Accounting Theory Eldon S. Hendriksen Michael F. van Breda Southern Methodist University US Fifth Edition Homewoed, IL 60430 Boston, MA 02116Preface This fifth edition, like its predecessors, is designed to provide a frame of reference for junior, senior, and graduate courses in financial accounting and financial accounting theory; seminars on financial accounting stan- dards and issues; and seminars on the theory of income and asset valua- tion. Those who wish to obtain a good understanding of financial account- ing standards or want a general survey of financial accounting theory and those who wish to study for the theory section of the Uniform CPA Examination should also find this book useful. It is assumed that the reader has a knowledge of the basic structure of accounting. Experience has shown, however, that mature students who have not studied accounting can understand the subject matter with con- current additional formal or independent study of this basic structure. A background in finance or economics can also lead into this book. A general frame of reference has been used to evaluate the many areas of financial accounting theory and practice. The frame of reference in- cludes a number of theories that are not necessarily consistent with each other and that may lead to different conclusions. Evaluations are made at three basic levels: : 1. The structural level—the relationships between and within procedural systems and financial reports. 2. The semantic interpretation level—the relationships of descriptions and measurements to real-world phenomena. 3. The pragmatic level—the reactions of all individuals affected by ac- counting reports, including users (individually and in aggregate) and producers of accounting information. Emphasis is placed on the inductive-deductive and the capital market approaches in the evaluations, although other approaches are discussed where appropriate. In some cases, the several viewpoints resulting from the different approaches are criticized without attempting to suggest a solution or the best alternative. In other cases, the authors have ex- pressed their own views and presented supporting evidence based on avi Preface priori logic and empirical findings where available. In all cases, suggested solutions are tentative and subject to change as new evidence becomes available. The first eight chapters of this edition develop the foundations of ac- counting theory. They include an introductory chapter, including a sec- tion on methodology, two chapters on the development of accounting, a chapter on how generally accepted accounting principles have evolved, a chapter describing the elements of financial reporting, a chapter on capital market theory, another on decision theory, and one on accounting regu- lation. The next three chapters examine the income statement. They include two chapters on income measurement and one on revenues and expenses. A chapter on reporting for price changes emphasizes their effect on in- come determination, but also discusses the problems of asset measure- ment under conditions of changing prices, including the use of current costs. This is followed by eight chapters on the statement of financial position, each growing more specific than the last. Assets are treated first, then liabilities, and finally equity. The final chapter discusses the disclo- sure of relevant information to investors, creditors, and other interested readers of financial statements. A revolution has occurred in accounting in the years in which this book has appeared. Where once inductive-deductive reasoning was dominant, today empirical studies cast in a pragmatic framework are the rule. This edition has sought to reflect this change by expanding its coverage of recent research, while not neglecting the contributions of earlier research- ers in accounting. Among the basic changes in this edition are: 1. Greater use of the FASB’s Conceptual Framework to unify material throughout the book. 2. The addition of two chapters to cover the early history of accounting and the search for accounting principles, respectively. 3. The addition of a section on ethics to the chapter on decision making. 4. Added stress on the importance of cash flows by integrating it with the capital-maintenance approach to income measurement, allowing the revenue-expense approach to income measurement to be given its own chapter. 5. The combination in one chapter of the recognition and classification of assets and liabilities, permitting one to survey the statement of position as a whole before examining its components. 6. Giving asset measurement its own chapter, allowing the chapter on inventory to be folded into the chapter on current assets. 7. Separating pensions from income taxes, enabling each to be treated at more length. 8. The addition of much new end-of-chapter material, including a number of new cases.Preface vii At the close of each chapter is a list of selected readings on specific parts of the chapter. These articles and sections of books have been selected on the basis of their quality, accessibility, readability, and ability to present the several sides of controversial topics. Because of the rapid expansion of the literature relevant to these topics, the selections repre- sent only a sample. Students are encouraged to make use of the many readings available including those that will become available after the publication of this book. There is no substitute for wide reading in the area of accounting theory to obtain an understanding and balanced evaluation of the many different points of view found in the literature. Also at the end of each chapter is a group of questions classified by topic. Many of these were selected from the theory section of the Uniform CPA Examination. We wish to express our appreciation to the officers of the American Institute of Certified Public Accountants for their kind per- mission to reprint these questions. Other questions, especially some cases, are used by kind permission of their authors. Those authors are recognized in footnotes to these cases. The remaining questions and cases were prepared by the authors for this edition. We wish to express our appreciation to the many students and col- leagues who have made comments on this and previous editions. We think especially of people like Willard J. Graham and Robert N. Anthony who contributed greatly to earlier editions. For this edition we are grateful to the Accounting Theory class at Southern Methodist University and its teaching assistants Melissa Chandler, David Kennedy, Mark Kohlbeck, and Mitch Mulvehill, who made many helpful comments on the manu- script. We are especially grateful to Professors Noel Addy, Tom Barton, Tom Burns, Michael Dugan, Joe Icerman, Gordon May, Lillian Mills, R. D. Nair, Thomas Sullivan, and Michael Vetsuypens, for commenting in detail on the manuscript. All their comments were most helpful, al- though for special reasons we may not have incorporated all of the ideas suggested. Whatever faults remain are our responsibility. We wish to express particular gratitude to Dr. J. Leslie Livingstone for his encouragement over many years. Most of all, we are indebted to our wives, Kathleen and Nancy, for their patience and support. : Our hope is that you, our readers, will enjoy using this book as much as we have enjoyed writing it. We like to think that this book belongs to all of us. We would be delighted to hear from you so that we might continue to edit it in ways that you would find most helpful. Eldon S. Hendriksen Michael F. van BredaChapter 1 Introduction and Methodology of Accounting CHAPTER OBJECTIVES After studying this chapter, you will be able to: Sketch various approaches to the development of accounting theories: tax, legal, ethical, economic, behavioral, and structural. Explain the different levels of accounting theories: syntactic, semantic, and pragmatic. Define various classifications of accounting theories: positive versus normative, empirical versus nonempirical, deductive versus inductive. Outline the means of verifying accounting theories. CHAPTER OVERVIEW Approaches to Accounting Theory Accountants have tried numerous approaches to solve questions like that of revenue recognition. Six approaches are outlined: tax, legal, ethical, economic, behavioral, and structural. Classifying Accounting Theories Accounting theory itself may be variously classified: by its level (syntactic, semantic, pragmatic); by its reasoning (deductive, inductive); or by its stance (normative, positive). Theory Verification Each approach to defining accounting theory requires a different method of verification.2 Chapter 1 Conclusion Each of the approaches described in this chapter has its place in accounting theory and will be used in inquiring into the nature of accounting, providing a framework for evaluating, developing, explaining, and predicting practice. Alleghany Beverages Corporation (ABC), a Maryland-based soft drink . bottling company, found itself in the early 1970s locked in an acrimonious debate with its auditors over its financial reporting. The company had formed a fully owned subsidiary, Valu Vend, to install soft-drink vending machines. The company recorded the sale of these machines as they were delivered to Valu Vend’s clients. More precisely, as ABC explained it ina footnote to the 10-K: Valu Vend sells its machines under conditional sales contracts. Under these contracts, a purchaser is required to make a $50 down payment and to pay the balance in equal monthly installments over a 48-month period after purchase. Under moratorium plans, the first of such monthly payments may begin 120 days or 210 days after the date of purchase, but all payments are completed within 48 months after purchase. The machines are sold to distributors and through the distributors to other purchasers, who may have their own locations for the machines. Each distribu- tor appointee is required to warehouse and distribute beverages in his market- ing territory and to establish sales and maintenance organizations. A letter to the shareholders (slightly shortened here) tells the rest of management’s side of the story: The Company has found it necessary to replace its auditors, Alexander Grant & Company. Our internal accounting staff had been working closely with Alexan- der Grant throughout the year, and had determined to adopt the accrual method of accounting, which is the method used in our industry. On March 2nd, we were informed by the Baltimore office of Grant that we must defer earnings from our Valu Vend subsidiary. During a long discussion, we were requested to provide supporting information from similar companies. This was done and our accounting method was substantiated. After much additional research and many meetings, on March 18, the Balti- more Grant office once again was prepared to return to the accrual method of accounting with substantially the same figures we had reported preliminarily. A meeting was held at the Grant main offices in Chicago on March 2ist, and we were informed that they would not accept our accrual accounting and proposed a hybrid approach which was unacceptable to us. We had no choice but to recommend to our Board that Grant be terminated. The issue at stake here is one of the most fundamental in accounting theory: When should revenue be recognized? The question the partici-Introduction and Methodology of Accounting 3 pants were forced to ask was a simple one, even if the answer was hard to come by. Could one treat the sale of a vending machine the same as one treated the sale of a bottle of pop? Is it appropriate to recognize a sale at the time of delivery when it is a conditional sale? Should the size of the deposit affect one’s decision? And what does one do about the fact that the sales are not to the ultimate customer but to an intermediary? The case raises a number of interesting points regarding accounting theory. First, it points out that theoretical issues are not just matters of “‘theory.’’ They have very practical implications for both management and the auditors. In this case, the refusal to recognize Valu Vend’s reve- nues at the point of delivery would have meant a 30 percent drop in sales for ABC. This might have prevented them from raising a loan in the marketplace, which would have stymied their expansion plans. From the auditors’ point of view, an unjustifiable refusal to provide an unqualified opinion could lead to a breach of contract suit from the company; an agreement to provide an unqualified opinion could lead to a class action suit from irate shareholders, if things turned sour. In every case, the lives and the livings of a variety of people are intimately affected by the out- come of questions such as these. In short, the application of theory can matter. Second, the case demonstrates that accounting theory is often a matter of professional judgment made by individuals involved with specific cases. It is not only the members of the Financial Accounting Standards Board (FASB) who are obliged to theorize; practicing accountants are often required to exercise their own judgments in theoretical issues, The- oretical issues are seldom completely settled by accounting authorities. Some of their guidelines, it is true, are quite detailed, but many leave a great deal of discretion to management and to the local auditors. Many theoretical issues, therefore, are decided at the local level. As the FASB put it: Accounting choices are made at two levels at least. At one level they are made by the Board or other agencies that have the power to require business enter- prises to report in some particular way or, if exercised negatively, to prohibit a method that those agencies consider undesirable. . . . Accounting choices are also made at the level of the individual enterprise. As more accounting stan- dards are issued, the scope for individual choice inevitably becomes circum- scribed. But there are now and will always be many accounting decisions to be made by reporting enterprises involving a choice between alternatives for which no standard has been promulgated or a choice between ways of imple- menting a standard.! Revenue recognition is a classic example of a broad rule which requires professional judgment at the local level. As one textbook defined the rule: Revenue should be recognized in the earliest period in which (1) the entity has performed substantially what is required in order to earn income and (2) the amount of income can be reliably measured,”4 Chapter I In many industries, the first part of this definition is assumed to occur at the time of delivery. In the case of Alleghany Beverages, the vending machines had been delivered. The second requirement was clearly met in management’s judgment. Why then the dispute? Apparently, Alexander Grant was uncomfortable with the claim that delivery in this case was substantial performance. Who was right? And who should determine who is right? Should the FASB or the SEC provide more specific guidelines to avoid cases like this? Arguments go both ways. Some argue strongly, as we shall see later, that managers, left to themselves, will come to resolutions that are perfectly satisfactory to all concerned. Others feel that it is the role of the accounting professional to make judgments like these. Take choice away, they say, and accountants are just clerks. Still others feel that the case makes it patently clear that managers and auditors cannot be left to set rules on their own. Managers will want to manipulate earnings, they say; accountants need the sanction of accounting standards to resist. A laissez-faire approach, they argue, results either in a proliferation of alternatives or in the selection of the weakest of several alternatives.* The jury is still out on who has the best of these arguments. Arguments aside, the imposition of accounting procedures by an official body seems to be the direction in which most countries are moving, particularly the United States, with the Financial Accounting Standards Board. For example, in the case of real estate accounting, revenue recog- nition rules have been stated in almost excruciating detail in SFAS 66. APPROACHES TO ACCOUNTING THEORY A Tax Approach Numerous approaches have been taken in an attempt to resolve knotty problems in accounting like the one raised by ABC. The paragraphs which follow outline some of the more common: tax, legal, ethical, eco- nomic, behavioral, and structural. Several of these approaches are en- larged on in subsequent chapters. Exhibit 1-1 on page 10 summarizes the points made in this section. The approach favored by many newcomers to accounting is to ask what the Internal Revenue Service (IRS) has to say on the subject. For in- stance, one might ask whether the IRS would permit ABC to recognize revenue at this point; alternatively, would it prohibit it? * This is said to follow Gresham’s Law, named after the 16th century English financier, Sir Thomas Gresham, who suggested that good money tends to drive out bad.Introduction and Methodology of Accounting 5 The first and most obvious dilemma with this approach is that it begs the question of how the IRS arrived at its conclusion. When one explores the theoretical origins of tax accounting, one rapidly finds that the objec- tives of tax accounting are very different from those of financial reporting. The IRS is not so much interested in measuring the income of a company as establishing a base for tax purposes. As a result, the conclusions of tax accounting are irrelevant for our purposes. This is not to say that the various income tax acts have not had a major impact on accounting practice in many areas. They were important in bringing the average accounting practice up to the standards of the better companies at the time. This created an improvement in general account- ing practices and in maintaining consistency. Also, the provision for de- preciation included in the 1909 Excise Act and in subsequent acts gave rise to the use of systematic depreciation methods, the search for better depreciation concepts, and the use of more appropriate methods for cal- culating depreciation costs. In addition, the requirements in the 1918 Act making inventories man- datory where necessary for the determination of income brought about widespread discussion relating to the appropriate methods of valuation. The acceptance in the early regulations of cost or market, whichever is lower, in the valuation of inventories led to a general adoption of this procedure and to discussions regarding the propriety of the concept. Fi- nally, as the next section shows, court cases regarding tax law have had considerable influence upon the development of accounting concepts. Regrettably, income tax rules have had adverse effects on accounting theory and principles in many areas. The tendency to accept income tax provisions as accepted accounting principles and practices is unfortunate. The following are examples: 1. Any depreciation method acceptable for tax purposes is accept- able for accounting purposes also, regardless of whether or not it follows good accounting theory in the situation. 2. LIFO must be used for financial reporting purposes if it is used in the tax return. 3. Items that otherwise might be capitalized in financial reports are charged to expense following the treatment in the tax return whére the company seeks to obtain the earliest possible tax deduction. 4. Since the tax law does not permit it, no provision is generally made in financial reports for ‘‘accruing’’ repair and maintenance expenses except indirectly and haphazardly through accelerated depreciation. In summary, the effect on accounting of taxation of business incomes in the United States and in other countries has been considerable, but it has been primarily indirect in nature. The tax laws themselves have not pio- neered in accounting thought. While the revenue acts did hasten the adop- tion of good accounting practices and thus brought about a more critical analysis of accepted accounting procedures and concepts, they have also been a deterrent to experimentation and the acceptance of good theory.6 Chapter I A Legal Approach CHECKPOINTS 1. List three positive influences tax accounting has had on financial reporting. 2. Give one example of where tax accounting and financial reporting differ, and one where they are the same. 3. What negative influences has tax accounting had on financial reporting? + A second common approach of newcomers to accounting to analyzing situations such as that in the ABC case is to suggest getting a legal opin- ion. Surely, some say, a sale should be recognized when legal title passes. Unfortunately, this does not solve the problem as easily as one might hope since generally title passes when the court litigating a particular case decides that it has. A case in point is the litigation in which Pennzoil claimed that Texaco had snatched Getty Oil away from them after a legal sale between Getty and Pennzoil had been concluded. Texaco responded that a handshake did not constitute a legal sale or, in other words, a passage of legal title. Most observers of the case seemed to agree with Texaco. The Texas courts, however, continued to find for Pennzoil. Eventually, Texaco settled out of court for $3 billion. Had there been a sale? Arguments still rage on both sides in this case. Much case law involves the nature of income. Consider, for instance, the case of Eisner v. Macomber heard in the U.S. Supreme Court in 1920. The issue was whether a stock dividend was income or not. Charles Evans Hughes, appearing for the defendant, declared that: It is of the essence of income that it should be realized. Potentiality is not enough. . . . Income necessarily implies separation and realization. The in- crease of the forests is not income until it is cut. The increase in the value of lands due to the growth and prosperity of the community is not income until it is realized. Where investments are concerned, there is no income until there has been a separate, realized gain. . . .3 Since there was no cash, he argued, there was no income. The argument was accepted by a majority of the Court.* Another intriguing case was James v. United States. This involved a man who embezzled $738,000 from his employer over the years 1951 * Justice Brandeis, in his dissent, pointed out that, if stock dividends were to go tax free, management would issue al! dividends in stock, leaving stockholders to cash them in.Introduction and Methodology of Accounting 7 through 1954. The IRS took him to court because he failed to pay income tax on his ill-gotten gains.4 Justice Whittaker took James’s side, arguing that he had no income, since an embezzler acquires ‘‘not a semblance of right, title, or interest in his plunder.’’ What he took, said the judge, was more in the nature of a loan! Following this logic, does this mean that a company involved in drug smuggling earns no income because it obtains no legal right to the monies it acquires? Should it, therefore, be exempt from income tax?* The FASB, in establishing a Conceptual Framework for accounting, investigated the use of law to establish accounting principles. They noted that in many situations there are economic as well as legal issues. ‘‘Law- yers and judges look at property and related concepts in much the same way that accountants and businessmen look at assets and have many of the same difficulties with definition.’’> That they do not always arrive at the same conclusion often reflects the fact that lawyers are usually inter- ested in income available for tax or income available for dividends and not income in the sense of an increment in value or a measure of operational efficiency.® In summary then, while law certainly provides numerous ex- amples that can stimulate thinking on questions of accounting theory, it is seldom the deciding factor.+ CHECKPOINTS 1. Define the term legal title. When does legal title pass when you purchase a car? When is a sale typically taken? 2. Define the term realization. Why might attorneys have placed so much emphasis on realization as a measure of profit? An Ethical Approach A third approach asks whether there is an ethical solution to the ABC dilemma? Is there something management ought to be doing? Is this something more than just following a set of generally accepted accounting procedures? In asking these questions in a separate section, there is no implication that other approaches have no ethical content, nor does it imply that ethical theories necessarily ignore all other concepts. Funda- mental ethical questions are at the heart of all modern theory building.’ * The question is actually moot since the government has the right to impose taxes on anything it chooses. + Organizations governed by regulatory accounting are exceptions to this general rule.Chapter I The ethical approach to accounting theory places emphasis on the con- cepts of justice, truth, and fairness. Interestingly, every one of these concepts has found its way into the Conceptual Framework created by the FASB. Considerations such as the absence of bias and representational faithfulness are both considered necessary characteristics of a reliable accounting system. Neutrality, meaning that information should not be colored so as to influence behavior in a particular direction, is an essential feature of standard setting. Ethical considerations, in other words, have a pervasive influence on all of accounting. In this particular case, one might begin by asking whether management was being fair to the shareholders by recording these transactions at this point. Or, one might ask the reverse question: Would management have been fair not to recognize revenue at this point? One might also ask whether the management of ABC was being truthful, although truth in accounting is difficult to define and apply. Many seem to use the term truth to mean ‘‘in accordance with the facts,’ which is equivalent to the concept of ‘‘representational faithful- ness,’’ defined in Chapter 5. However, not all who refer to truth in ac- counting have in mind the same definition of facts. Some refer to account- ing facts as data that are objective and verifiable. Thus, historical costs represent accounting facts to them. For others, the term truth is used to refer to the valuation of assets and expenses in current economic terms. For example, one practitioner claimed that financial statements display the truth only when they disclose the current value of assets and the profits and losses accruing from changes in values, although the increases in values should be designated as realized or unrealized.’ Many associate the term truth with propositions or statements that they believe to be established principles. For example, many consider the recognition of a gain at the time of the sale of an asset to be a reporting of “true’’ conditions. These same people feel that reporting an appraisal increase in the value of an asset, prior to sale as ordinary income, lacks truthfulness. Thus, the established rule regarding revenue recognition is used as a guide to determine the truth—not the other way around. This makes the truthfulness of the financial reports depend on the fundamental validity of the accepted rules and principles on which the statements are based. This is an inadequate foundation for measuring truthfulness. CHECKPOINTS 1. What does the term fair mean in an auditor’s report? Does this correspond with the term fair in ordinary discourse? 2. What do you mean by the word truthful in ordinary discourse? Does this correspond with the way you think about truth in accounting?Introduction and Methodology of Accounting 9 Economic Approaches In hopes of settling issues like those raised by ABC, accountants have long attempted to interpret accounting concepts in terms of economic concepts. In recent years, there has been a veritable explosion of research exploring the correspondence between economic interpretations and ac- counting data. The following sections lay out three different avenues in taking an economic approach to accounting: the macroeconomic, the microeconomic, and the corporate social. Macroeconomics. A macroeconomic approach attempts to explain the effect of alternative reporting procedures on economic measurements and economic activities at a level broader than the firm, such as an industry or the national economy. What effect, if any, would there be on the economy if every company recognized revenue at the point that ABC’s manage- ment would like to? Some want to go further than explanations and argue that one of the objectives of accounting should be to direct the behavior of firms and individuals toward the implementation of specific national economic poli- cies. For example, some argue that national economic objectives require accounting reports that will permit and even encourage higher dividends and larger capital expenditures during slack economic periods and dis- courage investments during periods of inflation. While most countries implement macroeconomic policies through mon- etary and fiscal policies and direct controls, some countries, notably Swe- den, do attempt to base accounting concepts and practices on macroeco- nomic goals.° One of the effects of this approach is that the objective of reporting stable earnings from year to year legitimizes the use of reserves and flexible depreciation policies. How this would help ABC’s manage- ment is unclear. Microeconomics. A microeconomic approach to accounting theory at- - tempts to explain the effect of alternative reporting procedures on eco- nomic measurements and economic activities at the level of the firm. Modern accounting theory, which is founded in microeconomics,. there- fore focuses on the enterprise as an economic entity with its main activi- ties affecting the economy through its operations in markets. This is the view adopted by the FASB in its Conceptual Framework. This approach takes as its fundamental premise that financial information has inevitable economic consequences. The exact form these consequences take is not always easy to determine and is subject to some dispute.!° More is said on this approach in Chapters 6 through 8. Suffice it to say for now that accounting theorists in this area tend to argue that, as long as the full facts are disclosed, it matters little how they are disclosed. They would probably feel that the recognition issues in the ABC case were10 Chapter 1 irrelevant to the marketplace, because there had been full disclosure of the facts. Any remaining interest in the issue would revolve around why management was interested in a higher rather than a lower income num- ber. What, they would wonder, was management’s real motivation? Corporate Social Accounting. The microeconomic view of accounting does not necessarily encompass all the effects companies have on society. The costs of environmental pollution, unemployment, unhealthful work- ing conditions, and other social problems are not normally reported by a firm, except to the extent that their costs are borne directly by the firm through taxation and regulation. Corporate social accounting seeks to address these issues. One prominent example of an attempt to include both social accounting and macroeconomic objectives within a theory of corporate reporting is provided in the Corporate Report, a discussion paper published by the Institute of Chartered Accountants in England and Wales.'! One of the report’s proposals is the publication of a value-added statement which allocates revenues, net of the cost of materials, to employees, creditors, and shareholders.'? These groups are often referred to collectively as the stakeholders of the company. Proponents of stakeholder analysis argue, with some justification, that orthodox accounting with its emphasis on shareholders, is really a subset of social accounting with its emphasis on the broader group of stakeholders. Recognition of the wider role that corporations play is also found in the enterprise theory of equity discussed in Chapter 19. In addition, the FASB formally recognized in their Conceptual Framework that there are many parties other than present owners interested in financial informa- EXHIBIT 1-1 Questions to Ask Tax What is the tax situation? Legal What is required by law? Are there any specific regulations covering this industry? Ethical What is the right thing to do? Is this fair presentation? Economic What effect will this accounting procedure have on the econ- omy? What effect will this choice of accounting procedure have on shareholders? Is there full disclosure of the facts behind the procedure? What effect will this have on other stakeholders? : Behavioral Why does management want to make this choice? Structural Is there a specific rule covering this situation? What is the defi- nition of revenue? What is GAAP? What are others doing in the industry?Introduction and Methodology of Accounting 11 tion. They include creditors, consumers, labor unions, trade unions, teachers, and, yes, students. Modern accounting theory too, as will be discussed in Chapter 8, recognizes that information itself is a public good with many of the same qualities as externalities, such as pollution. Finan- cial statements and unwanted noise, for example, are both free goods to the recipients. A market for each is difficult, if not impossible, to estab- lish. Much work, though, remains to be done in developing a complete the- ory of social accounting. Interest has been relatively low in the past, perhaps because organized labor, although a major stakeholder in compa- nies, has not played a large role in the United States in the establishment of accounting policy. This situation might change in the future if America moves more in line with European experience.!3 Additionally, as theorists come to terms with the public-good nature of financial information, they may well develop techniques to deal with other public goods that form the basis for the concerns of social accounting. Note that here, as elsewhere, ethics play an important role. The entity approach favored by the FASB assumes not only that firms do, but also that they should, maximize their profits. The reason for the latter is the economic theorem that, in a market economy, this leads to an ethically desirable outcome known as Pareto Optimality.* Social accountants re- spond with the claim that public goods invalidate this result, requiring a broader ethical approach to be taken. The point at this stage is not to take sides but to make the reader aware that ethical issues confront the ac- counting theorist at every point. CHECKPOINTS 1. Contrast macroeconomics with microeconomics. 2. Why is it not unreasonable to describe traditional accounting as a subset of social accounting? 3. Define the term stakeholder and contrast it with the term shareholder. A Behavioral Approach An alternative to the economic approach is to rely on the insights of . psychology and sociology in the development of accounting theories. The focus in this approach is on the relevance of information being communi- cated to decision makers and the behavior of different individuals or * This is described in Chapter 4.Rn Chapter 1 groups as a result of the presentation of accounting information. In the case of ABC, the question might concern what impact the early recogni- tion of profit, together with the disclosure of the controversy, might have on decisions being made by shareholders. The most important users of accounting reports presented to those outside the firm are generally considered to include stockholders, other investors, creditors, and government authorities; however, behavioral theories can also take into consideration the effects of external reports on the decisions of management and the feedback effect of the actions of accountants and auditors. Thus, behavioral theories attempt to measure and evaluate the economic, psychological, and sociological effects of al- ternative accounting procedures and reporting media. The behavioral approach to accounting theory has stimulated a search among both academic and practicing accountants for basic objectives of accounting and for answers to questions such as: Who are the users of published financial statements? What is the nature of the specific informa- tion wanted by the several user groups? Can common needs be found for the presentation of general-purpose statements or should specific needs be met?* How do investors, creditors, and managers react to different accounting procedures and presentations? CHECKPOINTS 1. Define the behavioral approach to accounting theory. Contrast it with the microeconomic approach. 2. List questions asked by accounting behavioralists. A Structural Approach The classical approach in accounting to solve problems like those raised by ABC might be called ‘‘structural’’ because it focuses on the structure of the accounting system itself. Most reasoning in this approach, particu- larly at the local level, is by analogy. It attempts to treat like with like. The judgment as to the most appropriate point at which to recognize a particular event is typically based on the moments chosen to record other events. In other words, accountants attempt to classify similar transac- tions similarly or, more formally, to seek consistency in recording and reporting transactions. It is only when they encounter a transaction which * Technically, no information is needed to make a decision, but information might be wanted because of uncertainties. The term needs is used here because of common usage.Introduction and Methodology of Accounting 13 does not fit into a previous mold that they are forced back to more basic principles. The whole process is reminiscent of the first week in Principles of Accounting. Most readers will be able to recall the anxious search, in those early days of learning accounting, for what names to put on journal entries. How should one classify a purchase of pencils? Should it be treated the same way as the purchase of widgets? What should go into supplies and what into inventory? It is clear from the ABC case that both auditors and management took a structural approach. Consistency was the first line of argument for the company and its critics. They had used delivery as the point at which they recognized sales in all their previous dealings. They planned to continue to use it in the belief that the new sales were similar to the old. The arguments from the auditors seem to have been that the transactions were different enough that a parallel could not be drawn. The principle of consistency was not disputed, simply the specific application. This process of classifying like data with like and then summarizing them ‘“‘in specific groupings (accounts and ledgers) and further summariz- ing the groupings into reports and statements’’ has been called ‘‘compact- ing.’’'4 Illinois professor A. C. Littleton described this process as similar to that of statisticians.!5 Both accountants and statisticians aggregate numbers to arrive at totals or averages. Both must be concerned with classifying things correctly. It is senseless to average temperatures over a year when one is trying to establish the average summer temperature. Similarly, accountants should classify economic events correctly to arrive at meaningful financial statements. In 1941, the Committee on Terminology of the American Institute of Accountants (AIA), the forerunner of the American Institute of Certified Public Accountants (AICPA), captured this compacting process in a widely quoted definition: Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions, and events, which are in part, at least, of a financial character, and interpreting the results thereof.'® Broader definitions of accounting are in vogue today, but the process of “recording, classifying, and summarizing”’ is still the heart of accounting. CHECKPOINTS 1. The AIA defined accounting as an art. How do you distinguish art from science? Why do you think they did not speak of the science of accounting? 2. Think back on the accounting you learned before entering this class. How much of it was based on a structural approach to accounting?14 Chapter I How much of it was based on economic theory? How much on the behavior of users? Provide an example of each approach from your own experience. CLASSIFYING ACCOUNTING THEORIES Regardless of the approach one takes to solving accounting problems, one is always left with the question: How can one tell whether one’s solution is correct? That leads to a second question: What does one mean by a correct solution in this context? Answers to these questions depend not only on the approach one has taken, but also on the form one’s reasoning has taken. Three ways of classifying the way people reason are discussed in the sections that follow. They are followed by a discussion of how one might determine correctness given the pattern of reasoning. More for- mally, we discuss how theories might be classified and then verified.* Exhibit 1-2 on page 19 summarizes the classification of accounting theo- ries. Theory as Language A first classification relies on the notion that accounting is a language. Many call it the language of business. Theorists suggest that there are three questions that should be asked about a language and the words and phrases that make up that language: 1. What effect will the words have on listeners? 2. What meaning, if any, do the words have? 3. Do the words make logical sense? Answers to each of these questions form part of the study of a language. Pragmatics is the study of the effect of language; semantics is the study of the meaning of language; and syntactics is the study of the logic or gram- mar of the language. Both the behavioral and the economic approaches alluded to above are primarily pragmatic in style, while the structural approach is primarily syntactic. Although it is fair to say that almost all current research into accounting is pragmatic in its orientation, semantics and syntactics are also important in accounting theory. Semantics is im- portant because ideally financial information has economic or physical content that is agreed to by both the producers and the users of the * This section draws heavily on the “Report of the Committee on Accounting Theory Construction and Verification,’’ The Accounting Review (Supplement 1971), pp. 37-45.Introduction and Methodology of Accounting 15 information. Syntactics is important in accounting because ideally one piece of financial information relates logically to another. Accounting numbers and classifications vary with respect to the degree of interpretation that can be inferred by the reader of accounting reports. For example, the item cash in the statement of financial condition is fairly well understood to mean what accountants intend it to mean. On the other hand, the classification deferred charges has no specific interpretation apart from the structural] processes that gave rise to it. The role of theories that emphasize semantics is to find ways to improve the interpretation of accounting information in terms of human observations and experience. The FASB, in particular, is working steadily to rid the balance sheet of items lacking in semantic content. Despite the efforts of the FASB, and hard as it is for newcomers (and the general public) to accept, many accounting concepts still have no semantic content. Consider again the ABC case and the question of when they should recognize revenue. Realize that no flashing light goes off in the real world telling accountants that the great moment of recognition has arrived. A signature on a contract is a real event, the delivery of a vending machine is a real event, the payment for the machine is a real event, but the moment of a ‘‘sale’’ is simply the moment at which a bookkeeper decides to record the transaction, no more and no less. Rec- ognition of sales, expenses, assets, and liabilities are all syntactic in ori- gin. There is no semantic counterpart to which one can point. CHECKPOINTS 1. Define the terms syntactic, semantic, and pragmatic as they apply to theory. 2. Consider one element in a balance sheet, such as inventory or accounts payable, and define it syntactically, semantically, and pragmatically. 3. Assets are sometimes said to be possessions of the company. What level of definition is this? Theory as Reasoning The second means of classifying the form of the theoretical debate is to ask whether the arguments flow from generalizations to specifics (deduc- tive reasoning) or whether they flow from specifics to generalizations (inductive reasoning). In accounting, the generalizations are often termed postulates. From these, accountants hope to deduce accounting princi- ples that will provide a basis for concrete or practical applications. With16 Chapter I the deductive method, practical applications and rules are deduced from the postulates and not from observing practice. With the inductive method, principles are induced from best current practice. , Deductive Reasoning. Objectives are an important part of the deductive process, because different objectives can require entirely different struc- tures and result in different principles. For instance, the basic objectives of tax accounting are different from those of financial accounting. This is one of the main reasons why rules for determining taxable income are different in many respects from the generally accepted practice for the determination of financial income. Sometimes, though, despite differ- ences in objectives, cost-benefit considerations demand a compromise. For instance, it is likely that individual users have different objectives in mind when using accounting data. It does not seem feasible, though, to set up an entirely different set of principles for every user! Instead, as a compromise, a general-purpose statement is produced. A more precise method of formulating the logic in deductive reasoning is found in the axiomatic or mathematical approach to accounting theory. In this method, mathematical symbols are given to certain ideas and concepts. The framework is provided in the form of mathematical models utilizing matrix algebra or symbolic logic. Constraints can be applied in the form of mathematical expressions. Therefore, starting with basic pos- tulates and rules of logical inference, theorems can be formulated and tested through mathematical operations. Thus, the axiomatic method can provide a very rigorous application of the deductive method. One of the main disadvantages of the deductive method is that, if any of the postulates and premises are false, the conclusions may also be false. Also, it is thought to be too far removed from reality to be able to derive realistic and workable principles or to provide the basis for practical rules. But these criticisms generally stem from a misunderstanding of the purpose and meaning of theory. It is not necessary for theory to be en- tirely practical for it to be useful in establishing workable procedures. The main purpose of theory is to provide a framework for the development of new ideas and new procedures and to help in making choices among alternative procedures. If these objectives are met, it is not necessary that theory be based completely on practical concepts or that it be restricted to the development of procedures that are completely workable and practi- cal in terms of current technology. In fact, many of the currently accepted principles and procedures are general guides to action rather than specific rules that can be followed precisely in every applicable case. Inductive Reasoning. The process of induction Consists of drawing gen- eralized conclusions from specifics. A typical inductive argument begins with a set of particular examples, claims that these examples are repre- sentative of some greater whole, and infers some generalization abouta Theory as Script Introduction and Methodology of Accounting 17 that whole. Usually, but not always, the specifics are based upon practical experiences such as the outcomes of experiments. Sciences that rely on experience are termed empirical. Experimental sciences are empirical by definition. Mathematics is inherently nonempirical. Accounting theory that collects financial data to induce its conclusions can be considered empirical. The structural approach, on the other hand, is typically nonem- pirical. Just because the observers look only at raw data does not mean that they do not need some initial postulates and concepts. By merely choos- ing what to observe they are reflecting preconceived notions of what might be relevant. By restricting themselves to the financial data of a firm, for example, they are drawing on certain postulates regarding the environ- ment of accounting. Furthermore, if they restrict themselves to observing only financial transactions, they may only confirm existing practice. In- duction and deduction, therefore, are really complementary. Almost all theories will include some elements of both deductive and inductive rea- soning. The advantage of the inductive approach is that it is not necessarily constrained by a preconceived model or structure. Researchers are free to make any observations they may deem relevant. The main disadvantage of the inductive process is that observers are likely to be influenced by subconscious ideas of what the relevant relationships are and what data should be observed. Another disadvantage of the inductive approach is that, in accounting, the raw data are likely to be different for each firm. Relationships may also be different, making it difficult to draw generaliza- tions. CHECKPOINTS 1. Contrast the terms deductive and inductive. 2. Contrast the terms empirical and nonempirical as they apply to accounting theory. 3. Why is it that accounting theory remains so controversial? Both inductive and deductive theories may be descriptive (positive) or prescriptive (normative.) Descriptive theories attempt to set forth and explain what and how financial information is presented and communi- cated to users of accounting data. Normative theories attempt to pre- scribe what data ought to be communicated and how they ought to be presented; that is, they attempt to explain what should be rather than what is. Inductive theories, by their nature, are usually positive; but it18 Chapter 1 does not follow that deductive theories are necessarily normative. One can begin with generalizations about how the world is perceived to be and draw from that specific deductions that are intended to be wholly descrip- tive. The question in the case of Alleghany Beverages of which revenue recognition method to use is a prescriptive or normative one for the participants because they are seeking an answer to what they should do. We could ask a more descriptive or positive question: Why did manage- ment want to accrue earnings? One answer might be that management was simply trying to do the theoretically correct thing (whatever that might be); another, more cynical answer perhaps, might be that manage- ment was trying to puff up earnings to impress shareholders and creditors. Whether they were or not is an empirical question. Accounting theorists are interested in answers to both kinds of ques- tions: the normative one that attempts to discover the best way of ac- counting for a transaction, and the positive one that attempts to discover how management and others decide which is the best way for them. The answers to these sorts of questions, together with the attempt to find these answers, constitute the subject of accounting theory. CHECKPOINTS 1. Define the structural approach. Why is it so closely associated with a positive approach to accounting theory? . Why are positive theories sometimes criticized? 3. Explain why a positive approach to theory is associated with inductive reasoning. Nn THEORY VERIFICATION Verification may be defined as establishing the acceptability, or the truth, of a theory. All theories should be logically sound, but beyond that the nature of verification will depend on the nature of the theory being veri- fied. Normative theories are judged one way; positive theories another. Normative theories, including the theory of verification itself, are judged by the reasonableness of their assumptions. Ideally, the assump- tions on which a normative theory is based, and the grounds on which they might be judged acceptable, are stated clearly in the theory. Others may then reject the normative conclusions by refusing to accept the as- sumptions, but the basis of disagreement is then well defined. Descriptive theories are evaluated in tWo different ways depending on whether they have empirical content or not. Syntactic theories are de-Introduction and Methodology of Accounting 19 EXHIBIT 1-2 Classifying Theories Theory Descriptive or Prescriptive (positive vs. normative) Reasoning Language 1. Deduction : 1. Syntactics (Is it logically sound?) (What are the rules?) 2. Induction 2. Semantics (What evidence is there?) (What does it mean?) 3. Pragmatics (What effect will it have?) scriptive theories which have no empirical content. They are confirmed by logic alone. For instance, the equation 2(y + 3) = 2y + 6 is true because of the agreed-upon rules of mathematics. Similarly, gross margin will be $500 if revenue is $800 and cost of goods sold is $300, not because of any empirical observations, but because of the agreed-upon rules of accounting. Many accounting propositions fall into this category and are true for syntactical reasons only. Consider, by way of a further example, the question of whether a particular item, such as a dry hole, is an asset or not. One might argue as follows: All assets have value to a company. A dry oil well has no value to a company. Therefore, the dry well cannot be an asset. This is a perfectly valid conclusion but we do need to be aware that the validity of our reasoning is completely independent of the meaning of the word asset. We can substitute nonsense words without affecting the truth of the conclusion. For instance, we could have simply said that if all bzrs have eechs, then x cannot be a bzr if it does not have an eechL Much reasoning in accounting, particularly in the structural approach, is syntac- tical in nature. It may be logically true but it lacks empirical content. Semantic theories, on the other hand, are descriptive theories that do ” have empirical content. Since they are intended to say something about the real world, their truth depends upon observation. For instance, that there is $56.23 in petty cash can be verified only by examination. Verifica- tion of semantic theories can be obtained from research studies which determine whether users of accounting information understand the infor- mation producers’ intended meaning, within the context of relevant theory.Pragmatic theories are also descriptive theories with empirical content. Pragmatic theories emphasize the usefulness of accounting to investors and others. Their verification depends not so much on their truth as on their value to users. In other words, one does not verify a pragmatic accounting theory as such, but rather its use. This, as will become appar- ent in the chapters that follow, has been the path taken by modern ac- counting theorists. Tests of descriptive theories are often cast in the form of predictions. For instance, the theory of gravity enables scientists to predict how falling bodies will behave and tests can be done to verify that they do indeed behave as predicted. The result, if the test is repeated sufficiently to satisfy observers, is said to be confirmation of the theory. On the other hand, if the theory fails to predict, or if anomalies are discovered, it is said to lack confirmation—or even be refuted.'7 Several authors have taken issue with this description of the scientific process. Thomas Kuhn, for instance, suggests that science proceeds by establishing what he terms paradigms, which may be defined as frame- works for generating research questions. Scientists do not so much con- firm or refute theories as find them more or less useful in provoking thoughtful questions about the nature of our world. They are discarded when they are no longer useful in generating questions.'® Others have rejected an approach to verification based purely on pre- dictions on grounds that predictions, in the social sciences particularly, are frequently unreliable because of their behavioral implications. For instance, the prediction of an economic depression may cause the govern- ment to take actions that may actually create or deepen the depression (such as hoarding or panic selling of securities), A theory that could lead to the prediction of business failure could actually bring about such a failure if people believed the prediction. By denying funds to a firm having difficulties, investors and creditors could cause the firm to go into bank- ruptcy. Accountants are not unaware of this possibility with traditional accounting procedures, and more accurate predictions could even multi- ply these concerns. Therefore, the ability to predict cannot be the only consideration in the development of theories in accounting. The use of predictions as the main criterion for the evaluation of ac- counting theory is also complicated by the fact that accounting theories are typically a blend of various forms of theorizing. Their confirmation, therefore, takes place at several levels: 1. Assumptions regarding the real world must be tested for correspon- dence between the statement and observable phenomena. 2. The interrelationship of the statements in the theory must be tested for logical consistency. 3. If any of the premises are based on value judgments, they should be accepted or rejected based on their correspondence to one’s own value judgments.CONCLUSION Introduction and Methodology of Accounting a 4. If there is inconclusive empirical verification, the conclusions of the theory or the hypothesis must be subjected to independent empirical verification. ———— CHECKPOINTS 1. How might one verify accounting theory? 2. Why is verification so important to accounting theory? Accounting theory, as described in this book, focuses on the set of princi- ples which underlie and, presumably, are supportive of accounting prac- tice: those generally accepted accounting principles (GAAP) to which auditors attest whenever they sign an opinion. It must be said at once, though, that accounting principles are only one force shaping accounting practice. Politics, economics, and law are among many powerful forces which contend with purely theoretical considerations to shape practice. Accounting theory, in addition to developing principles, also seeks to understand these forces. Restating all this more formally, and drawing on the definition of theory as found in Webster’s dictionary, accounting theory may be defined as a coherent set of hypothetical, conceptual, and pragmatic principles form- ing a general frame of reference for inquiring into the nature of account- ing.'? The definition is deliberately broad so as to encompass both the more traditional view of theory as a general frame of reference for the evaluation and development of sound accounting practices, and the more modern view of theory as a general frame of reference by which account- ing practice can be explained and predicted. An immediate caveat to this definition is that, while a single general theory of accounting may be desirable, accounting as a science is still in too primitive a stage for such a development. The best that can be accoin- plished in this developmental stage is a set of theories (models) and sub- theories that may be complementary or competing. But even this can be valuable. As Italian historian, Guglielmo Ferrero, once said, theory, which gives facts their value and significance, is often very useful, even if it is partially false, because it throws light on phenomena which no one has observed, it forces examination, from many angles, of facts which no one has hitherto studied, and it produces the impulse for more extensive and more productive researches, . . .2 The truth of this will become apparent as one examines the many different approaches to theory that have been developed.‘hapter 1 Simple questions, like when does one recognize a sale, form the core of accounting theory. From the very start of their studies in the discipline, accounting students have been grappling with questions like this—in other words with theoretical issues. As a result, most accounting stu- dents, unwittingly perhaps, bring a great deal of theoretical knowledge to a theory class. Accounting theory does not so much add new knowledge as systematize knowledge the reader already has. CHECKPOINTS 1. What is accounting theory? What are its objectives? 2. Is it important to have a definition of accounting theory? Why? SUMMARY Accounting theory has been defined as a coherent set of logical principles that: 1. Provides a better understanding of existing practices to practitioners, investors, managers, and students. 2. Provides a conceptual framework for evaluating existing accounting practices. 3. Guides the development of new practices and procedures. Numerous approaches to developing such a theory have been outlined in this chapter: tax, law, ethical, economic, behavioral, and structural. Each of the several approaches to accounting theory has some merit in helping to establish and evaluate accounting principles and procedures. Eco- nomic and behavioral approaches help set the stage for explaining the environment within which accounting operates and for selecting what data should be reported. The ethical approach provides fundamental ob- jectives in establishing accounting standards. The social accounting and macroeconomic approaches add to the controversies of theory develop- ment and application, and so on. Three levels of theory—syntactic, semantic, and pragmatic—were seen to exist and three ways of classifying theories were discussed: empir- ical versus nonempirical, inductive versus deductive, and normative ver- sus positive. No approach to accounting theory relies completely on a single method. This book favors an eclectic approach making use of those approaches and those levels as are most appropriate at the time. The aim of this book is to provide readers with a coherent set of logical principles for the evaluation and development of sound accounting practices in their professional lives.LIFO and the GNP Required: Introduction and Methodology of Accounting 23 The following chapter presents the historical development of account- ing theories in the belief that a historical perspective provides a better understanding of the several theories currently in circulation and why accounting is what it is today. One of the first steps to understanding the traditional, structural approach to accounting is an examination of the objectives, fundamentals, concepts, and elements on which it is based. These are found in Chapter 5, along with a discussion of the FASB’s Conceptual Framework. Chapter 6 presents a discussion of capital mar- kets theories and their relationship to accounting information, while Chapter 7 presents a discussion of research related to the individual deci- sion processes. Research findings are presented and discussed in later chapters relating to the specific topics. PROBLEMS AND CASES The widespread shift from FIFO to LIFO for inventory valuation pur- poses in 1974 had the effect of reducing the measured gross national product. Although the effect of inflation on inventory profits is removed by an inventory valuation adjustment, the adjustment did not allow for this shift. Some economists were concerned that this artificial reduction of reported GNP would have the effect of reducing consumer demand if it led consumers to anticipate a more severe recession than they otherwise might expect. Should the APB at the time have outlawed the use of LIFO for macro- economic reasons? Discuss. Alleghany Beverages Corporation The brief facts presented about Alleghany Beverages in the text provide endless food for thought. You are asked to present a number of possible solutions to the case, each emanating from the various approaches to theory discussed in this chapter. Specifically, you might consider the following issues among others. 1. How might you arrive at a deductive solution to their situation? How would this differ from an inductive solution? Was the company’s argument that accrual accounting was industry practice inductive or de- ductive? What other evidence might you gather? Is inductive reasoning always based on observations? 2. Are there ethical considerations in this case? Would one method have been fairer than the other? Given that everything we know about the24 Chapter 1 transaction was disclosed in the company’s financial reports and proxy statements, had the company not fulfilled all its ethical obligations? 3. Efficient-market theories suggest that full disclosure, even if it is narrative, should be sufficient. Apparently, the auditors disagreed. What is your position? 4. Outline a syntactic, semantic, and pragmatic avenue to a solu- tion. What would you need to do or to know for each? Six Flags Over Texas Required: On June 30, 1969, Great Southwest Corporation (GSC) sold an amuse- ment park in Dallas called Six Flags Over Texas to a group of private investors. The footnote describing this transaction read as follows: On June 30, 1969, Great Southwest Corporation sold all of the property and equipment of Six Flags Over Texas, an amusement park, for $40,000,000, re- sulting in a gain of $17,530,170. Upon completion of the sale, the purchaser, Six Flags Over Texas Fund Ltd., contributed the amusement park to a limited partnership in which Six Flags Over Texas, Inc., a wholly owned subsidiary of Great Southwest Corporation, is the General Partner and operator. As partial consideration for the sale, the Company received a 6!4 percent mortgage note in the amount of $38,031,585 which is secured by the amusement park. The note is payable in annual principle installments of $1,094,331 beginning in March 1971 and is subject to optional prepayments without penalty. Should this be recognized as a sale? If so, in what amount? Provide reasons for your answer. Elmo Company (November 1973) Part a. Elmo Company operates several plants at which limestone is processed into quicklime and hydrated lime. The Bland plant, where most of the equipment was installed many years ago, continually deposits a dusty white substance over the surrounding countryside. Citing the un- sanitary condition of the neighboring community of Adeltown, the pollu- tion of the Adel River, and the high incidence of lung disease among workers at Bland, the state’s Pollution Control Agency has ordered the installation of air pollution control equipment. Also, the Agency has as- sessed a substantial penalty, which will be used to clean up Adeltown. After considering the costs involved (which could not have been reasona- bly estimated before the Agency’s action), Elmo decides to comply with the Agency’s orders, the alternative being to cease operations at Bland at the end of the current fiscal year. The officers of Elmo agree that the airRequired: Required: Introduction and Methodology of Accounting 25 pollution control equipment should be capitalized and depreciated over its useful life, but they disagree over the period(s) to which the penalty should be charged. Discuss the conceptual merits and reporting requirements of account- ing for the penalty as a: 1. Charge to the current period. 2. Correction of prior periods. 3. Capitalizable item to be amortized over future periods. Part b. Elmo’s Davis Plant causes approximately as much pollution as Bland. Davis, however, is located in another state, where there is little likelihood of governmental regulation, and Elmo has no plans for pollu- tion control at this plant. One of Elmo’s officers, Mr. Pearce, says that uncontrolled pollution at Davis constitutes a very real cost to society, which is not recorded anywhere under current practice. He suggests that this ‘‘social cost’’ of the Davis Plant be included annually in Elmo’s income statement. Further, he suggests that measurement of this cost is easily obtained by reference to the depreciation on Bland’s pollution con- trol equipment. 1. Is Mr. Pearce necessarily correct in stating that costs associated with Davis’s pollution are entirely unrecorded? Explain. 2. Evaluate Mr. Pearce’s proposed method of measuring the annual ‘‘so- cial cost’’ of Davis’s pollution. 3. Discuss the merit of Mr. Pearce’s suggestion that a ‘‘social cost’’ be recognized by a business enterprise. PRIMARY SOURCES Those interested in learning more about the topics covered in this chapter might begin by consulting the following sources. Each has numerous excellent citations. Belkaoui, Ahmed. Accounting Theory, 2nd ed. San Diego: Harcourt, Brace Jovanovich, 1985. Kam, Vernon. Accounting Theory. New York: John Wiley & Sons, 1986. Most, Kenneth S. Accounting Theory, 2nd ed. Columbus: Grid Publishing, Inc., 1982. Wolk, Harry I.; Jere R. Francis; and Michael G. Tearney. Accounting Theory, 2nd ed. Boston: Kent Publishing Co., 1989.26 Chapter 1 SELECTED ADDITIONAL READINGS In addition to the works cited in the primary sources and the endnotes to this chapter, the reader is referred to the following authors: General Methodology American Accounting Association. ‘‘Report of the Committee on Foundations of Accounting Measurement.’? The Accounting Review, Supplement, 1971, pp. 37-45. American Accounting Association. ‘‘Report of the Committee on Accounting Theory Construction and Verification.”’ The Accounting Review, Supplement, 1971, pp. 53-63. American Accounting Association. Committee on Concepts and Standards for External Financial Reports, Statement on Accounting Theory and Theory Ac- ceptance (1977). Beams, Floyd A. ‘Indications of Pragmatism and Empiricism in Accounting Thought.”* The Accounting Review, April 1969, pp. 382-88. Caplan, Edward. ‘‘Accounting Research as an Information Source for Theory Construction.’’ The Accounting Review, Supplement, 1972, pp. 437-44. Devine, Carl Thomas. Essays in Accounting Theory, vol. 3 (Privately published, 1971), pp. 1-80. Hakansson, Nils. ““Normative Accounting Theory and the Theory of Decision.” International Journal of Accounting, Spring 1969, pp. 33-48. Kam, Vernon. ‘‘Judgment and the Scientific Trend in Accounting.’’ Journal of Accountancy, February 1973, pp. 52-57. Kuhn, T.S. The Structure of Scientific Revolutions, 2nd ed. University of Chicago Press, 1970. Larson, Kermit. ‘‘Implications of Measurement Theory on Accounting Concept Formulation.’’ The Accounting Review, January 1969, pp. 38-47. McDonald, Danie! L. Comparative Accounting Theory, Reading, Mass.: Addi- son-Wesley, 1972. Mattessich, Richard. ‘Methodological Preconditions and Problems of a General Theory of Accounting.” The Accounting Review, July 1972, pp. 469-87. Popper, Karl R. The Logic of Scientific Discovery. London: Hutchinson & Co., 1959. Sterling, Robert R. ‘‘An Explication and Analysis of the Structure of Accounting, Part One.”’ Abacus, December 1971, pp. 137-52; and ‘‘Part Two.”’ Abacus, December 1972, pp. 145-62. Sterling, Robert R., and Richard E. Flaherty. ‘‘The Role of Liquidity in Exchange Valuation.’’ The Accounting Review, July 1971, pp. 441~56. Yu, S.C. The Structure of Accounting Theory. Gainesville, Fla.: University of Florida Press, 1976. Pragmatic Theories Demski, Joel S. ‘Choice among Financial Reporting Alternatives.” The Account- ing Review, April 1974, pp. 221-32.Introduction and Methodology of Accounting 27 Hawkins, David F. ‘‘Behavioral Implications of Generally Accepted Accounting Principles.’ California Management Review, Winter 1969, pp. 13-21. Hofstedt, Thomas R. ‘‘Some Behavioral Parameters of Financial Accounting.’’ The Accounting Review, October 1972, pp. 679-92. Hofstedt, Thomas R. ‘‘The Processing of Accounting Information: Perceptual Biases.’’ Behavioral Experiments in Accounting. Edited by Thomas J. Burns. Columbus: College of Administrative Science, The Ohio State University Press, 1972, pp. 285-315. Normative Deductive Theories Bedford, Norton M. ‘‘The Impact of A Priori Theory and Research on Account- ing Practice,’ in The Impact of Accounting Research on Practice and Disclo- sure. Edited by A. Rashad Abdel-khalik and Thomas F. Keller. Durham, N.C.: Duke University Press, 1978, pp. 2-31. Langenderfer, Harold Q. ‘‘A Conceptual Framework for Financial Reporting.” Journal of Accountancy, July 1973, pp. 46-55. Pellicelli, Georgio. ‘‘The Axiomatic Method in Business Economics: A First Ap- proach.’’ Abacus, December 1969, pp. 119-31. Tippet, Mark. ‘‘The Axioms of Accounting Measurement.’’ Accounting and Busi- ness Research, Autumn 1978, pp. 266-78. Normative Theories Demski, Joel S. ‘“‘The General Impossibility of Normative Accounting Stan- dards.’’ The Accounting Review, October 1973, pp. 718-23. Hakansson, Nils H. ‘‘Normative Accounting Theory and the Theory of Deci- sion,’’ International Journal of Accounting Education and Research, Spring 1969, pp. 33-47. Predictive Ability American Accounting Association. ‘‘Report of the Committee on Corporate Fi- nancial Reporting.’ The Accounting Review, Supplement 1972, pp. 525-28. Ashton, Robert H. ‘“‘The Predictive-Ability Criterion and User Prediction Models.’ The Accounting Review, October 1974, pp. 719-32. Beaver, William H.; John W. Kennelly; and William M. Voss. ‘‘Predictive Ability as a Criterion for the Evaluation of Accounting Data.’’ The Accounting Review, October 1963, pp. 675-83. * Greenball, M. N. ‘‘The Predictive-Ability Criterion: Its Relevance in Evaluating Accounting Data.’’ Abacus, June 1971, pp. 1-7. Libby, R. ‘‘Accounting Ratios and the Prediction of Failure.’’ Journal of Ac- counting Research, Spring 1975, pp. 150-61. Louderback, Joseph G. III. ‘‘Projectability as a Criterion for Income Determina- tion Methods.”’ The Accounting Review, April 1971, pp. 298-305. Revsine, Lawrence. ‘‘Predictive Ability, Market Prices, and Operating Flows.”’ The Accounting Review, Suly 1971, pp. 480-89. Revsine, Lawrence. Replacement Cost Accounting. Englewood Cliffs, N.J.: Prentice Hall, 1973, pp. 86-138.Chapter | The Events Approach Benbasat, Izak, and Albert S. Dexter. ‘‘Value and Events Approaches to Ac- counting: An Experimental Evaluation.’’ The Accounting Review, October 1979, pp. 735-49. Johnson, Orace. ‘‘Toward an ‘Events’ Theory of Accounting.”” The Accounting Review, October 1970, pp. 641-53. Lieberman, Arthur Z., and Andrew B. Whinston. ‘‘A Structuring of an Events- -Accounting Information System.”” The Accounting Review, April 1975, pp. 246-58. Revsine, Lawrence. ‘‘Data Expansion and Conceptual Structure.’ Tke Account- ing Review, October 1970, pp. 704-11. Sorter, George H. ‘‘Events Approach to Basic Accounting Theory.’’ The Ac- counting Review, January 1969, pp. 12-19, Ethical Approaches Arnett, Harold E. ‘‘The Concept of Fairness.’ The Accounting Review, April 1967, pp. 291-97. Burton, John C., ed. Corporate Financial Reporting: Ethical and Other Prob- lems. AICPA, 1972, esp. pp. 17-27, 73-86, and 107-32. Pattillo, James W. The Foundations of Financial Accounting, particularly Ch. 3. Baton Rouge: Louisiana State University Press, 1965. Spacek, Leonard. A Search for Fairness in Financial Reporting to the Public. Chicago: Arthur Andersen & Co., 1969, particularly pp. 27-38 and 349-56. Corporate Social Accounting Approach ; American Accounting Association. ‘‘Report of the Committee on Accounting for Social Performance.’’ The Accounting Review, Supplement 1976, pp. 38-69. American Institute of Certified Public Accountants. The Measurement of Corpo- rate Social Performance. AICPA, 1977. Anderson, John E., and Alan W. Frankle. ‘‘Voluntary Social Reporting: An Iso- Beta Portfolio Analysis.’ The Accounting Review, July 1980, pp. 467-79. Burton, Eric James, and Manuel A. Tipgos. ‘‘Toward a Theory of Corporate Social Accounting: A Comment and Reply.”’ The Accounting Review, October 1977, pp. 971-73 and 977-83. Dierkes, Meinolf, and Raymond A. Bauer, eds. Corporate Social Accounting. New York: Praeger Publishers, 1973. Estes, Ralph. Corporate Social Accounting. New York: John Wiley & Sons, 1976. Ingram, Robert W. ‘‘An Investigation of the Information Content of (Certain) Social Responsibility Disclosures.”’ Journal of Accounting Research, Autumn 1978, pp. 270-85. Jensen, Robert E. Pkantasmagoric Accounting: Research and Analysis of Eco- nomic, Social, and Environmental Impact of Corporate Business. AAA Studies in Accounting Research, 1976.Introduction and Methodology of Accounting 29 Ramanatham, Kavasseri V. ‘‘Toward a Theory of Corporate Social Accounting.”’ The Accounting Review, July 1976, pp. 516-28. Spicer, Barry H. ‘‘Investors, Corporate Social Performance and Information Dis- closure: An Empirical Study.” The Accounting Review, January 1978, pp. 94— 111. Tinker, Anthony M.; Cheryl Lehman; and Marilyn Neimark. ‘‘Marginalizing the Public Interest: A Critical Look at Recent Social Accounting History,”’ in Behavioral Accounting Research: A Critical Analysis. Edited by K.F. Ferris. Columbus: Century VII Publishing Co., 1988. Macroeconomic Approach Enthoven, Adolf J. H. Accountancy and Economic Development Policy. New York: American Elsevier Publishing, 1973. Mueller, Gerhard G. ‘Accounting within a Macroeconomic Framework.”’ Inter- national Accounting. New York: MacMillan, 1967, Ch. 1. Verification of Accounting Theories American Accounting Association. ‘‘Report of the Committee on Accounting Theory Construction and Verification.’’ The Accounting Review, Supplement 1971, pp. 53-79. Gonedes, Nicholas J. ‘‘Perception Estimation and Verifiability.”’ International Journal of Accounting Education and Research, Spring 1969, pp. 63-73. Schrader, William J., and Robert E. Malcolm. ‘“‘A Note on Accounting Theory Construction and Verification.’’ Abacus, June 1973, pp. 93-98. Sterling, Robert R. ‘‘On Theory Construction and Verification.’’ The Accounting Review, July 1970, pp. 444-57. Williams, Thomas H., and Charles H. Griffin. ‘‘On the Nature of Empirical Verifi- cation in Accounting.’’ Abacus, December 1969, pp. 143-78. ENDNOTES 1, Financial Accounting Standards Board, Statements of Financial Accounting Concepts, No. 2 (FASB, May 1980), pars. 6 & 7. 2. Robert N. Anthony and James W. Reese, Accounting: Text and Cases (Homewood, Ill.: Richard D. Irwin, 1983), p. 132. - . . Eisner v. Macomber, 252 U.S. 189 (1920). . James v. U.S., 366 U.S. 213 (1961). . Financial Accounting Standards Board Discussion Memorandum, An Analy- sis of Issues Related to Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement (FASB, December 1976), pars. 116-123. 6. Henry Rand Hatfield, Accounting, Its Principles and Problems (reprinted by Scholars Book, 1971, originally printed in 1927), p. 250. 7. James W. Pattillo, The Foundation of Financial Accounting (Baton Rouge: Louisiana State University Press, 1965), p. 11. AWChapter 1 10. il. 12. 13. 14. 15. 16. 17. 18. 19. 20. . Kenneth MacNeal, Truth in Accounting (Philadelphia: University of Pennsyl- vania Press, 1939), p. 203. F. D. S. Choi and G. G. Mueller, International Accounting (Englewood Cliffs, N.J.: Prentice Hall, Inc., 1984), pp. 89-91. Stephen A. Zeff, ‘‘The Rise of Economic Consequences,’’ The Journal of Accountancy, December 1978, pp. 56-63. The Corporate Report (London, Eng.: Accounting Standards Steering Com- mittee of the Institute of Chartered Accountants of England and Wales, 1975). Gary K. Meek and Sidney J. Gray, ‘‘The Value Added Statement: An Innova- tion for U.S. Companies?’* Accounting Horizons, June 1988, pp. 73-81. Wiliam H. Beaver, Financial Reporting: An Accounting Revolution (Engie- wood Cliffs, N.J.: Prentice Hall, 1967), p. 8. James W. Pattillo, Foundation of Financial Accounting, p. 41. A.C. Littleton, The Structure of Accounting Theory, American Accounting Association Monograph No. 5 (AAA, 1958). American Institute of Accountants, ‘‘Review and Resume,'’ Accounting Ter- minology Bulletin No. 1 (New York: AIA, 1953), par. 9. Karl Popper, Conjectures and Refutations (Basic Books, 1965). Thomas S. Kuhn, The Structure of Scientific Revolution (Chicago: University of Chicago Press, 1962). Webster’s Third New International Dictionary, Unabridged (Springfield, Mass.: G. & C. Merriam, 1961), p. 2371. Gugliemo Ferrero, Les Lois psychologiques du symbolisme, p. viii; used by Karl Jung on the flyleaf introducing Part I of Symbols of Transformation (Collected Works, vol. 5, New York: Pantheon Books, 1956), p. 2.Chapter 3 The Century of the CPA CHAPTER OBJECTIVES ' After studying this chapter, you will be able to: Recount the origin of the Financial Accounting Standards Board and its predecessors. Contrast the organization of the Financial Accounting Standards Board with that of the Committee on Accounting Procedure and the Accounting Principles Board. Summarize the role of the Securities and Exchange Commission in setting accounting standards. Describe the origin of auditing in the United States and in Great Britain. Describe the importance of the concept of uniformity in the history of accounting standard setting and contrast it with the concept of flexibility. CHAPTER OVERVIEW The Origin of Regulation Financial regulation in America began with the railroads in 1887, the year of the founding of the AICPA. It spread to other industries in an attempt to control the giant trusts. The Crash of 1929 The crash led to the creation of the Securities and Exchange Commission in 1934 and the setting of accounting standards by the Committee on Accounting Procedures in 1938.The Century of the CPA 59 The Postwar Boom The increased participation of ordinary investors in the stock market led to increased demands for uniformity of procedures to permit comparisons and to the formation of the Accounting Principles Board (APB) in 1959. The Modern Era An inability to resolve fundamental issues in financial reporting led to the replacement of the APB by the Financial Accounting Standards Board, which is independent of the AICPA and has a full-time board. Conclusion In the century since the founding of what is today the AICPA, the numbers and influence of CPAs have grown dramatically. The period since 1887 might be called the ‘“‘Century of the Certified Public Accountant’ because it is this branch of the profession that has dominated accounting in the United States. So much so that many see public accountants and accountants as one and the same. This dominance is quite astonishing when one considers how long accounting has been in existence and that for most of those thousands of years it was performed by managerial accountants for managers. It is a reminder of how recent our industrial age is, with its myriads of investors, and the resultant need for auditors. This period could also be called the ‘‘Century of Financial Regulation,” because for the better part of 100 years the U.S. government has sought to control the flow of financial information. This is equally astonishing when one considers that for thousands of years accounting went completely unregulated. What makes it even more remarkable is that almost all the empirical evidence gathered by academics in the past 20 years indicates that regulation of financial markets is less necessary than regulation of the airline industry, the telephone industry, or the trucking industry, all of which have been deregulated in recent years! The chapter begins with the railroads and the first government regula- tory bodies. From there it moves into the 1930s, tracing the birth of generally accepted accounting principles and the rise of the Securities and Exchange Commission. English experience is used to highlight the pecu- liarities of the American experience in financial regulation. The drive to uniformity that characterized the postwar years and the reason for that drive in the search for comparability forms the next section. The chapter then leads into the origin, the subsequent history, and the shape of the FASB, which currently has the responsibility for determining GAAP. A short time line of the events covered in this chapter appears in Exhibit 3-1. The chapter concludes with a brief overview.60 Chapter 3 EXHIBIT 3-1 Century of the CPA 1830 Liverpool-Manchester railroad opens in Great Britain. 1844 Joint Stock Companies Act in Great Britain. 1886 First meeting of AAPA on De- cember 22. 1887 AAPA incorporated in New Formation of the ICC. York on August 20. 1890 Sherman Antitrust Act. 1906 Hepburn Act permitting ICC to establish uniform accounting tules. 1914 Clayton Antitrust Act. Outbreak of WW I. Creation of FTC. Opening of Panama Canal. Creation of FRB. 1916 AAPA becomes AIA. 1917 Uniform Accounting issued by FRB. 1919 End of WW I. 1926 NYSE requires unaudited annual reports, 1929 Stock market crash. 1933 NYSE requires audited annual Franklin Roosevelt becomes reports. President. Truth-in-Securities Act. Glass-Steagal Banking Act. 1934 Creation of SEC. 1936 CAP created by AIA. 1959 APB formed. 1965 Rule 203 issued. 1971 Failed attempt to reissue sub- stance of APB 2. 1973 APB replaced by FASB. ASR 150 released.The Century of the CPA 61 THE ORIGIN OF REGULATION Regulation in America began with the railroads. Invented in Great Brit- ain, the railway age began with the opening of the Liverpool and Man- chester line in 1830. The greatest development of railways came there in the 1840s, and by 1870 about three-fourths of the country’s mileage had been completed. In the United States, on the other hand, railroad con- struction had its greatest growth from 1878 to 1893, when the massive migrations of Americans across the continent led to a literal frenzy of railroad building.! Numerous disputes broke out as railroad barons expro- priated farmland for their lines. Also, during the early period of the rail- road industry in the United States it was not uncommon for promoters to pay huge dividends out of capital during the early life of a firm. Investors, believing that these dividends were indicative of the future income of the firm, paid high prices for the stock, only to find later that the huge divi- dends could not be continued without jeopardizing the future operations of the firm. When this became known, the market price of the stock would fall, creating huge losses for long-term investors who were the permanent stockholders. Interstate Commerce Commission Individual states attempted to protect their citizens against the activities of the railroad companies, but eventually in 1886, in the case of the Wabash, St. Louis, and Pacific Railroad Company versus Illinois, the Supreme Court held that commerce originating or ending beyond the boundaries of a state was beyond the power of that state to regulate. A year later, Congress established the first federal regulatory agency, the Interstate Commerce Commission (ICC), with specific authority to regu- late railroads.? The Hepburn Act of 1906 gave the ICC the authority to establish a uniform accounting system for use in establishing appropriate rail rates, thereby setting the stage for the century of regulation of ac- counting. In particular, that first charter to establish a ‘‘uniform’’ ac- counting system has haunted accounting ever since.? . Railroads were not the only sector of the economy to be experiencing growth and consolidation, causing great concern for many. John D. Rock- efeller and the Standard Oil Company led the way by creating a virtual monopoly in the oil business. Other monopolies followed in cottonseed oil (1884); linseed oil (1885); lead, whiskey, and sugar (1887); matches (1889); tobacco (1890); and rubber (1892). Household names like Armour and Swift controlled the beef industry, the Guggenheims the copper industry, the McCormicks the farm equipment business, and the Dukes the tobacco industry. A small handful of fabulously wealthy and often quite ruthless62 Chapter 3 men ran the country between them. Congress responded by passing the Sherman Antitrust Act in 1890. The Act proved relatively ineffectual as companies maneuvered around it, and as the Supreme Court found in favor of the monopolies in several key decisions. Creation of American Association of Public Accountants This was the world in which the early American accountants and their colleagues visiting from Britain found themselves. In October 1886, James T. Anyon arrived in New York from London to join the firm of Barrow, Wade, Guthrie & Company.* Edward Guthrie visited the firm in December 1886, and the two of them called a meeting of interested parties to set in motion an organization similar to the recently founded English Institute. (Chapter 2 tells of the founding of the English Institute.) Six or seven attended the first meeting on December 22, 1886. The following day the 10 then present voted to form the American Association of Public Accountants (AAPA), the forerunner to the AICPA. A year later on Au- gust 20, 1887, just six months after the founding of the ICC, the AAPA was incorporated in the state of New York with the eight Americans . signing the certificate; the two Britons were not permitted by state law to sign.4 From its inception, the new organization was determined to influence accounting standards. For instance, as early as 1894 the AAPA adopted a resolution recommending that the order of presentation in the balance sheet should be from the most to the least liquid—clearly indicating an emphasis on providing information for creditors. (British accounting, in- fluenced in its early years more by reporting to investors, reverses the order and continues to show owners’ equity in the top left corner and cash in the bottom right of a balance sheet.) A second example came in 1910 when a committee of the Association was appointed to formulate defini- tions of technical accounting terms in order to give uniformity to their meaning. The AAPA also attempted to make its influence felt in the area of income taxes. Federal Trade Commission Dissatisfaction with the inability of the government, despite the passage of the Sherman Antitrust Act, to control the growth of big business brought Woodrow Wilson to power in 1913 on the slogan of a ‘‘New Freedom’’ for the people. Within a year he had enacted the Clayton Antitrust Act. This Act greatly strengthened the government’s attack on * This was the first accounting firm in the United States.The Century of the CPA 63 monopolies, specifically outlawing interlocking directorates. That same year he created the Federal Trade Commission (FTC) to oversee the provisions of the Act. It had specific authority to investigate any practices that might lead to restraint of trade, and to issue ‘‘cease and desist”’ orders. Also, in 1914, the year that saw the start of World War I and the opening of the Panama Canal, the Federal Reserve Board (FRB) was formed, which, for the first time, created a publicly controlled central banking system in the country. Within three years the new regulatory bodies perceived a need for standardization in the preparation of financial statements submitted to bankers for credit purposes. The FTC took the lead by, as one writer put it, dropping a bomb on the fledgling accounting profession. It suggested that the FRB maintain a register of accountants considered acceptable to practice before the Board and the Commission. The specter of govern- ~ ment regulation of accountants caused an immediate flurry of activity, with the eventual outcome being the publication by the Federal Reserve Board in 1917 of a pamphlet entitled Uniform Accounting. The title was chosen in deference to the wishes of Edward N. Hurley, chairman of the FTC at the time. It was wholly inappropriate since the pamphlet said nothing about uniformity or about accounting; it was really an auditing document. The acquiescence of the AAPA in the unfortunate title left as a legacy ‘‘the belief held outside the profession that ‘uniformity’ was the solution to all accounting problems.’ The title was changed a year later to the more descriptive Approved Methods for the Preparation of Balance-Sheet Statements, but the damage had already been done. The significance of the 1917 document for students of accounting lies in its being the first formal statement of acceptable practice produced by American accountants, even though issued by an outside body.* It also marks the beginning of the curious relationship that the governing body of private accountants has had with government regulators ever since.® The pamphlet reappeared in 1929 under yet another title: Verification of Fi- nancial Statements. The 1929 revision was to serve as the official basis for audits of companies listed on the New York Stock Exchange from 1933 onward. . Regulation in Britain Regulation in Britain took a somewhat different path. As the last chapter pointed out, joint stock companies had risen and fallen with devastating effect in the 17th century. One result was the complete banning of such * The document was essentially the internal audit procedures manual in use at Price Waterhouse, written a few years previously by John C. Scobie (John L. Carey, The Rise of the Accounting Profession, vol. 1, New York: AICPA, 1969, p. 133.)4 Chapter 3 companies in the so-called Bubble Act of 1719. Early in the 19th century, the corporate form of organization was recognized as the most successful means of managing the new enterprises spawned by the Industrial Revo- lution. In 1825 the Bubble Act was repealed and corporations were per- mitted to once again obtain charters by direct negotiation with the Crown. Few businesses, though, sought incorporation by this means. Meanwhile, in 1811 back in the United States, an act was passed ena- bling manufacturing companies to incorporate simply by registration. The first modern statute permitting incorporation for any lawful business in the United States appeared in Connecticut in 1837. Once this new system of incorporation became available, the number of incorporations in- creased rapidly. Pressure was placed on the British legislature to make a similar scheme available. Their unfortunate experience with the South Sea Bubble led the British in the Joint Stock Companies Act of 1844 to permit incorporation by registration only if shareholders would accept unlimited liability. (General registration with limited liability was not in- troduced until the Act of 1855 and in the more complete Companies Act of 1862.*) As a further safeguard, the Act provided for the periodic balanc- ing of the accounts and the presentation of a ‘‘full and fair’’ balance sheet to stockholders. To ensure that such information was disclosed, the Act called for auditors, each of whom had to have at least one share in the company. These auditors were then permitted: to employ such accountants and other persons as they may think proper, at the expense of the company, and they shall either make a special report on the said accounts, or simply confirm the same; and such report or confirmation shall be read together with the report of the directors at the ordinary meeting.’ In other words, the auditors were not unlike a modern audit committee availing themselves of the services of a public accounting firm.t In short, as Littleton put it, ‘‘the audit was an instrument for the shareholders’ control over the discharge of the responsibilities which they had dele- gated.’’® The British Companies Act was not materially altered until 1908. Dur- ing this period, the general principle with regard to accounting matters was basically one of noninterference. In the Acts of 1900 and 1908, a trend was started toward the requirement of increasing amounts of specific and general financial disclosures in annual reports of corporations in the United Kingdom and in other countries influenced by the British laws. The 1929 Companies Act introduced sweeping changes, including a re- quirement that an income statement be disclosed. * Europe, with its medieval commendas, had known limited liability at least as far back as 1408 in Florence, + The term audit {= audio) derives from the practice centuries ago, before managers were literate, of accountants reading the accounts to them aloud.The Century of the CPA 65 The significant point to emerge from this brief survey of English experi- ence is that their history led to a policy of regulation by disclosure. This is very different from the policy of regulation by uniformity that has domi- nated American experience. The policy of disclosure was accompanied by an audit, which was lacking in the uniform approach of Americans. The audit requirement led to the earlier development of the accounting profession in Britain than in the United States. As a result, British ac- countants were a dominant influence in early American accounting.’ CHECKPOINTS 1. What is the ICC? the FTC? the FRB? When were they founded? 2. What was the South Sea Bubble? (Hint: Review Chapter 2.) 3. List three ways in which the original British auditors differ from today’s auditors. THE CRASH OF 1929 The crash of the New York stock market in 1929 left shock waves which continue to reverberate 60 years later. The decade leading up to 1929 was a good one—too good it would appear in retrospect. The ending of the Great War in 1919 released a pent-up demand for consumer goods, plants, and equipment, which fueled an investment boom. The rapid expansion of new industries such as radios, telephones, motion pictures, and, above all, the automobile added to the boom. Car production alone increased from 485,000 in 1913, through 1,934,000 in 1919, to 5,622,000 in 1929. Unofficial unemployment figures went as low as 3.3 percent. Prices were stable and even declined slightly. Labor productivity increased substan- tially. Investment on the New York Stock Exchange increased dramati- cally with average turnover rising fourfold from 1922 through 1929. These were some of the best years the American economy has ever had, Then in the space of two short months the boom collapsed and the Great Depression was ushered in. The first break in the stock market on September 5 was attributed to the dire predictions of Roger Babson, a respected financial advisor from Wellesley, Massachusetts. In the weeks that followed, government officials and so-called experts tried to allay the public’s fears—in vain because on Monday, October 21, and again on Black Thursday, October 24, the market, in record breaking levels of trading, dropped hundreds of millions of dollars in value. That Friday, Herbert Hoover solemnly announced that ‘‘the fundamental business of the country . . . is on a sound and prosperous basis.’’ The market re-66 Chapter 3 sponded on Tuesday, October 29, by plummeting almost perpendicularly. By the end of the day vast fortunes were wiped out, stockholders had lost $15 billion, more than one suicide was reputed to have occurred, and a great economy lay in ruins.!° The Great Depression was ushered in with all its concomitant misery and deprivation that statistics simply cannot fully capture. Private invest- ment dropped 90 percent. Production fell 56 percent. Arthur Andersen & Co. reported a drop of over one third in its fees between 1929 and 1932.!! ” As one business after another closed its doors, millions found themselves out of work, pushing unemployment figures to over 24 percent. Tax col- lections declined to the point where even school teachers and city em- ployees could not be paid." Soup lines lengthened across the country. More than 9,000 banks shut their doors in this period until by March 9, 1933 all the banks in the country were closed." To this day, the causes of the crash (and its effects) remain controver- sial. At the time, business was severely criticized for its perceived role. Accountants did not escape from this criticism unscathed. Adolph Berle, a Columbia University law professor and Gardiner Means, an economist, wrote an extraordinarily influential book that laid out the consequences, as they saw them, of industrial power and wealth being concentrated in the hands of a very few. They attributed this concentration of power, at least in part, to the lack of uniformity in accounting practices and claimed that: ‘‘So long as accounting standards are not hardened and the law does not impose any specific canons, directors and their accountants may frame their figures, within limits, much as they choose.’’ They laid the blame in this regard on ‘‘the fact that accountants themselves have as yet failed to work out a series of standard rules.’’'4 Auditor's Reports Required The New York Stock Exchange (NYSE) was among the first to react to the crash. In a speech before the convention of the American Institute of Accountants in September 1930, J. M. B. Hoxsey, executive assistant of the Committee on Stock List of the NYSE, severely criticized the lack of uniformity in accounting practice.* He was especially critical of practice in the areas of depreciation and consolidation, where no rules existed at the time. He complained that companies were not even disclosing which methods they were using. He pointed out that many companies still refused to release their revenue numbers on grounds that it would give advantage to competitors. In addition, he accused firms of being ultracon- servative in undervaluing their inventory and in taking excessive depreci- * The AAPA became the AIA in 1916.The New Deal “~~ The Century of the CPA 67 ation charges. (This was justified by firms as a necessary part of reporting to creditors.) He ended his speech with a plea for the provision of ade- quate, understandable information for stockholders, arguing that this in- formation should avoid misleading the stockholders and should aid them in determining the true value of their investments.!> The implicit criticism of accountants was a little unfair because several years earlier the AIA (the predecessor of the AICPA) had attempted fruitlessly to draw the NYSE into conversation. Also, the NYSE itself had been relatively lax in its listing requirements. Although it was orga- nized as early as 1792 to facilitate the exchange of corporate securities and governmental bonds, it did not attempt to obtain financial statements from listed companies until about 1866.'° That met with little success until, in 1900, it requested that all companies applying for listing on the Exchange agree to publish annual reports of their financial condition and Operating results. This agreement was expanded in 1926 to require all listed companies to publish and submit to stockholders an annual financial report prior to the annual meeting. These statements were not required to be audited, however. The AIA responded immediately to Hoxsey’s speech by creating a Special Committee on Cooperation with Stock Exchanges under the chairmanship of George O. May, chairman of the AIA. One immediate result was a requirement by the NYSE that after July 1, 1933, 89 years after a similar provision in Britain, all companies seeking listing with the NYSE would have to furnish financial statements bearing the certificate of accountants ‘‘qualified under the laws of some state or country.’’!” These audits were required to comply with the Federal Reserve Board’s Verification of Financial Statements published in 1929 and to provide an opinion on fairness, consistency, and, for the first time, conformity with ‘accepted accounting practices.” Despite the manifest response of accountants and the NYSE, many felt that business leaders were not doing enough. This was not completely untrue—many believed that the country had simply moved into the down phase of a temporary business cycle. On July 2, 1932, Franklin Delano Roosevelt, the Democratic nominee for president, went to Chicago to make his acceptance speech and pledged himself ‘‘to a new deal for the American people.’’ Herbert Hoover, a probusiness Republican, was swept from office. On March 4, 1933, in an inaugural speech delivered in drenching gusts of rain outside the east wing of the Capitol, the new president began his inaugural speech by asserting his ‘‘firm belief that the only thing we have to fear is fear itself.’’ After laying the blame for the Depression squarely at the feet of business, whom he described, using68 Chapter 3 powerful biblical imagery, as ‘“‘unscrupulous moneychangers desecrating the temple of America,’’ he demanded that the time had come to “‘restore that temple to the ancient truths,’’ claiming that the ‘‘measure of the restoration (would lie) in the extent to which we apply social values more noble than mere monetary profit,’”'® With that, Roosevelt’s famous first 100 days in office began. The Emer- gency Banking Act, enabling the banks to reopen, was passed first on March 9 after just four hours of discussion by Congress. The Truth-in- Securities Act of 1933, requiring the registration of securities offered for public sale and containing provisions against false representations and other fraudulent activities, followed on May 26. The Glass-Steagal Bank- ing Act, creating the Federal Deposit Insurance Corporation (FDIC) and authorizing the 100 percent insurance of bank deposits under $10,000, came on June 16. In three short months then, the financial world of laissez-faire had been transformed into one of intense regulation.'!9 The vast and swift political changes that were sweeping the country caught the accounting profession, which had no strategy for dealing with the proposed legislation, off guard. The situation was further complicated by the existence of two major organizations representing public accoun- tants, the Institute and the Society, and by the lack of leadership from the organization representing management accountants. (The story of these two organizations is told in Chapter 2.) Adding to concerns was the fear that accountants would be exposed to hostile cross examination because many perceived them to be responsible for the crash. As a result, the Institute did not appear at any of the hearings. One outcome was that the first draft of the Truth-in-Securities Act made no mention of auditors at all and later discussions seemed to suggest that government auditors would be appointed. Fortunately, Colonel Arthur H. Carter, senior partner of Haskins and Sells and president of the New York Society of Certified Public Accountants, saved the day for the profession by appearing before a Senate committee and persuading them that audits performed by private accountants were essential for the proper functioning of the Act.7° The Securities and Exchange Commission On June 26, 1934, the Securities and Exchange Commission (SEC) was created by an act of Congress which set up this independent regulatory agency of the U.S. government to administer the Truth-in-Securities Act of 1933, the Securities Exchange Act of 1934, and several other acts. (The 1933 Act was originally administered by the Federal Trade Commission.) The 1934 Act provides for the registration of securities with the SEC before they may be sold to the public (with certain exemptions). The Act provides for the disclosure of specific financial and other information by means of a registration statement and a prospectus, both of which areThe Century of the CPA 69 available for inspection by the public. In addition, the information avail- able to the public must be kept up to date by periodic financial statements and other information filed by the company. Many of these requirements are found in Regulation S-X. Should the financial statements contain a qualification, the SEC will issue a deficiency notice which will ultimately lead, if unresolved, to the delisting of the company’s stock and the sus- pension of trading in that stock.?! The Commission has broad powers to prescribe accounting procedures and the form of accounting statements used in filings. From 1936 to 1938, the Commission engaged in heated controversy regarding whether or not the Commission itself should promulgate a set of accounting principles to be followed by all firms in their filings. Due in large part to the persuasive- ness of the chief accountant of the SEC, Carmen Blough, and over the dissent of then SEC commissioner and later Supreme Court Justice Wil- liam O. Douglas, the Commission decided in 1938 to permit the profession to lead the way in the formulation of accounting principles. This policy was issued in the form of Accounting Series Release No. 4 (ASR 4), which stated that the Commission would accept only financial statements pre- pared in accordance with accounting principles which have ‘‘substantial authoritative support’’ or in accordance with rules, regulations, or other official pronouncements of the Commission or the chief accountant. This action established the policy of relying on generally accepted principles and practices as developed in the private sector by the accounting profes- sion. Committee on Accounting Procedure This relationship between the accounting profession and government reg- ulators, which has been a peculiar feature of American accounting, began with the Committee on Accounting Procedure (CAP), founded in 1936 by the AJA. Little was done until 1938 when, in a series of speeches, Carmen Blough threatened that the SEC would prescribe accounting principles if the profession did not respond more swiftly. The AIA responded by ex- panding the committee’s membership from 7 to 21 and by authorizing it to issue pronouncements on matters of accounting principle and proce- dure. The CAP continued to meet until 1959 and issued 51 bulletins. Eight were subsequently consolidated into Accounting Terminology Bulletin No. I, ‘‘Review and Resume’’; 31 were consolidated into Accounting Research Bulletin No. 43. None bore any particular relationship to the other; some were even inconsistent with one another, reflecting the piecemeal approach of the Committee. One should not be too critical, though, because the Committee did magnificent work in ridding account- ing of the worst excesses that characterized financial reporting in the 1920s.70° ~~ Chapter 3 CHECKPOINTS 1. What was the CAP? When was it founded? What were its official pronouncements known as? 2. Name at least one pronouncement of the CAP that is still in effect. 3. What is the SEC? When were the securities acts that created it passed? THE POST-WAR BOOM The end of World War II in 1945 released a pent-up demand for goods and services by consumers that caused the economy to surge ahead. Jobs boomed and wealth grew. This was the era of bobby-socks and poodle skirts; of Middle America moving out to the suburbs; of ‘‘Father Knows Best”’ on television; and of the Big Band sound with Benny Goodman, Frank Sinatra, and Bing Crosby. Universities prospered as servicemen and -women were able to return to school under the G.J. Bill of Rights. The newly found prosperity of middie-class America persuaded many people to invest in the stock market. In 1940 there were an estimated 4 million stockholders; by 1962 that number had risen to 17 million. Provid- ing these shareholders with appropriate information for their investment decisions was perceived to be a matter of national importance. The stan- dard investment advice given to investors at the time as to how to deter- mine the appropriate stock price of a company was that they should multiply the company’s earnings by a price-earnings ratio (PE ratio). The company’s earnings number is a key part of the PE approach to investment because this is the base which is multiplied to arrive at an estimate of the share price. Accounting was seen, therefore, as vitally important. Investors naturally enough expected that higher earnings per share would indicate a better company. Instead, as they were to discover, differences in earnings often meant no more than a different way of ac- counting for an event. Stated otherwise, differences in accounting earn- ings were discovered to be as much a matter of definition as of economic substance. | Accounting Alternatives One problem was that numerous reporting alternatives were open to man- agement at the time. For instance, in 1963, in response to a request from Congress, the SEC was obliged to list areas that could lead to material differences. The long list they drew up is shown in Exhibit 3-2.’ The Century of the CPA 1 EXHIBIT 3-2 Accounting Alternatives 1. Valuation of inventories (FIFO versus LIFO, still an option today), . Depreciation and depletion (tax versus book, ‘‘useful lives,’’ a major op- tion today). . Income tax allocation (later partially resolved by APB 1] and SFAS 96). . Pensions (later partially resolved by APB 8 and SFAS 87). . Research and development costs (later resolved by SFAS 2). . Goodwill (later resolved by APB 17). . Time of realizing income (still largely unresolved). . All-inclusive versus an operating concept of income statement (still a major issue today as a result of SFAS 52). 9. Intercorporate investments (still a question today). 10. Long-term leases (resolved by SFAS 13). 11. Principles of consolidation (largely resolved by SFAS 94). 12. Business combinations (largely resolved by APB 16 and 17), 13. Income measurement in finance companies (resolved by APB /3). 14. Intangible costs in the oii and gas industries (still an issue today).2* N WIAA RW Price Level Adjustments The relatively serious burst of inflation that accompanied the boom also seriously affected comparability and lead to a debate on ‘‘price-level de- preciation.”’ Later chapters pick up the details of this debate. In outline, the concern was that with rising prices regular depreciation was not suffi- cient to cover the replacement cost of plant and equipment. The sum of the annual depreciation charges equals the original cost of the asset. In periods of price stability, the replacement cost equals the original cost; in periods of inflation the replacement cost is greater. A grant from the Rockefeller Foundation funded a five-year study of the problem.?? Pub- lished in 1952, the report recommended that financial statements be ad- justed for changes in the general price level. That doughty fighter, George Q. May, by now retired, led the argument in favor of adjusting deprecia- tion to ‘‘current dollars,’’ but the SEC and public opinion were not in favor of the change so it was duly tabled to be picked up again by the FASB and the SEC 20 years later. Earning Power Debate To add to the confusion of investors, a vigorous debate was raging on the appropriate definition of earnings. The AIA argued that the real measure of interest to stockholders was the expected ‘‘earning power”’ of the firm, defined as the firm’s ordinary income, excluding extraordinary gains and72 Chapter 3 losses, determined consistently from year to year and uniformly across firms. This was also termed the ‘‘current operating income’’ of the com- pany. The concept of current operating income is not unreasonable; how- ever, the dilemma is that management has been tempted on numerous occasions to call all gains ordinary and all losses extraordinary in an attempt to puff up the potential earning power of the company. Such practices led the SEC and the AAA to call for an ‘‘all-inclusive’’ measure of income, that is, income including all gains and losses, thus preventing management from manipulating the earnings per share number. Calls for Comparability As aresult of these debates on the most appropriate definition of income, the call went out for uniformity in accounting: the same call that the FTC had made to accountants in 1917. Powerful voices were to press the argument. One of the most powerful was Leonard Spacek, senior partner of Arthur Andersen, who launched a campaign for ‘‘comparability.’’ In speech after speech, he denounced the profession, arguing that: Comparisons between two companies in the same industry, and to a greater extent between two companies in different industries and between entire indus- tries, are so arbitrary as to be not only worthless, but dangerous.”4 He attributed this lack of comparability to the inability of the Committee on Accounting Procedure to withstand the pressures of industry. In Au- gust 1957, in a speech before the annual convention of the American Accounting Association, he called for the creation of an Accounting Court of Appeals where arguments could be heard, decisions rationally made, and the plethora of reporting alternatives limited. Gradually, he felt, case law would create the conceptual framework for accounting that was sorely needed. In 1957 the AAA added its voice to the pressure for comparability, although not necessarily for uniformity, by issuing its third revision of Tentative Principles, now called Accounting and Reporting Standards. It noted that: Because the effective use of financial statements involves interperiod and inter- company comparisons, comparability of data over time and among companies is important. The principal barriers to such comparability are distortions result- ing from price fluctuations and variations in accounting methods.”6 However, it added: Uniformity of accounting method is neither expected nor necessarily desirable, but reasonable comparability of reported data is essential. . . . When alterna- tive practices in common use give materially different results, the practiceThe Century of the CPA 73 adopted should be stated and the data required to achieve reasonable compara- bility should be supplied.?” This paragraph was added possibly because of the criticism the 1936 edition received for its apparent support of uniformity.® Formation of the Accounting Principles Board In October 1957, Alvin R. Jennings, the president of the AICPA, re- sponded to these calls for comparability by proposing a new organization to examine basic accounting assumptions, identify ‘‘best’’ principles, and devise new methods to guide industry and the accounting profession.”° As a result of Jennings’ speech, a Special Committee on Research Programs was appointed in December 1957. Its report of December 1958 recom- mended replacing the Committee on Accounting Procedure with an Ac- counting Principles Board (APB) and an Accounting Research Division (ARD), both of which were formed in 1959. The objectives of the APB were to advance the written expression of generally accepted accounting principles, narrow the areas of difference in appropriate practice, and lead in discussions of unsettled and contro- versial issues. Its official pronouncements were intended to be based primarily on the extensive studies of the Accounting Research Division; its conclusions were to be supported by reasoning; and its opinions were to include minority dissents by members of the Board. The Board was to be composed of 18 to 21 members, selected primarily from the accounting profession but also including representatives of industry, the academic community, and the government (all members of the Institute, however). This last requirement raised the question of whether financial reporting standards should be set by accountants or by users and, if by accountants, whether management accountants should be allowed to participate. The Turbulent Sixties Events were to outrun the profession. The relative calm of the 50s was replaced by the turbulence of the 60s with flower children, Elvis Presley, the Beatles, and, dominating everything, the war in Vietnam. John F. Kennedy became the 35th president of the United States in 1960. The economy was struggling, so, to stimulate investment in new factories and machinery, his administration enacted an Investment Tax Credit. Put very simply, when businesses purchased qualifying assets, they were entitled to a reduction in their taxes equal to a percentage of the cost of the new assets. Arguments raged furiously on how one should account for74 Chapter 3 this. Some said that the tax rebate should be shown as a straight reduction in income tax expense. This ‘‘flow-through’’ method gave an immediate boost to reported net income. Others said that, in effect, the tax credit had lowered the cost of the new asset, the benefits of which would be felt over the life of the asset. Accordingly a ‘‘deferred’’ method should be used in which the benefits of the tax credit were taken over the life of the asset. In December 1962 the APB, in only its second opinion and by the narrowest of voting margins, ruled in favor of the deferred method. The argument was bitter and long. APB Opinion No. 2 (APB 2), which was issued with a considerable minority dissent, was not well received by professional accountants. Several Big Eight accounting firms announced that they would not abide by the Board’s decision. The SEC added fuel to the fire by issuing ASR 96 in which it announced that it would accept both the deferral method and the flow-through method. The resulting confu- sion forced the APB to reconsider its position and release an amendment (APB 4) permitting several alternatives, including the immediate reduc- tion of income tax expense. The loss of face for the new organization was devastating and resulted in much soul searching. In the belief that the theoretically correct method should rule, the APB made a second attempt in 1971 to mandate the deferral method in the context of APB /1, ‘‘ Accounting for Income Taxes.’’ Opposition from the Internal Revenue Service and others resulted in a clause in the Revenue Act of 1971 specifically providing ‘‘that no taxpayer shall be required to use any particular method of accounting for the credit for purposes of financial reports subject to the jurisdiction of any federal agency or re- ports made to the federal agency.’’*° This statement caused the APB to withdraw its recommendation prior to the final draft in order to restudy the case, pointing out the difficulty in resolving conflict in accounting arising from diverse objectives and diverse origins of concepts accepted as valid accounting theory. Authoritative Opinions The Opinions of the Accounting Principles Board and effective Account- ing Research Bulletins of the former Committee on Accounting Proce- dure, up to this point, were enforced primarily through the prestige of the Institute. This situation was changed by the investment tax credit contro- versy. To avoid similar cases in future, where firms simply refused to abide by AICPA rulings, the Council of the Institute adopted recommen- dations that after 1965 all departures from APB Opinions and effective Accounting Research Bulletins should be disclosed in footnotes to finan- cial statements or in audit reports of members. That is, all Opinions of the APB were considered to constitute substantial authoritative support for generally accepted accounting principles—thus for the first time addingThe Century of the CPA 15 EXHIBIT 3-3 Rule 203 A member [of the AICPA] shall not express an opinion that financial state- ments are presented in conformity with generally accepted accounting princi- ples if such statements contain any departure from an accounting principle promulgated by the body designated by Council to establish such principles [currently the FASB] which has a material effect on the statements taken as a whole, unless the member can demonstrate that due to unusual circumstances the financial statements would otherwise have been misleading. In such cases his report must describe the departure, the approximate effects thereof, if prac- ticable, and the reasons why compliance with the principle would result in a misleading statement. substance to ASR 4, dating back to 1938. Rule 203, with the replacement of the APB by the FASB, is still in force today. (See Exhibit 3-3.) While the Institute recognizes that there might be other sources of authoritative support, the decision in these cases rests with the reporting member. If individual accountants decide that the principle or procedure does not have substantial authoritative support, they are required to han- dle the situation in accordance with the Code of Professional Ethics of the Institute. If they decide that it does have support outside official pro- nouncements, they are required to disclose such departure if material. A failure to disclose is considered to be substandard reporting and is re- ferred to the Practice Review Committee of the Institute. The activities of this committee are concerned with educating the reporting members and encouraging them to comply with the above recommendations. The com- mittee also publishes bulletins periodically to encourage self-discipline among Institute members through education. CHECKPOINTS 1. What was the APB? When was it founded? What were its official pronouncements known as? 2. What is Rule 203 and what is its effect? 3. List three pronouncements of the APB that are still in effect. THE MODERN ERA The APB came under almost continuous attack during most of its life for its inability to fulfill its mission to narrow the areas of difference and inconsistency in accounting practice and advance financial reporting in76 Chapter 3 new problem areas. Much of the initial attack came from the accounting profession itself, as typified by Spacek’s comments.*! The writings of ‘“‘Abe’’ Briloff, Professor of Accounting at Baruch College, during this period also had a considerable impact in bringing the abuses of financial reporting in these areas to the attention of the financial community.*? But pressures also came from the SEC and other government agencies. Many predicted that if the APB did not accelerate its progress in establishing accounting principles, the SEC would take the initiative in doing so.33 Formation of the Financial Accounting Standards Board Both the AICPA and the AAA proposed studies on the most effective organization structure for establishing accounting principles. They also wanted to determine the basic objectives of financial accounting, which they hoped would serve as a guide in the establishment of principles. In December 1970, the president of the Institute called a special conference to discuss the establishment of accounting principles. This special confer- ence, consisting of representatives from 21 accounting firms, proposed that two studies be sponsored by the Institute. One study would explore the means by which accounting principles should be established. The other study would review the objectives of financial statements.* Follow- ing the approval of these proposals by the board of directors of the Institute, a seven-man group under the chairmanship of Francis M. Wheat, a one-time SEC commissioner, was appointed in March 1971 to study the establishment of accounting standards. The report of the Wheat Study Group was submitted to the AICPA in March 1972 and adopted by the AICPA Council in June.*4 Its recommen- dations led in 1973 to the demise of the Accounting Principles Board and to the establishment on July 1 of the Financial Accounting Foundation (FAF), separate from all other professional bodies, the Financial Ac- counting Standards Board (FASB), and the Financial Accounting Stan- dards Advisory Council (FASAC). The relationship between these three groups is diagrammed in Exhibit 3-4. Structure and Function The principal duties of the Foundation, which meets quarterly, are to appoint the members of the FASB and FASAC and to raise the funds for their operations. It is also responsible for appointing the members of the * The Accounting Objectives Study is discussed in Chapter 5S.The Century of the CPA 77 Government Accounting Standards Board. Thirteen of the trustees of the Foundation represent a variety of interested organizations: American Accounting Association 1 trustee American Institute of CPAs 4 trustees Financial Analysts Federation 1 trustee Financial Executives Institute 2 trustees National Association of Accountants 1 trustee Securities Industry Association 1 trustee Various governmental accounting groups 3 trustees EXHIBIT 3-4 The Structure of the Board’s Constituency Relationships The Constituency The Sponsoring Organizations The Foundation Nominations from the sponsors The Trustees Explain and seek views Appoint and fund Explain and seek views The FASB The Council Discuss and express views Source: The Structure of Establishing Financial Accounting Standards. Report of the Structure Commit- tee, Financial Accounting Foundation, April 1977, p. 48.78 Chapter 3 Two are appointed by the trustees themselves, and the sixteenth is the senior elected official of the AICPA. The Financial Accounting Standards Board itself consists of seven full- time members with a background mix that includes ‘‘major experience in public accounting, in business or industry, as a user of financial informa- tion, and as an accounting educator.’’* Its stated mission is to ‘‘establish and improve standards of financial accounting and reporting for the guid- ance and education of the public including issuers, auditors, and users of financial information.’’> The Financial Accounting Standards Advisory Council has a minimum of 20 members. The Council assists the Standards Board by maintaining contact with business and the accounting profes- sion, by suggesting new issues, by pressing or delaying old issues, and by acting as a sounding board on tentative positions taken by the Board. The Board also draws on the services of a full-time, closely associated re- search staff. An Independent Body Several significant things had to occur to permit the transition from the APB to the FASB. First, the AICPA had to relinquish its primary role, begun with the Committee on Accounting Procedure, in the setting of accounting standards. The AICPA has not relinquished its role com- pletely, though. The year prior to the formation of the FASB, it estab- lished the 15-member Accounting Standards Executive Committee (AcSEC) with authority to issue industry audit guides, accounting guides, and statements of position (SOPs). According to Dennis Beresford, cur- rently the chairman of the FASB, the role of AcSEC is ‘‘to offer guidance in areas too narrow for the FASB’s attention or when a Board pronounce- ment will not be sufficiently timely to solve immediate problems.’’?’ The FASB has subsequently converted several of these guides and SOPs into statements: examples include SFAS 63, ‘‘Financial Reporting by Broad- casters,’’ and SFAS 66, ‘‘Accounting for Sales of Real Estate.”’ In SFAS 32 and again in SFAS 83, the Board also endorsed AcSEC pronounce- ments as “‘preferable accounting principles’’ for the purpose of justifying an accounting change under APB 20. “Substantial Authority” Redefined Second, the new institutional structure had to be given some authority. This movement was initiated by the FASB’s Rules of Procedure which gave the APB’s opinions, to the extent that they had not been superseded or amended, the force of an FASB statement. The AICPA then amended Rule 203 to give FASB pronouncements official recognition by Certified Public Accountants.*8 The state Boards of Public Accountancy providedDue Process The Century of the CPA 719 another source of authority for the FASB through their licences to ac- countants to practice in their states. Each enforces compliance with GAAP as set by the FASB through its ethics regulations. State regulation .of the profession is also the means by which companies which are not SEC registrants are forced into compliance with GAAP. The Securities and Exchange Commission added their recognition through the following endorsement of the FASB which appeared in Accounting Series Release No. 150 issued in December 1973: the Commission intends to continue its policy of looking to the private sector for leadership and improving accounting principles and standards. . . . [Con- sequently,] principles, standards and practices promulgated by the FASB in its Statements and Interpretations will be considered by the Commission as having substantial authoritative support, and those contrary to such FASB promulga- tions will be considered to have no such support. The SEC did add that it will ‘‘continue to identify areas where investor information needs exist and will determine the appropriate methods of disclosure to meet these needs,”’ so the SEC did have some reservations in its endorsement of the FASB. At least government regulation in the United States has not placed rigid controls on the presentation of general financial statements or on the variety of accounting procedures in use. Rigid controls would have stifled the development of accounting theory, and the progress in accounting practice stemming from new ideas in theory. A third change was the introduction of a very deliberate process for arriving at a new standard. The process is outlined in Exhibit 3-5. The process, in brief, begins with the selection of an item for review. This is possibly the most important step of the process and is a long and a EXHIBIT 3-5 Steps in the FASB’s Due Process Preliminary evaluation Admission to agenda Early deliberations (discussion memorandum) Tentative resolution (exposure draft) Further deliberations (hearings) Final resolution (standard)80 Chapter 3 arduous task that involves many different organizations. At least four selection criteria are used: 1. The pervasiveness of the problem, i.e., the extent of the diversity of practice, the number of persons and interest groups affected, and whether the problem is likely to persist or is transitory. 2. The availability of possible solutions and the probability that one of them will materially improve financial reporting. 3. Technical feasibility, i.e., the availability of possible solutions and the state of other Board prospects that could have a bearing on the problem in question. 4. Practical considerations such as the political acceptability of an improved solution to a problem and possible reactions from the SEC or Congress.° An item, once selected, is made the subject of a task force. Often a discussion memorandum will result from the early deliberations and be sent to interested parties across the country for comments. The subse- quent reaction is folded into an exposure draft which will again be circu- lated for comment. Finally, a statement will emerge. Single copies of all these documents are available on request at no cost from the FASB’s Publication Office. Subscriptions to these documents are maintained by most accounting libraries. Articulate, well-reasoned responses are wel- comed by the Board. The discussion memoranda are of particular interest for students of accounting because they usually lay out the pros and cons of each issue in full. Emerging Issues Task Force Given the length of the process, the FASB deemed it necessary to estab- lish a group to attempt to resolve pressing issues rapidly. Accordingly, it created a 16-person permanent Emerging Issues Task Force (EITF) whose chairman is the FASB’s Director of Research and Technical Activ- ities. Most of its members are high-level technical experts drawn from accounting firms. Significantly, the SEC’s chief accountant is in attend- ance at each meeting. If a consensus can be reached, the solution is deemed to have authoritative support. If consensus cannot be reached and the problem is considered to fulfill the FASB’s other criteria, the issues will be placed on the Board’s agenda for later resolution. The EITF’s conclusions appear regularly in the Journal of Accountancy; a subscription to their decisions is also available from the FASB. Government Accounting Standards Board A Government Accounting Standards Board (GASB) was established in 1984 to parallel the FASB and, like it, to report to the Financial Account- ing Foundation. The GASB has five members, of whom two serve full-Ongoing Dissent The Century of the CPA 81 time and three serve part-time. These board members are appointed to five-year terms by the FAF acting in consultation with the Governmental Accounting Standards Advisory Council (GASAC) which, in turn, paral- lels the FASAC. From the start, sensitive issues of jurisdiction arose. The initial agreement was that the GASB would rule on issues affecting state and local governments, while all other institutions would remain the re- sponsibility of the FASB. Standards set by the prior organization, the National Council on Governmental Accounting (NCGA), would be bind- ing in the absence of a ruling by the GASB. Where neither the GASB nor the NCGA had ruled, the rules of the FASB would hold. In words that now appear prescient, Wharton professor David Solomons wrote: It is conceivable that at some time in the future a municipal transportation and a private transportation system, a state university and a private university, may find themselves having to follow divergent accounting standards. It is to be hoped that the two boards, working in close proximity to each other as they do, will be able to avoid such an undesirable state of affairs. During 1989, as a result of a five-year review, the FAF recommended that the FASB should become, in effect, the senior standard-setting body. A threat by governmentally owned entities to establish a separate standard- setting body led to a brief, but tense, standoff until the recommendation was abandoned. One of the difficulties with the APB was that it was composed only of members of the AICPA (including industry and academic members) and was appointed and financed by the Institute. The hope in creating the FASB was that a change to a semi-independent organization with a broader base of support and full-time members would overcome some of these difficulties, but many problems persist. In fact, despite both the efforts to broaden the participants and the institution of elaborate mecha- nisms to ensure full due process with each issue, controversies continue. Many of the controversies regarding accounting policy relate to a basic philosophy of the Board that reported earnings should highlight differ- ences in risk rather than obscure them through allocations or averaging, and that similar situations should be reported in similar ways. Industry has frequently opposed this policy and lobbied against exposure drafts and statements in oral and written presentations to the Board and to Congress and federal agencies in a number of cases. The adverse conse- quences perceived by corporate executives include anticipated increases in the cost of capital resulting from a greater fluctuation in reported earn- ings. As a result of this opposition, the FASB has changed its position on several exposure drafts and reversed itself on a few Statements.*!82 Chapter 3 More recently, criticism has focused on the volume of standard setting. While the formation of the FASB was particularly significant, because it moved the locus of standard setting from the hands of the profession more closely into the hands of the user community, it has not seemed to slow the production of regulations. The CAP produced 51 bulletins; the APB issued 31 opinions; by contrast the FASB has issued over 100 statements. Rising complaints from the business community about the sheer quantity of new rules, sometimes described as ‘‘accounting indigestion’’ and “‘standards overload’’ have led the FASB to strengthen the role of the FAF in determining the FASB’s agenda. Whether this will satisfy the critics, only time will tell. Broader issues have also impinged on the Board’s activities. For in- stance, a major controversy exploded on the scene in the last years of the Nixon era. During the Watergate investigations in 1973, it was discovered that 17 major companies, including names like Gulf Oil, Lockheed, and Northrop, had made illegal political.contributions. The SEC began an investigation to discover whether financial reporting provisions had been broken in the process. Tension heightened when the chairman of United Brands leaped to his death from the 44th floor of the Pan Am building rather than face disgrace. Congressman John E. Moss, chairman of the House committee with oversight responsibilities over the SEC, began an investigation into the effectiveness of the SEC itself. The sole witness heard by the committee was a long-time critic of accounting, Professor Briloff, who recommended, among other things, that the SEC set ac- counting standards in future. Not surprisingly, the Moss report con- demned the profession, and in particular the FASB, claiming that it had ‘‘accomplished virtually nothing toward resolving fundamental problems plaguing the profession. These include the plethora of optional ‘generally accepted’ accounting principles. . . ..’ They concluded that ‘‘to the maximum extent practicable, the SEC should prescribe by rule a frame- work of uniform accounting principles. . . .”’ History appeared about to repeat itself. In December 1976, after a year of investigation, a Senate committee under the chairmanship of Senator Lee Metcalf issued a staff report enti- tled The Accounting Establishment which was even more critical of the profession, if that were possible. They claimed that ‘‘the Financial Ac- counting Foundation (FAF) is the non-profit corporation organized by the AICPA and co-sponsored by. . . other private interest groups to operate the Financial Accounting Standards Board (FASB), which sets account- ing standards. . . . None of these private interest groups is suited to control the setting of accounting standards which affect the Federal Gov- ernment and the public.’’ Their recommendation was that Congress itself, not the SEC which they felt was too closely aligned with the accounting profession, establish accounting objectives which would lead to ‘‘uniform and meaningful accounting standards.’’ (emphasis added)CONCLUSION The Century of the CPA 83 The AICPA, understandably afraid that accounting would be swept from the private sector, reacted swiftly. In September 1977 it separated its membership into two groups: the SEC Practice Section and the Private Companies Practice Section. The Institute also established a Public Over- sight Board (POB) to exercise oversight of the SEC Practice Section and, simultaneously, instituted peer reviews. Whether this would have satis- fied the two leading critics of accounting was never put to the test. Con- gressman Moss did not return to Congress and Senator Metcalf died in 1978. The Foreign Corrupt Practices Act was passed in December 1977, outlawing bribery of foreign officials and mandating internal financial con- trols, but with that the interest of Congress appeared to wane. However, memory of how swiftly the private sector can lose its financial responsibil- ities remains. CHECKPOINTS 1. How many members does the FASB have? When was it founded? What are its official pronouncements known as? 2. What is the GASB? What is its role? What is the EITF? What is its role? 4. Briefly describe the role of the FAF and its relationship to the FASB. w What might one conclude, then, from this recounting of the first century of the AICPA and the regulation of financial reporting which has accom- panied it? It is probably fair to say that it has been a dramatic history. When the period began, industrial capitalism was in its infancy. Powerful trusts strode like colossi across the economic scene. Little financial infor- mation was provided the general public; there was little expectation that the titans of industry would supply details about their fiefdoms. Yet, less than a century later, a ‘‘people’s capitalism’’ was to arise in which ordi- nary folk would be encouraged to invest in corporations by the provision of relatively copious financial information. That this transformation oc- curred is partly due to the extraordinarily skillful and dedicated leadership of members of the accounting profession. To name one or even a few would be to slight a legion. It is also a curious history, though, in which leaders of the profession, politically averse to government regulation and believers in the virtues of private enterprise, found themselves drawn into widespread and perva- sive self-regulation in order to avoid what they perceived to be the greater4 Chapter 3 evil of external regulation. The process continues to this day. The result- ing institutional relationship in which the AICPA and the FASB effec- tively do the bidding of the government and, by so doing, draw off criti- cism which would otherwise flow to the SEC, is so familiar as to have lost its shock value. Itis a history in which standards have tended to be set reactively rather than proactively. From the outset, accountants have found themselves having to respond to threats of more regulation and increasing uniformity. Seldom have they had the luxury of being able to take the lead. In particu- lar, events have driven accounting away from May’s original concept of regulation by disclosure to regulation by uniformity. There are no signs that the pressure for uniformity will abate. On the contrary, companies in other countries, more hedged by government regulation, have never en- joyed this flexibility. It would appear, therefore, that as the globe con- tinues to shrink and accounting standards tend to draw closer to one another, the drive to uniformity might increase rather than decrease. Whether the end result will really be more information for shareholders or simply a more convenient system for bureaucratic enforcement of ac- counting rules remains to be seen. SUMMARY This chapter picks up the story of accounting approximately where the last chapter left off. Its primary focus is on the growth and development of the institutions that are responsible for accounting’s regulation: the AICPA (1887), the SEC (1934), the CAP (1936), the APB (1959), and the FASB (1972). It traces the origin of regulation back to the monopolies that were spawned in the late 1800s. Government regulation in that era pro- duced a system of uniform accounting which was originally rejected by public accountants but reluctantly accepted in the 50s and 60s under pressure from the public and the SEC. The chapter notes that the period since 1887, when the AICPA was founded, has been a momentous one for accounting and accountants. The year the AICPA was formed was also the year that financial regulation began in the railroad sector under the ICC. That regulation was extended to other sectors of the economy in 1914 with the establishment of the FTC, which was intended to control and prevent the abuses of monopoly power. The stock market crash in 1929 led to the creation of the SEC in 1934 to oversee financial reporting. The SEC gave authority to set stan- dards to the private sector in 1938: Subsequently the CAP (1933-59), the APB (1959-72), and the FASB (1972-present) have attempted to fill that mandate. The choice of organizations consisting primarily of public accountants to set standards for the regulation of accounting ensured that the profes-The Century of the CPA 85 sion would dominate the private aspect of the regulatory process. Both the CAP and the APB were directly under the control of the AICPA. Neither permitted non-CPAs to participate in the process except by sub- mission of comments. By contrast, the FASB is independent of the AICPA, and its members today primarily represent the user community. Regulation of accounting began with a call for more uniformity in ac- counting. Initially, accountants resisted the call, opting for flexibility ac- companied by full disclosure. In the decades since, companies have been reluctant to make full disclosure of their accounting practices while, of course, still preferring flexibility. Pressure has mounted, therefore, for uniformity in accounting often concealed in a call for comparability. The century of the CPA, therefore, has been characterized by three things: 1. Intense regulation quite distinct from the previous centuries of laissez- faire. 2. Domination of the field by public accountants as opposed to manage- rial accountants. 3. Increasing pressure to move to a uniform accounting system. Chapter 8 focuses its attention on the nature and problems of regula- tion. It concludes that one way to legitimize regulation is to provide a theoretical framework from which regulations might be deduced. Chapter 4 homes in on the search for accounting principles to provide this frame- work. The chapter picks up the story in 1933 when the first GAAP-driven auditor’s report appeared and explains how theorists have attempted to define just what generally accepted accounting principles are. Chapter 5 describes the Conceptual Framework that the FASB has developed—the most recent attempt to provide a theoretical constitution for accounting. QUESTIONS 1. Make a time line showing key dates in accounting from 1887 to 1987. Attach to it what events you can from your other reading. (You might want to fill in the dates when your parents and grandparents were born.) Can you interpret what was happening in accounting at the time in light of the other events? 2. Imagine that you are an accounting historian writing in the 21st century about the late 1980s to early 1990s. What do you think that they will say? 3. The modern development of much business education in the United States dates from the return of Gls to university campuses after the Second World War. Research the history of your business school to see whether there is any relationship at your institution. 4, Pick one of the topics listed in Exhibit 5-1 and read the relevant6 Chapter 3 statement on the subject by the FASB. In what ways did that statement limit the alternatives open to management? How, in your opinion, did those limitations improve the quality of financial reporting? 5. The chapter noted the increasing pressure for uniformity in finan- cial reporting that has been a distinguishing feature of regulation in ac- counting. Bertrand N. Horwitz and Richard Kolodny comment that ““some observers believe that the underlying reason for uniformity is that auditors prefer to operate in a tightly structured environment which mini- mizes judgment and, thus, the risk of legal liability. . . . An examination of the positions behind the ‘uniformity versus flexibility’ debate reveals that a major concern has been whether possible legal liabilities would be less under uniformity than under practices which permit alternatives.’ a. Based on what you know of accounting, do you agree or disagree with this claim? b. Are you aware, from your reading in other courses, of specific cases affecting accountants? If so, can you trace the impact they had on financial reporting? c. Is there any current litigation affecting accountants of which you are aware? If so, what effect do you think it will have on accounting? d. If you have done an auditing course, or are doing a concurrent auditing course, can you analyze the effect changing perceptions of accoun- tants’ legal liability might have had on financial reporting standards in this century? 6. Auditing, and in particular the auditors’ report, changed quite dramatically in this century. Consider the following list of reports, noting the dates in which each was being published. Compare these reports to the events of this chapter and see to what extent each reflects the changes discussed in this chapter. What caused the most recent change in audi- tors’ reports to occur? Statement 1: We have audited the books and accounts of the ABC Company for the year ended December 31, 1915, and we certify that, in our opinion, the above balance sheet correctly sets forth its position as at the termination of that year and that the accompanying profit and loss account is correct. Statement 2: We have examined the accounts of the ABC Company for the year ended December 31, 1931. In our opinion the accompanying balance sheet and statement of profit and loss set forth the financial condition of the company at December 31, 1931, and the results of its operations for the year ended that date. Statement 3: We have made an examination of the balance sheet of the ABC Com- pany as at December 31, 1933, and of the statement of income and surplusThe Century of the CPA 87 for the year 1933. In connection therewith, we examined or tested ac- counting records of the company and other supporting evidence and ob- tained information and explanations from officers and employees of the company; we also made a general review of the accounting methods and of the operating and income accounts for the year, but we did not make a detailed audit of the transaction. In our opinion, based upon such examination, the accompanying bal- ance sheet and related statement of income and surplus fairly present, in accordance with accepted principles of accounting consistently main- tained by the company during the year under review, its position at De- cember 31, 1933, and the results of its operations for the year. Statement 4: We have examined the balance sheet of the ABC Company as of Febru- ary 28, 1941, and the statement of income and surplus for the fiscal year then ended, have reviewed the system of internal control and the account- ing procedures of the company, and, without making a detailed audit of the transactions, have examined or tested accounting records of the com- pany and other supporting evidence, by methods and to the extent we deemed appropriate. Our examination was made in accordance with gen- erally accepted auditing standards applicable in the circumstances and it included all procedures which we considered necessary. In our opinion, the accompanying balance sheet and related statements of income and surplus present fairly the position of the ABC Company at February 28, 1941, and the results of its operations for the fiscal year, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year. PRIMARY SOURCES Those interested in learning more about the topics covered in this chapter might begin by consulting these sources. Each has numerous excellent citations. Briloff, Abraham J. Unaccountable Accounting. New York: Harper & Row, 1972. Carey, John L. The Rise of the Accounting Profession. New York: American Institute of Certified Public Accountants, 1970. Edwards, James Don. History of Public Accounting in the United States. East Lansing: Michigan State University Press, 1960. Miller, Paul B.W., and Rodney Redding. The FASB: The People, the Process, & the Politics. Homewood, Ill.: Richard D. Irwin, 1986. Previts, Gary John, and Barbara Merino. A History of Accounting in America. John Wiley & Sons, Inc., 1979.88 Chapter 3 SELECTED ADDITIONAL READINGS In addition to the works cited in the primary sources and the footnotes in the chapter, the reader is referred to the following authors: Securities and Exchange Commission Blough, Carmen. ‘‘Development of Accounting Principles in the United States,” Berkeley Symposium on the Foundations of Financial Accounting. Berkeley: Schools of Business Administration, University of California, 1967, pp. 1-14. Burton, John C. ‘‘Some General and Specific Thoughts on the Accounting Envi- ronment.’’ Journal of Accountancy, October 1973, pp. 40-46. Chatov, Robert. Corporate Financial Reporting. New York: The Free Press, 1975. King, Earle C. ‘SEC May Take Exception to Financial Statements Reflecting Application of Bulletin No. 32,’’ letter to Carmen G. Blough dated December 11, 1947. Journal of Accountancy, January 1948, p. 25. Pines, J. Arnold. ‘‘The Securities and Exchange Commission and Accounting Principles.’’ Law and Contemporary Problems, Autumn 1965, pp. 727-51. Previts, Gary John. ‘‘The SEC and Its Chief Accountants: Historical Impres- sions,”’ Journal of Accountancy, August 1978, pp. 83-91. Rappaport, Louis H. SEC Accounting Practice and Procedure. 2nd ed. New York: Ronald Press, 1963, chaps. 2 and 3. Skousen, K. Fred. An Introduction to the SEC. 4th ed. Cincinnati: South-Western Publishing Co., 1987. Sprouse, Robert T. ‘‘The SEC-FASB Partnership.’’ Accounting Horizons, De- cember 1987, pp. 92-95. Committee on Accounting Procedure “History of the Accounting Procedure Committee—from the Final Report.” Journal of Accountancy, November 1959, pp. 70-71. Accounting Principles Board Meyer, Philip E. ‘‘The APB’s Independence and Its Implications for the FASB.” Journal of Accounting Research, Spring 1974, pp. 188-96. Moonitz, Maurice. ‘‘Obtaining Agreement on Standards in the Accounting Pro- fession.’’ Studies in Accounting Research, No. 8. AAA, 1974. Rockness, Howard O., and Loren A. Nikolai. ‘‘An Assessment of APB Voting Patterns.’’ Journal of Accounting Research, Spring 1977, pp. 154-67. Sprouse, Robert T., and Detlev F. Vagts. ‘‘The Accounting Principles Board and Differences and Inconsistencies in Accounting Practice: An Interim Ap- praisal.’* Law and Contemporary Problems, Autumn 1965, pp. 706-26. Trueblood, Robert M. ‘‘Ten Years of the APB: One Practitioner’s Appraisal.” Tempo, Touche Ross, September 1969, pp. 4-8.The Century of the CPA 89 Financial Accounting Standards Board Brown, Paul R. ‘‘A Descriptive Analysis of Select Input Bases of the Financial Accounting Standards Board.’ Journal of Accounting Research, Spring 1981, pp. 232-46. Newman, D. Paul. ‘‘Coalition Formation in the APB and the FASB: Some New Evidence on the Size Principle.’’ The Accounting Review, October 1981, pp. 897-909. Newman, D. Paul. ‘‘An Investigation of the Distribution of Power in the APB and FASB.” Journal of Accounting Research, Spring 1981, pp. 247-62. Schuetze, Walter P. ‘‘The Early Days of the FASB.”’ World, Peat, Marwick & Mitchell, Summer 1979, pp. 34-39. Wishon, Keith, ‘‘Plugging the Gaps in GAAP: The FASB’s Emerging Issues Task Force.’ Journal of Accountancy, June 1986, pp. 96-105. ENDNOTES 1, Harold Pollins, ‘‘Aspects of Railway Accounting before 1868,”’ in A. C. Littleton and B. Yamey, Studies in the History of Accounting (London: Sweet & Maxwell, Ltd., 1956), p. 332. 2. Thomas K. McCraw, ‘‘Regulatory Agencies,’’ Encyclopedia of American Economic History. Edited by Glenn Porter. (New York: Scribners, 1980). 3. For more details on the links between GAAP and regulation see the Financial Accounting Standards Board Discussion Memorandum, An Analysis of Is- sues Related to Effect of Rate Regulation on Accounting for Regulated Enter- prises, FASB, December 31, 1979. 4. James Don Edwards, History of Public Accounting in the United States (East Lansing: Michigan State University Press, 1960), pp. 52-57. 5, Gary John Previts and Barbara Dubis Merino, A History of Accounting in America (John Wiley & Sons, 1979), p. 189. 6. ‘‘Uniform Accounting’’ also appeared in the June 1919, issue of Journal of Accountancy, pp. 401-33 and in Canadian Chartered Accountant, July 1917, pp. 5-33. 7. Joint Stock Companies Act, 1845 (Sec. 108). 8. For evidence that voluntary audits preceded this date, see Ross L. Watts & Jerold L. Zimmerman, ‘‘Agency Problems, Auditing, and the Theory of the Firm: Some Evidence,’ Journal of Law & Economics, October 1983, pp. 613-33. 9. The current state of accounting regulation in Britain is described in Michael Bromwich, The Economics of Accounting Standard Setting (Englewood Cliffs, N.J.: Prentice Hall, 1985). 10. Burton G. Malkiel, A Random Walk down Wall Street, 4th ed. (New York: W.W. Norton & Co., 1985). 11. Arthur Andersen, ‘‘The First Fifty Years,’’ quoted in John L. Carey, The Rise of the Accounting Profession, vol. 1 (New York: AICPA, 1969), p. 154.0 Chapter 3 12. 14. 15. 16. 17. 18. 19, 20. 21. 22. 23. 24. 25. 26. 27. . Carey, Rise of the Accounting Profession, vol. 2, p. 9. 29. 30. 31. 32. 33. 34. 35. 36. 37. Allan Nevins and Henry Steele Commager, A Pocket History of the United States, 6th rev. ed. (New York: Pocket Books, 1976), p. 414. . Robert Aaron Gordon, Economic Instability and Growth: The American Record (New York: Harper & Row, 1974). Adolph A. Berle, Jr. and Gardiner C. Means, The Modern Corporation and Private Property (New York: Jovanovich, Harcourt, Brace, 1932), pp. 182- 83 quoted in Flegm, pp. 70-71. J. M. B. Hoxsey, ‘‘Accounting for Investors,’’ Journal of Accountancy, 50 (October 1930), pp. 251-84. B. Bernard Greidinger, Preparation and Certification of Financial State- ments (New York: Ronald Press, 1950), p. 6. Carey, Rise of the Accounting Profession, vol. 1, p. 169. Janet Podell and Steven Anzovin, Speeches of the American Presidents (New York: The H. W. Wilson Company, 1988). Glenn G. Munn, Encyclopedia of Banking and Finance, 8th revised and ex- panded ed. by F. L. Garcia (Boston: Bankers Publishing Company, 1983). Carey, Rise of the Accounting Profession, vol. 1, pp. 182-92. Eugene H. Flegm, Accounting (New York: John Wiley & Sons, 1984), p. 79. Carey, Rise of the Accounting Profession, vol. 2, p. 110. Also Flegm, Ac- counting, pp. 87-88. . Changing Concepts of Business Income (New York: Macmillan, 1952). Carey, Rise of the Accounting Profession, vol. 1, p. 77. Leonard Spacek, ‘“‘The Need for an Accounting Court,’’ The Accounting Review, July 1958, pp. 368-79. American Accounting Association, Accounting and Reporting Standards Un- derlying Corporate Financial Statements and Supplements (Madison, Wis: AAA, 1957). Tbid. Alvin R. Jennings, ‘‘Present-Day Challenges in Financial Reporting,”’ Jour- nal of Accountancy, January 1958, pp. 28-34. Flegm, Accounting, p. 96. For example, see ‘‘A Search for Fairness,”’ in Financial Reporting to the Public, selected addresses by Leonard Spacek (Chicago: Arthur Andersen & Co., 1969). See Abraham J. Briloff, Unaccountable Accounting (New York: Harper & Row, 1972) and his articles in Barron’s and Forbes and in several accounting journals during the 1960s. See, for example, Robert N. Anthony, ‘‘Showdown on Accounting Princi- ples,’ Harvard Business Review, May-June 1963, pp. 99-106. Establishing Financial Accounting Standards: Report of the Study on Estab- lishment of Accounting Principles (New York: AICPA, 1972). Report of the Special Review Committee to the Board of Trustees (Financial Accounting Foundation, July 25, 1985), pp. 18-19. Facts about FASB, October 1983, p. | quoted in Solomons, Making Account- ing Policy, pp. 34-35. Dennis R. Beresford, ‘‘Emerging Problems: How the Profession Is Coping,”* Journal of Accountancy, February 1981, pp. 57-60.38. 39. 40. 41. 42. 43. The Century of the CPA 91 Under AICPA Rules of Conduct, Rule 203 as amended, May 1973 and May 1979. Paul B. W. Miller and Rodney Redding, The FASB: The People, the Process, & the Politics (Homewood, Ill.: Richard D. Irwin, 1986), p. 59. David Solomons, Making Accounting Policy (Oxford University Press, 1986), p. 36. For example, see FASB Exposure Draft, ‘‘Financial Reporting in Units of General Purchasing Power’’ of December 31, 1974; Exposure Draft ‘‘Con- stant Dollar Accounting’? of March 2, 1979; and FASB Statement No. 33, ‘Financial Reporting and Changing Prices’’ of September 1979. Quoted in Flegm, Accounting, pp. 142-50. “The Economic Effects of Involuntary Uniformity in the Financial Reporting of R&D Expenditures,’ Journal of Accounting Research, Supplement 1980, p. 42.Chapter 4 The Search for Principles CHAPTER OBJECTIVES After studying this chapter, you will be able to: Trace the development of accounting thought over the past 50 years. Contrast the various meanings of the word principles. Define what is meant by generally accepted accounting principles. , Analyze the impact the small investor has had on the development of accounting practice. Define what is meant by a postulate in accounting. Define what a standard is and how it differs from a principle. Explain why the search for principles was so frustrating. CHAPTER OVERVIEW The Search Begins The attempt to define generally accepted accounting principles is traced from the invention of the term in the 1930s to the end of World War II. The Search Quickens The end of World War II brought increasing prosperity, an emphasis on investing this new wealth in the stock market, and a renewed emphasis on sound financial reporting.The Search for Principles 93 The Search Shifts By the late 1960s, it was apparent that principles were hard to define and the search turned to a consideration of standards, which were seen as less pretentious. The Search in Retrospect Principles are difficult to define because of the inherent complexity of accounting theory. Their implications are sometimes difficult to sustain because of the economic consequences that flow from accounting information. Conclusion Broad concepts, whether called principles, postulates, or standards, are a necessary part of accounting. Nevertheless, it must never be forgotten that as a social science, accounting depends upon the wisdom, judgment, and integrity of accountants. Every audited financial statement today is accompanied by an auditor’s report attesting to its compliance with ‘‘generally accepted accounting principles.’ But what exactly are these principles? Are they the same that one finds in a ‘‘Principles of Accounting’’ text? And who decides what principles are accepted and how widely they must be accepted before they are considered to be generally accepted? What happens if these principles are required by the SEC, say, but not approved by practicing accountants, as has happened? Do they then conflict with generally ac- cepted accounting principles? What happens when the SEC's chief ac- countant concludes that ‘‘procedures so generally followed among ac- countants as to constitute substantial precedent are not always fundamentally sound?’”! And, just why do we nééd these principles in the first place? These questions have never been answered satisfactorily and have set the stage for an ongoing debate on just what precisely constitutes generally accepted accounting principles (GAAP), just what exactly the term principles means, and how these principles might be derived, if at all. This chapter outlines that debate as it has developed over the past 50 or 60 years. The first section relates how the word came to be chosen and the subsequent efforts to give it meaning. The second section develops an approach to theory building which uses the concept of postulates. The third section turns to the more recent approach based on objectives and standards. The rest of the chapter is a critical overview of the theoretical framework developed by the FASB. Later chapters develop at more length the revolutionary developments in theory which have taken place in the past two decades.94 = =Chnapter 4 THE SEARCH BEGINS* First Efforts The precise nature of accounting principles was a matter for debate from the very start as Exhibit 4-1 shows. The word principle derives from the Latin principe, meaning first in the sense of elementary. Since the first texts accounting students encounter are elementary, the term Principles of Accounting is wholly appropriate. What we study in a first accounting course are its principles in the sense of the material being first in time and first in terms of difficulty. However, these topics are not necessarily the principles of the subject in the sense of being first in logic or the subject’s foundation stones. One learns, for instance, a great deal of mathematics in school and in college without ever touching the deep philosophical ques- tions which form the foundations of that subject. Many use probability tables in statistics without ever delving into the precise nature of uncer- tainty. The same is true for accounting. Principles of Accounting might be a first course, but it is hardly a course in the fundamental truths of ac- counting. For a study of these, as opposed to an introduction to the elements of its practice, one must turn to a course in accounting theory. Many individuals and groups began work in the 1930s on elucidating what they thought should be meant by accounting principles. First out-of the block, somewhat to the chagrin of the AIA, was the American Accounting Association (AAA). Under the leadership of Michigan professor William Paton, who was appointed the first research director of the AAA at the start of 1936, the AAA published in June 1936 the first of what would be a series of brief monographs on the principles of accounting. The 1936 edition was entitled A Tentative Statement of Accounting Principles Un- derlying Corporate Financial Statements. Its expressed hope was that it would be possible ‘‘to agree upon a foundation of underlying consider- ations which will tend to eliminate random variations in accounting proce- dure resulting not from the peculiarities of individual enterprises, but rather from the varying ideas of financiers and corporate executives as to what will be expedient, plausible, or persuasive to investors at a given point of time.’’ In particular, the Association sought to eliminate the confusion arising from the revaluation of assets up and down according to changes in price levels and expected business conditions by emphasizing the cost basis of accounting. Some saw in this action an attempt to impose a uniform system on accounting; it really just reflected the distrust of * The title of this chapter derives from one in Stephen Gilman’s Accounting Concepts of Profit (1939). It was also used as the title of Reed Storey’s monograph (1964).The Search for Principles 95 academics for the subjective judgments of financial managers. A review of the accounting practices of the time certainly provides a good basis for their distrust; unfortunately, distrust does not necessarily lead to good accounting theory. Four years after the appearance of the Tentative Statement, Paton and Illinois professor A. C. Littleton, both members of the 1936 Executive Committee of the American Accounting Association, published An Intro- duction to Corporate Accounting Standards.° The intention of the authors EXHIBIT 4-1 The Nature of Principles Gilbert Byrne, in his prize-winning and influential paper presented at the Fiftieth Anniversary Celebration of the American institute of Accountants (AIA) in 1937, insisted that principles were fundamental truths.? Or, as Web- ster’s New International Dictionary puts it: ‘‘A fundamental truth; a compre- hensive law or doctrine, from which others are derived, or on which others are founded; a general truth; an elementary proposition or fundamental assump- tion; a maxim; an axiom; a postulate.” George May was to respond swiftly to Byrne’s suggestion that principles should be fundamental truths, arguing that the more appropriate definition was one from the Oxford dictionary, reading: ‘‘A general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or prac- tice.’’ He claimed that this was the meaning that the AIA committee intended when it used the term.? One has to give credence to May’s interpretation both because he essentially wrote the report and because this connotation corre- sponds most closely with the examples of principles that were attached to May’s letter of September 22, 1932.* Freely transcribed, these read: 1. Profit shall not be recognized before a sale occurs. 2. All expenses should be charged to the income statement and not to retained earnings. 3. The retained earnings of a new acquisition, earned prior to acquisition, may not be added to the retained earnings of the acquirer, that is, the purchase method rather than the pooling method should be used. 4. Dividends on treasury stock are not income to the company although trea- sury stock may be treated as an asset. . 5. Loans to related parties should be segregated from other loans.* These so-called principles are not Byrne’s broad underlying truths. They are much more in the nature of May’s rules. In fact, these principles presuppose the existence of the whole set of fundamentals that form the body of account- ing: They assume debits and credits, balance sheets and income statements, and so on. Nevertheless, they do give some rather fascinating insight into the way the known body of accounting was being manipulated at the time. * The background to this letter is described in the last chapter and in Chapter 8.