m—nuuww-n.~v.,.,_.‘,,,,-‘~-,'.r.'\

THE BALANCE SHEET
TO THE INCOME STATEMENT:
A STUDY IN THE HISTORY
OF ACCOUNTINGTHOUGHT

THESIS FOR THE DEGREE 0F Ph. D. '
MICHIGAN STATE UNIVERSITY ,
' CLIEFORD BROWN

1968

H 6.19"

LIBRARY “

Michic in State
University

      
   

 

This is to certify that the
thesis entitled

THE BALANCE SHEET
TO THE INCOME STATEMENT:
A STUDY IN THE HISTORY

OF ACCOUNTING THOUGHT
presented by

Clifford D. Brown

has been accepted towards fulfillment
of the requirements for

PhoD degree in Accounting

,flflfl/m

Major professor

Date November 14 , 1968

 

0—169

Clifford Brown

This dissertation is a study in the history of accounting
thought and it seeks to identify the nature of the shift in
emphasis from the balance sheet to the income statement as the
primary accounting report. It also presents the more important
forces reSponsible for this ascendancy of the income statement
utilizing an historical approach based upon the interpretation
of ideas and events.

In this study old corporate annual reports, selected
accounting literature, correspondence and internal income state-
ments from selected companies, governmental publications and
legislative acts, and interviews, where appropriate, were the
basic raw materials. The organizational scheme was to deter—
mine the interrelationships between past ideas and events in-
fluencing accounting actions. Under this approach both exogenous
and endogenous environmental variables can be related to the
study.

The conclusion reached in Chapters III and IV was that
there were essentially two shifts in emphasis from balance
sheet data to income statement data. There was an internal or
managerial shift and an external shift by stockholders, creditors,
and other parties outside the firm. The former shift, it was
contended, probably occurred with the advent of the corporate
form of business organization between 1880 and 1925. On the
other hand, the latter shift began in the 19203, accelerated in
the 19305, and was essentially completed by the early 19HOS.

The internal shift in emphasis was more difficult to docu—
ment than was the external shift. Information in the form of

letters, internal income statements, interviews, or combinations

Clifford Brown
of all three was obtained from various selected companies.
This information related to the nature and extent of internal
income reporting prior to the external shift in emphasis. From
this information it was concluded that there was no significant
internal shift in emphasis in the early 19308.

The external shift in emphasis was influenced by many
forces. The rise of the corporation was very important. It
prompted Professor Paton and others to focus attention on the
entity concept and the going-concern assumption. The emergence
of the investor's vieWpoint due to the rapid growth of stock
ownership by the general public created a new demand for infor-
mation. Investors sought growth as well as the safety of their
original investment. The income statement was useful for this
purpose because it yielded profit data very essential in analy-
zing investment alternatives.

The rapid fluctuation in the prices of goods and services
that began in the early 19203 left doubt as to the adequacy of
the balance sheet as a statement of values. But Federal taxa-
tion of income and related court decisions were the most im-
portant developments contributing to the emergence of income
reporting via the matching concept. Federal tax laws have con-
sistently required the cost basis for such items as depreciation
and inventories. This requirement naturally contributed to the
demise of the balance sheet as a statement of values and its
replacement with a statement of unallocated or residual costs.
The courts also influenced the emergence of the matching concept
because they became involved with the problem of identifying

what was income. In the famous decision of Eisner V. Macomber

Clifford Brown
it was held that income did not exist until it was severed
from capital. This meant that for most types of property
income could emerge only through sale or exchange of the
property. Thus accountants concentrated on rules and procedures
that would identify a severance or sale of assets. As a result
the transactions approach to income determination based upon

the realization concept became the general rule.

THE BALANCE SHEET
TO THE INCOME STATEMENT:
A STUDY IN THE HISTORY
OF ACCOUNTING THOUGHT

.3600

by CliffordrBrown

A THESIS
Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of
DOCTOR OF PHILOSOPHY

Department of Accounting and Financial
Administration

1968

-9

Copyright by
CLIFFORD DEAN BROWN
I968

Acknowledgments

 

A dissertation writer is always indebted to many others:
first of all, to those whose researches and scholarly activities
provided the sources upon which he draws. Furthermore, I wish
to add a special word of acknowledgment to my committee, par—
ticularly the chairman, Dr. Roland F. Salmonson.

I owe my wife, Carolyn E. Brown, a special debt for her
diligent typing and re-typing of the many rough drafts. Lastly,
many thanks must be added for the typing of the final copy to

Margaret Scanlin.

ii

TABLE OF CONTENTS
ACKNOWLEDGMENTS .
TABLE OF CONTENTS . . . . . . .

LIST OF ILLUSTRATIONS . . . . . . . . .

Chapter
I. AN HISTORICAL APPROACH TO ACCOUNTING . . . .

Introduction

Philosophy of History

Some Problems in the Study of History

Approaches to the Study of History of
Accounting Thought

II. GENERAL HISTORY OF FINANCIAL ACCOUNTING

General

Financial Accounting: Pre-adamite
Financial Accounting — 1900 to 1929
Financial Accounting - 1930 to 19H2
Financial Accounting - Contemporary

III. THE INTERNAL SHIFT FROM THE BALANCE SHEET TO
THE INCOME STATEMENT . . . . . . . . . . . . .

General

The New Emphasis on Profits
Evidence of the Internal Shift
Summary

IV. THE EXTERNAL SHIFT FROM THE BALANCE SHEET
TO THE INCOME STATEMENT . . . . . . . . . . .

General

Documentation of the External Shift From the
Balance Sheet to the Income Statement

Factors Affecting the External Shift

Summary

V. THE INTERACTION OF ECONOMIC THEORIES OF PROFIT
AND ACCOUNTING THEORY . . . . . . . . . . . .

Introduction

Importance of Profit Theory in Economics

Concept of Profit as a Class Income

The Concept of Profit as Surplus Remuneration to
the Entrepreneur

Summary of the Concept of Profit as Surplus
Remuneration to the Entrepreneur

Relationship of the Economist's Concept of Profit
as Surplus Entrepreneurial Remuneration to
Accounting

The Concept of Profit as a Return to Uncertainty
Bearing

iii

Page
ii

.iiiiv

16

37

7:4

105

V. — Interaction with Current Accounting
Thought and Practice

VI. THE INFLUENCE OF FEDERAL TAXATION 8 LEGISLATION . . . . 1H6

General
Federal Income Taxation
The Influence of the Securities and Exchange

Commission
Summary
VII. SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . 165
BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . 173

iv

Number

I.

II.

III.

IV.

VI.

VII.

VIII.

IX.

XI.

XII.

XIII.

LIST OF ILLUSTRATIONS
Page

General Electric
Consolidated Balance Sheet, January 31, 1895.... 23

List of Selected Companies Contacted .............. 5”

Sample Copy of Letter Mailed to H5 Selected
Companies...... ......................... . ....... 55

Westinghouse Electric
Statement of Consolidated Income and Profit 8
Loss for the Year Ended March 31, 1928 ........ 61

Westinghouse Electric
Comparative Statement of Operations for the
Period Ended March 31, 1928... ......... . ...... 62

Allied Chemical 8 Dye Corporation
Methods Bulletin in Use Before 1930 ..... ........ 6”
List of Manufacturing Cost Controlling Accounts. 65
Selling Expense Classification Showing the
Grouping of Selling Expense Accounts.......... 66
General Administration Expense Classification
Showing the Grouping of General Administration
Expense Accounts............................ 67

American Telephone and Telegraph Company
Combined Earnings and Expenses All Bell Operating
Companies in U.S. Including American Telephone
and Telegraph Company........................70

American Telephone and Telegraph Company
Comparative Statement of Earnings and Expenses...7l

List of Annual Reports Reviewed ..... .... ........... 81

General Electric
Consolidated Profit and Loss Account of January
31, 1895..... ......................... . ........ 83

General Electric
Comparative Statement of Income and Expenses.....8u

United States Rubber Company and Subsidiary Companies
Consolidated Income Statement for Year Ending
MarCh 31’ 1903.00.......0...0.0.00.00000000000086

United States Rubber Company and Subsidiary Companies
Consolidated Income... ..................... . ..... 87

CHAPTER I

AN HISTORICAL APPROACH TO ACCOUNTING

Introduction

 

This dissertation will be a study of one phenomenon
in the history of accounting thought. Specifically, it will
be concerned with the ascendancy of the income statement to
the status once held by the balance sheet as the primary
accounting report. What were the underlying forces, both
direct and indirect, that influenced this shift in emphasis?
But before this task is attempted the methodological approach,
as in any research, should be explained. Thus, the purpose
of this chapter is to introduce a philosophy of history and

relate this philosophy to the history of accounting thought.

Philosophy of History

 

Origin and Meaning of the Term

 

The term "philosophy of history" was coined by Voltaire
in the eighteenth century to simply mean critical or scienti-
fic thinking where the historian made up his mind for himself
instead of repeating the stories found in old works. However,

the term today is used in several different senses:

2.

1. To denote the principiant considera—
tion of the meaning, the methods, and the
canons of historical science.

2. To denote inquiry into certain

highly complex phases and products of

historical development - as the history

of institutions or of civilization.

3. To denote the explanation, from
philosophical principles, of historical

phenomena at large or the entire course

of historical development.

The first sense is of importance to this study because a
philosophy of history of this kind would be directed at

the problems resulting from an organized inquiry into one
phenomenon of the history of accounting thought-—the change
in emphasis from the balance sheet to the income statement.
To illustrate the importance of this first sense of the term
philosophy of history, it seems appropriate to trace its own
historical development. However, to do this it is necessary
first to define philOSOphy.

Among the various definitions of philosophy there are
some that are important in tracing the development of the
philosophy of history to be used in this study: a study of
the processes governing thought and conduct; originally, love
of wisdom or knowledge; the general principles or laws of a
field or knowledge, activity, etc. These definitions of

philosophy are directly useful as a starting point in tracing

the origins of the philosophy of history. Yet they are much

 

lJames Mark Baldwin, Dictionary of Philosophy and Psy-
chology (New York: The Macmillan Company, Inc., 1955), p. H77

 

3
too brief to provide a real understanding of the scope and
nature of philosophy. Therefore, for the essence of philos-
ophy the writer refers to the following quotation from
Collingwood:
Philosophy is reflective. The philoso—

phizing mind never simply thinks about an

object; it always, while thinking about any

object, thinks also about its own thought

about that object. Philosophy may thus be

called thought of the second degree, thought

about thought. For example, to discover the

distance of the earth from the sun is a task

for thought of the first degree; to discover

what it is exactly what we are doing when we

discover the distance of the earth from the

sun is a task for thought of the second

degree--in this instance for logic or the

theory of science...thus thought in it re—

lation to its object is not mere thought

but knowledge...for philosophy the theory

of knowledge.2

Thus, it might be said that philosophy is an attitude
toward knowledge, not just knowledge itself. Over the cen—
turies this attitude toward knowledge or, as it is called,
our philosophical tradition, has gradually changed. In sixth-
century Greece the foundations of mathematics were in the fore-
front. When Greek philosophers discussed their attidude
toward knowledge, they concentrated foremost on the theory of
mathematical knowledge.

In the Middle Ages, theology was at the center of the
picture, and the problems of philosophy were concerned with
the relations of God and man. From the end of the Middle
Ages to roughly the nineteenth century, the attitude toward

knowledge was concentrated on natural science, with the

 

2R. G. Collingwood, The Idea of History (London, England:

Oxford University Press, 19MB}, pp. 1—2.

 

u
relation of the human mind to the natural world. In this
latter period peOple started thinking seriously about history.
The result was the conclusion that a theory of knowledge
based on mathematics, theology, or science could not answer
all the problems involved in historical inquiry. Historical
thought had its own object and its own idiosyncrasies. For
example, it was realized that the past could not be per-
ceived by mathematical thinking because mathematical thinking
involved objects with no special location in time and space,
whereas, historical thought was concerned with particular
events in time and space. In addition, it was discovered
that theological thinking, concerned with an infinite object,
was also inappropriate because historical thought involved
events that were finite and plural. Lastly, scientific
thinking based upon observation and experiment was also
considered by most to be inappropriate to historical thinking
because the past has vanished and ideas about it cannot be
Verified like scientific hypotheses.3

As a result of this awareness that historical know-
ledge cannot proceed on the assumptions of mathematical,
theological, or scientific knowledge, a new phiIOSOphy began
to Gamerge in the nineteenth century. This new philosophy was
a twesult of the philoSOphical problems created by an organ—
iz“Sicisystem of historical research and is now known as the

Philosophy of history.

 

3Paul Edwards, Editor-in-Chief, The Encyclopedia of
Philosophy (New York: The Macmillan Company, Inc.,1967),
pp. 2H7-25H.

5
The next sections will be concerned with the mechanics
of the new philoSOphy of history. It is important that its
nature, object, method and value be explained not only because
of the implications to the history of accounting thought, but
because the three traditional philosophies of mathematics,

theology and science imply that historical knowledge is im—

possible.

The ObjectiVe of Historical Inquiry

The object of historical research obviously is implied
in the above reference to the phiIOSOphy of history. Yet it
seems appropriate that this object of history be explicitly
stated in order that the object of the history of accounting
thought, and consequently this study, can be clarified.

The object of the "literary historian" is to write
about the grandeur of the past for its own sake. Many great
works have been written with this object in mind. David
Hume's History of England and Edward Gibbon's The Decline and
£311 of the Roman Empire are two such examples. In
aCczounting, examples of "literary history" are: Arthur H.
w0C>lf's A Short History of Accountants and Accounting and
R0hmart H. Montgomery's Fifty_Years of Accountancy.

The object of the "scientific historian" is research or
iIlquiry aimed at discovering actions of human beings that
have occurred in the past. Actions of the past are not dis—
covered simply for their own sake. They are discovered be-

cause they help provide a perspective for making wise

6

. H .
ch01ces today. In accounting there are at least two books
written with this object in mind: A. C. Littleton and

V. K. Zimmerman's Accounting Theory: Continuity and Change

 

and Harvey T. Deinzer's Development of Accountinnghought.

 

A quotation from the former illustrates this "scientific"
approach:

As a basis for an examination of the
ideas'behind accounting actions, it is
convenient to consider first the nature
and usefulness of accounting theory viewed
in a historical perspective.

Behind all transmitted methods, there
must have been motivating ideas. If deter-
mined, these motivating ideas of accountancy
should help to explain why accounting has been
able to serve so well for so mag/centuries
and why it still shows such a remarkable
capacity of growth in service potential.

Similarly, a quotation from the latter also illustrates
the scientific approach:

The historical premise is that events
are interactions; the latter have both
antecedents and consequences. The more
influential of the events are brought for-
ward against a backdrop of the condition-
ing of environment. Further perspective may
be develOped by advancing certain of the
characteristic events, say the "accounting
events," towards the lens position, while
leaving the other factors in the background
as a conditioning flux.6

uCollingwood, op, cit., pp. 7—9

5A. C. Littleton and V.K. Zimmerman, Accounting Theory:
gzfllinuity and Change (Englewood Cliffs, New Jersey: Prentice-
Hall, Inc., 19627, p. 3

 

 

6Harvey T. Deinzer, Development of Accounting Thought
(New York: Holt, Rinehart, and Winston, Inc., 19657, p. 10

 

Historical Methodology

Historical methodology must also be satisfactorily
explained for a complete understanding of the philosophy of

history. There is unanimous agreement among historians

that historical methodology consists of the interpretation

of evidence. But there is disagreement as to what consti-

tutes historical evidence and how it is utilized in history.

Traditionally, historical evidence was that which

depended upon the testimony of others. Here the historian

decided upon that which he wanted to know and then went to

seuxrch for statements made by persons at the time of the

etmants, or by eyewitnesses, or by repeating what eyewitnesses

saixj, and so on for his evidence. This type of evidence is

vefiluable to the "scientific historian" if it helps him to

Inakus a decision. It is useless to him if he accepts it as a

Pewady-made answer because, by allowing someone else to make
tile: decision for him, he is giving up his autonomy—-a neces—

£3ar‘ycondition for a "scientific historian."

This autonomous condition implies a broader definition

(Df’ evidence which is the basis for today's philosophy of

hiistory. Mautz and Sharaf provide such a definition:

EI‘ History directs its attention to the
interpretation and understanding of the
past by studying the influences of events
and developments on the organization and

behavior of human groups. Its evidence con-
sists of documents, relics, and the written

recollections and impressions of people who

7 .
Collingwood, op, c1t., p. 252

8

knew or thought they knew something
about the period or event under

study.8

Their definition of evidence is particularly important to
this study because the author will utilize annual reports

of corporations, interviews, where appropriate, books and
periodical literature, court cases, legal documents and
other appropriate evidential material in an effort to ascer-

tain certain selective factors influencing the shift from the

balance sheet to the income statement as the primary accounting

report.
Now that the question of what constitutes historical

eVnidence for this study has been answered, the other question
of’ how it is to be utilized must also be answered in order to

urujerstand what is meant by the historical method and the

pkuilosophy of history. As was stated earlier, a consensus

dcxes not exist among historians as to the application of

eVidence in historical research. Irving M. COpi contends that
hiES‘torians must make use of hypotheses. For example, he states:
Just as the biologist must use the method
of science in formulating and testing his hypo-

theses, so the historian must make hypotheses,

too; Even those historians who seek to limit
themselves to bare descriptions of past events

must work with hypotheses.

Those that believe historical research involves hypothe-

SjJZing are few because the past has vanished, and ideas about

it: cannot be verified like scientific hypotheses. Most believe

historical research is inferential. To quote Collingwood:

8R. K. Mautz and Hussein A. Sharaf, The Philosophy of
, American Accounting Association Monograph No. 6

Auditin
(Hierican Accounting Association, 1961), p. 77.

9Irving M. Copi, Introduction to Logic (New York: The
Ibcmillan Company, Second Edition, 1961), p. 46.

9

History has this in common with every
other science: that the historian is not
allowed to claim any single piece of knowl-
edge, except where he can justify his claim
by exhibiting to himself in the first place,
and secondly to any one else who is both
able and willing to follow his demonstra-
tion, the grounds upon which it is based.

Furthermore, there seems to be general agreement that
the kind of knowledge obtained from inference or reasoning
can only be ascertained with probability. For example
Keynes states:

Part of our knowledge we obtain direct,
and part by argument. The Theory of Proba-
bility is concerned with the part we obtained
by argument,...

In most branches of academic logic, such
as the theory of syllogism or the geometry of
ideal space, all the arguments aim at demon-
strative certainty. They claim to be"con-
clusive." But many other arguments are
rational and claim some weight without pre-
tending to be certain. In Metaphysics, in
Science, and in Conduct, most of the arguments,
upon which we habitually base our rational
beliefs, are admitted to be inconclusive in a
greater or lesser degree. Thus for a philos-
Ophical treatment of these branches of knowledge,
the study of probability is required.11

To summarize at this point it is worth stating that the
Pfllifilosophy of history, denoting "the principiant consideration
of'the meaning, the methods, and the canons of historical
SC—i€ance," is reflective in the sense that the historian
alfi?ives at conclusions following rules of inference and based
uDon sufficient evidence to be persuasive to those who are
Willing and able to follow his demonstration. For a complete

'Dhilosophy of history in which this study in the history of

K

0 . .
l Collingwood, op. c1t., p. 252.

John Maynard Keynes, A Treatise on Probability
(London: The Macmillan Company, Inc., 19H8), p. 3.

10

accounting thought can be constructed, it is necessary to

consider the value of history.

The Value of History
Joseph Schumpeter's explanation of the value of history

is particularly important in a philOSOphy of history because,

as stated before, the three traditional philosophies imply

that historical knowledge is impossible. Schumpeter believes

that visits to the past have pedagogical value because those
who teach from the most recent works will soon find themselves
1J1 difficulty unless these works have a minimum of historical
:fiacts so that the student maygain an appropriate perspective,
a 19erspective which helps provide a basis for making choices

today.12 In addition, he thinks it necessary to study the

hixstory of any subject because it gives an awareness of the

Ilairure and speed of changing ideas within a discipline:

We learn about both the futility and

fertility of controversies; about detours,
wasted efforts, and blind alleys; about

spells of arrested growth, about our depen-
dence upon chance, about how not to do things,
and about leeways to make up for. We learn to
understand why we are as far as ye actually are
and also why we are not further. 3

In accounting the interaction of ideas and events make

CThange a permanent feature. A knowledge of the nature and

SEflaed of this change places us in a better position to under-
SlLand our discipline's weaknesses and development through

liime. Development of the forces shaping the change to the

\

12Joseph A. Schumpeter, History of Economic Analysis
(New York: Oxford University Press, 1961), p. 5

13Ibid., pp. 5—6.

ll

income statement can help us learn about those things in

the above quotation. Further, such a knowledge can give us

insights into possible improvements or alternatives to the

income statement.

The phiIOSOphy of history which was presented above
portrayed history to be (a) a type of research designed to
answer questions; (b) an attempt to discover actions of human
beings that have occurred in the past; (c) a process by which

evidence is interpreted; and, (d) a means whereby perspective

could be provided for making choices today. The next section

will.be concerned with some of the problems involved in

organized historical inquiry .

Some Problems in the Study of History
The historian is subject to many limitations in con—

Ciucrting his research. First, the raw materials at his

<iisxposal are limited. Much of the past was never recorded.

III éaddition, that which survives today probably is distorted.
Tfilixs distortion is particularly true in accounting thought
13em2ause its development has, historically, been dependent upon

Cfilaliges in practice. Unlike the history of economic thought

“Witfll its long list of historical pioneers and theoretical

‘jeNnelopments, accounting thought is fragmented and only im-

'P3¥icit1y documented in the business records existing at various

times.

Another limitation relates to the fact that since his-

tOI‘ical analysis is dependent mainly upon written records,

bias distorts the historian's View. There is bias in the

cmoosing of facts, bias in the organization of these facts, and

l2
ultimately in the interpretation of these facts.lu The first
two forms of bias can easily be overcome by explicitly reveal-
ing the actual raw material utilized, as opposed to those that
were available, and by explicitly stating the organizational
scheme. The former will be revealed throughout the disserta-
tion, whereas, the latter will be covered in the next section
by reference to the approaches to the study of the history
of accounting.

The third form of bias is the most complex and difficult
tc> evaluate. It is related to whether the historian should
Ineuintain his own canons and values or should attempt to
adhapt those of the people and the age with which he is con-
cnezcned in formulating his judgments. Few question that in-
fIDIPmed professional judgment, after a careful examination of
flies evidence, is an important aspect of historical research.
3111: the resultant product of the historian is conditioned by
irlifluences upon his judgment. Schumpeter contends that no
Irlatter how hard we try to "cast off" those influences of our
CNNTI environment we cannot succeed. Those who think they can
aINe open to suspicion. Consequently, he recommends that our
Véllues should be clearly stated in order that others will
ncrt be misled.15

This writer agrees with Schumpeter's position. Conse-

quently, the canons of "contemporary accounting theory"

1LiIbid., pp. 3-9

15Ibid.,

 

13
will be utilized where appropriate, although it must be
realized that some of the theories currently being advocated
awe not generally accepted in accounting practice.
There is a danger in evaluating the works of earlier
wniters by the canons of modern day theory. Likewise,
‘Uuare also is a danger in ancestral worship. The former
is aa common occurrence for those who regard earlier works
as Inere rudimentary developments. On the other hand, the
latrter is common for those who attempt to discover in past
thexories an idea or concept in advance of its time.
M. 131aug appropriately points out that, with a little training
in (Serman philosophy, these two types of dangers resemble two
polxar~opposite positions: "relativism and absolutism."16
The: relativist regards works of the past as a reflection of
the: conditions of the times; the absolutist concentrates his
effk>rts on the purely intellectual development in these
earfiLier works in an effort to trace the progression from error
to izruth in the development of his discipline. Further,
Blatug states that few people ever held strictly either of
thesue two extreme positions but can be placed somewhere on a
CODTIinuum between the poles. The absolutist's position will
essenntially be emphasized more in an effort to ascertain the
relative importance of the various selective factors influ-
encing the rise in the income statement. At the same time,
hoWever, the relativist's position will not be discarded because,

as Stated before, developments in accounting thought have

 

 

16M. Blaug, Economic Theopy in Retrospect (Homewood,
Illinois: Richard D. Irwin, Inc., 1962), pp. 1-2.

 

1H
traditionally been a function of accounting practice.

Approaches to the Study of the
History of Accounting Thought

There are at least four approaches, all of which involve
the interpretation of evidence, to a study in the history of
accounting thought .

The first approach would be to organize the study in
tervns of the dominant theme during a specific period. For
exeunple, as May suggests, accounting history could be divided
intxb three periods according to the relative importance of
the: forms of business enterprises: (a) individual ventures
eitflier proprietorships or partnerships; (b) corporations with
linrited liability and being owned and operated by few;

(0) and the corporation of today with the separation of owners
anti managers.17 This approach is rejected for the purposes
Of"this dissertation because the last form, the corporation
Witflu the separation of owners and managers, was operative
thrmoughout most of the period in which the transition from
the: balance sheet to the income statement occurred, at least
the: external shift by creditors and stockholders.

A second method would be to study the division of events
int<> a chronological time sequence. An example of this ap-

PrTMach can be found in an article by Lawrence Vance entitled

"IT“? Authority of History in Inventory Valuation."l8 This

 

 

17George 0. May, Financial Accountipg,(New York: The
Macmillan Company, 194?), p. 51.

18Lawrence Vance, "The Authority of History in Inventory
Vaantion," Accounting Review, (July, 19H3), pp. 218-227.

15
approach is also rejected, except for the brief history of
accounting presented in the next chapter, because it gen-
erally does not focus attention upon underlying motives for
accounting actions. Sequential time arrangement, although a
necessary condition, should not be the basic object in a
study in the history of accounting thought.

A third approach would be to organize ones findings in
such a way as to present a story. As mentioned earlier,
examples of this approach are numerous in accounting. This
approach has little value because emphasis is placed upon
recreating the spectacle of the past rather than upon reasons
behind accounting actions of the past.

The last important possible approach is to determine
the interrelationships between ideas and events, both en-
dogenous and exogenous. Why did certain ideas originate?

To what extent did events influence the development of these
ideas? This approach is usually the best because it enables
the researcher to relate the environment to changing ideas
and concepts. It will be the approach generally followed

in this study since the effects of environmental change
provided the seeds that resulted in the shift in emphasis

from the balance sheet to the income statement.

CHAPTER II

GENERAL HISTORY

OF FINANCIAL ACCOUNTING

General

In accounting today there exist many important and
complex problems. Some of these problems are a result of
the findings of current research such as the works of
Chambers, Edwards and Bell, the American Institute of
Certified Public Accountants, the American Accounting
Association, and many other persons and groups. These
individuals and groups have created much controversy and
Conflict within the profession not only by questioning
conventional so—called "generally accepted accounting
principles," but by their proposed alternatives.

Another basic source of problems facing the accounting
profession is the existence of certain ideas and practices

"2

that are a result of the "conventional wisdom. In fact,

 

lSee Raymond J. Chambers' concept of current cash equi-
valent in Accounting, Evaluation and Economic Behavior, 1966,
Prentice-Hall; the American Accounting AssociationTs recom—
mendation of current cost data in A Statement of Basic Ac—
counting Theory, 1966; The American Institute of Certified
Public Accountants' Research Studies; Edwards and Bell's
Theory and Measurement of Business Income, 1965, University
of California Press.

 

 

2John Kenneth Galbraith, The Affluent Society (Boston,
Massachusetts: Houghton Mifflin Company, 1958), Chapter II.
A phrase coined by Professor Galbraith to mean ideas that
are esteemed at any time for their acceptability.

l6

17

it might be said that the conventional wisdom is the basis
for many of the so—called "generally accepted accounting
principles." One such problem has resulted from the apparent
shift in emphasis from the balance sheet to the income state-
ment as the primary accounting report. The balance sheet to—
day is thought by many to be a collection of residuals instead
of an accurate statement of a firm's financial position. That
is, according to Robert T. Sprouse, the fundamental accounting
equation of assets equals liabilities plus owners' equity has
been drastically changed to: assets equal liabilities plus
"what-you-may-call-its" plus owners' equity.3

As stated in Chapter I, a study in the history of accounting
thought specifically concerned with the ascendancy of the
income statement to the status once held by the balance
sheet is the main topic of this dissertation. What were the
underlying forces, both direct and indirect, that influenced
this shift in emphasis? What were the contributions of various
authors, professional associations, governmental laws and regu-
lations, and other persons or groups to this shift? What
events were important? Why did they occur? Answers to these
and other questions are attempted in the pages ahead. It is
hoped that these answers will help provide a better under-
standing of the relative importance of the balance sheet and
the income statement while demonstrating the fact that their

existence is mutual and their properties interdependent.

 

3Robert T. Sprouse, "Accounting For What-You—May-Call-
Its," Journal of Accountancy, (October, 1966), pp. H5—59.

 

18
Also, such answers can help provide a perspective which in
turn can be utilized in analyzing the origins and nature of
Sprouse's "what—you-may-call-its." But before this task of
specifically documenting and presenting the most probable
reasons for the ascendancy of the income statement is under—
taken, it seems appropriate that a brief discussion of the
development of financial accounting up to 1940, the time the
shift was completed, be presented in order to gain a broad
perspective for concrete accounting actions of the past. This
brief summary of financial accounting will be presented from
a chronological approach. Little attempt will be made to
analyze the underlying motivations behind these past accounting
actions. Yet, an attempt will be made to concentrate on those
events that could have had an influence on the change in
emphasis from the balance sheet to the income statement and

will be further developed later in the dissertation.

Financial Accounting: Pre-adamite

 

Before Double Entry

 

Accounting has a history extending back many centuries.
In fact, there are even references to accountability for
stewardship in the Bible.” There are other early records
showing that piece-work rates and incentive bonus schemes

5

were discussed as early as 2,000 B. C. Next it might be

 

1+A. G. Donald, "Historical Background of Accounting as a
Control," The Accounting Digest, Vol. XXXIII, (October, 1967),
p. 19.

 

5 .
Ibld.

19

worth mentioning the eleventh-century A. D. DomesdayyBook

 

where an attempt was made to stocklist the assets of England
in single-entry style.6 The point of interest in these early
references is that people were held responsible for assets
and thus rendered a periodic account, either oral or written,
to a master. This periodic account could possibly be the
origin of today's balance sheet and income statement. But
the information available in these early periods is sketchy
and fragmented, rendering evidential support to conclusions
very tenuous, while supplying little to aid in the solving
of today's problems. Thus, it is necessary to trace briefly
the evolution of financial accounting based on the double
entry system from Luca Pacioli's well known lugu book

Summa de Arithmetics, Goemetrica, Proportioni et Prppor-

tionalita.

 

Period-From Pacioli to 1900

 

Pacioli's work is strikingly similar to what is found in
today's textbooks. He instructed his readers to utilize three
books: memorial, journal, and ledger. The memorial was a
,general book for recording all transactions of a business
chronologically and in detail. Entries were then analyzed
and transferred to the journal from the memorial. This recording
first in the memorial and then in the journal was necessary
because of the many coinage systems in use and because of the
lack of original business papers. The journal was posted
periodically to the ledger. The ledger contained a profit and

loss account which reflected certain results from various

 

61bid., p. 19—20.

20

ventures. In addition, the ledger provided for the eventual
transfer of the profit or loss to the capital account. Pacioli
suggested that the practice was not wide spread. He also sug—
gested that, before a new ledger was opened, a comparison of
the equality of debits and credits be made similar to today's
trial balance.7

The double-entry method, known as the Method of Venice,
spread rapidly throughout most of Europe. But it wasn't until
the industrial revolution of the eighteenth and nineteenth
centuries that it really flourished._ In fact, some have advo-
cated, like Werner Sombart, that "systematic or scientific
accounting, identified with the double-entry system, played an
important part in releasing, activating, stimulating and
accentuating the rationalistic pursuit of unlimited profit,
an essential element in the capitalistic spirit."8

The above mentioned process of Pacioli whereby a com-
parison of debits and credits in the old ledger was made
before opening a new ledger, was, according to Littleton,
later modified by including a so—called annual "balance account"
in the ledger itself.9 This balance account had all the

accounts in the old ledger transferred to it during the closing

 

7Pietro Grivalli, An Original Translation of the Treatise
on Double-Entry (New York: Harper Brothers, Inc., 1911), p.100.

 

 

8Basil S. Yamey, "Accounting and the Rise of Capitalism:
Further Notes on a Theme by Sombart," Journal of Accounting
Research, Vol. II, No. 2, (Autumn, 196%), p. 117.

9A. C. Littleton, Accounting Evaluation to 1900 (New York:
American Institute Publishing Company, Inc., 1933), pp. 127—130.

 

 

21

process. In short, all accounts with debit balances were
credited and the balance account was debited, while all those
with credit balances were debited and the balance account
credited. Then the new ledger was Opened from the data con-
tained in the balance account. Even though there exists no
conclusive evidence, Littleton believes that these early
balance accounts were c0pied out of the ledger and used as
separate statements.10

Once statements were separated from the accounts, what—
ever the reason, development was toward better arrangement of
figures for clarity of factual material and toward refine-
ments of classification to better reflect actual values. One

of the earliest approaches to the modern arrangement according

to Littleton appeared in 1788 in Introduction to Merchandise,
ll

 

by Hamilton. This book depicted the account form of the
profit and loss sheet and the balance sheet which was to con-
tinue in use throughout the nineteenth century, even though
the beginnings of the so—called report form can also be
traced to this early period.

Early American and British thought did not concentrate
on statement development probably because the proprietorship
form of business organization existed where the owners were
the managers and thus had access to the ledgers. But there
were exceptions. George Soule's pioneering works were dis-
tinctive achievements. His work on balance sheet construc-

tion was the most comprehensive attempted between 1880 and

1900.

 

lOIbid., p. 132.

ll;p;g,, pp. 1H0—1u3.

22

For example, in addition to definite instructions for balance
sheet preparation, which resembled present day columnar work—
sheets found in principles texts, he considered the balance
sheet to be of "particular service when the proprietor or
some of the partners of a business reside in cities or places
other than where the business is located, and it (balance
sheet) is always more convenient for references and preser-
vation than the books of the firm."12
The account form of statement presentation was also the
general rule in nineteenth—century England and America. In
fact, it was this form that was first to appear in published
annual reports, as indicated by the 1895 annual report of
General Electric, Illustration I, page 23. Patents and fran-
chises probably appear first because of their size. The sub-
traction of a mortgage from the corresponding asset was
popular at the time. The inclusion of profit and loss figures
on the asset side of the balance sheet seems highly unorthodox
from today's standards. Nevertheless, it was the method of

presenting deficits at this time. The arrangement of items

from fixed to a current basis was also typical of this era.

By the end of the nineteenth-century the form, especially

of the balance sheet, had been basically established even

though classification and subegroupings were crude. Subsequent

developments were generally in the direction of refinements

 

12George Soule, Soule's New Science and Practice of
Accounts (New Orleans, LOuisiana: unknown, seventh edition,

“TY—1 03 , p. 57.

23

 

 

 

 

 

 

 

 

 

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2H

and expansion of detail.13 Also by the end of the nineteenth-
century, develOpments in British and American law and auditing
had elevated the balance sheet to a position of prominence over
the income statement in external reports which was to con—
tinue well into the twentieth-century. A quotation from an

editorial in the AccountingfiReview makes this particular

 

point clear:

The British use of auditing for the pur—
pose of putting nineteenth-century corporations
under scrutiny probably had its inspiration in
the use made of auditing on feudal estates of
an earlier day. It seems probable that certain
existing concepts of accounting were established
at the same time, that is, before Italian methods
came into use in England. One idea having this
origin was the view that financial statements
were essentially reports of stewardship. The
charge and discharge statement certainly re-
flected that view very early; and the balance
sheet when it came into use much later, was
regarded as being more in the nature of a report
of a director's stewardship than a profit and
loss statement could be. Add to this the idea,
probably fully justified by nineteenth-century
competitive conditions, that the intimate
details usually placed in the profit and loss
statement were confidential, private information,
and the result may explain the fact that British
auditing practice, without neglecting examination
of profit and loss data, gave primary emphasis
to examination of balance sheet data....It is
therefore understandable that auditing should
give strong emphasis to the balance sheet. This
was particularly true in the United States at
the time when auditing was closely concerned with
the examination of balance sheets in support of
short—term credit.

...The prominence of balance sheet has
also been fostered by various statutory pro-
visions and numerous court decisions. This

 

13Littleton, op. cit., pp. 1H9-l53.

25

is true because accounting came into contact
with law only in special situations, usually
situations which could as easily be satisfied
by data from an appraisal statement of assets
and liabilities as by Tubalance sheet from
double—entry accounts.

Financial Accountingjl900 to 1929

 

General

The present so—called generally accepted accounting
principles evolved over the years in response to the
changing environment. But as mentioned in the previous
section, the essential form of financial statements had
evolved by the end of the nineteenth—century. For example,
the first really modern type of annual report was published
by the United States Steel Corporation in 1902. By 1916
General Motors Corporation began to publish a semiannual
report in addition to its regular annual report. Also, by
1926 a listed corporation on the New York Stock Exchange
was required to publish an annual report containing its
financial statements. Obviously, these events were mile-
stones in the development of external financial reporting.
Yet, in the first thirty years of the twentieth-century,
little progress, except for the standardization of finan-
cial statement formats, was made toward establishing stan-
dards to govern the preparation of financial statements.
Furthermore, with few exceptions, such as Paton's 1922

masterpiece Accounting Theory and Canning's 1929 book

 

 

lL'"Editorial," The Accounting Review, (July, 1945):
pp. 352-353.

 

26

The Economics of Accountancy, little progress was made toward

 

delineating the basic postulates underlying accounting.

Financial Statement Examinations
by Certified Public Accountants

 

 

In the first thirty years of this century many corporate
annual reports were, in terms of today's standards, grossly
misleading. Most companies, including the largest, were not
regularly examined by certified public accountants until the
middle of the nineteen twenties. Furthermore, the examina-
tions that were conducted were usually only at the request of
potential creditors, such as banks. The opinions of the
accountants preforming these examinations were short and usually
referred only to the accuracy of the statements and not to the
underlying principles and their consistency of application.15
For example, in the 1919 annual report of the General Motors
Corporation, accountants Haskins and Sells state in their
opinion letter: "We hereby certify that, in our opinion, the
accompanying Condensed Consolidated Balance Sheet for December
31, 1919, and related Summaries of Income and Profit and Loss
for the year ended that date are correct."

The Sixteenth Amendment and
Government Legislation

 

 

Governmental organizations and legislation influenced the
development of financial accounting during the first thirty

years of this century. For example, the Sixteenth Amendment

 

15Alvin R. Jennings "Accounting Research," The Accounting
Review, Vol. XXXIII (October, 1958), p. 5H9

 

27

in 1913 provided for the taxation of income. This amendment

and the subsequent legislation that followed had tremendous
impacts on the development of financial accounting. The legis-
lative acts of the early and middle nineteen thirties also
influenced the evolution of accounting, especially in the area
of financial reporting. In fact, the impact of federal taxation
and legislation will be considered in detail in Chapter VI as
one of the major forces influencing the external shift in

emphasis from the balance sheet viewpoint to the income state-

ment vieWpoint.

American Institute of Accountants'
Memorandums on Balance Sheet Audits

In the year 1917 a pamphlet entitled Approved Methods
for the Preparation of Balance Sheets Statements was pub-
lished by the American Institute of Accountants16 in co-
operation with the Federal Reserve Board and the Federal
Trade Commission for the purpose of improving the form and
content of financial reports of industrial and commercial
corporations. Included in this publication were suggested
forms of balance sheets and income statements for companies
whose financial statements were to be presented to financial
institutions, such as banks, for credit purposes. It must
be concluded that this effort was one of the very first or-
ganized attempts to standardize and provide authority for

‘various methods and practices. But this effort actually did

 

16
The American Institute of Accountants officially

changed its name as of June, 1957 to the American Institute
<of Certified Public Accountants.

28
very little to reduce the diverse treatments of like situa-
tions found in practice.
In 1929, a revised edition of this important publication

entitled Verification of Financial Statements (Revised) was

 

published also by the American Institute of Accountants. Like
the earlier edition, this revision focused attention on various
auditing procedures and the form and content of financial
statements to be utilized in obtaining credit. But unlike the
first edition, it paved the way for further cooperation between
the accounting profession and other governmental agencies
during the thirties. This cooperation that developed in the

thirties will be specifically covered in the next section.

Financial Accountingel930 to 19u2

 

General

Since 1930 there has existed intense interest in the
formulation of so-called "generally accepted accounting
principles" underlying financial statements. In fact, accord-
ing to Reed K. Storey, if the number of books and articles
concerned with the formulation and statement of accounting
principles is taken as an index of interest, there are at
least three easily discernible interest peaks since 1930.17

The first interest peak in accounting principles began

about 1930 and intensified in the second five years of that

decade. This peak was related to two important events: the

 

l7Reed K. Storey, The Search for Accounting Principles
(New York: American Institute of Certified Public Accountants,
196”), p. 3

 

29

publication of a report by the American Institute of Account—

ants entitled Audits of Corporate Accounts and establishment
18

 

of the Securities and Exchange Commission. The signifi-
cance of these two events, along with the depression of the
thirties, were the tremendous impacts upon latter deve10pments
in accounting theory and practice. As will be shown later in
this dissertation, these events were important factors result-
ing in the ascendancy of the income statement as the primary
accounting report to investors and other parties. Also, these
events were important because they resulted in the foundations
being laid for the guidance of all subsequent work on accounting

19

principles. That is to say, the basic concept which permits

a corporation to choose those methods and procedures which are
most appropriate for its own financial reports, within a
framework of generally accepted accounting principles, emerged
during the thirties and has guided the efforts of all parties

ever since.20

Activities of the American
Institute of Accountants

 

 

As early as 1866 the New York Stock Exchange had recognized
the need for release to the public of corporate financial state-
ments that were not misleading or confusing and that provided
full disclosure of information necessary for evaluating the

quality of corporate securities. Yet, as mentioned earlier, it

 

l8Ibid., p. 9.

19Ibid., p. 3.

20George 0. May, "Generally Accepted Principles of
Accounting," The Journal of Accountancy, Vol. CV (January,

 

30
wasn't until 1926 that a listed corporation was required to
publish an annual report containing its financial statements.
But by 1930 it was felt that cooperation between the New York
Stock Exchange and the American Institute of Accountants could
result in a higher quality of reporting by listed companies.21
Consequently, in 1930 a special committee of the American
Institute of Accountants was formed and headed by George 0.
May to work jointly with stock exchanges in an effort to im-
prove the caliber of financial accounting methods and procedures.
The special committee considered two alternative means
of reducing the numerous accounting methods and procedures
being used in practice. The first involved the use of a
designated authority whose function would be to select and
prescribe certain methods and procedures. Further, the methods
and procedures that were selected would then become binding on
all.corporations that fall within a certain class. Fortus.
Tuately, this alternative was rejected for fear that financial
aCicounting would become like regulatory accounting. The
53€3cond alternative allowed each corporation to select its own
InEi‘thods and procedures, provided that they were adequately
disclosed and applied with consistency. This second alternative
”V518 accepted and is the view that has survived in efforts to

$3tandardize financial accounting.22

K

21James Don Edwards, History of Public Accounting in the
kInited States (East Lansing, Michigan: Bureau of Business and
conomic Research, Michigan State University, 1960), pp. 150-151.

 

 

2
May, op. cit., pp. 2H—26.

31

In 1933 another committee known as the Special Com-
mittee on Development of Accounting Principles was formed by
the American Institute of Accountants. This committee issued
a report containing six basic principles, five of which had
previously been presented to the New York Stock Exchange by
the above mentioned committee working jointly with the Ex-
change. These six rules were very important first steps in
the development of so-called generally accepted accounting
principles.23

In 1938 a new committee known as the Committee on
Accounting Procedure and consisting of twenty—one members
from the accounting profession and the academic field
started a program of research which, together with a Com-
mittee on Terminology, resulted in the publication of fifty—
one opinions, known as Accounting Research Bulletins. The
Conmdttee's objectives were: (1) to develop and promote
genuerally accepted accounting principles and (2) to narrow
arxeas of difference and inconsistency in accounting prac-

‘tixae. The Accounting Research Bulletins reflected these two

 

Objectives since the approval of at least two-thirds of the

mennbers of the Committee were required for adoption. But

t1lease opinions were not directives to members of the Insti-
'ttrte and, consequently, received their authority only from

general acceptance by its membership.

\

23American Institute of Certified Public Accountants,
-ACccunting Research and terminology Bulletins (New York:
erican Institute of Certified Public Accountants, 1961,
final edition), preface.

 

 

32

Securities and Exchange Commission

 

During this first period of interest in accounting
principles an organization of the federal government was
created which was to have an enormous impact on the develop—
ment of accounting. The authority to administer the
Securities Act of 1933 was first given to the Federal Trade
Commission. This act was "an act to provide full and fair
disclosure of the character of securities sold in interstate
and foreign commerce and through the markets, and to prevent
frauds in the sale therof, and for other purposes."2l+

The Securities Act of 1933 disturbed the accounting
profession not only because it was felt that an unreasonable
amount of liability was imposed on the accountant, but be-
cause it was thought that this new legislation would result

in prescribed accounting principles.25
The Securities and Exchange Act of 193% provided "for
tflie regulation of security exchanges and over-the-counter
HMarkets operation in interstate and foreign commerce and
‘tlirough the mails, to prevent inequitable and unfair prac-
TIi.ces on such exchanges and markets, and for other purposes."26

{\Es in the case of the 1933 Act, this law was designed to pro-

‘tfiict the public from fraudulent and misleading practices

‘

2”United States Securities Act of 1933, An Act of the
Urlited States Government, May 27, 1933, Preamble.

25Edwards, op. cit., p. 156

26United States Securities and Exchange Act of 193H,
An Act of the United States Government, June 6, 193”, Preamble.

33

that effect the market price of corporate securities.27
The power of administration was taken away from the Federal
Trade Commission and vested in a new commission known as
the "Securities and Exchange Commission," or "SEC" as it is
commonly called.

The new Commission, like the Federal Trade Commission
under the 1933 Act, was given the power to prescribe forms
of financial statements. But the SEC chose at the outset to
consult with the accounting profession and left the latter
the responsibility of establishing reporting standards which
would be sanctioned by the Commission. This decision was
very gratifying to the accounting profession and has over the
years reduced the fear of dictated standards and unreasonable
amounts of liability.28

In 1937 the SEC started publishing opinions on various
accounting matters. These opinions were designed to develop
uniform practices in significant accounting problem areas.
These Opinions and regulations included the forms and content
for financial statements that must be filed with the Commission.
The influence of the SEC on the development of accounting
principles is obvious from the many books, articles, and
other publications. Furthermore, it will be shown that the
SEC was a prime factor influencing the change in emphasis

from the balance sheet to the income statement. This influence

 

27Louis H. Rappaport, SEC Accounting Practice and Pro—
cedure (New York: The Ronald Press Company, 1956), pp. 20-39.

 

28Recently (Fall, 1967), there have been some suggestions
that this policy may change. For example, in a WABC-TV inter-
view "You Want to Know," Chairman Manuel F. Cohen in talking
about comparability of financial statements suggested"that if
accountants don't keep moving expeditiously in this area that
the sEC can write their own rules."

3”

will be detailed further in this dissertation.

Activities of the
American Accounting Association

 

 

The American Accounting Association29 was reorganized
during this first so-called interest peak. Its objectives
were restated to include:

1. To encourage and sponsor research in
accounting and to publish or aid in the pub-
lishing of the results of this research.

2. To develop accounting principles and
standards and to seek their endorsement or
adoption by business enterprises, public and
private accountants, and governmental bodies.

3. To promote studies of accounting as
an agency for control of business enterprise
and economic affairs in general.

H. To improve methods of instruction

and to demonstrate the social benefits 0 a
more widespread knowledge of accounting.

These new objectives found expression during this period in
two formal statements prepared by the American Accounting

31 But W. A. Paton and

Association's Executive Committee.
A. C. Littleton, both members of the Executive Committee

at the time, elaborated and expanded substantially the basic

 

29At its 1935 annual convention the American Associa-
tion of University Instructors in Accounting changed its
name to American Accounting Association.

30"A Statement of Objectives of the American Accounting
Association," Accounting Review,Vol. XI (March 1936), p. l.

 

31"A Tentative Statement of Accounting Principles Under—
lying Corporate Financial Statements," AccOunting Review, Vol.
XI (June, 1936), pp. 187-191, and "Accounting Principles
Underlying Corporate Financial Statements," Accounting Review,
Vol. XVI (June, 19H1), pp. 133—139.

 

35
concepts contained in the above footnoted, 1936 statement.3
They succeeded in accomplishing much more than mere elabora—
tion as illustrated by the following quotation by the two
mastensthemselves:

We have attempted to weave together the
funadmental ideas of accounting rather than
to state standards as such. The intention
has been to build a framework within which a
subsequent statement of corporate accounting
standards could be erected. Accounting theory
is here conceived to be a coherent, coordinated,
consistent body of doctrine which may be com—
pactly expressed in the form of standards if
desired.

This discussion of the framework of

accounting standards seeks no extensive re-

form of corporation practices. The aim has

been to present a theory basis by means of

which corporation accountants may be helped to

make a realistic appraisal of their practices

and public accountants may be aided in review—

ing corporation reports.3

During the 1930's, like the first thirty years of the
twentieth—century, there was no drastic change in the form of
financial statements. But there was a change in the relative
importance of the financial statements themselves. Particu-
larly, there will be an attempt to demonstrate in Chapter III
the change in emphasis from the balance sheet to the income
statement as the primary accounting report for investors,
creditors and other outside interested parties. Also, it will

be shown that there is reason to believe that this shift was

external to the firm.

 

32W. A. Paton and A. C. Littleton, An Introduction to
Corporate Accounting Standards (Ann Arbor, Michigan:
American Accounting Association, 19H0), p. V.

33Ibid., Preface.

 

36

Financial Accounting—Contemporary

 

General

According to Storey the second cyclical peak of interest
in generally accepted accounting principles began shortly after
World War II and resulted mainly from some serious criticism of
certain practices developed during the war, of discrepancies
between taxable and reported net income, and of failure to ad-
just for the rapidly rising price level.34

This second interest peak was significantly different
from the first peak, even though the basic problem of stan-
dards underlying the preparation of financial statements re-
mained. The literature of this period reflects the .dominence
of the income statement and the accounting for income.

The last interest peak distinguished by Storey began in
1956 and still continues. This period also reflects the
prominence accorded the income statement, although there are
signs that indicate some feel it will see its demise.35
This period, like the post-war period, is not too significant
for the purposes of this dissertation because the income
statement was already unquestionably considered the primary

accounting report. That is to say, the shift had already

occurred.

 

3HStorey, op2 cit., p. 5

35R. J. Chambers advocates the capital maintenance ap-
proach to the calculation of income. Eldon S. Hendricksen
argues that both statements, under assumptions that are
substantially identical, theoretically can yield identical
answers to periodic income calculations. Others argue that
unless the income statement reports profits by division or
product line (the problem of conglomerate reporting), it will
lose its utility. '

CHAPTER III

THE INTERNAL SHIFT FROM THE BALANCE

SHEET TO THE INCOME STATEMENT

General
Before the advent of the corporate form of business
organization, the era when owner and manager were identi—
cal, and when business income or profits resulted from
successful ventures or from monopoly power, it was "unlikely
that annual income statements were of use for the purpose of
testing the profitability of operations as a whole as a guide

"1 On the other hand, the balance sheet was

to future action.
of considerable importance during this early era. For ex-
ample, Littleton suggested that in the fifteenth century the
balance sheet reflected a merchant's "estate" for property
tax purposes. In addition, he referred to the French ordi—
nance ("Inventaire") proposed by Jacques Savary in 1673 and
to other early examples which show the balance sheet as the
"estate" and the income statement simply a "proof of the

estate."2

 

1'Raymond J. Chambers, "The Implications of Asset Re-
valuation and Bonus Share Issues", Australian Accountant,
vol. 27 (November, 1957), p. 51H.

2A. C. Littleton, Accounting Evaluation to 1900 (New

York: American Institute Publishing Company, Inc., 1933),
pp. 132-136.

37

38
These examples of early practices suggest that the balance
sheet was accorded superiority over the income statement by
both internal users and external parties.

But, as is known today, the Opposite is the case. In-
come statement data are considered more important. Thus, there
was a shift in emphasis from the balance sheet viewpoint to the
profit and loss viewpoint. In fact, it will be shown that
there was a dual shift. That is to say, there was a shift to
the use of income data by management and there was one by
investors, creditors, and other external interested parties.
This chapter will be directed at the former shift not only
because it occurred first chronologically, but because it
was one of the forces responsible for the latter shift in
interest. Also, there be an attempt to demonstrate not only
the nature of this new emphasis on profits by internal manage-
ment, but to isolate those ideas and events that were instru-
mental forces influencing the shift.

The following chapter will be concerned with the docu-
mentation of the external shift in emphasis from the balance
sheet to the income statement. In addition, both endogenous

and exogenous reasons for this shift will be presented.

The New Emphasis on Profits

 

Beginnings of Industrialization

The numerous inventions in England, between 1750 and
1800, are important events because they ushered in what has
been called the Industrial Revolution by Arnold Toynbee.

English economic society needed only a slight stimulant to

39
crystallize in a new form, and the stimulant came from in-
ventions in the textile industry in response to the rapidly
increasing foreign and domestic demand for goods and services.
The inventive genius of James Hargreaves in his spinning
jenny (1764), Richard Arkwright in his water frame (1769),
Samuel Crompton in his spinning mule (1779),and Kay (1738)
and Cartwirght (1784) in their perfection of power weaving
introduced mechanical inventions that made possible the pro-
duction of a greatly increased quantity of goods through the
use of the factory system. In addition, the improvement of
the steam engine by James Watt in 1785 was also a milestone
because it enabled the supplanting of power provided by
animals.3 Although these inventions and improvements had
substantial impacts on all subsequent aspects of economic
activity and were themselves the result of many complex and
remote causes, their immediate impact on the internal shift
in emphasis from the balance sheet to the income statement
point of View is minimal because the proprietorship and part—
nership forms of business organizations still dominated. As
a result, owners were generally managers who had no reason for
testing the profitability of Operations as a whole as a guide
to future action. Nevertheless, there were scattered develop-

4

ments in cost accounting during this period which indicate

 

3Edward McNall Burns, Western Civilizations (New York:
W. W. Norton and Company, Inc., 1958) pp. 636-642.

 

L'For a good summary of these developments see S. Paul
Garner, "Highlights in the Development of Cost Accounting,"
IPeprinted in William E. Thomas, Jr. editor, Reading in Cost
fgzcounting, Budgeting and Control (New Rochelle, New York:
Eiouth-Western Publishing Company., second edition, 1960),

I>I>. 2-14. '

 

40
that a change was in the making. In addition, there were
signs that the rise of the factory system would eventually
require a new form of business organization—-the corporation.
Particularly, the main signs were the huge capital invest-
ments that were beginning to be needed and the increasing-

ly competitive environment making survival tenuous at best.

The Second Industrial Revolution

 

The Industrial Revolution in about 1860 entered a new
phase so different from what had preceded it that some his-

torians call it the Second Industrial Revolution. The events

 

which ushered in this new phase were mainly: (1) the Bessemer
process for making steel; the perfection of the dynamo; and
the invention of the internal combustion engine.5 These and
other events resulted in the development of an industrial
society based on technology, mass production, and mass mar—
keting. In America a system based on partnerships or joint-
stock companies emerged and has been called Industrial Capi-
talism. The great industrial capitalists, like Andrew
Carnegie, Samuel Slater, Philip Armour and Gordon McKay, were
specialists of production rather than finance and followed a
social code from the philosophy of Social Darwinism. This
code held that economic life was, like biological life, the
survival of the fittest. Professor Kroose's remarks about the
industrial capitalist are particularly significant:

Usually starting on a small scale, he raised

most of his capital by plowing earnings back into
his business. He despised financial mechanisms,

5Burns, op, cit., p. 643

41

such as balance sheets, income statements, and

value based on earnings, and drew no distinction

between the stockholder and the speculator.6

In the quest for increased supply of goods through the
principle of survival of the fittest, the industrial capitalist
naturally placed heavy emphasis on efficiency as measured by
the volume of output (e. g. tons of steel). These men con—
centrated on dynamic individuals placed in the right jobs and
encouraging rivalries between managers and superintendents in
an effort to squeeze even greater efforts. They generally did
not believe in "evaluating a business on the basis of its
earning power."7 Thus, they did not concentrate on income
statement data or elaborate cost accounting systems. Never-
theless, their emphasis on efficiency was to continue into
the corporation and provide impetus for the forthcoming shift

to income and expense data.

The Rise of the Corporations

 

By 1890 the state of technological progress and the
’growing consumer demand for mass—produced goods required large
iamounts of capital. Furthermore, the bitterly competitive at-
mosphere that the great industrial capitalists had created
with their ruthless tactics resulted in a high bankruptcy rate
and a high degree of insecurity among average businessmen.

As a result, there was a need for a type of business organi-

zation that would provide the necessary capital and yet reduce

¥

6Herman E. Kroose, American Economic Development
(Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1962)p.275.

71bid., p. 276

42
the high degree of personal liability.

The corporate form of business organization, although
legally sanctioned much earlier,8 was ideally suited to ful—
full these two needs through its stock ownership, limited
liability, transferability of interests, and separation of
owners and managers features. The new force generally con-
sidered responsible for the initiation of this corporate
revolution in America was the so-called financial capitalist9——
the banker, the investment banker, and the insurance company.

The business policies of the financial capitalists were
quite different from the:hmhstrial capitalists. They tended
to spread their influence over many different industries in-
stead of specializing in a single business. Consequently, the
financial capitalists were instrumental in many reorganizations
and consolidations. As a result, their interests were too
diversified to permit them to undertake an active entre—
preneurial role in the actual day-to—day decision—making of a
business. Thus, managers were appointed to assume this func-

tion. This delegation of authority to management eventually

 

8The first modern corporation law in the United States
was passed by the Connecticut legislature in 1837, although
New York State had passed a less modern version in 1811. In
England the first modern corporation act was the British Com—
panies Act in 1862, although a less compleuaact was passed in
1855.

I. Pierpont Morgan was the chief representative of the
new financial capitalists. For a good discussion of his ex-
ploits see Lewis Corey, The House of Mopgan (New York: Grosset
and Dunlap, Inc., 1930). For example, beibecame the head
railroad financier in 1879 when he handled the sale of 250,000
Shares of New York Central stock; in 1892 he helped organize
‘the General Electric Company; in 1901 his capital conSolidated
.firms producing sixty percent of the nation's steel into the
LInited States Steel Corporation; also he was an important factor

lDehind the establishment of American Telephone and Telegraph
CkDmpany, International Harvester, as well as holding a con-

‘t1?011ing interest in a number of commercial banks, trust com—
IDEinies and 1nsurance compan1es.

 

43
resulted in the emergence of a new force, the professional
. 10
manager1a1 class.

As one might eXpect, financial capitalists were more
interested in financial policy than in any other aspect of
business activity. They preferred corporate finance rather
than industrial management as the following quotation reveals:

Income statements and balance sheets,

earnings per share, security prices, capitali-

zation and security flotations interested them

much more than the index of industrial produc-

tion, the outppt of pig iron, or the volume of

car loadings.

Although the financial capitalists were important
factors contributing to the internal shift in emphasis, as is
obvious from their financial policies, it was the new pro-
fessional managerial class resulting from the corporate form
of business organization that was really important.

The ascendancy of the professional manager, like all
,changes in business history, was not a revolutionary change.
It took place gradually and reflected among other things the
government's increasing economic influence as evidenced by
the anti-trust legislation, the increasing importance of
labor unions, and the public concern over the standard of

12 The most important factor, however, was the in-

living.
creasing complexity of the business enterprise itself. Stock-
holders were becoming so numerous and businesses so large and

complex that it became impracticable for the owners to both

 

loE. A. Johnson and Herman E. Kroose, The American

Econom (Englewood Cliffs, New Jersey: Prentice—Hall, Inc.,
IS60), pp. 250-254.

11 .
Ibid., p. 251

 

l2Ibid., p. 261

44
control and operate their corporations. Thus it became
feasible for a group of professionals, who were specialists,
to make the necessary decisions. No single individual
possessed the breath of knowledge or the time and energy to
make all the decisions of a large corporation. In short,
the directors of a large corporation had "to use accounting
and statistics;' the management had to be departmentalized;
and experts in each field became important?l3

Among other things, the two more important impacts on
accounting thought and practice at first were the need to
test the profitability of operations through the use of cost
and revenue data by the professional managers and the emphasis
on the balance sheet for external parties to meet the demands
of the auditors, owners, and the financial capitalists, par-
ticularly banks. This latter phenomenon, the emphasis on
the balance sheet for external parties, was enhanced because
of the widespread fear that legislation requiring the presen—
tation of audited balance sheets, such as the Joint Stock
Companies Act of 1862 in England, would also appear in the
United States. For example, Section 94 of this British Act
stated that the auditors must disclose "whether in their
Opinion the balance sheet is a full and fair balance sheet."11+
On the other hand, there were no pressures demanding the dis-

closure of income statement data in the early years of the

corporate form of business organization. In fact, it was the

 

l3lbid., pp. 262-263.

lL'A. C. Littleton and V. K. Zimmerman, Accounting Theory:
Continuity and Change (New Jersey: Prentice—Hall, Inc., 1962),
p. 106.

 

 

45
.general belief that profit and loss data were confidential

information that could, if disclosed, aid competitors. As

a result, income statements were seldom released that pro-

vided any meaningful information.

Evidence of the Internal Shift

 

Development of Cost Accounting

One of the most significant developments that provides
evidential support for the internal shift in emphasis was
the rapid emergence of cost accounting between 1885 and 1930.
One of the earliest works in this area was Henry Metcalfe's

Cost of Manufactures, published first in 1885. Although many

 

of the ideas and techniques suggested by Metcalfe were not
unknown, their integration into a unified costing system was
a significant accomplishment because the beginnings of cost
control for profit improvement were introduced.15
Two years after the first edition of Metcalfe's book
appeared, two English practicing cost accounts, Garcke and
Fells, published the first edition of their book Factory
Accounts. Despite the fact that they introduced a scheme for
showing the flow of cost through the firm that resembles to-
day's method,16 the most striking innovation was their pro—
cedure for integrating cost accounts with financial accounts

in the general ledger. From this procedure it would be a

simple task to use revenue accounts and those cost accounts

 

lsS. Paul Garner, "Highlights in the Development of
Cost Accounting", op2 cit., pp. 9-10.

168. Paul Garner, Evolution of Cost Accounting to 1925

(University, Alabama: University of Alabama Press, 1954), p.257.

 

46

for the calculation of profit and loss from Operation.

American writers quickly espoused this idea of integra-
ting cost and financial accounts. For example, John Whitmore
was one such early writer. In expanding on a series of
articles by A. Hamilton Church, Whitmore implied the new
emphasis on profits in the following quotation from his series
of articles:

The fundamental principle is always the

same, namely the principle of making a record

sufficiently full to constitute a clear accounting

for factory expenditure; and the object of the

accounts is always the same1 namely, to elimiL

nate waste from Operations.
Furthermore, in commenting on the relationship of factory
accounting to managerial organization he stated:

The organization of a factory and its

system of accounts and records are so closely

allied, are so inseparable, that to talk of one

is necessarily to talk of the other.18

Lastly, after detailing his cost system and the neces—
sary journal entries to iintegrate it into the financial
accounts, Whitmore explained: "profits are determined on the
basis of these cost figures...giving thus the net result of

"19 These quotations indicate it was recognized

operations.
that the integration of cost accounts into financial accounts
made possible an improved method for calculating profit and

loss through the matching of revenues and expenses.

 

l7John Whitmore, "Factory Accounts as Applied to
Machine Shops" The Journal of Accountancy, Vol. II (August,
1906), p. 249.

 

l8,
Ib1d., p. 345.

lg;pid., Vol. III (November, 1906), p. 31

47
Other writers followed Whitmore's idea of account inte-
_gration while stressing the importance of cost accounting
for profit improVement through coSt control. ”For example,
J. Lee Nicholson treated the matter at length in his 1909

Book Factory Organization and Costs, his 1913 book Cost

 

Accounting-Theory and Practice, again in a book published

 

in 1919 with J. D. Rohrback entitled Cost Accounting, and

 

finally in 1923 in his book Profitable Management. Nichol-

 

son's 1909 publication was important because he went to great
lengths to specify what we would call today a cost center
where costs were to be accumulated under the three main
elements, direct labor, materials, and burden. But, most
importantly, he introduced a system of distinguishing the
sales for each division or department so that gross profit
calculations could be made by division or department.
The significance of this development is that it provides
further evidence of the extent to which income statement
data were being utilized internally. Nicholson in his 1913
work elaborated on the ideas and methods contained in his
first book. Furthermore, he presented an elaborate pro-
cedure for coordinating the cost and financial ledgers through
the use of two reciprocal accounts.21

Although Nicholson's 1919 and 1923 books refined and
elaborated his earlier publications, several quotations will

indicate the importance accorded income and expense data.

 

20J. Lee Nicholson, Factory Organization and Costs (New
York: Kohl Technical Publishing Company, 1909), pp. 31—33.

218. Paul Garner, Evolution, Op. cit., p. 271

 

48

Furthermore, these quotations also show that the integration

of cost and financial accounts was complete. The former is

illustrated when he stated:

The methods of modern business have
become exceedingly technical and complex.
But their objective is easy to define--
it is control of the busineSS° and control
is wanted to insure profits.2§

Account integration is suggested in the following:

Cost accounting, as a science, is a
branch of general accounting...With the
cost books once established, the best modern
usage is to incorporate their record in total
in the general financial books. In this way
the modern cost system builds up an inter-
working series of accounts which furnish the
basis for a detailed study of the Operations
of a manufacturing business.

Other American writers such as Frank E. Webner and
C. E. Knoeppel, the engineer-accountant, were also espousing
ideas and concepts similar to Nicholson. For example, Webner
stated "the slogan of present-day industry is efficiency."2ur
Furthermore, he also felt that cost accounts and general
accounts should be integrated.25 C. E. Knoeppel stated in
describing the relationship between accounting and engi-
neering:

Accounting and engineering are concerned

with the same thing-—reducing costs--for only
through a reduction of costs can larger profits

 

22J. Lee Nicholson, Profitable Management (New York:
The Ronald Press Company, 1923), preface.

23J. Lee Nicholson and John F. D. Rohrback, Cost
Accountipg (New York: The Ronald Press Company, 19I9), p. 5

 

 

2L'Frank E. Webner, Factory Costs (New York: The
Ronald Press Company, 1911), p. 25.

 

251bid., p. 29.

49
or increased margin of sales be expected.2

Before leaving this section it is worth mentioning the
cost convention, as Paton called it, that became a basic
assumption in cost accounting. This convention is important
because it became integrated into the matching concept as its
characteristics indicate. A quotation from Gilman makes this
point clear:

This new subdivision of accounting (cost
convention) was based upon a convention that
costs could be transferred from one object to
another, from one classification to another,
and from one activity to another. Thus, the
depreciation of a building operates as a
transfer of value from the building itself to
the materials in progress of manufacture,
simultaneously lessening one value and in~
creasing another.

This convention enables the cost account—
ant to visualize a flow of values springing from
expenditures of various types, through classified
channels, finally attaching themselves to, and
increasing the valuation of, the materials in
process of manufacture. Direct labor and various
other factory costs, such as rent, heat, light,
property taxes, insurance, and supervision, came
to be regarded as assets because they attach them-
selves to materials in process.

This convention is important because it attempted to show a
direct relationship between specific items of income to
specific items of cost-outlay. The lacking element for the
matching concept was the identification of the items to

specific time periods.

 

26C. E. Knoeppel, Organization and Administration (New
York: Industrial Extension Institute, V01. 1, 1921), p. 245.

27Stephen Gilman, Accounting Concepts of Profit (New
York: The Ronald Press Company, 1939), p. 29.

50

Activities of the Scientific Management Engineers

 

The activities of the so—called scientific-management
engineers, although not a direCt indication of the shift by
management to income statement data, provides indirect evi-
dence of the new emphasis. This evidence is revealed through-
out their writings because of the emphasis accorded efficency
of operations, which in turn, implies an emphasis on profits.
For example, Frederick W. Taylor, considered the father of
scientific management, stated in one of his famous books:

The principal object of management

should be to secure the maximum prosperity

for the employer, coupled with the maximum

prosperity for each employee.

Further, he used the words "maximum prosperity" in their
broad sense to mean not only large dividends for a firm or
owner, but the development of every branch of business to its
highest state of excellence, so that prosperity may be per-

manent.

In his 1903 more technical book, Shop Management, Taylor,

 

as a means of measuring efficiency, turned to or worked directly
with cost accountants. Cost accounting techniques were used

to compare the actual cost of an operation to its predeter—
mined cost. This comparison was actually the beginning of
standard costs where the difference between standard and actual
cost could be used as a basis for investigating waste and in-
efficiency. Taylor believed this method of measuring efficiency

represented the principle of scientific management—-"knowing

 

8Frederick W. Taylor, The Principles of Scientific
Management (London and New York: Harper and Brothers Publishers,
1911), p. 9. i

29 .
Ib1d.

 

 

51

exactly what you want men to do, and then seeing they do it
in the best and cheapest way."30

Another famous American engineer, Henry L. Gantt, con-
centrated his efforts on the matter of idle time and capacity
by proposing that indirect expenses chargeable to output of
the factory should bear the same ratio as those chargeable at
normal capacity. In short, he was introducing what today is
the notion of "normal" burden and predestined overhead rates.
This emphasis on overhead costs and Taylor's use of elementary
standard costing is important because it helped provide a
means for a better matching of revenues and expenses. As a
result, the utility of the income statement was enhanced.

There were many other scientific management engineers
whose efforts are indicative of the fact that an internal
shift to profit and loss data had occurred. For the purposes
of this study a reference to an article by C. Bertrand
Thompson is sufficient to demonstrate this shift, even though
these engineers were not specifically concerned with the ac-
counting problems associated with the matching process.

The development of the factory system

brought with it many new problems connected

with the organization and labor, the structure

and equipment of factories, and the techniques

of production. By successful manufactures

these problems have always been solved in a way

to make manufacturing at a profit possible.

Early solutions, however, were necessarily
crude and roughshod. With the enormous 1ncrease

 

30Frederick W. Taylor, Shop Management (New York: Harper
and Brothers Publishers, 191177’p. 21.

 

l
Eldon S. Hendricksen, Accounting Theory (Homewood,
Illinois: Richard D. Irwin, Inc., 1965), pp. 30-31.

 

52

in demand for manufactured products, in the
investment of capital, and the number of men
engaged in business, with the consequent
deve10pment of ever-keener.competition the
early methods have been found insufficient.
Especially within the last twenty years a
degree of skill and technical training has
been brought to bear upon the solution of
factory problems which has made modern
factory management much more elaborate, 32
refined, and effective than ever before.

Evidence from Selected Firms

 

Developments in cost accounting and the activities of
the scientific management engineers provide a certain kind of
documentation for the new emphasis because the techniques,'
procedures, and theories proposed were all geared :at cost
reduction for increased efficiency of Operations, which in
turn, would hopefully result in increased profits. In essence,
one might postulate that the most logical reason for these
developments and activities was the increased demand for in-
formation by management resulting from the rise of the cor-
porate form of business organization and the changing com—
petitive environment which evolved from the industrializa-
tion of society. Even though the literature of the cost ac-
counting and scientific management writers is highly sugges-
tive of the internal shift in emphasis, it is not conclusive
enough to conform with the requirements of "scientific"
historical research as suggested in Chapter 1. Thus, as part
of the research for this study an attempt was made to secure

early internal income statements to ascertain whether income

 

32C. Bertrand Thompson, "The Literature of Scientific
Management," Quarterly Journal of Economics, Vol. XXVII (1914),
p. 506.

 

53
data were actually emphasized before the shift from the
balance sheet to the income statement occurred for external
parties in the early 1930's.

The investigation conducted started with the selection
of 45 businesses, shown in Illustration II, page 54, which
were listed on the New York Stock Exchange on or before 1920
(25 were listed in 1912) and which still survive. No attempt
*was made to select randomly the sample or to calculate its
confidence limits. The governing factor was survival of the
firm today so that the desired information could be more
readily Obtained. On the other hand, companies were selected
form various industries so that a cross section of data could
be obtained in order to indicate the scope of internal state-
ment used before 1930. Although a statistically testable
sample was not drawn, the selection was appropriate because
the number of corporations listed on the New York Stock Ex-
change in 1920 or before was relatively small as compared to
today. As a result a sample of 45 companies would, if sta-
tistically verified, be more than enough to provide 95% to
98% confidence limits.

The second step was to mail a copy of the letter shown
in Illustration III, page 55, to the controllers of each of
the previously listed 45 companies asking for internal income
statements for a period before the external shift from the
balance sheet to the income statement as the primary accounting
report occurred during the early 1930's. Of the 45 companies,
to whom the letters were mailed, nine did not reply at all and
eight either stated that their records did not extend back, for

some reason or another, to that era or their company's policy

10.
11.
12.
13.

14.

15.

16.
17.
18.
19.

20.

21.

22.

54

ILLUSTRATION II

 

LIST OF SELECTED COMPANIES

Allied Chemical Corporation 23.

Allis-Chalmers Company 24.

American Can Company 25.

American Ship Building Com- 26.
pany

American Smelting & Refining 27.
Company

28.
American Steel Foundries,Inc.
29.
American Telephone & Telegraph
Company 30.
Anaconda Company 31.
Armour and Company 32.
B. F. Goodrich Company 33.
Bethlehem Steel Corporation 34.
Brunswick Corporation 35.
Coca-Cola Company 36.
Crucible Steel Company of 37.
America
38.
E. I. duPont deNemours and
Company 39.
Eastman Kodak Company 40.
F. w. Woolworth Company 41.
General Electric Company 42.
General Motors Company
43.
International Harvester
Company
44.
J. C. Penney Company, Inc.
Kellogg Company 45.

CONTACTED

Kennecott Corporation
Liggett 6 Myers Tobacco,Inc.
National Biscuit Company

National Steel Corpora-
tion

New York Air Brake Company
Otis Elevator Company
Owens-Illinois

Phelps Dodge Corporation
Procter & Gamble Company
Pullman Incorporated

P. Lorillard Company
Remington Office Equipment
Republic Steel Company

S. S. Kresge Company

Sears Roebuck & Company
Sinclair Oil Corporation
Standard Oil Company (N.J.)
Uniroyal (U.S. Rubber)
United Fruit Company

United States Envelope
Company

United States Steel Cor—
poration

Westinghouse Electric
Company

White Motor Corporation

55

ILLUSTRATION III

 

SAMPLE COPY OF LETTER MAILED TO
45 SELECTED COMPANIES

October 30, 1967

Mr. James Jones

Vice-President and Comptroller
XYZ Corporation

1690 Erie Road

Pittsburgh, Pennsylvania 15230

Dear Mr. Jones:

As a Doctor of PhilosOphy candidate in Accounting I am doing
my dissertation in the area of the history of accounting
thought. Specifically, this study will be concerned with the
shift in emphasis from the balance sheet to the income state-
ment as the primary accounting report.

Since the XYZ corporation was a pioneer in the development of
annual reporting to stockholders, your old statements are an
invaluable aid. However, it seems necessary to ascertain
whether or not an elaborate income statement was prepared
internally, as Opposed to the condensed version for external
reporting, before the shift in emphasis occurred during the
early 1930's. If there were elaborate income statements
prepared at this time I would very much appreciate a copy of
one or visit your company to examine them if they are un-
available.

Thank you for your anticipated co-Operation.

Sincerely yours,

Clifford D. Brown
Doctoral Candidate
Michigan State University

CDB/ceb

56

did not permit them to divulge such information. The re—
maining twenty-eight companies that did reply sent copies of
early internal income statements, disclosed their nature in
a letter, or included combinations of both.

Upon analyzing these internal statements and letters
it was concluded that income statement data were highly sig-
nificant for internal management long before the shift in
emphasis occurred for external parties, such as investors and
creditors. These statements and letters do not, however,
specifically document a shift from balance sheet data to in-
come statement data by internal management. They simply
suggested that no shift occurred internally during the early
1930's, the time that, as will be shown later in this chapter,
it occurred in the minds of external parties. This latter
suggestion is particularly important to this dissertation,
even though as was detailed earlier in this chapter or an
earlier chapter there is reason to believe that the rise of
the corporation in response to the changing economic scene
resulted in the increased emphasis on profit and loss data
by internal management between 1890 and 1930. A documentation
of the fact that profit and loss data were extensively used
by management before 1930 is sufficient evidence to conclude
that the shift in emphasis from the balance sheet to the
income statement in the 1930's as the primary accounting report
was an external shift only. On the other hand, this conclusion
does not preclude one from suggesting that the external shift
did not have an impact on internal accounting. To be sure,

the refinement of the matching concept and the resulting

57
principles underlying the preparation of financial statements
that resulted from this new external emphasis on the income
statement affected internal accounting by providing better
techniques and methods for the assembly and communication of
more relevant and timely information.

Some selected quotations and examples from these replies
will now be presented in support of the above conclusion.

Mr. John N. Hart, Vice-President and Controller of the B. F.
Goodrich Company in his letter of November 28, 1967 made the
following statement:

The shift in emphasis, which you are con-

cerned with, is a shift made by creditors and

stockholders who are outside the business as

compared to internal operating people who are

concerned with the day—to-day problems of

production and sales.

Furthermore, he stated in reference to internal balance
sheets prior to 1930 "that very few operating personnel below
the senior corporate executive received balance sheets." On
the other hand, in reference to internal income statements of
this early era he stated that they "varied in degree of
'elaborateness' depending upon the level of management to
which they were furnished."

Mr. G. D. Dearlove, Assistant Comptroller of International
Harvester Company in commenting on his company's internal in-
come statements prior to 1930 stated:

While there have been changes in phi—

losophy and improvements in format over the

years, internal income statements of the

Company have always been in sufficient detail

to provide adequate information for internal

management purposes and, therefore, of neces-

sity, have generally been more complete than
statements appropriate for external reporting.

58
Mr. Fillmore B. Eisenberg, Vice-President and Controller
of the Coca-Cola Company wrote regarding the form of his
company's internal income statement prior to the 1930's the
following:

....for internal management purposes we
have always prepared more detailed statements
than those published in the annual reports to
stockholders. Over the years these statements
have taken various forms and emphasis has been
directed to different areas depending on the
nature of conditions and problems extant at
the time, since as you know our Company has
deveIOped greatly and in many directions over
its long history. Our objective with regard
to internal management statements has always
been to supply operating managers with suf-
ficient detail, either in the income state-
ments, or as supporting schedules to allow
them to have a comprehensive picture of cur—
rent operations. Such information would in
general consist of sales, both dollars and units
of product, details of manufacturing expenses
and other cost of sales items and details of
various operating expenses.

Mr. Charles C. Link, Jr., Assistant Comptroller of
American Smelting and Refining Company wrote the following
in reference to his company's internal income statements
before 1930:

In connection with your recent letter
concerning income statements prior to the 1930's,
you are correct in your assumption that ASARCO
prepared for internal use a more detailed income
statement than that used in its external reporting.

Basically, the Company philosophy has
always been oriented toward reporting earnings
by .management responsibility. Each plant or
mine is treated as an individual profit center,
and an individual profit and loss statement is
prepared by each (generally on a monthly basis).
This was true even before 1930.

The internal income statement before 1930
included three main groups: smelting and refining
plants, mines, and all other items. Each plant
and mine was listed and the total earnings of

59

each group reported- The plants were the
respOnsibility of the Vice-President in
charge of Smelting and Refining, while the
mines were the responsibility of the Vice-
President in the Mining Department. Each
of these vice-presidents had group mana-
gers in turn responsible for certain sub-
'divisions (Mexican smelters, Mexican mines,
Southwestern Mining Departments, etc.)

The "all other items," which were
small in number, were the responsibility of
other Company officials although not then
important enough to be reported in sub-groups.

This early basic system is still in use
today, but it has been expanded to reflect
larger volume of business and the importance
of additional activities now performed by the
Company.

Mr. N. E. Jones, Associate Comptroller of the Procter
and Gamble Company in commenting on his company's income
statements prepared for internal use prior to 1930 wrote:

Income statements prepared for internal
use prior to 1930 were just as elaborate and
detailed as those prepared after the shift in
emphasis occurred during the early 1930's.

Our perusal of the available internal records
in the 20's and 30's shows no shift in emphasis
or detail. The change which occurred was an
external change. 5

An executive of a large steel company answered in his letter
as follows:

In both the period prior to the early
1930's and the current period there are
detailed supporting statements for internal
use-~many more now than in the early period
due to the decentralization of management
and the general trend to responsibility
accounting at all levels. The availability
of data processing equipment serves these
needs but additiOnally provides more detail
which could not have been provided under the
essentially manual techniques employed in the
earlier years.

Mr. E. A. Bescherer, Specialist——General Accounting
Research, of the General Electric Company stated in his

reply:

60

A review of our reports at that time
indicates that there were more elaborate
reports prepared internally from at least
the mid-1900's. For example, for 1930 a
statement was prepared which analyzed
operating results down through "Profits
available for dividends" by major segments
of the business. In addition, there were
more detailed breakdowns of a number of the
items, such as "Income from other sources,"
shown in the published statements.

This statement by Mr. Bescherer is supported and documented
in a series of three books entitled General Electric's Growth,

General Electric's Organization, and The Work of a Professional

 

 

Manager copyrighted by the General Electric Company under the
title Professional Management in General Electric.33
The Assistant Controller, F. G. Saviers of Westinghouse
Electric Corporation stated in his reply that "in the year
1928 the corporate statement (income) included considerably
more detail than that which was published in the Annual Re—
port." To verify this he included a COpy of the income state-
ment as published in the Annual Report of 1928, and a copy of
the internal income statement for the same year. These state-
ments are reproduced as Illustrations IV page 61 and Illus-
tration V page 62 respectively. Furthermore, he felt that
"there were many detailed statements prepared for internal
use for such items of expense as distribution, administration,
and etc." even though, in accordance with company policy,

these detailed statements were not retained. At a glance, one

of the significant features of the internal income statement

 

3See for example Chapter Two, Evolution of Organization,
in Book One, General Electric's Growth (United States of
America: General Electric Company, 1953), pp. 23—58.

61

ILLUSTRATION IV

 

WESTINGHOUSE ELECTRIC STATEMENT OF CONSOLIDATED

INCOME AND PROFIT & LOSS FOR THE

YEAR ENDED MARCH 31, 1928

Gross Earnings:
Sales Billed

Cost of Sales:

Factory Cost, including depreciation of
Property and Plant and all Distribution,
Administration and General Expenses; and
Taxes ...............................

Net Manufacturing Profit
Other Income:

Interest, Discount and Miscellaneous In-
come and Profits.....................

Dividends and Interest on Sundry Stocks
and Bonds Owned .....................

Gross Income From All Sources
Deductions from Income:

Interest Charges......................
Net Income for the Year .................
Dividends on Preferred and Common Stocks.
Surplus for the Year ....................
Surplus, March 31, 1927..................
Gross Surplus............................

Adjustments:
Reserves for possible adjustments of
book values of Investments in Affiliated
Companies,
Accounts Receivable and Miscellaneous
Charges,
of certain Investments...............
Patents, Charters, Franchises, Etc.,
written down to nominal value........
Total.........
Less balance of Reserve previously
appropriated for Federal Income Taxes,
not required.........................

Surplus, March 31, 1928, Per Balance Sheet.

 

for Pensions and for Notes and

less profit realized on the sale

 

XXXX
XXX}!
XXXX

XXXX

XXXX XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXX)!
XXXX

XXXX

XXXX

XXXX

XXXX XXXX
XXXX

 

62
ILLUSTRATION V

WESTINGHOUSE ELECTRIC COMPARATIVE STATEMENT

OF OPERATIONS FOR THE PERIOD

ENDED MARCH 31, 1928

Net sales billed .........................
Cost of sales billed......................
Per cent of net sales billed...........
Manufacturing profit......................
General expenses:
Distribution...........................
Administration.........................
Total...........
Gross operating profit....................
Per cent of net sales billed...........
Other charges against operations..........
Miscellaneous charges..................
Standard development-Unapplied.........
Total...........
Net operating profit......................
Per cent of net sales billed...........
Other income:
From investments.......................
Dividends-Other proprietary compan1es..
Interest and discount..................
Royalties..............................
Miscellaneous..........................
Total...........
Gross income (Line 13 plus 20)............
Deductions from income:
Interest charges.......................
Federal taxes accrued and miscellaneous
Total...........
Net income.............................
Surplus adjustments, net..................
Inter-manufacturing company dividends.....
Surplus for period........................
Surplus beginning of period...............
Surplus available for dividends and other
purposes.................................
Dividends on capital stock:
Preferred stock........................
Common stock...........................
Total..........
Surplus end of period.....................

XXXX
XXXX

‘XXXX
XXXX

XX XX
XX XX

XXXX
XXXX
XXXX
XX XX
XXXX

XXXX
XXXX

XXXX
XXXX
XXXX
XXXX
XXXX

XXXX

XXXX
XXXX

XXXX
XXXX
XXXX
XXXX
XXXX

XX XX

XX XX
XXXX

XXXX

XXXX

XXXX

XXXX

XXXX
XXXX

63

or the Comparative Statement of Operations as it is called,
was the separation of Manufacturing Profit expressed both in
dollars and as percentages of net sales billed. On the other
hand, in the published statement of Consolidated Income and
Profit and Loss, these items were included in one figure, the
Cost of Sales, leaving a Net Manufacturing Profit balance.
These alternative treatments suggest the importance given to
profit and loss data for internal purposes as Opposed to the
condensed version for external purposes prior to the occurrence
of the so-called shift in emphasis in the early 1930's.

Allied Chemical Corporation's Assistant Comptroller,
Mr. F. L. Linton, stated in his reply that:

Allied Chemical was organized in 1920 by

the alliance of five companies which subsequently

became operating divisions. The income statements

prepared for the managements of these companies

and the consolidated income statement were much

more detailed than the published condensed version.

Another major supporting schedule presented

sales quantities, sales dollars, cost of sales and

‘gross profit by major products or major product

pgroups.
Furthermore, he included selected copies of his company's old
methods bulletin which show the composition of the internal
income statement and the major supporting schedules of ex-
penses which were used prior to the 1930's. These copies
are shown in Illustration VI, pages 64, 65, 66, and 67. From
the detail of the items under income and surplus classification,
the list of manufacturing cost controlling accounts, selling
expense classification, and the general administration expense

one is led to believe that profit and loss data were exten--

sively utilized for both planning and controlling of operations

64

ILLUSTRATION VI

 

ALLIED CHEMICAL & DYE CORPORATION

Methods Bulletin in Use Before 1930

 

Sales

Sales - Domestic
Sales - Export-Direct and
Foreign
(102) Sales - Export -
Direct
(103) Sales - Export -
Foreign Branches
Total Sales
Discounts
Sales - Net
Cost of Sales
Gross Profit

Deductions from Gross Profit

Selling Expense

General Administration
Expense

Freight Car Operations -
Net

Marine Equipment Operations-
Net

Idle Plant Expense

Miscellaneous
Other Deductions

Qperating Profit
Other Income

Interest
Dividends
Commissions and Brokerage -
Net
Operating Contracts - Net
Discount on Purchases
Barrett Building and Other
Rentals - Net
(120) Rentals - Net
(122) Barrett Building
Company - Net

 

Other Income (Continued)

 

Miscellaneous
Engineering and Other.
Services Rendered -
Net
Tully Farms Operations

Gross Income

 

Deductions from Gross Income

 

Federal and Canadian Income
Taxes
(126) Federal Income Taxes
(127) Canadian Income Taxes
Interest
(128) Interest on Funded
Debt
(129) Other Interest
Bad Debts Reserve
Miscellaneous
(130) Minority Interests

Net Income

 

Surplus at Beginning

Surplus Adjustment

 

Surplus Adjustment - Credit
Surplus Adjustment - Debit
Deductions from Surplus, Etc.

Dividends — Preferred
Dividends - Common

Surplus - Balance Sheet

65

ILLUSTRATION VI - continued

 

LIST OF MANUFACTURING COST CONTROLLING ACCOUNTS

 

Raw and Productive Materials Consumed
Productive Labor
Manufacturing Expense
Fuel
Manufacturing Supplies
Maintenance
Power
Plant Transportation
Warehousing
Tests and Inspection
Research and Development
Plant Administration
Depreciation
Dismantling and Retirements
Insurance - Other Than Fire
Insurance - Fire
Taxes
Other Manufacturing Expenses

By-Products, Residuals, Etc.

ILLUSTRATION VI

- continued

 

ALLIED CHEMICAL & DYE CORPORATION

Selling Expense Classification Showing the Grouping of

Selling Expense Accounts.

Classification

 

Salaries:

Managers and Salesmen
Office Employees
Warehouse Employees

Mixing Department Employees

Laboratory Employees
Other Employees

Expenses of Employees:

Managers and Salesmen
Other Employees
Office OperatinggExpense:

Supplies & Incid. Exp.,
Office, the., etc.

Supplies & Incid. Exp.,
Laboratory

Stationery and Printing

Postage

Telephone, Telegraph
and Cable

Light, Heat and Power

Buildipg and Equipment

Expense:

Repairs and Renewals -
Buildings

Repairs and Renewals -
Office Equipment

Repairs and Renewals -
Other Equipment

Depreciation - Bldgs., &

Office & Other Equipment

Rent of Offices & Bldgs.

Brokerage

Storage
Advertising:

Samples

Advertising

Newspapers, Period-
icals and Exhibits

Circulars, Catalogues,etc.

 

Classification

ContainerspiPackages,
Packing Material, Etc.

Freight and Express:
Freight and Express -
Inward
Freight and Express -
Outward

Trucking and Drayage:

Trucking Employees
Supplies and Expenses
Repairs & Renewals -
Trucking
Depreciation -
Trucking
Insurance - Trucking
Taxes - Trucking
Drayage

Insurance and Taxes:

Insurance - Other
Taxes - Other

Other Expenses:

Bank Exchange and
Collection Fees

Profit and Loss on
Foreign Exchange

Bad Debts Collection
Expenses

Amortization of Lease-
hold Expenditures

Export Charges

Custom Duties

Barrett Specification
Inspection

Other Expenses

ILLUSTRATION

67
VI - continued

 

ALLIED CHEMICAL

& DYE CORPORATION

General Administration Expense Classification Showing the
Grouping of General Administration Expense Accounts.

Classification
Salaries:

Officials and Department
Heads

Clerks and Attendants

Engineers

Chemists

Office Building Employees

Expenses of Employees:

Transportation and
Pullman Fares

Other Expenses

Entertainment

Law Expenses and Special
Services:

Trademark and Patent
Expense

Law Expense

Law EXpense

Special Services

Special Services

Office Operating Expense:

Stationery and Printing

Telephone, Telegraph and
Cable Service

Postage

Incidental Expense

Light, Heat and Power

Office Supplies

Classification
Building and Equipment Expenses:

Rent of Offices and
Buildings
Depreciation of
Buildings
Depreciation of
Equipment
Amortization of Lease-
hold Expenditures
Repairs and Renewals -
Equipment
Repairs and Renewals -
Buildings
Rental of Office
Equipment
Contributions, Subscriptions
and Membership_;
Selling Expense
General Administration
Expense

 

 

Insurance and Taxes:
Fire Insurance
Employer's Liability
Insurance
Other Insurance
State Income Taxes,
Other Taxes

Pensions

Other Expenses:

 

Domestic Exchange
Foreign Exchange - Net
Royalties

Other Expenses

 

68

before the 1930's. Thus, as with the preceeding examples,

no significant shift from the balance sheet to the income
statement internally occurred during the 1930's.

The Comptroller, T. A. Murphy, of the General Motors
Corporation likewise stated in his reply the following:

The scope of internal income reporting
has not changed appreciably since the early
1920's. We have, of course, made improvements
in reporting techniques but, for the most part,
these improvements have principally tended to
reduce the great volume of data which formerly
was reported to management in order to tell the
financial story in as concise a manner as pos-
sible. Significant financial reports which
were prepared in this early period, as well as
today, included the forecast income statement
and financial budgets. These financial tools,
which are commonplace now with most companies,
were not so widely used by other concerns at
that time. However, in General Motors, it
could be fairly stated that increasing emphasis
has been placed on forward estimates rather than
historical data.

As to our published financial statements,

you may also find it interesting to note that

since 1923 the income statement has preceded the

balance sheet in the annual report to the stock-

holders of the Corporation.
The above statement by Mr. T. A. Murphy can further be verified
by reference to the famous work of the late Alfred P. Sloan, Jr.,
former chairman of the Board of Directors of General Motors.
For example, he stated that since the early 1920's "the basic
elements of financial control in General Motors are cost, price,

"3” These items, as is

volume, and rate of return on investment.
well known, depend upon accurate and timely profit and loss data.
The next reference to be submitted in support of the

aforementioned.conclusions was supplied by Mr. R. Leopold, Super-

vising Accountant, of American Telephone and Telegraph Company.

 

3”Alfred P. Sloan, Jr., My Years With General Motors
(Garden City, New York: Doubleday and Company,Inc.,196H), p. 1H0.

 

69

Illustration VII page 70 shows a comparative internal income
statement for 1907. Illustration VIII page 71 shows a com-
parative external earnings statement for 1907. These two
illustrations also indicate the greater detail accorded items
in the internal income statement. For example, expenses were
listed separately for internal purposes, whereas, only one
figure was presented in the internal statement.

The last, but certainly not the least, evidential support
that will be presented consists of an interview with Mr. W.
Dean Reed, Assistant Comptroller of Owens-Illinois Corporation.
During the course of the interview selected internal income
statements from 1907, the beginning of the company, until 1990
period were reviewed. The format of the income statement did
not change appreciably during the period examined, except to
accommodate the changing scope of operations. If anything,
the complexity of these early statements was reduced between
1907 and 1990. This reduction was the result of two forces.
First of all, as more modern technology was applied to account-
ing methods and procedures the centralization of accounting
functions became possible. For example, the accounts receivable,
accounts payable and payroll records were consolidated and no
longer a task for individual plants. Secondly, the reorganization
of the company into separate Operating divisions, along with the
development of cost centers and re8ponsibility accounting, re—
sulted in a reduction in the complexity of company and plant-
wide internal income statements even though the complexity and
frequency of lower level supporting reports were increased.

The significant point, as the above evidence reveals,

in U.S.

7O

ILLUSTRATION VII

 

AMERICAN TELEPHONE AND TELEGRAPH COMPANY

Combined Earnings and Expenses All Bell Operating Companies
Including American Telephone and Telegraph Company.

(Instrument rental and other duplications excluded).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

GROSS EARNINGS 1906 1907 Increase
Exchange service xxxx xxxx xxxx
Toll service xxxx xxxx xxxx

Total telephone earnings xxxx xxxx xxxx
Private line service xxxx xxxx xxxx
Sub-licensee service xxxx xxxx xxxx
Messenger xxxx xxxx xxxx
Real estate xxxx xxxx xxxx
Dividends & interest xxxx xxxx xxxx
Miscellaneous xxxx xxxx xxxx

Total other earnings xxxx xxxx xxxx
Total gross earnings xxxx xxxx xxxx

EXPENSES
General xxxx xxxx xxxx
Operating xxxx xxxx xxxx
Maintenance xxxx xxxx xxxx

Total telephone expenses xxxx xxxx xxxx
Private line xxxx xxxx xxxx
Sub-license xxxx xxxx xxxx
Messenger xxxx xxxx xxxx
Real estate xxxx xxxx xxxx
Miscellaneous xxxx xxxx xxxx

Total other expenses xxxx xxxx xxxx
Total expenses (except int. xxxx xxxx xxxx

NET EARNINGS
Deduct interest balance xxxx xxxx xxxx

xxxx xxxx xxxx
Dividends declared by

licensee companies xxxx xxxx xxxx
By A. T. & T. Co. xxxx xxxx xxxx

Total dividends xxxx xxxx xxxx
Deduct dividends received

by A.T.&T.Co. from licen-

see companies xxxx xxxx xxxx
Dividends (duplications

excluded) xxxx xxxx xxxx

Undivided profits xxxx xxxx xxxx

 

 

 

AMERICAN

71

ILLUSTRATION VIII

TELEPHONE AND TELEGRAPH COMPANY

Comparative Statement of Earnings and Expenses

EARNINGS:

 

D1v1dend800...OOOOOOOOOOOOOOO

Interest and other revenue

from associated and licensed

companies..................
Telephone Traffic (net)......
Real Estate.............

Other Sources...
EXPENSES..........
NET EARNINGS......
Deduct Interest...
Dividends Paid....

Balance...

Carried to Reserves......
Carried to Surplus.......

1906

XXXX

XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX

XXXX
XXXX

1907

XXXX

XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX

XXXX
XXXX

72
is there was no shift in emphasis from the balance sheet to
the income statement as the primary accounting report for
managerial use. The latter report, it was felt by Mr. Reed,

was always the prime report throughout his company's history.

Summary

This chapter was concerned with the new emphasis on
profit and loss data by internal management of a firm that
generally appeared between 1885 and 1930. A long chain of
ideas and events were presented that eventually culminated
with income data being considered of upmost importance to a
successful evaluation of a company's operations as a guide
to future action.

The beginning force that set this chain of ideas and
events into motion was the numerous inventions that appeared
in England shortly after 1750, even though they were them-
selves the result of many complex and remote causes. These
inventions helped pave the way for the industrialization of
society through the use of the factory system. Even though
old forms of business organization, particularly the sole
proprietorship, still dominated at the outset, the increasing
need for huge amounts of capital was beginning to be felt.
This need was accentuated by a series of inventions around
1860: (l) the Bessemer process, (2) the perfection of the
dynamo, (3) the internal combustion engine.

The original reaction to these new inventions and econo-
mic circumstances was the emergence of what has been called
industrial capitalism, based on the partnership or joint-
stock company form of business organization. The industrial

capitalists despised financial statements. Yet his tactics

73
of cut-throat competition and emphasis on efficiency created
an industrial community where investment requirements were
tremendous and survival very tenuous. Thus, conditions were
ripe for a type of business organization that could provide
the necessary capital and yet reduce the high degree of per-
sonal liability. As a result, the corporate form of business
organization, through the help of the so-called financial
capitalist, became popular.

The financial capitalists tended to spread their in-
terests over many businesses and were instrumental in many
reorganizations and consolidations. As a result, managers
were appointed to assume the function of operating the business.
A new managerial class developed which found it necessary to
use accounting and related statistics in its decisions be—
cause no single individual possessed the breath of knowledge
or the time or energy to make all the decisions. Income and
expense data for the purpose of testing the profitability of
operations as a guide to future action became an integral part
of the accounting data required by these professional managers.
On the other hand, balance sheet data were still considered
the more important to the financial capitalist and other ex-
ternal parties.

The last topic presented as evidence of this internal
shift in emphasis was reference to the works of the cost account—
ants and scientific management writers. Furthermore, reference
was made to certain replies from various corporations which
indicated that income and expense data were highly significant
for internal purposes long before the external shift in em-

phasis occurred in the early 1930's.

CHAPTER IV

THE EXTERNAL SHIFT FROM THE BALANCE

SHEET TO THE INCOME STATEMENT

General

In Chapter II, and again in Chapter III it was suggest-
ed that developments in British and American law and auditing
were major factors tending to preserve the balance sheet in
a position of prominence over the income statement as the
primary external financial report until well into the 19308.
For example, the Joint Stock Companies Act of 1894 in Britain
required the presentation of a "full and fair" balance sheet
to the stockholders but did not even suggest than an income
statement be presented. Furthermore, it was also stated
that this policy was continued in Section 99 of the 1862 Act
when it stated that the auditors must disclose "whether in

their opinion the balance sheet is a full and fair balance

sheet."

Although in the United States similar legislation did
not appear, the rise of financial capitalism and the emer-
.gence of the so-called balance sheet audit produced the same
effect. But this prominence did not last. In fact the in—

come statement eventually superseded the balance sheet in

terms of importance to external parties. By 1934 the impact

79

75
of this changing emphasis can even be found in publications
of the American Institute of Accountants. For example, in
its 1939 statement entitled "Audit of Corporate Accounts" the
following passage appeared:
The earning capacity is the fact of
crucial importance in the valuation of an
industrial enterprise, and therefore the
income account is usually far more impor—
tant than the balance sheet.
Furthermore, by 1990 the shift to the income statement was
almost entirely complete in the minds of external parties

like stockholders and creditors. George 0. May stressed this

fact when he wrote in the May, 1937 issue of the Journal of

 

Accountancy that the determination of income "is now generally

 

recognized as the most important problem in the field of finan-
cial accounting."2 The next section will be concerned with a
documentation of this external shift.

Documentation of the External Shift

from the Balance Sheet
to the Income Statement

 

 

 

In Accounting Textbooks

 

In 1908 Sprague wrote: "The balance sheet may be consider-

ed the groundwork of all accountancy, the origin and terminus

n3

of every account. Likewise, Henry Rand Hatfield in his 1909

book Modern Accounting contended that the balance sheet is the

 

 

1American Institute of Accountants, Audit of Corporate
Accounts (New York: American Institute of Accountants, 1939),p.10.

2George 0. May, "Improvement in Financial Accounts? The
Journal of Accountangy, (May, 1937), p. 396.

 

3Charles E. Sprague, The Philosophy of Accounts (New York:
The Ronald Press, 1908), p. 26.

76

goal of all accounting.Ur Roy B. Kester in his book Account-

ing Theory and Practice also maintained a similar belief.5

As time went on these authors tended to alter their
views with respect to the importance of the balance sheet.
For example, Hatfield wrote in his 1929 principles book,
in commenting on the changes in the field of accounting since
his above mentioned 1909 publication, the following:

Accounting is essentially of a twofold
character. It seeks to disclose the facts
regarding the amount and kind of assets and
liabilities. In addition to this and of equal
if not superior importance, is the information
which it gives in regard to the proprietorship,
and the various causes which have contributed
to this result. The showing of assets is the
main function of the balance sheet... The
exhibit of the changes in proprietorship is
embodied in an income or profit and loss state-
ment. Each of these statements has its own
value and use.6

Kester in his 1922 revision of his aforementioned 1917 book
essentially continued the view of the importance of the
balance sheet as the most useful statement, particularly for
credit purposes. But in the third revised edition in 1930

he wrote:

The two basic problems of accounting are
concerned with the determination of: (1) the
worth or proprietorship of a business at a
given time; and (2) the success or failure of
a business endeavor during a given or definite
period of time. .

 

L'Henry Rand Hatfield, Modern Accounting (New York: D.
Appleton and Company, 1909), p. 3—9.

5Roy B. Kester, Accounting Theory and Practice (New
York: The Ronald Press Co., 19177, Chapter 1.

6Henry Rand Hatfield, Accounting: Its Principles and
Problems (New York: D. Appleton and Company, 1929), p. 290.

7Roy B. Kester, Accounting Theory and Practice,op. cit.,
(1930 edition, Vol. 1), p. 35.

77

From here Kester then went to great lengths to explain that
profit is a part of prOprietorship in the accounting equation
of asset—liabilities = proprietorship. In addition he empha—
sizes the balance sheet approach for the calculation of in-
come even though it is to management's advantage "to maintain
the proper relationship between income and expense," implying
the matching process.8

The fourth revised edition of 1939 has some notable
changes that indicate how Kester viewed the changing emphasis
from the balance sheet to the income statement. These changes
were criticisms of current balance sheet constructions and the
use of a new profit equation to introduce the matching con—
cept of income-costs = profit.9 The criticisms of the balance
sheet related to the problem of datum content and value con—
tent necessary for a clear financial condition.10

Other less theoretical textbooks also indicate the
shift in emphasis that occurred. In principles text written
by Mo Kinsey, later by Mc Kinsey and Noble, subsequently by
Noble, then Noble and Niswonger, and currently by Niswonger
and Fess, this change is also reflected. The first edition
of 1929 considered the balance sheet as "one of the most

important statements that the proprietor receives."ll

 

8Ibid., p. 39.
91bid., 1939 edition, p. 36.
lOIbid., pp. 26-27.

11James 0. Mc Kinsey, Accounting Principles (Cincinnati,
Ohio: Southwestern Publishing Co., 1929), p. 21.

 

78
This statement was repeated in the 1935 edition12 and the

13 But it was omitted in the fourth edition in

1939 edition.
describing the importance of the balance sheet. Instead, the
essence of this above quoted statement was ascribed to the
income statement as follows: "The amount of profit or loss
incurred during a given period is the most important single
fact of the period."ll‘l In addition, the transactions approach,
rather than the capital maintenance approach, to income de-
termination was now emphasized for the first time.

Robert H. Montgomery, although the champion of the
balance sheet audit for many years, also reflected the in-

creased importance of the income statement in the later edi-

tions of his famous book Auditing Theory and Practice. For

 

example, in his first edition of 1912 he stated that "where
there is an audit department properly conducted, or where
the purpose of the examination is to determine the net worth
of the concern, the auditor will usually confine himself
entirely to the items of the balance sheet."15 This view
continued even in his 1939 edition as others were recom-
mending the use of the term financial statements and em-

phasizing the importance of the income statement. The

 

12James 0. Mc Kinsey and Howard S. Noble, Accounting
Principles (Cincinnati, Ohio: Southwestern Publishing Co.,
second edition, 1935), p. 15.

13
Ibid., 1939 edition, p. 7.

 

 

1L'Howard S. Noble, Accounting Principles (Cincinnati,
Ohio: Southwestern Publishing Co., fourth edition, 1995), p. 91.

15Robert H. Montgomery, Auditing Theory and Practice
(New York: The Ronald Press Company, 1912), p. 72.

 

 

79
following quotation indicates this view:

The importance of the balance sheet not
only as the ultimate goal in the conduct of an
audit but also as a basis for the determination
of audit procedure, warrants attention.16

Furthermore, the income account was still being treated as

a supplement to the balance sheet, although he admits that

. . . . . . 17
an audit 18 not completed until it also 18 examined.

The 1990 sixth revision contained some changes over its
predecessor editions, reflecting among other things the
change in emphasis from the balance sheet to the income state—
ment, the pronouncements of the American Institute of Account-
ants, the American Accounting Association, and the SEC. Most
notable was the use of the term financial statements in refer-
ence to the extend of the audit and the introduction of the
short form audit report. But he still has a yearning for the
good "old" balance sheet prominence as is evidenced by the
following passage:

In recent years great stress has been laid
on the importance of the income statement to an
understanding by investors and others of the
financial affairs of a corporation. It is said
that the value of a business, and consequently
of its assets, depends almost entirely on its
earning power. Because of this feeling, there
has been a tendency to belittle the balance
sheet as a source of information, and to view
the accounting problems largely from the point
of view of the income statement ... however, the
balance sheet also has information for the intelli—
gent reader which, in some circumstances at least,
is of equal importance to that displayed in the
income statement.

 

16Ibid., 1939 edition, p. 78.
17Ibid., p. 956.

18Ibid., 1990 edition, p. 59.

80
Many other works could be cited as evidence of the
shift from the balance sheet to the income statement. But
the point is clear that the groundwork for the shift was
laid in the 1920's, accentuated in the 1930's and completed
by 1990. The next section will be concerned with this shift

as it evolved in corporate annual reports.

In Financial Reports of Corporations

 

A brief survey of some of the older published annual
reports, shown in Illustration IX, page 81, reveals that there
was a gradual emergence, not a sudden or dramatic appearance,
of the presentation of income statement data as they are
reported today. Furthermore, it seemed apparent that there
was significant decline in the complexity of the balance sheet.
In fact, the contrary was observed, that is balance sheets
became more and more complete and informative in terms of
today's standards. But the important point is that income
information in early reports either was nonexistent or con-
sisted of a simple T account copied from the ledger, whereas,
the balance sheet was the main center of attraction. This
situation changed over the years until, by 1950, 18 of the
20 companies examined displayed modern type income statements.
Thus, it might be said that there was actually no shift in
emphasis but simply the emergence of income reporting from
either no data at all or rudimentary presentations to the in-
come statement as it is known today. This emergence, although
starting in the 1920's and early 1930's, was accelerated after
the creation of the SEC and was completed by the mid-1990's.

The following examples will support these observations.

81

ILLUSTRATION IX
List of Annual Reports

Reviewed

Company

1. Allis-Chalmers Company

2. American Can Company

3. Anaconda Company

4. B. F. Goodrich Company

5. E. I. du Pont

6. F. W. Woolworth Company

7. General Electric Corporation

8. General Motors Corporation

9. International Harvester Company
10. Owens-Illinois

11. P. Lorillard Company

12. Procter & Gamble Company
13. Pullman Incorporated
14. Republic Steel Corporation
15. Sears Roebuck Company
16. Standard Oil Corporation (N.J.)
l7. Uniroyal

18. United Fruit Company

19. United States Steel Corporation
20. Westinghouse Electric

Reports Reviewed

1912-15;

1915-50
1915-50
1914-50
1914-50

1914-50

1893-1950

1916-50
1917-50
1907-50
1924-50
1919-50
1920-50
1918-50
1906-50

1918-50

1892-1950

1900-50

1912-50

1906-50

1917-50

82

In its third annual report of 1895 General Electric
presented a Consolidated Profit and Loss Account as shown in
Illustration X, page 83. Yet despite this inclusion, the
report highlighted a discussion of the valuation of assets,
reassuring the stockholders that all assets were conser-
vatively valued. In 1912 the company published a crude
Condensed Profit and Loss Account in multiple-step form.
Even though this was an advancement, in terms of today's
standards of presentation, the report still highlighted
balance sheet data. In its 1926 annual report a Comparative
Statement of Income and Expenses replaced the old Condensed
Profit and Loss Account as shown in Illustration XI, page 89.
Yet, little explanatory information was provided for income
statement items. It wasn't until its 1930 annual report
that the company presented on the first two pages detailed
data as to earnings both past and present. By 1991 the emer-
gence of income reporting was essentially complete for the
General Electric Company. That year's annual report con—
tained detailed explanations of each section of the income
statement, including appropriate explanations of taxes ex-
pense, depreciation, and even dividends. In fact, at the be-
ginning of the report there was a special section entitled
"Highlights of the Year" containing sales, profits, dividends,
and earnings per share data.

In its first annual report of 1893 the United States
Rubber Company (Uniroyal) included a balance sheet in modern
type report format, but included no income statement data nor

even sales data. The tenth annual report of 1903 saw the

83

 

 

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89

ILLUSTRATION XI

 

GENERAL ELECTRIC COMPANY

Comparative Statement of Income and Expenses

Net sales billed..........................
Less: Cost of sales billed, including
Operating, maintenance and depreciation
charges, reserves and provision for all
taxes..................................
Net income from sales.....................
Income from other sources:
Income from associated companies.......
Income from miscellaneous securities...
Interest and discount..................
Income from U.S. Government securities.
Royalties and sundry revenue...........

Total income..............................

Less: All interest payments and in 1925,
premium on debentures retired..........
Addition to general reserve............

Profit available for dividends............
Less: 62 cash dividends on special stock..
Profit available for dividends on special

stock..................................
Less: Cash dividends on common stock......
Surplus for the year......................
Surplus at January 1......................

Less: Dividends paid in special stock:
$1 per share in 1926 (equivalent to $4
per share on old $100 par value stock)
and $5 per share in l925..............
Surplus at December 31....................

1926

XXXX

 

1925

XXXX

 

 

85
inclusion of a crude Consolidated Income Statement as shown
in Illustration XII, page 86. The detail and information con—
tained in this first statement left something to be desired.
Although the income statement changed gradually over the next
15 years, it was the 1928 annual report that evoked comments
by the auditors in their opinion letter and the Chairman in
his letter to the stockholders as to the need for more elab—
orate figures in the income statement. By the 1936 annual
report there was increased attention given to profit and loss
figures. In addition, the income statement, for the first
time, was presented in comparative form as shown in Illustra-
tion XIII, page 87. Finally, by 1992 the annual report con-
tained detailed explanations of the items included in the
income statement. In short, the emergence of income reporting
for Uniroyal was also essentially completed.

General Motors and particularly United States Steel
Corporation were good examples of the early development of
income reporting. But other companies did not develop modern
type income reporting until well into the 1930's and some—
times the early 1990's, even though most published rather com-
prehensive balance sheets much earlier. For example, Eastman
Kodak Company first published an income statement in 1935,
but prepared an internal income statement prior to that date.

Standard Oil Company of New Jersey published a verbose,
but quantitatively lacking,report in 1918. It wasn't until a
"revision in the chart of accounts and accounting procedure,

in conformity with accepted principles of accounting, which

86

ILLUSTRATION XII

 

UNITED STATES RUBBER COMPANY

AND SUBSIDIARY COMPANIES

Consolidated Income Statement for Year Ending

Gross Sales, Boots and Shoes ...............

Net Sales, Boots and Shoes and Miscellaneous

Cost of Goods Sold.....................

Manufacturing Profits..................

Freight, Taxes, Insurance, General and

Selling Expenses.................
Operating Profits...................
Other Income........................
Total Income........................

Less:

Interest and Commissions on Funding

Notes and Borrowed Money.........
Interest on Boston Rubber Shoe Co.

DebentureSO.......O..............

Interest Allowed Customers for Pre-payments.

Net Income to Surplus....................

Deductions from Surplus, Bad Debts,

Etcoo

Surplus for Period.......................

" April 1’ 1902......0.............

" March 31, 1903...................

March

31,

1903

XXXX

 

XXXX

XXXX

XXXX

XXXX

XXXX

3.1992

XXXX

XXXX

XXXX

XXXX

XXXX
XXXX
XXXX
XXXX

XXXX

87

ILLUSTRATION XIII
UNITED STATES RUBBER COMPANY
AND
SUBSIDIARY COMPANIES

Consolidated Income

 

Sales, after all returns, discounts excise
and sales taxes, transportation and
allowances.................................
Cost of goods sold, including depreciation
of $5,535,346 for 1936 and $5,581,878
for 1935...................................
Gross Profit...........................
Administrative and General Expenses....
Profit from Operations.................
Dividends received from affiliated companies
in 1936; from U.S. Rubber Plantations, Inc.
in l935....................................
Deferred income credits, less charges.........

Interest on funded indebtedness...............
Net Income Before Provisions...........

Provision for Federal income taxes ($2,371,206
for 1936;
profits tax of subsidiaries ($874 for 1936;
none for 1935) and foreign income taxes....

Provision for fluctuation in raw material

prices................................0....

Net Income for the Period..............

$1,488,441 for 1935),undistributed

XXXX

£1255

XXXX
XXXX
XXXX

XXXX
ma
XXXX
XXXX
XXXX

XXXX

XXXXL'

XXXX

 

XXXX

XXXX
XXXX
XXXX
XXXX

XXXX
XXXX
XXXX
XXXX
XXXX

XXXX
mat.

XXXX

 

88
became effective on January l, 1939"19 that a modern type
consolidated income statement was published. Sears, Roebuck
8 Company in its 1908 annual report also presented figures
for gross sales, sales returns and allowances, dividends,
and selling expenses along with a rather elaborate balance
sheet in modern report form. But it wasn't until 1920 that
a simple income statement was published and 1930 for the
first comparative income statement. In 1935 the annual re—
port contained the first income statement as it is presented
today by the company. By 1991 bold captions reported the
financial highlights, particularly earnings per share, net
sales, dividends, among others.

Other examples could be presented. But the results
would be similar. In particular, the emergence of income
reporting as it is known today was a phenomenon of the
1930's and early 1990's even though earlier examples can be

found.

In Journal of Accountancy Editorials

 

The important literature, both theoretical and practi-
cal, to the shift in emphasis will be presented in the sec-
tion entitled "Factors Affecting the External Shift". But
at this time it seems appropriate that reference be made
to the changing emphasis as reflected in editorial releases

of the Journal of Accountancy_since this publication more than

 

any other is representative of the state of "positive" ac-

counting theory and practice.

 

19Report of the Standard Oil Compapy_(incorporated in
New Jersey), for the Year Ended December 31, 1939, p. 13

 

89
Up until about 1928 editorials in the Journal were
specifically geared to emphasizing the significance of the
balance sheet. But in the February issue of that year
A. P. Richardson, editor, commented on the importance of

20 In

Irving Fisher's definition of income to accounting.
December of the same year there was an editorial denying
the fact that the balance sheet reflects "future earning
power" as some have advocated?1
In the January, 1929, issue the editor suggested that
the need for an accepted definition of net profits was an
"illustration of the imperative need for agreement upon the
meaning of phrases so that they may be something more than

"22 This reflects the increased concern with

'just words'.
income calculations. The May, 1930, editorial contains a
discussion of the importance of earnings per share that
seemed to have attracted a good deal of attention at that
time. The editorial stated that"we do not believe that the
earnings 'per share' play as an important a part in the
creation of market values as a good many pe0ple seem to
think."23

The first editorial to specifically mention the report-

ing problems created by the enormous increase in the number

 

20"Income Defined at Last", Journal of Accountancy,
Vol. 95 (February, 1928), pp. 125—127.

 

21"The Meaning of a Balance Sheet", Editorial, Journal
of Accountancy, Vol. 96 (December, 1928), pp. 995-996.

 

22"What Are Net Profits?", Editorial, Journal of Account-
ancy, Vol. 97 (January, 1929), pp. 99-96.

 

23"Earning Per Share," Editorial, Journal of Accountancy,
Vol. 99 (May, 1930), p. 323.

 

90
of shareholders in corporations in the past fifteen years
was in the July, 1930, issue. Here the editor stated that
"the enormous increase which has taken place in the number
of shareholders in corporations in the past fifteen years
has attracted the attention of the public to the financial
statements of corporations whose stocks are bought and sold
for the purposes of investment and speculation."24 But it
wasn't until the June, 1932, issue that the question of

25 In the March, 1934,

income was discussed at any length.
issue the shift to emphasis on the problems resulting from
the calculation of income in editorial presentations was

essentially completed.26 It is in this issue that a review

of the American Institute of Accountant's publication

Audit of Corporate Accounts appears. This document, as has

 

been mentioned before, contended that the income account is
in most instances more important than the balance sheet. The
editorial policy now also clearly began to reflect this fact.

In American Institute of Accountants'
Memorandums on Balance Sheet Audits

 

 

The 1917 memorandum entitled Approved Methods for the

 

Preparation of Balance-sheet Statements, prepared by the

 

American Institute of Accountants at the request of the

 

2U"'Clear Statements Needed," Editorial, Journal of Account—
ancy, Vol. 50 (July, 1930), pp. 5-6.

25"What Is Income," Editorial, Journal of Accountancy,
Vol. 55 (June, 1933), pp. 901-902.

 

26Editorial, Journal of Accountancy, Vol. 57 (March, 193m),
pp. 168-172.

91
Federal Trade Commission, clearly indicates the emphasis on
providing information for creditors through the balance sheet.

In 1929, a revised edition entitled Verification of Financial

 

Statements (Revised) was published. This revision, like the

 

earlier edition, set forth suggestions for the verification
and preparation of statements, particularly the balance sheet.
But the emphasis on certain profit and loss statement items
such as depreciation indicate the increasing attention devoted
to income data.

As far as the balance sheet was concerned, most instruc-
tions related to the audit and presentation of balance sheet
accounts while advocating the use of the cost or market which-
ever is lower rule. On the other hand, departures from the
cost basis of accounting were allowed "if the property valua-
n27

tion is stated on the basis of an appraisal at a given date.

The 1936 revision entitled Examination of Financial

 

Statements by Independent Public Accountants serves as addi-

 

tional evidence of the external shift in emphasis to the income
statement over the 1929 edition. For example the preface
states:

Development of accounting practice during
recent years have been in the direction of incre—
ased emphasis on accounting principles and con-
sistency in their application,....The suggestions

-contained in this bulletin are intended to apply
to examinations by independent public accountants
of financial statements prepared for credit pgr—
poses or for Annual reports to stockholders.

 

 

7Verification of Financial Statements (Revised)
(Washington, D. C.: U.S. Government Printing Office, 1929), p.13.

28American Institute of Accountants, Examination of Fin-
ancial Statements by Independent Public Accountants (New York:
American Institute Publishing Company, January, 1936), p. v.
(Underline added for emphasis.)

 

92

The following quotations from the 1936 revision indicate

the changing external shift in emphasis from the balance sheet

to the income statement for investors and other external parties:

1.

From an investor's point of View, it is
generally recognized today that earning

Acapacity is of vital importance and that

the income account is at least as impor-
tant as the balance sheet.“8

 

 

The development of accounting conventions
has been influenced largely by a recognition
of the importance of the income account.

As a rule, the first objective has been to
secure a proper charge or credit to the
income account for the year, and in general
the presumption has been that once this is
achieved, the residual amount of the ex-
penditure or the receipt can properly find
its place in the balance sheet at the close
of the period. Thus the changes in the
balance sheet from year to year are in

many aspects more significant than the bal-
ance sheets themselves.5U

 

One of the important features of the 1936 bulletin was

the absence of all mention to the balance sheet audit. Instead,

the use of the term "examination of financial statements" was

substituted. Thus, one of the main factors temporarily counter-

acting those forces which normally would have shifted the

emphasis from the balance sheet to the income statement had been

eliminated.

 

29Ibid., p. 9. (Underline added for emphasis.)

30Ibid., pp. 9-5. (Underline added for emphasis.)

93

 

‘v’

Factors Affecting the
External Shi t

 

General

The rise of the corporation with the separation of owners
and managers was a prime factor in the growing emphasis on in—
come statement data. This was in contrast to earlier periods
where the major function of accounting statements was to provide
information for credit purposes. Creditors were mostly inter-
ested in the financial position of a borrower. The balance sheet
seemed sufficient to fulfill this need. Furthermore, its con-
tent had been designed with this need in mind. Paton reflected
this point of view when he wrote that:

...the periodic statement of assets and

equities, if well arranged, throws much light

upon the position of the several interests from

the standpoint of safety of principle....With

respect to a single balance sheet this is

especially true in the case of short term credi-

tors. The bank which is extending a sixty-day

loan to an enterprise, for example, is interested

above all in the probable cash position of the

concern at the date of payment, and the comparison

of liquid assets and current liabilities which is

facilitated by the balance sheet is highly sig-

nificant in this connection.

The growing widespread ownership of stock that began early
in this century and accelerated rapidly in the 1920's tended to
shift the spotlight from creditors, such as banks, to the pro-
viders of equity capital. This latter group was not only inter—
ested in the amount of their investment, but also in the factors
contributing to its growth or lack of growth. Stephen Gilman

made this point clear in the following passage from his famous

1939 book:

¥

31William A. Paton, Accounting_(New York: The MacMillan
Company, 1926), p. 979.

 

99
While the creditor's rights are still

considered of great importance, the stockholder,

who was previously the forgotten man of finance,

has found champions who insist that accounting

owes an obligation not only to him who supplies

temporary capital but also to him who supplies

permanent capital.32

The stockholders as a group were primarily interested in
the prospective return on their investment through dividends,
and the growth in the price of their shares. In addition, since
they were removed from the day—to—day operations of the business,
there was a tendency to seek useful, readily-understood informa-
tion on the efficiency of management. A single gauge of value,
if developed, would certainly be a tremendous aid to the relai
tively uneducated and bewildered investor who was looking for
a simple way of ascertaining where to invest funds.

Accounting responded to this new demand by placing greater
emphasis upon the income statement. But this new emphasis did
not appear overnight. It took the interaction of ideas and
events before the increased emphasis occurred. Of all the ideas
that were important, the most influential consisted of the pop—
ularization of the entity theory and the going-concern assump-
tion by Professor Paton. Paton himself noted this when he wrote
in 1990:

Another important result of using the enter-

prise as the focus of attention has been the develop-

ment of the going-concern assumption, with deriva-

tive stressing of the interpretation of business

operation as a continuing stream of activity. The
increasing consideration being given to income

 

32Stephen Gilman, Accounting Concepts of Profit (New
York: The Ronald Press Company, 1939), pp. 27—28.

 

95

measurement and reporting is presumably a manifes-

tation of the influence of the business—enterprise,

managerial point of view.

Many events were very important factors in the new emphasis
on profits. But there are three that were more important than
any others; the awakened interest in the investor's view—point,
the fluctuations in the prices of goods and services that be-
gan in the early 1920's, and the influence of government taxation

and legislation. The interaction of these and other ideas and

events will now be considered.

The Entity Theory and Going—Concern Postulate

The emergence of the entity theory and the corollary
concept of the going-concern in response to the rise of the
corporate form of organization, interacted with the economist's
concept of profit as surplus entrepreneurial remuneration to
provide the theoretical ground work for the shift in emphasis
from the balance sheet to the income statement in financial
accounting.

This interaction between economics and accounting will
be covered in detail in Chapter V. Its influence on the shift
in emphasis is very important and discussion will be deferred

until then.

The Changinngrice Level

 

Before the 1930's historical costs emerged as the "gen-
erally accepted" basis for reflecting balance sheet values only
because it was generally thought that these historical cost

figures approximated value. In short, although historical cost

 

33William A. Paton, "Recent and Prospective Developments
in Accounting Theory" found in Mary E. Murphy, editor, Selected

Readings in Accounting and Auditing (New York: Prentice—Hall,1nc,,
1952), p. 28.

 

96

figures were accepted, firms did not hesitate to write assets
up or down because the balance sheet was treated as a state-
ment of valuations. This view was expressed by many early
writers particularly in their treatment of depreciation as
essentially a valuation concept.3u As a result, "among the
many kinds of financial statements which confront the man in
business today, the balance sheet holds the most important
place."35

The march of events, the sharp decline in prices in 1921-
23, prompted many individuals to start questioning the utility
the balance sheet. For example, Littleton contended in 1923
that the fluctuating price level renders the customary balance
sheet ineffective at times as a guide to action. Nevertheless,
he contended that cost should be consistently used in all ac-

counts and statements.36

Eric Kohler writing in a 1936 issue

of the Accounting Review also argued that balance sheets are
misleading and are actually a liability to the financial analysts.
Furthermore, he contends that balance sheets are poor because of

a lack of a common valuation basis for each of the terms.37

 

3”See for example William Morse Cole, Accounts, Their
Construction and Interpretation (New York: Houghton Mifflin
Company, 1908), pp. 70-80 and Earl Saliers, Principles of
Depreciation (New York: The Ronald Press Company, 19157 pp.139-
173.

 

 

 

 

35
Chester B. Couchman, The Balance Sheet (New York: The
Journal of Accountancy, Inc., 1923), p. 3.

36A. C. Littleton, "Principles of Valuation as Related to
the Balance Sheet," Papers and Proceedings of the Eighth Annual
Meetin (1923), American Association of University Instructors
in ccounting, VII, pp. 19—15.

 

37Eric L. Kohler, "Tendencies in Balance Sheet Construction,"

The Accounting Review, Vol. I (December, 1926), pp. 1-3.

97
The initial reaction to these attacks on the balance
sheet was to focus attention on principles of valuation in
an effort to improve the stature of the report. The litera-
ture on this subject is quite extensive. However, probably
the most outstanding contribution in this area was by an
economist, John B. Canning. In his book, The Economics of

Accountancy, he states, in the first of his two chapters on

 

valuation, that "an attempt will be made to describe their
(accountants) valuation process and to suggest certain means
whereby this process may, in due course, be changed for the
better."38
.There was another group of accountants led by Littleton,
Paton, and others who responded to these fluctuating prices
by advocating, instead of changing valuation bases, the strict
adherence to historical costs because value is subjective.
Professor Littleton points out this dilemma between those who
believe balance sheets should represent "value" and those,
like himself, who ascribe to the cost principle as follows:
Balance sheets by valuation, ..., create
serious problems of income determination,....Yet,
on the other hand, neither is accountancy able to
hold to the purely cost, or outlay, balance sheets,
because to do so, it is thought, would destroy the
instrument as "a statement of values" which seems
to be the sine qua non of credit granting.39
He then goes on to argue that cost prices are recorded in ac-

counting because they are ascertainable facts, not because they

represent value. If accountants are going to keep supplying

 

38John B. Canning, The Economics of Accountancy (New York:
The Ronald Press Company, 1929), p. 198.

39A. C. Littleton, "Value and Price in Accounting," The
Accounting Review, Vol. IV, (September 1929), p. 198.

 

98
accurate financial data then they must stick with cost prices
and not "venture outside the realm of known facts" where value
is found.”0

The collapse of the stock market in the autumn of 1929
and the Great Depression that followed naturally led to a
loss of confidence in the balance sheet and to a desire for
something new and more reliable for the purpose of analyzing
investment alternatives. The speculative orgy of the pre—
depression days based on frequent and pptimistic revaluations
of assets, dividend distributions based on inflated values,
and heavy reliance on book value of stock had ended.l+1 Prices,
wages, interests, rents, and profits decreased drastically in
the early years of the 1930's. Assets were no longer the most
important element in success. It was income. In fact, the
general saying was "you can't eat assets."

In conjunction with the great depression and the legis-
lation that it triggered, the national departure from the gold
standard was the final blow to the question of asset valuation.
It was felt that now accounts must reflect dates of acquisi-
tion because dollars change value. Otherwise, no additivity
of asset values would be possible. An editorial in the J22;-

nal of Accountancy makes this point clear:

 

Its (departure from gold standard) com-
plications are almost limitless, and if the
accountant is to be absolutely logical he will
probably find himself confronted with theupeces-
sity of building up a scheme of dating...

 

L”Ibid., p. 153.

1”John Kenneth Galbraith, The Great Crash (Boston:
Houghton Mifflin Company, 1961), p. 179.

 

L'2"Fruits of Experiment," editorial, Journal of Accountancy,
Vol. 56 (November, 1933), p. 321.

 

99

The Emergence of the Investors' VieWpoint

 

As was mentioned before the rapid growth of stock owner-
ship by the general public after World War II began to create
a new demand for information. Three men, William Z. Ripley,
J. M. B. Hoxsey, and George 0. May were probably the best ex—
ponents of this emerging point of View. Mr. Ripley began stating
his case for an improvement in accounting standards for annual
reporting as early as 1915 when he criticized the accounting

93

practices of railroads. But it was his 1927 book Main Street

 

and Wall Street, portions of which appeared as articles, that

 

attacked the accounting information available to stockholders

and investors. In Main Street and Wall Street, which are

 

synonyms for the phenomenon of widespread ownership and the
financial power in our great capital centers respectively,

the author states that "the sudden advent of widespread pop-

ular ownership of corporations since the World War has created
entirely new circumstances and conditions in the business world."L'L‘L
As a result of these new circumstances he argued that two es—
sentials were needed to provide better accounting data: "an
adequate balance sheet and income statement."L'5 Of the two
statements the income statement "is perhaps more significant
both immediately and prophetically." Yet, of the two, "it is

. , u
the income statement that 18 more apt to be suppressed." 6

 

”3 William Z. Ripley, Railroads, Finance and Opganization
(New York: Longmans, Green andTCompany, 1915).

L”William Z. Ripley, Main Street and Wall Street, (Boston:
Little, Brown, and Company, 1927), p. 156.

 

 

us .
Ibid., p. 171

L'SIbid., p. 172.

100
He then proceeded to make a scathing attack on the state of
current annual reporting. For example, he stated that
"Singer Manufacturing Company produced a 'picture—book' annual
report" whereas, "National Biscuit Company doesn't include
such 'newfangled gewgaws as income accounts or depreciation.'"”7
Mr. Hoxsey, as Executive Assistant to the Committee on
Stock List of the New York Stock Exchange, addressed the annual
convention of the American Institute of Accountants in 1930.
In this address he pointed out the following:
The need of accurate information for the
aid of management is still paramount; but, under
conditions of today, the next object in order of
importance has become to give to stockholders, in
understandable form, such information in regard to
the business as will avoid misleading them in any
respect and as well put them in possession of all
information needed, and which can be supplied in
financial statementsli to determine the true value
of their investment.
He then went on to make a plea that accountants should refrain
from certifying financial statements unless adequate information
as to interest, cumulative dividends, sinking funds, sales or
gross revenue, operating and other income, and surplus are in-
cluded.”9
The New York Stock Exchange also recognized the emergence
of the investor's viewpoint. As a result in 1930 the Exchange

recognized the need for cooperation between the American Insti—

tute of Accountants and itself. Thus, in 1930 the American

 

1”Ibid., p. 162.

H8J. M. B. Hoxsey, "Accounting for Investors," Journal of

Accountancy, Vol. I (October, 1930), p. 252.

 

 

L'9Ibid., pp. 259-261.

101
Institute of Accountants appointed a special committee on
cooperation with stock exchanges. This new committee, under
the direction of George 0. May, in an effort to improve the
quality of financial reporting recommended certain objectives
to the New York Stock Exchange. These objectives emphasized
the fact that the earning capacity of a business is of crucial
significance in ascertaining the value of its assets. These
recommendations as presented below will reflect this emphasis.

1. To bring about a better recognition by the
investing public of the fact that the
balance sheet of a large modern corporation
does not and should not be expected to repre—
sent an attempt to show present values of
assets and liabilities of the corporation.

2. To emphasize the fact that balance sheets are
necessarily to a large extent historical and
conventional in character, ....

3. To emphasize the cardinal importance of the
income aCcount, such importance being explained
by the fact that the value of the business is
dependent mainly on its earning capacity; ....

9. To make universal the acceptance by listed
corporations of certain broad principles of
accounting which have won fairly general accep-
tance, and within the limits of such broad
principles to make no attempt to restrict the
right of corporations to select detailed methods
of accounting deemed by them to be bestsadapted
to the requirementcf their business....

These objectives clearly indicate the importance now
beginning to be accorded the income statement. These recom—
mendations were widely circulated and helped make corporations
aware of their responsibility for financial reporting. Also,
they were deemed so important that the essence of these recom-
mendations were subsequently adopted as part of the philosophy

0f the SEC.

‘

50American Institute of Accountants, Audits of Corporate
A<Scounts, 1933. Reprinted in Eldon S. Hendricksen, 0p. cit.,p.63.

 

102

Other Factors Influencing the External Shift

 

Many other ideas and events contributed to the shift in
emphasis from the balance sheet to the income statement. The
activities of financial analysts contributed to this shift
because of their criticisms and analysis of financial statements.
For example, from the latter part of the nineteenth century the
work of analysts, particularly in the area of ratio analysis,
underwent changes that were similar to those previously mentioned
in accounting. In the early period (1900—1919) ratio analysis
was divided into credit analysis emphasizing the ability to pay
and managerial analysis emphasizing profitability measures.51
This situation reflects the use of the balance sheet for external
parties and the income statement by management.

The decade from 1920 to 1929 resulted in increased activity
by financial analysts. The writers of this period, such as James
Bliss and Stephen Gilman, began to View the function of finan-
cial management as an integral part of over-all management in—
stead of a staff speciality concerned with fund-raising.52
Attempts were made to develop ratios that reflected the relation-
ships between costs, revenues, turnover, earnings, and other
fundamental relationships in an effort to find better gauges of

53

the value of a firm's securities. These relationships, as is

obvious from the previous sentence, required accurate information
that is found in income statements. Consequently, financial

analysts began to exert pressure for better income statements.

__

51James O. Horrigan "A Short History of Financial Ratio
Analysis", The Accounting Review, Vol. XLIII (April, 1968),

 

Ezra Solomon, The Theory of Financial Management (New
York: Columbia University Press, 19637, p. 2.

53James O. Horrigan, op, cit., p. 287.

103
Thus, they, too, were a force contributing to the shift in
emphasis.

Another factor contributing to the external shift in
emphasis came from the courts which advocated the view that
accounting should reflect that income which is legally avail-
able for dividends. This legal—dividend emphasis also was
incorporated into various state laws. The famous American
Malting Company court case (Hutchinson v. Curtiss, 92 N.Y.S.
70, 1909) held that contracts calling for future delivery and
payments were not a basis for declaring dividends because
such dividends would be mere "paper profits.” In the 1885
case of Jennery v. Olmstead (36 Hun 536, affirmed 105 N.Y.S.
653, 13 N.E. 1926) it was held that appreciation in the value
of United States bonds held by banks should not be taken into
a profit and loss account and thus be made available for
dividends. The General Corporation Law of 1927, Section
8623—28, of Ohio stated that "cash dividends shall not be
paid out of surplus due to or arising from (a) unrealized
appreciation in value of or revaluation of fixed assets..."

The point is clear, the legal-divided emphasis accom-
panying the growth of the corporation tended to result in
more and more accounting questions to be answered in terms of
their effect upon the income account. Thus, the income state-
ment was considered more and more important.

Many other factors contributed to the ascendancy of the
income statement, the development of national income accounting,
accounting research of the American Accounting Association, the

influence of regulatory commissions, the development of railroad

109
accounting and many others. But this coverage is excluded

because their significance is indirect and minimal.

Summary

This chapter was concerned with the external shift in
emphasis from the balance sheet to the income statement that
began in the 1920's, accelerated in the 1930's and culminated
in the early 1990's.

A documentation of this external shift was presented by
reference to the transition in accounting textbooks, in finan-
cial reports of corporations, in the Journal of Accountancy
editorials, and in the American Institute of Accountants

Memorandums on Balance Sheet Audits.

 

There were many factors affecting the external shift in
emphasis. The rise of the corporate form of business organiza-
tion in response to the industrialization of society was a
prime factor in the growing emphasis on profits. This new
emphasis manifested itself in an internal shift in emphasis
that was discussed in Chapter III. The external shift occurred
after the internal shift and resulted from the interaction of
ideas and events. The most influential ideas consisted of the
popularization of the entity theory and the going—concern assump-
tion by Professor Paton, Littleton and others.

Many events were very important factors to the external
shift. The most important three were: the awakened interest
in the investor's vieWpoint, the rapid fluctuation in the prices
of goods and services that began in the early 1920's, and the
influence of governmental taxation and legislation. The latter

will be discussed thoroughly in Chapter VI.

CHAPTER V
THE INTERACTION OF ECONOMIC THEORIES OF PROFIT

AND ACCOUNTING THEORY

Introduction

 

In this chapter the interaction of ideas and events
between economics and accounting in response to environmental
forces will be presented. Attention is first directed at
the economist's concept of profit as a class income as re-
flected in the writings of the Mercantilists, Physiocrats,
and the Classical school which found expression in certain
accounting practices, relationships indicated in financial
statements, and in the proprietary theory of accounting.

Next, an effort will be made to demonstrate the inter-
action between the economist's concept of profit as surplus
entrepreneurial remuneration reflecting the corporate re-
volution to the revival of the entity theory, which in turn
was a force in the elevation of income accounting.

Lastly, as a sort of a sequel to reinforce the contention
that significant interaction between economic concepts of
profit and accounting theories occur, the parallelisms between
profit as a return for uncertainty bearing and current deve10p-
ments in accounting thought will be briefly explored. It is
hOped that these comparisons will demonstrate that both dis-
ciplines have been influenced by similar forces so that future

problems can be identified.
105

106

Importance of Profit Theory in Economics

In this study the terms "profit" and "income," although
in some contexts different, are used interchangeably. They
play an important role in economic theory. For example, the
study of the various types of income and corresponding re-
cipients forms that part of economic theory commonly known as
distributive theory. Furthermore, in a capitalistic system of
production and exchange one of the most important, if not the
sole, motivating force is the quest for profits.1 This means
that concepts of income and profits are also basic to production
and exchange, prices and value, national income and other
economic theories. Likewise, since today it is generally accepted
that accounting is a "process of identifying, measuring and
communicating economic information to permit judgments and
decisions by users of the information,"2 these theories can be
valuable to the accountant. For example, Phillips states:
"progress in accounting theory must begin with income concepts."3
Likewise, Edwards and Bell state:

The problem of income has been an especially
perplexing one in part because economists have
approached it with essentially subjective concepts
derived from expectations concerning future events,
while accountants have insisted on objectivity and
the measurement of actual, unfortunately often his-
torical, events. The apparent impasse between these
two points of view has led many to resign themselves

to the impossibility of reconciliation, and thus has
tended to widen the gap between the two disciplines.

lCampbell R. McConnell, Economics: Principles, Problems,
and Policies (New York: McGraw-Hill Company, Inc., Second Edition,
, P. .

 

2American Accounting Association, A Statement of Basic
Accounting Theory (Evanston, Illinois: AmeriCan Accounting
Ngsociation, 1966), p. 1.

3 . . .
A G. Edward Phillips, "The Accretion Concept of Income,"
_5;counting ReView, Vol. XXXVII (January, 1963), p. 19.

 

107

Yet, except for the difference in perspective, the

two often deal with related problems and rely on

similar data.”
Therefore, a study of economic concepts of income as they have-
evolved in economic thought could possibly shed light on certain
developments in accounting thought; for example, the change in
emphasis from the balance sheet to the income statement.

Economists may be broadly placed under three groups, ac-
cording to the different ways which their classifications of
income rests and, consequently, their definitions of profit.
The earlier writers and the classical school regarded profit
simply as the income of the one enjoying the economic status
of an employer or owner of capital. It will be seen that this
View reflects the class structure of early economic societies.
The immediate successors of the classical school viewed profit
to be a surplus reward to the entrepreneur. This View tends
to reflect the economic importance of the corporate form of
business organization. The usefulness of this conception lies
in the emphasis given to the entrepreneur as the agent of in—
dustrial progress and it reflects that stage of development
when production begins to depend upon borrowed capital and the
owners are distinct from the managers. The third View, and
the modern generally accepted treatment, is to regard profit as
a return to uncertainty bearing. This view is an abstract con-
ception and it attempts to show that the presence of uncertainty

about the future may allow positive profits to exist.

”Edgar 0. Edwards and Philip w. Bell, The Theory and
Measurement of Business Income (Berkeley and Los Angeles,
California: University of California Press, 1965), p. viii.

 

5M. Blaug, Economic Theory in Retrospect (Homewood, Illi-
mDis: Richard D. Irwin, Inc., 19627} pp. 931—935.

108

Concept of Profit as a Class Income

 

Mercantilists

 

Mercantilism is the name usually used to denote the econ-
omic views which prevailed among European statesmen from the
sixteenth to the latter part of the eighteenth century.6 Al-
though there was no unified "school" of mercantilist's writers,
Heckscher contends that mercantilist's literature did reflect
the prevailing conception of the relationship between the state
and its wealth in the period before the advent of romanticism.
Thus, certain doctrinal threads such as a concept of profit can
be found in their writings.

The economic problems of the mercantilist's period re-
sulted from the development of an exchange economy. Discussions
of money, foreign trade, and public finance dominated most
writings. This emphasis on money generally led the mercantilists
to identify money as income. Particularly, the general belief
was that income consisted of a sort of superior wage and a
synonym for monetary "gain."8 Thus, yearly profit and loss con-

sisted simply of increases or decreases in money whether it be

that of the state, the merchant, or the individual.9

 

6Lewis H. Haney, History of Economic Thought (New York:
The Macmillan Company, fourth edition, 1999), pp. 111-112.

7Eli F. Heckscher, Mercantilism (London: George Allen
and Unwin, Ltd., Vol. 2, 1935), p. 15.

 

 

81bid., pp. 206-207.

91bid., p. 207.

109

Physiocrats

About 1750 in France a brilliant group of philoSOphers
J<nown as "les Economistes" and "les Physiocrates" started
Inodern political economy.10 Chief among the physiocrats
vvere Mirabeau, Quesnay, Turgot and DuPont de Nemours. Agri-
cnilture was looked upon as the only source of wealth. It
its difficult to present a short summary of Physiocracy. But
a.<quotation from Meek's famous work gives the needed essen-

'tidals:

The Physiocrats assumed that the system of
market exchange which it was their main purpose
to analyze was subject to certain objective econ-
omic laws, which operated independently of the will
of man and which were discoverable by the light of
reason. These laws governed the shape and move-
ment of economic order, and, therefore, the shape
and movement of the social order as a whole. Now
the relationships between the different variables
in a system of market exchange are very intricate——
so much so, indeed, that in a certain sense every-
thing can be said to be dependent upon everything
else. If the laws governing the particular type
of exchange economy with which the Physiocrates
concerned themselves were to be ascertained, it
was, therefore, necessary to put these variables
into manageable form-~in other words, to construct
what we would call today an abstract theoretical
model of the economy.

In the construction of their theoretical models, the Physio—
er551138 endeavored to discover some key variable. The variable

LIES€Eclwas the capacity of agriculture to create a net product,

-EL‘ 53s- a disposable surplus over costs. The selection of this

I)6119”tticular variable transferred the investigation of profit from

‘t . . . .
}1€3 £3phere of Circulation as espoused by the mercantilists to
ei__p‘~__p

fp}1 10Phillip Charles Newman, The Development of Economic
E;-Ei%%gggp (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1952),
- 14..

Idea 11Ronald L. Meek, The Economics of Physiocracy (Cambridge,
£353c‘ichusetts: Harvard University Press, 1963), p. 19.

110

the sphere of production, thereby, laying the foundations for
‘the analysis of capitalist production.12

The concept of profit as being merely a "surplus" of
'the agricultural entrepreneur simplifies the contribution made
loy'the Physiocrats to that of land rent as the only income in

tflie nature of a surplus, with all other returns being merely

cxompensation for costs. However, at the same time their theor-

ertical system assumed a "capitalist" system. This apparent

czcuitradiction came to the surface as a result of the "conven-

‘tixonal wisdom" and resulted in substantial advances by later

Ffli3rsiocrats, namely Turgot, towards the Classical concept of

1517c>fit as formulated by Adam Smith.“r This transition can be

sseeean by comparing Quesnay's views of profits to those of Turgot.

Quesnay divided society into three classes: The culti—

\7a11:ors (productive class), artisans (the stipendiary class),

€1I1<i proprietors (disposable class). He recognized the exis-

Tiéaxice of entrepreneurial profits in both agriculture and

Jrhairiufacturing, but contended that land rent was the sole income

j—Il ‘the nature of a surplus by:

(a) Including in the returns of the agri-
cultural entrepreneur a sort of superior wage for
what he called his "trouble, labour, and the risks

of his enterprise."

(b) Using a model of the industrial sector

which assumed that industry was carried on by
workers on their own account, so that any "profit"
which‘in fact emerged could be regarded either as

the result of monopoly or as a "net product in
reverse."
\

(3 12Karl Phrx, Theories of Surplus Value, translated from
eaI‘l‘nan by G. A. Bonner and Emile BurnsiiNew York: International

Publishers, 1952), p. 95.
13Meek, op. cit., p. 298.

1”Ibid.
15Ibid., pp. 306-307.

 

111

Turgot likewise divides society into three classes: produc—

tive, stipendiary, and disposable. But he points out that

the growth of capital in the stipendiary class has necessitated

a division of this class into "two orders": capitalist or under-

takers and simple workmen, similarly the productive class into

farmers and cultivators.16 Thus, with this division, he argues

that profit is the income secured by the actual employer of
capital, which can be found in five different ways: (a) in
purchasing a landed estate; (b) in taking a lease of an estate
and cultivating it as a tenant-farmer; (c) in investing in in-
dustry; (d) in investing in commerce; and (e) in making loans

at interest.l7 Yet he kept to the old physiocratic system by

further arguing that investments in agriculture yield the

highest profits. After Turgot the only remaining task was to

remove this Physiocratic obsession with agriculture, and the

way was clear for the emergence of the Wealth of Nations.18

C_las S ical School

The classical school, like earlier writers, generally re—

gar-(fled profit to be the income of those who had the status of

an employer of capital. Particularly, the classical writers

contended that profit was the income obtained from the employ-

ment of stock or capital by its owners. Adam Smith utilized

this conception of profit. In fact it is even suggested from

the heading of Book I "Of the Causes of Improvement in the
\ .

an 16Anne—Robert—Jacques Turgot, Reflections on the Formation
bed the Distribution of Riches (New York: The Macmillan Company,
Print of the 1775 edition, 1911) pp. 11-15.

l7Ibid. ,Tl’ 71.

l8Meek, op, cit. , 'II’ 312.

112
Phcoductive Powers of Labour, and of the Order According to
\driich its Produce is Naturally distributed among the different
Ranks of the People."
In Chapter VI of Book II entitled "Component Parts of
tlie Price of Commodities" Smith stated that "the profits of

srtock are only a different name for the wages of a particu—

lxar sort of labour, the labour of inspection and direction."19

Fhirther, with this concept of profit Smith goes on and makes

TliJS famous statement:

As the price or exchangeable value of
every particular commodity, taken separately,
resolves itself into some one or the other, or
all of those three parts (wages, rent, profit)
so that of all commodities which compose the
annual produce of the labour of every country,
taken complexly, must resolve itself into the
same three parts, and be parcelled out among
different inhabitants of the country, either
as the wages of their labour, the profits of
their stock, or rent of their land. The whole
of what is annually collected or produced by
the labour of every society, or what comes to
the same thing, the whole price of it, is in
this manner originally distributed among some
of its different members. Wages, profits, and
rents are the three original sources of all .
revenue as well as of all exchangeable value.20

F5?C>rn this statement on the division of the annual produce,
53n15;1:h then considered the money value, called revenue, of
't}1€3 annual produce in Book 11, Chapter II. Here, gross revenue
“75153 defined as "the whole annual value of land and labour;"
IIEETI :revenue as "what remains free...after deducting the expense

()1? Inuaintaining first...fixed, and secondly,...circulating capi-
tal . H 21
\

33 19Adam Smith, The Wealth of Nations (New Rochelle, New
€323¥fl<§i Arlington House, Edwin Cannan, editor, reprint of 1776
lstldon), Book I, Chapter V1, p. 52.

20Ibid., Book 11, pp.55-57.
2libid., Book II, pp.309-305.

113

Other classical writers also meant by profits the income

obtained from the employment of stock or capital by its em—

ployers. For example, Ricardo stated in the preface of his

Principles that "the produce of the earth" is divided among

 

f

the

"three classes of the community, namely, the pr0prietor of
the land, the owner of the stock or capital necessary for its

cultivation, and the labourers by whose industry it is culti-

vated."22 Further, he spoke of "the proportions of the whole

produce of the earth which will be allotted to each of these

classes, under the names of rent, profit and wages." Malthus,

although violently disagreeing with Ricardo as to the causes

of fluctuation in profits, described profits as "that portion

of the national revenue which goes to the capitalists in return

for employment of his capital."2Ur John Stuart Mill referred

to profits as "the share of the produce of the capitalists" or
25

the "gains of the persons who advance the expense of production."

flimHIary of the Concept of Profit
as a Class Income

Earlier writers and the classical school generally re—

garded profit as a class income. The Physiocrats postulated a

C301'1cept of profit in the form of a "surplus" accruing to the

agJI‘Z'chultural entrepreneur. The classical school generally

\
22David Ricardo, The Principles of Political Economy and
on (New York: E. P. Dutton and Company, Inc., reprint of

Taxati
the 181 edition, 1937), original preface, p. l.

23 ,
Ibid., pp. 1—2.
(N 2”Thomas R. Malthus, Principles of Political Economy
eciTV‘7.York: Augustus M. Kelley, Inc., 1951, reprint of the 1820
lthn), p. 262.
Yo 25John Stuart Mill, Principles of Political Economy (New
lggk 3 Augustus M. Kelley, Bookseller, reprint of third edition
2 1961), Book II, Chapter XV, p. 905.

3

119
regarded profit as the return for the owner of capital al-

though at times it was not clearly distinguished from interest.

Influence on Accounting Thought and Practice

The importance of the economic concept of profit as a

class income to accounting in general and to the shift in
interest from the balance sheet to the income statement in

particular is indirect and not a result of any overt effort

to borrow from economics. But the economic concept of

profit as a class income found expression in certain practices

or relationships indicated in financial statements and in the

development of the proprietary theory of accounting. In fact,

there probably was an interaction of the two disciplines, or,

one might argue that the influence could even have been from

accounting to economics.

Chapter II pointed out that the essential form of
financial statements was nearly completed at the turn of this

century although underlying concepts were still not developed

Further, it was also pointed out that accounting before this

time was designed to aid the owner-manager in a very limited

manner in his business ventures. In fact, early accounting

thought and practices were constrained by a tremendously dif—

ferent type of economy from that existing today. Practically

all business was transacted by a sole proprietor in his own

behalf; the separation of management and ownership was almost

unthinkable.
\
2 . .
63 .SHendPlkSon contends that the "fields of accounting and

C101"lcbmics developed during the nineteenth century and the early

EWentieth century independently of each other." Eldon S.
enCilrikson, Accounting Theory (Homewood, Illinois: Richard D.

IPWin, Inc., 1965), p. us.

115
According to Edward Peragallo in a period extending

from 1559 to 1795, roughly the era of the Mercantilists and
Physiocrats, accounting literature began to break away from
nuare description of business practices and include elements
of theoretical research even though the double entry method

as espoused by Pacioli remained essentially unchanged.27

Thno important developments early in this period parallel the

previously mentioned economic views of the mercantilists and

physiocrats with respect to their conception of profit.

The first important development was the introduction in
l608 by Simon Stevin of the use of a "balance account" to
:fEicilitate annual profit and loss calculations instead of
at the end of each venture. This practice was followed by
a proposal in 1673 by a French writer, Jacques Savary, that
a balance sheet (”Inventaire") be required by merchants at

least every two years so all of their "fixed and movable pro-
IDEBITties and their debts receivable and payable" be disclosed.28
frlieaire exist some parallelisms between the mercantilists' and

IDTlsrssiocrats' concepts of profit and the above-mentioned develop-

DHEEInfts in accounting. Yet it was the introduction of the French

1:}léecory "des cinq comptes generaus" (of the five general accounts)

3111. ‘the latter part of the eighteenth century that really re-

SeJubiled their concepts of profit. In addition, the classical

E3 27Edward Peragallo, Origin and Evolution of Double Entry
OC>kkzee in (New York: American Institute Publishing Company,
1938 , p. 73.

28A. C. Littleton, Accounting Evolution to 1900 (New York:
(\nnEIfiican Institute Publishing Company, Inc., 1933), pp. 132—136.

116
concept of profit as the income of those who had the status
of an employer of capital and the proprietary theory of

accounting also had certain parallelisms.

Edmond Degrange was responsible for developing the
French theory "des cinq comptes generaus" in his 1795 book
"La Tenue des livres rendue facile, ou Nouvelle methode

d' enseignement de la tenue des livre en single et double

partie"(Bookkeeping made easy, through the Account Method of
Teaching both Single and Double Entry).
This book attempted to place double entry on a theor-

etical footing. He divided accounts into two groups: the first

included those of debtors and creditors, and the second, gen-
eral accounts of the proprietor which included cash, merchan-

dise, negotiable instruments receivable and payable, and

profit and loss. The proprietor was the center of the ac-

counting process. The essence of the method was debit him
Who receives and credit him who gives. Degrange's theory

attempted to personalize all accounts and transactions in an
attempt to represent the debtor and creditor relationships
between merchants and classes in French economic society. This
a~‘t‘I:empt resembles certain aspects of the Physiocratic system.
Particularly, it is an accounting system that stressed the pro-
PI‘ietary class and attempted to represent interrelationships

between economic classes.

In the early stages of the industrial revolution in Amer—

lea the great merchant capitalists--John Hancock, Stephen Girard,

Elias Darby, and John Jacob Astor-—emerged. These men operated

their empires mostly by a unique system of barter and treated

117

each undertaking as a separate venture. As a result, there

was no need to calculate periodic profit and loss.29 As the

industrial revolution proceeded, new conditions created a

need for new forms of business leadership. To fill this need

the industrial capitalists like Andrew Carnegie, Philip Armour,

and Gordon McKay appeared. These men applied new technology

and mass production techniques while operating their businesses

as essentially owners-managers.

Economists responded to these new environmental circum-
stances by concentrating on a class income concept of profit
obtained from the employment of capital by its employers.
Accountants likewise responded, although a little later than
economists, by developing the proprietary theory of accounting.

The German author Scha°r and an American writer Charles E.

Sprague were mainly responsible for its development. The

latter developed his version in 1880 by contributing a series

Of articles to a New York periodical, The Bookkeeper under the

title "Algebra of Accounts."

The central concept in the proprietary theory is that

the prOprietor is placed in the central position of the account-
ing equation. Assets represent things owned by the proprietor

wh-eI‘eas liabilities were his debts. Nominal accounts represented

cnie-I‘lges in the pr0prietorship. The maintenance of the proprietor' s

 

 

\
9 . . . . .
L - 2 W. T. Baxter, "Accounting in Colonial America" in A. C.
lt‘tleton and B. S. Yamey (eds.), Studies in the History of
(Homewood, Illinois: Richard D. Irwin, Inc., 1956)

QQOL'u’itin
pP- 28 -281.

Je 30Herman E. Kroose, American Economic DeveloPment (New
rsey: Prentice-Hall, Inc., 1962) pp. 272—275.

Un‘ 31A. C. Littleton, Essays on Accountancy (Urbana, Illinois:
lVersity of Illinois Press, 1961), p. 63.

118
"capital" resulted in a structure based on the accounting
equation or balance sheet.32 Thus, in accounting statements
and other presentations, profits, as in the economists' theory,
were considered a class income of the proprietor.

The Concept of Profit as Surplus
Remuneration to the Entrepreneur

General

In 1803 Jean-Baptiste Say was the first to distinguish
the concept of an entrepreneur-business manager from the capi—
talist—employer and to define his functions. The entrepreneur
was made "the principal and active agent of production" and is

the distributor of the product to "the productive services in

33

accordance to their function." In short, Say's system in-

troduced explicitly the three factors of production by utilizing
a concept of the entrepreneur which paved the way for later

profit theories and, as we shall see, influenced the development

of the entity theory in accounting.

Francis A. Walker

Francis Walker introduced the concept of the entrepreneur
into English economics in 1887.31+ He approached the subject of ’
profit by considering "the share of the produce going to the
employer" who "may or may not be the owner," but "constituted a

distinct class, either naturally or artifically defined."

32Hendrickson, op. cit., p. 29.

33Charles Gide and Charles Rist, A History of Economic
Doctrines (New York: D. C. Heath and Company, second English
ealtion, 1999), pp. 128—129.

3L'Francis A. Walker, "The Source of Business Profits,"
:flye Quarterly Journal of Economics, Vol. I (April, l887),pp. 265-288.

3SIbid.. p~ 259-

119
Business profits were considered to be the remuneration of this
employing class.36 According to Walker business profits for
a businessman would be the difference he could make as an em-
ployer versus an employee. Thus, he conceived the minimum

37 If an

rate of profits to be the current rate of wages.
employer makes more than the current rate of wages, it is the
result of his superior business ability, and it was measured
by the surplus "after payment of wages, the purchase of mater—
ial and supplies, and the repair and renewal of machinery and

plant."38

F. W. Taussig

 

Professor Taussig of Harvard was another exponent of
the concept of profit as surplus remuneration to the entre—
preneur. Like Walker, he regarded business as a form of
wages.39 His classification of incomes was based upon the
return from three factors: land, labor and capital. This
classification is implicitly revealed in the following
passage:

The business man stands at the helm of
industry and guides its operations....He pays
to the hired workman his stipulated wages.
Similarly, to those who lend him money, he pays
interest. It is his weighing and guessing of
the money—making possibilities of different
sites that determine the rent of urban land,
and he pays to landowners their rents. After
making these payments, he retains in his own
hand what is left. His income may, therefore,
be described as a residual.

 

36Ibid., p. 270.
37Ibid., p. 271.
381bid., p. 279.

39F. W. Taussig, Principles of Economics (New York: The
Macmillan Company, 19137: Vol. II, p. 158.

”01bid., p. 159.

 

120
Taussig contended that this position of residual
claimant was the reason for the business man's irregularity
of income and was caused by his "assumption of industrial
hazards" viz. casualty losses, price fluctuations, inven-

91 Over

tions and new processes, and fluctuation in demand.
a period of years, Taussig then argued that the effects of
these hazards balanced out, and the critical variables thus
causing differences in the long-run earnings of different
business men are the possession of the qualities shrewdness,

ability, and skin.”2

J. A. Hobson

 

Hobson divided factorial incomes of rent, wages, and
interest each into three parts. Each part represented a
sort of "charge" to total income from the productive process.
The first charge was for costs, "that part of the product
necessary to maintain the current output of productive
energy in a factor of production." That portion of the
product which remained after these costs were defrayed he
called surplus. This surplus was then divided into produc-
tive and unproductive portions. The former represented the
second charge and consisted of payments to owners of the
factors of production in excess of cost as are necessary to
evoke an increase of industrial structure or power(i. e.

growth in the supply of these factors). The latter,

 

”llbid., pp. 159-160.

”ZIbid., p. 161.

121
unproductive surplus, consisted of the remaining part of the
surplus that must be paid to the owners of the factors of
production as are 393 necessary to secure an increase of in-
dustrial structure or power.

The question that is relevant is: Where does the Surplus
originate? It comes from the other factor of production,
"ability," that is, the ability of the entrepreneur to organize
and direct production. Hobson believed that the payment of this
ability factor, excluding interest and payment for risk, but
including what was commonly termed "wages of management or
superintendence," was profit.uu In short, he thought profit
to be the necessay supply—price to stimulate the activity of
the entrepreneur. Its theoretical maximum consisted of the
"difference between the sum of the productivity of the separate
unorganized units of the factors of production and the sum of
their productivity when organized," whereas, its theoretical
minimum simply represented the above-mentioned first charge
to total income.”5 The actual profit was between these upper
and lower limits and depended upon: (1) bargaining power of the
entrepreneur over the other factors, and (2) the competitive
situation for the firm's products.Ll6 Thus, it must be concluded
that Hobson also regarded profit as the remuneration of the

entrepreneur and dependent upon his ability even though like

n

I+3J.A. Hobson, The Industrial System, an Inquiry into
'Qgpned and Unearned Income (London, England: P. S. King and Son,
Ltd., revised edition, 1910), pp. 56-82.

””Ibid., p. 122.

usIbid., p. 129.

L*5Ibid., p. 129-125.

122
every other income the surplus obtained over the minimum
supply-price is a function of various competitive conditions

in the bargaining process.”7

Herbert J. Davenport

 

Another economist who represented the concept of profit
as surplus entrepreneurial remuneration is Professor Davenport.
Like the previous writers he stated that "compensation for the
entrepreneur is profit,"“’8 where "all employers of labor or of
instrumental goods for hire are entrepreneurs, no matter whether
the prospective product is to be offered for sale or not.“49
He presented three alternative explanations for profit: (1) "ex-
ceptional, unclassified, irregular gains--conjunctive profits...,
(2) compensation for the independently working human factor in
production..., and (3) compensation for the independent human

"50 Davenport preferred the third

factor in the quest for gain.
sense because it denoted "compensation falling to independent
business activity after such apportionment as is possible has
been made for rent, interest, wages, and other outlays." Fur-
ther, in this sense "profit stands as merely one form of remun-
eration of labor" and is thus a form of wages to the entrepreneur
for entrepreneurial activity as such.51

From this notion of profit Professor Davenport then stated

‘that this profit goes "to him who takes the risk." Furthermore,

”7Haney, 0p. cit., p. 871.

|+8Herbert Joseph Davenport, The Economics of Enterprise
(New York: The Macmillan Company, 1913), p. 67.

 

IL'gihid., p. 139.

50Ibid., p. 909.

51Ibid.

 

123
he stated that it is in the very "nature of entrepreneur labor
that it is the labor of the risk—taker."52 This View, as will
be discussed later, anticipated Knight's concept of profit,

viz. profit as a return to uncertainty bearing.

John Bates Clark

J. B. Clark, an American economist, developed a dynamic
theory of the entrepreneur which was to have an important in—
fluence on the development of profit theories in economics and
accounting. As has been shown, early writers and the classical
school generally conceived the entrepreneur to be the capitalist-
employer. It was further shown that Walker differentiated the
capitalists from the employer, who may or not be the same.
Clark went one more step and confined the entrepreneur to a
solely coordinating role. For example he states:

This purely coordinating work we shall call

the entrepreneur's function, and the rewards for

it we shall call profits. The function in itself

includes no working and no owning of capital: it

consists entirely in the establishing and main-

taining of efficient relations between the agents
of production.

In short, the entrepreneur became "the man who coordinates capi—
tal and labour, without in his own prOper capacity furnishing
either of them."5u Thus, he postulated that the three functions
of the capitalists,the manager, and the owner, although fre-

quently combined as one and the same person, were theoretically

distinct.

‘

5216id.

 

53John Bates Clark, The Distribution of Wealth (New York:
films Macmillan Company, 1899), pp. 2-3.

5”John Bates Clark, "Insurance and Business Profits,"
IESinuarterly Journal of Economics, Vol. II (October, 1892), p.96.

129

According to Clark the rewards of these three functions
were also distinct because the growth of corporations had
tended to separate these functions into bondholders and credi-
tors, salaried officials representing owners, and stockholders
respectively.55 Pure profit in the proprietorship form of
business was the return of simple ownership. However, in the
large corporation with many stockholders "pure profit resides
in the portion of dividends that is in excess of current inter—

. . . 56
est on the paid in capital."

Clark's measure of profit was similar to the cash method
used by today's accountants. For example, he stated:

Defray all the expenses of bringing a pro-

duct into existence, sell the article for what

you can get, and, if you have anything more in

your hands than you had at the beginning of the

operation, you have received a true profit....

an excess of an entrepreneur's receipts over all

his disbursements.

Although Clark felt that "risk—taking" is necessary,
it was not considered a part of pure profit, as will be shown
in Knight's theory. Capitalists were considered the risk-takers.
Their return is interest. Profit "begins only when something
comes to the entrepreneur over and above this and all other

disbursements.58

Eyederick Barnard Hawley
The "risk theory of profits" proposed by Hawley was a theory

«1150 based on a concept of pure profit as a residual surplus

 

55Ibid., pp. us—u9.

56John Bates Clark, "Profits Under Modern Conditions,"
Eglitical Science Quarterly,Vol. II, p. 607.

 

57Clark, "Insurance and Business Profits," op. cit.,p. 91.

Ibid.

 

125
return to the entrepreneur. His theory is summarized in his
own words as follows:

The final consumer is forced to include in
the price he pays for any product not only enough
to cover all items of cost to the entrepreneur,——
among which items is a sum sufficient to cover the
actuarial or average loss incidental to the risks
of all kinds necessarily assumed by the entrepreneur
and his insurers,--but a further sum, without which,
as an inducement, the entrepreneur, or enterpriser,
and his insurers will not undergo or suffer the
irksomeness of being exposed to risk.

This surplus of consumer's cost over entre-
preneur's cost, universally regarded as profit, and,
from the nature of the case, an unpredetermined
residue, is the inducement for the assumption by the
entrepreneur, or enterpriser, of all risks, whatever
their nature, necessitated by the process of pro—
duction. As an inducement to any given action and
the reward for the action are the same thing,—-the
difference being not in the thing itself, but only
in the point of time from which it is looked upon,--
the unpredetermined residue which served as the
inducement to risk at the commencement of any indus-
trial transaction must necessarily, when determined
and realized at its close, be regarded as the result,
or reward, of the risks undergone.59

It appears that Hawley's concept of pure profit only
differed from that of Clark's in their respective concept of
the entrepreneur and the capitalists and his emphasis on risk.
As was stated earlier Clark maintained that the capitalist is
the risk-taker and his reward is interest which included rent.
The entrepreneur he explained:

becomes the owner of the product of this industry,

as they are turned out, and sells them in the mar—

ket for what he can get. In acquiring this owner—

ship, he must pay all costs entailed in creating

the product; and among the cost to be thus defrayed

is the entire sum paid over to the capitalists as
an offset of risk. 0

59Frederick B. Hawley, "Reply to Final Objections to
the Risk Theory of Profits," Quarterly Journal of Economics
Vol. XV, (August, 1901), p. 610.

 

60Clark, "Insurance and Business Profits," op.cit.,p. 96

126
Thus, Hawley believed that profit was "the result of risks wisely
selected."61 He made pure profit a specific reward for the
service of risk-taking. Enterprise was considered the fourth.
factor of production. Profit was a cost in the supply price of
the product. Profit was the cause of rent, interest, and wages.
Enterprise was considered the servant of society, whereas the

other three factors were the servants of enterprise.62

 

Alfred Marshall
Marshall's approach to a theory of profit, although basic—
ally a surplus—reward—of—the-entrepreneur was rather eclectic.

For Marshall, business profits Were the total net gains from a-

63

business which motivated a man in his business. This usually

implies a composite of many items as is shown in a quotation
from Schumpeter:

But in it (Marshall concept of profit) the
ordinary reader finds a fricasee of such things
as: earnings of management of all possible kinds,
including also the earnings of better than com-
mon management; gains from successful risk-taking
and uncertainly bearing...; gains from advantage
‘incident to the control of particular factors,
some of which would, in other firms, not contri-
bute as much to results as they do where they
are; chance gains to the owner as residual clai-
ment...; and, among other things, gains which
accrue to a firm as it grows, or because it has
grown, rglative to its competitors or absolutely
or both. H

 

6lFrederick Barnard Hawley, Enterprise and the Productive
Process (New York and London: G. P. Putnam's Sons, The Knicker-
bocker Press, 1907), p. 108.

 

621bid., p. 96.

63Alfred Marshall, Principles of Economics (London: Mac-
millan and Company, Ltd., eighth edition, 1920, first edition,
1890), p. 73.

 

6“'Joseph A. Schumpeter, History of EconomicsAnalysis
(Ahew York: Oxford University Press, 1959), p. 1099.

 

127

Certainly this concept of profit is quite different from

those concepts which explain profits as a result of only one

factor. The wide range of possibilities as Marshall referred

indicates the difficulties he thought were in this area of
theory.

Irving Fisher
Schumpeter contends that Irving Fisher was America's

"greatest scientific economist."65 He was interested in measu—

ring income and profit as surplus remuneration to the entrepreneur

as is demonstrated in his famous book The Nature of Capital and

Shicome when he writes:

This book is an attempt to put on a rational
foundation the concepts and fundamental theorems

of capital and income. It, therefore, forms a
sort of philosophy of economic accounting, and,
it is hoped may supply a link long missing between

ideas and usages underlying practical business

transactions and the theories of abstract economics.66

In formulating his theory of income and profit, which was

bafiBically a surplus reward of the entrepreneur, Fisher differ-
erltiilated between a stock and a flow of wealth. A stock of wealth

313 ainy given point of time he calls "capital;" the flow of ser—
"67

Vchzeas from this stock during a period of time is "income.

PiEsl'ieruses the term wealth to identify "material objects owned
Having seen what

bS’ finndividuals" and that provide a service.

EELESIIGEr defined wealth to be, it is necessary to examine its first

e S s e ntial attribute-materiality .

\

65Joseph A. Schumpeter, Ten Great Economists from Marx to

iS§Z§1335§£§ (New York: Oxford University Press, 1965), p. 223.
66Irving Fisher, The Nature of Capital and Income (New York

Pi - -.
51(21Ttlfillan Company, 1906), p. Vii.

67Ibid., p. 51.
68Ibid., p. 3.

128

Materiality of wealth is important because it provided

the basis for a physical measurement of the various articles

of wealth. Fisher pointed out that even though each item of

wealth has a unit of measurement (i. e. pounds, feet, gallons),

it is convenient to measure the combined value of aggregations

of wealth in terms of money. The term value is important for

this measurement process and was made to depend upon price;

that of price, in turn, on that of exchange; and finally, that

of exchange on that of transfer. Starting with transfer Fisher

then discusses the sequence which later enters into the account-

ant's debits and credits.69

Like the first attribute of wealth, materiality, the

secnond ownership, must be reviewed in order to clearly under—

stan d Fisher's theory .

Fisher contended that to own wealth is to have a "right

tC) ijhe benefits of wealth."70 For example, to own a loaf of

brxeaid meant to have the right to satisfy one's desires (i.e.

eéit: .it, sell it, and etc.). The flow of benefits from wealth,

111 ifhe most general sense, is what is meant by income, accord-

illég to Fisher.71 It is a utility concept of income.

Opposed to the benefits or services derived from wealth

alpei costs. Fisher called these costs "negative benefits or

diSServices." The purpose of wealth, as previously mentioned,

Was to furnish the owner satisfaction from its use. This satis-

faction may be an event he did not wish to happen. Sometimes,

\
Yko 69Irving Fisher, Elementary Principles of Economics (New
>1?}<-= The Macmillan Company, 1911), pp. 10—15.

7OFisher, op. cit., The Nature of Capital and Income, p.18.

7llbid., p. 101.

129

however, wealth can provide no benefit without entailing some

cost (1. e. preventing what is desirable or causing what is

undesirable). For example, one must maintain a house (repairs,

enjoy its use; a businessman must
72

taxes and etc.) in order to
pay a worker to obtain the benefits of his services.

Starting with these concepts of services and disservices,

Fisher then formulated the necessary requirements for the com—

pletion of every economic event. There must be an "acting"

instrument or set of instruments, and there must be an instru-
ment or set of instruments acted upon, which he labeled "active"

and."passive," respectively. For example, the equipment of a

ttxol manufacturer and his employees' labor are active in making
a liammer, whereas, the materials contained in the hammer are

Luasssive. Later, the hammer in the hands of a carpenter building

a 11c>use is active; the lumber used in the constructing, passive.

TC> 1:hese double—faced events Fisher gave the name "interactions"--

It . . . . . .
a. 53erv1ce of the acting instrument and a disseerce of the in-

Ertletiment acted upon."73

Interactions were the key because income for any group of
capital consisted of the interactions taking place within that

g17<>11p. But it is the outer fringe of services that constitute

t17L1€3 income of that group. To Fisher, this final income was

-pfs§7<211ic income, of which money income was an approximation.

It was shown that Fisher viewed the term "capital" as not

-tc> IDEE confined to any particular kind of wealth, but it applies

\
72Fisher, 0p. cit., Elementary Principles, pp. 21-23.

3 .
Fisher, op2 cit., The Nature of Capital and Income,p. 199.

130
to all kinds existing at an instant of time. In addition, it
was shown that Fisher regarded income as consisting simply of
the benefits of wealth. Finally, Fisher believed both can be
subjected to money measures, even though approximated at times.
In spite of this close association, capital and income
have been essentially considered separately. The question now
is: how did Fisher pass from capital to income and income to
capital? This bridge or link was the rate of interest, which
necessarily involves the discounting of expected future income.
To use Fisher terminology: "the rate of interest is the premium
vdiich present goods command over similargoods of the future."7u
IT: short, Fisher used the rate of interest as the appropriate
ditscount factor to translate future money-values into current
Hubruey-values. The rate of interest is thus a link between
\Nalnies at two points of time. Or more specifically, the value
CDf' cany item of capital is the discounted value of income expected
3frk3rn.that capital. As Fisher states:
The present worth of anything is what men
are willing to give for it. In order that each
man may decide what he is willing to give, he must
have: (1) some idea of the future benefits his
purchase will bring him, and (2) some idea of the
rate of interest by which these future values may
be translated into present values by discounting."75
With the above discussion of Fisher's concept of income
<3C>nߣ>leted, it now seems appropriate to consider the impact of
-t}1€3 <2oncept of profit as a surplus return to the entrepreneur on

‘t}1€3 sshift in emphasis from the balance sheet to the income state—

mEI'lt .
\
7L'Fisher, 0p. cit., Elementary Principles, pp. 96—97.

7SIbid., p. 99.

131

Summary‘of'the.Conceptfiof'ProfitrasVSurplus
Remuneration to the Entrepreneur

 

 

The importance of this concept of profit to economics
was the fact that profit was no longer identified with any
particular class but was a sort of opportunity payment or re—
ward for managerial skill. The entrepreneur or organizer of
the productive process was made the central "cause" of profit.
His function was theoretically distinguished from the capitalist-
owner reflecting the increased importance of the corporation
with its corresponding separation of stockholders and managers.
Profit was measured by economists espousing this concept by the
surplus or residual amount remaining after making necessary
factor payments for land, labor, and capital. Some of the
writers felt that profits were the result of superior managerial
ability. Others believed it resulted from the assumption of
risk. But all believed that interest was a return to the factor
capital and must clearly be separated from profit.

Relationship of the Economist's Concept of Profit as
Surplus Entrepreneurial Remuneration to Accounting

General

The latter part of the nineteenth and early part of the
twentieth centuries saw the downfall of the industrial capitalist
and the emergence of the corporate form of business organization.
Gardiner C. Means suggested that:

This development, culminating in the separa-

tion of ownership and control has brought a change

in the character of industry as revolutionary as that

produced by the industrial revolution with its corres—

ponding division of function, the separation of labor

and control.76

‘

75Gardiner C. Means The Cor orate Revolutio ' °
”Jew York: The Crowell-Collier PuBIisHing Company, 1962), p.CI5.

132
As was mentioned before, economists responded to this changing
economic scene by developing a concept of profit based upon
surplus entrepreneurial remuneration. Accountants also respon-
ded to the changing environment by reviving the entity theory
and introducing the going concern concept, thus, calling for a
periodic annual report of management's accomplishments, which
in turn, led to matching revenue realized against cost consumed
through the tool of the income statement as a practical solution
to the calculation of income.

The entity theory stresses the separateness of the "busi-
ness" and the proprietor like the economist's entrepreneurial
theory. The fundamental accounting equation becomes Assets:
Equities. Littleton points out that with the entity theory new
emphasis is directed at distinguishing between capital and in-
come, a necessary condition for an accurate measurement of
income as Irving Fisher apprOpriately pointed out. For example
Littleton stated in discussing the difference between the pro-
prietary and entity theories:

...so fundamental a difference in point of

View as this must be indicative of an underlying

difference in the concepts of the real function

of bookkeeping and of capital and income. Capital,

according to the proprietorship view, is the pro-

prietor's contribution; liabilities are merely nega-

tive assets. But in the entity theory, capital is

the sum total of property active in the business

from Whatever source derived;...Protit, according

to the proprietary theory, is an increase in the

net figure of positive and negative property

(i.e. net assets); in the equity theory, profit is

the excess of the proceeds recovered over the out—

lays advanced during the business process. In the

first view, profit is any increment to proprietor—

ship however obtained; in the other, it is the reward

for managerial skill in advancing such outlays as will
produce an excess when recovered.77

 

77Littleton,’0p.' cit., Accounting Evolution to 1900, p. 192.

 

133
From this quotation two important ideas remind one of

the economist's concept of profit as surplus remuneration of

the entrepreneur. Particularly, profit as "the excess of the
proceeds recovered over the outlays advanced" is very similar

to how the above—mentioned economists viewed profit (viz. "sur—
plus after payment of wages, the purchase of materials and
supplies, and the repair and renewal of machinery and plant.")78
Secondly, profit as the "reward for managerial skill in ad-
vancing such outlays as will produce an excess when recovered"

is exactly the same notion utilized by most proponents of the

surplus entrepreneurial reward concept of profit.

William Andrew Paton

 

Although development of the entity theory during the
latter part of the nineteenth century occurred in Germany, it
was Paton who was primarily responsible for its introduction
and expansion in the United States. In his 1922 edition of

Accounting Theory, he clearly recognized "the relations between

 

certain accounting concepts and fundamental classes of economic

theory. For example, in discussing one of his fundamental

classes "properties" he wrote:

A consideration of the relation of the class,
"properties," to the economist's concept, "wealth,"
will serve to throw some light upon the fundamental
nature of this accounting category. In general it
may be said that anything which can conStitute
wealth may, under certain circumstances, become an
asset to the accountant.80

 

78See footnote 38, 90, and 93.

79William Andrew Paton, AccOunting Theory(Chicago, Illinois:
Accounting Studies Press, Ltd., 1962, reprint of the 1922 edition),
P- v. '

801bid., p. 33.

 

139

Furthermore he stated: "Evidently the accountant's class,

prOperties, is somewhat akin to the economist's capital."81

The most significant relation between economics and
accounting for the purposes of this study was his adoption
of the entity theory. In the preface of Accounting Theory

he wrote:

In this book,...., an attempt has been
made to present a restatement of the theory
of accounting consistent with the conditions
and needs of the business enterprise "par
excellence," the large corporation, as well
as applicable to the simpler, more primitive
forms of organization. The conception of the
business enterprise as in all cases a distinct
entity or personality--an extension of the 82
fiction of the corporate entity--is adopted,....

Further, in his chapter on the postulates of accounting Paton

stated:

The concept of the business entity is con—
stantly used outside the corporate form of or-
ganization by economists and others interested
in the business process.83

Along with the entity theory the concept of "going con-
cern" was also listed as a corollary postulate. Littleton con-
tends that the "relationship between regular periodic reporting
and the concept of enterprise continuity is clearly evident."
Particularly, he believes that "periodic reports were the con—
"89

sequence of the acceptance of the idea of enterprise continuity

With the acceptance of the entity theory and periodic reporting

n

8libid., p. 35.
821bid., p. v.
83Ibid., p. 979.

8"FA. C. Littleton and V. K. Zimmerman, Aeoounting Theory:
Egfljjnuity and Change (Englewood Cliffs, New Jersey: Prentice-
Hall, Inc., 1962), pp. 55-56.

 

135

the ground work in theory was complete for the shift in
emphasis from the balance sheet to the income statement and
the development of the transactions approach to income account—
ing. To use Emily Chen Chang's words:
The income statement is elevated as the

most significant financial statement, an exhibi—

tion of management accomplishments and a measure-

ment of the corporation's earning power; while

the balance sheet is belittled as a means of

carrying forward unamortized acquisition prices,

an exhibition of unfinished jobs. The business

entity is the center of attention, and the in-

terests of individual stockholders are pushed
into the background.

The Concept of Profit as a Return
to Uncertainty Bearing

General

In an earlier section of this chapter the interaction of
ideas and events between accounting and economics in response
to environmental forces was presented.

For example, the introduction of the so-called "balance
account" by Simon Stevin, the "Inventaire" by Jacques Savary,
and Edmond Degrange's theory "des cinq comptes generoux" re-
sembled certain of the ideas found in the mercantilists' and
physiocrats' writings. Furthermore, it was shown that there
was an interaction between the classical economist's concept of
profit as a result of the employment of capital and the develop-
ment of the proprietary theory in accounting.

In the next section the economist's concept of profit as
a surplus remuneration to the entrepreneur, in responding to the

corporate revolution was related to the revival and expansion

‘

85Emily Chen Chang, "Business Income In Accounting and
Economics" * Accounting Review, Vol. XXXVII (October 1962), p.638.

 

136
of the entity theory in accounting. It was then argued that
the entity theory and the corresponding going concern concept
led to periodic reporting of management's accomplishments. The
outcome was the transactions approach to income accounting and
a belittling of the balance sheet.

As an appropriate sequel it seems desirable to briefly
demonstrate, as further proof of interactions of ideas and
events in economics and accounting, the relationship of the
economist's concept of profit as a return for uncertainty

bearing to current accounting thought.

Frank Knight

 

Frank Knight developed a theory of profit which showed
that the presence of uncertainty about the future may allow
entrepreneurs to earn positive profits despite product ex—
haustion and competitive equilibrium.86 Unlike J. B. Clark and
F. B. Hawley, profit appeared only when there is an accretion
to the present value of the expected future net receipts of a
firm's capital. In addition, he criticized both the dynamic
theory of Clark and the risk theory of Hawley as applied to the
entrepreneur. Concerning the former Knight wrote: "it is not
dynamic change, nor any change as such, which causes profit."87
The latter, Hawley, was criticized because "he treats risk as a

known quantity and concentrated on entrepreneurial 'ability'."88

 

86M. Blaug, 0p. cit., p. 939.

87Frank H. Knight, Risk, Uncertainty and Profit (New York:
Kelley and Millman, Inc., 1952, reprint of the 1921 edition),p.38.

 

88Ibid., p. 95.

137

Professor Knight formulated his analysis of the cause
of profit on what he called "unmeasurable uncertainty." He
believed that individuals do not act upon inferences of logical
reasoning, based upon exact knowledge of things. Instead indiv—
iduals act upon estimates, opinions, judgment, or intuition based
upon imperfect knowledge of the data and their environment.89

Estimates were considered somewhat like a particular
type of probability judgment. He regarded this type as true
"uncertainty" and "liable to err" because these estimates were
incapable of being based upon any classification of instances.
This inability of classifying instances was the important fact
that differentiated estimates from’é priori judgments and sta-
tistical probability judgments. These latter types of judgments
were measurable more or less and were called "risks."90

It is this unmeasurable uncertainty that was the cause
of profit and loss. Furthermore, unmeasurable uncertainty forced
the entrepreneur to exercise "responsible control" and to bear
its burden. This control and uncertainty-bearing, unlike Hawley's
formulation, was inseparable and was the chief function of the
entrepreneur.91 According to Knight profit was caused by the
margin of error in calculation on the part of the non-entrepreneurs
who did not force successful entrepreneurs to pay as much for the
factors of production as they could have been forced to pay.

In short, profit was the difference between "extante" and "expost"

calculations.

 

89Ibid., pp.223—233.
90Ibid., pp.223-233.
911bid., p. 278.

92Ibid., p. 289.

138

J. R. Hicks

 

Professor J. R. Hicks defined what may be considered the
dominant current economic concept of income for an individual
as "the maximum value which can be consumed by an individual
during a week and still expect to be as well off at the end of

"93

the week as he was at the beginning. In short, "the pur—

pose of income calculations is to give people some idea as to
the amount they can consume without impoverishing themselves."9u
This immeasurableness was the case since prices change both
relatively and absolutely in addition to the change in the
quality of goods produced with the passage of time. Thus, the
amount of money that an individual can spend during a given
period and still expect to be as well off at the end of the
year as he was at the start involves both utility measurement

and index number problems.95

If, on the other hand one could
Specify a utility function, a solution would be to hold utility
constant for the period and measure one's total expenditures
during the period. The amount of these total expenditures
would be income for the period. If, however, prices change
then consumption does not represent income because the same
"basket" of goods that keeps utility constant also changes.

But Hicks does think that, if certain assumptions are made and

price indices are available, one's "ex-poste" income could be

calculated. A quotation from Hicks makes this point clear:

 

93J. R. Hicks, Value and Capital: An Inquiry into Some
Fundamental Principles of Economic TheOry (Oxford: The Clarendon
Press, second edition, 1950), p. 172.

 

9L'Ibid.
95

 

Ibid., pp. 179-176.

139
If capital values of an individual's pro-

perty can be ascertained at the beginning and

ending of a period and if we assume we can

measure consumption then one's ex—poste income

can be calculated.96

From the definition of an individual's income Hicks
then defined business income as the "maximum amount which the
firm can distribute as dividends and still expect to be as
well off at the end of the period as it was at the beginning."
He furthergoes on to state that being well off meant "main-
taining capital intact in terms of discounted value of expected

"97 Here as with Knight, it seems evident

future net receipts.
that the future expected net receipts of the factors of pro-
duction purchased by a business entity were unknown and sub—
ject to risk and uncertainty. It also seems evident that Hicks
was implying the capital maintenance approach to periodic in-
come measurement. Particularly, the calculation of income
involves the capitalization (present discounted value) of the
net cash flow to be received by the business at the beginning
and ending of the period.

Interaction with Current Accounting
Thought and Practice

 

 

Familiarity with current accounting thought and practice
makes one realize the growing importance of the concept of cap—
italization and uncertainty. This growing importance interacts
with the concept of profit as the return to uncertainty bearing
with its emphasis on the capital maintenance approach to income

measurement and can be said to exist in two significant trends.

 

96Ibid.

 

97Ibid., pp. 179-180.

190
The first significant trend is the attempt to make the
balance sheet a better tool for valuation and income determina-
tion. One of the leading proponents of this View is Professor
Chambers. For example, he states:

It is contended,..., that the swing from
the balance sheet viewpoint to the profit and
loss viewpoint has gone too far. It has gone
so far, it is believed, because of the desire
to bolster conventional accounting methods. In
changing conditions the conventional profit and
loss account gives a better approximation to
current net profit than the conventional balance
sheet gives to current financial position. If
one claims that the profit and loss account is
the most important statement, one can make light
of the defects of the conventional balance sheet....

It does not follow from the statement
"earning power is the significant basis of enter-
prise value" that "the income statement is the
most significant accounting report." The income
statement does not show earning power; it shows
earnings. Earning power is only ascertainable
from a comparison of earnings with the sum employed;
net profit of itself is not significant. It fol-
lows that the income account and the balance sheet
are of equal importance for this purpose, and that
the further the asset values move from invested
cost without restatement of those values and of
the shareholder's equity, the greater is the
distortion of the current relationship between
net profit and the sum employed.

In his recent book, Accounting, Evaluation and Economic
Behavior, a case is made for the reinstatement of the balance
sheet as the primary accounting report. Here, Chambers com-
pares business entities to individuals as "homeostatic systems"
being influenced by a host of factors, one of which is economic
phenomena. The condition which has the greatest influence on
the choices of an actor, as he describes it, is his "present

position in relation to his environment at any point of time."

 

98Raymond J. Chambers, "The Implications of Asset Revalu-
ation and Bonus Share Issues," Australian Accountant, Vol. 27
(November, 1957), pp. 519-515.

 

191
In fact, this position "is the determinant and predictor of
future positions, as it is also the resultant of past positions."
Knowing this position is a necessary, but not a sufficient,

99 To business

condition for successful choosing or acting.
entities it is financial position as reflected in the balance

sheet that serves as the basis for successful choosing or

acting. The income statement "is derived, fundamentally, by
reference from two successive statements of financial position."100
As a result, the income statement is reduced in importance while
the balance sheet is elevated in importance. That is to say,
the capital maintenance approach to income determination is
adopted.

Chambers is decisively different than economists with
respect to his valuation concept used for income calculations.
He generally adopts what is called the "current cash equivalent"
basis for valuation as Opposed to capitalized values based
upon expectations. For example he states:

Calculations about future conditions and

events are always and inevitably hypothetical.

No proposition relating to the future is a state-

ment of fact. One may use past experience and

present knowledge of facts and relationships in

forming propositions about the future. But those

. . . f . l 101

propOSItions are belie s or expectations on y.

It seems that future expectations are most relevant. Current
prices under pure competition reflect the interaction of supply

and demand forces. One of the most important forces that in-

fluence these prices are expectations. Thus, current prices are

 

9 . .

Raymond J. Chambers, Accounting,Evaluation and Economic
Behavior (Englewood Cliffs, New Jersey: Prentice-Hall, Inc.,1966),
PP- -

0

 

Ibid., p. 118.

101Ibid., p. 83.

192
significant, as Chambers suggests, under perfect markets
because they reflect expectations not just because they are
objective. In imperfect markets current prices are signifi-
cant only because they represent the lowest minimum subjective
value to an actor comtemplating a purchase. For example, a
businessman would not be willing to purchase a machine if its
discounted value to him is less than its market price. In
short, the principle of capitalization based upon expectations
is essential to the whole problem of valuation, which in turn
is the basis for action. Thus, valuation is subjective. Re—
sulting income calculations are tentative and uncertain. To
the extent the current cash equivalents approximate capitalized
values then they are relevant to accounting because they meet
the other standards of verifiability, freedom from bias, and
quantifiability as recently proposed by the American Accounting
Association. But to argue that current cash equivalents and
resulting current position are the theoretically correct basis
for action is incorrect.

The second significant trend is the movement toward re—
vising the meaning of the realization concept in an effort to
provide better income data and to upgrade the status of the
balance sheet. Traditionally the time of sale has been the
general rule for the recognition or realization of revenue, be-
cause it is argued that (l) the price of the product is now
established, (2) an exchange or new asset has been acquired,
(3) the sale in most instances is deemed to be the most signifi—
cant event to a firm, and (9) most of the costs relating to the

product have been incurred and are readily determinable.102

 

102Hendrickson,‘ op. cit., p. 138.

193

In short, the general view is that realization is the recog-
nition of revenue when an exchange or severance has occurred.

The effect of this strict adherence to the realization
concept is that traditional accounting income does not recog-
nize (1) changes in net assets not realized in the period
(i.e. value added approach), (2) changes in price levels,
(3) unexpected changes in expectations, and (9) expected

103 With the possible exception of (3)

changes in goodwill.
economists take into consideration all these factors in cal-
culating income.

Today the traditional realization concept is under attack
as evidenced by the volumes of literature. Sprouse and Moonitz
reject the concept because it is in conflict with the postulate

10” Instead they advocate that recognition should

of continuity.
be granted in the period in which the major economic activity
occurred, providing objective measurements of this activity is
available.105 They also believe adjustments for price level
changes should be recognized in the period of occurrence. The
American Accounting Association has likewise broadened the
meaning of realization to include "a change in an asset or
liability" if it is "sufficiently definite and objective to
warrant recognition in the accounts." Thus realization can re-

sult from "an exchange transaction between independent parties,

or in established trade practices, or on the terms of a contract

 

103Chang, op. cit., p. 691.

10L'Robert S. Sprouse and Maurice Moonitz, "A Tentative
Set of Broad Accounting Principles for Business Enterprises,"
Accounting Research Study No. 3 (New York: American Institute
of Certified Public Accountants, 1962), p. 15.

105

 

Ibid., p. 97.

199
performance which is considered virtually certain."106
Floyd W. Windal believes that this American Accounting
Association definition of realization is broadly stated and
seemed to be equally applicable to expenses, gains and losses
and other changes in assets and liabilities. For example, he
stated that "the key point is whether a change in an asset or
liability, presumably any change, has become sufficiently
definite and objective to warrant recognition in the accounts."107
He considered an item objective if it appeared "substantially
the same to all accountants examining it." By definiteness
an item "must appear unlikely to be reversed."108 Further-
more, in his concluding remarks Windal suggested that the
criteria for realization may change with time. In fact, com-
puters, economic structures, and economic stability "may make
it possible to forcast with great certainty what lies ahead
for an enterprise."109
From the above statements relative to the realization
concept, there is evidence that accountants are relaxing the
strict requirements of the traditional view. The result is
that many contend income accounting should recognize (1) changes
in net assets not "realized" in the period if objective veri-
fiable evidence exists, and (2) gains and losses from price

movements, both general and relative. Thus, the difference

between economic income and accounting income is narrowed to

 

106American Accounting Association Committee on Accounting
Concepts and Standards, ACCOuntingand Reporting Standards for
Corporate Financial Statements and Preceding Statements and
Supplements (Columbus, Ohio: American Accouniing Association,
1957), p. 3.

107Floyd W. Windal, "The Accounting Concept of Realization,"
’Accounting Review, Vol. XXXVI (April, 1961), p. 250.

lOBIbid., p. 252.
1091513., p. 208.

 

 

 

 

195
(1) changes in expectations and (2) expected changes in
goodwill. If computers, economic structures, economic sta-
bility, and fiscal policy continue to reduce uncertainty,
then it might be possible to use probability values in ac-
counting calculations, thus narrowing the area of disagree—
Inent even more. Furthermore, it is felt that concentration
on valuation and measurement theory can also reduce the dif—
ference. The problem should not be the balance sheet versus
the income statement approach to income calculations because
valuation of assets and liabilities in the former is merely
shifted to the valuation of assets and liabilities entering
amid leaving the firm in the latter. Both approaches yield
identical results under appropriate valuation methods and

:identical assumptions.

CHAPTER VI

THE INFLUENCE OF FEDERAL

TAXATION 8 LEGISLATION

General

The advent of income taxation and other Federal legis-
lation was a factor of marked consequence in the promotion
of the income statement viewPoint. Many feel that it is not
an exaggeration to say that this development has had more
influence than any other factor in bringing about the ascen-
dancy of income accounting based upon systematic accounting
methods. H. C. Daines suggested this in the following passage:

The income tax objective is reflected in

the attitude on the part of certain business-

men and accountants that the books of accounts

should be kept so as to properly record the taxa—

ble income. It can be said that many believe

that this point of view constitutes the primary

purpose of accounting.

Federal income taxation, beginning with the 1899 and 1909
acts, was firmly established with the adoption of the Sixteenth
Amendment early in 1913. The passage of the first act under
this Amendment in 1913 and subsequent legislation imposing even
higher rates based upon income and net earnings naturally led

businessmen to consider it imperative that profit figures be

calculated with the greatest possible degree of precision to

 

1H. C. Daines, "The Changing Objectives of Accounting",
The Accountipg Review, Vol. IV (June, 1929), p. 103.

 

196

197
insure that minimum legal amounts of taxes were paid. The
task of computing this periodic business income was naturally
the domain of the accountant. As a result, accountants began
to focus increased attention upon the problems associated with
the matching of costs and revenues (i. e. timing, recognition,
allocation, etc.). The end product of this increased attention
was the tendency to present more detailed income statements,
in terms of form and content. In fact, in many cases the emer-
gence of income reporting for external purposes appeared in
smaller companies for the first time simply because the neces-
sary information was prepared for tax purposes.2 On the other
hand, to suggest that the emergence of income reporting for
external parties was solely the result of income taxation is,
of course, untrue. The important point, however, is that the
tax laws forced businessmen, if they wanted to minimize taxes,
to keep appropriate records as to revenue and expense. The
other condition that resulted in the emergence of income re-
porting was, as mentioned before, the demands and legislation
resulting from the increased importance of the small investor.
Both the developments in income taxation and the requirements of
various governmental legislation as they relate to the external
shift from the balance sheet to the income statement are the

subject matter of this chapter.

 

2Paton, William A., Accountipg (New York: The Macmillan
Company, 1926) pp. 1—2.

 

198

Federal Income Taxation

 

The Problem of Income
The taxation of income reflects the long term shift
from property to income as a measure of economic well being
(wealth) or power.
The Sixteenth Amendment to the Constitution stated in
Article XVI:
The Congress shall have power to lay and

collect taxes on incomes, from whatever source

derived, with apportionment among the several

states, and without regard to any census or

enumeration.

One of the first problems encountered as a result of this
statement was interpretation of the term income. Much con-
fusion resulted because of the various meanings that were
available. Economists, as is evidenced by the previous chap-
ter, proposed definitions that ranged from the extremely sub—
jective or psychic concepts to the more practical or real in-
come concepts. Accountants proposed definitions that, in the
broadest sense, approached the economic concept of real income
to the narrow money income concept, which reflects only realized
increases in the monetary valuation of resources. The courts
provided definitions that concentrated on the idea of a "gain"
as being regarded as income. For example, the U. S. Supreme
Court in the famous Eisner V. Macomber case clarified its posi-
tion from previous decisions (Stratton's Independence V. Hou-

bert, 231 U. S. 339, 915 and Doyle V. Mitchell Brothers Com—

pany, 297 U. S. 179, 195):

199
Income may be defined as the gain derived
from capital, from labor, or from both combined,
provided it be understood to include profit
_gained through a sale or conversion of capital
assets,...3
This decision crystalized the past vague interpretations
of the courts and gave the business community a framework for
developing accounting concepts of income that would be accept-
able for tax purposes, even though the Revenue Act of 1918 had
recognized that "net income of a taxpayer computed in accor—

dance with the method of accounting regularly employed" was an

acceptable basis for taxable income.

Accrual Accounting

 

Although not specifically required, Federal income taxa-
tion encouraged accountants and businessmen to use the accrual
basis of income determination. This encouragement made it neces-
sary for those businesses that adOpted the accrual basis to
match revenues with appropriate expenses in ascertaining taxable
income.Ll

As early as 1918 the tax regulations allowed taxpayers to
use accrual accounting for income determination:

Gains, profits, and income are to be in-

cluded in gross income for the taxable year in

which they are received..., unless they are

included when they accrue...in accordance with

the approved method of accounting followed by

the taxpayer.

This emphasis on accrual accounting was subsequently repeated

 

3Eisner V. Macomber, United States Supreme Court, 252, a
decision of March 8, 1920, p. 183.

 

UrGeorge 0. May, "Taxable Income and Accounting Bases for
Determining It", Journal of Accountancy, Volume 25 (October, 1925),
pp. 250-251.

5

 

The 1918 Regulation 95, Article 52, quoted in Charles J.

Gaa, The TaxatiOn 0f Copporate InCome (University of Illinois
Press, 1999), p. 98.

150
in the regulations in 1921 and 1929 and has remained substan-
tially the same even though at times tax methods have deviated
from what is considered "good" accounting procedure. Despite
these deviations, it is generally agreed that the acceptance
and encouragement of accrual accounting by the tax authorities
was a major factor contributing to the development and wide—
spread use of the matching concept in the business community.
As a result, the groundwork both in theory, such as Paton's
popularization and expansion of the entity and going—concern
postulates, and in tax regulations and laws was being laid for
the ascendancy of the income statement to a position as the
primary accounting report for stockholders and other external
parties. The only catalyst needed was the previously mentioned
fluctuations in prices and the newly emerging investor's view-

point.

Depreciation

 

Federal tax laws had a noticeable effect upon other ac-
counting theories and practices which resulted in an increased
emphasis on income accounting. For example, the tax law, more
than any other factor, probably was responsible for the change
in attitude of the business community with respect to the theory
that accrued depreciation of fixed assets was a current expense.

Before the 1913 Federal tax law,depreciation, if recorded
at all, was widely viewed as a valuation concept.6 Systematic
depreciation methods had been devised much earlier than this
time. For example, the straight—line, reducing balance, sinking-

fund and annuity methods, and the unit cost method were not

 

6Eldon S. Hendrickson,Accounting Theory (Homewood, Illinois:
Richard D. Irwin, Inc., 1965), p 31.

 

151

unknown in 1913.7 After the 1913 tax law, however, deprecia-

tion became an important item particularly because it was an
allowable deduction for income tax purposes. Paton in commen-
ting on this new emphasis on depreciation made the following
statement:
Before the days of income taxation it was

very difficult for the accountant to convince

the business man, especially the owner of a

small enterprise, that it was important for

the Value expiration of his fixed assets be

accrued upon his books. Now he appears to

appreciate the significance of accrued depre—

ciation very clearly, and no urging is required

to induce him to book a liberal allowance.8

The subject of the proper accounting for depreciation
upon the passage of the 1913 tax law immediately became a
question of controversy. The tax laws have consistently
required the cost basis employing the straight—line or units

9 Yet, as mentioned above, there were

of production methods.
those who viewed depreciation essentially as a valuation con—
cept. For example, the 1913 law permitted depreciation de-
ductions as follows:
Section IIB (Individuals) that in com-
puting net income for the purpose of normal tax
there shall be allowed as deductions:
a reasonable allowance for the exhaustion,
wear and tear of property arising out of its
use or employment in the business....

Section IIB (Corporations)....

All losses actually sustained within the
year and not compensated by insurance or otherwise,

 

7Earl A. Saliers, Principles of Depreciation (New York:
The Ronald Press Company, 1915), pp.’139-173.

 

8William Andrew Paton, Accounting Theory (Accounting
Studies Press, Ltd., 1962, reprint of the 1922 edition), p. 19.

9

 

The 1959 code allows accelerated methods of depreciation.

152

including a reasonable allowance for de-
preciation by usei wear and tear of pro-
perty, if any....

The tax law of 1916 left most of the provisions for
depreciation as they were in 1913. But the Act of 1918 made

one notable change -— it included "a reasonable allowance for

"11

obsolescence in addition to exhaustion, wear and tear.

Prior to this time it was necessary to dispose of property to
claim a loss due to obsolescence. In addition, Article 161,
Regulation 95 states:

A reasonable allowance for the exhaus-
tion, wear and tear and obsolescence of pro-
perty used in the trade or business may be
deducted from the gross income. For conveni-
ence such allowance will be referred to as
covering depreciation, excluding from the term
any idea of a mere reduction in the market
value not resulting from exhaustion, wear and
tear and obsolescence. The proper allowance
for such depreciation...is the amount which
should be set aside for the taxable year in
accordance with a consistent plan by which the
aggregate of such amounts for the useful life
of the property in the business will suffice,
with the salvage value, at the end of such
useful life to provide in the place of the
property its cost, or its value as of March
1, 1913, if acquired by the taxpayer before
that date.12

 

Here the regulations specifically indicate that a deprecia-
tion deduction cannot be based solely on declining market value.
On the other hand, cost or March 1, 1913 value is deemed the
acceptable basis. The Revenue Act of 1929 contained the same

provisions with minor exceptions as follows:

 

10United States Government, Underwood—Simmons Tariff Law,
1913, Regulations 33.

11United States Government, Revenue Act of 1918, Section

l2Ibid., Article 161, Regulation 95, underline added for
emphasis.

153

Sec.209...(c) The basis upon which depletion,

exhaustion, wear and tear and obsolescence are

to be allowed in respect of any property shall

be the same basis as is provided in subsection

(a) or (b) for the purpose of determining the

gain or loss upon the sale or the disposition of

'property...13
Section (a) in the above quotation was with the cost basis
if the property was acquired after February 28, 1913.
Section (b) in the above quotation allowed cost or value at
March 1, 1913, whichever is greater. With the exception of
the March 1, 1913 value or cost whichever is greater pro-
vision, the cost basis for depreciation was clearly expressed.
In fact, subsequent tax laws also clearly required the cost
basis for the calculation of depreciation.

Even though the tax laws consistently required the cost
basis for the calculation of depreciation allowances, there
exiSted some confusion, at least in early tax laws, among the
business community and the tax authorities as to the responsi-
bility for ascertaining all the facts necessary to a proper
determination of the amount of depreciation. Generally, the
tax authorities had prepared the necessary schedules and had
been placed in the position of having to demonstrate "clear
and convincing" evidence that the taxpayers claim was unreason-
able.l” This policy of the Internal Revenue tended to slow the
development of accurate and detailed records that had originally

been started with the passage of the 1913 law. In February,

1939 the Treasury issued Treasury Decision 9922 which reversed

 

this policy. This decision was clarified and expanded in 1939

 

13
209(c).

United States Government, Revenue Act of 1929, Section

1Eugene L. Grant and Paul T. Norton, Jr., Depreciation
(New York: The Ronald Press Company, 1999), p. 212.

 

159

and 1936 as Mimeograph 9170 and issued by the Bureau of In-

 

ternal Revenue. A quotation from the 1936 revision reflected
this change in policy:
Treasury Decision 9922 approved February

28, 1939, provides that taxpayers claiming

deductions from_gross income for depreciation

furnish full and complete information regarding

(l) the cost or other basis of assets for which

depreciation is claimed, (2) the age, condition

and remaining useful life of the asset, (3) the

proportion of the cost or other basis which has

been recovered through depreciation allowances for

prior taxable years, and (9) such other informa—

tion as may be required to establish the correct-

ness of the deduction or to determine the amount

of the deduction properly allowable....

One of the principal purposes of Treasury

Decision 9922 is to place the burden of proof

of the correctness of deductions claimed for 5

depreciation squarely upon the taxpayer,....1
This change in philosophy was the catalyst that was necessary
to encourage the recording of depreciation in the accounts
on a cost basis. Taxpayers now clearly had the responsibility
of keeping adequate accounting records for depreciation based
upon cost. M. E. Peloubet, in commenting on T. D. 9922, em-
phasized this point when he stated that the "best position for
the taxpayer to be in regarding depreciation...is to have a de-
tailed record of each item included in his accounts for buildings,
machinery and equipment or other depreciable assets showing cost
or basis,date acquired, expected life, depreciation written off
and all pertinent data." Furthermore, he wrote "the further the

taxpayer departs from these conditions the more difficulty he may

have in establishing his position."16 The possibility of the

 

15United States Government, Treasury Department, Office of
the Commissioner of Internal Revenue, Mimeograph 9170 (Revised)
(Washington, D. C., U. S. Government Printing Office, 19365, p. l.

16M. E. Peloubet "Depreciation Under the Revenue Act of

1939," Journal of Accountancy, Vol. 58 (September,1939).pP-l89-185o

155

loss of allowances and the fear of tax suits made the calcu—
lation of depreciation based on costs a necessary function to
be performed by accountants.

In summary, the effect of taxation upon depreciation
accounting resulted in the recording of depreciation based
on cost. This practice helped to create what Littleton calls
the balance sheet dilemma. That is to say, circumstances in
the early part of this century, such as rising prices and the
wave of mergers and consolidations, resulted in much impor—
tance being attached to the balance sheet as a statement of
values. But, on the other hand, this emphasis on valuation
created problems for the determination of income, i. e. recog-
nition of revenue before realization. As a result, the cost
basis was deemed more appropriate for income determination.
Since the tax laws generally favored the purely cost or outlay
methods for income determination, business men tended to adopt
them in their accounts. As a result, the status of the balance
sheet as a statement of values decreased, whereas, the income

statement grew in importance.

Inventories

 

One of the most significant features in accounting for
inventories or stock in trade has been the emphasis placed upon
cost or other input value calculations that are matched against
revenue in determining income. This emphasis upon the matching
concept placed the accountant in the previously mentioned balance
sheet dilemma. Specifically, the matching of cost and revenues
resulted in inventory procedures that did not produce the values

desired by those using balance sheets for credit purposes.

156

Federal taxation with respect to inventories, among
other things such as the growth of the corporation and price
fluctuations, was a primary factor influencing this emphasis
on the matching concept. Paton, once again, recognized this
influence as early as 1922. For example, he stated:

The influence of the closing inventory

balance upon the exhibits of net incomes...

is of such consequence as to call for the

most searching scrutiny of inventory prac-

tices and an insistence upon the use of

rational and accurate principles and pro—

cedures. Particularly in these days of

serious tax levies upon incomes and profits

has the entire inventory process become a

matter of the utmost importance to all con-

cerned. The business man can no longer be

satisfied with an inventory, calculated by

the cubic yard, for example,.... 7

Tax laws and various regulations initially favored
specific identification of costs with revenues as the method
for allocating inventory to cost of goods sold for income
determination. But the 1918 regulations accepted the first-in,
first—out method of allocating costs between inventories and
cost of goods sold.18 The FIFO method was accepted primarily
because it yielded a good approximation of the results obtained
under specific identification. In addition, it was felt that
FIFO combined all elements of profit and recognized them at the
time of sale, i. e. it does not permit the recognition of un-
realized gains and losses. Furthermore, it resulted in the pre-
sentation of ending inventory balances at the most recent cost

19

for balance sheet purposes. This acceptance of the FIFO method

 

17W. A. Paton, "Valuation of Inventories," Journal of Ac—
countancy, Vol. 39 (December, 1922), p. 932.

 

 

181918, Regulation us, Article 1532.

lgHendrickson, op. cit., p. 269.

157
by the tax authorities tended to favor those who espoused
the balance sheet as a statement of values for credit pur—
poses.

The widespread use of FIFO resulted in various attempts
by those advocating the matching concept to point out its
inadequacies for use in the matching of current costs with
current revenues. For example, a publication by the Ameri-
can Institute of Accountants contained a statement that op—
posed the traditional belief that the flow of costs should
follow the flow of goods:

...it may not be a matter of great

importance whether cost of goods on hand

is determined on the theory that the

first goods in are the first goods to go

out, or that the last code in are the

first goods to go out.

This statement, along with the standard arguments rela—
tive to variations in periodic profits resulting from use of
FIFO, was employed in attempts to justify the use of the LIFO
method. As a result of these efforts the Internal Revenue

21 confirmed in 19u7

Code was changed in 1939 and a Tax Court
the acceptance of LIFO. These actions left the door open for
all taxpayers to use LIFO in their accounts. The final down—

fall of the balance sheet as a statement of values or near

value was now completed. The income objective prevailed.

 

20Examination'of Financial Statements by Independent Public
Accountants (New York: AmerICan Institute of Accountants, 1936),

p. 3.

 

21Hutzler Brothers, 8th Tax Court 19, 1997.

158

The Influence of the Securities
and Exchange Commission

 

 

Background

 

The legislation leading to the formation of the SEC in
the 1930's was not a spontaneous reaction to the depression.
In fact, there is evidence that this legislation had many
historical antecedents. Particularly, some contend that the
laws were directed toward the financial practices of a pros-
perity period rather than those found more often in a depression
era.22 Time and time again the financial scandals and mal-
practices of the late 1920's were discussed in 1933 and 1939
before the Senate Committee on Banking and Currency by experts
in accounting, business and law. In short, the passage of the
Securities Act of 1933 and the Securities Exchange Act of 1939
reflects the public awareness of the emerging investor's point
of view. In addition, not only the specific requirements of
these acts were important, but the fear of regulation tended to

produce improvements in financial reporting practices.

Scope of Federal Securities Laws

 

Commerce Clearing House, Inc. stated in its review of
the securities laws:

The federal securities laws govern companies
that seek to acquire new capital by the issuance
of securities to the public, and persons in the
business of buying and selling securities....They
are designed to protect the interest of investors

 

22J. R. Taylor, "Some Antecedents of the Securities and
Exchange Commission," Accounting Review, Vol. XVI (June, 1991),
p. 188.

 

159

and the public by certain disclosure require-

ments and by prohibiting fraud and manipulative

practices.2
This statement clearly reflected the fact that the new in-
vestor's viewpoint had found expression in legislative acts.
The laws required the issuer of securities to make available
to potential investors certain information about the issuer
and the securities offered including, among other things, the
plan of distribution, use of proceeds, capital structure,
summary of earnings, organization, affiliations, description
of businesses and property, pending legal proceedings, and
financial statements.2u The registration requirements as set
forth in the laws, particularly with respect to the nature
and form of financial statements, indicated the new emphasis
accorded the income statement. For example, Schedule A (25)
of the Securities Act of 1933 states that:

...a balance sheet as of a date not more

than ninety days prior to the date of filing the

registration statement showing all the assets of

the issuer, the nature and cost thereof, whenever

determinable, in such detail and in such form as

the Commission shall prescribe, including, surplus

of the issuer showing how and from what sources

such surplus was created, all as of a date not

more than ninety days prior to the filing of the

registration statement....25

This statement, although for the balance sheet, implied

that the income objective is more significant for at least two

reasons. First of all, the reference to assets recorded on a

 

23Commerce Clearing House, Federal Securities Law Reports

 

(New Jersey: Commerce Clearing House, Inc., 1967), p. 101.

2”Ibid., p. 10a.

25United States Securities Act of 1933, An Act of United
States Government, May 27, 1933, Schedule A (25).

160

cost basis, as stated before, was the condition considered
necessary for the matching concept. In other words, this view
is supported by those who believe that the balance sheet is a
residual statement and reflects cost awaiting assignment to
revenue. The second point is the reference to the surplus
account of the issuer. This also reflected the increased em—
phasis on income accounting since it was considered necessary
to identify the sources from which a surplus was created.

Schedule A (25) referred to the registration require—
ment of the income statement as follows:

...a profit and loss statement of the

issuer showing earnings and income, the nature

and source thereof, and the expenses and fixed

charges in such detail and such form as the

Commission shall prescribe for the latest fis—

cal year for which statement is available and

for the two preceding fiscal years, year by

year, or ... Such statement shall show what

the practice of the issuer has been during the

three years or lesser period as to the character

of the charges, dividends or other distributions

made against the surplus accounts, and as to

depreciation, depletion, and maintenance charges,

in such detail and form as the Commission shall

prescribe,...
This quotation is important because it demonstrated the extent
the law required income statement data. Information as to
depreciation, expenses, and distributions against the surplus
accounts was seldom disclosed in published annual reports

27

prior to this time. As a result of the passage of the law
companies included this information in annual reports since

it was made public by the disclosure requirements contained in

the law. As a result, income statement data appeared in annual

 

26Ibid., Schedule A (26).

27T. H. Sanders, "Influence of the Securities and Exchange
Commission upon Accounting Principles," The Accounting Review,
Volume XI (March, 1936), pp. 73- 79.

 

161
reports, corresponding to the emergence of income reporting

that was documented in Chapter IV.

The Securities Exchange Act of 1939

 

The Securities Exchange Act of 1939, like the 1933 Act,
was designed to protect the investing public. Under this
act, registration was necessary by any company that sought to
acquire new capital by the issuance of securities to the
public. Also, this act required that financial data be kept
current by means of periodic reports which are attested to by
independent public accountants.28

Under this act, the SEC has broad powers to specify the
form and content of financial statements and other reports
required to be filed. It has specific authority to require the
following:

The Commission may prescribe,...., the

form or forms in which the required informa-

tion shall be set forth, the items or details

to be shown in the balance sheet and the

earnings statement, and the methods to be

followed in the preparation of reports, in

the appraisal or valuation of assets and

liabilities, in the determination of depre—

ciation and depletion, in the differentiation

of recurring and nonrecurring income, in the

differentiaEion of investment and Operating

income,.... 9
The above statement indicated that the SEC had the authority to
prescribe accounting procedures and the form of financial state-

ments. Also, it seems quite obvious that this authority encom-

passed specific areas that are very relevant to a proper matching

 

28Commerce Clearing House, op. cit., II 20, 332—33.

29United States Securities Exchange Act of 1939, An Act
of the United—States Government, June 6, 1939, Section 13 (b).

 

162

of costs with revenues, i. e. depreciation, recurring and non-
recurring items, and differentiation between capital and in-
come. But the specific recommendations were essentially left
to the accounting profession, even though the latter group was
very much influenced by the policies of the SEC. As is now
known, the accounting profession developed principles of ac-
counting that reflected the attention directed to the income

statement.

Accounting Series Releases-Regulation S-X

The Securities and Exchange Commission in 1937 began
a program of publication of opinions on accounting principles
for the purpose of contributing to the development of more
uniform standards for financial statements. These opinions

are contained in the Accounting Series Releases and Regulation

 

S-X which contained the requirements for financial statements
filed with the Commission as prescribed under the various acts.
On April 25, 1935 the SEC stated its administrative
policy with respect to financial statements that reflect the

dependence placed upon the accounting profession.

In cases where financial statements filed
with this Commission pursuant to its rules and
regulations under the Securities Act of 1933 or
the Securities Exchange Act of 1939 are prepared
in accordance with accounting principles for
which there is no substantial authoritative sup-
port, such financial statements will be presumed
to be misleading or inaccurate despite disclosures
contained in the certificate of the accountant
or in footnotes to the statements provided the
matters involved are material. In cases where
there is a difference of opinion between the
Commission and the registrant as to the proper
principles of accounting to be followed, dis-
closure will be accepted in lieu of correction
of the financial statements themselves only if

163
the points involved are such that there is sub-
stantial authoritative support for the practices
followed by the registrant and the position of the
Commission has not previously been expressed in
rules, regulations, or other official releases

Of the Commission, including the published Opinions
Of the chief accountant. 0

This statement of policy is significant because it enhanced
the status of the American Institute of Accountants and its
Opinions on relevant accounting issues. Thus, subsequent
Opinions on accounting principles, emphasizing the importance
of the income statement, by the Institute were carefully re-
viewed and heeded by the business community. George 0. May
supported this view as was evident in the following passage,
even though he believed the formulation Of the Commission was
unnecessary:
...Its (SEC) decisions on general account-

ing questions have usually been reached after con-

sultation with the Institute, its influence on

accounting practice in the field Of general busi-

ness has undoubtedly been beneficial. However,

this benefit has arisen from the enforcement of

rules which were laid down prior to its creation,

and from strengthening the position of the account-

ant in relation to the corporation3 rather than
from the formulation of new rules.

Summary

This chapter was concerned with the influence of taxation
and other government legislation on the shift in emphasis from
the balance sheet to the income statement by external parties.
It was concluded that the passage Of the Sixteenth Amendment and

subsequent legislation led business men to consider it imperative

 

30United States Securities and Exchange Commission, "Re-
lease NO. 9: Administrative Policy on Financial Statements,"
Accounting Series Releases (Washington: United States Government
Printing Office, 1936), pp. 5-6. '

 

31George 0. May, Financial Accounting: A Distillation of
Experience (New York: The Macmillan Company, 19933, p. 67.

169
that profit figures be calculated with thngreatest possible
degree of precision. As a result, accountants began to focus
attention on the determination of periodic income.

Federal income taxation encouraged accountants to use
the accrual basis for income determination. This led to in-
creased attention to the matching of revenues with expenses
within a specific time period. Depreciation and inventory
accounting for the purpose of calculating taxable income were
factors contributing to the external shift in emphasis. The
tax laws consistently required depreciation and inventories to
be calculated on a cost basis for the purposes of ascertaining
taxable income. This led to the adoption Of the cost basis
for general accounting and to the balance sheet dilemma, that
is, to the controversy between those who felt the balance sheet
should represent a statement of values and those who felt it
should be based upon cost.

The legislation leading to the formation of the Securi—
ties Exchange Commission, the Securities Act Of 1933 and the
Securities Exchange Act of 1939, also was an important force
contributing to the external shift, especially in corporate
reporting. This legislation was important because it reflected
the new investor's vieWpoint and it prompted the accounting
profession to undertake extensive research focused on those

principles underlying the preparation of financial statements.

CHAPTER VII
SUMMARY

This dissertation is a study in the history of accounting
thought and it seeks to identify the nature of the shift in em—
phasis from the balance sheet to the income statement as the
primary accounting report. It also presents the more important
forces responsible for this ascendancy of the income statement
utilizing an historical approach based upon the interpretation
of evidence resulting from the interaction of ideas and events.
This historical approach was based upon a philOSOphy of history
that emerged in the nineteenth century. The philOSOphy of his-
tory that emerged was deemed to be (a) a type of research or
inquiry designed to answer questions; (b) an attempt to dis-
cover actions of human beings that occurred in the past; (c) a
process by which evidence is interpreted; and (d) a means where—
by perspective could be provided for making choices today. In
applying this philosophy of history the historian is confronted
with many problems. There is first the problem Of his raw ma-
terials. Much of the past was never recorded. Another problem
relates to the fact that bias distorts his view. But bias can
be effectively handled by revealing the raw materials used, by
explicitly stating the organizational scheme, and by revealing

the standards that condition the historian's interpretations.

165

166

In this study old corporate annual reports, selected
accounting literature, correspondence and internal income
statements from selected companies, governmental publications
and legislative acts, and interviews, where appropriate, were
the basic raw materials. The organizational scheme was to
determine the interrelationships between past ideas and events
influencing accounting actions. Under this approach both ex-
ogenous and endogenous environmental variables can be related
to the study.

Contemporary accounting theory was used as a framework
for making judgments necessary to interpret past accounting
actions that may have contributed to the matching concept as
it is known today. It also served as a basis for demonstrating
the continued interaction between accounting and economics.
Furthermore, contemporary accounting theory was valuable par—
ticularly because accounting actions of the past could be
viewed through its lens. For example, those forces contributing
to the decline of the balance sheet as a statement of values
could be easily identified since it was known that the cost
principle eventually emerged.

The history of accounting, with emphasis on the United
States, was briefly traced. Early examples Of rudimentary peri-
odic reporting before the famous work of Luca Pacioli in 1999
were noted. The period from Pacioli to 1900 was also briefly
covered. The ideas and events that were of particular signifi-
cance in this period were the widespread use of the double entry
method especially during and after the industrial revolution,
the separation of statements from the general ledger, the develop-

ment of the essential form of present-day financial statements,

167
particularly the balance sheet, and most important of all the
rise of the corporate form Of business organization. The next
period examined was that of 1900 and 1929. This period was
very important because the groundwork in theory and practice,
along with crucial exogenous forces, appeared which were to have
a decisive impact on the external shift in emphasis from the
balance sheet to the income statement as the primary accounting
statement. The theory was popularized by William A. Paton, the
practice was that which resulted from the tax laws and the activ-
ities of the American Institute of Accountants, especially their

Memorandums on Balance Sheet Audits, while the exogenous vari-

 

ables were mainly the fluctuations in prices, the rapid increase
in mergers and consolidations, and the increased public owner-
ship Of securities. Finally, financial accounting from 1930 to
the present was reviewed with emphasis on the 19308. The im-
portant factors consisted of the activities of the American
Institute of Accountants and the American Accounting Association,
the Securities Act of 1933 and the Securities Exchange Act of
1939 as administered by the SEC, New York Stock Exchange activ-
ities, and the Great Depression.

The conclusion reached in Chapters III and IV was that
there was essentially two shifts in emphasis from balance sheet
data to income statement data. There was an internal or manager—
ial shift and an external shift by stockholders, creditors, and
other parties outside the firm. The former shift, it was con-
tended, probably occurred with the advent of the corporate form
of business organization, characterized by the separation of

owners and managers, between 1880 and 1925. On the other hand,

168
the latter shift began in the 19208, accelerated in the 19308,
and was essentially completed by the early 19908.

The internal shift in emphasis was more difficult to
document than was the external shift. Information was Obtained
in the form of letters, internal income statements, interviews,
or combinations of all three from various selected companies.
This information related to the nature and extent of internal
income reporting prior to the external shift in emphasis. From
this information it was concluded that there was no significant
internal shift in emphasis in the early 19308. Income reporting
was considered very important to management for the purpose Of
testing the profitability Of Operations as a guide to future
action long before the external shift even before this time.

The most probable force that set the chain of ideas and
events into motion which led to the emergence of income state-
ment data in managerial decisions was the sudden increase in
inventions that appeared in England shortly after 1750, even
though these inventions were themselves the result Of many
complex and remote causes. These inventions helped pave the
way for the industrialization of society through the use Of the
factory system. It now became necessary to accumulate large
amounts Of capital to meet the technical requirements for mass
production. In addition, the industrialization of society in—
creased the degree Of competition which made survival tenuous
at best. As a result, a system based on partnerships or joint—
stock companies emerged which has been called Industrial Capi—
talism.

The great industrial capitalists were specialists of pro-

duction rather than finance and followed a social code from

169
the philosophy Of Social Darwinism. Financial mechanisms,
such as balance sheets and income statements, were despised
by the industrial capitalist. Yet much emphasis was placed
on efficiency as measured by the increase in the physical
volume of output (e. g. tons of steel).

In the last quarter of the nineteenth century the state
Of technological progress, the increasing demand for mass
produced goods, and the bitterly competitive atmosphere that
the industrial capitalists had produced with their ruthless
tactics created a need for a new type of business organization.
The corporation with its features Of stock ownership, limited
liability, transferability of interests, and separation of
owners and managers was ideally suited to fulfill this need.

The financial capitalist-~the banker, the investment
banker, and the insurance company-—initiated the corporate
revolution in America. The financial capitalist was not inter—
ested in the day-tO—day Operations Of the business since he
spread his interests over many different industries. Therefore,
managers were appointed to assume this function. As a result,

a new professional managerial class emerged.

The professional manager was a specialist who depended
upon accounting, statistical and economic data in making decisions.
Since he was held responsible for his performance and since com—
petition was keen, he needed tO test the profitability of Opera—
tions as a guide for future actions and did so through the use
of cost and revenue data. The development of cost accounting
and the work Of the scientific engineers between 1885 and 1930

provided evidential support for this internal shift in emphasis.

170
Furthermore, a survey Of selected companies indicated that
profit and loss data were accumulated and used internally
long before the external shift in emphasis occurred in the
early 19308.

The external shift in emphasis was the result of many
forces. Like the internal shift, the rise Of the corporation
was very important. It prompted Professor Paton and others
to focus attention on the entity concept and the_going—concern
assumption. The emergence of the investor's viewpoint resul-
ting from the rapid growth of stock ownership by the general
public resulted in a new demand for information. Investors
sought growth as well as the safety of their original invest-
ment. The income statement was useful for this purpose be-
cause it yielded profit data very essential in analyzing
investment alternatives.

The rapid fluctuation in the prices Of goods and services
that began in the early 19208 left doubt in people's mind as to
the adequacy of the balance sheet as a statement of values.

But Federal taxation of income and related court decisions were
the most important deve10pments contributing to the emergence
Of income reporting via the matching concept. Federal tax laws
have consistently required the cost basis for such items as
depreciation and inventories. This requirement naturally con—
tributed to the demise of the balance sheet as a statement and
its replacement with a statement of unallocated or residual
costs. The courts played a key role in the emergence Of the
matching concept because they became involved with the problem
Of identifying what was income. In the famous decision of

Eisner V. Macomber it was held that income did not exist until

171
it was severed from capital. This meant that for most types
of property income could emerge only through the sale or ex-
change Of the property. Thus, accountants concentrated on
rules and procedures that would identify a severance or sale
of assets. As a result the transactions approach to income
determination based upon the realization concept emerged.

The main lesson to be learned from this study is that
accounting evolution involves the interaction Of ideas and
events which makes change a permanent feature. It demonstrated
the futility of arguing about how progress in accounting pro-
ceeds since both practice and theory interact to cause change.
Those forces that were considered to be primarily responsible
for both the external and internal shift in emphasis involved
developments in accounting practice and theory, and exogenous
changes in other disciplines. For an appropriate perspective
in making decisions one should be cognizant of these forces.

For example, it was concluded that one of the major reasons for
the external shift was the emergence Of the investor's vieWpOint
resulting from the corporate revolution. Investors demanded
information that was useful in ascertaining the relative pro-
fitability of various investment alternatives. The income state—
ment was an excellent means for supplying this information.

Today the environment has changed. Corporations have
evolved into a new dimension—-conglomerates. No longer is
the"conventional" net income as significant to investors. Infor—
mation is being demanded concerning the profitability Of divisions
and product lines. Once again the SEC is interested in seeing
that these new investor demands are met. As a result, the ac-

counting profession, if it is to maintain its autonomy, must take

172

an active role in providing the kinds of information demanded.

The shift in emphasis also clearly shows the importance
of specifying objectives. This involves an understanding of
not only the types of information demanded, but also a general
knowledge of the groups demanding the information. The con—
sequences of emphasizing the creditor vieWpoint in determining
the type Of information supplied by accountants were revealed.
It was shown that Objectives Of accounting should not only
consider creditors but managers and investors and other outside

interested parties.

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CLIFFORD DEAN BROWN 1969

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