. .I-IIEuIIMIIJIHIJ-HL ill/ll!I/ll/I/lllll/lfllllfl/ll it f mm 3 293 01005 2979 1 fiiehigafi 5”“ d University This is to certify that the thesis entitled A Theoretical Justification and Application of a Current Value Accounting Model for Agricultural Cooperatives presented by Michael Leroy Fassler has been accepted towards fulfillment of the requirements for Master of Science degree in Agricultural Economics W r U ' Major professor Dr. Glynn McBride Date August 13, 1984 0-7 639 MSU LIBRARIES w » RETURNING MATERIALS: Place in book drop to remove this checkout from your record. FINES will be charged if book is returned after the date stamped below. A THEORETICAL JUSTIFICATION AND APPLICATION OF A CURRENT VALUE ACCOUNTING MODEL FOR AGRICULTURAL COOPERATIVES By Michael Leroy Fassler A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of MASTER OF SCIENCE Department of Agricultural Economics 1984 {i E? 1'71} 3'} ABSTRACT A THEORETICAL JUSTIFICATION AND APPLICATION OF A CURRENT VALUE ACCOUNTING MODEL FOR AGRICULTURAL COOPERATIVES By Michael Leroy Fassler Agricultural cooperatives use the historical cost accounting model to measure financial performance. An implicit assumption made in the use of the model is that the price level is stable. However, the price level is not stable, therefore historical cost measurement is distorted, and the model does not measure financial performance with' the cooperative economic goal and principles as its basis. A link between cooperative theory and a current value accounting model is established by reviewing cooperative theory and associating it with the concept of physical capital maintenance, the basis of income measurement for the current value accounting model. Historical cost fixed asset valuation and income measurement for a sample of grain marketing/farm supply cooperatives are adjusted to current value using a price indexing methodology. The two models are then compared. Empirical results suggest that measurement variances between the two models are not substantial due to the nature of the type of business in which the sample is engaged. A modification of the cooperative principle of “service at cost" is suggested along with various means of applying current value information to the decision-making process. ACKNOHLEDGEHENTS I would like to take this Opportunity to extend by sincerest appreciation to the individuals whom have provided me with the guidance and assistance required to pursue a graduate degree and prepare this thesis. Dr. Glynn McBride has stimulated my interest in agricultural cooperatives throughout my graduate program and provided me an insightful "sounding board” in the conception and preparation of the thesis. The project would not have been possible without the assistance Dr. Harold Ecker supplied in order "to get my foot in the door“ to obtain the sample financial data. Additionally, his efforts in the review of the manuscript provided me with a substantial amount of direction. Dr. Randall Hayes freely shared his wealth of knowledge in the more technical aspects of accounting and provided a number of useful suggestions during the preparation of the text. Ms. Laura Emmer of Farm Bureau Services, Inc., assisted in the collection of data, and without her efforts the data would not have been so readily available. Ms. Cindy Elder of the Louisville Bank for Cooperatives patiently and diligently assisted in the lengthy process of editing and preparation of the final manuscript. ii Mr. William Burghardt has been one of the most influential “devil's advocate" throughout my graduate program and in the choice of a career path. Additionally, he has continually generated an air of excitement about agricultural finance. To all of the above goes a great deal of appreciation. However, the primary providers of emotional as well as financial support have been my parents. Without their contributions, the completion of a graduate degree would not have been possible. I am indebted to them for this support. in TABLE OF CONTENTS CHAPTER PAGE I. INTRODUCTION TO STUDY 1.1 IntI‘OdUCtion O O O O O O O O O O O O O O O O O O 1.2 Research Objectives . . . . . . . . . . . . . . . 1 3 Research Project Outline . . . . . . . . . . . . II. THEORETICAL AND PRACTICAL REVIEH “NH The Inherent Inconsistency . . . . . . . . . . . 1 Literature Review . . . . . . . . . . . . . . . . 4 Hilliam Paton - 1922 . . . . . . . . . . . . . . 4 Edgar 0. Edwards and Philip H. Bell - 1961 . . . 6 Sandilands Report - 1975 . . . . . . . . . . . . 10 Securities and Exchange Commission - 1976 . . . 13 Financial Accounting Standards Board - 1979 14 Summary of Literature Review . . . . . . . . . . 17 Evidence of the Impact of Inflation . . . . . . . 18 Non-cooperative Entities . . . . . . . . . . . . 18 Agricultural Cooperatives . . . . . . . . . . . I22 Chapter Summary . . . . . . . . . . 23 0 03019me NNNNNNNNNNNN o hwwwNNNNNNNI-P O 0 NH III. COOPERATIVE PRINCIPLES |—' Introduction . . . . . . . . . . . . . . . . . . Economic Distinction Between Cooperatives and Non-cooperatives . . . . . . . . . . . . . Legal Acts and Agricultural Cooperatives . . . . Sherman Antitrust Act . . . . . . . . . . . Clayton Act . . . . . . . . . . . . . . . . Capper-Volstead Act . . . . . . . . . . . . Cooperative Organizational Structure and Relationships . . . . . . . . . . . . . . . . Principles of Cooperative Finance . . . . . . . 1 IV. CONCEPTS OF INCONE AND CAPITAL MAINTENANCE AND RESPECTIVE ACCOUNTING MODELS o o o o o o o o o o \IOSU'I‘hU-J 0) wwwww 000.) o o 01 #00000)“ NH 0 (.0th con 4 1 Introduction . . . . . . . . . . . . . . . . . . 4 2 Financial and Managerial Accounting . . . . . . 4.3 Objectives of Accounting Information . . . . . . 4 4 I. Concepts of Income and Capital Maintenance . . . mmv—‘H iv VI. 0 o m‘PWNt-P I O waO—o O N!" 0 NH 0505050505 mmmmmm 05050505050505 0 U'IUTUTD-h bwwwww NNNNNNH 0 Financial Capital Maintenance and the Historical Cost Accounting Model . . . . . . . Purchasing Power Capital Maintenance and the Constant Dollar Accounting Model . . . . . Physical Capital Maintenance and the Current Value Accounting Model . . . . . . . . Chapter Summary . . . . . . . . . . . . . . . . THE THEORETICAL LINK Introduction . . . . . . . . . . . . . . . . . . Conceptual Frameworks . . . . . . . . . . . . . Proprietary Theory . . . . . . . . . . . . . . . Entity Theory . . . . . . . . . . . . . . . . . Perspective Theory . . . . . . . . . . . . . . . Member Perspective, Physical Capital Maintenance, and the Current Value Accounting Model . . . . . . . . . . . . . . . Chapter Summary . . . . . . . . . . . . . . . . CURRENT VALUE ACCOUNTING MODEL SPECIFICATION Introduction . . . . . . . . . . . . . . . . . . The Basis for Valuation . . . . . . . . . . . . Current Cost Valuation . . . . . Replacement Cost Valuation . . . Net Realizable Value . . . . . Economic Value . . . . . . . . . The Choice of A Current Valuation Classification . . . . . . . . . . Methods of Current Cost Adjustments Direct Pricing . . . . . . . . . . Unit Pricing . . . . . . . . . . . Functional Pricing . . . . . . . . Indexing . . . . . . . . . . . . . Adjustments to the Historical Cost Accounting Model . . . . . . . . . . . . . . . Income Statement . . . . . . . . . . . . . . . . Balance Sheet . . . . . . . . . . . . . . . . . Index Adjustment Methodology . . . . . . . . . . Index Sources . . . . . . . . . . . . . . . . . Adjustment Procedures . . . . . . . . . . . . . CHARACTERISTICS OF THE SAMPLE AND EMPIRICAL RESULTS Introduction . . . . . . . .~. . . . . . . . . . Sample Characteristics . . . . . . . . . . . . . Historical Cost Financial Relationships . . . . Historical Cost Financial Statements . . . . . . Balance Sheet . . . . . . . . . . . . . . . . . Comparative Relationship . . . . . . . . . . . . Results and Interpretation . . . . . . . . . . . V PAGE mwNI—u-I £000 05 05 V05 taxoooxrwn- bwwNv—II—I NVNGWr—‘H CHAPTER PAGE 7.4 Income Statement . . . . . . . . . . . . . . . . 10 7.4.1 Comparative Relationships . . . . . . . . . . . 10 7.4.2 Results and Interpretation . . . . . . . . . . . 11 7.5 Chapter Summary . . . . . . . . . . . . . . . . 18 VIII. DECISIONMAKING APPLICATIONS 1 Int FOdUCtion O O O O. O O O O O O O O O O O O 2 Price Determination for Services . . . . . . 3 Fixed Asset Management . . . . . . . . . . . .4 Financial Structure Planning . . . . . . . . 5 6 O O O O 014>HH Cash Patronage and Dividend Distribution Policy . . . . . . . . . . . . . . . .‘. . . . Implications for Cooperative Principles and Equity Redemption . . . . . . . . . . . . . . 8 IX. SUMMARY, CONCLUSIONS, AND RECOMMENDATION \1 wI—u—o 9.1 sumary O O O O O O O O O O O I O O O O O O 0 O 9.2 Conclusions . . . . . . . . . . . . . . . . . . 9.3 Recommendations . . . . . . . . . . . . . . . . APPENDIX TABLES OF RAH DATA BIBLIOGRAPHY vi LIST OF TABLES CHAPTER - TABLE PAGE VII - H Comparative Capital Intensity Relationships . . . . 6 VII - 2 Net Current Cost Of Plant And Equipment As A Percentage 0f Net Historical Cost Of Plant And Equipment . . . . . . . . . . . . . . . 8 VII - 3 Capital Expenditures For Plant And Equipment As A Percentage 0f Net Historical Cost Of Plant And Equipment . . . . . . . . . . . . . . . 9 VII - 4 Current Cost Depreciation Expense As A Percentage Of Historical Cost Depreciation Expense . . . . . 12 VII - 5 Historical Cost And Current Cost Net Margins As A Percentage Of Total Sales . . . . . . . . . . . 14 VII - 6 Current Cost Return On Sales Differences From Historical Cost Return On Sales (Realized Holding Gains As A Percentage Of Sales) . . . . . . . . . . . . . . . . . . . . 15 VII - 7 Cash Distribution As A Percentage 0f Historical Cost Net Margins And Current Cost Net Margins . . 17 APPENDIX-A.1 Grain And Farm Supply Sales As A Percentage Of Total saTES O O O O O O O O O O O O O O O O O O O 1 APPENDIX-A.2 Fixed Assets As A Percentage Of Total Assets . . . 2 APPENDIX-A.3 Labor Expenses As A Percentage Of Total Expenses . . 3 APPENDIX-A.4 Historical Cost Depreciation Expense As A Percentage Of Total Expenses . . . . . . . . . . . 4 APPENDIX-A.5 Total Historical Cost Expenses . . . . . . . . . . . 5 APPENDIX-8.1 Net Current Cost Of Plant And Equipment . . . . . . 6 APPENDIX-8.2 Net Historical Cost Of Plant And Equipment . . . . . 7 APPENDIX-0.1 Capital Expenditures For Plant And Equipment . . . . 8 vii CHAPTER — TABLE. PAGE APPENDIX-C.2 Net Historical Cost Of Plant And Equipment . . . . . 9 APPENDIX-0.1 Current Cost Depreciation Expense . . . '.° . . . . 10 APPENDIX-0.2 Historical Cost Depreciation Expense . . . . . . . 11 APPENDIX-E.1 Total Sales . . . . . . . . . . . . . . . . . . . . 12 APPENDIX-E.2 Historical Cost Net Margins . . . . . . . . . . . . 13 APPENDIX-E.3 Current Cost Net Margins . . . . . . . . . . . . . 14 APPENDIX-E.4 Realized Holding Gains . . . . . . . . . . . . . . 15 APPENDIX-E.5 Earnings Distribution In Cash . . . . . . . . . . . 16 viii LIST OF FIGURES CHAPTER - FIGURE PAGE II - 1 The Price Level As Measured By Selected Price Indices . . . . . . . . . . . . . . . . . . 2 V - 1 Flow Diagram of Relationship Between Members and The Current Value Accounting Model . . . . . . . . . . . . . . . . 8 VII - 1 Capital Intensity Continuum . . . . . . . . . . . . 5 ix CHAPTER I INTRODUCTION TO STUDY 1.1 Introduction The historical cost accounting (HCA) model is the conventional accounting model both cooperative and non-cooperative agricultural businesses use to measure financial performance.1 Although the economic goal of these two types of business organizations differ, the accounting model used for measurement is the same. The shortfall of using the HCA model to measure the financial performance of agricultural cooperatives is that the price level in the economy is not stable. Thus, it is believed that the HCA model does not measure such performance with cooperative economic goals as its basis. The HCA model is based on acquisition values (historical cost) measured in nominal dollars, and one implicit assumption underlying the model is that the value of the historical dollar equals the value of "today's" dollar. hi other words, the price level is assumed to be stable. This is inconsistent with economic reality since the price level has changed over time, and dollars expended at different points in time are not additive because of their differing values. Due to the inherent inconsistency in the use of the HCA model in conjunction with an unstable price level, there have been two accounting models proposed in the accounting literature and by the 1A cooperative entity is defined as a business enterprise whose economic purpose is to provide goods and/or services to its members who are also the owners of the business. For comparison, a non-cooperative business has the economic goal of maximizing the value of owners' investment in the business by selling goods and/or services to people who are not the owners. 2 Financial Accounting Standards Board (FASB) as a supplement or alternative to the HCA model. These models are the constant dollar accounting (CDA) model and the current value accounting (CVA) model. The CDA model restates historical cost/nominal dollars to equal units of general purchasing power. lfistorical costs ck) not change, rather they are restated in constant dollars by adjusting them for changes in the general price level, a proxy for the general purchasing power of the dollar. Thus, the underlying objective of the CDA model is to measure financial statement accounts in dollars of equal purchasing power to obtain a constant or uniform measuring unit. The objective of the CVA model is to determine the effects of specific price changes of assets held on the financial perfOrmance of a business organization. This model measures and reports assets and expenses at current values which specifically relate to the productive assets used and products sold by the business. 1.2 Research Objectives The CDA and CVA models discussed above have been brought to the forefront of accounting theory due to the inherent problem in the use of the HCA model. This research project attempts to go one step further with accounting models and financial performance measurement for agricultural cooperatives. It is hypothesized that when the price level is unstable, the HCA model does not coincide with the economic reason for which agricultural cooperatives exist. Additionally, it is hypothesized that the HCA model can present a distorted measurement of financial performance for agricultural cooperatives when the price level is changing. The primary objective of this project is to provide a theoretical 3 link between the economic goal of agricultural cooperatives and an accounting model which utilizes cooperative economic goals as the basis for financial performance measurement. A further Objective is to determine if, and to what extent, an alternative accounting model provides a different assessment of the financial performance of a sample of agricultural cooperatives. The means to accomplish these objectives are to: (1) compare cooperative theory to the capital maintenance concepts underlying the HCA, CDA, and CVA. models and determine which model best represents cooperative theory; (2) apply the alternative accounting model to a sample of grain marketing/farm supply cooperatives; (3) compare the results of the HCA model with the alternative model to determine the extent to which HCA financial statement accounts have been distorted, emphasis being placed on income statement accounts; (4) determine the extent to which distortions in HCA earnings have led decision-makers to liquidate the capital of their organizations through earnings distributions; (5) suggest how use of the alternative accounting model may provide useful financial information to cooperative decision-makers. . After settling (”I one particular alternative accounting model on the basis of its theoretical underpinnings, the focus of the project will take a decidedly practitioner's approach by applying the model to a sample of cooperatives and suggesting how the additional information can provide input into the decision-making process. 1.3 Research Project Outline Chapter two of this research project begins with a discussion of an economic phenomenon, inflation, and how it can affect the operations of 4. not only agricultural cooperatives, but the majority of other bUsiness organizations as well. With these developments in mind a literature review of major theoretical and practical developments concerning alternative accounting models is presented. In chapter three agricultural cooperative principles are discussed which have a bearing on the choice of an accounting model. Focus is placed on the primary economic distinction between cooperative and non-cooperatiwe organizations, legal acts which have facilitated the formation and development of agricultural cooperatives, the organizational structure of cooperatives, and cooperative finance related principles. Chapter four briefly discusses the distinction between financial and managerial accounting along with the basic objectives for compiling accounting information. In addition, the three accounting models (HCA, CDA, and CVA) briefly touched on above are discussed in more detail with emphasis on their respective concepts of capital maintenance and income. Using the material presented in chapters two through four, chapter five provides the theoretical justification for the use of a current value accounting (CVA) model for the financial performance measurement of agricultural cooperatives. Chapter six begins with the specification of the CVA model used in the empirical analysis. The specification entails Choosing a current value Classification, a description of the adjustments made to the HCA model, and the method of adjustment. Characteristics of the sample of cooperatives are discussed and analyzed in chapter seven along with a description of the HCA model 5 the cooperatives are using. The empirical results are also presented by comparing HCA model accounts with the CVA model accounts. As stated above, emphasis is placed on income statement results. Chapter eight discusses decision-making applications using the CVA financial information. Although an exhaustive set of applications is not presented, the ones included provide cooperative decision-makers with fundamentals relevant to the application of CVA information to the decision-making process. Chapter nine provides a summary, conclusions, and recommendations. Focus is placed on the costs and benefits of implementing an alternative accounting model. Also, questions concerning the reliablity of the CVA system are addressed along with related areas in which additional research is required. CHAPTER II THEORETICAL AND PRACTICAL REVIEH 2.1 The Inherent Inconsistency Although the historical cost accounting (HCA) model is the conventional accounting model business firms use to measure their financial performance (income statement) and financial position (balance sheet), its adequacy' is being seriously challenged by some accounting theorists and practitioners. The primary reason for this challenge is due to the economic phenomenon of inflation. Inflation is defined as "a sustained upward movement in the aggregate price level which is shared by most products."1 Inflation is typically measured using price indices which provide proxies for the level of prices and direction of price movements. Figure 1 illustrates the level of prices from 1973 to 1982 by showing the consumer price index for all urban consumers (CPI-U) and the producer price index for all commodities (PPI) over this period. The CPI-U is a statistical measure of the cost of a fixed or constant "market basket“ of consumer goods and services. The PPI is a measure of prices at the primary market level for finished, intermediate, and crude goods. As seen in Figure 1, the level of prices has increased significantly over this ten year period. 1Gordon, Robert J.,‘Macroeconomics, Little, Brown and Company, First Edition, 1978, p. xxxi. 1 PRICE LEVEL 350 300 PPI 250 200 CPI-U 150T b0000000000. 0.000.000.0000000000000 P00000000... 0... P0000000... lOO 1972 1974 1976 1978 1980 1982 YEARS Source: Business Statistics, 1982: A supplement to the Survey _O__i: Current Business Statistics, 23rd Edition, U. S. Dept. Of omerce, Bureau of EconomicTAnalysis, Nov., 1984. Figure 1 The Price Level As Measured By Selected Price Indices (1973 - 1982) It has been set forth in the literature that if the HCA model is used during an inflationary period, the income and financial position of a business organization is not measured realistically. The basis 3 for this argument is that as the value of the dollar declines during periods of inflation, balance sheet items (assets, liabilities, and owners equity) are measured in terms of dollars of varying purchasing power. Therefore, the dollar values shown represent the summation of unequal measurement units. Because the measurement units are unequal, any summation, strictly speaking, is uninterpretable. The effect of this is to make the interpretation of balance sheet accounts difficult. When measuring financial performance for a period using the HCA income statement (revenue less expenses equals net income), the distorted asset accounts are expensed which in turn distorts the net income figure. The cost of goods sold (C065) and depreciation expenses are based on the acquisition costs of inventory and depreciable fixed assets as carried on the balance sheet, and therefore are distorted. Thus, net income is distorted. The inherent problem with using the HCA model can be summarized as follows: The most persistent and significant criticism of the conventional model based on historical or acquisition costs is that it ignores the economic facts of life.2 2Davidson, Sidney, Clyde P. Stickney, and Roman L. Weil, Intermediate Accounting: Concepts, Methods, and Uses, The Dryden Press, rthIOI'I, p. zs-To 2.2 Literature Review 2.2.1. Willial Paton - 1922 One of the earliest authors to incorporate the concept of price level adjusted accounting information into the theory of accounting is William Paton. Although the emphasis of Paton's research is on the underlying concepts and principles of accounting, one chapter of his book is dedicated to what he feels is a drawback to the HCA model.3 The pitfall Paton discusses pertains to the effect of wide fluctuations in prices on the economic accuracy of HCA data. He incorporates the' concept of price level adjusted accounting information with the existing theory of accounting in an effort to develop a refined theory upon which accounting procedures can be based. He believes this concept correlates more closely with actual economic situations. Paton .states: It is clear that original cost is not an ideal expression of true value, or an ideal basis for depreciation charges, in a period of either rising or falling prices.4 In his development of the concept of price level adjusted accounting information, Paton advocates the use of HCA adjustments using techniques ‘which' show the effect of changing prices on the specific assets held by an enterprise, rather than the effect of change in the general price level. He offers the following as his reasoning: It is above all important that the accountant's statements present as accurately as possible a 3Paton, William Am, Accounting Theory, The Ronald Press Company, New York, 1922. 4ibid., p. 425. 5 picture of current data in terms of the actual dollar as of the date of the statements. And'this is not a matter of general price movements - which may be said to express the fluctuations in the significance of money - but of specific price and value changes. The particular business enterprise does not embrace goods in general but special classes of structures, commodities, services, and rights. It is thus the function of accounting to follow the investment of the specific business as it takes shape in various concrete items, and to register the effects brought about by changes in the values of these particular items.5 Paton identifies some potential problems if HCA information is used to make business decisions. These center on earnings distribution and the~ maintenance of the productive capacity of organizations. He states: . . . depreciation accounting does not involve provision for physical replacements or the 'maintenance of capital in any ultimate sense. Continuous and successful operation, of course, requires the preservation of physical capital; and this means that in a period of rising prices not all of the apparent net earnings can be safely disbursed to investors.6 . Paton believes that if earnings distribution are based on the HCA earnings figure, insufficient earnings are retained by organizations to enable them to replace productive capacity (plant and equipment) as it Sibid., p. 429. 5ibid., p. 439. 6 is consumed. This is based on the premise that during a period of rising prices, net earnings are overstated due to understatement of depreciation. Thus, with earnings distribution based on the HCA earnings figure, the payout percentage will be too high. 2.2.2 Edgar 0. Edwards and Philip W. Bell - 1961 The work of Edwards and Bell is one of the most widely cited publications in attempts by accountants and economists to develop a more comprehensive and realistic means of measuring financial performance than provided by the HCA model. The major theoretical thrust of their efforts is the development of a bridge between income measurement as economists view it, and as accountants attempt to measure it. Economists approach income measurement-with subjective concepts taken from expectations about future events. Accountants, on the other hand, seek objectivity and the measurement of historical events. Edwards and Bell, however, contend that: . . . except for the difference in perspective, the two often deal with related problems and rely on similiar data. Because both points of view have proved themselves so useful in regard to their own special problems, a reconciliation is needed which does not at the same time destroy either the subjective approach of the economist or the accountant's emphasis (Ni objective events. 7 Thus, Edwards and Bell deal with and accept both points of view in an attempt to narrow the gap. 7Edwards, Edgar O. and Philip W. Bell, The Theor and Measurement of_ Business Income, University Of California—Press, I961,_p. viii. 7 Edwards and Bell approach financial performance measurement from a managerial accounting point of view. They believe the primary reason for. compiling accounting data is for management to evaluate paSt business decisions, and then to use the information for planning purposes. In doing so, they contend, management compares actual results with their expectations at the point in time when a decision was made, note and determine what caused any discrepancies, and then use the information to either change expectations about what they cannot affect, or make decisions which will bring future results in line with present expectations. Thus, . . . insofar as possible, accounting data must measure the actual events of a particular period, no more and no less. Events of earlier periods must not be confused with events of the current period; nor must any events of the current period 8 be omitted. Since there are changes in the economy which are difficult to predict (one being the inflation rate), expectations often (A) not coincide with ex post results. As such, management needs accounting data designed to interpret these changes as they occur. Edwards and Bell believe that: Unfortunately, the kind of accounting data currently being developed for both internal and external users falls far short of this ideal . . . (since) traditional accounting procedures are predicated implicitly on the utter absence of change.9 81bid., p. 5. 9ibid., p. 6. 8 The change which Edwards and Bell concern themselves with is the change in prices of specific assets held by a firm (specific price level changes). To a lesser extent, they investigate changes in the general price level. Thus, for both situations they believe the HCA model falls short of providing management with the relevant data for decision-making purposes during an inflationary period. Edwards and Bell emphasize changes in prices of specific assets held by the firm because of the relevance to their managerial accounting emphasis. They contend that since management is concerned with the allocation of resources held by the firm, changes in the specific prices of resources is the most relevant information for their decision-making purposes. Changes in the general price level are only important to the extent that they influence changes in the prices of specific assets held by the organization. They develop two concepts of income meaSurement as alternatives to HCA income measurement which they believe more realistically measure the extent to which past decisions have been right or wrong, and thus aid in the formulation of new decisions. These two concepts are realizable profit and business profit. Realizable profit is based on the measurement of opportunity cost and Edwards and Bell believe it to be the ideal cohcept for short-run income measurement purposes. It is made up of two components, realizable operating profit and capital gains. They define this concept of profit as follows: 9 Realizable operating profit is the opportunity cost of assets at the beginning of a production moment which is subtracted from the opportunity cost of assets at the end of a production moment. Operating profit arises because at least some of the assets of the firm have changed their form (or place) during the production moment. Operating profit is attributable solely to this change in form. Capital gains, on the other hand, result from holding activities alone» The amount of the gain is determined by subtracting the opportunity cost of the assets at the beginning of 'the holding interval from the opportunity cost of the same assets at the end of the holding interval. Except for the initial acquisition of inputs, capital gains result from Changes in date. The same value concept is applied to the same asset at two different points in time, any difference which is noted is a capital gain.10 The business profit concept is based on current cost data (current cost of existing assets held), and Edwards and Bell believed it has important advantages over the former when the long run is considered. It is also made up of two components: current operating profit and realizable cost savings. They define current operating profit as follows: Production itself generates no profit in the current cost approach because outputs are valued as the sum of the current costs of contained inputs. Profit arises when an exit value is substituted for the current cost of the inputs sold. 11 10 In other words current operating profit is the excess of the current value of goods sold over the current value of inputs used to produce the goods sold. It is arrived at by matching current costs of production with current sales values. The realizable cost savings component of business profit results from an increase in the current cost of assets held. The "savings“ can be attributed to the fact that the cost of an input increases between the time it was acquired and the time of its use during periods of inflation. Thus, the "savings" is the result of purchasing an asset before its price increases. Edwards and Bell advocate that HCA earnings arise from two activities, Operations of a firm and the holding of assets, during a period of inflation. In order to arrive at optimum business decisions, they maintain it is necessary for management to have accounting information which distinguishes between the two activities as they arise from two distinctly different economic forces. 2.2.3 Sandilands Report - 1975 During June of 1975 a study was completed in the United Kingdom (UK) which sought to begin the transition in the UK from presentation of financial information using the HCA model to presentation using the CVA model. The study was commissioned due to rampant inflation in the UK. The accounting standard setting bodies in the UK believed that the HCA model was no longer sufficient for presenting the true financial condition of companies to investors, creditors, management, and the government. The inflation accounting committee concluded that: 10ibid., p. 88. 11ibid., p. 97. 11 . . . the existing accounting conventions have failed to indicate the extent of the crisis and it has been suggested to us that they may even have added to the problems of companies by presenting misleading information to} management, employees, shareholders and others. In particular it has been suggested to us that on the basis of the 'profits' shown in their accounts companies have taken decisions (Ni dividends, wage and salary increases and other matters which contributed to the crisis p by prejudicing the future of the companies E themselves. Moreover, itewas suggested that by : applying tax assessments to the conventional ‘ 'profits' declared by companies ( albeit with certain adjustments and allowances) the Government itself has contributed to the liquidity crisis of 12 industry. Lf'i-DIO‘ ‘EJH ".q.l‘- . .. |.| - The Committee drafted three recommendations they believe should be implemented as quickly as possible due to the problems inflation is inflicting on the operations of companies in the UK. They are: "'T I..-h‘m_llWM.j-IJL ‘ nu. ‘ I. _, w. - .._. First, we consider that it is essential that accounts should allow for changes in costs and prices. Secondly, we consider that existing accounting conventions do not do so adequately, and tend to present the affairs of companies in a misIeading way. Historic cost accounting has served companies well for centuries, and retains many useful features during a period of rising costs and prices. However, its overall usefulness is sharply reduced during such a period as a direct result of some of the conventions on which it is 12Inflation Accounting Committee. Inflation Accounting: Report of thg_ Inflation Accounting Committee, London: Her Majesty's StatTOhery Office, 1975, p. 35. 12 based. Thirdly, .. . . we consider that the most fruitful line of development in inflation accounting is a system based on the principles of value accounting, which shows the specific effect of inflation on individual companies. We recommend that a system to be known as Current Cost Accounting should be developed.13 Current cost of assets, as the committee defines it, is a representation of their "value to the business". The "value to the business" of an asset is to be equated with the amount Of the loss suffered by the company if the asset is lost or destroyed. The committee takes the stance that there could be a number of ways of determining the value of an asset to a business. It could be the current purchase price of an asset (replacement cost), net realizable value (sales proceeds resulting from liquidation), or "economic value" which is the net present value of future cash flows generated from use of the asset in the production and sale of a product. In addition, the Committe emphasizes that there is no clear, predefined way to determine "value to the business" for all companies concerned. Rather, a good deal of judgement is involved as "value to the business“ can differ substantially depending on the particular operating characteristics of a business. 13ibid., p. 3. 13 2.2.4 Securities and Exchange Co-nission - 1976 14 In March of 1976 'the Securities and Exchange: Commission (SEC) issued Accounting Series Release (ASR) No. 190 which requires the largest of the U.S. corporations to disclose replacement cost information for fiscal years ending after December 25, 1976. This release applies to all SEC registrants whose inventories and gross property, plant and equipment are (1) greater than or equal to $100 million dollars, and (2) represents 10% or more of total assets. Accounting Series Release No. 190 evolved as a result of the Commission's belief that the HCA model is providing misleading information to security analysts and investors. They believe supplemental information is necessary in90rder to present the "economic reality" of companies' financial performance. The SEC defines replacement cost as "the amount that would have to be paid in the normal course of business to Obtain a new asset of equivalent operating or productive capacity."15The SEC's interpretation of productive capacity is the company's ability to produce and distribute their line of products. ‘ The required replacement cost information includes: (1) year-end replacement cost of inventory, (2) year-end gross replacement cost of productive capacity, (3) year-end depreciation replacement cost of productive capacity, (4) cost of sales based upon the cost Of replacing the goods at the time they were sold, (5) depreciation expense based on the average replacement cost of productive capacity for the year, (6) narrative explanation of 14This review is based on SEC Re lacement Cost Accounting: A_Guide to_ Implementation, Touche Ross—ETCO., 1977. 15 ‘ ibido, p0 1‘40 14 assumptions and methods used, and (7) other information to prevent disclosures from being misleading. 2.2.5 Financial Accounting Standards Board - 1979 In September of 1979 the Financial Accounting Standards Board (FASB) issued Statement No. 33, Financial Reporting and Changing Briggs, This statement establishes standards for reporting the effects of unstable prices on the financial performance and position of publicly held corporations with either (1) inventories and gross property, plant, and equipment greater than $125 million or (2) total assets amounting to more than $1 billion (after deducting accumulated depreciation). Statement No. 33 is based on objectives detailed in the FASB Concepts Statement No. 1, Objectives gf_Financial Reportingby_Business Enterprises. Concepts Statement N0. 1 inclUdes the following financial reporting objectives: . . . financial reporting should provide information to help investors, creditors, and others assess the amounts,.timing, and uncertainty of prospective net cash inflows to the enterprise (paragraph 37). It also calls for the provision of information about the economic resources of an enterprise in a manner that provides direct and indirect evidence of cash flow potential (paragraphs 40 and 41), and it concludes that management is accountable to the owners for protecting them to the extent possible from unfavorable economic impacts of factors in the economy such as inflation or deflation (paragraph 50).16 1"6Financial Accounting Standards 'Board, Statement of Financing (Footnote continued) 15 The Board believes it is necessary to disclose inflation adjusted financial information to assist management, creditors, and investors in making prudent business decisions. From both a micro and macro perspective the Board feels that if inflation adjusted financial information is not available, it will have adverse affects regarding the following types of decisions made by managers, investors, and economic policy setting bodies: . . . the cost of capital may be excessive for enterprises that can use capital most effectively. Resources may be allocated inefficiently and all members of society may suffer. Furthermore, people in government who participate in decisions on economic policy may not obtain the most relevant information on which to base their decisions.17 It is anticipated the adjusted information will be used for: a. Assessment of future cash flows. b. Assessment of enterprise performance. C. Assessment Of the erosion Of’ operating capability. d. Assessment of the erosion of general purchasing power.18 The FASB statement emphasizes that there will be no change in the primary financial statements (HCA model) since Statement No. 33 is largely of an experimental nature. Rather, the information is to be 16(continued) . Accounting Standards No. 33, Financial Reporting and Changing Prices, FASB, Stanford, CT, September, 1979, par. 2. 17 ibid., par. 4. 18ibid., par. 3. 16 used as supplementary information with the user gleaning relevant information through comparison with the HCA model results. In particular, it requires the disclosure of the following for enterprises with fiscal years ending on or after December 25, 1979: a. income from continuing operations adjusted for the effects of general inflation, b. the purchasing power gain or loss on monetary items, c. income from continuing operations on a current cost basis, d. the current cost amounts of inventory and property, plant, and equipment at the end of the fiscal year, and e. increases or decreases in current cost amounts of inventory, and property, plant and equipment, net of inflation. In sumary, disclosure requirements “a" and "b" relate to the constant dollar accounting (CDA) model, "c" and "d", relate to the current value accounting (CVA) model and requirement "e“ is a product of both models. According to the Board, current value refers to the ”current cost of the existing assets held by the enterprise." Thus, with regard to the CVA model, the current cost measurements relate to the assets owned and used by the enterprise and not to assets that would be used to replace them. The Board allows considerable flexibility to the preparers of the supplementary information. It is a requirement, however, to disclose in the notes to those statements the methodology for the adjustments as well as the rationale behind it. The primary reason for this flexibility is the experimental nature of the statement, since preparers and users of these supplementary financial reports have not 17 reached a consensus on the relative usefulness of constant dollar and current cost information. 2.2.6 Summary of Literature Review Dwo prominent theoretical works (Paton and Edwards and Bell) and three authoritative, professional pronouncements (Sandilands, SEC ASR No. 190, and FASB Statement No. 33) have been reviewed. Although written by different authors and in different time periods, there is considerable consistency worthy of being noted. Paton and Edwards and Bell advocate use of inflation adjusted financial information relative to specific assets held by an organization. Edwards and Bell suggest more detail and procedures which build on the more general concepts which Paton suggests. The thrust of their theories, however, is essentially the same. The Sandilands report and the SEC ASR No. 190 also advocate the use of the CVA model and are attempts to implement Edwards' and Bell's concept of operating profit and realizable cost savings which follow Paton's prescription. Although terminology' differs somewhat, consistency among these two professional announcements is evident. The FASB's pronouncement suggests use of the CVA model in addition to the CDA model. This, however, is based largely on debate among practitioners as to the best model to implement. In effect, the FASB attempted to cover both schools of thought on inflation adjusted financial information. The primary difference between the three professional pronOuncements relative to the CVA model is the interpretation of current valuation. The Sandilands Committee recognizes "value to the business" as the best method, the SEC advocates current valuation on 18 the basis of "replacement cost," and the FASB is in favor of “current cost of existing assets." This is indicative of a significant amount of debate about the "best" current valuation interpretation to implement. 2.3 Evidence of the Impact of Inflation 2.3.1 Non-cooperative Entities A study was conducted by the American Institute Of Certified Public Accountants (AICPA) which focuses on evaluating the results of the implementation of FASB Statement N0. 33. The study serves to indicate the significant effect inflation can have on the financial performance of a company. The data used are taken from the 1980 annual reports of companies which are required to comply with FASB Statement No. 33. What follows is a brief review of this study to indicate how inflation has affected the earnings and financial position of publicly held companies. The research relates the FASB Statement No. 33 disclosures to changing prices and capital formation, taxation, dividend payments, and the impact of inflation. It has been maintained by many accounting theorists and practitioners that unless revenues are greater than the current value of the resources consumed in operations, a partial liquidation of the company can be occurring. ‘ The following is an excerpt from the management letter to the stockholders of Campbell Taggart, Inc. concerning capital formation and is typical of such comments in management letters 0f corporations reporting under Statement No. 33. Management Summary. As shown by the accompanying finanCial analysis, severe inflation distorts the historical financial reporting of business, giving the false illusion of high profits 19 when, in fact, real profits - profits after deduction of inflation effects - have failed to keep pace with the rising costs of replacing buildings, machinery and equipment, maintaining inventories, and supporting new research and development. The growth of a company's assets and financial results must be substantially higher than increases in inflation or that company will suffer gradual liquidation.19 With respect to taxation, some companies comment on the impact which changing prices have on the relationship between reported income and taxes. They typically refer to "effective tax rates," or the relationship between actual taxes paid and earnings under the CDA and/or CVA accounting system. A typical management letter relative to this is as follows: In addition, provision for taxes on income has not been restated under either the constant dollar or current cost presentations although operating expenses have been increased $3.1 million and $3.2 million, respectively (1979 and 1980). This results in an increase in the effective tax rate from 51.0% under the historical cost method to 57.7% and 58.1%, respectively under the constant dollar and current cost methods. This relationship indicates the adverse effect of fixed tax rates in periods of rapid inflation.20 ‘ 19Goodman, Hortense, CPA (AICPA), et. al., Illustration ahd Analysis ‘Q:_Disclosures of Inflation Accounting Information - A survey of the a licatfiin of fh—e requirements 9_ Statements NIB-s.- , E and .33, American-Institute of CertifiedTPublic Accountants, p. 10. 20 ibid., p. 11. 20 Another widely held view is that changing prices can affect the relationship between reported profits and dividend payments. With respect to the impact of dividends on operations, a number of companies refer to the liqUidity squeeze caused by the need to maintain a "real" level of dividend payments and concurrently increasing investment in assets. The comment below from 'the Dayton Hudson Corporation is typical. Inflation is also increasing our need for capital. The adjustment to net earnings for current costs includes only the amounts necessary to replace existing facilities. Our cash flow must be sufficiently high to allow us to increase our capital base. Internally financed investment can take place only after payment of taxes and must compete with dividends for limited funds. In the future, the Corporation intends to use external sources more than we have in the past to make up the balance of our needs.21 In their analysis of the impact of inflation, the AICPA details key differences between the historical cost, constant dollar, and current cost information using aggregations of financial data based on fifteen Standard Industrial Code (SIC) classifications.’ The basic results are summarized as follows: (1) CDA and CVA income from continuing operations as a percentage of HCA income from continuing operations range from 25% to 77% and 5% to 69% respectively. (2) The ratio of current value of inventories to historical value range from 1.14 to 3.16. (3) The ratio of current value of gross property, plant and Zlibido, p. 120 21 equipment to historical value of gross property, plant and equipment range from 1.26 to 2.01. (4) The ratio of constant dollar and current value net assets to historical value net assets range from .81 to 2.48 and .84 to 2.81, respectively. A (5) Whereas effective tax rates under the HCA system range from 32% to 46%, they range from 44% to 268% for the CDA system and 46% to 92% for the CVA system. (6) The results of the relationship between CDA and CVA earnings per share (eps) and HCA eps range from 25% to 77% and 6% to 73% respectively. (7) Finally, profit retention as a percentage of shareholders' equity is on average 6.59% using the HCA system and 4.93% on the CDA basis. Capital is depleted by 2.45% on the CVA basis. ' The wide ranges of the relationships within both the CDA and CVA methodologies is due to differing degrees of capital intensity, differing methods of valuing inventory, differing levels of inventory turnover, and the types of fixed assets owned. For example, declines in profits after adjusting for changing prices are larger for more capital intensiwe operations. The relationship between current value of inventories and historical value of inventories is lower for the wholesale and retail industry, this being a reflection of high inventory turnover ratios in the wholesale and retail industry. In addition, the ratio of current value of gross property, plant and equipment and historical value of gross property, plant and equipment was higher for more capital intensive industries with long lived fixed assets such as "fining and construction. Thus, the extent of the CDA and CVA measurement variances from the HCA model measurements are not only dependent on the level of inflation, but also the relative Characteristics of the particular firm being analyzed. 22 2.3.2 Agricultural Cooperatives Although extensive inflation adjusted financial information has not been compiled for agricultural cooperatives, Rolf E. Haugen of Land 0' Lakes, Inc., a regional cooperative, succinctly summarizes his position that inflation has affected Land 0' Lakes, Inc. as well as other agricultural cooperatives. In 1974 our assets totaled $230 million. If we added the annual inflation to that amount, we would have needed an additional $210 million to finance those same assets in 1980. We saw an actual equity increase of $119 million during that same six year period. The message is that our increase in equity could not even finance asset inflation to say nothing about needed expansion that occurred during that. time. There is no question this same situation occurred in nearly all cooperatives.22 Haugen's statement suggests that inflation has also had an adverse impact on cooperative operations. In general, since cooperatives are operating in the same economic environment as publicly traded corporations, it: is doubtful that cooperatives can escape inflation's impact. In addition, since the financing arrangement of cooperatives has its own peculiar characteristics, the adverse effects of inflation may have stronger implications for cooperatives, particularly' with respect to the redemption of members' equity. E 22American Cooperation - 1982, “The Equity Problem - Survival," Haugen, Rolf, E}, American ‘Institute of Cooperation, 1800 Massachusetts Avenue, N.W. Washington D.C., Library of Congress Catalog Card Number 265276 - ISBN 0-938868, April 1982, p. 305. 23 2.4 Chapter Summary A discussion of a major shortcoming of the HCA model has been presented, along with a literature review and information which suggests the extent to which HCA data provides misleading information on the earnings and financial position of business organizations. The missing link, however, is a theoretically and practically sound conclusion as to which alternative accounting model and method of inflation adjusted measurement is best suited ‘to ‘the informational needs of agricultural cooperatives. The remainder of this research presentation seeks to provide this link for agricultural cooperatives. CHAPTER III COOPERATIVE PRIINIIPLES 3.1. Introduction This chapter highlights agricultural cooperative principles which are relevant to the theoretical justification of an alternative accounting model for agricultural cooperatives. A full scale treatment of cooperative principles is not intended, rather only those necessary for background information, and ones which will be referred to in subsequent chapters are presented. 3.2. Economic Distinction Between Cooperatives and Non-Cooperatives The motivation behind the cooperative form of organization is to realize economic benefits for its members through cooperative marketing and purchasing activities. Economic benefits primarily come in the form of competitive prices, access to markets, and a stable supply of inputs. Taken together, these benefits are intended to improve the individual members' economic position. Operations are “service-oriented," and agricultural producers become members of cooperatives in order to take advantage of the services rendered, not primarily as investor-owners. With service as its primary objective, the cooperative organization seeks to develop the best use of members' resources in an effort to meet members' needs economically and efficiently. The reason members invest in a cooperative (to acquire services), and the rationale for the cooperative's existence (to provide services) thrusts the engagement of the two parties into a "business objective" relationship. The net effect of this relationship is that the» member is doing 1 2 business with himself as the cooperative can be viewed as either a forward integration (marketing cooperative) and/0r backward integration (farm supply cooperative) of the individual members' farm Operations. There have been many definitions of agricultural cooperatives set forth which present broad concepts of what cooperatives are and how they operate. In virtually all of them, however, the definition is founded on the concept of a voluntary, self-help economic association of individual producers with the common interest of bettering their economic situation through cooperative action. Service (FCS) has concluded that: (1)- (2) (3) (4) (5) (5) (7) The basic purpose of cooperatives is to render economic benefits to members. Cooperatives are organized around the mutual interest of members. Risks, costs, and benefits are shared "equitably" among members. Cooperatives are nonprofit enterprises in the sense that they are organized for the economic benefit of members as users of the cooperatives' services and not to make profits for the cooperatives as legal entities or for their members as investors. Cooperatives are democratically controlled. Members of cooperatives have an obligation to patronize their cooperative. Cooperatives do business primarily with members.1 1Legal Phases of Farmer Cooperatives, Information 100, The Farmer Cooperative Farmer Cooperative Servizg, U.S. Department of Agriculture; May, 1976, p. 4. 3 A non-cooperative organization's primary goal is to maximize the value of shareholder's equity by capital gains_thr0ugh the form of stock price appreciation and by ordinary income through the form of corporate dividends. Although there are: many similarities in 'the physical operations of a cooperative and a non-cooperative, the pattern of decisions concerning comodities handled, services rendered, and operating procedures are made primarily with a "profit-minded" orientation. Owners strictly have an "investor relationship" with the organization, and benefits accrue to investors on the basis of the amount of capital committed to the organization. Normally, there is no other economic relationship between the investor and the organization other than the "investor relationship". To contrast this with the seven cooperative criteria as outlined by the PCS, one could say that: (1) The basic purpose for the existence of non-cooperatives is to render economic benefits to stockholders in the form of maximization of the value of stockholders' equity. (2) NonAcooperatives are organized around the mutual interest of stockholders strictly as investors. (3) Risks, costs, and benefits are shared among stockholders on the basis of the proportion of equity ownership in the organization. (4) Non-cooperatives are "for profit" enterprises to make profits for the organization in order that dividends may be paid and/or the stock price may appreciate - the basic determinants of the value of the investment. (5) Control of a non-cooperative by any one stockholder is in proportion to the amount of equity interest in the organization, since the 4 number of votes is based on the number of shares of stock owned. (6) Investors in a non-cooperative have no obligation to patronize that organization. (7) Non-cooperatives only incidentally transact business with stockholders. Although cooperatives and non-cooperatives have many operational similarities, the economic reason for the existence of the two forms of organization differs substantially. Thus, the basic economic objective of the two are quite different, and this has important implications in decision-making processes. For example, in answer to the question, “What's different'in managing a cooperative from any other type of business?“ Ralph Hofstad of Land 0'Lakes offered this answer: “Decision making technique is identical but the cooperativels objectives are different, therefore the manager's conclusions will be different."2 3.3. Legal Acts and Agricultural Cooperatives3 To understand why and how cooperatives came into being as a major force in the agricultural economy, a review of their legal history is warranted. This section will provide a brief overview of three acts of Congress which, have had a significant impact on the origination, organization, and expansion of operations of agricultural cooperatives to ‘what they are today. These three acts are: (1) the Sherman 2Cooperative Management, Cooperative Information Report 1, Section 8, Uhitedi States Department Of Agriculture, Agricultural Cooperative Service, June, 1981, p.3. 3This section is based on Knapp, Joseph G., Cgpper-Volstead Impact On Cooperative Structure, Information 97, Farmer Cooperative Sgrvice, U.ST Department Of Agriculture, February, 1975. 5 Antitrust Act (1890), (2) the Clayton Act (1914), specifically section six, and (3) the Capper-Volstead Act (1922). 3.3.1 Sherman Antitrust Act The Sherman Antitrust Act was favored by farmers who were seeking protection from “trusts" which were negatively influencing prices paid in the supply input market and prices received for products produced. ' Producers believed that control of the "trusts“ would put them in a more competitive position in the economy, as they were in large part at the mercy of private enterprise. During this period, cooperative marketing organizations were, just coming into being in the economy. The Sherman Act was eventually interpreted by the courts on the basis of the "Rule of Reason" rather than on the per se illegal basis. This meant that large business combinations were not restricted as long as their methods of operation were not "unreasonable." The Sherman Antitrust Act, however, did not fully address the specific problems of farmers, Until amended by the Clayton Act 24 years later, the Sherman Act was the unmitigated law of the land, but it provided no barrier at all to the growth of powerful business corporations. There was a tendency for the law to be strictly construed so that more concern was attached to the techniques of restraint of trade than with the great problem of monopoly power that concerned farmers. Morever, under the Rule of Reason enunciated by the Supreme Court in 1911, large business combinations were not restricted, so long as their methods were not deemed “unreasonable." Thus, when farmers began to develop strong cooperative marketing organizations after 1890 they ' found the Sherman Act more of a barrier than a 6 help. In fact, the act was frequently used against 4 them. During the early 1900's the first major agricultural cooperatives were being started. Despite the problems with the Sherman Act, these organizations were seen as a means to improve the bargaining power of farmers. Confronted by large corporate organizations on every side, farmers increasingly became convinced that their economic salvation depended (Ni their ability to fashion counter forms of organization adapted to their own needs. This desire to emulate the power of the big business corporation while preserving their own economic and social independence was thus a powerful factor, favorable to the development of cooperative organizations.5 3.3.2 Clayton Act I The Clayton Act of 1914 was designed to permit farmers to cooperatively market their products and purchase inputs while protecting them from the aspects of the Sherman Act which had previously been counterproductive to their efforts to increase their bargaining power. Section six of the Clayton Act permitted the formation .of business organizations for the mutual benefit of its members rather than for commercial profit provided they were non-stock organizations. This, however, was not designed to exempt farmers and their cooperative organizations from (antitrust action. Rather, it 4ibid., p. 2. 51pm, p.3. 7 stipulated that just because farmers organized for cooperative economic reasons, the organization was not to be disallowed. In short time, however, it became evident from various legal actions charging cooperatives with restraint of trade and the *wording Of the act pertaining to ownership of capital stock, that the Clayton Act would not fully serve the needs of farmers. With that, there was a drive for enactment of legislation which would be more precisely tailored to the needs of farmers. 3.3.3 Capper-Vblstead Act The Capper-Volstead Act is the result of the drive for more effective legislation and is viewed as “The Magna Carta of Agriculture“ as it provides for the development of strong, well organized, and well financed cooperative businesses. The Capper-Volstead Act is in line with the courts' former enunciation of the rule of reason as it tailors an institution to fit the particular characteristics of agriculture. The main thrust of the Capper-Volstead Act allows farmers to organize for their mutual benefit and not be in violation of the Sherman or Clayton Acts. In order to ensure this, an association cannot transact business with non-members to an extent greater than that with members and one of the following requirements has to be met: (1) no member of the association is allowed more than one vote because of the amount of stock or membership capital owned, or (2) such an association is not permitted to pay dividends on stock or membership capital in excess of eight percent per annum. Nothing within the act permits the creation of a monopoly, monopolistic practices, and Section two of the Act is designed to prevent "undue enhancement of prices.“ The Capper-Volstead Act is not designed as a device to allow farmers to 8 cirCumvent antitrust laws. Rather it recognizes the particular problems of agriculture and allows industry participants to organize in . such a manner that they will be on an even keel with other forms of business. The Capper-Volstead Act recognized the fact that if farmers were to continue to provide a stable supply of food products to consumers at reasonable prices (a public interest aspect of the legislation), they require cooperative groups which allow them to maintain a competitive position in the marketplace. Throughout the legislative debate leading up to the Act, as well as in the wording of the Act, legislators recognize the need for service organizations to maintain a competitive position. Thus, legislation was enacted to allow farmers the right to organize themselves so that necessary services could be competitively provided. 3.4. Copperative Organizational Structure and Relationships Organizational structure and relationships are an important factor . in the determination of the information which is provided to the key players which constitute an organization. The key players in the cooperative organizational structure are the members, the board of directors (BOD), and management. This section will provide background on the organizational structure of cooperatives with emphasis placed on respective responsibilities and the flow of communication between the key players. Producers form agricultural cooperatives in order to obtain needed services to enhance their individual economic situation. Along with the potential benefits of cooperation go the responsibilities to: (1) provide risk capital through front-end capital contributions and 9 non-cash patronage refunds, (2) understand and provide direction to the cooperative through the B00, and (3) have a voice in the broadest decisions relating to those required by State statutes and those required by the bylaws of the organization. It is the responsibility of the members to elect a competent board Of directors to represent their interests. The 800, which typically consists entirely of members, are elected by the members to represent them. They are the policymaking arm of the cooperative with respect to establishingoperational policies, long range plans, and control to ensure that management is operating the cooperative for the mutual benefit of members. "The board is a device through which members are able to retain involvement in, and maintain internal control of their cooperative.“6 A cooperative manager's role is to help formulate and then to execute policies, to operate the cooperative in an efficient, business-like manner on a day to day basis, and to maintain the financial stability of the association as it pursues its objectives. The BOO ‘hires management and delegates much of its authority to management, yet they are ultimately responsible for the viability of the cooperative. Often there are questions which arise with respect to the structural division of responsibility between the board and management, and often they overlap. In short, however, management is Charged with carrying out the policies established at the board level. 6Biggs, Gilbert W., Farmer Cooperative Directors ; Characteristics, Attitudes, U.S, Department Of Agriculture, Economics, Statistics, And Cooperative Service, FCS Research Report 44, February, 1978, p. i. 10 3.5. Principles of Cooperative Finance There are three Rochdale principles, derived from the objectives for which the cooperative form of organization was established, which directly affect the financial affairs of a cooperative.7 Cooperatives are organized by and for its members, and members receive the economic benefits of membership in proportion to their use of the cooperative. Along with these benefits goes the responsibility of members to provide equity capital in proportion to their use of the cooperative, the first cooperative finance principle. This ensures that members who are using the services of the cooperative are financing the assets that produce those services. Efficient implementation of this principle provides for an equitable financing arrangement among members. The provision of financing from the membership comes in three forms: (1) purchase of capital stock, (2) earnings retention on the basis of patronage, and (3) per unit capital retains. Capital stock is typically divided between common and preferred, voting and non-voting. When a producer becomes a member of a cooperative, a share of voting common stock is issued which entitles that member to one vote. This share of stock is usually minimal in amount. Other common and preferred shares are sometimes issued to raise additional capital. However, these normally do not carry any voting rights except in the case where the cooperative's bylaws stipulate that each member is allowed more than one vote. Dividends are sometimes paid on preferred shares, while most comon shares are non-dividend bearing. These capital shares are then retired or sometimes transferred to younger 7The Rochdale principles are principles of cooperation which grew out of a consumer cooperative organization in England in 1844 and provided the foundation for cooperative organizations in the United States. 11 members when a member either quits farming, severs the member-cooperative relationship, retires, or passes away. The second method of member financing occurs through earnings retention on either an allocated or unallocated basis. Earnings retained on an allocated basis are distributed to members on the basis of the volume of business transacted with the cooperative. Of these allocations, legal statutes require that twenty percent be paid in cash to cover the tax liability of patrons incurred by the allocation. Any percentage of the remaining eighty percent of earnings may be retained as an equity investment. The allocated equity capital is then transferred back to the patron either through a revolving fund or base capital plan method. If a portion of earnings are retained on an unallocated basis, the cooperative bears the tax liability of this portion and this equity is not revolved to members.8 The third method of equity financing is through per unit capital retains and is primarily used by marketing cooperatives. Per unit capital retains are amounts invested in cooperatives through deductions made from sales proceeds based on physical units marketed. These retains are then placed in a revolving fund and retired in the same manner as earnings. These three methods of financing are designed to facilitate the principle of current members providing current financing. The second finance related prinCiple is that only limited interest can be paid directly to capital stock if members vote on any basis other than one-member, one-vote. The dividend rate on stock is not to 8For a detailed discussion of these two methods of equity redemption, see Brown, Phillip F. and David Volkin, Equity Redemption Practices Of Agricultural Cooperatives, FC Research Report 41,- United States Department Of Agriculture, Farmer Cooperative Service, April, 1977. 12 exceed the legal rate of interest in the state of incorporation or eight percent per annum, whichever is greater. The effect of this principle is to maintain member control of the cooperative. With a limit to allowable dividends, capital contributions to cooperatives by investors other than members is normally not viewed as an attractive investment opportunity. Strictly speaking, investors are interested in maximizing the return on their equity investment in the form of cash. Knowing the cash return in the form of dividends based on an equity investment in a cooperative is limited, the typical investor would not consider a cooperative equity investment attractive. Members of a cooperative, on the other hand, derive a "return" primarily from the service benefits of the cooperative. Earnings distribution on the basis of patronage, the third principle, concerns a "price-adjustment" mechanism. Since cooperatives have a "business objective" relationship with members (provision of services), and not an "investor" relationship, the cooperative seeks to 1 provide services at cost to the members. Cooperatives charge market prices for goods sold or pay market prices for commodities members produce. Earnings are then distributed to individual members on the basis of the volume of business transacted with the cooperative. The “net price“ paid by members to a supply cooperative is the market price less the present value of the patronage refund. For marketing cooperatives, the "net price" received by members is the market price plus the present value of the patronage refund. Thus, prices are adjusted (overcharges are refunded), and the net effect is that the cost of providing the service to the member by the cooperative is the same as the Cost to the member Of acquiring the service. These 13 principles serve to shift the economic benefits of cooperative membership away from ownership and towards use of the services of the cooperative, the economic concept upon which cooperative Organizations are founded. CHAPTER Iv CONCEPTS OF INCONE ANO CAPITAL MAINTENANCE AND RESPECTIVE ACCOUNTING NOOELs 4.1 Introduction Each accounting model has a different concept of capital which is used as a basis for measurement. These concepts of capital and their respective accounting models are:- (1) financial capital and 'the historical cost accounting (HCA) model, (2) purchasing power capital and the constant dollar accounting (CDA) model, and (3) physical capital and the current value accounting (CVA) model. The first step in choosing an accounting model is to determine which concept of capital correlates with the economic objectives of the organization for which it will be used. With this in mind, these concepts .of capital and their corollary accounting models will be reviewed. As a preface to the discussion of capital concepts and accounting models, it would be well to review the two classifications of accounting information and_the general objectives of accounting measurement. 4.2. Financial and Managerial Accounting In a business organization management and investors are in general separate and to a certain extent are interested in the compilation of accounting information in varying degrees of detail and format. This .dichotomy leads to two classifications of accounting, managerial accounting and financial accounting, each based on the group of people it is to serve. The purpose of financial accounting is to “offer information to investors and lenders that is useful in assessing returns and risks associated with investment alternatives . . . it 2 should provide information on the efficiency and effectiveness with which management has used and is likely to use resources committed by the firm.“ 1 In other words, this information is used to determine if management is bearing their fiduciary duties properly. Much of the financial information required to be provided to investors by management is stipulated by ‘the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). The. FASB and the SEC work in tandem to develop financial reporting standards. These standards are designed to ensure the provision of information to the investing public which is reliable, comparable between firms, and consistent. Although the SEC has the legal authority from Congress to set accounting standards, this government organization has delegated much of the responsibility to the FASB.2 Managerial accounting information, on the other hand, is used by management in the decision-making process. Although much of ‘the financial and managerial accounting information ‘will overlap, managerial accounting information is more detailed in order to provide adequate information for day-to-day decisions as well as longer run planning functions. 1Davidson, Sidney, Clyde P. Stickney, and Roman L. Weil; Intermediate Accounting: Concepts, Methods, App Uses; The Dryden Press, Edition, page 26-1. For a more in-depth review of the accounting standard setting process, see Davidson, Sidney et.al., Intermediate Accountin: Concepts, Methods, and Uses, The Dryden Press, 198I782 Edition, Chapter 1. 3 4.3. Objectives of Accounting Information A study group from the American Institute of Certified Public Accountants (AICPA) has provided a summary statement of the objectives Of accounting information *which relates to both 'the financial and managerial accounting perspective. Accounting is not an end in itself. As an information system, the justification of accounting can be found only in how well accounting information serves those who use it . . . the basic objective of financial statements is to provide 3 information useful for making economic decisions. From the managerial accounting perspective, information needs of management are dictated in large part by the economic goal of an organization since this information is used to make decisions in an effort to achieve this goal. Thus, accounting information should be linked to the economic goals of an organization in order to make sound business decisions relative to these goals. Yuji Ijiri contends that the managerial accounting point of view tends to neglect the fact that accounting also has the purpose of maintaining an information flow from management to investors so management can be held accountable for their actions._ 3Study Group on the Objectives of Financial Statements, Objectives pj_ Financial Statements, American Institute of Certified Public Accountants, New York, October 1973, p. 61. 4 Viewed in this manner, accountability has clearly been the social and organizational backbone of accounting for centuries. . . . Implicit in accountability are the goals to be achieved. Proper accounting for activities, therefore, calls for the measurement of performance with respect to these goals.4 Ijiri goes on to state that . . . in order to understand accounting measurement in current accounting practice, accounting measurement must be analyzed from the viewpoint of performance measurement . . . Performance measurement may be defined with reSpect to many kinds of goals, such as economic, social, or engineering. However, the goals that are most commonly observed in accounting are economic goals. Accounting measurement may then be characterized as primarily economic performance measurement . .. .5 Ijiri places an emphasis on financial accounting information and takes a narrower view of the reason for this information than the AICPA. He advocates, however, that accounting information is useful to the decision making process by management, but it is only a part of the information which is used.6 Ijiri and the AICPA view the reason for' economic performance measurement from somewhat different perspectives. However, a common -4Ijiri, Yuji; Theor Of Accounting Measurement, Studies In Accounting Research £19, er cah‘ACcountingAssociation, page 32 to'33. 51pm" p. 34. 61bid., p. 47. 5 theme in the two views is that accounting information must be based on the economic goals of the organization in order for the concerned parties to make business decisions relative to these goals. 4.4. Concepts of Income and Capital Maintenance The measurement of accounting income seeks to approximate economic income. Economists typically define a man's income in terms of his satisfactions or inner enjoyments. Goods are defined as material objects whose use affords satisfaction, and services are actions which provide satisfactions. A man's well-being at any moment is measured by his command over satisfactions at that moment, and his total income for the year is the net amount of well-being over which he has acquired command during that period. 7 The classic definition of income is espoused by Sir John Hicks. He states: We ought to define a man's income as the maximum value which he can consume during a week, ahd still expect to be as well off at the end of the week as he was at the beginning.8 To adapt the above to a business organization setting, the income of a business is the amount it can distribute to equity owners at the end of the year and still be as well off at the end of the year as at the beginning. Relative to capital maintenance, if the company is equally as well off at these two points in time, then the organization has maintained its capital. There are different concepts of capital however, and the question becomes, "Which concept of. capital is the 7Baxter and Davidson, Studies ip_ Accounting Theory, 1962. 8Hicks, J. R., Va__l__ue _a__nd Capital: A_n_ Inguiry Int___o_ _S__ome Fundamental Principles Of Economic Theory, Second Edition, Oxford At The Clarendon Press, 1946, p. 174. 6 best representation for income measurement of agricultural cooperatives?” 4.4.1 Financial Capital Maintenance and the Historical Cost Accounting Model Financial capital maintenance is the dominant view now generally accepted for financial performance measurement. It is the capital concept upon which the HCA model is based, as the HCA model reports transactions on the basis of historical costs measured in nominal dollars. The financial capital concept purports to maintain the monetary value of assets contributed by owners at the time they were contributed and the unadjusted monetary value of earning retained by the entity. Income is measured only after the investment measured in monetary 'units is recovered.9 As discussed at the beginning of chapter two, it is maintained that the HCA model and associated financial capital maintenance concept, can provide a distorted measurement of financial performance under conditions of an unstable price level. 4.4.2 Purchasing Power Capital Maintenance and the Constant Dollar Accounting Model The use of the purchasing power capital maintenance concept for financial performance measurement measures income in terms of dollars of equal purchasing power or constant dollars, thereby obtaining a uniform measuring unit under unstable price level conditions. This concept of capital underlies the CDA model, and it reflects effects of 9Gamble, George 0., “Concepts of' Capital Maintenance," Journal .2: Accounting, Auditipg, and Finance, Summer 1980, page 223. ' 7 general price level changes on the operating performance and financial position of the firm. _It purports to maintain the purchasing power of stockholder's equity as of the beginning of the period plus or minus any changes such as additional investment and dividends on stockholder's equity during the period. Thus income is not measured until the purchasing power of those amounts has d.1° been maintaine The CDA model takes into account the changes in the general price level as it converts dollars of differing purchasing power to those of equal purchasing power. Thus, the cost of fixed assets are adjusted on the basis of general price level changes since the time of acquisition of the assets, and depreciation is computed on the basis of these adjusted values. Similiar adjustments can be made for inventories, and the cost of goods sold reflects the change in the general price level. In turn, earnings are adjusted to reflect the general price level changes, and the "real" progress and changes in owner's equity in terms of general purchasing power can be determined. These adjustments are particularly relevant to investors in non-cooperative businesses who are seeking a return 91 and o_n_ their investment in cash which at least keeps pace with general price level changes. Since investors postpone current consumption of a general market basket of goods in order to invest, their primary interest is to receive cash in the future in an amount that will purchase at least the same market basket of goods (a "real" return ‘pf. investment) and loibid.. pp. 225-226. 8 preferably' more ‘than one general market basket. of’ goods (a "real" return pp_investment). In other words, they are interested in a "real" economic rate of return in terms of general purchasing power. The CDA method of measuring income determines whether or not an entity has the earnings capacity to provide this return. 4.4.3. Physical Capital Maintenance and the Current value Accounting Model The physical capital maintenance concept of capital provides the base of measurement for the CVA model. This model reflects the effects of specific price changes of assets held on the operating performance and financial position of a firm. The purpose underlying the physical capital maintenance concept is that of maintaining the productive capabilities of an organization. Capital is defined as the operating assets of an entity. Thus income is not recognized until a 11 provision has been made to replace thoSe assets. When using the CVA model the value of fixed assets and inventories are adjusted to reflect changes in their specific prices. During periods when the prices of these assets are increasing, historical cost depreciation and cost of goods sold are adjusted to current value to reflect these higher prices. Therefore, when the -current value expenses are subtracted from revenue, earnings are not realized unless revenue is sufficient to cover the current value of expenditures. If revenue is sufficient for this, adequate earnings are realized to maintain the physical productive capacity of the enterprise. .llibid, p. 229. 4.5. Chapter Summary Three concepts of income and capital maintenance and respective accounting models have been presented. Each of the three has been advocated as being the "correct" one for financial performance measurement by various accounting theorists and practitioners. However, as far as a choice of an accounting model for agricultural cooperatives, the link between the fundamental economic goal of cooperatives and an accounting model has not been established. Materials presented in the following chapter seek to provide this link. CHAPTER V THE THEORETICAL LINK 5.1. Introduction The theoretical link between the economic goal of cooperatives and the appropriate accounting model to use in measuring the financial performance of agricultural cooperatives will be established in this chapter. The logic behind the link builds upon the concepts presented in chapters two through four. 5.2. Conceptual Frameworks In choosing an appropriate accounting model for any type of business organization, a conceptual framework for viewing the organization must first be laid. The conceptual framework provides for identification of financial performance viewpoint characteristics of relevant parties (members and managemeht in the case of agricultural cooperatives). These viewpoint characteristics have an important bearing on the type of accounting information needed, and therefore the specific objective of accounting information for the organization, the correct concept of capital to employ, and the appropriate accounting model. Thus, the conceptual framework will coincide with the accounting model and the capital concept underlying it. The choice of the conceptual framework is one of whether the cooperative should be viewed as a focus of the individual interests of the member-owners (proprietary theory), entirely separate from its member-owners (entity theory), or a hybrid of the two (perspective theory). A choice between these three must precede acceptance of either the CDA or CVA model. 5.2.1 Proprietary Theory If agricultural cooperatives were viewed as proprietary concerns, this would involve . . . . . the assumption that the entity has no existence apart from its owners and that accounting for the entity really is accounting for the owner's resources and obligations. Under this theory, stockholders' equity is described as being the stockholders' property. The need to maintain or increase their property in terms of general 1 purchasing power is especially appropriate . . . According to the proprietary theory of the firm, the assets of the organization are owned by the individual stockholders and the liabilities are considered as liabilities of 'the individual stockholders. Individual owner's equity is viewed as a claim by individual stockholders to the percentage of assets financed by it and liabilities as a claim to the percentage of assets which they finance. Following this logic, the cooperative is viewed as a composite of individual members' interests in the cooperative. If a member withdraws membership and his investment from the cooperative, the cooperative, as it was, ceases to exist as a "going-concern" since one part of the composite organization is lost. The proprietary theory provides the ideal characterization of an unincorporated business partnership. Under the legal statutes of the majority of the states, the personal assets of the partners as well as business assets are subject to claims of creditors if the partnership, 1American Institute of Certified Public Accountants, The Accounting Responses ‘Ip_ Changing Prices: Experimentation With —F3ur SMOdels, AICPA,Inc., New York, New York, 1979, p. 34. 3 as a business concern, does not meet its financial Obligations. In addition, investors in a partnership (the partners) are interested in increasing individual wealth through the partnership concern. The increase in wealth is obtained through salaries and by withdrawing earnings in order to comand control over consumption of a general market basket of goods in their individual private lives. The proprietary theory does not present the proper framework for the modern cooperative organization. The majority of agricultural cooperatives exist as incorporated organizations.2 AS such. members do not have a claim to the assets of the cooperative, unless of course the organization and its assets are liquidated. In this case, creditor obligations would be met- first, and any residual proceeds would be distributed in some fashion to the equity investors. Also, any liabilities are liabilities of the cooperative, and as such creditors do not have recourse to the individual members if the cooperative fails to meet its financial obligations. Thus, from a legal and financial standpoint the proprietary theory does not provide the proper conceptual framework for agricultural cooperatives. 5.2.2. Entity Theory The characterization of agricultural cooperatives under the entity theory is to say that . . . the firm is the sole focus of attention, and outsiders' interests, including stockholders', are viewed as essentially alike . . .3 2Legal Phases pj_ Farmer Cooperatives, Information 100, Farmer Cooperative Service, 07S. Department of Agriculture, May 1976, p. 38. 3American Institute of Certified Public Accountants, op. cit., p. 38. 4 ‘ According to this theory the cooperative is viewed as a distinct business concern, separate from ‘the individual members' interests. Assets belong to the entity. Liabilities and owners' equity represent the sources of financing of these assets, and therefore are the liabilities and equity of the cooperative. Legal facts support the entity theory as the member owners of the cooperative assume no liability for its debts, and they have no claim to the assets of the cooperative. Under the entity theory, if a member terminated his membership, the cooperative as it was will continue to exist, since it is viewed as distinctly separate from the members. In addition, when measuring the financial performance of a business organization, one basic accounting principle which applies is that . . .financial statements are prepared for an identifiable economic entity: Under a free market economic system, resources are committed to various units of activity, or entities (business -firms, industry associations, and so on). These entities then use the resources received to generate a return for the providers of capital. Financial statements provide information for* assessing 'the accountability of these entities for the resources received.4 Although the entity theory provides a better characterization of modern agricultural cooperatives than the proprietary theory, it is not quite complete. To describe the cooperative as strictly independent of its members is remiss because the reason underlying the existence of a cooperative is the common interest that members have in the services 4Davidson, Sidney, et. al., op. cit., p. 2-29. 5 the cooperative provides. Since the cooperative would not exist if it were not for this common interest, the cooperative cannot be viewed as strictly independent of those members. This must be accounted for in the conceptual framework to complete the characterization. 5.2.3 Perspective Theory In order to rectify this shortcoming of the entity theory as a conceptual framework for agricultural cooperatives, the perspective theory suggested by Paul Rosenfield is particularly applicable. The perspective theory is a framework . . . in which information about a separate entity and its resources and obligations and changes in them is designed from the perspective of the parties who have an interest in the entity.5 The entity and perspective theories are very similiar from the standpoint that financial information is prepared for an identifiable economic entity under both conceptual frameworks. However, the perspective theory goes a step further. It stipulates that the basis fOr the financial information is determined by the nature of the vested interest the principals have in the economic entity. With the perspective theory the needs of the cooperative's members and the goal of the cooperative organization come into focus. The function of an accounting model and explanation of accounting principles and procedures is stated in terms of the needs and purposes of the owners of the cooperative. In other words, the accounting model chosen is influenced by the purpose to be served by the result. This 5American Institute of Certified Public Accountants, 0p. cit., p. 43. 6 purpose stems from the perSpective of cooperative members, and as will be developed, is intertwined with the concept of physical capital maintenance. If the design is based on the perspective of cooperative members, a sense of identity with the cooperative existing to serve members is better established. 5.3. Meder Perspective, Physical Capital Maintenance, and the Current Value Accounting Model As brought out in chapter three, the goal of agricultural cooperatives is to provide service to its members which will aid these agricultural producers in improving their individual economic situation. Cooperative principles shift the emphasis of the organization away from ownership as in non-cooperative firms with maximization of the market value of the firm as the goal, and toward patronage of the cooperative with service to members as the goal. The existence of agricultural cooperatives stems from needs of members, and they are member-service oriented to fulfill these needs. Thus, it follows that the perspective from which members view their cooperative is its capability to provide, and its performance in providing those services. A significant part of the capability to provide such service is maintenance of the capacity to do so over some indefinite period of time. Members provide equity capital to the cooperative to finance assets which will produce service. Assuming members are interested in the ability of the cooperative to provide service as a “going concern,“ the cooperative must maintain the capacity to do so. As fixed assets are used to distribute inputs, market products, and generate services, they deteriorate and eventually must be replaced to continue generation of these activities. The primary factor in . 7 maintaining service capability, is_maintenance of the capacity to own service producing assets, since fixed assets form the physical productive capacity of the cooperative- Under the CVA model the physical capital maintenance concept is employed, and earnings are not realized until provisions have been made to maintain the physical capital of the cooperative, its service producing assets. Thus, the perspective theory and physical capital maintenance provide the ideal link to the economic goal of agricultural cooperatives. In turn, the CVA model is the corresponding accounting model to use for the financial performance measurement of agricultural cooperatives. This line of reasoning is summarized in Figure 1. Members‘ needs dictate the economic goal of the cooperative, and the goal determines the perspective from which they view the performance of the c00perative as it strives to attain this goals. In turn the objective of accounting information is provided, and the objective of accounting information dictates the capital maintenance concept (physical capital) employed, and the appropriate accounting model (CVA model). UMBER NEEDS (Service) - ECONOMIC GOAL (Generate Service) COWAL FRAMEWORK (Perspective Theory) L omcnv: or accouu'mc INFORMATION | (Financial Performance Measure-cut) CAPI'IAL MAINTENAEE COME]?! (Physical Capital Maintenance) ACCOUNTIM MODEL (CVA.Hbde1) FIGURE 1 Flow Diagram of Relationship Between Members and The Current Value Accounting Model 5.4. Chapter Summary The CVA method of measuring financial performance takes into account the service orientation of cooperatives. It should therefore, in theoretical terms, provide the most realistic and relevant. assessment of financial performance and the information necessary in making decisions as a cooperative strives to provide service to 9 members. Thus, physical capital maintenance and the CVA model is linked to members' perspective and the goal of the cooperative form of organization. CHAPTER VI CURRENT VALUE ACCOUNTING MODEL SPECIFICATION 6.1 Introduction This chapter provides the specification of the current value accounting (CVA) model used for empirical analysis. A basis for current valuation is first determined and one method of making current value adjustments is chosen. In addition, the accounts in the historical cost accounting income statement and balance sheet affected by adjustments are presented along with the formulas used for calculations. 6.2 The Basis for Valuation There are a number of classifications of current value which can be used in a current value accounting model, and one must be chosen before implementing such a model. These can be reduced to four basic classes: (1) current cost, (2) replacement cost, (3) net realizable value, and (4) economic value. These classifications can be» more generally classified as (1) entry (Edwards and Bell) or sacrifice (Ijiri) values (current cost and replacement cost), and (2) exit (Edwards and Bell) or benefit (Ijiri) values (net realizable value and economic value). A brief discussion of these two broader classifications, and how they provide a basis of measurement for accounting models will prove useful to understanding the concept of current valuation and the choice of a current value classification. Entry or sacrifice values represent the amount of disutility or outflow of economic resources required to obtain other economic ' resources. The economic resources obtained are then used in the 2 production of economic goods and/or services. Exit or benefit values, on the other hand, represent the utility or inflow of economic resources obtained from selling or consuming goods and services. All accounting models are based on "value differentials," since income measures are based on the difference between two accounting values. For example, the HCA model is based on an exit-entry (benefit-sacrifice) differential since income .is measured by the difference between realized selling prices (exit or benefit values) and historical acquisition costs (entry or sacrifice values). Revenue from sale of products or service will always be an exit or benefit value, inhile expenses can be based on either an exit (benefit) or entry (sacrifice) value. Thus, the choice of a current valuation basis for expenses will determine the value differential for the CVA model. 6.2.1 Current Cost Valuation Current cost valuation emphasizes measurement of depreciation and asset values based on assets owned by an entity. Although this could pertain to identical assets, service potential in terms of operating costs and physical output capacity as embodied by the assets presently owned is the crux of the current cost valuation. In other words, if identical assets or assets with equivalent service potential were purchased by a coOperative, equivalent services could be produced. Current cost is an entry or sacrifice value since there is an outflow of economic resources to acquire the assets. This measurement can be made by: 3 (1) Measuring the current cost of a new asset that has the same service potential as the used asset had when it was new (the current cost of the asset as if it were new) and deducting an allowance for depreciation; (2) Measuring the current cost of a used asset of the same age and in the same condition as the asset owned; (3) Measuring the current cost of a new asset with a different service potential and adjusting that cost for the value of the differences in service potential due to differences in life, output capacity, nature of service, and operating costs.1 6.2.2 Replacement Cost Valuation Replacement cost valuation represents the cost to acquire currently the best asset available to undertake the function of the present asset owned. This differs from current cost as defined above in that it ,emphasizes assets that would replace those owned if replacement were to occur. No adjustment is made for differential output capacity and operating costs if a technologically advanced piece of equipment would replace the equipment currently owned. Like current cost, replacement cost is an entry or sacrifice value since there is an outflow of economic resources to purchase the replacement asset. 6.2.3 Net Realizable Value Net realizable value is the cash or trade-in value that is received if an asset is sold or traded, less any related costs incurred by 1Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 33, Financial Re ortin and Changing Pricesz FASB, Stamford, CT, September, 1979, pp. 16-20. 4 selling or trading the asset. In terms of the general categories of valuation detailed above, net realizable value is an exit or benefit value since there is a cash, or its equivalent, benefit from ' liquidation of an asset - an inflow of economic resources. 6.2.4 Economic Value Economic value represents the net present value (NPV) of future cash flows generated from use Of an asset in a production process. This is an exit or benefit value since there are economic resource inflows derived from using the asset in a production process. The NPV of cash flows is arrived at by offsetting cash inflows with cash outflows over a period of time and discounting the difference back to the present using a relevant discount factor. 6.2.5 The Choice Of A Current Valuation Classification As discussed above, there are various current valuation classifications and one must be chosen. Justification for use of one of the classifications is based on two factors: (1) the cooperative and accounting theory outlined in chapters three through five, and (2) the concept of a “going concern.“ The "going concern" concept relates to the assumption that a cooperative \Nill continue to operate in an ongoing fashion and not liquidate their fixed asset base in the course of normal business activities. Calculation of the net present value of future cash flows is typically used in a decision-making process where major capital expenditures are being considered or for the valuation Of an entire company or subsidiary. Rarely, if ever, does it prove useful in determining the value of individual assets. It would be extremely difficult, if not impossible, to determine the revenue and cost streams 5 associated with individual assets, no one of which makes up a significant part of an entity's asset base as with the cooperatives under study. In addition, there are obvious problems with determining what discount factor should be used for discounting the cash flows generated as well as the time period over which the cash flows are projected. Thus, if the NPV valuation method were used to value assets currently, changes in the value of assets would be partially due to the discount factor chosen and the cash flow time period used, factors not necessarily, relevant to specific price' changes. Additionally, 'the current valuation would be based on a market exit value. This implicitly violates the assumption of a "going concern.“ Thus, economic value is rejected as a basis for current valuation on the grounds that it does not lend itself well to valuation of individual assets, and its use would violate the “going concern” assumption. In reviewing the applicability of net realizable ‘valueg it is readily apparent this would also violate the "going concern" assumption. It is a market exit value based on the premise of liquidation of the fixed assets of the cooperative, and thus would not be useful in placing a value on assets given the research goal at hand. According to FASB Statement No. 33, net realizable value should be used if the assets are expected to be sold and this amount is less than the current cost of the asset. The information (Hi what assets are expected to be sold" is not readily available, and there is no reliable means of’ estimating liquidation values. Therefore, net realizable value is not used for valuation of any fixed assets in the sample. Replacement cost valuation pertains to the best asset available to undertake the function of the present asset owned, and thus does not 6 focus on the assets held. One cooperative finance principle discussed in chapter three is the principle of service at cost. In keeping with this principle, if fixed assets are valued at replacement cost as defined above, the value may or may not apply to the assets presently held. If replacement cost is the basis for current valuation, current value depreciation expense is calculated accordingly. The altered depreciation expense would not only reflect possible changes in the price level, but also price changes due to technological advancement. If, for example, there had been technological advances, either increased physical output capacity or reduced operating costs could be the result of the advance. A price change of the asset could be due to the influence of the advanced technology, rather than strictly a change in the price of the asset. In effect, current members using the services of the cooperative could be "penalized“ through depreciation expense based on the advanced asset, an asset from which they did not reap benefits through lower operating costs or increased productive capacity. Thus, if replacement cost valuation is used, the cooperative finance principle of service at cost is violated. Furthermore, if earnings are distributed under a CVA model using replacement cost valuation, the earnings distributed do not correspond with assets used to generate those earnings. Therefore, the earnings distribution would not follow the principle of current members providing current financing through the vehicle of revolving patronage refunds. The current valuation method which best fits cooperative theory, as well as the “going concern" assumption, is current cost. Current cost 7 focuses on the assets currently held by the cooperative, and asset valuation and depreciation expense based on it will represent the current cost cfl’ providing existing service potential. Since current cost valuation focuses on assets presently owned, it is in keeping with the principle of service at cost, and in turn, provision of current financing by current members. Thus, current cost will represent the current value of consumption of capital assets presently owned, assets from which current members reap current benefits. In terms of the “going concern" assumption, current cost is an entry (sacrifice) value and earnings are not realized until provisions have been made for continuation of existing service potential. Thus, current cost parallels the “going concern“ assumption. Additionally, with the use of current cost in a current valuation model, the "value differential" of the model will be that between exit (benefit) values (revenue from sale of product and services) and entry (sacrifice) values (current cost of existing service potential.) 6.3 Methods of Current Cost Adjustments At this juncture, the major question to be answered before implementing the current cost accounting model concerns the method of making the current cost adjustments. The choices include: (1) direct pricing, (2) unit pricing, (3) functional pricing, and (4) indexing.2 6.3.1 Direct Pricing Determining current costs by the direct pricing method involves gathering current market price data for individual assets. Sources include purchase orders and invoices, published price lists, 2 Financial Re ortin and Chan in Prices: A guide tg_implementing FASB Statement 3_, ouc e-ROSS E Co., 1979, p. 78. 8 manufacturer's quotes, supply contracts, updated standard costs, and appraisals. The advantages of this method include the high degree of objectivity, and the feasibility of the use of the price for identical assets. Disadvantages primarily involved include the problem that detailed information required sometimes is not readily available. In addition, the asset may no longer be produced, and this would preclude the use of some of the above-mentioned sources. Another major disadvantage is typically there is considerable expense in terms of time and money to determine current costs using direct pricing. Although an attractive method of determining current cost information, direct pricing is rejected for this research effort on the grounds that the detailed information and necessary resources are not available. 6.3.2 Unit Pricing Unit pricing -is a form of direct pricing and involves the accumulation of cost. elements in,order to identify unit costs e.g., cost per bushel to construct a concrete grain silo. An advantage over direct pricing is that unit pricing may not require as detailed a record system as direct pricing. Once unit costs have been determined and the .quantity of assets to be revalued is established, the calculation is relatively simple. Problems arise with the objectivity of the information and current cost per unit may not include all costs if the asset were purchased, e.g. delivery costs. The type of information necessary for unit pricing is physical in nature, e.g. square-footage of warehouse space or grain storage capacity and is not available to this researcher. Thus, this approach is not taken. 6.3.3 Functional Pricing Functional pricing is used to determine the current cost of a production process with results expressed as cost per unit of output. The current cost of the function is calculated rather than the current cost of the specific asset. An. advantage of this method is that detailed information on individual assets is not required, however measurement of the cost and output capacity of similiar facilities is required. The primary disadvantage is that it maybe difficult to identify a logical cutoff point for the pricing of functions. To use this method requires much of the physical plant information required for unit pricing, and as mentioned above, is not available. Thus, the functional pricing method is not a reasonable alternative for this project. 6.3.4 Indexing Indexing involves the restatement of the base cost of an asset or group of assets by an appropriate index relating to specific price Changes of those assets. ' Advantages include ready availability of published indices, and ease of implementation. Disadvantages revolve around the possibility that up-to-date and accurate historical cost records may not be available, description of the assets in historical cost records may not be adequate, indices specifications may not match the assets, and items covered by the indices may change. The indexing method is chosen to make current cost adjustments for this research effort due to the fact that the information required to make such adjustments is included in the audited financial statements of the sample chosen for analysis. This includes a description of the individual assets held, date of acquisition of the assets, gross 10 historical costs, depreciation rates, depreciation expense for each asset, and accumulated depreciation data. In terms of objectivity, objective price indices are readily available to make the current cost adjustments.i 6.4 Adjustments to the Historical Cost Accounting Model Adjustments to the HCA model can be categorized by balance sheet adjustments and income statement adjustments. As mentioned earlier, the primary research goal places the emphasis on income» statement adjustments. The following is a description of the accounts adjusted in the income statement and the balance sheet. 6.4.1 Income Statement According to FASB Statement No. 33, the income statement accounts that should be adjusted to current cost values are the cost of goods sold (COGS) and depreciation expense. The COGS account is not adjusted in this analysis due to the method used to determine it in the HCA financial statements and the high inventory turnover rates of products handled. These two factors taken together will tend to place values on inventory and COGS which are representative of current cost. Inventory items are valued using the first-in, first-out (FIFO) cost-flow assumption in the historical cost financial statements. The FIFO method assumes that the oldest materials and goods are sold first. The FIFO cost-flaw assumption assigns the cost of the earliest units acquired to the withdrawal from inventory for measurement of the COGS, and the cost of the most recent acquisitions to the ending inventory. High inventory turnover rates are due to the seasonal nature of the commodities handled. Inventory items can be Agrouped according 'to grain, farm supply inputs (chemicals, fertilizer, fuel, etc.), and 11 merchandise (building supplies, hardware items, etc.). Inventory turnover rates are calculated for the farm supply inputs and merchandise classifications by dividing COGS by average month-end inventory values. These turnover rates are then averaged by the above classifications for the sample of cooperatives over ‘the five ;year period. The average inventory turnover rate for farm supply inputs is 11.48 times and merchandise 3.04 times. The implication of this is that since products handled turned through the facilities more than once a year, inventory is held for relatively short periods of time. In turn, price changes of products in the farm supply inputs and merchandise Classifications for COGS measurement purposes are reflected approximately three times per year and twelve times per year, respectively. Thus, it is assumed that price appreciation/depreciation of these inventory items is already reflected in the historical COGS account, and therefore historical COGS is representative of current COGS. Unique aspects of grain marketing make current cost adjustments to grain COGS irrelevant. Due to the nature of the grain market, grain prices are highly volatile. Given this, grain merchandising practices such as back to back cash sales, basis merchandising, and hedging are utilized to reduce the price risk associated with grain merchandising. Whichever technique is used, the grain marketing firm typically locks in a margin (cents per bushel) on grain purchased and then marketed. In effect, no matter what prices are paid and received for grain, a certain amount of margin is typically realized. Relative to COGS, the COGS amount can fluctuate considerably, yet margins realized on each 12 bushel marketed will typically remain fairly stable. The level of margins realized is more dependent on the merchandising techniques used and the expertise of the grain merchandiser than any other factors. The situation concerning depreciation expense arising from 'the capital consumption of plant and equipment is far different. In this case, fixed assets, by their nature, are held by a firm for at least a year to generate services for the members. It is hypothesized that historical value depreciation expense can differ considerably from current cost depreciation expense if the value of the asset changes over time. Thus, current cost adjustments are made for historical cost depreciation of plant and equipment. 5.4.2“ Balance Sheet In reference to valuation of farm supply input and merchandise inventory and FASB Statement No. 33, inventories are to be measured at current cost or lower recoverable amount at the measurement date. No adjustments to these inventory items are made in this analysis since the historical cost financial statements value inventory at lower of cost or market. Thus, if market value is less than historical cost, farm supply input and merchandise inventories are already adjusted downward to their recoverable amount as specified in FASB Statement No. 33.. Since a FIFO method of inventory valuation is used to determine the COGS for the operating statement, the inventory valuation at the balance sheet dates is the value of the most recently acquired inventory. This in combination with the high inventory turnover rates suggests that inventory values as shown in the HCA balance sheet are representative of the current cost of acquiring the same inventory. Balance sheet adjustments to grain inventory are also irrelevant 13 for this analysis. There is a ready market for grain on a daily basis, and current values of grain are established daily. Grain inventory is valued at the market price on the balance sheet date for the sample, and the market price is the price paid to producers, the current cost to the cooperative. In effect, grain is already valued at current cost, and therefore no grain inventory valuation adjustments need be made. Current cost adjustments. to property, plant, and equipment are required by the FASB Statement No. 33. Property, plant, and equipment is to be valued at the current cost or the lower recoverable amount of the assets' remaining service potential at the measurement date. Adjustments to plant and equipment at each of the five year-end dates for cooperatives analyzed are made in this analysis since these are long-lived assets and with price changes, their value can change considerably. I Adjustments to land values are not made for two reasons: (1) land is not a depreciable asset, does not "wear out, and thUs never needs to be replaced, and (2) there are no readily available and reliable indices to make a valuation of the land owned by the cooperatives, since local market conditions can vary substantially depending on local economic situations. If land values were adjusted to a current cost basis, the current cost Of total assets would be changed by the difference between the current cost and historical cost of land. 6.5 Index Adjustment Methodology 6.5.1 Index Sources Two sources provide the indices to make the current cost adjustments to the historical cost financial statements of the sample. ' 14 The base year for all indices is 1967 = 100. The indices are: (1) the producer price index (PPI) and (2) the Engineering News Record building and construction indices for the Detroit metropolitan area. In addition to a general PPI which shows the general rate and direction of price movement at the primary market level for finished, intermediate, and crude goods, there are also PPI's for various categories of primary market level goods. For example, there is a PPI for agricultural equipment with narrower categories such as tractors, elevators, nurse tanks, etc. The PPI's are calculated as weighted averages of price changes and only measure "real" changes. Influences such as changes in quality, quantity, terms of sale, etc. are factored out of the calculations. Prices used in the construction of the PPI'S are generally selling prices of manUfacturers, although some are list prices, book prices, or book quotes. The Engineering News Record (ENR) building and construction indices are cost ihdices for total construction and for buildings. They are calculated for various major metropolitan areas around the country as well as nationally on a monthly basis. Both the construction index and the building index have four components - three material items and one labor component. The three material items are the same for both the ENRB and the ENRC and these items are: (1) the base price of structural steel, (2) the net price of cement, and (3) lumber. The labor component for the ENRB is a composite of the labor rate for three skilled construction positions; carpenters, bricklayers, and structural iron workers. The ENRC labor component is the common labor rate. The ENRB index is used to adjust to current COSt the historical values of buildings and structural improvements shown in the audited 15 financial statements over the five year period analyzed. These buildings include warehouses, offices, grain storage bins, etc. The ENRB is used for adjustments of the above-listed assets since skilled labor is typically utilized in their construction. The ENRC index is used primarily for such items as land improvements and blacktopping. The common labor rate, the labor component of the ENRC, is more reflective of labor utilized for this type of construction. Both groups of indices are “Laspeyres” indices. The weights of the indices are quantities of the base year (1967), and the weights are assigned to a particular item for the given year. The weight represents the relative importance of the commodity with respect to other commodities included in the computation. 6.5.2 Adjustment Procedures Four primary current cost calculations are made for plant and ~equipment in order to provide comparative current cost financial information. They are: (1) current cost depreciation expense (CCDEP), (2) net current cost of plant and equipment at the end of the year (NCCPEE), (3) current cost net margins (CCNM), and (4) realized holding gains (RHG). The above accounts can be defined as follows: (1) CCDEP: represents ' the current cost of expiration of service potential of plant and equipment throughout the operating year measured on the basis of the average current cost of the assets' service potential during the period of use. (2) NCCPEE: represents the current cost of acquiring the same service potential as embodied by the assets owned, relative to the amount of depreciable life remaining, a proxy for useful life. A 16 (3) CCNM: represents that part of net margins, as determined by the historical cost accounting model, which arise from operations of the cooperative. The CCNM is equivalent to what FASB Statement No. 33 defines as current cost income from continuing operations. (4) RHG: represents that portion of historical cost net margins which arise from holding an asset. The holding gain arises from owning the asset while the price of the asset is changing over the course of an accounting period. Calculations for each plant and equipment asset listed in the fixed asset schedules are made to determine the above categories of current cost information. These are then totaled to determine aggregate amounts for each entity for each fiscal year. In order to arrive at the above calculations for each asset, preliminary calculations are necessitated. They are as follows: (1) DEPRATE = HCDEP / GHC, where DEPRATE = depreciation rate; HCDEP = historical cost depreciation; and GHC = gross historical cost. (2) CFBYR PIBYR / PIACQYR, where CFBYR = conversion factor, beginning of year; PIBYR = price index, beginning of year; and PIACQYR = price index, acquisition year. (3) GCCPEB = GHC * CFBYR, where GCCPEB = gross current cost, beginning of year; GHC = gross historical cost; and CFBYR - conversion factor, beginning of year. (4) CFEYR PIEYR / PIACQYR, where CFEYR = conversion factor, end of year; PIEYR = price index, end of year; and PIACOYR = price index, acquisition year. (5) GCCPEE = GHC * CFEYR, where GCCPEE = gross current cost, end of year; GHC ='gross historical cost; and CFEYR = conversion factor, end of year. (6) are (1) (2) (3) (4) 17 %DEPLEYR = (1 — AOEYR/GHC), where %DEPLEYR = percent of depreciable life remaining, end of year; ADEYR = historical cost accumulated depreciation, end of year; and GHC = gross historical cost. Using these preliminary calculations, the four primary calculations made using the following formulas: CCDEP = (GCCPEB + GCCPEE / 2) * DEPRATE, where CCDEP = current cost depreciation; GCCPEB = gross current cost, beginning of year; GCCPEE = gross current cost, end of year; and DEPRATE = depreciation rate. NCCPEE = GCCPEE * %DEPLEYR, where NCCPEE = net current cost, end of year; GCCPEE = gross current cost, end of year; and %DEPLEYR= percent of depreciable life remaining, end of year. CCNM = HCNM + HCDEP - CCDEP, where CCNM = current cost net margin; HCNM a historical cost net margin; and CCDEP = current cost depreciation. RHG = CCDEP - HCDEP, where RHG = realized holding gain; CCDEP a current cost depreciation; and HCDEP a historical cost depreciation. Two implicit assumptions being made by using the indexing adjustment procedures outlined should be detailed at this point. It is assumed the adjustments reflect the current cost of the same service potential of the used assets of the cooperative as if they were new, less the allowance for depreciation. Additionally, it is assumed the price indices correlate closely with the assets and price changes of those assets owned by the sample of cooperatives. CHAPTER VII CHARACTERISTICS OF THE SAMPLE AND EMPIRICAL RESULTS 7.1 Introduction Results of the empirical analysis are presented and interpreted in this chapter using percentage relationships. These relationships compare results of financial data criteria as Shown in the historical cost financial statements with results of the current cost accounting model implemented. Five relationships are analyzed, one dealing with balance sheet accounts and four with income statement accounts. Prior to presenting the results and interpretation, however, selected historical cost financial relationships are presented to provide perspective on the extent of involvement of each cooperative in the grain versus farm supply business and the degree of capital intensity of each. The degree of capital intensity has a direct bearing on the extent to which price changes affect the financial performance of an organization. Additionally, details regarding preparation of the historical cost accounting financial statements are presented to provide information on the data which are adjusted to current cost. 7.2 Sample Characteristics Nine grain marketing/farm supply cooperatives from the state of Michigan were Chosen for the empirical analysis. Ten organizations were asked to participate in the study, and nine of the ten responded favorably. The number of cooperatives for the sample was determined on the basis of access to financial statements with sufficient detail to 1 2 make current cost adjustments, and the necessity to maintain the project at a manageable level. The analysis covers a five year period for two reasons: (1) the necessity of consistency of auditing procedures with respect to inventory valuation and depreciation methods, and (2) to maintain the project at a manageable level. Of the nine organizations in the sample, the five year period for five of the entities is from fiscal year ends 1977 through 1981, and for four of the entities, fiscal year ends 1978 through 1982. The cooperatives have various months in which their fiscal years end. One year of historical cost financial data (cooperative number nine, 1982) does not have sufficient detail in the fixed asset schedule to make current cost adjustments. Thus, there are forty-four years of historical cost financial data for which adjustments are made. Average total sales for two of the cooperatives over the five year period is approximately $12 million with average total assets over the five year period at $4.1 million and $4.85 million. Two Other' cooperatives have average sales between $1.1 million and $1.4 million with average total assets of $345,000 and $761,000. The average sales for the other five cooperatives ranged from $3.6 Inillion to $5.7 million along with average total assets ranging from $1.5 million to $2.8 million dollars. The sales volume and asset bases of the sample cooperatives are representative of local grain/farm supply cooperatives in the state of Michigan. Additionally, the nine cooperatives represent approximately twenty percent of the grain/farm supply cooperatives in Michigan. The sample is non-random as the cooperatives are hand-picked in order to 3 ensure a reasonable degree of uniformity in the composition of fixed asset bases to facilitate the current cost adjustments. 7.2.1 Historical Cost Financial Relationships To provide financial information which characterizes the sample, the following relationships are tabulated and analyzed: (1) grain and farm supply sales as a percentage of total sales (appendix Table A.1.), (2) fixed assets as a percentage of total assets (appendix Table A.2.), (3) labor-related expense (salaries and images, payroll taxes, and fringe benefits) as a percentage of total expenses (appendix Table A.3.), and (4) historical cost depreciation expense as a percentage of total expenses (appendix Table A.4.). The composition of sales relationship is> provided to gain perspective on the primary lines of business in which the sample cooperatives are engaged. Using (approximately fifty percent grain sales and fifty percent farm supply sales as a breaking point, it is seen that none of the cooperatives in the sample are primarily engaged in the grain business. Five of the cooperatives (numbers 2, 3, 4, 6, and 7 - grain/farm supply cooperatives) are engaged in the grain business to approximately the same extent as the farm supply business over the five year period. Four of the cooperatives (numbers 1, 5, 8, and 9 - farm supply cooperatives) are primarily engaged in the business of selling farm supplies. Thus, the weight toward at least fifty percent farm supply business should be noted in the interpretation and use of the empirical results. The fixed asset, labor-related expense, and depreciation expense relationships provide an indication of the relative capital intensity of the cooperatives. The fixed asset relationship ranges from 15.7 4 percent (cooperative number 7, 1980) to 45.3 percent ,(cooperative number 6, 1978) with an average of 25.2 percent and a median value of 30.5 percent. Labor-related expenses as a percentage of total expenses ranges from 40 percent (cooperative number 4, 1981) to 60.7 percent (cooperative number 2, 1979) with an average of 49.9 percent and a median value of 50.4 percent. The depreciation expense relationship ranges frmn 5.5 percent (cooperative number 1, 1981) to 18.2 percent (cooperative number 6, 1982) with an average of 8.9 percent and a median value of 11.9 percent. Generally speaking, an agri-business organization primarily engaged in the grain business will be more capital intensive than one primarily involved in the farm supply business. If viewed on a continuum as in Figure 1, the degree of capital intensity will increase as more of the business shifts towards grain. All of the cooperatives in the sample have at least fifty percent of total sales volume in farm supply sales in one or more years. Taken as a whole, these three relationships suggest that the relative degree of capital intensity of the sample is towards the bottom half of the scale. 1001 501 1002 PART! SUPPLY FARM SUPPLY GRAIN BUSINIISS BUSINESS ~ BUSINESS IICREASING DEGREE OF CAPITAL INTENSITY Figure 1 Capital Intensity Continuum If the three relationships are analyzed. for the farm supply cooperatives and the grain/farm supply cooperatives as separate categories, the data suggests that the degree of capital intensity as represented by these three relationships is higher for the grain/farm supply cooperatives. 6 Table 1 Comparative Capital Intensity Relationships (Percent) FarmSupply ‘GrainiFarmSupply Relationship Cooperatives Cooperatives (1. 5. 8. 8- 9) (2. 3. 4. 5. 4 7) Average Medain Averagefiedian Range Value Value Range Value Value Fixed Asset 16.2 -37.4 24.3 26.8 15.7 -45.3 29.2 30.5 Labor Expense 43.8 -58.1 50.0 51.0 40.0 -60.7 49.7 50.4 Depreciation Expense 505 " 908 706 7.7 608 -1802 909 1205 Source: Appendix Tables A.2. - A.4. As noted in Table 1, the average and median values for the fixed asset and depreciation expense relationships are higher for the grain/farm supply cooperatives. On the other hand, values for the labor expense relationship are slightly higher for the farm supply cooperatives. Thus, a higher degree of capital intensity is suggested for the grain/farm supply cooperatives. 7.2.2 Historical Cost Financial Statements The historical cost financial statements are prepared in accordance with generally accepted accounting principles. Inventory is valued at the lower of cost or market on a first-in, first-out (FIFO) basis with provisions for any obsolete items. Fixed assets are recorded at cost, and depreciation is computed using the straight-line method generally within the following guidelines: buildings - 20 to 40 years, machinery - 10 years, and trucks and Spreaders - 3 to 8 7 years. The inventory valuation and depreciation methods are consistent for all cooperatives for the five years analyzed. 7.3 Balance Sheet 7.3.1 Comparative Relationship The balance sheet relationship is a comparison of the net current cost of plant and equipment at the end of the year (NCCPEE) to the net historical cost of plant and equipment at the end of the year (NHCPEE). This percentage relationship provides an indication of the extent of the variation between historical cost valuation and current cost valuation of plant and equipment. Asset values compared are on a net cost basis, net cost representing gross cost less accumulated depreciation. It is expected that this relationship will be greater than 100 percent in all years analyzed. Although the price level as represented by the producer price index and the Engineering News Regggg building and construction indices increases in each year, the relationship will not necessarily increase with each succeeding year. The NCCPEE:NHCPEE relationship is influenced by fixed asset expenditures, and will increase with each succeeding year only when a stable asset acquisition pattern exists. 7.3.2 Results and Interpretation Summary figures for the balance sheet relationship NCCPEE:NHCPEE are provided in Table 2. .AS seen in Table 2, the percentage relationship was greater than 100% in all cases. A percentage relationship greater than 100 percent suggests an undervaluation of 8 assets when HCA measures are used. A relationship of exactly 100 percent would suggest that historical cost fully represents current cost. TABLE 2 Net Current Cost Of Plant And Equipment As A Percentage Of Net Historical Cost Of Plant And Equipment (Percent) COOPERATIVE # 1977 1978 1979 1980 1981 1982 1 148.1% 189.5% 215.2% 138.8% 141.3% N/A- 2 144.0% 131.0% 117.7% 134.8% 139.3% N/A 3 145.1% 156.3% 167.5% 178.2% 185.8% N/A 4 142.3% 168.4% 178.1% 185.9% 124.6% N/A 5 143.6% 128.3% 136.4% 145.0% 143.5% N/A 6 N/A 148.0% 160.6% 164.0% 177.0% 174.7% 7 N/A 178.9% 180.5% 189.2% 175.4% 158.1% 8 N/A 161.2% 164.6% ' 168.8% 146.7% 146.8% 9 N/A 119.2% 122.7% 130.8% 133.1% N/A Source: Appendix Tables 8.1. and 8.2. The value of the NCCPEE:NHCPEE relationship varies over the five year period due to unstable asset acquisition patterns. Since fixed asset expenditures are at current cost in the year incurred, "above normal" capital expenditures will tend to increase the historical cost of net plant and equipment at the year end to a value more reflective of the current cost of net plant and equipment. In turn, this will lower the NCCPE:HNCPE relationship from one year to the next since historical cost then becomes more reflective of current cost. sustained increases in prices as Theoretically speaking, with 9 represented by the price indices used, the NCCPEE:NHCPEE will never fall below 100 percent. It will, however approach 100 percent as substantial fixed asset expenditures force net historical cost to be more reflective of net current cost. Table 3 provides data on the relationship between expenditures for plant and equipment and the net historical cost of plant and equipment at the beginning of each year for all cooperatives and years analyzed. The data further suggests the impact capital expenditures have on the NCCPEE:NHCPEE relationship. For example, the relationship for cooperative number 8 decreased from 168.8% to 146.7% from 1980 to 1981 when the capital expenditure relationship increased from 12.6% to 53.0%. Note this correlation between these relationships for other cooperatives and years. TABLE 3 Capital Expenditures For Plant and Equipment As A Percentage 0f Met Historical Cost Of Plant And Equipment (BYR)* (Percent) R # 9 9 1 37.4% 2.9% 8.5% 228.0% 28.0% N/A 2 24.2% 28.1% 42.5% 40.4% 26.6% N/A 3 62.6% 5.0% 5.0% 6.4% 13.2% N/A 4 22.2% 8.2% 5.9% 6.9% 220.4% N/A 5 2.1% 86.2% 10.1% 9.8% 26.2% N/A 6 N/A 66.9% 7.8% ‘ 8.7% 2.6% 12.8% 7 N/A 8.1% 21.6% 15.2% 47.8% 65.1% 8 N/A 11.4% 12.3% 12.6% 53.0% 17.3% 9 N/A 26.6% 42.9% 35.9% 23.2% N/A *Beginning Of Year Source: Appendix Tables C.1. and C.2. 10 7.4 Income Statement 7.4.1 Comparative Relationships Four income statement relationships are analyzed to determine the extent of the hypothesized distortion in historical cost income measurement. They are a comparison between (1) current cost depreciation (CCDEP) and historical cost depreciation (HCDEP), (2) return on sales on a current cost basis and return on sales on an histOrical cost basis, (3) realized holding gains (RHG) as a percent of total sales, and (4) cash distributions at the end of the year (CD) and current cost net margins (CCNM). Cash distributions represent cash patronage, dividend, and income tax payments at each fiscal year end. The HCNM account used in the inCome statement relationships is HCNM before taxes. The first income statement relationship (CCDEPzHCDEP) provides an indication of the extent to which'current cost depreciation expense varies from that obtained using the HCA model. It is anticipated this relationship will be greater than 100 percent in all years analyzed. This is to say that depreciation is expected to be understated in "real" terms when the HCA model is used. The rationale for calculating the values for the relationship is to determine the extent of the distortion. The return on sales (ROS) calculation, the second income statement relationship, is a commonly used measure of profitability. It compares earnings to sales for a particular accounting period (in this case a fiscal year) to determine what percentage of the total sales dollar constitutes earnings. The current cost ROS (CCNM:SALES) and historical cost ROS (HCNM:SALES) are calculated and then compared by 11 subtracting the current cost return from the historical cost return to determine the extent of variation between the two percentage relationships. The difference between historical cost ROS and current cost ROS is equal to RHG:SALES, the third income statement relationship. It is indicative of that portion of HCNM which generates a ROS from holding activities. The ROS relationships provide perspective of profitability in "real“ terms as compared to ‘the~ historical cost profitability measurement. LaStly, the fourth relationship (CD:CCNM), is an indicator of the extent to which capital is distributed relative to net margins realized on a current cost basis. This relationship will provide insight as to the extent, if any, that earnings distributions have liquidated capital of the cooperatives. If more cash is distributed than realized in "real" terms (current cost net margins), then capital liquidation can be said to occur. Thus, a CD:CCNM relationship greater than 100% is indicative of capital liquidation through earnings distribution. The CD:CCNM relationship is also compared with the relationship between cash distributions and HCNM. This comparison suggests whether or not HCNM have prompted decision-makers to pay out significantly more in cash than would have been paid if net margin distributiods were based on the current cost measurement. 7.4.2’Results and Interpretation Results of the first income statement relationship analyzed, CCDEPzHCOEP, are tabulated in Table 4. As seen in Table 4 the CCDEPzHCDEP relationship was greater than 100% in all years for all cooperatives. A relationship of exactly 100 percent would suggest 12 that HCDEP is fully representative of CCDEP. The higher the percentage relationship is above 100 percent, the greater the extent to which the HCA model understates depreciation expense. TABLE 4 Current Cost Depreciation Expense As A Percentage Of Historical Cost Depreciation Expense (Percent) COOPERATIVE 4 1977 1978 1979 1980 1981 1982 1 149.8% 140.7% 149.2% 167.7% 140.4% N/A 2 135.2% 140.5% 145.3% 139.1% 140.3% N/A 3 149.9% 152.7% 155.7% 178.9% 190.3% N/A 4 165.4% 164.7% 171.8% 173.5% 151.5% N/A 5 137.3% 140.7% 138.5% 143.0% 145.0% N/A 6 N/A 148.8% 147.1% 156.1% 166.3% 159.4% 7 N/A 151.1% 155.5% 154.0% 151.4% 141.8% 8 N/A 155.6% 153.3% 173.9% 157.8% 149.5% 9 N/A 144.7% 146.4% 135.7% 152.7% N/A Source: Appendix Tables 0.1. and 0.2. The results of the CCDEP:HCDEP relationship are fairly consistent for each of the cooperatives over the years analyzed. In three cases year to year changes in the relationship are greater than 20 percentage points, but not higher than 27.3 percentage points. Changes in the relationship are between 10 and 20 percentage points in nine cases, and in all other cases the year to year fluctuations are less than 10 percentage points. Like the NCCPEE:NHCPEE relationship, the CCDEP:HCDEP relationship is influenced by capital expenditures. With a substantial amount of 13 capital expenditures in one year, the historical cost of plant and equipment is more reflective of current cost, and in turn historical cost depreciation is more refleCtive of current cost depreciation. Thus, there will tend to be a subsequeht reduction in the CCDEP:HCDEP relationship from one year to the next as for cooperative number one between 1980 and 1981. For the cooperatives taken as a whole, the depreciation relationship ranges from a low of 135.2 percent to a high of 190.3 percent. Average and median values are 152.9 percent and 162.5 percent respectively. Variations between cooperatives are influenced by the different compositions of plant and equipment and their related price changes. In general, however, the depreciation relationship is reasonably consistent. Data for the comparative return on sales (ROS) calculations are provided in Table 5. These data suggest that profitability as measured using the HCA model is very close to being representative of CCA profitability measurement. The percent differences between HCA ROS and CCA ROS are very consistent for individual cooperatives over the years analyzed (see Table 6). For the cooperatives as a whole, in only three instances (cooperative 4 iri 1977, 1978, and 1979) is the difference greater than one percent. Additionally, differenCes are within a tight range (0.3 percent to 1.3 percent). For all cooperatives and years, the average difference is 0.7 percent and the median deviation is 0.8 percent. The consistency of the results also suggest a certain amount of reliability in the current cost adjustment methodology used. .c.m . .~.u mo~n8h newconq< "oucaom 14 (\z (\z. 8.8 «.8 8.8 8.. 8.8 8.8 5.8 8.8 (\2 «\z a ".8 8.8 .8.~. ~.8 8._ e.~ 8._ 8.“ .8.~V .8.~. (\z (\z 8 .8... .8... 8.8 _.~ 8.8 8.8 8.8 m._ «8. ~.8 (\z (\z A 8.8 8.8 8.8 5.8 8.8 «.8 ~.e 8.8 . 8.8 ..8 (\z (\z 8 (\z <\z 8.. 8.8 .8.~ 8.8 . _.~ L.~ 8.~ 8.~ . L.~ _.m 8 (\z «\z 8.8 8.“ 8.m 8.8 8.8 8.8 “8.88 5.8 N.A 8.~ 8 (\z <\z A8.88 «.8 A8.. ~.8 «.8 8.~ N8. ..8 8.. e.~ m <\z <\z 8.. 8.8 8.5 8.5 ~.L _.e 8.8 _.8 8.8 8.8 N <\z (\z 8.“ _.~ 8.~ 8.8 _.~. L.~ 8.8 8.“ A_.88 A8.~8 _ mm—am mu—om mmpmm mw—nm mmpnm mmpmm mm—nm mopam mwpam mwpam mw—om mm—nm ‘ 03.995259 :2 88 >2 8: >288 228: >28 >28: >28 :28: >2 8 :28: >28 >28: ~88~ a88_ 88a“ 85m. 8~a_ Asa“ Accoucoav «open —ouch ac unaccoucom < n< nepacu: an: «889 aeoccau e=< umou poo—coum_= m «pack 15 TABLE 6 Current Cost Return On Sales Differences From Historical Cost Return On Sales (Realized Holding Gains As A Percentage Of Sales) (Percent) COOPERATIVE 4 1977 1978 1979 1980 1981 1982 1 0.5 0.5 0.6 0.5 . 0.3 N/A 2 0.5 0.5 0.4 0.5 0.5 N/A 3 0.8 0.7 0.7 0.8 0.8 N/A 4 1.3 1.1 1.1 0.8 0.9 N/A 5 0.4 0.5 0.5 0.5 0.5 N/A 5 N/A 0.8 0.5 0.7 0.8 0.9 7 , N/A 0.4 0.5 0.5 0.3 0.5 8 N/A ‘ 0.9 0.8 0.8 1.7 0.8 9 N/A 0.5 0.5 0.5 0.6 N/A Source: Table 5. The relationship shown in Table 6 (HCA ROS minus CCA ROS) also represents the values for the RHG:SALES relationship. For example, in 1981 for cooperative number 5, HCNM:SALES equals $276,253 / $5,116,057 or 5.4 percent and CCNM:SALES equals $245,749 / $5,116,057 or 4.8 percent, a difference of 0.6 percent. Likewise, RHG:SALES equals $30,558 / $5,116,057 or 0.6 percent. Whether the difference between HCNM:SALES and CCNM:SALES or the RHG:SALES is analyzed, the meaning is the same. Both represent the percent of the historical cost sales dollar which constitutes earnings generated from holding activities. Data in Table 6 suggest that holding activities have a positive, but not strong influence on the historical Cost earnings of the sample. ‘ 16 The fourth income statement relationship is summarized in Table 7. A comparison is made between cash distributions and HCNM and cash distributions and CCNM. Cash distributions are equal to the amount distributed in cash patronage, dividends, and income taxes at the end of each fiscal (year. For interpretive purposes, the higher ‘the CD:HCNM relationship, the lower the percentage of net margins before taxes retained by the organization on an historical cost basis. The CD:CCNM relationship in Table 7 indicates the extent to which cash distributions have occurred relative to earnings from operating activities. If CD are greater than CCNM, the CD:CCNM relationship is greater than 100 percent. This suggests the cooperative has distributed more in cash than earned from operating activities (“real" terms), and therefore has liquidated capital. This occurs in two cases (cooperative numbers 3 and 7 in 1978). If the CD:HCNM relationship is negative, it indicates there has been a cash payout when negative HCNM are realized. This occurs for association number 8 in 1978. In this instance cash payments are in the form of dividends and/or income taxes. Dividends, but not cash patronage refunds, can be paid even if net margins are negative. Also, income taxes could be incurred for non-patronage sources of income, e.g. interest on investments. On the other hand, if the CD:CCNM relationship is negative, it indicates there are cash payments in a year when CCNM are negative. This occurs in five situations: cooperative number 8 in 1978 and 1981, cooperative number 4 in 1978, and cooperative number three in 1980 and 1981. For all other cases, the CD:CCNM relationship is not greater than 42.9 percent. 17 .888: apneom 2858 888.88.88.88 888 «acmemuuum .8.u=8=.u uoa.u=< “oucaom 88888885 58. 88888. 888 .8888.>.8 .888888885 8888 . 28.588.858.8 8888. o.m~ 58.8.. 8.8. 5.85 8.8. 8.88 .55.8. ~.- c.m~ a.- ~.o~ c.m~ e.m~ m.c~ ~.- a.~e 5.@. m.. m.o~ m.¢~ m.¢. ~.- m.m. ~.5. m..~ c.m. m.~ 5.85 5..5 58.8. 58.8. 8.88. ..55 8.85 8.5. 8... ..8 55.888 8.85 8.88.. 8.85 <52 <52 <52 <52 m._~ _.mm o.~m e.m~ «\z <\z <\z <52 <52 ~.o— m.m~ w..~ m..~ <\z o-ONMVLDVOI‘QG <52 <52 m.¢~— ~.n~ <\z <\z «.mw ~.m~ <\z (\2 <5: <\z <52 <52 <52 <52 <\z <\z _mmmm moo. zzu: zzuu 8..5 8.85 8.5. ..5. 8.85 8.5. 5.8. 5..5 8.8. 8.85 8.55 8.85 8.8. 8..5 8.5. 8.8. 8..5 5.5. 5.5. 58.58 5.8 8.8. 8.8. 5.8. 8.8. 8.85 ..8. mama .8888 .88. 888. :29: zzuu mum. zzuz e.g. m.- <5: <5: :zuu :20: msou. _zzou :zu: ssmn ‘ w>~h<¢uacou 88.8.8: .8: 8888 8eecc88 888 88.8.8: 88: .888 .88.5888_= 88 8888888585 5 8‘ 888.888.588.8 8888 5 8.885 18 In effect if either (1) the CD:CCNM relationship is greater than 100 percent or (2) the CD:CCNM relationship is less than zero, this is an indication the association has paid out a larger amount in cash than realized from operating activities, and thus a liquidation of capital has occurred through historical cost earnings distribution. In general, there is not overall evidence that the cooperatives in the sample have been liquidating the capital of their organizations in this manner. This suggests that the extent of the overstatement of net margins on an historical cost basis has not had an adverse impact on decisions relative to cash distributions of earnings. 7.5 Chapter SI-ary The results of the CCA model implemented are not as radically different from the HCA model as anticipated and seen in other types of industries.1 The general explanation for this is that the cooperatives analyzed are not as capital intensive as companies in other types of industries such as mining and construction or the utilities industry. Although it would be impossible for the agricultural cooperatives in the sample to escape the economic hardships incurred by inflation, the research results do not present strong evidence that the HCA model has presented a substantially different assessment of financial performance and the value of fixed assets. 1For an analysis of results for other industries, see Goodman, Hortense, CPA (AICPA), et. al., Illustrations and Analysis of Disclosures of Inflation Accountin Information: A surve 6f tHE' application ngthe requirements g: FAéB Statements N05: 33, 39, 40; 353' 412_ American Institute Of Certified Public Accountants. CHAPTER VIII DECISION-MAKING APPLICATIONS 8.1 INtroduction Empirical results do not indicate that the HCA model provides a substantially different assessment of financial performance than the CCA model for the sample of cooperatives analyzed. However, the degree of distortion only bears tangentially on whether or not CCA information can be useful to cooperative decision—makers. As will be discussed in this chapter, CCA information can provide relevant information for various types of decisions. These include: (1) the determination of prices for services, (2) fixed asset management, (3) financial structure planning, (4) cash patronage and dividend distribution policy, and (5) equity redemption. The application of current cost information to these decisions is addressed in the remainder of this chapter. 8.2 Price Determination for SerVices Typically, grain marketing/farm supply cooperatives will provide a variety of services to members such as fertilizer blending, delivery and spreading, crop spraying, petroleum delivery, and grain drying. As discussed in chapter six, current cost data for cost of goods sold and inventory valuation typically will not provide relevant financial information for grain marketing/farm supply cooperatives. Market price fluctuations due to seasonality overshadowing annual price fluctuations is the basis of this. For plant and equipment, however, current cost financial information can prove useful in setting prices for the above-mentioned services since depreciation is clearly 2 understated when the straight line depreciation method and the HCA model are used. As discussed in the theoretical sections, the economic goal of cooperatives is provision of services, and a significant aspect of the ability to do so is maintenance of physical capital. Relating this to the pricing of services generated by plant and equipment, it is necessary to generate adequate revenue from its use to maintain productive capacity. This includes covering all current costs associated with the use of plant and equipment. If services are priced to cover current cost depreciatiOn expense on equipment owned, as well as current cash operating expenses, adequate funds will be generated to maintain physical capital and therefore productive capacity. A related application area is the use of current cost data in break-even analysis, a financial planning technique. Break-even analysis is a means of determining what quantity of a product or service must be sold at a particular price to cover variable and fixed costs of selling the product or providing a service. The contribution margin per unit (e.g. ton of fertilizer delivered) is first calculated by subtracting variable costs per unit from the selling price per unit. Total fixed coSts, which include depreciation, are then divided by the contribution margin per unit to determine the number of units which must be sold at a particular price to break-even. Break-even analysis is typically used when evaluating the profit potential of capital expenditures and for small business unit analysis. If current cost depreciation expense is used in place of historical cost depreciation expense, 3 more realistic assessment of 3 the “real" break-even point can be made. The use of break-even analysis and the inclusion of current cost depreciation expense as a fixed cost component will provide cooperative managers a more useful tool to use in evaluating profitability. Additionally, break-even analysis can provide input into decisions concerning the divestiture of certain services which are not profitable. If provision of a service is not profitable on an historical cost basis, evidence in this study suggests it certainly will not be profitable on a current cost basis. Thus, the service will not perpetuate itself from the standpoint of maintaining the physical capital necessary to generate the service. The current cost information will provide management with a more realistic assessment of the extent to ‘which profitable aspects of the operation are subsidizing a money losing venture. At that point, realistic information is available to management and the board to decide whether or not a particular Service is important enough to the membership to warrant subsidization to any extent. Realistically, current cost financial information cannot be the sole basis of a pricing decision. A grain marketing/farm supply cooperative typically operates in a highly competitive local market environment. Price competition often forces management to price a service (e.g. fertilizer delivery) below cost in order to increase the sales volume Of a product (e.g. fertilizer). In effect, margins on additional volume realized are expected to subsidize the cost of the provision of the service. Even with this situation, management will be better able to realistically assess the extent of the subsidy with the current cost financial information. 8.3 Fixed Asset Management Revaluation of equipment to current cost, e.g. trucks and fertilizer Spreaders, can provide useful information for planning the replacement or capital repair of equipment. In short, it provides information for capital resource allocation decisions. If current cost information on such equipment is updated annually, management will have more accurate information to determine whether, from a cost-benefit standpoint, it is more economical to replace equipment or make expenditures for capital repairs. Such current cost information will assist management in concentrating on the longer run maintenance of productive capacity. If maintenance of long run productive capacity is ignored, the alternative may be decreased efficiency and a deteriorating competitive position due to use of run-down, inefficient equipment. A 'related analytical procedure which will assist management in evaluating the maintenance of productive capacity over the long run, is a comparison of depreciation and fixed asset expenditures as shown in the sources and uses of funds statement. Depreciation represents a “source" or inflow of fUnds generated from operations since it is a non-cash expense. On the other hand, fixed asset expenditures are a "use" or outflow of funds. Often, a comparison is made between depreciation and fixed asset expenditures in financial analysis to determine if a company is maintaining its facilities. Historical cost depreciation is based on historical values. Fixed asset expenditures, on the other hand, occur in the current year, and stated values of ‘the expenditures represent current values. Therefore, the comparison between HCDEP and fixed asset expenditures is, strictly speaking, illogical. If CCDEP is related to fixed asset expenditures, the analysis becomes logical since both are stated at current values. If an organization consistently spends less on fixed assets than the level of current cost depreciation, at some point the productive capacity of the physical facilities will decline to the point where products and services cannot be provided in an efficient manner. Thus, a comparison of CCDEP and fixed asset expenditures can provide a more realistic indication of whether an organization is maintaining its productive asset base over the long run. 8.4 Financial Structure Planning In order to remain at a "steady state" of productive capacity, capital provisions must be made to replace equipment, to say nothing about expansion. With increases in prices of the equipment owned by a cooperative, greater amounts of capital must be comitted to replacement as assets deteriorate, otherwise the fixed asset base can be eroded. Thus, in the long-term more capital must be acquired either internally or externally to finance the maintenance and/or expansion of the fixed asset base. Externally generated funds could come from two sources, both of which are limited for many cooperatives in today's economic environment. These sources of external funds are: (1) the sale of stock to. members and (2) long-term debt financing. Access to member equity through the sale of stock is limited due to the cash flow "squeeze" farmers in general have been experiencing since the late seventies. Debt capital, on the other hand, is limited by the need to balance the level of long term debt with equity to maintain an. 6 adequate solvency position. This is particularly critical since the solvency position of agricultural cooperatives as a whole has deteriorated in recent years.1 Thus, the case can be stated for the need for a greater reliance on internally generated funds through net margin retention to capitalize the maintenance of cooperative fixed asset bases. Current cost accounting information can be used to determine the distribution of net margin retentions within the cooperatives' capital structure in order to provide for internally generated capital to finance the maintenance of fixed asset bases. After paying twenty percent of net margins in cash as required by law, the remaining eighty percent of net margins can be retained by a cooperative within the equity structure in one of two ways. 2 The retention can be as either deferred patronage refunds or unallocated retentions. Deferred patronage refunds are allocated among members according to the percentage of business transacted with the cooperative.. These refunds represent taxable income to members, and are redeemed in cash to patrons at some point in time. Net margins retained on an unallocated basis, however, represent taxable income to the cooperative, are not allocated to patrons, and are retained on a permanent basis. In other words, the unallocated retentions represent a "permanent" source of equity capital in the sense that they are not redeemed unless the cooperative is dissolved. With increasing prices, the situation can develop where adequate 1See Griffin, Nelda, et. al., The Changing Financial Structure gf_ Farmer Cooperatives, United States Department Of Agriculture, Economics, StatisTics, and Cooperatives Service, Farmer Cooperative Research Report 17, March, 1980. 2See Accounting and Taxation for Cooperatives, Fourth EditiOn, Touche Ross & Co., October, 1978. 7 funds are not available for replacement of productive capacity. In this situation, if sufficient earnings are generated and retained on an unallocated basis to compensate for the underprovision of funds (the. underprovision determined using current cost financial, information), a cooperative will have sufficient funds or maintain the solvency structure to borrow long-term funds to replace fixed assets. Additionally, the equity will not be distributed unless the cooperative is dissolved, therefore the redemption of the equity will not compete for capital that can be used to replace productive capacity. 8.5 Cash Patronage and Dividend Distribution Policy Anothee decision-making application using current cost financial information relates to the cash patronage and dividend policies of a cooperative. Cash patronage, dividend, and income tax payments represent forms of earnings distribution. The tax liability incurred by a cooperative is determined by the level of earnings, the amount of net margins retained on an unallocated basis, and the adeptness of management at tax planning. However, there is not a great deal of choice in the matter of income tax payments; income taxes must be paid. Earnings distribution in the form of cash patronage and dividends, however, has some latitude. Although the level of earnings and tax laws (twenty percent requirement) force cooperatives to pay cash patronage in years in which positive net margins are realized, any percent above twenty can be paid and the decision is left to the discretion of the board. Likewise, dividend payments on stock is at the discretion of the board. The question of the level of cash patronage and dividends arises 8 on an annual basis. As indicated in chapter seven, a CD:CCNM relationship greater than 100 percent is indicative of a liquidation of capital. Thus, to prevent this liquidation and to determine the level of cash patronage and dividends, management and boards may find CCNM a useful measuring stick on which to base earnings distributions. 8.6 Implications for Cooperative Principles and Equity Redemption The redemption of member equity is intertwined with the cooperative principles of "service at cost" and "the provision of current financing by current members." The "service at cost" principle is interpreted as “service at historical cost" by c00perative decision-makers since the HCA. model is the generally accepted accounting model used to measure net margins. Cooperatives charge market prices for goods sold or pay market ‘prices for commodities members produce, earn a margin, and return savings or net margins above costs to patrons in proportion to their use of services. For supply cooperatives, the "net price“ paid by members is the market price less the present value of the patronage refund. For marketing cooperatives, the “net price" received by members is the market price plus the present value of the patronage refund. Cook suggests that there are increasing pressures in the form of (1) economic pressures, (2) cooperative principle pressures, (3) psychomemblic pressures, and (4) institutional pressures on cooperatives to redeem member equity. 3He summarizes his findings by Saying that: 3Cook,_ Michael Lee, An Economic (And Le al Anal sis 0f Farmer Cooperative Eguity Cngtal TRedemption Po Cies, unpuEliSfiEd Ph.D. dissertation, The University of Wisconsin-Madison, 1976, p. 22 9 The member-patron equity redemption problem can be succinctly defined as one whereby ' farmer cooperative associations which build their equity capital base with contributions from member-patrons (both stock purchases and deferred patronage refunds) have been faced with increasing demands for patron serviCes at the same 'time 'the . member-patrons' farm business has become a high capital demanding industry. This demand for equity capital at both the cooperative wholesale and the farm business levels has created a "paradoxical conflict" between the member-patrons and his cooperative.4 The empirical research contained herein suggests that cooperative net margins as determined by the HCA model are overstated. In turn, the portion of net margins allocated to members as deferred patronage refunds are also overstated. Given that deferred patronage refunds are overstated, the overstatement adds to the "equity redemption problem." Replacement of fixed assets (productive capacity) and equity redemption are competing uses of capital, and with increasing capital needs due to higher replacement costs, it is likely these higher costs and subsequent need for more capital have been a major cauSe for a slowdown in the redemption of member equity. Consequently, the "net price" of buying from a cooperative increases or the "net price" received from a cooperative decreases as the length of the redemption period increases. I The "current members providing current financing" principle is also based on equity redemption being operat'ionalized. If member 10 equity is not redeemed in a "reasonable period of time," the principle is violated, and inevitably leads to inequities among the membership. Apparently, this is what has prompted members to demand more timely redemption of their equity. One aspect of rectifying these problems lies at the heart of the basic cooperative principle of "service at cost.“ What cost? Historical cost or current cost? The principle is more appropriate if stated as "service at current cost." By adopting an objectively based current cost accounting model, earnings will be more realistic. In turn, the data which cooperative decision-makers use to allocate earnings will be reflective of current cost and will assist cooperatives in maintaining reasonable equity redemption periods. Therefore, an equitable financing arrangement; will more likely be operationalized. 4ibid, pp. 232-233. CHAPTER IX SUMMARY, CONCLUSIONS, AND RECOMMENDATIONS 9.1 Summary This research project investigates the appropriate accounting model agricultural cooperatives should use under the condition of an unstable price level. A theoretical link is made between cooperative principles and the physical capital maintenance concept of income measurement. In turn, a current value accounting model is chosen as the "best“ accounting model due to physical capital being its basis for income measurement. Specifically, current cost is believed to provide the proper “value differential" with which to measure income on a current value basis. Given the goal of providing cooperative management with practical information, the CCA model is applied to a sample of grain marketing/farm supply cooperatives and results compared with those of the historical cost accounting model. Additionally, various means of applying current cost information in a decision-making framework are suggested. 9.2 Conclusions The empirical results indicate that the current cost accounting model does not provide a decidedly different assessment of financial performance than the historical cost accounting model. The basis of this includes three factors: (1) the type of business, (2) the primary types of expenditures for operations, and (3) inventory valuation methods and inventory turnover rates. These factors are somewhat interrelated. 2 The fact that the sample of cooperatives are not operated with a high degree of capital intensity results in a lower degree of distortion in income measurement with the historical cost accounting model than would occur with more capital intensive firms. An interrelated aspect of this is the types of expenditures involved in ' operations. As seen in chapter seven, labor costs are the primary component of annual expenditures. Additionally, other operating expenses such as utility expenses and cash equipment operating expenses constitute a significant portion of total expenses. Thus, these cash expenditures are incurred at current cost in an ongoing fashion, and lead to less distortion in income measurement. As discussed in chapter six, historical cost accounting inventory valuation methods and inventory turnover rates present a situation .where no adjustments in these areas are warranted. These three factors taken together provide a situation where the HCA model does not create a high degree of distortion in income measurement. Although the degree of distortion with the historical cost accounting model is not high, current cost information can provide useful information to management. The benefits of the data, however, must be weighed against the costs associated with generating the information. Cost associated with its compilation Oinclude Staff resource requirements, maintenance of a data base to make adjustments if done internally, consulting fees for development and implementation of procedures, and costs of computer hardware and software if the process is computerized. A substantial port-ion of these costs are "front-end" costs, and if the process is computerized, the ongoing costs associated with preparation will be low. 3 A general statement of the cost-benefit tradeoff cannot be made for all cooperatives. The cost-benefit analysis must be made on a case by case basis. Additionally, the benefits of preparing current cost financial information will certainly only accrue to the organization which employs it in their decision-making process. 9.3 Recommendations Price changes in the economy pervade the entire business structure and have broad financial reporting and internal planning implications. Even though historical cost accounting information can distort the measurement of financial performance of agricultural cooperatives, the mainstay of the model is that it is objectively based. Therefore, the HCA model has been the long-standing, well-accepted model in the area of cooperative accounting and finance. In the move toward current cost accounting, more assumptions are made than with historical cost accounting. These assumptions relate to the means of determining current costs and are more subjective in nature than those on which the historical cost aCcounting model is based. The degree of objectivity has important implications for the reliability of the current cost information. 1 Only one method of determining current costs (indexing) has been used in this project. Other techniques need to be tested and compared in order to determine the most reliable method due to the subjective nature of the adjustments. The question of reliability is critically important if the current cost information is used to make decisions which will directly impact members, e.g. earnings distribution. 4 It is recommended that the CCA model be used as a supplement to the HCA model at the present time by compiling the information and phasing it into -the decision-making process where applicable. Accounting principles and standards are developed over relatively lengthy periods of time to ensure that they provide a solid and reliable f0undation f0r informational and reporting purposes. Therefore, adoption of new principles and standards should occur in an evolutionary manner. If there is ever to be a wholesale displacement of the HCA model, it realistically can come only after years of testing and general agreement among theoreticians and practitioners that such a major change is warranted. 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