
life for track components while the actual life is consider-
ably longer. The application Of depreciation accounting
would divide this charge into the depreciation and mainte—
nance elements.

It was possible to establish that a relationship
exists between earnings and betterment expenditures. This
conclusion was premised on a quotation in Chapter III which
indicated that carriers adjust their betterment expenditures

depending upon financial ability.18

For only three rail-
roads, it was possible to Obtain from the 1962-66 published
financial statements the dollar amounts Of betterment expen-
ditures, gross Operating revenue, net income, and revenue-
ton miles.19 Gross Operating revenue and net income before
betterment expenditures were adOpted as measures Of finan-
cial ability while revenue-ton miles serves as an indication

Of track component usage. Table 11 presents the coefficients

of rank correlation derived for these three companies.

 

18See Chapter III, n. 33 and following.

19Atlantic Coast Line, Delaware and Hudson, and
Erie-Lackawanna.

90

Table 11. Correlation with betterment expenditures

 

 

 

Atlantic Delaware Erie—

Coast Line and Hudson Lackawanna
Gross revenue .94 .37 .83
Net income .94 .43 .94
Revenue-ton miles .94 .09 .83

 

Although the coefficients Of rank correlation for the
Delaware and Hudson were low for all three relationships,
the coefficient for net income is the largest. The Erie-
Lackawanna showed a greater correlation with net income
while the Atlantic Coast Line showed a high degree Of corre-
lation with all three. Data availability made it impossible
to repeat this correlation analysis for a longer period Of
time. It is not possible to generalize from these results,
but it is possible to state for these firms that a more than
casual relationship exists between earnings and betterment
expenditures. Usage and betterment expenditures seem to be
less closely related to each other for two Of these rail-
roads.

Seventeen firms in the sample disclosed information
about company sponsored pension plans. In two cases it was
not possible to determine the accounting method employed by

the company. Table 12 presents the data for the remaining

91

Table 12. Sample of 1966 annual reports—-pension plan
accounting methods

 

_— —4—

 

 

Total Operating Revenue (in millions)

 

0— $100- $200- Over
$100 $200 $300 $300 Total

 

Current expense only 1 0 0 0 1
Current and interest 3 0 l 0 4

Full recognition of
past service 2 2

_ _ _l __ __
2

Total 6 2

 

fifteen classified by size Of the firm. It appears signif-
icant that either larger firms have pension plans while
smaller firms do not or that larger firms disclose these
plans while smaller firms do not. It is also significant
that, as the analysis moves from smaller to larger firms,
the tendency for the railroads' pension plans to be fully
accrued increases. The effect on earnings Of these larger,
more profitable railroads would be less than the effect on
earnings of the smaller roads.

Interstate Commerce Commission requirements include
depreciation accounting for certain kinds Of assets. When
these requirements were finally instituted, they were to
apply to qualified assets acquired after January 1, 1943.
The Uniform System of Accounts does not, therefore, authorize

the depreciation of assets acquired before that date. Six

92

railroads in the sample disclosed that their published
financial statements contained no depreciation on assets of
this type. The Gulf, Mobile and Ohio Railroad Company, in

the notes to the financial statements, states that "the

Company has recorded the estimated accumulated depreciation
applicable to depreciable property prior to January 1, 1943."20
The Reading Company indicates that "except to the extent Of
approximately $12,000,000" it remains "consistent with the
practice generally followed by Class I railroads" in that

"no provision was made for depreciation of road property

"21 NO exception was taken bY any

prior to January 1, 1943.
certified public accounting firm for not depreciating these
assets. The effects on net income and financial position
were not considered material or a qualification would have
been given for that reason.

Although only eleven railroads prepared a reconcilia-
tion between net income on the basis of the Interstate Com-
merce Commission requirements and on the basis of generally
accepted accounting principles, it was possible to make
adjustments to the reported net incomes Of twenty-eight

firms, through generous use Of the notes to the financial

statements, tO approximate a reconciliation. Table 13

 

201966 Annual Report Of the Gulf, Mobile and Ohio
Railroad Company, p. 12.

211966 Annual Report of the Reading Company, p. 12.

93

Table 13. Sample of 1966 annual reports--rcconciliation between bases of net income*

 

 

 

Uniform System Adjustment After Adjustment

Atlantic Coast Line 22,048,000 (5 8,134,000) $ 13,914,000
Chesapeake and Ohio 66,096,033 (7,000,000) 59,096,033
Chicago, Burlington and Quincy 25,082,397 (4,300,000) 20,782,397
Chicago and Eastern Illinois 3,255,052 (1,556,000) 1,699,052
Chicago Great Western 1,396,036 (670,000) 726,036
Chicago, Milwaukee, St. Paul and

Pacific 8,129,944 5,643,576) 2,486,368
Chicago and North Western 26,074,648 (6,184,000) 19,890,648
Chicago, Rock Island and Pacific 7,433,887 5,536,339 12,970,226
Delaware and Hudson 5,104,410 (600,000) 4,504,410
Denver and Rio Grande Western 12,895,409 (2,411,067) 10,484,342
Great Northern 36,547,109 (2,400,000) 34,147,109
Gulf, Mobile and Ohio 7,487,779 (1,843,000) 5,644,779
Illinois Central 23,340,996 (5,479,000) 17,861,996

Louisville and Nashville
Missouri-Kansas-Texas
Missouri Pacific

Monon

New York Central
Norfolk Southern
Reading

St. Louis-San Francisco
Seaboard Air Line

SOO Line

Southern Pacific

Texas and Pacific

Union Pacific

Western Maryland
Western Pacific

Total

28,516,789
(7,834,989)
26,747,000
1,717,756
65,531,812
(104,866)
1,592,081
12,384,000
16,113,988
6,532,485
102,372,379
5,219,471
109,791,622

5,604,363

8,710,294

$627,785,885

(8,666,000)
(1,409,793)
(6,235,000)
(708,000)
(12,000,000)
(260,000)
(2,000,000)
(2,041,000)
(3,326,000)
(1,000,000)
(12,653,194)
(2,367,000)
(20,700,000)
(1,226,000)
(2,016,000)

($117,292,291)

19,850,789
(9,244,782)
20,512,000
1,009,756
53,531,812
(364,866)
(407,919)
10,343,000
12,787,988
5,532,485
89,719,185
2,852,471
89,091,622

4,378,363

6,694,294

$510,493,594

 

*The adjustments are primarily the tax effects of guideline depreciation,
accelerated depreciation, amortization Of defense facilities and other elements Of

deferred taxes.

94

presents this attempted reconciliation. The total net
income of $627,785,885, based on the requirements Of the
Uniform System of Accounts, would be reduced to $510,493,594
if those listed at the end of the table were the only adjust-
ments necessary to reconcile the two bases of reporting.
The change amounts to 18.7 per cent of the total net income
based upon the Uniform System's requirements. By firm, the
range of percentage change is from 7 per cent to 248 per
cent with the median change being 23 per cent. There was
but one of the railroads, the Chicago, Rock Island and
Pacific, whose net income based on generally accepted
accounting principles was greater than the net income for
Interstate Commerce Commission purposes. Presented on the
basis of return on total assets employed, the adjustments
produced a reduction Of .57 per cent. The return, based
upon net income determined according to the requirements of
the Commission, was 3.01 per cent while the comparable
return using the adjusted net income was 2.44 per cent.
Confusion created by this single factor, the magni-
tude of the dollar difference and the percentage difference,
particularly when reflected on a per-share basis, was the
major reason for the decision by the Illinois Central Rail-
road to revert back in 1966 to reporting the earnings Of the
railroad exclusively on the basis Of the Uniform System of

Accounts.

95

‘We made the decision to revert to our policy Of

reporting railroad [financial results] on an ICC

basis for a number of reasons. The primary one

was that reporting on generally accepted as well

as ICC basis (ICC basis required by Commission)

created a great deal Of confusion both from the

analysts' point of view, and particularly, news-

paper reports Of our earnings. Some publications

would report both bases, some would report net

income dollar amount on one basis and net per

share on the other, Often leading to complaints

by analysts.22
Opinions of Financial Analysts

Financial analysts, as sophisticated users Of pub-

lished financial statements, were contacted for their Opin-
ions On the relative applicability Of the Uniform System and
generally accepted accounting principles for railroad finan-
cial reporting. The annual reports of companies are distrib-
uted to stockholders and probably are used more for judging
investment decisions than for any other single purpose. It
would seem that the Opinions Of trained financial analysts
as to the proper accounting basis for railroad reporting
would be invaluable. A general conclusion will be stated at
this point, to be more fully evaluated later. Financial
analysts seem to feel that the requirements Of the Inter-
state Commerce Commission are more relevant for railroad

financial reporting because Of the nature Of the economic

conditions facing the industry, primarily the federal income

 

22Letter dated January 10, 1968, from G. K. weigel,

Vice President and Comptroller, Illinois Central Railroad.

96

tax environment which favors the railroads under this
accounting system.

Since the Congress and the Treasury instituted new
depreciation guidelines and the 7 per cent investment credit,
controversy has existed over the differences between the
accounting methods prescribed by the ICC and those endorsed
by the accounting profession. On the surface, it has ap-
peared to some trust Officers and security analysts that
Class I railroad earnings have been overstated and the
apparent earnings recovery of recent years has been illusory
in part.23 Hayden, Stone, Incorporated disagrees.

This brokerage firm thinks that the rails will con-
tinue to enjoy large tax benefits indefinitely because of
their unique situation. The guideline life established for
fleet equipment was fourteen years while present average age
Of such equipment is about sixteen or seventeen years, quite
close indeed. (But, this average age would indicate a ser-
vice 1ife Of perhaps 25-35 years.) Many railroads, with
sizable tax loss carry-forwards from accelerated deprecia-
tion, retirements, and abandonments have not yet taken
advantage Of the shorter depreciation guidelines. 'These
railroads continue to use the lives, established by the
Interstate Commerce Commission, which are longer than the

guideline lives established for tax purposes. Since the

 

23Hayden, Stone, Incorporated, Railroad Industry
Review: 1967 (New York: Hayden, Stone, Incorporated, 1967),
p. 43.

97

railroads have the Option of adopting guideline lives at any
time, Hayden, Stone, Incorporated feels that the present low
effective tax rates—-in 1966, federal income taxes averaged
only 17 per cent of the Class I railroads' reported net
income--must simply be thought of as likely to continue
indefinitely, with an upward bias as the industry's gross
revenue and net income rise by reason Of anticipated indus-
try growth.24 When Congress reinstated the 7 per cent.
investment credit in 1967, a prior provision was modified to
allow this credit to Offset up to 50 per cent Of an individ-
ual carrier's federal tax liabilities instead Of the pre-
viously allowed 25 per cent. Hayden, Stone, Incorporated
predicts that this should enable the Class I railroads to
increase their earnings by as much as $25 or $30 million in
1967 and in succeeding years.25 Additionally, such things
as the recently approved merger between the Pennsylvania and
New York Central railroads whereby small, deficit producing
railroads are absorbed into a large system.will allow for
higher after-tax earnings because Of utilization of tax loss
carry-forwards as well as substantially better utilization
Of resources. Considering all Of these factors, Hayden,
Stone, Incorporated states that rail earnings are not over-

stated as presented on the basis of the Uniform System

 

24Ibid.

251bid., p. 44.

98

because Of economic circumstances which are peculiar to this
industry.

Karl Ziebarth, an analyst for the above mentioned
brokerage firm, states that "the Uniform System of Accounts
probably gives a better general picture (of railroads) than

. . . . . . 26

does the accounting ba51s used in industrial corporations."

The Uniform System of Accounts does, broadly

speaking, impose greater comparability on rail-

road management than does so-called "generally

accepted" accounting on industrial companies.

However, a caveat must be given: one must be-

come thoroughly familiar with the basis of the

Uniform System Of Accounts, in order to under-

stand what the management Of a railroad is

doing.
Ziebarth feels that greater comparability is evident in
railroad reporting than in the annual reporting of indus-
trial corporations. However, it is apparent that he thinks
that uninformed users of financial data had best refrain
from attempting to analyze railroad annual reports. Gener-
ally accepted accounting principles may not lead to as much
comparability but may be less likely to be misinterpreted by
the less sophisticated user. "General acceptance" may pro-
fess substantive support to the financial statements, but

the number Of alternatives available under generally

accepted accounting principles may make the presentation of

 

26Letter dated January 11, 1968, from Karl Ziebarth
Of Hayden, Stone, Incorporated.

271bid.

99

"true“ net income less likely. Ziebarth states that the
Uniform System requires full disclosure, more so than for
industrial companies, but one must know where to look to
find out what has happened. "From the point of View of the
analyst, the railroad accounts are, once you master the
intricacy Of ICC accounting, quite reliable indications of
the performance Of the individual carrier and Of the indus-
try."28

Ziebarth presents three arguments for the use for
financial reporting of the Uniform System of Accounts:
federal income tax structure, continuity, and the psychology
of railroad management. He argues that the present system
Of special tax reductions for railroads is built around the
existing ICC accounting system. Any change in this account-
ing system might hurt the railroads tax-wise or would
require substantial changes in the tax laws, "which Congress
might be loath to make."29 The second reason is that, by
using the same basic system Of accounts for fifty-three
years, the Interstate Commerce Commission has Obtained long-
term statistical data of considerable significance, which is
not obtainable for any other industry.

It is interesting to note that consistency or con-

tinuity has been adjudged highly important by accountants as

well as financial analysts. The independent auditor attests

 

281bid. zglbid.

100

that the generally accepted accounting principles have been
applied consistently with those of the preceding year. In a
recently published study, Andrew McCosh presents the results
Of a simulation designed to determine the differences result-
.ing from the consistent application through time of various
sets of accounting policies. His conclusion is, essentially,
that consistency in accounting policies, however diverse
these policies may be, will lead to earnings per share
results that depict economic fluctuations more accurately
and similarly than even moderately inconsistent applications
of accounting policies, however initially similar these may
have been.30 In other words, when two companies are subject
to the same economic fluctuations, their stockholders will
receive information that is essentially identical if the
companies use their accounting policies consistently through
time, no matter how different these policies may have been
initially. Restating this conclusion in the form of a
recommendation, McCosh makes the following statements:

The results Obtained in this research indicate

that instead Of trying to promote intercorporate

comparability by making all firms use the same

methods, those who seek to improve the useful-

ness of accounting should concentrate on getting

companies to hold consistently to the accounting

policies they now employ. In this way, the in-
formation made available to stockholders will be

 

30Andrew M. McCosh, "Accounting Consistency--Key to
Stockholder Information," The Accounting Review, October,
1967, p. 699.

101

made comparable as between companies, without

forcing corporate management to use an account-

ing procedure they consider unsuited to their

company.
This argument supporting consistency, on the basis that
better information is derived if policies are followed con-
sistently, tends to reinforce Ziebarth's second reason for
retaining the Uniform System.

The third reason for retention of the Uniform System
advanced by Ziebarth was a psychological Observation consid—
ered worth making: the railroad industry tends to oppose
change of any sort with an almost frenzied determination to
preserve the status-quo, so that any revisions in the rail-
road accounting system will, as a practical matter, be
unlikely.32 It may be that railroad managements are simply
conservative, old—fashioned, or stodgy but more likely they
are convinced that the quality of results Obtained and con-
sistency Of application are sufficient cause to remain
adamant against change. Some railroad management conclu-
sions about the Uniform System are presented later in this
chapter.

As was indicated in the case of the Illinois Cen-
tral's change back to the Uniform System for financial

reporting, having two bases for financial reporting raises

more problems than it solves. John Kaptain states that,

 

311bid., p. 700.

32Letter from Karl Ziebarth.

102

while he believes generally accepted accounting methods to
be more conservative and more desirable, "the investing
public does not appear to recognize the distinction" between
the Uniform System and generally accepted principles of
accounting.33 Ziebarth corroborates this comment in his
explanation of the reason for the railroads not reporting
according to generally accepted accounting principles.

A few years ago several railroads reported

eXperimentally on a "generally accepted" basis.

What happened was that the market did not in-

crease the multiple to that Of an industrial

stock, instead, the lower earnings reported

under the "generally accepted" basis were
simply valued with the normal railroad multiple.

34
In other words, the lack Of sophistication on the part of
the investing public makes it impractical for railroads to
report in any way other than in accordance with the regula-
tions Of the Interstate Commerce Commission. "From this,
one would conclude that there is no incentive for the indus-
try to change its system from the basis now prescribed by
the ICC."35
Ray E. Lee, Jr., an analyst with Francis I. duPont &

CO. states another virtue Of the Uniform System basis Of

financial reporting which could be lost to readers of annual

 

33Letter dated November 29, 1967 from John Kaptain

Of Merrill Lynch, Pierce, Fenner & Smith, Inc.

34Letter from Karl Ziebarth.

351b1d.

103

reports should a complete conversion to generally accepted
accounting principles take place.

There is also a virtue to the present arrange—

ment that railroads present a considerably more

massive set of figures for inspection than does

the average industrial company. Under any

change to "generally accepted" principles,

there is the practical danger that the companies

would be allowed to reduce their presentations

to the bare minimum figures given by others, in

which any presumptive improvement in the over-

all system would be more than dissipated in end

result.36
The amount Of financial and Operating data disclosed by
railroad companies is apparently useful to financial ana-
lysts in their evaluation of investment potential. Reduc—
tion in the amount of detail presented, should railroads
deem it appropriate to conform their reporting to industrial
standards, would apparently lead to a considerable reduction
in the value Of railroad annual reports.

It is significant that some financial analysts, the
most sophisticated users of published annual reports, state
that the Uniform System of Accounts, the requirement for
record keeping and reporting to the Interstate Commerce

Commission, best reflects the financial results for the

railroad industry.

 

36Letter dated February 20, 1968.

104

RailroadAQuestionnaire

A ten-question questionnaire was prepared and sent
to the chief financial officer Of each Of the audited rail-
roads in the sample (Appendix B). The goal Of the question-
naire was to elicit responses from the railroads concerning
the method Of financial reporting used, the advantages and
limitations of the Uniform System Of Accounts, and any fore-
seeable modifications in the prescribed accounting require-

37 questionnaires mailed

ments. Twenty-four of the thirty
were returned (80 per cent) and the greater proportion Of
the results are analyzed in this section. Part C Of the
questionnaire is analyzed in Chapter VI.

The first three questions are interrelated and must
be analyzed jointly. Table 14 presents the responses to
Questions A-1,2,3 and 4 and thus contains some conclusions
about railroad views toward generally accepted accounting
principles. Although 58 per cent Of the respondents feel
that the Uniform System restricts managerial freedom in
reporting to financial statement users and 84 per cent indi-
cate that generally accepted accounting principles are at

least as meaningful as the Uniform System for this reporting

purpose, only 8 per cent of the respondents purport to use

 

37There were 31 audited annual reports in the sample,
however, the Missouri Pacific owned 95.5 per cent of the
stock of The Texas and Pacific Railway Company as Of January
17, 1967, and the same Officers control both companies.

105

Table 14. Questionnaire results (Questions A-l,2,3,4)

1. System Of financial reporting used:

 

a) Uniform System of Accounts. 29%

b) "generally accepted accounting principles." 8%

c) combination of (a) and (b). 63%
2. Fair presentation achieved?

a) Yes. 96%

b) NO. 0%

c) Not certain. 0%

NO response. 4%

3. "Generally accepted accounting principles":

a) are superior for railroad reporting. 42%

b) are equally as meaningful as Uniform System. 42%

c) are less meaningful than Uniform System. 0%

d) are not relevant to railroad reporting. 16%
4. The Uniform System severely restricts managerial

freedom in reporting:

a) Yes. 21%

b) Yes, but not severely. 37%

c) Does not restrict. 42%

generally accepted accounting principles as the basis for
their financial statements and 96 per cent indicate that
they believe their annual reports fairly present the finan—
cial position and results of operations for their company.
One rationale for the nonuse of generally accepted account-
ing principles even though the results Of their application
is considered to be at least as meaningful as the results
Obtained from the use of the Uniform System could be the
reason advanced by the Illinois Central.38 The difference

between the net income derived from the two bases of

 

38See above, n. 22.

106

financial reporting is apparently not compensated for by the
users Of the financial statements. Therefore, the incentive
to change to reporting according to generally accepted
accounting principles is substantially reduced. Another
reason for the continued use of the Uniform System as the
basis for reporting to others than the Interstate Commerce
Commission is reflected in the answers to Question 2. 'Since
the books and records Of railroad companies are required to
be kept on the basis of the prescribed system and the finan-
cial statements, preponderantly prepared on this basis,
apparently fairly present the economic circumstances of the
firm, the incentive to prepare the financial statements on
an alternative basis is substantially reduced. In answer to
Question 1, 63 per cent of the respondents indicated that
their financial reporting was a combination of generally
accepted accounting principles and the Uniform System. But
these roads did not incorporate tax allocation and deprecia-
tion accounting for track components into their reporting
system. These being the significant differences between the
two systems, this 63 per cent was considered to be reporting
according to the Uniform System of Accounts.

In order to evaluate the benefit of improvement in
railroad financial reporting, conformity of the Uniform Sys-
tem.with generally accepted accounting principles, and the
value of the Commission's attempts to mitigate the differ—

ences, the responses to Questions A—5,6 and 7 are presented

107

in Table 15. At least 69 per cent of the respondents state
that railroads have problems Of more significance than the
improvement of financial reporting. Since 79 per cent feel
that the Commission's attempts to conform the Uniform System
with generally accepted accounting principles are leading to
improvement in railroad financial reporting, one can con-
clude that the railroad companies would, at least for the
present, prefer to maintain a passive role and allow the
Commission to be the active party. There were 46 per cent
of the respondents who indicated that the Commission might
prescribe either depreciation accounting for track compo-
nents or deferred income tax accounting with the preponder—

ance considering the former to be more likely. Even though

Table 15. Questionnaire results (Questions A-5,6,7)

5. WOuld conformity of Uniform System with generally
accepted principles be improvement?

a) Yes. 79%
b) NO. 17%
c) Not certain. 4%
6. Will Commission prescribe in the near future: (Yes)

a) depreciation accounting for track components? 38%
b) deferred income tax accounting? 8%
c) both of these? 21%
d) neither Of these? 25%

no response. 8%

7. How important, to railroads, is improvement in

reporting?
a) very important. 8%
b) equal in importance to solution of other

problems. 25%
c) less important than (b). 42%
d) insignificant relative to (b). 17%

no response. 8%

108

the effort that would be involved in implementing the former
could be fantastic, a possible tax advantage through double
deduction could result from its implementation. The imple-
mentation Of the latter, given current economic conditions,
would have an adverse effect on railroad reported income.
The respondents, therefore, appear to be expressing what
they would accept from the Commission rather than what might
be prescribed. However, since the Commission generally
responds to the justified wishes Of the regulated firms, the
railroads are more likely to get what they want than what
they do not want. It appears, from the analysis presented
in Chapter III,39 that neither depreciation accounting for
track components nor tax allocation are being currently con-
sidered by the Commission for foreseeable implementation.

On the question as to whether the Uniform System is
as applicable to internal accounting as it is to external
reporting, 75 per cent Of the respondents indicated that they
found it necessary to develop an internal accounting system
for managerial decision-making purposes. There were only 13
per cent that found the Uniform System adequate for both
purposes, while 4 per cent could find no acceptable alterna-

tive and 4 per cent did not respond to the question.

 

39See Chapter III, sections entitled "Accounting for
Federal Income Taxes" and "Betterment Accounting."

109

The principal weakness of the Uniform System of

Accounts, . . . , is that it is virtually impos-

sible to obtain reliable cost data from the

Uniform System. This is because the System is

keyed to the aggregate system costs, rather than

to the costs Of a specific service.
The response to the questionnaire bears out Ziebarth's com-
ment. In fact, the Interstate Commerce Commission recog—
nizes this limitation and encourages the companies to devel-
Op an effective internal accounting system and to seek
assistance from certified public accountants as well as the

Association of American Railroads.41

System of Financial Rgporting

The two concepts that together determine which
system of accounting better presents financial position and
the results of operations Of any company appear to be rele-
vance and comparability. If certain principles Of account—
ing are not relevant to the recording and reporting of the
significant economic events facing a particular firm, they
should not be used as the results of their application could
be misleading to users Of these results.

If it may be assumed that the purpose Of published
financial statements is to allow an interested outside party

to assess the financial position and results Of Operations

 

40Letter from Karl Ziebarth.

41From an interview, January 29, 1968, with Richard
J. Ferris, Assistant Director, Bureau Of Accounts, Inter-
state Commerce Commission.

110

of a firm, a recent article by John K. Simmons42 becomes
relevant to this discussion. Simmons makes a strong case
for comparability being the only relevant use Of published
financial data. According to Simmons, an abstraction of the
economic position of any company is highly subjective and
likely to be misleading. As a result, an assessment Of the
relative economic position Of two or more companies is
likely to be made by comparing directly the various economic
circumstances of one company with those of other companies.
This is why a concept Of comparability is important. In
order for these comparisons to be meaningful in the deter—
mination of relative economic position, the economic circum-
stances must be reflected on an equivalent basis among the
companies being compared. Simmons considers any item
reported separately on the financial statements as a
reported economic circumstance. Since accountants prepare
the financial statements, it is a function Of accounting to
determine whether any two items should be considered as
being similar or different economic circumstances. In order
for comparability to be maximized, the following conditions
must be satisfied by equivalent events being compared:

1. Equivalent statement presentation

a. Statement caption

b. Statement classification
c. Detailed information

 

42John K. Simmons, "A Concept Of Comparability in
Financial Reporting," The Accountinngeview, October 1967,
pp. 680-692.

111

2. Equivalent measurement

a. Valuation basis

b. Measuring unit . . 43

c. Economic flow approx1mat1on.
Uniformity is the key to the equivalent statement presenta-
tion of any given economic circumstance by two or more com-
panies. As it applies to accounting in connection with
financial statement presentation, uniformity is the absence
Of variation in the statement presentation variables in the
reflection of a given economic circumstance by two or more
companies. It does not imply that all companies must have
identical economic circumstances or that different circum-
stances should receive identical accounting treatment.
Under the equivalent measurement caption, uniformity is
again the key as far as the valuation basis and the measur-
ing unit to be employed are concerned. Economic flows appli-
cable to a given (the same) economic circumstance, however,
may differ markedly between two companies. Equivalent mea-
surement and reflection Of a given economic circumstance, in
such a situation, would require nonuniform approximation
procedures, procedures appropriate to the underlying flows
of the respective companies. If the economic flow pattern
is similar for two companies in respect to a given economic
circumstance, a uniform method would be necessary for equiv-

alent approximation. If the pattern differs between the two

companies, uniformity in the method of approximation could

 

431bid., p. 683.

112

not possibly produce comparability. Uniformity in the state-
ment presentation variables (caption, classifications, and
detailed information), as well as the valuation basis and
the measuring unit, is typically necessary to produce com-
parability in the reporting of a given economic circumstance.
Uniformity in accounting approximation methods, however, pro-
duces comparability only where the economic flow being
approximated is similar for both companies.

The practical difficulty of most significance re-
lates to the measurement Of these economic flow patterns.
If it were possible to accurately measure the flows, then
a uniform accounting method could be assigned to each flow.
If there were perfect markets in reality, then it could be
expected that economic flows for a given economic circum-
stance would be the same among firms in a given industry.
On this basis, uniform accounting methods could be pre—
scribed which would, when consistently applied, yield compa-
rable financial information for each firm within an industry.
Since, at least in general, imperfect labor, capital and
information markets exist, the applicable economic flows
arising from a given economic circumstance may affect the
firms within an industry in varying manners, justifying

alternative approximation methods.

113

,As indicated in Chapter II, the Uniform System has

44 The railroad company

the capacity to accept variations.
must submit evidence to the Interstate Commerce Commission
that the financial position and/or the results Of Operations
would be more properly presented before the Commission will
consider approval of the departure from uniformity. In
other words, factual evidence Of the relevant economic flows
pertinent to the subject under consideration determines the
accounting practice to be followed. Because Of the Commis-
sion's authoritative, but impartial, position, its pre-
scribed practices may be considered to be more appropriate

than those principles, considered to be generally accepted,

selected by the management of a nonregulated firm.

Summary

Even though the Interstate Commerce Commission has
allowed the railroads to apply generally accepted accounting
principles as the basis for their reporting to others than
the Commission since 1962, the majority continue to use, in
substance, the Uniform System of Accounts for all financial
statements. Of the 31 audited 1966 annual reports in the
sample, 27 received qualified Opinions and 23 of these were
for lack of a provision for deferred federal income taxes.

None of the financial statements were qualified for the use

 

44See Chapter II, n. 38 and following.

114

Of betterment accounting for track components. For 28 firms
it was possible to approximate a reconciliation between net
income stated on the two reporting bases. This reconcilia-
tion revealed that if net income were reported on the basis
Of generally accepted principles it would have been 18.7 per
cent lower than if reported on the basis Of the Uniform
System. The sheer magnitude Of this difference, as well as
its direction, has served as a strong deterrent to generally
accepted reporting. Hayden, Stone, Incorporated believes
that rail earnings are quite reliably reported on the basis
of the Uniform System and this conclusion is reinforced by
the responses to the railroad questionnaire. If flow-through
accounting for income taxes and betterment accounting for
track components are relevant for railroad reporting, as are
the corresponding generally accepted principles, perhaps it
should be the responsibility Of independent auditors to

accept this fact.

CHAPTER V

THE AUDITOR AND RAILROAD

FINANCIAL STATEMENTS

Introduction

The American Institute of Certified Public Accoun-
tants has established a definite View toward auditor respon—
sibility related to railroad financial statements. This
perspective has been developed over time and is reflected in
auditing standards, Accounting Principles Board Opinions and
the formation and activities of a Committee on Relations
with the Interstate Commerce Commission. At one time,
because their accounting was regulated, railroad financial
statements were not considered to be subject to a comparison
with generally accepted accounting principles in the audit
Opinion statement. This situation has been rectified but
railroads are still considered somewhat apart from other
types of business firms, as evidenced by the special
Institute Committee.

There have been comments made, both from within and
without the accounting profession, that the Institute's
position should be reevaluated. This chapter develops the

Institute view toward railroad financial statements, some

115

116

criticisms of this view, and proposes a more adequate
philosophy of responsibility for the auditor and the profes-

sion.

History
Prior to 1957, it had been noted in the literature

that railroad accounting differed from the accounting prac-
ticed by industrial companies. Two basic problems were
recognized: multiple purpose use of data prepared primarily
with one purpose in mind, and the role Of the accounting
profession relative to stating an Opinion on financial state-
ments based on a system other than generally accepted ac-
counting principles. George 0. May, one Of the most pro-
lific writers on railroad accounting, highlighted the regu-
latory purpose behind financial statements prepared from the
Uniform System of Accounts and questioned the use of these
statements for other purposes.1 He also criticized the
accounting profession for attempting to make these state-
ments serve multiple purposes through the use of footnotes
to the statements.

Criticisms have Often been based on the fact

that methods have differed, without regard to

the question whether in a particular case the

method followed was prejudiced to any legiti-
mate interest. These criticisms have resulted

 

1George 0. May, "Improvement in Financial Accounting,"
Dickinson Lectures in Accounting (Cambridge, Massachusetts:
Harvard University Press, 1943), p. 7.

117

in many footnotes to published statements—-

footnotes not always lucid, and the gradual

accumulation of which has undoubtedly tended

to the confusion of stockholders and investors.

Preoccupation with the importance of not mis-

leading investors has obscured the desirability

of enlightening them.2
May suggested that the role of the profession should be one
of cooperation with regulatory agencies and the acceptance
of a responsibility for the maintenance and wise development
of accounting principles, at all times retaining indepen-
dence not only from clients but also from the regulatory
agencies.3 The accountant's obligation for the development
of sound accOunting principles was to the public, which in-
cluded regulated firms.

It appears that this philosophy was paid only lip
service until 1957, when the Committee on Relations with the
Interstate Commerce Commission was formed. From 1957 to the
present, this Committee has served as a mediation panel
between the Institute and the Commission. Both parties can
present problems for consideration by the other and this
participative approach to problem solving has brought the
two organizations much closer together. The profession has

become more informed relative to railroad accounting and the

Commission more fully understands the position Of the

 

2Ibid., p. 36.

3George 0. May, "Accounting and Regulation,” The
Journal Of Accountancy, October 1943, p. 301.

118

certified public accountant. It is readily apparent that
the Commission reacted positively to the formation of the
Institute Committee by the number Of immediate changes made
to the Uniform System following the suggestions of the
Committee.4

One example of abrogation of the concept of respon—
sibility as presented by May was the practice of certified
public accountants. Prior to 1961, auditors' opinions on
railroad financial statements expressed conformity with the
prescribed accounting principles and practices rather than
conformity with generally accepted accounting principles.
One exception is found in the audit Opinions rendered on the
financial statements of the Chicago and North Western Rail-
way Company by Arthur Andersen & CO.5 Beginning with its
first audit Of the Company in 1956, Arthur Andersen & CO.
compared the financial statements with generally accepted
accounting principles and qualified its Opinion because the
Company followed betterment accounting for track components.
In 1958, at the request Of Leonard Spacek, then Managing
Partner of Arthur Andersen & Co., the American Institute's

Committee on Professional Ethics considered the question of

whether public accountants' opinions with respect to the

 

4See Chapter II, n. 31 and following.

5See for example: 1956 Annual Report, Chicago and
North Western Railway Company, p. 19.

119

financial statements of certain railroads were in violation
of Article 2.02(e) of the AICPA Code of Professional Ethics,
which states:

2.02 In expressing an opinion on representa-
tions in financial statements which he has
examined, a member or associate may be held
guilty of an act discreditable to the profes-
sion if . . .
(e) he fails to direct attention to any
material departure from generally accepted
accounting principles or to disclose any
material omission of generally accepted
auditing procedure applicable in the cir-
cumstances.

The Committee on Professional Ethics concluded, after con-
sidering the question for eight months, that an auditor's
Opinion which states that the financial statements of a
railroad are in conformity with accounting principles pre-
scribed by the Interstate Commerce Commission, without mak-
ing reference to generally accepted accounting principles,
is not in conflict with the rule referred to above. The two
principal reasons given by the Committee for this conclusion
were as follows:

(1) There is a "strong presumption that the

accounting prescribed by the ICC constitutes

generally accepted accounting principles in

that industry."

(2) "The Institute's Auditing Procedure Com-

mittee has not spoken specifically on the

reports of railroads or other regulated com-
panies. In the absence of some authoritative

 

6American Institute of Certified Public Accountants,
By:Laws, Code Of Professional Ethicsy_Numbered Opinions of
the Committee on Professional Ethics, Objectives of the
Ipstitute Adopted by the Council (New York: American Insti-
tute Of Certified Public Accountants, 1964), p. 30.

120

statement by the committee prescribing the re-

porting standards for what has been concluded

is a special reporting problem, the validity of

any reporting practice must rest on general use

and general acceptance. The practice Of report-

ing on railroad financial statements in terms of

accounting principles prescribed or authorized

by the Interstate Commerce Commission appears to

be widespread."
The Committee on Auditing Procedure disagreed and subse-
quently issued its opinion, stating in effect that generally
accepted accounting principles are sufficiently broad to
apply also to regulated companies and are therefore appro-
priate as a basis for the auditor's opinion. Material vari-
ances from generally accepted accounting principles, and
their effects, should be dealt with in the independent
auditor's report in the same manner followed for companies
which are not regulated. Ordinarily, this would require
either a qualified or adverse Opinion on such statements.

Tax allocation.-—Concurrently with the settlement Of

the auditor's position relative to published financial state-
ments prepared according to the Uniform System Of Accounts,

the tax allocation issue was in the throes of change. When

the Interstate Commerce Commission made its decision that

 

7Reprinted in: Arthur Andersen & Co., Accounting
and ReportingyProblemp of the Accounting Profession (2nd ed.;
Chicago: Arthur Andersen & Co., October 1962), pp. 119-120.

8Committee on Auditing Procedure, Qualifications and
.Disclaimers, Statements on Auditing Procedure, NO. 32 (New
York: American Institute of Certified Public Accountants,
1962). p. 72.

 

121

flow-through accounting would be followed by railroads,9 the
Committee on Accounting Procedure of the American Institute
Of Certified Public Accountants was already on record as
approving this action.

. . . where charges for deferred income taxes
are not allowed for rate-making purposes,
accounting recognition need not be given to

the deferment of taxes if it may reasonably be
expected that increased future income taxes,
resulting from the earlier deduction Of declin-
ing-balance depreciation for income-tax purposes
only, will be allowed in future rate determina—
tions.

The first Opinion issued by the new Accounting Principles

Board in 1962 essentially affirmed the position taken by the
Committee on Accounting Procedure, and extended the reason-
ing to cover the treatment Of guideline depreciation also.ll
There were several dissents to this Opinion, two of which
referred to the special treatment accorded regulated indus-

12 The essential issue raised was whether reporting

tries.
of annual income should be controlled by present or pre-

dicted practices dictated by Commissions, the Congress,

 

9See Chapter III, n. 16 and following.
1'OCOmmittee on Accounting Procedure, Accountipg_
Research Bulletin NO. 44 (Revised) (New York: American
Institute of Certified Public Accountants, July 1958),

p. 3-A.

11Accounting Principles Board, New Depreciation Guide-
lines and Rules, Opinion NO. 1 (New York: American Institute
of Certified Public Accountants, November 1962), p. 2.

12Arthur M. Cannon and Leonard Spacek dissented on
this basis.

122

state legislatures, and the courts. The second Opinion
rendered by the Board reaffirmed the position taken on allo—
cation in its prior opinion and extended it to cover the
treatment Of the investment credit. The Board placed one
qualification upon its disallowance of flow-through account-
ing, that exception being that if the application of flow-
through accounting affects the rate-making process, it is
an acceptable accounting practice for financial reporting.
In other words, any prescribed accounting requirement which
differs from generally accepted accounting principles, that
affects the rate-making process, is acceptable for financial
reporting.13 In Opinion No. 6, the Board removed the neces-
sity for disclosure of the difference in net income gener-
ated but stated, in revision of Accounting Research Bulletin
NO. 44 (Revised):

9. When a company subject to rate-making

processes adOpts the declining-balance method

Of depreciation for income tax purposes but

adopts other appropriate methods for financial

accounting purposes, . . . , and does not give

accounting recognition to deferred income taxes,
disclosure should be made of this fact.

 

13Accounting Principles Board, Accountipg for the
Investment Credit, Opinion NO. 2 (New YOrk: American
Institute of Certified Public Accountants, December 1962),
p. 8, and in Addendum, p. 10.

14Accounting Principles Board, Status of Accounting
Research Bulletins, Opinion No. 6 (New YOrk: American
Institute of Certified Public Accountants, October 1965),
p. 43.

123

Opinion NO. 11, the application of which requires tax allo-
cation rather than flow-through, does not apply to those
"regulated industries in those circumstances where the stan—
dards described in . . . APB Opinion No. 2 are met. . . ."15

The net result of this historical development indi-
cates that the authoritative voices of the accounting pro-
fession have successively reaffirmed that firms, whose net
income is used for rate-making purposes by regulatory
agencies, may use flow-through accounting for financial
statement presentation if it is presumed that the regulatory
agency will apply its rate-making criteria consistently over
time. The tenor Of the arguments presented by the Committee
on Professional Ethics, the Committee on Auditing Procedure,
the Committee on Accounting Procedure, and currently, the
Accounting Principles Board is that regulatory accounting
designed for rate-making purposes is "generally accepted"
accounting for the industry in which it is required.

The development, in Chapter II, of the rate-making
process employed by the Interstate Commerce Commission indi-
cates that the net income figure is relevant in the process
but that rates are not necessarily reduced as net income
rises. Rate setting and adjustment are based primarily on

an equitable balance in the transportation industry. In

 

15Accounting Principles Board, Accounting for Income
Taxes, Opinion No. 11 (New York: American Institute of
Certified Public Accountants, December 1967). P. 156.

124

other words, since billing rates are not adjusted by the
regulatory authority in response to the level of income,
the railroads are not excluded by the Accounting Principles
Board from following tax allocation. Therefore, because tax
allocation is a generally accepted accounting principle and
independent auditors base their opinions on the application
of these principles, railroads receive qualified Opinions.

Betterment accountipg.--The Committee on Relations
with the Interstate Commerce Commission approved betterment
accounting for track components as an acceptable practice in
the railroad industry. One of the primary reasons for this
acceptance was a lack of evidence indicating that deprecia-
tion-maintenance procedures provided more appropriate charges
to income. By not qualifying their audit Opinions for the
use of betterment accounting, certified public accountants
have accepted the Committee's opinion that this accounting
practice is a generally accepted principle for the railroad
industry.

This acceptance has been questioned by Arthur
Andersen & CO. in a letter to the American Institute written
September 17, 1963.16 The arguments against betterment

accounting, however, are based upon previous Institute

 

16Arthur Andersen & Co., Letter to American Institute
of Certified Public Accountants Reggesting Reconsideration of
Its Position Regarding Replacement Accounting in the Railroad
Industry (Chicago: Arthur Andersen & Co., September 17,
1963).

125

statements on depreciation accounting. The Arthur Andersen
& CO. letter essentially argues that betterment accounting
is not in conformity with these previous statements of the
Institute and, therefore, should not be considered a gener-
ally accepted principle of accounting.

The Institute has not commented on the Arthur
Andersen & Co. letter so its current position on betterment
accounting must be considered to be the position expressed
by the Committee. In other words, betterment accounting is
generally accepted for the railroad industry.

Criticisms from'Within the
Accounting Profession

One of the most vocal critics Of the accounting pro-
fession has been Leonard Spacek, Chairman Of Arthur Andersen
& Co., who argues that general acceptance Of accounting
principles is not a justification for their application.
Rather, it is the reasoning as to fairness and soundness
that justifies the use of an accounting principle.17 He
blames government involvement in accounting develOpment on
the failure of accountants to develop sound accounting prin-

18

ciples. His dissent to Opinion No. 2 of the Accounting

 

l7Leonard Spacek, "A Report by a Critic Of His
Profession," a speech presented at the Sixth Annual Account—
ing Forum of Hayden, Stone, Incorporated, November 10, 1967.

18Ibid.

126

Principles Board has already been reported in this chapter.19
His dissent to Opinion NO. 4 follows similar lines in that
he is Opposed to an increase in the number of alternative
practices accepted by the profession. This emphasis on
minimizing alternative accounting practices is not apparently
a pressure for uniformity, but rather an urging for compara-
bility. Although he tends to use uniformity and comparabil—
ity interchangeably, his plea is as follows:

As nearly as possible, only one accounting method

should be used for fully comparable transactions.

Since there are shades of difference in the cir—

cumstances Of the many transactions, net income

reported can have some range of variation—-some

difference in hue--even in similar situations.

But the result must remain within the spectrum

Of the basic color.
Spacek criticizes the accounting profession for allowing
general acceptance to inhibit the development of sound
accounting principles which could be applicable to all
industries whether regulated or not. He concludes that fair
presentation of financial results is questionable when the
basis upon which the principles are founded is as weak as
general acceptance.

John L. Carey, Executive Director Of the American

Institute of Certified Public Accountants, suggests that the

 

19See n. 12 and following.

20Leonard Spacek, "Comparability in Financial
Reporting," The IAS Balance Sheet, 1, NO. 3, International
Accountants Society, Inc., Chicago, 1967, 2A.

127

wide-spread acceptance of the standard short form Opinion,
and the auditing standards and procedures on which it is
based, may have a stultifying effect on the attitudes Of
public accountants. "May CPAs . . . be discouraged from
venturing outside the conventional scope of the standard
Opinion by providing explanations and interpretations which
would be helpful to readers of the statement?"21 Certified
public accountants were asked in interviews whether the
auditor should disclose the following items in his opinion,
if not disclosed by the railroads in notes to the financial
statements:
1) differences in philosophy between the Uni-
form System and generally accepted account-
ing principles,
2) dollar amounts not material in the current
year but related to differences between the
systems, and
3) a precise statement of the system of account—
ing used by the railroads.
The preponderance of Opinion was that the auditor's respon-
sibility toward disclosure relates only to material depar-
tures from generally accepted accounting principles (such as
the absence of a provision for deferred taxes). Taking an
exception in an audit opinion is a harsh act on the part of

the auditor and is the best recourse open because an adverse

Opinion would be less valuable and more confusing to the

 

21John L. Carey, The CPA Plans for the Future

(New York: American Institute of Certified Public Accoun-
tants, 1965), p. 191.

128

reader. Only under unusual circumstances does an auditor
need to depart from the standard Opinion.22 These excep-
tional circumstances do not include the eXpressed intent of
a railroad company to report according to a system Of
accounting that is not generally accepted, since there is
usually but one material variance and that can be handled
by qualifying the standard Opinion. The magnitude of the
dollar value of the variance is of no consequence other than
in determining materiality.

Eldon Hendriksen raises an issue which, in many ways,
parallels the two previously raised when he states, in rela-
tion to the auditor's statement of Opinion:

When accounting theory is further developed

as an evaluation tool, the terms "logical" and

"appropriate" should be substituted for "gener-

ally accepted." General acceptance does not

make the methods logical or logically derived

from accounting postulates and principles.
Hendriksen echoes the argument advanced by Spacek that
general acceptance does not necessarily yield acceptable
accounting principles. This quotation indicates that vari-

ations in methods of applying these accounting principles

would be allowed where appropriate. "Generally accepted"

 

22From interviews,January 24, 1968, October 24, 1967,
and January 24, 1968, respectively, with James R. DePauw of
Arthur Andersen & Co., Ernest J. Rua, Jr., of Peat, Marwick,
Mitchell & Co., and Howard Dudley Murphy of Price Waterhouse
& CO.

23Eldon S. Hendriksen, Accountinngheory (Homewood
Illinois: Richard D. Irwin, Inc., 1965), p. 464.

129

could imply mediocrity in the principles developed as differ-
ing views need to be somehow compromised. "Logical" and
"appropriate," however, would conceivably free the auditor
from the pressure of accepting only what is "generally
accepted" and thereby improve financial reporting. At the
same time, it would force the auditor to evaluate the appro-
priateness of the method being applied, which is not cur—
rently required.
Criticisms from Outside the
Accounting Profession
Karl Ziebarth, a financial analyst with Hayden,

Stone, Incorporated, states that:

The auditor must, . . . , be sure to say or to

specify in his letter [Opinion] that the account-

ing system is kept under the rules Of the ICC,

and it varies widely in both concept and practice

from the accounting principles used in industry

generally.24
In other words, since the accounting system used by railroad
companies is prescribed by a regulatory agency, the accoun-
tant should be obligated to inform stockholders of the same.
If a financial analyst would require such a disclosure, this
information should be even more important to less sophisti-
cated users of financial statements. John G. Kaptain, an

analyst with Merrill Lynch, Pierce, Fenner & Smith, Inc.,

reinforces this requirement by stating that "the investing

 

24Letter dated January 11, 1968.

130

public does not appear to recognize the distinction" between
the two methods of accounting.25 If investors do not under-
stand that there is a difference, the reasons for the differ—
ence, and the extent of the difference--and the railroad
companies do not disclose this information in footnotes to
the financial statements--then these analysts feel that the
auditor should. This is essentially the same argument

raised previously by John L. Carey.

John Thackray presents an observation that strikes
at the heart of the difference between the sophisticated and
unsophisticated users of financial information. He notes
that, to the outsider, the term "generally accepted account-
ing principles" seems clear enough, but the auditing profes-
sion well knows that these four innocuous-sounding words are,
in fact, deceptive rather than illuminating.26 He goes on
to say:

[Accounting firms] are extremely sensitive on
the question of accounting principles--for it
strikes at the very heart of the only commodity
that independent auditors have for sale: skill,
judgment and integrity.27
Thackray suggests that generally accepted accounting princi-

ples are neither as substantive nor as protective as the

 

25Letter dated November 29, 1967.

26John Thackray, "Civil War Among the Auditors,"
Duds Review, April 1964, p. 43.

271bid.

131

unsophisticated reader might initially believe. They are
man-made rules and only have assurative qualities because Of
the skill, judgment and integrity of the accounting profes-
sion. Should any of these three attributes become questioned
by statement users, generally accepted accounting principles
could lose any value they might have had. The substantive
value of general acceptance was previously questioned by
Leonard Spacek.

The chief financial Officer of a Class I railroad,
when interviewed, stated that the skill, judgment and
integrity of the accounting profession is threatened by the
nature of the principles being generated.28 This doubt of
the profession's quality is reflected in the confusion,
rather than protection, of the investing public created by
highly technical and incomplete bulletins. He cites, as an
example, the provision in Accounting Principles Board Opinion
NO. 9 which states, in essence, that earnings per share,
where convertible preferred stock is outstanding, must be
reported on a fully-diluted basis.29 The Opinion is inade-
quate as it does not require disclosure Of the pertinent
events that must take place before this dilution can occur.

The earnings per share reported may therefore be misleading,

 

28Interview January 23, 1968.

29Accounting Principles Board, Reporting the Results
of Opgrations, Opinion NO. 9 (New York: American Institute
of Certified Public Accountants, December, 1966), pp. 123-
124, 137-138.

132

even to the sophisticated user of the financial statements

if the probability of full dilution is very small. The
information could also be misleading if the dilution were
expected to occur but only in the distant future. The call
features, if any, should also be disclosed. Reporting fully-
diluted earnings per share may provide for better financial
reporting, but users of the reported information must also
understand the background and relevance of the modification

or the figures are susceptible to misinterpretation.

Relevant Auditor Repponsibility
A highly developed economy and free and active
capital markets gO hand in hand with a highly-respected and

30 Continued

competent independent accounting profession.
confidence in financial reporting and the profession is
essential to our economy and neither unnecessary criticism
Of nor passive indifference by the profession should be
allowed to erode this confidence.31 The Securities and
Exchange Commission has stated flatly of the public accoun-
tant that "his duty is to safeguard the public interest, not

that of his client. ."32

 

30James J. Mahon, "Accounting Principles Debate and
Investor Confidence," Financial Executive, December 1966,
p. 32.

31Ibid.

32Touche, Niven, Bailey & Smart, 37 S.E.C. 629,
670-71 (1957).

133

The certified public accountant is required to
attest to the fairness of presentation Of information pre-
sented in the financial statements to which his opinion is
directed. The guide to fair presentation which is required
is conformity with "generally accepted accounting princi-
ples."33 Some principles, of course, are required upon
which to judge fair, as Opposed to biased, presentation.
But, there are serious doubts as to whether general accep-
tance yields acceptability with regard to accounting prin-
ciples. Hendriksen indicates that perhaps general accep-
tance is a stOp-gap measure to be used only until accounting
theory is further developed as an evaluation tool, whereupon
the words "logical" and "appropriate" will be adOpted to
better reflect the accountant's approval of the principles
employed by his client.34 On the surface, this sounds rea—
sonable but the responsibility Of the auditor is not ade-
quately defined by this statement. If accounting principles
are generally accepted and fair presentation implies only
conformity with these principles, then the auditor need not

exercise professional judgment--indeed he need not even be

a professional.

 

33Committee on Auditing Procedure, Auditing Stag:
dards and Procedures, Statements on Auditing Procedure,
No. 33 (New York: American Institute of Certified Public
Accountants, 1963). P. 16.

34See n. 22 and following.

134

If, however, the accountant is not ham-strung with
"general acceptance" and must evaluate the practices em-
ployed by management in terms Of the fairness of presenta-
tion derived from their use, professional judgment is indeed
required. If the "relevance" standard, advanced by the
American Accounting Association Committee, for reported data
may be extended to the principles by means of which the data
are accumulated, this point may be clarified.

Relevance is the primary standard and requires

that the information must bear upon or be use-

fully associated with actions it is designed to

facilitate or results desired to be produced.

Known or assumed informational needs Of poten-

tial users are of paramount importance in

applying this standard.35
If relevance may be considered as the primary standard for
information, may it not also be considered the primary stan-
dard for judging the principles under which the information
is developed for financial reporting.

The challenge to produce sound, unbiased

accounting today is directed to the public

accountant. The challenge is whether the pub-

lic accountant has the will and the integrity

to report the facts--economic realities--to all

segments of the public in a truthful and mean-
ingful manner.3

 

35Committee to Prepare a Statement of Basic Account-

ing Theory, A Statement of Basic Accountinngheory (Evanston,
Illinois: American Accounting Association, 1966), p. 7.

36Leonard Spacek, "A Report by a Critic of His
Profession."

135

The import of all this is that one portion of auditor respon-
sibility is the exercise of professional judgment in the
determination as to whether the principles applied by a
client firm are logical or appropriate, i.e., relevant, to
the data being presented. It is not acceptable for the
certified public accountant to look only to what other public
accountants are accepting; he should make his own independent
appraisal and his audit opinion should reflect the exercise
Of professional judgment.

If the public accountant possesses the analyt-

ical ability to determine the economic facts

and at the same time has the fortitude and in-

tegrity to report impartially what he finds, he

will perform that service which has been assigned

to him by all segments Of the public.37

The other aspect of auditor responsibility has to do

with the development of guidelines to fairness of presenta-
tion. It is no longer possible to say that fairness is pro-
duced by the application of generally accepted accounting
principles for two reasons. First, the principle that gen-
eral acceptance produces acceptable accounting principles
has been questioned. Second, careful analysis will show
that this reasoning is circular: fair presentation is the
application of generally accepted accounting principles.
Generally accepted accounting principles are those developed

to yield fair presentation. Fair presentation is not sepa-

rately defined.

 

37Ibid.

136

It is necessary to borrow another informational
standard from the American Accounting Association Committee,
that of "freedom from bias," in order to establish adequate
guidelines to fairness.

Freedom from bias means that facts have been

impartially determined and reported. It also

means that techniques used in developing data

should be free of built-in bias.
Fairness of presentation requires freedom from bias because
of the many users accounting serves and the many uses to
which accounting information may be put. This is especially
true in published financial statements where current and
potential investors, employees, creditors and labor inter-
ests, to name a few, have an interest in the data presented.
The presence of bias which may serve the needs Of one set of
users cannot be assumed to aid or even leave unharmed the
interests of others. In order for financial statements to
be fairly presented, there must be freedom from intentional
or statistical partiality if at all possible.

The two elements of auditor responsibility described
above make it essential that the auditor step beyond the
confines of the standard audit opinion and the related stan-
dards on each audit examination. lkfizonly must the auditor

evaluate the accounting principles applied by the client

firm, but his responsibility should extend to ability to

 

38Committee to Prepare a Statement of Basic Account-
ing Theory.

137

justify the reasoning upon which his opinion rests. He no
longer should be allowed to hide behind the shield Of gen-
erally accepted accounting principles but should be required
to be able to justify his Opinion. This would result in a
more professional standing for the profession because logical
reasoning substantiated by factual evidence would be the
basis upon which the accountant's opinion would rest.

This concept of auditor responsibility, if accepted
by the profession would also improve comparability between
the financial statements of different companies. The con-
cept of fairness would remove intentional bias and the con-
cept of relevance would represent a concerted attempt to
properly recognize the pertinent economic flows in each
enterprise. The concept of comparability advanced by John K.
Simmons would become more of a reality than exists at the
present time.39

The discussions in Chapter III relative to flow-
through accounting for federal income taxes and betterment
accounting, as practiced by the railroads, has shown them
to be reasonable alternatives to the generally accepted
treatments followed by the accounting profession. Flow-
through accounting for federal income taxes has resulted

in a presentation of net income similar to that which would

 

39See Chapter IV, n. 42 and following.

138

have been Obtained had partial allocation been prescribed by
the Commission. Partial allocation was considered in this
thesis to be consistent with current accrual accounting and
representative of the economic realities facing the rail-
roads. Betterment accounting was considered as relevant as
depreciation accounting for track components because Of the
stable physical quantity of the asset and the nonmaterial
effects of the change—over experienced by the Canadian rail-
roads.

The American Institute nearly applied the concept Of
responsibility recommended herein in its acceptance of bet—
terment accounting for railroad track components. Based
upon the Canadian conversion experience, the Institute
appears to have made the correct decision--to allow better-
ment accounting--but not based upon factual evidence that
betterment accounting was at least equally as applicable as
depreciation accounting. The closest the Institute came to
exercising this type of reasoning was the acceptance of this
accounting practice on the basis that depreciation account-

ing was not known to be more proper under the circumstances.

Summary

The American Institute of Certified Public Accoun-
tants has established the guidlines for the profession but
these have been based upon general acceptance, which is at

least questionable. If railroad accounting practices

139

prescribed by the Interstate Commerce Commission served only
the purpose Of rate regulation, this accounting would be
considered by the Accounting Principles Board to be gener-
ally accepted. Since other purposes for the prescribed
accounting also exist, railroad financial statements pre-
pared on this basis are not considered by the Board to
fairly present the financial position and results of Opera—
tions of these companies. Considering fairness of presenta-
tion to be exemplified by freedom from bias and using the
concept of relevance as the basis upon which accounting
principles are to be judged, railroad financial statements
represent a fair presentation even though generally accepted

accounting principles are not applied.

CHAPTER VI
CONCLUSIONS AND RECOMMENDATIONS

Introduction

The Hepburn Act of 1906 gave a fledgling governmen-
tal Commission the authority to prescribe uniform accounting
principles for the then dominant mode Of surface transporta-
tion in the United States. :The primary purpose to be served
by the "Accounting Classifications for Steam Railroads" was
rate regulation. It was felt that rate regulation was neces-
sary to eliminate the abuses of speculative railroad build—
ing, irresponsible financial manipulation, fluctuating and
discriminating rate adjustments, and the overreaching exer-
cise of monopoly power which existed in the railroad indus-
try. An accounting system, now known as the "Uniform System
of Accounts for Railroad Companies," was developed by the
Commission, in conjunction with industry accounting person-
nel, from the most acceptable of the accepted accounting
principles in use in the industry.

The growth in the public accounting profession, and
its mid-twentieth century emergent interest in the railroads,
brought about immediate and substantial changes in railroad
accounting principles. The American Institute of Accoun-

tants, in 1956, established a Committee on Relations with

140

141

the Interstate Commerce Commission which may be given much
Of the credit for these modifications. It was a petition
brought by one of the firms in this developing accounting
profession that resulted in the ruling by the Commission
allowing railroad companies the Option to report to stock-
holders according to "generally accepted accounting princi-
ples." The railroads had remained publicly quiet during
these petition proceedings and, in general, rejected the
Option. Even in their 1966 annual reports, they predom-
inantly reported their financial position and results of
Operations in accordance with the prescribed accounting of
the Commission.

The accounting profession began to base its state-
ment of Opinion for railroad annual reports on the applica-
tion of generally accepted accounting principles in 1962,
since the Commission had ruled that these principles were
acceptable for financial reporting to stockholders. One
accounting firm qualified its Opinions on railroad state-
ments for the practice of betterment accounting in lieu Of
depreciation accounting for track components. This reason
for qualification created an inconsistency within the public
accounting profession because the other firms had accepted
the Opinion Of the Institute Committee in 1957 that better-
ment accounting was a generally accepted principle of
accounting in the railroad industry. Since tax allocation

was generally accepted by the accounting profession,

142

substantially all railroad annual reports began to be qual-
ified for not applying this principle. In 1958, the Commis-
sion had ruled against tax allocation for reporting to the
Commission, on the basis of arguments presented by the
regulated companies and its own judgment, and the railroads
generally reported according to the prescribed accounting in

their annual reports to stockholders.

The Study and the Conclusions

This divergence in practice raises questions signif—
icant to contemporary accountants. The answers to some Of
these questions were seen to be the goals of this thesis.

Why, since the Commission allows it, do the rail-
roads refuse to base their annual reporting to stockholders
on generally accepted accounting principles and instead
consistently follow the Uniform System of Accounts through
which action they acquire qualified audit Opinions on their
financial statements? There are at least three reasons why
the railroads have not conformed their annual reporting to
generally accepted accounting principles. The first relates
to the concept Of fair presentation. Of the railroad compa-
nies surveyed, only 8 per cent based their financial report-
ing on generally accepted accounting principles while 96 per
cent felt that their annual reports achieved the goal of
fair presentation. If the railroads believe that fair pre-
sentation is achieved through application Of the Uniform

System, there is little incentive to make the conversion.

143

The second reason relates to the extent and effect Of the
difference between the financial results presented under the
two bases of reporting. For twenty-eight railroads it was
found that 1966 net income would be reduced 18.7 per cent if
restated to conform with generally accepted accounting prin-
ciples. Since it appears that investors do not fully com-
prehend the difference between the two systems of accounting
and reporting on the basis of generally accepted principles
would require the disclosure of two net income figures,
there is even less incentive to change the basis upon which
financial reporting rests. The third consideration is the
acceptance, by financial analysts, of reporting according to
the Uniform System. Financial analysts prefer the Uniform
System because it is geared to railroads, it produces more
comparability, and it has led to the presentation Of more
detailed data than would generally accepted accounting prin—
ciples. Thus, the railroads have little incentive to pre—
pare their annual reports to stockholders in accordance with
generally accepted accounting principles.

DO the railroads have any theoretical or practical
justification for applying betterment accounting in lieu Of
depreciation accounting for track components and flow-
through accounting for federal income taxes in lieu Of tax
allocation if such principles are not generally accepted for

other types of businesses?

144

The Committee on Relations with the Interstate
Commerce Commission approved betterment accounting for the
railroads on the basis that no evidence existed establishing
depreciation accounting as more acceptable. Factual evi-
dence was presented by two Canadian railroads that experi-
enced conversion from.betterment to depreciation accounting
which indicated that neither the asset account balances nor
the annual charges to income are materially different
between the two asset accounting principles when applied to
mature firms. This is practical justification for continu-
ing to use a principle which has been consistently applied
for nearly a century.

The Accounting Principles Board requires comprehen-
sive deferral for federal income taxes, an ultraconservative
principle based upon a going concern concept under which the
total tax on pretax accounting income will equal the total
tax on taxable income over the life Of the firm. Although
comprehensive deferral is based upon a liability concept,
little consideration is given to the possible payment of
this liability created. In this writer's Opinion a more
valid conception of tax deferral would be to base the liabil-
ity on the significant probability of aggregate reversal of
tax deductibility, i.e., the liability would reflect the
amount of these deferred taxes that would become payable in
the predictable future. This approach, "partial allocation,"

yields no allocation (flow-through) when aggregate reversal

145

(actual payment) is highly improbable. The Interstate
Commerce Commission ruled in favor of flow-through account-
ing in 1958 on the basis of the speculative nature of any
future liability. The Commission is prepared to re-evaluate
its position on accounting for federal income taxes should
an aggregate reversal become more probable, i.e., a liabil-
ity is necessary for future income taxes when there is an
expectation that payment will be required. Since no aggre-
gate reversal has taken place and there is no significant
probability of reversal in the immediate future, there is
both theoretical and practical support for the position
taken by the Commission and the railroads.

If there is theoretical and/or practical support for
betterment accounting and flow-through accounting as prac-
ticed by the railroad companies, why do certified public
accountants qualify their audit Opinions on the financial
statements of these firms? As was indicated previously,
betterment accounting is considered by certified public
accountants to be generally accepted in the railroad indus-
try and a qualification is not given for the application of
this principle. The use Of flow-through accounting for
federal income taxes, however, does garner a qualified
Opinion for the financial statements because certified
public accountants do not consider this principle to be gen-
erally accepted. The independent auditor attests to fair—

ness of presentation and uses, as his guide, generally

146

accepted accounting principles. The belief that the uniform
application of generally accepted accounting principles to
all firms in all industries inevitably results in fair pre-
sentation has previously been questioned. Railroads should
not receive qualified Opinions on their financial statements
for the application of flow-through accounting if this prin-
ciple best approximates the appropriate economic flows.
Rather than rely on Opinions of the Accounting Principles
Board, and other elements Of general acceptance, as the
acceptability test for accounting principles, the indepen—
dent auditor should evaluate the underlying economic flows
in the industry or firm in order to decide whether the prin-
ciples applied by the client firm are appropriate. The
basis Of the auditor's Opinion on financial statements
should be the application Of relevant accounting principles
which can be expected to produce a fair presentation.

Two side issues, relevant to the quality of railroad
accounting and annual reporting, were also examined. Would
the application of generally accepted accounting principles
yield more comparability among the companies in the railroad
industry than does the application of the Uniform System?
Does the Uniform System guarantee more uniformity in record-
ing and reporting than would generally accepted accounting
principles?

Comparability, uniform reporting Of like economic

events, is perhaps better achieved under a system of

147

prescribed accounting which emphasizes this concept. The
application of generally accepted accounting principles
allows relatively more alternative treatments than does the
application of a uniform system, these alternatives being at
the Option of management. The Uniform System provides for
relatively more uniform treatment because alternatives are
granted by the Commission only upon submission Of evidence
indicating that an alternative practice would more adequately
present the economic realities behind the financial position
and results of Operations of the requesting firm. Financial
reporting on the basis of economic flows may yield more
comparability than financial reporting based upon principles
of accounting selected by management from among those gener-
ally accepted. From the above, it would appear that the
Uniform System would guarantee more uniformity in recording
and reporting than would generally accepted accounting prin—
ciples. But the current trend in the accounting profession
is toward greater uniformity. Accounting Principles Board
Opinions have tended to prescribe uniform accounting princi-
ples without allowing for alternatives even if the pre-
scribed principles are not applicable to individual firms.
While the Interstate Commerce Commission tends to stress
comparability, the Accounting Principles Board appears to be
emphasizing uniformity.

.Another portion of the thesis studied the position

of the Commission in relation to the railroads, which is

148

almost that of an industry board of directors. Rather than
being primarily restrictive, the Commission's emphasis has
evolved into one Of fostering the transportation industry.
This philosophy was supported in Part C Of the railroad
questionnaire where 50 per cent of the respondents predicted
a growing industry under continued regulation while only 13
per cent stated that the industry would decline. When asked
whether or not uniform accounting appeared to them necessary
for effective regulation, 71 per cent indicated that it was
necessary. These responses, in conjunction with responses
to other questions, indicate a general feeling of acceptance
on the part of railroad financial executives as to the
extent and focus Of Commission regulation Of the railroad

industry.

The Impasse

This thesis has delved into what were considered the
most important immediate issues regarding railroad financial
reporting and auditor responsibility and a solution was
proposed. Certain underlying and long-term issues were
briefly disclosed that will need continuing future evaluation.

The accounting profession, very young relative to
other professions, is in conflict with an Old and well estab-
lished agency Of the government. Since 1957, the profession
has certainly been successful in its endeavors to reform the

accounting practices prescribed by the Commission as there

149

are but two significant variations remaining between the
Uniform System of Accounts and generally accepted accounting
principles. One of these differences is considered material
enough to warrant a qualified audit Opinion on railroad
financial statements.

Qualification of the auditor's opinion appears to
have had a minimal effect, if any, on the railroads involved,
even though the accounting profession feels that this is a
harsh act on its part. The railroad industry would probably
appreciate a clean Opinion but is unwilling to modify its
financial presentation to remove the variances with gener-
ally accepted accounting principles. Railroad industry
Officials are not convinced that such qualified audit Opin-
ions have injured their position in the capital markets. As
one industry official confided in an interview on January 23,
1968:

Sophisticated financial analysts recognize the

auditing firm's qualification for deferred taxes

in the proper light: the statements fail to con-

form to generally accepted accounting principles

in this respect. The sophisticated analyst dis-

counts this type Of qualification as he has the

figures available to make the adjustment should

he choose to do so.
It is practically certain that the uninformed investor does
not understand the tax allocation issue. To this person,
the assurance provided by an auditor's signature may out—
weigh any words used by the auditor. The informed investor,

who would be disturbed by what the auditor says, realizes

that the information necessary to recast the financial

150

statements to the basis of generally accepted accounting
principles is generally available in the footnotes and
therefore disregards the qualification. The railroad indus-
try appears to attempt to conform its financial reporting
closely to generally accepted accounting principles in order
to avoid qualifications on issues other than tax allocation
as the majority of qualifications are for that purpose only.
The Securities and Exchange Commission.--The Securi-
ties Act of 1933 specifically exempts railroad securities
from the jurisdiction of the Securities and Exchange Commis—
sion, which was established for stockholder protection. In
a letter dated December 12, 1967, Lindsey J. Millard, Asso-
ciate Chief Accountant Of the Securities and Exchange Commis-
sion, stated that growth in the number of audited railroads,
the use of generally accepted accounting principles in the
financial reporting of some railroads, and railroad holding
company activity which requires audited financial statements
has resulted in "a trend toward better financial reporting
by railroads." Millard speaks for a commission which has
preferred to indirectly exercise its influence over finan—
cial reporting by supporting the accounting profession. In
this letter, Millard pointed to the Securities Act Of 1933
and the Securities Exchange Act of 1934 as the reasons why
the Commission has not and will not become involved in the
railroad annual reporting issue. It is not that the Commis-

sion would not like to have jurisdiction over railroad

151

securities. In the case of Allegheny Corp. v. Breswick & Co.
[353 U.S. 151 (1957) and 355 U.S. 415 (1958)], the Inter-
state Commerce Commission and the Securities and Exchange
Commission had agreed that the latter had jurisdiction over
the subject securities. But the courts disagreed and
awarded jurisdiction to the Interstate Commerce Commission.
If any responsibility for the protection of railroad secu-
rity holders exists, it must rest with the Interstate Com-
merce Commission. This Commission's responsibility may be
found in Section 20(a) of the Interstate Commerce Act where
the phrase "compatible with the public interest" is repeat-
edly used in describing the accounting responsibilities of
the Commission. But a study of the Act and the regulations
enforcing the act does not disclose any detailed regulations
designed to protect shareholders.

The Securities and Exchange Commission requires
independently audited financial statements from subject
corporations and unqualified audit opinions. Independent
auditors base their Opinions upon fairness of presentation
generated from the application Of generally accepted account-
ing principles, which have been developed over time in a
competitive atmosphere. Conversely, the Interstate Commerce
Commission has a small, highly specialized audit staff which
performs the specialized, transactional audit required by
the Commission. One of the unaudited railroads in the 1966

sample, in a letter dated January 31, 1968, confided:

152

. . ..Company does not have audits by certified

public accountants because it feels that the

periodic audits performed by the Interstate Com-

merce Commission, which are quite detailed, are

sufficient for its and the public's protection.
Independent audits are not a substitute but may serve as
added insurance to the Commission against major misstate-
ments. The Commission, in conjunction with the railroads,
has develOped the accounting system required for reporting
to it. This uniform system was originally developed in an
essentially monopolistic setting for an exclusively regula-
tory purpose. The accounting required by the Commission has
evolved into a system, accepted by financial analysts, which
is considered by the regulator and the regulated to fairly
present railroad financial and Operating data. But, it
differs from what the Securities and Exchange Commission
requires Of those subject to its control. TwO powerful
governmental agencies, one established to protect investor
interests, are in disagreement over the system Of accounting
to be followed by those firms subject to their control and
on the use and value of independent audits.

The New Yprk Stock Exchange.--The New York Stock
Exchange, through letters to listed railroads in 1962 and
1963 from Phillip L. West, Vice-President, encouraged the
railroad industry to conform its annual reporting to the
basis of generally accepted accounting principles. Since

that time, however, no action has been taken either in the

form Of additional encouragement or in the form of negatively

153

sanctioning those railroads that refuse to conform. The
Stock Exchange appears to be accepting what the Securities
and Exchange Commission will accept, which happens to be
what the Interstate Commerce Commission accepts. This
action reduces any security which users of railroad finan-
cial data may imply to the fact of exchange listing. The
Exchange has sanctions which could be employed but refuses
to exercise these sanctions for three apparent reasons. One
reason is the effect on its influence of reversing its stand
on historically acceptable railroad reporting. The second
is the disruptive effect on the economy, the railroad indus-
try, and the Exchange that could come about should it mas-
sively delist those railroads refusing to conform. The
third is that the sanctioning of nonconforming railroads
would be acting counter to the Securities and Exchange Com—
mission, the generally more dominant organization and a
government agency as well, because of the Commission's
requirement not to tamper with the accounting required of
federally regulated firms. The listing requirements Of the
Exchange, therefore, are no comfort to any who might rely
upon Exchange listing as an indication that generally
accepted accounting is being followed.

The Commission and the railrg§g§.--The Interstate
Commerce Commission and the railroads eXpress the view that
application of the Uniform System Of Accounts leads to

annual reports which are fair presentations. Should public

 

.111 It 15 .

154

priorities shift from that of rate regulation to capital
acquisition, fair presentation would become a greater issue
in the future. Although it has not to the present, railroad
annual reporting according to the Uniform System could
achieve sufficient public disfavor that the railroads would
receive less advantageous treatment in the capital markets
than they have enjoyed in the past. The railroads might
then be forced to adOpt generally accepted accounting prin-
ciples for financial reporting to the public. It is con-
ceivable that the Commission's stand on tax allocation could
be proven to be incorrect by the passage of time. It would
be quite embarrassing to this governmental agency to have to
admit serious misstatement Of railroad income and equity over
a considerable period Of time. It is conceivable that the
railroads may someday restate the track accounts and begin
to use depreciation accounting rather than betterment
accounting. Such a restatement could evidence substantial
asset and equity misstatements that might have accrued over
time. It is also possible that such an asset restatement
and change in accounting policy could have an effect on
rates charged by the railroads because the capital turnovers
are low and rate margins must be high in order to service
capital. Such a rate increase, should it result, might
indicate that the use of betterment accounting had led to
the creation of a rate structure that did not sufficiently

provide for capital maintenance. The effects on the railroad

155

industry, both in terms Of the impacts on the financial
statements and on the rate adjustments, if any, that would
be required in order to maintain the level of current earn-
ings, should be subjects of future inquiry. Asset, income,
and equity misstatements from any source could adversely
affect the railroads in the capital markets.

The trend in the economy toward more government
control may be mitigated in the case of the railroads by the
mature status of the industry and the intense competition
developing in the transportation sector. Should the rail-
road industry become much less regulated, it could become
subject to at least two pressures it presently does not face
that could be affected by its system of financial reporting.
Much less regulated, the railroads could be placed in more
direct competition with industrial and other nonregulated
concerns in the capital markets. Pressure could be brought
to bear on the railroads by the capital markets to conform
their reporting to the same system used by the other firms
competing for funds. Another consequence of being less
regulated could be the subjection of railroad securities
to therules of the Securities and Exchange Commission.

This development could force all railroads to be indepen-
dently audited and to report according to generally accepted
accounting principles. In sum, it may be advantageous for

the Commission and the railroads to seriously reconsider

" -I)A~‘p- '

156

their position in this impasse and the implications of main-
taining the status quO.

The_ggcounting profession.--The growth of the govern-
mental sector of the economy could pose difficulties for the
accounting profession. One of these is that the strength Of
the profession is being tested in a conflict with a regula-
tory agency over accounting principles. Its response to
this situation may well establish the ability of the profes-
sion to deal with future conflicts with regulatory agencies.
Another problem is that failure to resolve this impasse
could foretell of future situations of this nature that
could develop between the accounting profession and this
growing governmental sector. Another difficulty may be
created by a lack Of resolution Of the conflict between the
profession and the Interstate Commerce Commission. A weak
stand, or no stand, on the part of the profession could
raise a question about the importance Of the issues in dis—
pute and perhaps Of the importance Of the opinion expressed
by independent accountants on financial statements.

One major question facing the accounting profession
is whether it is properly qualifying railroad annual reports.
One guide defining a concept Of relevant auditor responsibil-
ity was presented and discussed in Chapter V. But this
approach could conceivably result in division within the
accounting profession. Differing viewpoints as to circum-

stances, as well as differing circumstances, could yield

__-, 2 1. ..us,~..-J . r. —

157

unqualified audit opinions for some railroads and qualified
opinions for others. Currently auditors seem to follow
uniform qualification procedures because in unity there is
some strength. As an example, two of the largest certified
public accounting firms, Haskins & Sells and Price Water-
house & Co., dissented from Opinion No. ll of the Accounting
Principles Board. Their dissents both reflected a desire On
the part of these firms to apply a concept of partial alloca-
tion in the reporting of federal income taxes. The applica-
tion of such a concept of tax allocation could result in
unqualified opinions being granted by the firms to railroad
companies which they audit. But Russell D. Tipton, in a
letter dated March 1, 1968, and Heward Dudley Murphy, in a
letter dated February 16, 1968, both affirmed that though
their firms disagreed with the decision of the Board, this
decision would be followed by both firms. Misinterpretation
of circumstances or an improper view toward the circumstances,
under the suggested "relevance" approach, could lead to in-
consistent auditor opinions and perhaps incorrect action
taken by users of published railroad financial data. The
accounting profession should seriously consider these impli-
cations.

Another major question facing the accounting profes—
sion relates to the power of the audit opinion qualified for
lack of a deferred tax provision. Apparently, in the case

of the railroads, this qualified audit opinion on financial

.K I

158

statements carries very little if any threat to the ability
of the firm to operate and acquire needed capital. .Although
the Securities and Exchange Commission has no control over
railroad financial reporting, informed users of reported

data could press for conformity of the Uniform System with
the requirements of this Commission. The fact that any such
pressure has had no recent effect places the accounting pro-
fession in a somewhat weaker position relative to railroad
audit opinions than it enjoys relative to other segments of
the American economy. Because of SEC requirements, much of
American industry is vitally affected by-a qualified audit
opinion on published financial statements. But the growing
trends toward railroad involvement in holding company activ-
ity may permit the qualified audit opinion to begin to

affect the railroads as the consolidated financial statements
of the holding company are subject to the regulations of the
Securities and Exchange Commission. For other railroads, the
accounting profession may need to determine another method of
showing displeasure toward railroad annual reporting since
qualification is not appreciably effective. Short of govern-
mental action, the Institute Committee on Relations with the
Interstate Commerce Commission might act as the influence
toward mitigating the need for qualification. ,Ernest J. Rua,
Chairman of the Committee, stated, in an interview on
October 24, 1967, that one of the primary functions of the

Committee is to assist the Interstate Commerce Commission in

159

conforming the Uniform System.with generally accepted
accounting principles. But Rua suggests that movement
toward such conformity would be facilitated by the support
of financial analysts and investment bankers, who currently
accept financial statements prepared on the basis of the
Uniform System.

The accounting profession needs to reconsider its
position in relation to maintenance of the status quo. Non-
action on the part of the profession would continue the
impasse with the fairly predictable result that the qual-
ified audit opinion on railroad financial statements would
consistently lose value over time unless the Uniform System
is brought into conformity with generally accepted account-
ing principles or the profession's stand on tax allocation
is revised so as to exclude railroad financial statements
from qualification. As indicated, financial analysts, the
Securities and Exchange Commission, and the New YOrk Stock
Exchange accept the Uniform System for financial reporting
so the accounting profession must press for change alone.
Assuming that the Interstate Commerce Commission and the
railroads remain adamant against change and the accounting
profession is convinced that modification is desirable, a
threat more powerful than qualification will need to be
developed. Perhaps the most reasonable approach to be
adopted by the profession would be to utilize the existing

Institute Committee on Relations with the Interstate Commerce

160

Commission to effect some reconciliation. This Committee
had astonishing success when first formed and has acted as

a mediation panel since 1957. Perhaps a joint study by the
Commission and the Committee of the principles of accounting
that have led to the impasse could point the way to resolu-
tion of the conflict. The implications of the impasse on
all parties and the effects of different approaches to
reconciliation could be intensively studied. It is doubtful
if any of the parties involved truly wish to be in conflict
with the others. Through cooperation between the Institute
Committee and the Interstate Commerce Commission, a solution

equitable to all involved parties seems attainable.

APPENDIX A

SAMPLE OF CLASS I RAILROADS

l. Atchison, Topeka & Santa Fe
2. Atlantic Coast Line
3. Baltimore & Ohio (included in Chesapeake
& Ohio
4. Bangor & Aroostook
5. Boston & Maine
*6. Canadian National
*7. Canadian Pacific
8. Central of Georgia (included in Southern)
9. Chesapeake & Ohio
10. Chicago, Burlington & Quincy
11. Chicago & Eastern Illinois
12. Chicago Great Western
13. Chicago, Milwaukee, St. Paul & Pacific
14. Chicago & North Western
15. Chicago, Rock Island & Pacific
16. Delaware & Hudson
l7. Denver & Rio Grande Western
18. Erie-Lackawanna
19. Great Northern
20. Gulf, MObile & Ohio
21. Illinois Central
#22. Kansas City Southern
23. Lehigh Valley
24. Louisville & Nashville
25. Maine Central
26. Missouri-Kansas-Texas
27. Missouri Pacific
28. Monon
29. New YOrk Central
T30. New York, New Haven & Hartford
31. Norfolk Southern 38. 500 Line
#32. Norfolk & western 39. Southern Pacific
33. Northern Pacific 40. Southern
34. Pennsylvania 41. Texas & Pacific
35. Reading 42. Union Pacific
36. St. Louis-San Francisco 43. Western Maryland
37. Seaboard Air Line 44. Western Pacific

162

LIST OF COMPANY NAMES

 

*Canadian companies, therefore not included in the

sample.

¢Would not respond to request for financial statements,

therefore not included in the sample.

fIn trusteeship,

therefore not included in the sample.

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APPENDIX B

RAILROAD QUESTIONNAIRE

165

The ten question questionnaire reproduced herein was
sent to the chief financial officers of thirty audited rail-
roads in the sample. Twenty-four of the thirty responded

(80 per cent). The thirty audited railroads were:

Atlantic Coast Line
Chesapeake & Ohio

Bangor & Aroostook

Boston & Maine

Chicago, Burlington & Quincy
Chicago & Eastern Illinois
Chicago Great Western
Chicago, Milwaukee, St. Paul & Pacific
Chicago & North Western
Chicago, Rock Island & Pacific
Delaware & Hudson

Denver & Rio Grande Western
13. Erie-Lackawanna

14. Great Northern

15. Gulf, Mobile & Ohio

16. Illinois Central

17. Louisville & Nashville

18. Missouri-Kansas-Texas

19. Missouri Pacific

20. Monon

21. New YOrk Central

22. Norfolk Southern

23. Northern Pacific

24. Reading

25. St. Louis-San Francisco

26. Seaboard Air Line

27. 800 Line

28. Southern Pacific

29. Western Maryland

30. Western Pacific

H
oomqmmewNI—a

F‘H
Nye

166

February 5, 1968

Dear Sir:

In connection with my doctoral dissertation entitled "Rail-
road Financial Reporting and Auditor Responsibility," I have
prepared the following questionnaire. I would appreciate it
if you would complete it and return it to me in the enclosed
envelope.

The form of the questionnaire lends it to rapid answering in
that an "x" can be placed in the ( ) following the answer
preferred. There is also a section provided for comments
and amplification of answers. Total time to complete the
questionnaire should not exceed ten minutes.

This information will be kept confidential. The nature of

my dissertation is such that I am working with aggregates

and percentages. It would not only be unethical but also
impractical to identify the responses of individual railroads.

I intend to provide a summary of the results of this question-
naire to each respondent and therefore would appreciate your
co-operation.

Yours truly,

Phillip A. Jones, Sr.

 

167

RAILROAD QUESTIONNAIRE

System of Financial Reporting to Stockholders

1. Are your company's financial statements prepared in
accordance with:
a) The Uniform System of Accounts for:
Railroad Companies? (
b) "generally accepted accounting principles?" (
c) a combination of the two systems?

2. Would you say that your 1966 Annual Report "fairly
represented the financial position and results of
operations" of your firm?

a) Yes.
b) No.
c) not certain.

AAA

3. "Generally accepted accounting principles" for

financial reporting are:
a) superior to the Uniform System.of Accounts. ( )
b) equally as meaningful as the Uniform

System of Accounts. ( )
c) inferior to the Uhiform System of Accounts. ( )
d) not relevant to railroad financial

reporting. ( )

4. Do you feel that the Uniform System severely restricts
managerial freedom in portraying the effects of
economic events upon the firm?

a) Yes. ( )
b) restricts, but not severely. ( )
c) does not restrict. ( )

5. Do you feel that the attempts of the Interstate
Commerce Commission to conform the Uniform System to
"generally accepted accounting principles" are lead-
ing to improvement in railroad financial reporting?

a) Yes. ( )
b) No. ( )
c) Not certain. ( )

6. Do you feel that either of the following will be
prescribed by the Interstate Commerce Commission
in the foreseeable future?

a) depreciation accounting for track
components.

b) deferred income tax accounting.

c) both of these.

d) neither of these.

“AAA
vvvv

B.

168

7. How would you evaluate improvement in financial
reporting practices relative to the other diffi-
culties faced by the railroad industry?

a) very important.
b) equal in importance.
c) of less significance.
d) insignificant.

AAAA

System for Effective Managerial Information Gathering

Does the Uniform System of Accounts provide a mech-
anism whereby information for effective managerial
action is readily available or was it necessary for
you to develOp your own internal accounting system
for managerial decision making and analysis of
internal operations?
a) The Uniform System serves both external and
internal reporting purposes adequately. ( )
b) The Uniform System is not adequate for
internal accounting but we have found no
acceptable alternative so continue to
use it. ( )
c) The Uniform System is used for external
reporting but we have developed an internal
accounting system for managerial decision
making purposes. ( )

General

1. Considering the maturity of the industry, do you
feel that it is necessary for railroads to have
uniform accounting systems in order for effective
regulation to be achieved?

a) Yes.
b) No.
c) not certain.

AAA
vvv

2. How would you assess the future of the American
railroad industry under continued regulation?
a) a growing industry.
b) a stable industry.
c) a declining industry.

AAA
VVV

Comments

If there is any question which you feel needs a more
amplified answer, please feel free to add your comments
here. Thank you for your participation.

169

April 1, 1968

Dear Sir:

Attached is a summary of the questionnaire re5ponses as

I promised. I appreciate your c00peration in responding.
The participation in this study was excellent. Out of 30
firms surveyed, 24 responded (80%) so the results are quite
representative of the sample. Since these 30 roads were
selected on the basis of size and investor interest, these
results may be representative of the industry.

Thank you again for your participation.

Yours truly,

Phillip A. Jones, Sr.

170

SUMMARY OF RAILROAD QUESTIONNAIRE RESPONSES

System of Financial Reporting_to Stockholders

1.

Are your company's financial statements prepared in
accordance with:
a) The Uniform System.of Accounts for‘

Railroad Companies? 29%
b) "generally accepted accounting principles?" 8%
c) a combination of the two systems? 63%

Would you say that your 1966 Annual Report "fairly
represented the financial position and results of
operations" of your firm?

a) Yes. 96%

b) No. ..

c) Not certain. ..
No response. 4%

"Generally accepted accounting principles" for
financial reporting are:
a) superior to the Uniform System of Accounts. 42%
b) equally as meaningful as the Uniform

System of Accounts. 32%
c) inferior to the Uniform System of Accounts. ..
d) not relevant to railroad financial

reporting. 16%

Do you feel that the Uniform System severely
restricts managerial freedom in portraying the
effects of economic events upon the firm?

a) Yes. 21%
b) restricts, but not severely. 31%
c) does not restrict. 42%

Do you feel that the attempts of the Interstate
Commerce Commission to conform the Uniform System to
"generally accepted accounting principles" are lead-
ing to improvement in railroad financial reporting?

a) Yes. 79%
b) No. 17%
c) not certain. 4%

Do you feel that either of the following will be
prescribed by the Interstate Commerce Commission

in the foreseeable future?

a) depreciation accounting for track components.38%

b) deferred income tax accounting. 8%
c) both of these. 2D%
d) neither of these. 25%

no response. 8%

171

How would you evaluate improvement in financial
reporting practices relative to the other diffi-
culties faced by the railroad industry?

a) very important. 8%
b) equal in importance. 23%
c) of less significance. 42%
d) insignificant. 17%

no response. 8%

B. System for Effective Managerial Information Gathering

Does the Uniform System of Accounts provide a mech-
anism whereby information for effective managerial
action is readily available or was it necessary for
you to develop your own internal accounting system
for managerial decision making and analysis of
internal operations?
a) The Uniform System serves both external

and internal reporting purposes

adequately. 13%
b) The Uniform System is not adequate for

internal accounting but we have found no

acceptable alternative so continue to

use it. 8%
c) The Uniform System is used for external

reporting but we have developed an

internal accounting system for managerial

decision making purposes. 75%

No response 4%

C. General

1.

Considering the maturity of the industry, do you
feel that it is necessary for railroads to have
uniform accounting systems in order for effective
regulation to be achieved?

a) Yes. 7I%
b) No. 23%
c) not certain. 4%

How would you assess the future of the American
railroad industry under continued regulation?

a) a growing industry. 50%
b) a stable industry. 33%
c) a declining industry. 13%

no response. 4%

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