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The Usefulness And Limitations Of Accounting Reports For Testing The Theory Of The Firm: An Appraisal
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The Usefulness And Limitations Of Accounting Reports For Testing The Theory Of The Firm: An Appraisal
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T his d isser ta tio n has been 61— 6300 m icro film ed ex a ctly as rec eiv ed PARKER, W illiam M cFadden, 1909- THE USEFULNESS AND LIMITATIONS OF ACCOUNTING REPORTS FOR TESTING THE THEORY OF THE FIRM: AN APPRAISAL. U n iv ersity of Southern C alifornia P h .D ., 1961 E co n o m ics, co m m erce— b u sin ess University Microfilms, Inc., Ann Arbor, Michigan THE USEFULNESS AND LIMITATIONS OF ACCOUNTING REPORTS FOR TESTING THE THEORY OF THE FIRM: AN APPRAISAL by William McFadden Parker A Dissertation Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree DOCTOR OF PHILOSOPHY (Economics) June 1961 UNIVERSITY O F S O U T H E R N CA LIFO RN IA GRADUATE SCHOO L UNIVERSITY PARK LOS ANGELES 7 . CALIFO RNIA This dissertation, written by ..................... under the direction of his.-.Dissertation Com mittee, and approved by all its members, has been presented to and accepted by the Dean of the Graduate School, in partial fulfillment of requirements for the degree of D O C T O R OF P H I L O S O P H Y Dean Date. DISSERTATE Chairman TABLE OF CONTENTS CHAPTER PAGE I. INTRODUCTION ................................ 1 Purpose and Background of the Study . . . 1 Statement of the purpose • •...••. 1 Importance of the s t u d y............... 2 Prior contributions 3 Sources of Data and Methods of Procedure . 4 Sources of d a t a ................... . . 4 Methods of procedure .........• . • . 4 Organization of the Remainder of the Dissertation ........... ........ 5 II. BASIC ECONOMIC CONCEPTS IN THE THEORY OF THE FIRM ........................... 9 Capital, Income, and Value . .......... 10 Profit of the F i r m ............. 22 Profit and Distribution Problems ......... 29 Varying Economic Concepts of Cost .... 32 Fixed and variable costs •••«••.• 33 Long- and short-run costs............. 34 Explicit and implicit costs . . . . . . 35 Traceable and untraceable costs .... 36 Production and distribution costs . . . 3$ Risk and Uncertainty ............. 39 iii CHAPTER PAGE III. THE THEORY OF THE FIRM..................... 45 History of the Controversial Issues . . . 45 The Theory of Profit Maximization .... 50 The marginal analysis ........... 50 Alternate versions of profit maximization 53 Supplementary clarification ........... 53 Linear programming ................... 59 The theory of games 65 Some remaining questions ........ 69 Substitutes for Profit Maximization . . . 72 Summary .............. 79 IV. ACCOUNTING METHOD......................... 31 Introduction .............................. 31 Valuation........................... 33 Accounting Terminology and Concepts. . . . 94 Industrial Cost Accounting ..•••••• 104 Deferred Costs and Depreciation ........ 107 Fixed-Variable Criterion for Costs .... 112 The Imputation of Costs to Product .... 114 Joint and Common Products............... 115 Distribution Costs ............. ••••• 117 Accounting for Monopolistic Advantages • • 119 Price Level Adjustments ................. 120 Direct Costing 123 iv CHAPTER PAGE Standard Costs . » • » ................ • . 126 The Funds Statement...............• • • • 127 V. AN EVALUATION OF ACCOUNTING WITH RESPECT TO THE THEORY OF THE FIRM..................... 129 Statement of Method • • . • ........ 130 The Income Statement......* ............... 132 Revenue.................................. 133 C o s t s.......... 139 Imputed costs • . ................ 146 Joint and common costs.......... • • • 147 Linearity in costs..................... 149 The cost function . . . . . . . . . . . 151 Selling costs .......................... 152 Marginal cost analysis.............. • • 157 Programming • 162 Average cost ••••••••••.••• 165 Profit.................................... 174 Interest................................ 177 The Balance Sheet ............... • • • • . ISO The Funds Statement ....... 1S6 , . ’ ! VI. SUMMARY AND CONCLUSIONS ........... ..... 190 BIBLIOGRAPHY ....................................... 200 APPENDIX A. Illustrative Balance Sheet . .......... 223 APPENDIX B. Illustrative Statement of Income and CHAPTER PAGE Retained Earnings 224 APPENDIX C. Illustrative Funds Statement ......... 225 APPENDIX D. Illustrative Schedule of Working Capital 226 CHAPTER I INTRODUCTION It has been suggested that accounting data may be used by economists to test theories of the firm formed a priori. Such possibility is implied in the following; In the last few years accounting has played an important role in the development of economic theory with every indication that it will become even more important in this area in the future. This develop ment has been especially important in the theory of the firm. The • • • studies of businessmen’s pric ing activities, decisions in business firms, and so forth, have all tended to show that the economic theory of the firm is rather unrealistic and in need of some greater study and revision. It has been natural that the economists looking at this theory and trying to make it more closely conform to reality have turned to accounting to help them. Not only have accounting data helped economists to test the reality of their assumptions but also such data, as an important tool of management, have shown the.way to the development of better theoretical tools,1 I. PURPOSE AND BACKGROUND OF THE STUDY Statement of the purpose. It is the purpose of this dissertation to analyze and evaluate the characteristics of the financial data which are produced by conventional accounting procedures, with special reference to the use of ^ohn T, Wheeler, "Economics and Accounting," Hand book of Modern Accounting Theory. Morton Backer, editor (New Tories Prentice-Hall, Inc., 1955)* pp* 51-52, such data in empirical research when carried on for the purpose of validating theories of the firm. Importance of the study. The potential value of a study such as this arises from several sources. In the first place, the so-called economic theory of the firm is itself not in the best possible condition. There has been so much misunderstanding and disagreement as to the meaning and correct applications of the theory as to constitute a real impediment to constructive work in the area. Further more, some of the most serious misunderstanding and con tention has arisen in connection with certain empirical studies and surveys, involving accounting data, which have been made by economists. The misunderstanding, lack of communication, and general ignorance of each other’s specialty that exists between accountants and economists is a widely recognized, and deplored, condition. Accounting has borrowed heavily from English classical economics, especially with respect to terminology, but otherwise the two disciplines have developed independently. Accounting uses economic terminol ogy, but it has given its own meanings thereto. A clarifi cation of certain concepts and terms common to both is assumed to be a necessary part of a study of this kind. Any possible clarification of the status of the theory of the firm or reconciliation of terminological differences between accounting and economics will be, however, only incidental outcomes- The principal values which it is hoped may result from this undertaking are as follows; for economists, a better understanding of the accounting processes and the characteristics and limita tions of the resulting statistical product, particularly with regard to its use as just described; for accountants, some indication as to how their product might be used by economists, and suggestions for possible improvements. It is assumed that the use of accounting data and statements by economists in connection with their studies of the firm can be important, that it will increase if properly encour aged, and that accountants have an interest in making their product useful and available to economists* Prior contributions. Accountants and economists have written extensively on subjects of common Interest. Compari sons have been made and contrasts drawn. In general, the tendency has been to make such comparisons without refer ence to any specific problem. In contrast, this study has as its objective the evaluation of the suitability of accounting data for use in a very specific and closely defined economic purpose. So far as the writer knows, this study has not been duplicated elsewhere. II. SOURCES OF DATA AND METHODS OF PROCEDURE Sources of data. The materials for this disserta tion have been drawn from articles appearing in profession al accounting and economics journals, textbooks, and collected articles and essays. It seems desirable to state at this point that, while accounting is a practical art, such practice is governed by a body of well-defined and widely-recognized conventions, rules, and principles. Although accounting practices do vary, and accountants regularly disagree over important questions, there is none theless an impressive amount of uniformity in the work of this profession. This is particularly true with respect to the practice of accountants in the English-speaking world, the area to which this study has been confined. Finally, there exists an extensive literature on the subject of accounting, written both by scholars and by practitioners, so that generalizations are possible. Methods of procedure. It must be emphasized that economic principles and theories pertaining to the firm are taken as given in this study. Qualitative judgments are confined to the question of the relevancy and value of accounting data with respect to the work of economists in the area which has been designated. Further explanations of the methods used appear in the following section. III. ORGANIZATION OF THE REMAINDER OF THE DISSERTATION Chapter II, "Basic Economic Concepts in the Theory of the Firm," consists of a review of certain economic con cepts and a discussion of some of the practical diffi culties which may attend their use in practice* The pur pose of this chapter is to review what may be called the "principles" of economics which may have a bearing on the theory of the firm. The topics covered may be further characterized as belonging in the area of microeconomics. In addition to serving as a background to the discussion of the theory of the firm in Chapter III, the chapter is . intended to prepare the way for the evaluation of account ing method in terms of its relevancy to such theory. The latter, it seems evident, depends upon the extent to which the accounting approach to certain problems corresponds, or can be reconciled, with that of economists. The discussion in Chapter III, "The Theory of the Firm," is an attempt to clarify in a systematic manner the outstanding issues, as they appear to the writer, among economists relative to this area. As already indicated, the treatment is generally descriptive and uncritical, although a certain value judgment may be implicit in the final selection of a definition of the theory of the firm which is deemed to be most appropriate where accounting is involved. The topics covered include the so-called "traditional" theory, the controversies that have arisen with respect to the latter, and descriptions of the various supplements and clarifications that have appeared. Finally, there are included some models which may be regarded as substantial departures from the postulate of profit maxi mization. Chapter IV, "Accounting Method," is a descriptive discussion of accounting method. An attempt is made to outline, in lay language, the underlying conventions, principles, rules, and standards which govern the practice of accountancy in the English-speaking world. The emphasis is on the corporate, industrial concern, in accordance with the complexities and importance of that type of enterprise. Chapter IV contains nothing of a purely mechanical or pro cedural nature. Bookkeeping techniques and the minutiae of accounting adjustments are entirely omitted. The purpose is to make clear to the reader the fundamental nature, and the limitations, of the statistical data that are produced by the usual accounting processes, especially those of cost accounting. The content is limited to those elements in accounting practice which, in the judgment of the writer, have a bearing on the announced subject of this study. Chapter V, "An Evaluation of Accounting with Respect to the Theory of the Firm," may be said to be the principal chapter of this dissertation. The general content has, perhaps, been made apparent by this time. One point, how ever, must be emphasized. There is no intention here of passing judgment on the general principle of using empiri cal data to "test” or "verify” a theory. It is assumed that economists may wish to use accounting data for pur poses suggested by those terms, and the objective of this dissertation is to indicate the kind of material which will ordinarily be available to them for that purpose, parti cularly with respect to the economic content thereof. As is explained in Chapter V, it is necessary to make a somewhat arbitrary assumption concerning the form and degree of refinement of the accounting data that may be available to one who is doing economic research on the firm. For the most part, the evaluation of accounting in this study is carried on in terms of the conventional, general-purpose statements, or reports, which are prepared at periodic intervals by every business firm of any conse quence. Chapter VI, "Summary and Conclusions," contains a review of the principal findings in the dissertation. In addition, some consideration is given to the possible ways in which accounting reports might be made more useful for the theory of the firm without Interference with the estab lished objectives of the accountants and their employers 3 or their clients whom they serve on a professional basis. CHAPTER II BASIC ECONOMIC CONCEPTS IN THE THEORY OF THE FIRM The treatment herein of certain selected economic concepts is largely definitional. The objective is to present what appears to be the established meaning of the various terms that one encounters in the literature on the theory of the firm. However, much more is involved than mere terminology and definitions, and an effort has been made to reveal and clarify the basic concepts and hypo theses which are used by economists in their work in the area of the firm. The material is arranged in a descending order of generality. Thus, the first topic is '^capital and income" and the related question of "value." This is followed by a provisional step-by-step model for the measurement of economic "profit," as defined from the point of view of the individual firm. Finally, certain special variations in the meaning of "profit" and "cost" are discussed. As explained in the introductory chapter, this part of the dissertation is intended to be descriptive and un critical. The entire effort, however, unavoidably involves selection, and thus the exercise of critical judgment. There is, for example, no such thing as "the" definition of "profit," or probably of any other concept discussed 10 herein; hence the necessity of selecting and pruning. The method used is that of presenting the points of view of selected economists. The treatment emphasizes the fact that we are dealing with personal opinions and with controversial theories. As implied above, this has required the writer to use judgment as to what is appro priate and applicable to the general subject of this dissertation. In some cases, a "principle" is offered without reference to any "authority." In such instances, the implication is that, in the opinion of the writer, the principle is sufficiently established to justify such treatment. I. CAPITAL, INCOME, AND VALUE Not all of the total problem of capital is con sidered here. The existence of capital is taken as an established fact. No explanations for its existence are considered, nor are the origins of its "value" in real terms taken up. Instead, the object of investigation is the economists* identification, definition, and measure ment, in monetary terms, of capital and income, and value.'*' lThe looseness in terminology by both accountants and economists creates difficulties in this area. The words income. return, and revenue are used interchangeably in parts of the following discussion. This is necessary in order to keep the paraphrasing of various authors* works as faithful to the originals as possible. The difference between capital and income relation ships in monetary terms and those in real terms has been 2 clearly set forth by Fisher. Wealth— in the form of real, productive resources--yields income in real terms. But the value of capital (which can be expressed only in the common denominator of money) stems from, is produced by, income, rather than the other way around. Trees are the physical source of fruit, but the value of the fruit establishes the value of the tree. The monetary capital value of any asset, according to Fisher, is the discounted value of the income which is expected to develop from such asset. In terms of actuarial mathematics, the capital value of an asset is the present worth of the net receipts series which it is expected to yield. The determinant variables which are involved are the expected net receipts, the time sched ule thereof, and the rate of discount which is applied thereto. The clearest practical example of Fisher’s analysis is found where an investor purchases an annuity, a situa tion which is implicit in many business transactions. Assume that an annuity of $10,000, payable at the end of each of twenty years, is acquired at a price set to yield O Irving Fisher, The Theory of Interest (New York: The Macmillan Company, 1^30). 12 k% per annum, compounded annually. Under these terms, the cost (investment) will be $135,903, rounded to the nearest whole dollar. This figure is the sum of the present values of each annual payment discounted back to the purchase date. Thus, the price, and the "value,” of the first pay ment is ($10,000)(1.04) that of the second, ($10,000) -2 (1.04) ; and so on. Assuming that the schedule and magnitude of the rents are unchanged, the capital value of the asset which yields such payments can change only as the rate of dis count changes. A fall in the rate of discount increases such value, and a rise therein decreases it. We postpone for the moment the question of what constitutes the rele vant rate of discount. In any case, changes in the rate of discount do not, in Fisher’s system, result in income or in losses of income. They are adjustments in capital value only* The distinction between capital values and income is of great importance. The following passage has been very widely quoted by both economists and accountants: . . . it would seem that we ought to define a man’s income as the maximum value which he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning.3 3John R. Hicks. Value and Capital (Oxford: The Clarendon Press, 1939i, p* 172. 13 The purport of the above seems clearly to be that no income can be counted until capital is recovered in full. In the annuity example above, the total "income,” in the Hicksian sense, must be $200,000 less $135,903, or $64,097, the total amount that one could spend without invading the original capital invested, assuming that such original investment is the correct measure of how "well off" one is. If no change takes place in the original discount rate of 4$, the amount of $64,097 would be what Fisher would call the "return over cost," Under his system, such a return is a value concept, computed by deducting from the "income" received the discounted capital value of that income. When the assumed rate of discount changes during the life of an investment, the return over cost (which some would call "net income") changes accordingly. Capital and income, when defined in monetary terms as they are here, are interrelated concepts, and they can not be treated as independent questions, Fisher’s "return over cost" is a highly specialized concept. It is applicable to the case of an investor who must make a commitment in the present on the basis of an expected future return. The original act of investment is only a minor event. The beneficiary of future income is faced with the continuous alternatives of maintaining 14 the investment in future income or of not so doing* His "cost" if he does so elect to invest, or not to disinvest, is the present value of the remaining income stream, -which is set by the prevailing rate of discount* Fisher stipu lates that the relevant rate of discount is that rate of interest which would be earned by the next best alterna tive investment open to the investor* Thus the return over cost is found by subtracting from income an oppor tunity cost, an important concept which economists apply widely in their work. Fisher's return over cost is not applicable to every class of distributive share. Unless a "factor" is in a position to choose between a present sum or future receipts, it receives no "return1 * in the Fisher sense* This is especially apt to characterize the situation of wage earners, for example* The analysis can be applied, however, to a group of residual investors by treating all of the distributions to the other factors as negative ele ments in the calculation of "income** * This leads to one possible definition of "profit," and will be discussed further under that heading. Confusion seems to exist over the relationship between Fisher’s "rate of return over cost" and Keynes’ "marginal efficiency of capital*" Keynes’ own explanation is as followsi 15 More precisely, I define the marginal efficiency of capital as equal to that rate of discount which would make the present value of the series of annui ties given by the returns expected from the capital asset during its life just equal to its supply price. * Elsewhere, he says: Although he does not call it the "marginal effi ciency of capital," Professor Irving Fisher has given in his Theory of Interest (1930) a definition of what he calls "the rate of return oyer cost" which is identical with my definition.5 Alchian points out, correctly in the judgment of the writer, that Keynes is wrong in stating that his "definition" is identical with that of Fisher.^ The difference between them can, however, be satisfactorily reconciled. Keynes* marginal efficiency of capital is a rate of discount which is implicit in the relationship between what the investor must pay for his capital assets (the "supply price") and the expected return thereon* It is a hypothetical rate that the potential investor is supposed to compare with the cost of borrowing the funds (interest John Maynard Keynes, The General Theory of Employ ment. Interest and Money (New York: Harcourt, Brace and Company, n.d*), p* 1^5* 5lbid.. p. 140. ^Armen A. Alchian, "The Rate of Interest, Fisher*s Rate of Return over Costs and Keynes* Internal Rate of Return." The American Economic Review. XLV (December. 1955), pfT?3-Z=Zr.-------------------- 16 rate) which are necessary in order to finance the invest ment. Fisher*s rate of return over cost is likewise a hypothetical rate by means of which the investor judges the desirability of making an investment; but in the case of the Fisher analysis, the emphasis is on the alternate investment possibilities. Stated differently, one approach sees the investor as borrowing new funds, while the other sees him as selecting the best disposition of existing funds. Thus it would appear that the two "rates" of Fisher and Keynes are not quite the same thing, but that they are used for similar purposes; namely, to postulate a rationale of investment. If the interest rate paid by those who borrow funds to buy capital assets equals the rate of return to the best alternative investment, and if the businessman does push his new investments to the point of equilibrium between the marginal efficiency of capital and the cost of borrowing— then the actual cost of the marginal new invest ment will equal Fisher’s capital value of expected returns, and the two rates in question will be equal in amount if not identical in concept. Keynes* "marginal efficiency of capital" has as one of its variables the actual cost of the capital asset (the "supply price"). Specifically, the rate may be computed 17 by solving the following equation for “i": 0(1*1)^ - R* "C“ is the actual ccst of the investment, not based on any opportunity-cost principle; "t" is the number of time periods over which the investment yields the expected returns; “R“ is the expected returns* The rate so computed is frequently called the "internal rate of return*Such a rate may not properly be used as the discount rate for the purpose of computing the “value” of the capital asset in Fisher’s formula* To do so involves circular reasoning, since the internal rate depends, in part, on the very magnitude (capital value) that it purports to determine* In the theories of capital and income which have been discussed in the foregoing, there is implied an impor tant principle, especially with respect to this study* It is that if net income is the residual after capital has been recovered, the rate of discount used to establish a capital value must also be the rate of net income. The analysis of capital and income in monetary terms results in the possibility of changing capital values, even though the absolute amount of income (in the gross ^Kenneth E* Boulding, Economic Analysis (third edition; New York; Harper & . Brothers, 1955J, p* 867* id sense) and its time schedule do not vary. Thus Kicks gives as his second definition of income (net after capital allowance) when interest rates are expected to change: We now define income as the maximum amount the individual can spend this week, and still expect to be able to spend the same amount in each ensuing week.® This, presumably, can be interpreted to mean that a change in the rate of interest (appropriate rate of dis count for the firm in question) results in an adjustment in capital values and hence in a concomitant adjustment in net income (return over cost). Thus far, the question of capital and income has been analyzed in terms of an isolated investment and with out consideration of the problem of defining income over a time period less than the entire life of an investment. The income received by the firm in actual practice is derived from a complex array of many investments, over lapping one another with respect to their time schedules. The problem of computing income over a time period is met by economists, in part, through the adoption of the concept of "user cost," prominently identified with J. M. Keynes. The latter*s definition of the "user cost" of the equipment of the firm may be paraphrased as the difference **Hicks, op. cite, p. 174« 19 between the value of an asset as it would have been had it not been used to produce the revenue of the period and the actual value at the end of the period, less the optimum cost of maintaining such asset in an idle state over the period in question.9 "User cost," in other words, is the cost of using an asset rather than not using it. The diminution of value during a time period is, to Keynes, the measure of the cost of using equipment. The "values" which are so lost are computed specifically by • calculating the discounted value of the additional prospective yield which would be obtained at some later date if it were not used now,"10 Thus user cost depends upon the same basic approach to value as that found in Fisher’s treatment! namely, the principle of the discounting over time of prospective yields, plus the concept of opportunity cost.^ This latter principle requires some further analysis at this point. An opportunity cost is a measurement of the sacri fice that one makes when he elects to use a resource of any ^Keynes, oj>. cit., pp* 66-73• 10Ibid., p. 70. llThese have also been called "alternative-use" and "displacement" costs. 20 kind for a certain purpose, and thereby gives up all alter nate uses thereof* The sacrifice can be measured by re ference to any other feasible use; but, of course, only the next best use is assumed to be significant. When applied to the consumer, the sacrifice is commonly defined as the loss in subjective satisfactions available in the best alternative use of resources. In the case of the business firm, where resources are consumed predominantly for the purpose of producing goods for sale in the market, the appropriate measure of an opportunity cost is usually assumed to be the net monetary return that could have been had from the best alternate use of the resources in ques tion, A second technical matter requires examination be fore the elements in the economist’s computation of period ic profit can be assembled; namely, depreciation. Deprecia tion, to the economist, is related to capital value. It seems reasonable to suppose that its origins lie in the basic proposition, already noted, that final profit may not be computed without a suitable allowance for the recovery of capital. Where the period of time for which profit is computed overlaps completely the period covered by the economic life of an investment, there is no substantial problem involved. Where (as is almost always the case) that is not true, it is considered inappropriate to require 21 a full and immediate recovery of capital before profit is recognized. Instead, a deduction is made in each period for an amount deemed appropriate under the circumstances, and it is called "depreciation." The basic purpose of a periodic allocation of depreciation is to reflect in the current period the full economic effects, extending beyond the current period, of the activities therein. Keynes* "user cost” subsumes depreciation, inasmuch as it, in effect, measures the loss of capital value attri butable to the use of an asset during a period. There is, however, an alternate recognized approach to depreciation among economists, based on the "reproduction" cost of a depreciable asset. The reproduction value of an asset is the cost to duplicate such asset under current circumstances. This might be called a saving approach to value; the fact that the asset exists and belongs to the firm means that its cost need not be expended again. The value theory just described is in harmony with the interpretation of depre ciation which relates it to the replacement of the asset. An example of this is found in the following; The manner in which this fthe maintenance of capital^ takes place may be illustrated by the depreciation account which appears on the books of every manufacturing enterprise. The manu facturer knows that his machinery wears out, and 22 that if his capital is to remain unimpaired, he must set aside something annually to replace it. 2 A very common treatment of depreciation by econo mists who use this second approach is to assume that the firm looks upon its depreciation deductions as hypotheti cal contributions to a sinking fund, which is being built up to equal "reproduction cost" coincidentally and propor tionately with the realization of the returns from the investment. Summary. The purpose of this section has been to establish the interrelationships and interdependencies of the economists* concepts of capital, income, cost, and value, together with a preliminary introduction to the problem of computing "profit" attributable to arbitrary time periods, which typically do not correspond to the life period of any given investment. It is the judgment of the writer that the broad principles brought out to this point have a wide acceptance among economists in general. In the next section, more specific questions are taken up. II. THE PROFIT OF THE FIRM It is now possible to construct a tentative, working 12F. W. Taussig, Principles of Economics (third edition revised; New Yor^s The Macmillan Company, 192#), I, 77. model for the economic measurement of "profit” as it per tains to the individual business firm. The objective at this point is to throw some light on what it is that econo mists as a group appear to have in mind when the word is used by them in connection with the theory of the firm. The observations made here are, however, necessarily sub ject to the limitations which are inherent when one at tempts to generalize about the thoughts of many men, and no precise definition of economic profit can be made with out stipulating the point of view adopted and the analyti cal purpose for which the definition is developed, The starting point in the computation of ex post^ economic profit will be called "revenue” ("income" in Fisher’s terminology.)^ An important characteristic of revenue is that it includes both capital recoveries and Fisher’s "return over cost," Revenue appears to corres pond, in general, to the amount visualized as flowing into firms in the economists’ conventional diagrams depicting the circular flow of money. The exact definition is hard to document, but money receipts appear to be what most 13For reasons which are explained in Chapter III, there is no occasion for the discussion of ex ante profit, ^Beginning here, the terminology must be tightened, and the definitions adopted will be adhered to, as fully as possible, throughout the remainder of this dissertation. 24 economists have in mind* From revenue are deducted certain explicit expendi tures of a monetary character, which, for the moment, will be defined as all expenditures of a current, non-invest ment nature except those which have been designated as withdrawals of profit itself* The amounts deducted are thus the objective profit-determining expenditures of the firm in the period involved, and they constitute a type of "cost." From this intermediate point, economists then customarily take into account the implicit adjustments, a second type of cost which is not based upon any explicit contractual transaction, but which economists feel must be included* One example of this type of cost is a con sequence of the use of the time-period convention* Where the firm owns assets capable of yielding limited monetary ic net return over more than one period, ' the effect of the realization of any portion of such return in a given per iod is to reduce the net return available from this source in future periods* Economists feel that in this situation -*-5*phe phrase "net return” will henceforth be used to designate (1) any intermediate figure less than "revenue" and greater than "profit" and (2) any partial net contribution of a given investment or transaction to "profit*" "Profit" will refer ordinarily to the final residual return to owners, subject to the variations in meaning which are brought out in other discussion in this chapter* 25 there is an element that should be, and actually is, interpreted by businessmen as a reduction of current pro fit and therefore as a "cost*0 The principal implicit cost of the above descrip tion is depreciation. As indicated in the previous dis cussion, depreciation may be interpreted as a sacrifice which is measurable by the use of the opportunity-cost principle, or it may be considered to be a cost in the sense that the gradual use of an asset results in the destruction of its capital value, and that the profit cal culations "of the current period must include a provision for its eventual replacement. The underlying principle which is involved may be described as the maintenance of money capital over time, and it is related to Hicks* definitions of income. The foregoing principle is assumed by economists to be also applicable to other analogous situations where the effects of current operations are assumed to carry over into other periods, without being adequately measured by any explicit transaction. The principal case to which the principle is extended is that of inventories. The existence of unsold or unconsumed stocks of goods at the beginning or the end of a period of profit reckoning means that the explicit expenditures thereon require adjustment, amounting in effect to the adding in of the opening "value" 26 of beginning inventories and the subtraction of the clos ing. Depreciation on equipment and inventory adjustments for goods have been cited as examples only of a general economic principle. How far economists would carry the application of these principles would depend upon the individual analyst and his objectives. There is another kind of implicit cost which appears in connection with a certain adjustment of account ing data that economists insist upon before such data are considered usable for the purpose of economic analysis. It is claimed by economists that accounting procedures almost invariably fail to give adequate explicit recogni tion to interest, rent {especially in the sense of payment for the use of property), or wages. The result, it is said, is that accounting "profit” frequently includes one or more of these distributive shares. Economists, there fore, when they use accounting data, require an adjustment for implicit (sometimes called "imputed") interest, rent, and wages, and they use the opportunity-cost principle to measure these elements statistically. Marshall recognizes such imputed costs in the following: What remains of his £the businessman* sj profits after deducting interest on his capital at the 27 current rate • • • is generally called his earnings of undertaking or management.lo The existence of imputed wages in profit is suggested in the following: Finally, we may regard the supply price of busi ness ability in command of capital as composed of three elements. The first is the supply price of capital; the second is the supply price of business ability and energy; and the third is the supply price of that organization by which the appropriate business ability and the requisite capital are brought together. We have called the price of the first of these three elements interest: we may call the price of the second taken by itself net earnings of management. and that of the second and third, taken together, gross earnings of management.17 Of the two imputations, interest and wages, the first is the principal problem in the reported profit of the modern corporate enterprise, in which management is typically separated from ownership. In the small, unin corporated business, however, the "profit" to owners may often include returns that should be, in part, considered wages and interest. Finally, economists sometimes wish to impute a "normal" profit in certain situations. This type of pro fit may be described as a return which can be foreseen ^Alfred Marshall, Principles of Economics (eighth edition; London: Macmillan and Co., timited, 1936), p. 7k* 17ibid.. p. 313. 2d and which, therefore, the market can valuea The remainder of total profit is then a "pure” profit, which can not be so foreseen nor valued by the market. The occasion for postulating the existence of normal profit is any monopo listic situation, such as a franchise, which is sufficient ly well established and identifiable as to enable one to id impute to it a measurable net return. In addition to its relationship to revenue, normal profit thus implies the existence of an explicit asset, such as the "goodwill" of the accountant, and the amortiza tion of such an asset presumably enters the calculation as an implicit cost. From the total profit figure which is left as a residual to the proprietors of the enter prise, a deduction is made for imputed interest, rent, and wages. Following that, a further deduction is made for the normal profit attributable to monopolistic advantages. The remainder is "pure" profit. The remainder of this chapter pertains to a further examination of certain aspects of profit determination which appear to require additional special consideration. These are discussed under the headings of "Profit and Distribution Problems," "Varying Economic Concepts of id John F. Due, Intermediate Economic Analysis (third edition; Homewood, Illinois: Richard D. Irwin, Inc., 1956), pp. 440-43# 29 Cost,** and "Risk and Uncertainty*" III. PROFIT AND DISTRIBUTION PROBLEMS "Profit" is an ambiguous concept in economics, and some limited discussion of the alternate meanings thereof is neededThe explanation just completed above is appropriate for the concept which regards profit as the residual return to the owners of the firm* All "costs" are assumed to be of an essentially determinant nature, based upon contractual arrangements with the non-ownership groups from whom the factors of production are obtained* The imputed deductions from the total residual re turn, which were described earlier, represent an attempt to arrive at a final figure which may be regarded as a return that is uniquely available to the ownership class* The causes of such a return are the subject of an exten sive literature, in which the reasons for the existence thereof are developed* Frank H. Knight reasons that in a world of certain ty, where all human and property services could be ob tained on a contractual basis, made in advance, profit 19For a more extended discussion of the development of profit theory in economics, see: Robert A* Gordon, "Enterprise, Profits, and the Modern Corporation," Read ings in the Theory of Income Distribution. William Fellner ana Bernard F* Haley, editors (Philadelphia: The Blakis- ton Company, 1951)* pp* 556-70* would have no existence* In other words, the categories of interest, rent, and wages would be adequate for all distribution analysis in the absence of uncertainty* Pro fit results from the fact that the suppliers of services and the owners of property can not or will not make con tracts for an uncertain return, and the final return in a capitalistic economy is immeasurable in advance of the sale of the finished product* The entity receiving pro fit, positive or negative, receives a return that may be construed as the reward for the assumption of the risks caused by uncertainty. Knight insists, however, that mere risk-taking without uncertainty is not a profit-earn ing function, so that insurable risks are not included in 20 his concept of profit* Schumpeter characterizes "profit" as having its genesis in dynamic innovations* In a static economy, rent, wages, and a small amount of consumer's interest would constitute the distributive categories* Profits (and with them, productive interest) would disappear* Very briefly, Schumpeter's reasoning in this matter is 20Frank H* Knight, "Profit," Readings in the Theory of Income Distribution. William Fellner and Bernard t* Haley, editors (Philadelphias The Blakiston Company, 1951)» pp« 533-46* For a more extended discussion, see his Risk. Uncertainty and Profit (New Tork; Kelley & Miliman, Inc., iV5t)* 31 that when production and consumption become routine, repetitive, and standardized, the true entrepreneurial function simply vanishes, leaving at most a high-level managerial function, the rewards for which are nothing 21 more than wages. Others attribute profit to the existence of a vari ety of institutional and monopolistic advantages, arising from diverse sources. As we have seen, this particular source of profit is sometimes assumed by economists to be % capitalized and the return imputed to such capital value treated as a cost to be deducted so as to leave a "pure” profit. Profit, when attributed to one of the foregoing circumstances, is a measure of the contribution to revenue which monopolistic advantages are supposed to make. Pro fit, when simply defined as the residual amount left to the owners of the firm, may or may not be assumed to be a measure of the same thing. The implication in all of this is that profit is not treated in all economic analysis as the mere passive residual share of a given amount of revenue. The whole process may be turned around, so that the necessary 21Joseph A. Schumpeter, The Theory of Economic Development (Harvard Economic Studies, Vol. XtVt. Cam bridge, Massachusetts: Harvard University Press, 1949). 32 "rewards" to the factors of production explain and account for revenue* For example, in the economists* work in imperfect or monopolistic competition, "normal" profit, as defined before, may be treated as a price-determining fac tor like interest, wages, and other explicit costs* Thus the definition of profit, its magnitude, and the magnitude of revenue are interrelated questions, and the identifica tion of the cause of profit may be a necessary part of any definition thereof* IV. VARYING ECONOMIC CONCEPTS OF COST This section includes certain variations in the economists* definition of cost which did not fit conven iently into any previous discussion. The different approaches, however, are significant for this study* The subject of cost is probably the most important common pro blem for accountants and economists, and it has, of course, a great deal of relevancy to the theory of the firm* The way in which economists deal with the problem of costs may be characterized as "different costs for 22 different purposes*" This flexible treatment of costs 22J* Maurice Clark, Studies in the Economics of Overhead Costs (Chicago: The University of Chicago Press. 1923), Chapter IX* 33 has resulted in a rather extensive group of special defini tions, or types of costs, which have been recognized by economists* It is interesting to note that, for the mo3t part, the different classes of costs fall into dicho tomies* The following pairings include all of the different types of cost categories which, in the judgment of the writer, are important for this study* Fixed and variable costs* This classification of cost distinguishes between those that do not vary with output (are considered to be largely independent thereof) and those which, approximately at least, do vary in rela tion to the volume of output of the firm* Two further specifications must be made (and econo mists recognize this) before one can apply the principle of fixed and variable costs* In the first place, the unit by which output is measured must be, for most busi nesses, arbitrary* This is true even in the uncommon case where the firm manufactures only a single homogeneous pro duct* It can be demonstrated, for example, that a distinc tion between fixed and variable costs where output is measured in pounds could yield a different result from one where the unit of product was defined in gallons* Sec ondly, the range of output (assuming that the problem of 34 measuring the latter is solved) affects the separation of fixed from variable costs. It seems to be generally re cognized that few, if any, costs are fixed over an unlim ited range of output, but rather that they move in steps, so that the range must be specified in designating a fixed cost figure. Some common synonyms for the fixed-variable classi fication are "general-speci <X" and "supplementary-prime•" Long- and short-run costs. The criterion for deter mining whether a cost is "long" or "Short" run is that of adaptability to an existing situation or condition. In the short-run, the firm can not make adaptations by chang ing the size of the production unit; in the long run, it can. Thus it can be said that the total cost of a given output will be of a certain magnitude until the firm can make adaptations, after which the costs may change. A relationship exists between the concepts of fixed- variable and long- or short-run costs. It Is commonly said that in the long run all costs are variable. The explana tion of this is that the whole concept of a fixed cost is one that remains unchanged at different levels; but that has no meaning unless it is assumed that we are analyzing the results of using a given plant size at different op tional levels of output, and this is a short-run analysis. 35 In the long-run analysis, it is assumed that the firm has time to, and does actually, adjust its size to the most economical production of whatever quantity of out put is selected. There is no question of using the same plant at varying rates of activity, and hence fixed costs simply have no meaning in the long-run analysis. Some economists recognize a third category of "con stant variable costs." These costs are variable in the sense that they are entirely eliminated at zero output, but they tend to remain fixed at any level of output above zero.^ Explicit and implicit costs. These have been dis cussed at length in an earlier part of this chapter, but some further points should be made. Both fixed and vari able costs may be further differentiated as explicit or implicit. The’ adjectives "outlay," "out-of-pocket," "absolute," "Expenditure," and "recurrent" have all been used as synonyms for "explicit," reflecting the fact that this type of cost arises from the current payment of money. Implicit costs do not involve the outlay of money in the same period over which profit is computed, and thus are 23Due, of>. cit., pp. 154-55* 36 sometimes called "allocable costs."2^ Opportunity costs belong in the implicit group, since the opportunity prin ciple is a method of imputing, or allocating, a non-expend iture cost to an accounting period* Traceable and untraceable cost3* The criteria of economists for associating given costs with given segments 25 of production appear to be those of effort and sacrifice* The obvious examples of traceable costs would seem to be with respect to materials which are physically embodied in the product or labor visibly expended thereon* In the modern industrial plant, the cases where such direct rela tionships can be convincingly established are probably very few. Economists, however, seem usually to be content to define "cost" in the general way and not to concern them selves beyond establishing the concept* t Most economists would probably agree that any attempt to impute costs to specific units of product is an uncertain procedure and must depend to a great extent on the assumptions made by the one who does it* Even an 24lbid*, p. 153* 25jKenneth E. Boulding, The Skills of the Economist (Cleveland: Howard Allen, Inc., 1958J, p. 45; and Marshall, op* cit., p. 339* 37 apparently obvious "traceable” cost is such only if the assumptions are valid- As one example only, suppose a workman, on overtime, completes a certain "job" in the plant and receives premium pay- Should this entire cost of labor, which was unquestionably expended on a known job, be assigned thereto? Or is it to be recognized that other jobs also have contributed to the paying of overtime premiums, since, without them, the work in question might have been completed during regular working hours? Where a firm manufactures but one undifferentiated product, costs may be "untraceable" with respect to indivi dual units. The greatest difficulty, however, is the typical case of different products which are sold in differ ent markets. These "untraceable" costs are called "common" and "joint" costs- The distinction between the two which we shall adopt here is that common costs refer to the total cost of two or more different products processed together under circumstances that permit varying proportions. That is, the firm is able to change the relative quantities of the various products manufactured in a "common" process. Joint products will be taken to mean two or more different products which can be manufactured together only in one unvarying ratio. The classical example of the latter type is found in the meat-packing industry, where nature imposes a fixed relationship between the various joint products 3# that emerge. The distinction between the two types of costs lies in the voluntary nature of the proportions manufactured "in common" rather than "jointly." It seems apparent that economists would find it relatively convincing to impute a cost to a common product when it is known that such cost could be saved by simply not manufacturing the item in question. To return to the packing industry, however, the imputation of a part of the purchase price of a steer to its hide, or any other part, seems rather unconvincing to economists in the face of the fact that the packer has no options in the matter. The recognition of the difficult economic problems associated with joint production goes at least as far back as J. S. Mill, who is frequently quoted 26 in that area. Production and distribution costs. The distinction between the cost of manufacturing goods and that of selling them is especially important in the theory of monopolistic competition. Chamberlin provides the following definition; Cost of production includes all expenses which must be met in order to provide the commodity or service, transport it to the buyer, and put it into his hands ready to satisfy his wants. Cost 26john Stuart Mill, Principles of Political Economy (revised edition; New York: The Colonial Press, 1*99), II, *7-9. 39 of selling includes all outlays made in order to secure a demand, or a market, for the product* The former costs create utilities in order that demands may be satisfied; the latter create and shift the demands themselves* A simple criterion is this: of all the costs incurred in the manufacture and sale of a given product, those which alter the demand curve for it are selling costs, and those which do not are costs of production**7 V. RISK AND UNCERTAINTY It is probably true that economists in general recognize that businessmen face uncertainties and that they must be thought of as striving to maximize expected profits, which can not be known objectively in advance* There is a school of thought, however, that regards "established" theory as inadequate on the grounds that in it the entrepreneur is assumed, implicitly at least, to measure the risks, but otherwise to act as though he is certain as to what his risks are* This school further asserts that a model of profit maximization which properly incorporates what is called "uncertainty" as well as "risk" will lead to a different solution from one that does not 27Edward Hastings Chamberlin, The Theory of Monopolistic Competition (seventh edition; Harvard Econo mic Studies, Vol* XXXVIII* Cambridge, Massachusetts: Harvard University Press, 1956), p* 123* 40 distinguish between these two concepts. The reasoning by which uncertainty is introduced into the analysis of profit maximization is as follows. The entrepreneur knows that his estimates may be wrong, but this involves more than the recognition of risk. The latter is measurable, and it is not the entrepreneur’s real problem in planning. Risks can be treated as though they were certainties, in the sense that only a single plan is made to deal with them. A company may, for example, deliberately and irrevocably omit an expensive quality control procedure because the management feels sure that it knows the probability limits of an occasional appearance of a defective part, and is willing to accept the consequences thereof in preference to expensive con trols. This is an example of risk without subjective uncertainty. Each individual part represents a tangible risk, but there is no recognized uncertainty as to the total percentage of defective parts. Where, however, uncertainty exists as to the true probability distribution of ri3k, the entrepreneur is led to act in such a way as to enable him to change and adapt his plans as matters progress. His plans are formed to 2&Albert Gailord Hart, Anticipations. Uncertainty. and Dynamic Planning (New York: Augustus M. Kelley, Inc., 1951). 41 allow for alternate moves, for flexibility. They allow him to defer certain decisions until the results of other decisions become apparent; and, to repeat, it is not the measurable risks that lead him to this sort of alternate, sequential planning. The ideas which are expressed in the foregoing are a very different thing from the belief that subjective ex ante profits can be adequately disposed of by multiplying them by a comprehensive coefficient in order to reduce them to some "certainty equivalent." The fault with such procedure, as Hart points out, is that it merges risks and uncertainties into one undifferentiated end-result and thereby obscures the alternate planning that may be prac ticed.^ An illustration may help to make the situation clearer. A firm might construct a machine capable of operating in only one manner, using one pattern of input factors and producing one type of product only. If it turns out, in retrospect, that the firm would have had no motive to alter its original plans, then the firm may be said to have maximized its profits in one sense. ^Albert Gailord Hart, "Risk, Uncertainty, and the Unprofitability of Compounding Probabilities," Readings in the Theory of Income Distribution. William Fellner and Bernard Haley, editors (Philadelphia: The Blakiston Company, 1951), pp. 549-50. But consider the possibility that the inflexible plan might appear, ex post, to have been less profitable than some other feasible plan that was open before the firm committed itself. In that light, from an ex ante viewpoint, did the firm maximize its profits? It can be argued that the entrepreneur in actual life would be ex pected to seek some sort of flexibility in his planning, which would lead perhaps to eventual profits less than those which he would have gained had he built an unadapt able plant and had been right in so doing, but more profit able than had he done so and been badly wrong. Such a profit might be considered a maximum under an analysis that recognizes the provision for uncertainty as a normal procedure— a legitimate cost, in a sense— in business planning. The justification for regarding an uncertainty model as a true maximization criterion may be better appreciated when it is understood that the return from a single, isolated investment is not the real issue, accord ing to the proponents of this "theory." When a firm faces a series of risky situations and makes irrevocable deci sions for dealing with them, some may be "good" and some "bad." It appears plausible to think that a flexible policy that leaves the way open for amendments (allows for uncertainties) could, on balance, yield higher absolute levels of profit than would the use of inflexible plans. 43 That, at least, appears to be the position of the econo mists who are mentioned here* One connection between uncertainty as to future events and ex post profit is through the imputed costs, particularly t t user cost,** When an asset not capable of unlimited service is used in a given period, the "expect ed" future "yields" are reduced, and the magnitude of such reduction is counted as a cost of the period. To this point, economists appear to be in general agreement. The question of how, in the face of uncertainty, one should impute a value to the diminution in expected yields is, however, unsettled. Gordon mentions "certainty equivalents" as an impli- 30 cit assumption in the marginal analysis* Hart, as we have seen, is critical of the procedures which seem to be implied in that phrase. It is not the purpose of this chapter to make evaluations, but it should be noted that the particular problem above involves criteria of maximiza tion, Hence, it is directly relevant to user cost only if it is assumed that the full definition thereof is to be interpreted as the diminution in maximum expected yields ^Robert A. Gordon, "Short-Period Price Determina tion in Theory and Practice," The American Economic Review. XXXVIII (June, 1948), p. 266. 44- result ing from the use of an asset during a period. In any case, it is evident that the deductions for imputed costs leading to ex post economic profit will be ambiguous unless the treatment of uncertainty is made clear. CHAPTER III THE THEORY OF THE FIRM During the past two decades, there has been some controversy and apparent misunderstanding among econo mists over the question of the proper meaning and use of the phrase "the theory of the firm," The controversy has involved also the question of the validity of what we shall call the "traditional" theory of the firm and of the methodology of economic analysis in general. I. HISTORY OF THE CONTROVERSIAL ISSUES The center of the dispute has been the traditional profit-maximization theory (known also as the "economic" or "income" theory). This phrase, in its strict inter pretation, refers to the proposition that the private busi ness firm, through the decisions of its management, ad justs its affairs solely by reference to the criterion of maximum profits. It is commonly presumed that profit maximization is attained when output is adjusted to the point where marginal cost equals marginal revenue. Thus it is that those who are considered to be defenders of the traditional theory have been called "marginal!sts," as distinguished from their "antimarginalist" critics. The difficulties which economists have had can be 46 1 briefly described as follows® Largely on the basis of empirical studies and questionnaires, certain economists have asserted that business managers either are not moti vated to adopt a policy of profit maximization by means of what is usually referred to as the practice of margin alism, or that they are unable to pursue such a policy because they lack the essential information® This is the contention of Hall and Hitch, and Lester, whose surveys and articles may be said to have touched off the original controversy® These writers, and the "antimarginalists" in general, imply that average-cost pricing more correctly describes the practices of the typical firm® Gordon, among others, makes this point very strongly® ^For a review of this controversy, see the follow ing series of articles: R® L® Hall and C® J. Hitch, "Price Theory and Business Behavior," Oxford Economic Papers. No® 2 (May, 1939), pp. 12-45; Richard A® Lester, "Shortcomings of Marginal Analysis for Wage-Employment Pro blems," pie American Economic Review. XXXVI (March, 1946), pp® 63-62";™Fritz Machlup, "Marginal Analysis and Empiri cal Research," Ibid®. XXXVI (September, 1946), pp® 519- 54; Richard A. Lester, "Marginalism, Minimum Wages, and Labor Markets," Ibid,, XXXVII (March, 1947), pp. 135-46; Fritz Machlup, "feejoinder to An Antimarginalist," Ibid®, pp® 146-54; George Stigler, "Professor Lester and the Mar- ginalists," Ibid.. pp. 154-57; Henry M® Oliver, Jr®, "Marginal Theory and Business Behavior," Ibid.. XXXVII (June, 1947), pp. 375-63; H® A. Gordon, "Short-Period Price Determination in Theory and Practice,** Ibid®, XXXVIII (June, 1946),; pp. 265-66; James S. Earley, "Re cent Developments in Cost Accounting and the ’Marginal Analysis*," The Journal of Political Economy. LXIII (June, 1955), pp. 227-4^; James S. Earley, "Marginal Policies of •Excellently Managed* Companies," The American Economic 47 Among the defenders of the marginal analysis, Machlup takes exception to the factual conclusions drawn by the critics from their empirical studies and questions the procedures used. In particular, he argues that while the routine daily procedures in the firm may not appear to be based upon marginalist considerations, they never theless may be made in harmony with broad policies which themselves are set by the use of that principle. A more fundamental argument by Machlup is to the effect that if it may be assumed that the firm (meaning, of course, the management thereof) is basically inter ested in a maximum of profit, then the principle of mar ginalism becomes a highly effective and simplifying ana lytical tool. It is, he thinks, the natural, inevitable way for one to think if he desires to maximize profits, and it corresponds closely to the way in which most major decisions are actually made. Review. XLVI (March, 1956), pp. 44-70; Julius Margolis, "The Analysis of the Firm: Rationalism, Conventionalism, and Behaviorism," The Journal of Business, XXXI (July, 195&), pp* 187-99; Diran Bodenhorn, "A Note on the Theory of the Firm," Ibid.. XXXII (April, 1959), pp. 165-74; and Julius Margolis, "Traditional and Revisionist Theories of the Firm: A Comment," Ibid.. pp. 178-82. In addition, the following books may be consulted: Milton Friedman, Essays in Positive Economics (Chicago: The University of Chicago Press, 1953); Tjailing C. Koopmans, Three Essays on the State of Economic Science (New York: McGraw-Hill Book Com pany, Inc., 1957); and Fritz Machlup, The Economics of Sel lers1 Competition: Model Analysis of Sellers * Conduct (Baltimore: The Johns Hopkins Press, 1952). 46 Traditional theory has been defended on grounds other than appeals to the "facts" of business aims and methods* The defenders charge the critics of the theory with a misunderstanding of the logical structure thereof and the correct methodology in its use* Friedman, for ex ample, insists that the purpose of an economic model is to enable the user to make reliable predictions. The real issue, he believes, is whether the implications of the mar ginal analysis conform to the observed experience of the firm. Friedman carries this sort of reasoning even far ther and postulates that only the maximisation of returns is consistent with survival. Thus, only the firms that behave as if they have full knowledge of and utilise their marginal costs and revenues can remain in existence*? Under these circumstances, the economists are justified in adopting the simplifying hypothesis of marginalist prac tices because the results thereof correspond with reality; ^For similar approaches to the question of mar ginalism, see the following! Armen A* Alchian, "Uncer tainty, Evolution, and Economic Theory," The Journal of Political Economy. LVIII (June, 1950), pp. 211-21; Stephen Enke, "On Maximizing Profits: A Distinction between Cham berlin and Robinson," The American Economic Review. XLI (September, 1951), pp* 566-7#; and Edith Tilton Penrose, "Biological Analogies in the Theory of the Firm," Ibid.. XLII (December, 1952), pp* 604-19* 49 and the fact that the economic model does not faithfully mirror all of the incidental activities of the firm is irrelevant* The critics, in rejoinder, question the usefulness and value of a theory which misrepresents the decision making processes of a firm, even though it does so only by implication* To this group, it is not sufficient that a theory yield accurate predictions as to the market behavior of the firm* To paraphrase Margolis, a theory is ineffi cient when it ignores how a firm reacts to and controls its environment, and when it fails to describe thi many con straints against the maximisation of profit, in the tradi tional sense, that are a part of the very structure of the organization and the environment of the modern firm* The critics thus can be characterized as insisting that a theory be judged by its methods and assumptions as well as by its results. It seems apparent from the foregoing that a clear and unambiguous definition of the profit-maximization theo ry of the firm would require at least that one stipulate whether the theory refers to objectives of the firm or to the actually attained results of its operations. In addi tion, it is necessary to distinguish between assumptions which are derived from a priori reasoning and those based upon empirical observations* In view of the controversies and the objective of this study, there is an evident need for a neutral defini tion of the theory of the firm which will resolve some of the confusion without implying any judgment in the areas of what may be called true disagreement. Furthermore, there is required a definition which implies the use of the same basic kinds of variables as those which accounting purports at least to measure! namely, capital values, income, revenue, cost, and other closely related concepts* We shall start with the theory of profit-maximization. II. THE THEORY OF PROFIT MAXIMIZATION The Marginal Analysis Boulding reasons that every business organization has a set of identifiable variables. A theory of opti mization or maximization requires that some quantity which is a function of all other variables be treated as a measure of desirability. Maximization implies limitations. Boulding suggests that the combinations of the variables in a firm are limited by "transformation functions." The transformation functions are classified as those of mere consumption (or loss), internal production, and exchanges with the environ ment (purchases and sales). The limitations to trans formation are those relative to production and to the 51 market* The former limit the physical output obtainable from given inputs; the latter are imposed by purchase and sales functions. In terms of this analysis, profit is a dependent variable, and all of the determining factors of revenue and cost are independent variables. The traditional theory makes profit the measure of desirability, whereupon total revenue becomes an advantageous, and total cost a disadvantageous, independent variable. The theory then asserts that the firm will optimize profit to the limits set by the transformation functions.3 Under this approach, as Boulding says, n. • • the marginal analysis, in its generalized form, is not an analysis of behavior but an analysis of advantage.”^ Thus, the marginal analysis is not a theory of the firm. It is rather a prescription for attaining the assumed objective of maximum profit. The marginal analysis may be further characterized as simply the logical deduction which follows when maximum total profit is understood to correspond to the maximum difference between total revenue and total C03t. 3Kenneth E. Boulding, The Skills of the Economist (Cleveland: Howard Allen, Inn., 195t£). ^Ibid., p. 60. 52 A workable definition of the theory of the firm which can be derived from the foregoing and used in this dissertation is that of a hypothesis, presumably having economic significance, to the effect that the organization will be so conducted and managed as to bring about certain measurable results* The "testing" of such a theory by the use of accounting data is assumed to consist of an empirical in vestigation in which accounting reports are studied for the purpose of comparing results with predicted outcomes* If, in retrospect, it appears that the outcomes are those which are either stated explicitly or implied in the theory, then the theory may be said to be supported by the empirical evidence, or at least not to be contradicted thereby* The sense in which the available factual evi dence may be said to "prove" a hypothesis is not, however, an issue invthis dissertation* The only objective is to evaluate accounting data as one possible source of mean ingful evidence* It thus is assumed throughout the entire evaluation that accounting statistics will be used only to measure and indicate attained results, as distinguished from mere intentions and objectives* Nothing in this selection of an interpretation of the theory of the firm is intended to imply an evaluation 53 by the writer of the general merits of the controversial positions which have been reviewed. It is assumed at this point, and the subsequent discussions should verify the fact, that the interpretation of the theory of the firm as it is apparently understood by such writers as Boulding and Friedman is virtually the only one for which account ing data can have a potential relevance. It is apparent that some economists do not accept the general hypothesis that firms adjust their operations so as to equate marginal costs to marginal revenues, or otherwise maximize profits. It is felt, too, that the phrase "maximization of profit" is ambiguous and subject to several different reasonable interpretations. Before one can evaluate accounting data in connection with the theory of the firm, it is necessary to consider what appear to be the major forms that economists regard as possible. Such alternate hypotheses may be regarded as different versions of profit maximization, supplementary clarifica tions thereof, or possibly outright substitutes for profit maximization. Alternate Versions of Profit Maximization Boulding suggests that the "simple maximand" is "net revenue," the difference between the value of the product and the "cost" of the assets which are sacrificed 54 in the productive processes. This, however, abstracts from time and capital structure. If we do not so abstract, two consequences ensue. First, the injection of time as a variable means that some sort of discounting of future "values" must be considered. Second, the admission of capital structure as a variable requires that "return" and "profit" be more specifically defined. Some possible alternate objects of maximization which have been suggested by economists who have considered the problem may be summarized as (1) the rate of return on the total assets, (2) the rate of return on the entre preneur’s own capital only, (3) the internal rate of return, and (4) the present value of the future net receipts. The difference between {1} and (2) and the conse quences of postulating one in preference to the other is suggested in the following: . . . it is possible to distinguish two separate theories of production leading to two different con cepts of profit. On the one hand, we have Wieksell and the Austrian school for whom capital is money and profit is indistinguishable from interest. Pro duction is organized so as to maximize the rate of return on money invested. On the other hand, what 5Ibid.. p. 45. %ee Kenneth E. Boulding, Economic Analysis (third edition; New York: Harper & BrotHers7T^5577*cHap. 39* and Friedrich A. Lutz, "The Criterion of Maximum Profits 55 we shall call the neoclassical theory of production centers on the idea of a production function which includes money capital as a factor on the same basis as any other. Money can be freely purchased at a market price by the "entrepreneur" whose aim is to maximize his own remuneration which is the residual "profit."7 Continuing, the same authors say: . . . the fact that two theories of profit lead to the same general equilibrium is not sufficient to make them the same theory. . . . the two theories of pro fit, the Wicksellian and the neoclassical, lead to different conclusions. Both optimum scale and opti mum technique of production will be different in each case.8 Thus in one view, the firm is seen as maximizing the returns to a more or less set quantity of capital furn ished, presumably, by the residual owners. The second ver sion postulates the firm as an organization which freely purchases capital from "outside" investors, treats the interest thereon as a "cost," and maximizes the rate of residual profits. This latter approach, implying free access to outside capital, is made the basis for a familiar hypothesis, as follows: in the Theory of Investment," The Quarterly Journal of Economics. LX (November, 1945)* pp. 56-77* ^Andre Gabor and I. F. Pearce, "The Place of Money Capital in the Theory of Production," The Quarterly Journal of Economics. LXXII (February, 1958), p. 537. 8Ibid., pp. 538-39. 56 Now it is obvious that the actual rate of current investment will be pushed to the point where there is no longer any class of capital-asset of which the marginal efficiency exceeds the current rate of interest* In other words, the rate of investment will be pushed to the point on the investment demand-sched- ule where the marginal efficiency of capital in gen eral is equal to the market rate of interest.9 It should be noted that "profit," or the more gener al term "return," is defined differently in these two general cases. In the first, interest is a part of the quantity being maximized (although, presumably, not itself the object of maximization). In the second case, interest is one of the deductible costs, and the "return"to be maxi mized is less thereby. It seems reasonable to infer that both of the fore going hypotheses refer to an "economic" definition of net return or profit, especially in connection with the defini tion of cost. This is not true of the internal rate of return, which corresponds closely to the accounting approach to income. The maximization of the internal rate of return reduces to a problem of how to make the best of a given investment. The opportunity cost principle is not rele vant in this situation, since the actual eost is accepted 9Keynes, oj>. cit., pp. 136-37* 57 as given* The variables are time and rate of return over actual cost* The possibility that it is this rate, rather than another, that the firm might be expected to maximize arises from the belief that where the firm faces a series of investment opportunities {which is what actually is the case), the best results are attained by maintaining each separate commitment until the point of maximum internal rate of return is reached, liquidating that investment, and re-investing the proceeds in a new venture*^ Item (4), referring to the present value of future net receipts, introduces the variable of time* The rate of discount is usually stipulated as the "market rate of interest." It seems probable that economists actually have in mind here Fisher’s opportunity rate* The four categories mentioned probably should not be regarded as being mutually exclusive. For example, the maximization of a rate, as in (2), could lead to outcomes identical with the results of maximizing absolute amounts, as in (4)> if by "net receipts" is meant the "return" remaining to owners* In summary, it would appear that the hypotheses lOBoulding, op* cit•, Chap. 39* 56 regarding what the firm maximises may be classified accord ing to the following dichotomies! rates of return versus discounted absolute amounts thereof, economic versus accounting-type versions, and net returns on total resources versus residual profits to owners* In addition to the variations in the general ob jects of maximization, which we have discussed above, there is also the question of the criteria of maximization. How does one know when, for example, maximum profit has been attained? Supplementary Clarification It seems evident that a complete and unambiguous formulation of a theory of the firm must include not only a general statement of the outcomes of operations, but also a precise stipulation as to how such results are to be measured. It then follows that accounting must be evaluated with such criterion of measurement in mind. The traditional criterion for the maximization of profit, or any variation of net return, is the marginal analysis. That is, maximum profit is said to be earned at the level of output where marginal costs equal marginal revenues. If one is to form a judgment as to the suit ability of accounting data as a source of useful empirical evidence for testing a profit-maximization hypothesis, it is necessary to know the extent to which the accounting processes are capable of indicating marginal costs and revenues. But, to repeat, that will be true only if the marginal analysis is assumed to be the criterion of profit maximization. If some other measurement is postulated, accounting must be evaluated in relation to that different criterion. The search for alternate criteria has led to two significant developments in recent years. These are linear programming and the theory of games. Linear programming. In the attempt to strengthen the theory of the firm, certain economists have examined the marginal analysis, as they understand it to be con stituted, with reference to the "realities" of the produc tive processes. Perhaps the most explicit criticism, and counterproposal, is made by the proponents of the linear- programming analysis, known alternatively as "activity analysis." The authors of the linear-programming approach appear to assume that established marginal analysis is 11 represented by the so-called "Cournot-type" model. The actual justification for this assumption is not an issue here, but it is necessary to examine the characteristics H-So named after Antoine Augustin Cournot (1B01-77), generally characterized as the founder of the mathematical school of economics. 60 of the analytical device to which the proponents of linear- programming object. The principal feature of such a model is the fact that it provides the means for determining with great mathematical precision an equilibrium (greatest profit) position for the particular firm, even though the assump tions are complicated by multiple products and multiple choices in input factors. The mathematics used is the differential calculus, made possible by the fact that the economic concept of margins corresponds to the first deri vative of a continuous function. The assumptions in this analysis, however, corres pond with precision to reality only if the following is true. Production and sales must be continuously variable. That is, the firm must be in a position to change its out put and its sales by such small quantities that the assump tion of infinitesimal variations is not unreasonable. Like wise, the same situation must exist with respect to the application of the various input factors. Moreover, it must be possible to vary each input and output magnitude independently of every other variable. In an agricultural situation, for example, it must be the case that the func tional relationship between crop output and the input of irrigation does not change as the input of fertilizer varies, and vice versa. Finally, the range of output open 61 to the firm must be unrestricted* The model contains no provision for restricted access to the market or for capa city limitations to production* The foregoing assumptions are not necessarily the voluntary choice of any economist* They are implicit and unavoidable in the mathematics employed in this particular analysis* Under linear programming, in contrast to the fore going, management is assumed to have a limited number of discontinuous choices of product or factor combinations, and the variables may be interdependent. The latter state ment means that the functional relationship between the total cost of a given input factor and total output is not independent of the variations in the applications of the other factors. The principal contribution of linear- programming analysis is the provision for the effects of bottlenecks in a plant manufacturing two or more products which must utilise some departments in common. The pre sence of such "constraints," to use the mathematical lan guage of linear programming, makes it unrealistic to treat the production levels of two such products as mutually independent problems; and, of course, sets a limit to the absolute total output of all products* It has been sug gested, too, that the constraints may not always be invol untary or based on technological plant conditions* Manage ment may, for example, wish to maximize profit subject to 62 the constraint of maintaining liquid assets at a certain ratio to total assets*12 Under the circumstances outlined above, the attain ment of maximum profit may require an election, with dis continuous choices, between numerous combinations of pro ducts, between alternate patterns of input factors to be applied in the manufacture of a single product, or a com bination of these two cases* The mathematics used to solve complex cases is matrix algebra, which deals with finite differences rather than with infinitesimal varia tions* Linear programming is offered by its proponents as a substitute for the marginal analysis, to be applied in those situations where the physical facts of production and the market conditions do not correspond with those which are implicit in the latter* As might be supposed, the authors of the linear-prograraming approach to the theory of the firm seem to feel that it is more appropriate for the modern industrial situation than is the older analysis* As Dorfman points out, the latter had its ori gins in an agricultural age, and is not inappropriate to that type of enterprise* Thus he writes: 12Kenneth £• Boulding and W* Allen Spivey, Linear Programming and the Theory of the Firm (New York: The Macmillan Company, I960),p* 2(517 63 The entire analysis depends upon being able to differentiate the production, revenue, and cost functions with respect to each input and output independently, a mathematical procedure which has operational significance only when corresponding variations of values are possible in the phenomenal world. Such cases do exist in economics, character ized by production situations in which the field of technical choices includes infinitesimal variations of individual inputs and outputs. The classical Ricardian case, agriculture, is an example of such technological situation. There it is technologically feasible to vary the quantities of seed, labor, and fertilizer, and the like used per acre over a wide range without altering the method of production in other respects.13 Further light is thrown on the differences between the assumptions implicit in the traditional marginal analysis and in linear programming by the following! The marginal analysis assumes that the quantities Of each factor and product can be varied infinitesi- mally and individually. Marginal analysis grows out of the concept of "dosing," best exemplified in agricultural production. In linear-programming terminology, the usual marginal analysis assumes that an infinite number of different processes are avail able, each derived from a similar one by a slight alteration in the proportions of inputs and outputs. Linear programming, by contrast, assumes that the production function can be decomposed into a finite number of activities, each characterized by physi cally determined ratios among inputs and outputs. Linear programming grows out of the limitations of production with the use of machinery.14 ^Robert Dorfman, Application of Linear Programming to the Theory of the Firm (Berkeley; University or Cali fornia PrSssf I95TT7 pT lO . ^Robert Dorfman, Paul A. Samuelson, and Robert M. Solow, Linear Programming and Economic Analysis (New York: McGraw-Hill Book Company, Inc., 1956), p. 141. 64 In addition to the explicit assumptions in linear programming, certain others are clearly implied. The theory derives its name from the assumptions always made that the profit contribution per unit of product is the same over the entire range of production and sales which is open to the firm. This suggests constant selling prices and constant costs per unit at all relevant levels of out put.^ Furthermore, if the linear-programming "profit” is assumed to include an allowance for the imputed costs, such as depreciation, then these must be computed in such a manner as to reflect linear relationships to output. The above-mentioned implication as to selling prices and the assumption of the existence of uncorrectable con straints of various kinds make this a short-run analysis. Linear programming represents an attempt to provide a more realistic criterion of maximum profit in the modern industrial plant. The emphasis is essentially in the area of costs, with an implicit assumption that the firm sells in a competitive market and at determinate prices. Where a perfect market for either purchasing or selling may not be assumed, neither may the linear relationship between ^Actually, it is only the difference between revenue and cost which must be a linear function of output. profit and volume. The solution of a maximization problem in such a case is provided by the nonlinear-programming analysis. As long as the market prices can be treated as given data, the use of nonlinear-programming equations involves at worst somewhat more difficult mathematics and possibly the limitation of solutions to approximations. This leads logically to the consideration of the case where market prices, especially selling prices, may not be treated as given, and may actually be indeterminate. The principal analysis which has been formulated to meet this problem is discussed in the next section. The theory of games. This technique has been borrowed by economists from military science, where ana logies to certain types of economic competition can be found. Without reviewing in detail the various forms of market structure, it may be said that game theory becomes relevant in all cases where the seller has an election or choice as to his output and price policies, but can not determine the ultimate effects thereof without taking into account the induced reactions of his competitors to his decisions. Game theory has no applications to cases of pure competition or pure monopoly, for reasons that seem apparent, but the analysis would ordinarily apply very definitely to the oligopolist. It is also relevant to the 66 market situation known as "monopolistic competition," since the principal requirement of relatively few interdependent sellers is usually associated with that kind of market. The specific reasoning, then, is that in many modern situations, the individual seller can not count on his policies being ignored by his rivals, and such policies may conflict with their interests as they see them. The result is, as previously suggested, that the competitor can not arrive at any conclusions as to the effect of a change in output or price without taking into account the possible reactions of his rivals. The difficulties in this situa tion become acute if one supposes that all sellers are aware of the necessity of taking into account a rival’s reactions, and are aware, too, that their rivals will take that fact into consideration, and so on in an endless regression. Under these circumstances, game theory may help to solve the problem of profit maximization. Solutions involve mathematical procedures which make use of matrix algebra to supply a "strategy" for sellers who find themselves in the circumstances just out lined. Variations in the assumptions are possible. The most important are with respect to the number of "players," the question whether the total gross income to be di vided is fixed or can be varied, and the objectives of the players. 67 Whether a determinant solution to a game problem is possible apparently depends upon such assumptions, Dorfman, Samuelson, and Solow say! The upshot of our cursory discussion of general game theory provides convincing solutions of con flict situations only in the two-person constant- sum case* In more general cases the concepts of and approach of game theory have provided a con venient and suggestive framework for analysis, but no really satisfactory basis for finding concrete solutions has yet been proposed*16 The "two-person constant-sum" case refers to a "game" between duopolists who "play" under such circum stances that the total income to be divided between them is fixed, and the gain of one can be only at the expense of the other* Shubik suggests the usual indeterminateness of game solutions in the following! The meaning of solution in an economic situation needs stressing* Of course, the actual result of any bilateral bargain will be a single imputation? but the economic assumptions made are usually not strong enough to enable the economist to forecast the specific imputation that will be chosen* Often all that he can do is to indicate a range in which the outcome must fall*17 It appears that the solution which game theory l6Dorfman, Samuelson, and Solow, op* cit•, p* 444* 17MartIn Shubik, Strategy and Market Structure. (New York! John Wiley & Sons, Inc*, 1959), pp* 45-6'. 6S usually offers is that of a strategy for the firm, whereby it can maximize its gross income subject to whatever con- lf$ straints are involved, but that it often does not yield the definite solution needed before the analysis can be integrated with the marginal or the programming analysis* The most specific connection between this aspect of the theory of the firm and accounting is that some strategies of business competitors which have been postu lated include as a variable the financial structure of the firm* It is hypothesized that rival firms may assume that the ability of an opponent to absorb financial losses will partially determine his reaction to various moves, such as a price cut* Furthermore, such capacity is assumed to be measurable in game theory* Examples of such measurable variables which have been suggested by different writers are fixed or sunk costs, which measure the ability or willingness to absorb losses in a price war; and liquidation values of assets, which indicate the possibility that a rival may elect to 18a common constraint which seems to be assumed by writers who prepare specific solutions to games is to the effect that the firm wishes to play it safe and to elect a strategy which will yield the highest return if the rival firm reacts in the most undesirable manner* It is, of course, the existence of different possible assumptions of this type that makes game solutions indeterminate* 69 surrender the market entirely and permanently. Again, a knowledge of one's own price structure in comparison with those of a rival may make it possible for one to estimate the kind of compromise or settlement which will appeal to the self-interest of all concerned, and hence will consti tute the solution to a game. The question of market structure and game theory is vastly more complex and extensive than it may have been made to appear in this brief sketch. However, the writer has avoided all matters that appeared not apt to raise any question about accounting procedures and the stated objec tives of this dissertation. It perhaps should be added that the principles of game theory can be applied to oligopsony as well as to oligopoly, but the greater inter est appears to be with respect to the seller and his problem of revenue maximization. Some Remaining Questions There still remain some important sources of ambi guity, relative to the meaning of profit maximization, which could not conveniently be discussed heretofore. They relate to the question of subjective versus objective profit and to the time-span over which the components thereof are presumed to be measurable. These two problems are, moreover, closely interrelated. The following quota tions reveal the nature of the ambiguities: 70 • • . vre must see what conventional theory means by "maximum profits" and by the cost and revenue functions which determine profits* In short, should these functions be interpreted "subjectively" or "objectively"? • • • At the one extreme is the view that the relevant cost and revenue functions are purely subjective and are to be interpreted as including all possible anti cipated effects on profits over the indefinite future, whether these effects can be quantitatively deter mined or not* * . • Some economists take the opposite view and assume that the relevant cost and revenue functions have a determinate, objective basis* In this version, the theory of the firm posits that ob jectively measurable marginal cost will tend to be equated to equally measurable marginal revenue*^9 Where the businessman*s horizon extends beyond the short period of price theory, marginal theory can apply the principal r sic 1 of profits-maximization in either of two ways* It can compress the indefinite future into the present, include all relevant antici pations in the cost and revenue functions of the present period, and say that price and output are determined by the equality of marginal revenue and marginal cost* Here the static tools of a single period*s cost and revenue functions are used* Or the theory of the firm can attempt to be "dynamic" by introducing separate cost and revenue functions for each period within the businessman’s horizon (i.e., multi-period analysis)* In this case, the equilibrium condition of maximizing the present value of future earnings need not result in equating marginal cost and marginal revenue of the current period* Instead, cost-revenue relationships dated through time are explicitly introduced into the analysis*20 ^Robert A* Gordon, "Short-Period Price Determina tion in Theory and Practice," The American Economic Review. XXXVTII {June, 1948), p. 268. 2QIbid*. p. 279* 71 The question as to the length of time over which "maximum" profit is computed has a bearing on how one should classify certain objectives of the firm. Gordon says: The relation between these semi-pecuniary con siderations and profits-maximization may be ex pressed as follows. Granted the ultimate objective of maximum profits, the business man— for a variety of reasons— adopts an array of semi-pecuniary, sub ordinate objectives. Two difficulties then arise in relating pursuit of a subordinate objective to the usual concept of profits-raaximization. It may be impossible, even conceptually, to express a functional relationship between profits and various degrees of fulfillment of the subordinate objective. (In some cases, because of ignorance or "irration ality." the subordinate objective may become pri mary. 5 Secondly, marginal adjustment toward the secondary objectives may be impossible.21 The implications in all of the foregoing for the "theories" that we have discussed may be summarized thus. If it is assumed that the "maximization of profit" refers to the immediately observable, objective "short-run" effects on the variables of cost and revenue, then the alternate objectives which we have mentioned may be reasonably re garded as separate "theories" of the firm. 22 If, however, one adopts the "long-run" assumption 21lbid., p. 270. 22*^0 phrases "short-run" and "long-run" do not mean the same thing here that they do when used in connec tion with fixed and variable costs, as discussed in Chap ter II. In the present usage, the distinction is between immediate outcomes in the narrow sense as against ulti mate outcomes in the broader sense. 72 with its subjective implications, then many of what Gordon calls "subordinate" and "semi-pecuniary" objectives may be thought of as simply incidental measures to assure the attainment of ultimate maximum profit. An example of this possible variation in viewpoint can be found in the treat ment of the firm’s liquidity. In one view, the preserva tion of liquidity appears to be an objective in its own right. In the other, it can be interpreted as merely one of the precautions taken to guarantee and safeguard pro fits over the "long run." Again, the adoption of the long-run definition of profit maximization introduces the difficult question of the impact of uncertainty on the measurement thereof. In this connection, the reader may wish to re-examine the material in Chapter II (pages 39-44). One of the problems in evaluating accounting data as a measure of the results of operations will be to infer the extent to which uncer tain future costs and revenues may be reduced to some kind of objective measurement in the present. III. SUBSTITUTES FOR PROFIT MAXIMIZATION A few proposals have been advanced which represent more than mere alternate forms or supplementary clarifica tions of the profit-maximization hypothesis. Boulding, who has been a persistent critic of the profit-maximization or "income” theory* develops his argument against it in a way that raises some highly relevant questions for this study. Under favorable circumstances, such as rising prices, what prevents a firm from borrowing infinite amounts of money and making unlimited profits? Boulding classifies the deterrents as worsening transformation functions and uncertainty. The first explanation does not in itself lead to an alternant theory; it is more in the nature of a clarification of the marginal analysis. How ever, uncertainty, coupled with market imperfections which make it difficult to transform one asset into another, forces the entrepreneur, as Boulding describes it, to bal ance lucrativity against security. The need for security makes the financial structure of the firm a matter of major importance to the management and such considerations as preferred asset ratios and the desire to avoid debt can be regarded as primary objectives on a par with profit maximization— so much so, in fact, that the tendencies to maintain a given structure become automatic. This "theory" is enunciated in the following: The simplest theory of the firm is to assume that there is a "homeostasis of the balance sheet"— ^Boulding, The Skills of the Economist, p. 57. 74 that there is some desired quantity of all the var ious items in the balance sheet, and that any dis turbance of this structure immediately sets in motion forces which will restore the status quo. Thus, if a customer purchases finished product, this diminishes the firm’s stocks of finished product and increases its stocks of money. In order to restore the status quo the firm must spend the increased money stock to produce more finished product. On these assumptions the firm’s production, and indeed the production of the whole society, is a necessity imposed on it by the fact of consumption. Because moth and rust corrupt we must weave more cloth and smelt more iron. Every act of production, of course disturbs the stocks of raw materials and goods in process, which also have to be replaced. Hence consumption directly "causes" production in such a system, and, be it noticed, without any intervention of a price system or any assumption of maximizing profits or any other vari able. 24 Continuing, the same writer says! My main cause for dissatisfaction with the existing theory of the firm lies in its deficiency in capital theory. The usual marginal analysis treats the firm as if it had nothing but an income account; it has no balance sheet, no capital problems, and no dyna mics; it maximizes an odd variable called "net revenue," of which no accountant ever heard, and presumably lives happily ever after. Consequently, the economist has been able to give only fragmentary accounts of inventory changes, investment structures, liquidity positions and like problems.25 The literature relative to this type of theory is rather sparse, and it appears that most of the research into balance sheet relationships is yet to be done. One ^Kenneth E. Boulding, A Reconstruction of Economics (New York: John Wiley & Sons, Inc., 1950), p. 27. 25lbid., p. viii. can only speculate as to the details of all the hypotheses that may be developed in this area, but the following ob servations on the theory in general may be made. The im plications in the points made by Boulding appear to be that the assets of the firm are not properly to be treated as mere incidental matters, of interest only in connection with their ability to generate income. Thus the study of assets may not appropriately be made a valuation problem alone. The composition, patterns, and interrelationships of the assets may be the basis for a separate, identifiable theory of the firm, from which significant predictions can be made. The compulsion to maintain a given set of bal ance sheet and income statement relationships may be as real as any compulsion to maximize profits, according to the doctrine of "homeostasis." ° As a concrete example of this type of theory, Eiteman suggests that business firms seem to use their inventory levels as guides to action, re-ordering when certain minimums are reached and cutting prices when inventories increase above a "normal" level. This process, he implies, is sometimes substituted for the 26]3oulding defines this term as the "ability of an organization to maintain a given structure in the face of a changing environment." The Skills of the Economist. p. 75. 76 27 usual practices associated with profit maximization* In addition to his balance sheet theory, Boulding also postulates the theory that the same kind of tendencies appear in connection with the growth of the firm. There may exist, he believes, an ideal or homeostatic rate of growth, as measured by such variables as total assets, income, and turnover. The principle usually described as "average” or "full-average" cost pricing may be classified as a second major alternative, theory of the firm. It is not especially identified with any individual economist, but it is probably the most widely and strongly supported counter proposal offered by critics of the traditional theory of profit maximization and the marginal analysis. This theory seems to be implied indirectly if not explicitly by writers who speak of "fair" or "target" returns on invest- ments and similar objectives of management. Otherwise, one usually sees the explicit statement that management adopts average-cost pricing. A theory such as is relevant 2?Wilford J. Eiteman, Price Determination; Busi ness Practice Versus Economic Theory (Bureau ofBusiness Research, University of Michigan, 1949)* 2% e e Robert F. Lanzillotti, "Pricing Objectives in Large Companies." The American Economic Review. XLVIII (December, 195#J, pp* 921-40* 77 in this study can not be inferred in these cases unless, for example, a "target" rate of return is stipulated. When the hypothesis is stated in the usual direct way, then it must be specified how "cost" is defined, particularly with reference to the inclusion of any allowance for "profit" and the amount thereof. If these necessary clarifications are made, we have a theory that can lead to predicted results which are objectively measurable. The theory will be subject to different versions, and criteria will be available for purposes of analysis! namely, average cost and selling prices. This type of theory is essentially contradictory to the traditional hypothesis of profit maximization. It implies limited objectives; and it makes no use of the usual concepts of maximization, such as opportunity cost and provision for uncertainty. Fellner offers a theory which is related to average cost theories, but is different in that it is a species of maximization theory. It is suggested that when the uncer tainties felt by management pertain to the cost and revenue curves, the tendency may be to set output at the level where the difference between average variable cost and sales price is greatest, thus providing maximum safety 73 29 against unfavorable shifts in these functions. This appears also to offer a genuine theory of the firm. Objectively measurable results—-pertaining to volume of output, cost, and revenue— may be predicted, and the criteria are specified. Finally, it has been suggested that the firm maxi mizes a flow of liquid funds in lieu of a "profit" flow, or that it maximizes the turnover of "working capital. This class of hypothesis has been placed with the alter nate theories, but it seems logically possible that it could be interpreted simply as another criterion of pro fit maximization. For our purposes, however, it does not appear that it would make any difference exactly how the liquid funds question is formally interpreted, since the only objective here is to infer how well accounting reports may reflect the flow of funds and throw light on the econo mists* hypotheses concerning such flows. In summary, there appears to be a group of hypo theses which constitute something more than supplementary ^^William Fellner, "Average-Cost Pricing and the Theory of Uncertainty," The Journal of Political Economy. LVI (June, 1943), pp. 249-52. See alio his Competition Among the Few (New York: Alfred A. Knopf, 1949)> pp. 146- 57. ^Eiteman, 0£. cit.. Chap. 2. clarifications or alternative versions of the "income" theory of the firm. They generally imply something which is contradictory to the postulate of absolute profit maxi mization, and, as such, they seem to qualify as genuine, separate theories of the firm. They may be classified as theories of preferred structures, average-cost pricing, and funds. As previously stipulated, such theories are considered to be relevant to this dissertation only when they are presumed to be used to predict results and out comes which are potentially measurable by accounting statistics. Among the theories which we have recognized, a cer tain overlapping is noticeable. Thus, preferred asset ratios may be included as "constraints" in the linear- programming analysis of profit maximization, and the asset structure may also be one of the variables in game theory. Again, liquid assets are a part of the subject matter of the homeostatic tendencies in Bouldingrs hypotheses. IV. SUMMARY The objective in this chapter was to establish a definition of the theory of the firm which would be suit able for the purposes of this dissertation. The definition found to be appropriate was that of a hypothesis upon which economic predictions can be based. Consistently 80 therewith, it was further determined that the type of theory with which we are logically concerned is a theory of results. It pertains solely to the measurable outcomes of whatever the entrepreneur is assumed to do, without reference to his motives or intentions, or to any non- quantitative criteria. The conclusion was reached that some controversial subjects, notably the so-called practice of marginalism, should not be regarded as a theory of the firm, but rather as one of the possible criteria for the maximization of "profit." The latter phrase, then, refers to a true theory of the firm, as we have defined it here. Examples were cited indicating that the traditional "profit" theory is subject to varying interpretations, that the criteria of profit maximization also vary, and that a number of "semi-pecuniary" theories are currently in cir culation. Whether such models are true alternate theories of the firm or merely phases of long-run profit maximiza tion will depend upon the point of view adopted with regard to what may be called the "time-perspective." Finally, it was noted that ambiguities may exist as to whether profit maximization is intended to be a sub jective or an objective concept. This problem was shown to be related to the further possible ambiguity as to the treatment of time in defining maximum profit. CHAPTER IV ACCOUNTING METHOD Introduction The accounting process makes use of an integrating and controlling device known as the accounting equation. It is important for economists to grasp the significance of this device, since there is more involved than just the mechanics of bookkeeping. The equation takes several forms* The one best suited for our present purposes is as follows; Assets = Liabilities + Proprietorship It is assumed in this discussion that the two mem bers on the right side of the equation represent the claims, often called ’ ’equities," of two distinct classes of investors; namely, those who furnish capital on a con tractual basis, and those who do so on a non-contractual, ownership basis* In the corporate enterprise, which is the sort that will ordinarily be assumed in this study, the second category is the stockholders* group. It is assumed that prima facie the "proprietorship" group is that which is represented by management, whose behavior is an important question in theories of the firm. Any enterprise of consequence will have a large number of assets of very diverse nature. Likewise, the 32 liabilities are apt to be numerous in type, and even the proprietorship category tends to be broken down into numer ous sub-categories to show legal as well as economic rela tionships. The balance sheet of the firm is nothing other than an exhibit of the accounting equation, wherein the various assets, liabilities, and proprietorship categories are arranged to show the equality between the total assets and the total equities. While many published balance sheets are very carelessly and ambiguously constructed, they are still basically an arrangement of the equation. Throughout all proper double-entry accounting pro cedures, the integrity of the equation is maintained with absolute rigidity. No increase, for example, is ever made in an asset unless it is offset by an equal decrease in another asset, an increase in a liability, an increase in proprietorship, or some combination of those possibilities. This rule, whose purpose is to maintain integrity and accuracy, places certain limitations and inflexibilities on the accounting processes, as will be seen later. Very broadly, the work of the accountant consists of the analysis of every business transaction which he regards as reducible to expression in monetary terms, and the recording of the effect thereof on the basic account ing equation. The accountant starts with the equation as it exists at the moment of the birth of the enterprise and thereafter keeps perpetual running accounts of the changes in that equation which are brought about by the transac tions of the firm. The end result is that a balance sheet stating the firm’s financial "position" can, if necessary, be prepared at any moment. In practice, the procedures necessary to prepare a balance sheet from the underlying records, which continue almost automatically accumulating the necessary data, are expensive in terms of the cost of clerical help. Consequently, the preparation of balance sheets is ordinarily limited to certain conventional in tervals, such as the month, the quarter, or the year (cal endar or fiscal). By tradition, reinforced by United States income tax regulations, a period of twelve months is the longest interval customarily permitted between dates for the preparation of balance sheets. It seems probable that the selection of the year as the maximum interval is based on the assumption that each period should cover all four seasons. In that connection, it is impor tant to realize that the interval between balance sheets is automatically the period for reckoning profit. The year may be said to be the standard period for computing profit, and when shorter intervals are used, the usual attitude toward them is that they are simply fractional parts of the fundamental accounting period. While it is easier to explain accounting in terras of the balance sheet and the equation upon which it rests, a second financial document, which will be called the "income statement," is for many purposes of much greater importance to all concerned* The income statement is considered by some to be technically subordinate to the balance sheet, since it is a mere schedule which shows the details in explanation of one kind of change that takes place in the proprietorship member of the equation: namely, the "profit" of the peri od intervening between the dates of the preparation of the balance sheet. The word "profit" was written within quotation marks because, unfortunately, accountants have been about as slipshod in their definitions of it as have economists. For the moment, just one relatively easily understood case of varying usage will be explained. The traditional emphasis by accountants has been on the proprietor*s equity. The result is that accounting "profit" has meant the residual net return left to stock holders of a corporation after the deductions for interest of all kinds. Under this approach, the income statement is definitely a schedule prepared entirely from the point of view of the legal owners of the enterprise. Some writers, notably Paton, insist that less emphasis should be placed upon the source of capital and more upon the use that is made of the aggregated capital. To Paton, the important purpose of accounting is to reflect the way in which management has used the resources placed at its disposal; and he argues that all capital, regardless of whether it is supplied by bondholders or by stock holders, becomes inextricably mixed in use. Therefore, the important net return figure is that reached before the payment of interest.’ * ’ The only real difference in the results is that in 2 the proprietary approach, interest is just another cost; while with Paton’s "all capital" treatment, interest and net return to stockholders (which most accountants would call "profit") are considered to be anti-climactic "dis tributions" of the important net return before interest allowances. More needs to be said about the accountant’s treatment of distribution problems, but first it may be helpful to study some illustrations. Appendix A shows a model balance sheet, and a con densed statement of income and retained earnings is William Andrew Paton, Accounting Theory (New York; The Ronald Press Company, 1922T* ^The accountant would probably use the word "expense" here. "Cost" has another special meaning in accounting, as will be explained later. S6 illustrated in Appendix B. It is not asserted that they are typical* There is no stereotyped form for these statements. The exhibits do, however, incorporate various arrangements that have been recommended at one time or another by leading writers and actually used in practice. Finally, the statements are greatly simplified, and many business situations that are of interest to professional students of accounting are not reflected in these exhib its. Even these condensed statements contain material which requires a great deal of further explanation, but for the moment only these points are emphasized. As previously explained, the balance sheet is pre pared on periodic dates. It is a static instrument, pur porting to show the "position” of the firm, and the in terested parties therein, at a moment of time. The func tion of the accountant is to keep systematic record of the changes that take place in every asset, liability, and proprietorship element that appears on the balance sheet. At the end of each "period,” the new net balance for each item in the balance sheet is computed, and the new state ment is assembled. The purpose of the income statement is to show the dynamics of the situation by explaining just how one impor tant change took place in the balance sheet between dates— 87 that is, over the accounting "period*” The income state ment measures something that conceptually is similar to the "profit," the stream of revenue less costs, that many economists deem to be the object of maximization by the firm. The two concepts are only similar, however, and the differences are of great importance to this study. The statement in Appendix B represents an attempt to reconcile the two points of view mentioned on pages £4- $5. The net return of the "all capital" school appears as an intermediate figure, and then interest is deducted to arrive at the accountant's profit remaining for the stockholders. The retained earnings balance is the net cumulative results of all past profits less the dividends that have been paid back to the stockholders. The capital stock figure is the dollar amount of the original invest ment by stockholders. Thus the proprietary equity as developed by accountants, in its simplified form, consists ordinarily of the amount invested by stockholders, plus their accumulated accounting profits, less the dividends paid out. The mechanics of the accounting process are of very little concern from the standpoint of economics, but a few observations may not be inappropriate. As stated previous ly, the accountant undertakes to analyze nearly every transaction that is susceptible of monetary measurement, excluding only certain types that he does not consider to 3 be the proper concern of the accounting process* Having analyzed the transaction, the accountant takes steps to assure that the effect on the fundamental equation is pro perly recorded. In spite of the heavy and bewildering deluge of transactions that pours down every minute of the day in even a medium-size concern, the accounting pro cesses are capable of digesting the data with surprising efficiency and facility. The principal reason for this is that most business transactions actually consist of a relatively few different types, so that the handling of much accounting data consists of accumulating, by routine bookkeeping processes, aggregates of identical transac tions, which are thereafter dealt with as single, summary amounts. Valuation Although the conventional balance sheet, including that in Appendix A, seems never to stress the fact, every asset recognized by accountants can be classified accord ing to the following outline: ^The principal type of transaction which is cus tomarily excluded is that which, in legal terminology, is "wholly executory." That is, neither party has performed any part of the agreement. 89 I. Assets susceptible of direct valuation. II. Assets requiring indirect valuation. A. Assets subject to amortization or con sumption. B. Assets not so subject. Direct valuation is possible only when the asset is in the form of money itself, liberally interpreted, or when it is readily convertible into money in a reasonably determinable amount and in accordance with the normal expectations of the situation. To some extent, the accountant is arbitrary with respect to what he treats as an asset subject to direct valuation. Generally, his criterion is objective evidence other than the mere opinion of the management. Examples of directly valued assets are currency, bank accounts and other monetary credits which are readily available, and, in general, all direct claims payable in money within a relatively short period of time. The last includes amounts owed by customers and other debtors. The reference to cus tomers* accounts emphasizes a related accounting principle regarding inventories. With minor and rare exceptions, the accountant will not value inventories at their expected monetary yield. A definite sale must take place before the full market "value” of inventories is allowed any recogni tion, and this, of course, results in the receipt of a different asset to replace inventory. The valuation pro blem with respect to inventories is important because it is 90 related to the determination of profit. The refusal to recognize the full market value of inventories until it is authenticated by sale means that the contribution to pro fit is likewise delayed. The accountant characterizes this principle as that of not recognizing "unrealized" income. The consequence of all of this is that inventories become indirectly valued assets. The full significance of direct valuation is seen when one considers the alternate valuation approach. Assets not directly valued are almost exclusively carried on accounting books and appear on balance sheets at the historical cost thereof, and this cost is the amount of money paid, or promised, to acquire them* It must be added, incidentally, that all historical cost "values" are subject eventually to removal from the asset total. De tails of such operations, however, are better dealt with in the later explanation of the measurement of accounting profit. The group not susceptible of direct valuation con sists then, as we have said, of the historical money costs of valuable considerations acquired. They include only cost outlays made for the purpose of obtaining some sort of valuable services which will, presumably, contribute in some manner to the objectives of the firm. They do not include all historical outlays, but only those which are 91 deemed to pertain to future revenue or other purposes. The group (II—A) which is subject to amortization or consumption would include such things as the cost of raw materials still on hand, the cost of the unsold pro duct of the firm {including labor, raw materials, and allocated overhead), the cost of insurance paid nin ad vance,” the unamortized cost of plant and equipment, et cetera. Examples of the members of Group II-B would be the cost of land acquired, securities purchased, and the like. In their origins, the members of this class of asset are identical with the first indirectly valued group described above. As indicated in the outline, they differ from them in that they are not considered to be subsequently subject to amortization or consumption. That is, this class is not presumed to be used up in the process of pro ducing or selling the product of the firm* This does not mean, however, that such assets are unrelated to production. It may serve to clarify matters if we say that they are of such nature that the economist might compute a user cost of zero in many, but not necessarily all, periods. The assets of the other class, in contrast, are presumed regularly to have a positive user cost. To repeat, the second principal class of asset mentioned above is distinguishable from the first class in that the members thereof represent nothing that is money, can be used as money, or is a direct claim to money or its equivalent. They do represent the amount of money, or its equivalent, which has been expended for certain purposes in the past. These purposes are indicated by the account ant as well as he can by the titles he gives to the assets, such as; machinery, buildings, land, prepaid insurance, raw materials, et cetera. The continued presence on the balance sheet of these historical data indicates that the firm is judged still to be, in a legal and physical sense, in the beneficial possession of the objects and rights originally purchased. Assets such as these are, for the most part, never converted directly into money, although some are. In any case, the possibility of conversion into money is not directly reflected in the accounting treatment of such assets. This may be contrasted with the assets of the first class, every one of which is intended to re flect a direct measurement of potential money resources to the firm. In summary, there are, in one sense, but two kinds of accounting assets; namely, money (broadly defined) and the historical memoranda of money outlays, made to acquire all kinds of property rights (real assets) which are still available to the firm. Within the second class, however, it is possible to distinguish between assets which are 93 presumed to be subject to consumption and systematic amortization and those which are not. The activities of the firm lead to a monetary cycle, the description of which may help to clarify the points made above. The firm acquires money from various sources. Money is expended to acquire the factors of production. Accounting convention requires that purchased factors of production be treated as assets, and such assets are "valuedn at the amount of money expended upon them. By a process to be described later in detail, the accountant attempts to arrange and combine his historical cost data so as to reflect the physical facts of produc tion. Thus on the balance sheet of an industrial concern, one can expect always to find two important assets whose titles indicate that they represent respectively the in ventories of raw materials and of finished product. The first typically represents the cost to the firm of partly processed ingredients acquired from other firms. The second inventory figure is an aggregation of the costs just described upon which have been superimposed further firm outlays, generally classified as direct labor costs and manufacturing "overhead." The matter of the cost accounting methods which culminate in the aggregated, undifferentiated figure attached to finished product is perhaps the most important question which is discussed in 94 this chapter* The last phase of the cycle occurs when finished product is sold, and the firm once more has a directly- valued resource representing money or an enforceable claim thereto* It must be understood that the categories of assets just described are not often recognizable in published statements* Nevertheless, the distinctions made here are correct. Perhaps the most ambiguous treatment is that of finished product* Since the asset is but a short step away from conversion to money, it is often grouped with the "money" assets and treated as a part of "working capi tal," in spite of the fact that this creates a non-homo- geneous group. Finished product is an asset which has been subjected to considerable tampering by accountants, resulting sometimes in departures from what are supposed to be established principles* This matter is further discussed at a later point. Accounting Terminology and Concepts Before the discussion is carried further, it is necessary that some rules of terminology be adopted* "Revenue" means the proceeds from the sale of the product of the firm. In concept, it corresponds fairly closely to economic "revenue" as defined in Chapter II. Differences 95 between the two approaches may exist, and they will be discussed; but they are not, so to speak, of an inherently contradictory or antithetical nature* , l Cost,, , in accordance with the more careful account ing usage, does not mean to the accountant what it common ly does to economists* Accounting costs refer to assets. The deductions from revenue which lead to profit are called "expenses,” and these correspond roughly to what economists call "costs.” In accounting language, the firm acquires goods and services at a cost; and as such re sources are consumed (sacrificed) in the production of revenue, they become expenses. It is sometimes difficult to maintain this distinction in this discussion, because accountants often do not. For example, the "Cost of Finished Product Sold" (Appendix B) is an "expense" in accordance with the foregoing definition. To avoid confusion, it is assumed for the remainder of this chapter that the point of view of the proprietary investors prevails, so that interest, if it is paid, is simply another expense* Under this simplified approach, revenue minus expenses and losses equals profit. This assumption is made purely for convenience, and the discard ing thereof would require no modification of any principle that is discussed hereinafter. The expression "net returif Is used for the purposes described in the footnote on page 96 24. The word "income" is used occasionally for conven ience where we wish to refer in general to the concept of a return in excess of capital.^ Of the components of profit, the concept of reven ue is the most clear-cut. Accounting revenue is the aggre gated sales prices of all goods sold to the customers of the firm during a specified period. The principal char acteristic of accounting revenue that needs emphasis is the use of the accrual convention. This convention does not in itself affect the ultimate total revenue, but it does modify the timing of revenue recognition. To explain without detail, the accrual procedure requires that reven ue be recognized when a sales agreement is made which can reasonably be regarded as final and enforceable. The sub sequent collection of money from the customer is not, of course, counted again as revenue. While the role of money has been emphasized in this discussion of revenue, it is perfectly acceptable account ing practice to base the recognition of revenue on a sales transaction which will not be consummated by any money payments. When this sort of transaction occurs, the ^It should be noted that these principles are not observed precisely in the income statement of Appendix B, which was prepared on the basis of common accounting prac tice. The latter is often inconsistent in these matters. 97 accountant falls back on some monetary "equivalent" to measure the non-monetary consideration received from the customer, but the criteria for such measurements are not entirely clear. The accountant does not hesitate to split a single transaction into parts. Thus with custom work being con structed to special order, where the sale is really made in advance of physical delivery, the revenue may be re corded partly in one period and partly in another, as the construction progresses. This is in contrast with the treatment of goods manufactured for stock, where the un certainties involved preclude the accounting recognition of revenue prior to a sale. In the discussion of the recognition of revenue, and in almost all areas of accounting practice, one can state only what is generally true. It must always be un* derstood that exceptions are common. Accountants have a certain freedom in the exercise of discretion; and, of course, there are always those who simply do not observe what is generally regarded as good practice. On the other hand, the lay reader should not get a false impression from the foregoing. Among English-speaking accountants at least, and in many cases beyond that group, there exists much uniformity of theory and practice in the essentials. This is most true among the licensed professional 96 accountants, who are under pressure to maintain standards. Expense, the negative element in the calculation of profit, involves vastly greater problems and difficulties than does the positive element, revenue. As a start, the very general principles will be explained, and then the details of industrial "cost" accounting can be examined. An accounting expense has been defined as an amount deducted from revenue to arrive at profit. Typically, if not always, it is the historic amount of money paid to ac quire the input factors deemed to be related to the current revenue. The procedure, very broadly stated, is that costs are recognized when input factors are acquired. When revenue is recognized, the accountant surveys the situa tion to determine which of the previously recorded costs of production (and distribution) may be imputed to such revenue. The amounts so determined are transferred to ex pense accounts. At the same time, it is the custom to search all cost accounts for cases of historical expendi tures which have not and will not contribute to the genera tion of revenue or other business objective of the firm. Under some practices, these costs are also treated as expenses, but some accountants insist that this latter class of deduction be given separate recognition under the heading of "losses." Whether or not separate recognition of expenses and losses takes place, the profit of a period is revenue less expenses and losses. The relationship of the time period to net income, therefore, may be summar ized as follows. Revenue is defined in terms of a time period. Expense is defined with reference to revenue it self. The latter is true in the sense that the accountant tends to establish revenue first, and then to search for "matching1 1 expense components. Losses are defined in terms of the time period, and they are ordinarily deducted in the time period during which they are first discovered. This latter statement is not always true, and sometimes losses are recorded by reducing the asset involved and, simultaneously, the proprietorship of the firm. This pro cedure prevents the reduction of the periodic profit by the amount of the loss, and is commonly referred to as a "capital" adjustment. The criteria for choosing a treat ment for losses are vague, and represent one of the more muddled areas in accounting theory. This question seems to warrant a digression at this point. It was explained in Chapter II that under FisherTs treatment of capital and income, any change in either the expectations of future net return or in the applicable rate of discount would result in an adjustment, upward or downward, of the capital value of the related asset. It was emphasized, too, that such adjustment would not be 100 considered an element in the computation of "income,1 ’ If the accountant were to adopt this point of view, the appropriate accounting adjustment would consist of a change in the asset "value," accompanied by a direct and similar change in some proprietorship account. In terms of Appendix A, "securities" and "retained earnings" might be reduced simultaneously by some amount, perhaps to re flect reduced future dividend income prospects. To apply the principle correctly would require also that the ad justment appear in Appendix B after the figure represent ing the balance of retained earnings on January 1, I960, this being necessary in order to forestall any possibility that the adjustment could be construed as an element in the computation of profit for the current period. The accounting processes and conventions permit this sort of adjustment in theory; and some, if not all, accountants clearly understand the principle involved. However, the distinction between capital adjustments and income, in the economic sense especially, is not consistently maintained by accountants, and practice is generally unsystematic. The principal explanation for the conditions that exist is the historical cost convention for valuing assets. Recognition of advances in capital values is virtually forbidden by accounting tradition, because it would con stitute a departure from such cost. Reductions are 101 recognized on the grounds that they are "lost" historical costs. But where reductions are made, the procedures as a whole tend to be, as we have indicated, most unsystem atic. Furthermore, accountants usually recognize only reduced net return prospects as bases for capital adjust ments. In general, they ignore changes in "opportunity" value which are induced by fluctuating rates of return in the investment markets. To return to the main course of the discussion, historical costs not transferred to expense or loss accounts are treated as assets. They are the second class of asset mentioned on page &9 in connection with the dis cussion of the balance sheet. The eventual disposition of nearly all such assets is that they become either expenses or losses. To summarize, the processes of accounting consist of the careful recording of all money, or acceptable money equivalents, received by the firm. The source of all money receipts is construed as being either revenue, pro prietorship contributions, or loans from creditors. As money is expended to acquire the' input factors of the firm, such "costs" are recorded historically. They are held in suspense and treated first as assets. In the computation of profit, the negative element consists of . 10Z such costs as are deemed to have contributed to, and been consumed in, the revenue generating processes; and, some times, there is included also the costs that are thought to represent assets which have lost permanently all power to contribute to the firm’s business objectives# Costs not so disposed of are treated by convention as assets and appear as such on the balance sheet. Although it is essen tially only a bookkeeping matter, it may be of some value to mention at this point that expenditures which are assum ed to have made their entire contribution to revenue in the same period as that in which they are incurred are not usually given the preliminary status of assets, but instead are "expensed1 1 immediately and directly* These expenses correspond to the economists’ "explicit" or "expenditure" type of "cost," except that the accounting "accrual" prin ciple is applied to all costs and expenses just as it is to revenue. Expenses are recognized as soon as a liabil ity to pay for them is incurred, so that the accountant’s figures do not correspond exactly to the monetary outlays. It may clear up a possible question to mention also that accounting "losses" may arise not only from costs pre viously treated as assets, which have been discussed in connection with the problem of capital-value adjustments, but also from current expenditures or accruals which are 103 judged to have been unproductive from the outset. In all of the foregoing processes of determining profit, the accounting equation is maintained. The exist ence of a positive profit means that, as a matter of arith metic, the firm’s excess of assets over liabilities has increased by that amount, and the integrity of the equation is maintained by adding such profit to the proprietorship member thereof. The discussion to this point has passed over the great problems and difficulties that are met in the actual practice of computing expenses and losses. Briefly, the problems that must now be examined in detail stem from the following sources. One arises from the time discrepancy between the acquisition and payment for an input factor and the realization of related revenue. A second major problem is created by the accountant’s feeling that the process of combining the various and diverse factors of production into a single product ought to be reflected in some way by his accounts. The third difficulty arises from the need to identify.input factors ivith specific units of product. These problems are dealt with under the general 5 subject of industrial cost accounting. 5For an excellent discussion, intelligible to lay men, of the processes by which the total cost of production is attained by accountants, see W. A. Paton and A. C. 104 Industrial Coat Accounting In what follows, it is assumed that the industrial situation is that of mass production of homogeneous pro ducts. It is further assumed that the unit of product used for purposes of cost accounting is the same unit as that used in the market for the product. The mass produc tion assumption means that output involves relatively large numbers of units of product, regardless of what measuring device is used. Large-scale production of homo geneous products usually results in the use of what is called "process cost accounting." The conditions which lead to the use of process cost accounting systems are typi cal of modern industry, and process costs present the most extensive opportunities for making significant comparisons between accounting and economics. The following discussion will, therefore, be based entirely on such cost accounting procedures. Nothing is lost, however, by this restriction, since the basic principles would not be modified by the assumption of any other system in general use. It is assumed also that the accounting period is a year of any twelve consecutive months. Broadly speaking, the purpose of process cost Littleton, An Introduction to Corporate Accounting Standards (American Accounting Association, 1940), Chap. ill. 105 accounting is to arrive at an aggregated total "cost" fig ure which may, by accounting criteria, be attributed to the production of the firm during a given accounting peri od. Typically, the only individual unit cost that is produced by this system is the average cost, the quotient of total costs divided by total production. The principles whereby the total costs for a period are derived are in harmony with the very general principles of accounting as previously explained. The firm makes a series of explicit outlays for goods and services. The amounts of such outlays which are not thought to be related to current production (production within the period) are deferred and excluded from the cost of current output. Historical outlays from past periods are, however, added to the cost of current production if it is thought that they have contributed to such output; otherwise, they con tinue to be held in suspense for the future. Thus, the formula for the accountants cost of production is current outlays, less that portion thought to relate to future pro duction, plus certain costs carried forward from the out lays of past periods. Attributing costs of any description to production does not in itself create an expense. Finished product is "inventoried." That is to say, the cost thereof is treated as an asset until the output is sold. Thus the accountant’s "expense" with respect to finished product is the cost of goods produced in the past and currently sold, plus the cost of goods currently produced and sold. The total ex pense for any period includes, in addition, the selling expenses and certain so-called "administrative" expenses. The last are expenses which the accountant is unable to classify as either production or distribution elements. In an industrial plant, the assets of the firm will in clude the original, historical costs of goods and services of all descriptions which have been incurred and are not considered to pertain to current or past production, plus the costs assigned to partially finished output, plus the costs assigned to finished, but unsold, goods. They are of the second type of asset described on page 89, those which are indirectly valued only. It should be noted that the all-important "cost of finished product sold" (actually, an accounting "expense") is derived by two essentially separate procedures involv ing certain conventions which are discussed in detail later. The first procedure is that of imputing cost to current production. The second is that of imputing past and current costs of production to the units sold during the period. The foregoing is only a very general statement of cost accounting procedures as they are commonly practiced. 107 There remain to be discussed more specific aspects of cost accounting practices. The discussion which follows imme diately deals with a series of separate topics. Each is discussed on as independent a basis as possible, but accounting procedures are much too highly interdependent to permit the consideration of any problem in isolation. Not all of the problems of cost accounting are mentioned. Only those thought to have relevance to this dissertation are included. Deferred Costs and Depreciation In terms of the statistical magnitudes and the com plexities involved, the most important example of the costs which accountants hold in suspense as "assets" are those of acquiring the physical plant and equipment. They are the basis for the accountant’s measurement of "depre ciation." The accounting explanation for depreciation, which is at least implicit in all that is done, may be summarized as follows. The firm acquires its depreciable plant and equip ment for a known total outlay of money. Such outlay is a part of the "cost" of all goods produced through the use of such resources. The problem is to identify the entire output emanating from a given investment and then further to allocate the total cost appropriately to the individual units of production, or at least to definite segments thereof. The chief difficulty stems from the fact that • ’profit” is computed periodically, while the total yield from an investment can not be known until the asset reaches the end of its useful life. Thus, the cost ac countant must assign some fraction of the total asset cost to an individual segment of production long before he knows for certain how much the asset will produce. The methods whereby the total historical monetary outlay for a depreciable asset is allocated to the output attributed thereto take two basic forms. One procedure consists of dividing the cost of the facilities by the estimated total number of units of pro duct which can be obtained by the us§ thereof. This yields the average depreciation expense per unit of pro duct which is added to the aggregated cost of production for any period. An important result of the use of this method is a depreciation expense which fluctuates in pro portion to output. The second general method consists of estimating the retirement date of an asset, and then assigning some portion of its cost to the production of each period of use. The most familiar technique, and probably the one most commonly used in actual practice, is the so-called "straight-line” method, which consists simply of assigning an equal portion of cost to the production of each year. 109 Variations in the second method exist, of course. Thus it is that the policy sometimes is to assign relatively more of the total cost to the output of the earlier years as an offset to expected higher maintenance expenses in later years. The basic characteristic of the second general method, however, is that every accounting period over which the asset is expected to be held before retirement is assigned, in advance, some fractional share of the cost of such asset, and this is done without reference to the relative amount of use to which the asset may be put in any given period.^ It is probably fair to say that accountants appre ciate the arguments that can be offered in favor of the first, "usage," method of computing periodic depreciation. However, aside from considerations of expediency because of its simplicity, the straight-line method appeals to accountants apparently because they recognise that the re tirement of industrial equipment is brought about by obso lescence as well as by physical deterioration. This leads the accountant to adopt a depreciation method which is a function of time rather than use. ^To be precise, total depreciation is defined as cost of acquisition less any expected recovery in the form of salvage on the retirement of the asset. 110 Depreciation accounting thus has the general result of treating the total cost of depreciable assets as costs of whatever product is manufactured during the useful life of such assets and, of course, by such assets* The pro cesses of allocating these costs to the output of differ ent time periods result in the existence, at any given moment, of a deferred cost, which is considered to be applicable to future output* This segment of cost appears on the balance sheet as an asset* It is evident from the foregoing that the accountants treatment of depreciation is not an economic revaluation technique. The accounting "value" of any partially depreciated asset is not even an estimate of the discounted net return expected from the future use of the asset* Accounting depreciation, there fore, is not based on the same principles as the econo mists* "user cost," and any similarity in results will be purely coincidental* Accounting textbooks do suggest methods for giving more economic content to depreciation procedures, but the extent to which such suggestions are put to actual use is very doubtful. A rather common proposal has been to adopt the economic definition of depreciation as the periodic contribution to a sinking fund which will accumulate to the reproduction cost of the asset at the date of retire ment. Another proposal amounts to computing the economists* Ill "internal rate of return" from the investment in the asset* The periodic depreciation, then, would be the amount of capital assumed to be recovered through the operations of each year* Again, a version of opportunity cost has been sug gested* In this case, the depreciation is based on what it is thought the asset would realize in immediate sale, rather than upon its original cost* Finally, accountants have been greatly concerned in the post-war inflationary period over the "usefulness" of depreciation data based on historical costs, and consideration has been given to the possibility of adjusting such figures by the use of price indices. Accountants, however, are seriously restricted by the tradition that the total depreciation which is charge able as an expense, or a loss, is set exactly by the original dollar cost, and almost everything in the double- entry apparatus reinforces this principle* It stems, evidently, from the long-establi3hed presumption that the purpose of accounting is one of stewardship and the pre servation of strict objectivity in all reporting on what may be called the financial, as distinguished from the economic, position of the firm* The accountant is reluc tant to depart from what he regards as the essential, objective facts of the case: namely, the literal number 112 of dollars paid to acquire the services of an asset* The general outcome of this attitude has been that proposals to use anything other than historical cost for depreciation and valuation purposes rarely get beyond the talking stage* The discussion of deferred costs and depreciation has been entirely in terns of the latter. However, the underlying accounting principles are the same for all cases where the firm purchases an asset of any kind which is capable of rendering services over more than one ac counting period, but not perpetually* This is true in spite of the unsystematic treatment that can be found in textbooks, on published financial statements, and else where* Thus, for example, when the firm pays for fire insurance on its plant for three years in advance, the usual procedure is to consider that one-third of the total premium is a cost of the production each year during which the firm receives the services of the insurance protection* At the end of the first year, an asset amounting to two- thirds of the premium would appear on the balance sheet. At the end of the second year, it would be one-third, and so on. Fixed-Variable Criterion for Costs Cost budgeting, as it is usually practiced, is based upon a period of twelve months* For accounting purposes, the budget practices of the firm determine the fixed- variable classifications of a cost* That is, a production coat is treated as being fixed if, over the budget period, it is considered not to vary in proportion to the volume of output. This would appear to mean that an accounting cost is "fixed" over the short-run period as defined on pages 34-35« For most situations, one year is sufficiently short so that one can safely assume that the fixed costs of the accountant are defined in terms of existing facili ties, Changes in capacity will, of course, be reflected by revised definitions of fixed costs in subsequent account ing periods. The general principle which determines fixed costs for any given period, however, will be based upon an implicit assumption of an unalterable productive capacity. In a process situation, it is customary to regard each recognizable process, or department, as a center for the accumulation of costs. Furthermore, it is the custom to transfer costs in aggregated amounts from the accounts of one department to others in a manner that is intended to correspond to the physical movements of the products themselves from department to department. Departmental cost accounting thus entails a great deal of cost alloca tion from one department to another, in which all sorts of bases and formulas are used, A principal result is that the distinction between fixed and variable costs may easily become lost; and, when these internal transfers are 114 completed, it is not at all easy for an outside observer to see what has happened* The Imputation of Cost to Product In other parts of this chapter, there were mentioned the costs that are "attributed” or "assigned” by account ants to the production of a given period. The criteria that the accountant uses in determining the relationship between costs and product include, it appears, two prin ciples. Where possible, the principle of "responsibility" is applied. Raw materials and labor of a type that can be directly observed to be expended on a given segment of output are charged to that output under that principle. Where, however, direct observation does not reveal any convincing case of responsibility, as defined above, the accountant turns to the alternate principle of "benefit.” This is often the expediency adopted in cases of joint or common products, when direct imputation is thought to be impossible. An example is that of the cost of maintaining a building which is used for the production of two or more different products. Typically, the relative amount of floor space devoted to the respective products is used to measure the benefit to each, and hence the amount of cost assignable to each. Most methods of assigning deprecia tion to the output of different periods, previously 115 described, may be thought of as applications of the bene fit principle* Finally, this general observation may be made* Economists often deal with abstractions, and they are not handicapped by many practical considerations* That is, they define the cost of producing a given product and have no further problems* The cost accountant, on the other hand, is apt to have no real interest in an abstract defini tion; his problem is that of disposing of and classifying certain concrete cost figures. In doing so, he feels the need for definite, tangible criteria and justification. Sometimes, he refrains from making a definite allocation of a cost even though he knows that it really should be assigned to a more specific category than he gives it* This seems to explain the almost inevitable appearance on the income statement of the expense category commonly labelled "general" or "administrative" expense* Joint and Common Products Where costs are clearly related to production alone, the cost accountant will usually make a complete allocation to the various products which are involved, no matter how arbitrary and expedient the procedures may turn out to be*? This is noticeably true of joint or common ?See, however, the discussion of "direct costing*" 116 costs# The reason for this that is usually given is the need for inventory figures to satisfy balance sheet re quirements#, It is possible, too, that the practice of com puting "gross margin" {revenue less cost of finished pro duct sold) for individual products may impel accountants to allocate all production costs to individual products# The significant difference between joint and common production costs is not always given consideration by cost accountants# The following quotation from a well-known collegiate textbook is an example: In general, there are three important methods of allocating the joint costs of production to the joint products: a# The market price method, whereby common costs are allocated to the several commodities in proportion to the relative market values of the products obtained# b. The unit method, whereby the common costs are distributed to joint products on the basis of the proportionate amount of common material in terms of pounds • • • or gallons found in the ultimate products* c# The survey method, whereby common costs are ^ allocated to joint products arbitrarily • . #8 Cost accounting does, however, have several differ ent techniques for dealing with the multiple product pro blem, and where production is truly "in common," the A John G# Blocker, Co3t Accounting (second edition; New York: McGraw-Hill Booic Company, inc•, 1943), p# 654* 117 accountants sound instincts often lead to the selection of a method that reflects the economic facts of production. Thus, the physical weights of common products may be used as a basis for dividing the total costs among them if it is apparent that weight "causes” costs. The joint cost situation, when it is recognized as such, may be dealt with by using the relative market values of the products as a basis for assigning costs. This is essentially a case of the application of the benefit prin ciple, and it also implies a recognition that no cause and effect relationship between any one product and total cost exists. Any textbook on cost accounting will list numerous procedures or formulas for the division of joint or common costs. Omitting those which represent pure expediency, they are of essentially two types: namely, some variation of the relative market value method or one based upon ob served physical relationships to cost, such as weight, volume, number of individual units, and the like. Distribution Costs In recent years, distribution (selling) costs have gained increased attention from cost accountants, where in the past they were not accorded the refined analysis customarily given production costs. In some respects, cost accountants have succeeded in bringing more lid flexibility to the analysis of distribution costs than to those of production. Thus, for example, it is coming to be recognized that the assignment of a given item to the fixed or variable category will depend upon whether one is trying to measure the contribution of a class of customer or the contribution of, for example, a sales territory. The foregoing is based essentially on the assumption that there may be numerous "ultimate objects of costing" with respect to selling expenses, while the product itself is 9 the only costing objective in the factory. It may be informative to compare Chamberlin’s de finition of selling costs (page 39) with the following, which is representative of the accountant’s approach: Distribution costs include all costs incurred from the time the product has been put in a saleable state until it is converted into cash. Thus they involve the functions of selling, storage, transportation, financing, credit, and collection. The major items of expense include advertising, selling expenses, packing, storage, transportation, financing, credit, , q collection expense, and sales administrative expense. Further matters related to distribution costs are discussed in the following section. ^Lawrence L. Vance, Theory and Technique of Cost Accounting (Brooklyn: The foundation Press, Inc., 1952), p. 492. ■^Blocker, oj>. cit.. p. 21. 119 Accounting for Monopolistic Advantages In Chapter II, mention was made of the capitaliza tion of monopolistic advantages and the relationship between the latter and the concept of normal profits* Accountants, in theory if not greatly in practice, appear to be aware of this question, but accounting has its own special rules* The tradition having the greatest influence is that which opposes the recognition of assets or expenses which are not actually paid for by an explicit outlay of money or its acceptable equivalent* While thi3 rule is not always enforced where a "tangible" asset is acquired, it is certain to be insisted upon when the ques tion arises of capitalizing superior earning power. Thus, if the firm is obliged to pay for all of its special earn ing powers by purchasing what accountants call "goodwill," by buying established patents, or by heavy advertising out lays, something approaching "pure profit" may result from the accounting processes, provided, of course, that the assets involved are amortized periodically. But superior earning power developed internally is not recognized in advance of its actual realization. A concrete example of this is found in the accountant’s attitude toward patents. This asset may be recognized to the extent of such explic it outlays as research costs, attorneys’ fees, costs of models, et cetera, but that is all, regardless of what 120 the patent may be worth to the firm in terms of future revenue• Even where explicit expenditures have been made to acquire a capitalized market advantage, the American ac countant , at least, shows a propensity to avoid charging the cost to an "intangible” asset if possible. The in come tax regulations exert a pressure to charge the out lay to an asset which can be readily amortized as a peri odic expense, such as buildings or machinery. On the occasion when some such asset as "goodwill” is actually given separate recognition, there is a reluctance to amor tize the asset as an expense. Instead, it is treated as a direct reduction of proprietorship. Furthermore, the amortization is apt to take place over some completely arbitrary period of time. Price Level Adjustments At the present time, the effects of inflation on accounting data constitute, possibly, the greatest worry to the more thoughtful members of the accounting profes sion. It is apparent that many writers have serious doubts concerning the adequacy of some long-established principles. The problem takes two forms, as the profession appears to see it. First, the lag between the acquisition of a factor and the eventual sale of finished product yields a special gain, in terms of absolute dollar amounts, 121 during inflation. Many accountants and economists object to the use of historical accounting cost for the purpose of computing profits under these circumstances. Princi pally, the objection is based on the assertedly deceptive nature of inflationary gains. It is said that, since the firm and its stockholders must buy in an inflated market, conventional cost accounting leads to overstated profits with reference to purchasing power. The second objection is made with respect to the comparability of accounting data over time. Unadjusted figures of all types are considered to be non-comparable, and hence misleading, when the general price level changes over time. Thus, for example, statements showing a doub ling of the firm’s gross income between 1946 and I960 would be deceptive, since it would presumably be explain able in part by inflation. Many detailed plans for the use of index numbers to rectify recorded accounting data have been suggested. One of the principal targets has been depreciation, because the costs of relatively long-lived assets are more seri ously affected by price level changes than are other costs. To date, however, there has been virtually no implementa tion of these plans in practice. The only plan to deal with inflation that has been put into actual practice is the device known as the ”LIFO" 122 principle for inventories* The history of this device throws a great deal of light on the way in which account ants tend to solve their problems and warrants, perhaps, some extended discussion* Where the firm handles large quantities of homo geneous items, either as raw materials or as finished pro duct, it has always been the practice in keeping inventory records not to attempt to keep track of the cost of indi vidual items* Thus, a retail store accountant would never think of trying to identify individual bars of soap and the cost thereof of each* Instead, it has been the custom to adopt an arbitrary assumption concerning the order in which fungible goods are requisitioned from stock* Before the current inflationary period, a very common assumption was that of "first-in, first-out" (FIFO), meaning that it was always presumed that any given article removed from stock was the oldest item then on hand, so that it was assumed to have cost the price of the oldest acquisitions not yet exhausted by requisitioning* The well-established custom of making practical assumptions as to the flow of goods has given the members of the profession a means for dealing with inflation while continuing to base their procedures as much as possible on the objective "facts," something which other price-level adjustment plans appear not to do* 123 By the tour de force of switching the assumed order in which goods are moved out of stock to "last-in, first- out" (LIFO), the accountant is able to arrive at a cost of goods sold figure which is based on recent rather than older purchase prices, since the recently acquired goods reflect the latest price-level situation. It is not the primary intent in this chapter to make critical evaluations of any accounting practice. How ever, the following characteristic of LIFO is offered as a fact. This device does not discriminate between dollar gains due to relative price increases and those derived from general inflation. To the extent that LIFO is effec tive at all, it suppresses all gains of a "market" nature, without reference to their origins. At an earlier point, it was intimated that the deters mination of the current costs of production did not com pletely settle the matter of the expenses of the period, since inventories had to be taken into account (page 105), It should be apparent now that, even after periodic produc tion costs are determined, accountants still have some serious problems to settle before they are able to arrive at their "cost of finished product sold" for the period. Direct Costing In terms of th^. widespread and sustained interest which it has aroused among cost accountants, and in view 124 of their apparent willingness to experiment with it in actual practice, "direct costing" is probably the most im portant movement yet undertaken by accountants explicitly to meet the criticisms of the economists and businessmen who complain that accounting cost data are unusable for economic analysis and unsuitable and misleading for pur poses of rational management of the firm* The technique in question receives its name from the fact that only so-called "direct" costs of production are charged thereto, all other factory costs being treated as "period" costs* The latter are listed as deductions of the period for purposes of computing profit, but not under the heading of "cost of finished product sold*" In terms of the arrangement of Appendix B, which is not based on direct-costing assumptions, this procedure would result in a substantial reclassifying of some ex penses from "cost of finished product sold" down to the group which includes "selling" and "general and adminis trative" expenses, possibly under a title such as "indi rect factory expenses*" A second result would be a reduction of the "cost value" assigned to unsold finished product inventory on the schedule of working capital (Appendix D). The purpose of "direct costing," it seems clear, is to develop production and inventory cost figures which 125 can serve, at least approximately, the purposes of margin al costs, although it seems impossible that anyone familiar with the two concepts would mistake them for equivalents* The precise kind of costs which the various propo nents of this device have in mind is uncertain# It is commonly said that the direct and period cost dichotomy 11 corresponds to that of fixed and variable costs. On the other hand, one reads that direct costing is a policy of excluding from the costs of production all of those which can not be traced "directly and conveniently" to specific units of productThe possibility that the "direct" and the "variable" costs of accountants may not amount exactly to the same thing does not seem to have been recognized by all writers* This was true, for example, in the Hep- worth-Neilsen articles referenced below. In view of the foregoing source of possible ambi guity, an unequivocal general definition of this cost con cept is difficult. The situation in which the account ant’s direct cost is most apt not to correspond to his variable cost is that in which common or joint production ^Samuel R. Hepworth, "Direct Costing— The Case Against," The Accounting Review. XXIX (January, 1954), pp. 94-99. ■^Oswald Neilsen, "Direct Costing— the Case ’For’," Ibid.. pp. 39-93* 126 exists* The advantages claimed for direct costing, about which there appears to be more agreement, seem to imply that what is really wanted is true variable costing, rath er than costs of production limited to those which have obvious and immediate physical relationships to the indi vidual units of product* Standard Costs The standard cost of production may be defined as the cost that would be incurred at a relatively high level of effectiveness and efficiency with respect to the pur chase and use of the factors of production. When a com plete system of standard costs is in operation, the stan dards are applied to all of the costs of the firm, and not to the costs of production alone* Standards are developed for both prices and quantities wherever they are used. In establishing standard costs, the procedures appear typically to be that of taking as given the funda mental economic decisions relative to the volume and composition of output, following which standards of effi ciency in the acquisition and consumption of the factors of production, and perhaps of distribution, are establish ed. The usual approach may be characterized as an engi neering rather than an economic one* In general, the use of standard costs does not 127 seriously modify the total cost which appears on the in come statement* If standard costs do appear thereon at all, the variations therefrom will ordinarily appear also as special losses or gains; and the net effect is a total cost figure based on the historical costs actually in curred* Furthermore, standard costs are often used only for comparison purposes and for internal control, so that they have little effect on the conventional, general-pur pose statements* Perhaps the most material and noticeable effect of the application of the standard cost principle is found in the practice of excluding from the cost of finished product a portion of the fixed cost which is imputed to unused plant capacity* Costs so excluded commonly appear in the income statement under a title indicating that they are a cost of "idleness.” As indicated above, how ever, the net result of such procedures is simply to re classify the accounting costs and not to modify the total thereof. The Funds Statement There remains to be discussed one more important accounting report. It is called here the "Funds State ment," although it has numerous names. The purpose of this statement is to reveal the sources from which working capital was obtained and the objects upon which it was 128 expended during an accounting period. Such interval ordi narily corresponds to the period for which conventional profit is computed. Appendix C is such a statement; and Appendix D, a supporting schedule, illustrates the usual content of working capital as the accountant defines it. The only part of the statement which may not be readily understood is the procedure by which the contri bution of current operations as a source of working capi tal is computed. To obtain this quantity, the accountant begins either with profit or some intermediate figure on the income statement and then adds back to such figure all of the non-fund deductions that were made originally in the computation thereof. This adjustment includes all depreciation and analogous accounting expenses. The re sult is equivalent to the sales revenue, which ordinarily increases working capital in its entirety, less those ex penses or losses which entail the diminution of working capital. It is noticeable that the accountant’s interpreta tion of working capital, which he obviously thinks of as "funds,” is very liberal in terms of liquidity, as seen by the inclusion of trade accounts receivable and inventories. Some statements, incidentally, go somewhat further than this with respect to what is admitted to the "current asset" group. CHAPTER V AN EVALUATION OF ACCOUNTING WITH RESPECT TO THE THEORY OF THE FIRM The designated purpose of this chapter is to evalu ate accounting procedures as a source of empirical data which may be used for a specific purpose# The special use of accounting data which is to be considered is in connec tion with the testing of the predicted results of opera tions which are postulated explicitly, or by implication, in a theory of the firm# It is assumed that such testing can have no meaning unless the economic "results" in question are presumed to be measurable by reference to a set of specified variables, such as marginal cost and revenue# Once the variables are established, the evaluation of accounting is then properly accomplished by determining the extent to which such ac counting statistics can be suitably employed to measure the indicated economic variables# The economic variables which are implied in the theories which have been reviewed in Chapter III include total, average, and marginal costs and revenues# In addi tion, several different versions of costs were shown to have a possible relevancy to our subject# They were re placement, opportunity, and historical costs# 130 With respect to balance sheet elements, discounted capital value is a significant variable in some phases of the theory of the firm. In other cases, it is apparent that some method of measuring the structure of the assets and the patterns of the financing of the firm is implied, if not made explicit, and so too with respect to the amounts and rates of interest paid out to investors. Final ly, some economists apparently assume that the concept of liquid funds is sufficiently specific to be reducible to measurements. In general, the variables implied in this paragraph are not so clear-cut in economic writings as are those of costs and revenues, and the evaluation of ac counting data with reference thereto must be corresponding ly less conclusive and satisfactory. I. STATEMENT OF METHOD The method adopted consists of an examination of the three principal accounting reports, and the accounting procedures that underlie them, in the order of their appar ent importance to this study. The statements so discussed are those which appear in the appendix section: namely, the income statement, the balance sheet, and the funds statement. These three general-purpose statements which are evaluated represent substantially the entire source of accounting information which is ordinarily available to 131 all persons other than those who are personally connected in some capacity with the individual firms. The possibility that, in particular instances, the economists doing research in .the theory of the firm might have access to supplementary data is not precluded. In some cases, the result might be to make accounting state ments much more useful to the employer thereof. This is not intended, however, to be a study of the data which are available to management. We are not concerned with the supplementary information and explanations and the expert technical analyses which may be performed on raw account ing data by engineers, management specialists, and account ants themselves. Instead, it is intended to evaluate the routine, conventional practices that are reflected in the general-purpose statements upon which outside observers must generally depend. It should be repeated that the theory of the firm is taken as given in this study. It is anticipated that some of the observations on accounting procedures which are made may lead the reader to infer that a given theory is "wrong" because management can not have the information which is implied in the theory. The point of view, how ever, which is emphasized is that of an impartial observer who wishes to test a hypothesis without prejudging the question in any way, but who is properly concerned over 132 the content and characteristics of the data upon which he may have to rely* To the extent possible, each statement and subdivi sion thereof is evaluated with respect to all of the phases of the theory of the firm that appear in Chapter III. To be perfectly meticulous in this, however, would result in excessive involvement. The references to the various theories of the firm, and especially to the numerous inter pretations to which some are subject, is held, therefore, to a fairly general level. In addition, it is assumed that accounting concepts may be profitably compared with related economic concepts where it is convenient to do so and with out, in every case, tying the discussion to any specific aspect of firm theory. It Is not certain that all varia tions and interpretations of the theory of the firm have yet appeared, and consideration of the economic content of accounting data should not be rigidly restricted by any such assumption. II. THE INCOME STATEMENT The accountant’s income statement reduces, in its essentials, to the following: revenue minus expenses (and- sometimes losses) equals profit. The economists’ analogous formula, as described in Chapter II, states that revenue minus costs equals profit. The surface resemblance of one 133 for the other makes it feasible to compare the components of accounting profit, on a step-by-step basis, with their economic counterparts* In what follows, the word "cost" is employed almost exclusively, and it means "expense" when used with reference to accounting* The use of the word "profit" presents its usual difficulties. We shall use it frequently without qualification, but the general meaning intended is that of the residual return to the ownership class. As explained earlier, "net return" will be used to mean any partial contribution to "profit," such as the net return attributable to an investment in an individual asset* Revenue Accountants frequently mention the "realization" and the "accrual" conventions in explaining their approach to revenue. These words are sometimes loosely used, inter changeably on occasion, but it is clear that they refer to two well-established practices. The realization convention is negative; it bars any recognition of expected revenue beyond the recovery of the accounting "cost" of production until such revenue is validated by a sale transaction with a customer* The accrual convention is most properly thought of as being positive; it requires the recognition of revenue on the occasion of a sale and without any delay to await the actual receipt of money. 134 As was explained in Chapter IV, the refusal to anticipate "unrealized" revenue means that all accounting assets are maintained at historical costs and that there is no adjustment for capital gains in the economic sense* The consequences of this practice fall on the asset values and on the periodic profit. The latter tends to include capi tal gains, without specific identifications as such, in the period when revenue is "realized." It must be empha sized, however, that this convention does not, in itself, cause any discrepancy between accounting and economic reven ue when the latter is strictly defined as gross receipts. The second accounting (accrual) convention, however, does cause a deviation between the two. The almost universal practice of recognizing reven ue when a sales transaction occurs means that such income is tied to the movement of real goods, and thus is disas sociated from the inward flow of money. The extent to . which accounting revenue is divorced from money flows de pends upon the credit terms granted to customers, and the discrepancy is largely in the form of a time-lag. Accounting income statements do not ordinarily distinguish between cash and credit sales, showing instead one aggregated amount; and they supply no exact informa tion on the flow of money into the firm. Any information of that sort must be sought in the funds statement. 135 The fact that the typical accounting revenue is not money income means that it is not precisely relevant to any economic concept of value which is based on the dis counting of expected net receipts over time® At least one version of the theory of the firm, as we have seen, postu lates the maximization of the present value of the expected future "profit" streams, and revenue is an essential com ponent of profit. It is not always clear whether the revenue which economists assume to be subject to discount ing means monetary receipts, but nothing else seems logi cally plausible* Discounting for time is pointless unless it is money receipts that are involved, and not the ac quisition of mere prospective claims to money. It would not seem reasonable to assert that the investor cares how long he must wait for the appearance of an account receiv able, which is only an intermediate event, or that he can normally exact a "return" for such delay; it is reasonable to assume that the time delay for monetary purchasing power is important and discountable. In mitigation of the foregoing is the fact that short-term credit to customers, which characterizes many businesses, would not cause a material discrepancy between money flows and accounting revenue. Furthermore, it is usually possible for an observer to adjust reported reven ue to a close approximation of the money receipts from 136 customers for any accounting period. This requires a simple arithmetical comparison of the trade accounts re ceivable balances at the beginning and end of any period for which the desired computation is made. An increase in the latter should be subtracted from reported sales revenue, and a decrease added. The "realization" convention of accounting is often discussed in conjunction with revenue, although the con nection therewith is not really important. The signifi cant repercussions of this convention are upon the capital values of assets and upon certain phases of accounting income in the net return sense. With regard to revenue, it need only be pointed out that this principle forbids the recognition of the latter prior to a completed sale to a customer. This in itself conflicts with no economic principle. Any discrepancy between economics and account ancy in this particular instance arises from the refusal on the part of the accountants to take into consideration, for asset valuation purposes, the expected proceeds of the future, and not from their insistence upon realization as the criterion for the ultimate reporting thereof. The effects of this convention upon asset valuation and pro fit, and the related question of uncertainty, are further discussed under the heading of "costs." In summary, the accountants preoccupation with 137 the sale transaction as the occasion for the recognition of revenue {the assignment thereof to a given period of profit reckoning) causes him first to reject the full anticipation of revenue through asset valuation procedures (capital adjustments); and then to insist upon such re cognition, normally without even discounting for time, at the intermediate date of legal sale* Thus, the orderly assignment of profit over time, which is inherent in Fisher's theory of capital and income, is not accomplished* The next question relates to accounting revenue and the economic concept of marginal revenue. In a highly competitive situation, where the demand schedule for the individual firm is very elastic, the amount of each sale tends to equal, of course, its marginal contribution to total revenue. The literal amount of the individual sale is, however, all that the accountant ever records. In imperfect market situations, marginal revenue must be a hypothetical figure, computed by making comparisons between assumed total revenue figures at various physical volumes of sales. There simply is nothing in the accountant's treatment which reflects this economic concept. That, however, is no more true of accounting data than of any other literal, objective information respecting "actual" individual sales transactions which have been completed, and it should not be construed as a deficiency which is peculiar to accounting. Any attempt to infer marginalist practices on the part of the individual company could start properly with the actual recorded dollar volume of revenue for any given period of time, as revealed by the accounting reports. From that point, however, any further information needed to make marginal comparisons would of necessity have to be drawn from sources essentially external to the firm. A study of the market structure in which the firm operated would be required. This would not mean, however, that a study of recorded sales transactions might not be useful in establishing a hypothetical marginal revenue curve for the firm. Brief attention should be called also to the fact that accounting practice sometimes involves crudities in the treatment of discounts, transportation costs, and allowances of various kinds, all of which make difficult a precise determination of the effective price at which a given transaction has occurred. We shall not discuss these difficulties further because it does not appear that they are usually material in comparison with the total volume of revenue, regardless of how seriously wrong they are when viewed as a matter of logic. Some related defi ciencies, however, are taken up later under the heading of "selling costs." 139 Costs Much more than in the case of revenue, the "cost" of economists is a highly variable concept. Consequently, a comparison between it and the accounting counterpart must depend ultimately upon what kind of economic theory of the firm is postulated. For the moment, it is assumed that the economic model which is sketched on pages 22-29 in Chapter II provides a suitable working formula for the "cost” which is implicit in most theories of the firm. The basic division of cost in the economic model is that between the so-called "explicit expenditures" and the "imputed opportunity" types. Accounting methods, as we have said, tend to result in costs which assume a simi lar appearance. That is, accounting costs represent (1) in part direct monetary outlays of the period and (2) partly "depreciation" of capital assets, "adjustments" for inventories, and other cost deductions based on imputations as distinguished from "explicit" transactions. Accountants separate total expenditures into cur rent costs and capital outlays according to the principles explained in Chapter IV, i.e., expenditures assumed to "contribute" or be "related" to future revenues and busi ness purposes are excluded from current costs and "deferred" to future periods as assets. Economists apparently assume a similar separation based upon what, to the best of the 140 writer’s knowledge, are substantially the same criteria* The accountant’s approach is pragmatic and based on what he would call practical judgment. That descrip tion is imprecise, but anything more exact would be diffi cult to attain. Perhaps it will suffice to say that, on the whole, economists would be justified in accepting the accountant’s judgment as to what in principle constitutes a current cost as distinguished from a capital outlay. The more frequent divergencies between accounting and economic costs appear in the imputations that are made following the acquisition of a capital asset. One practice, however, causes a discrepancy of another type, at least for some economic purposes. The accrual convention, previously discussed in connection with revenue, requires the accounting recognition of cost when the services are received by the firm, an event which often antedates the actual monetary payment. Accrual accounting, applied to both revenue and cost, thus pro duces nothing which is exactly the same thing as the net receipts upon which Fisher’s discounted capital value is based. As was suggested in the discussion of revenue, however, the discrepancy may not be serious, since the time-lag is relatively short in most cases. Accounting and economic costs diverge most seri ously, of course, in the case of imputed deductions. The 141 differences between the two have already been described at some length, but a practical illustration may be useful. Assume that a machine is purchased at a cost of $43,295* The expected receipts attributable to this in vestment are $15,000 per annum for five years, and the related annual monetary outlays are expected to be $5,000. Under these circumstances, the internal rate of return is 5% compounded annually. Suppose, further, that the best alternative opportunity rate of return is 4$* The capital value of this investment, under the economic definition, is the present value of $10,000 (expected net receipts) per annum for five years, dis counted at 4% compounded annually, or $44,513* There is an immediate capital gain of $1,223; and, as Knight says of these circumstances: . . . in any such a case, the historical cost will be treated as if it did not exist. The amount of capital is always the capitalized value of an expected future stream of service.^ The economist's version of the life history of this investment, assuming no further changes with regard to expectations or opportunity rates, would be as follows: ^Frank H. Knight, "Capital, Time, and the Interest Rate," Economica, new series, Cl3 (August, 1934), p. 277* 142 EXHIBIT 1 Costa______________ Capital at Year Revenue Explicit Imputed Net Return Year-end 0 #44,513 1 #15,000 # 5,000 # 3,219 #1,731 36,299 2 15,000 5,000 3,543 1,452 27,751 3 15,000 5,000 3,390 1,110 13,361 4 15,000 5,000 9,246 754 9,615 5 15.000 5.000 9.615 335 -0- $75.000 $25.000 $44.518 $5.482 The "net return” above is Fisher*s "return over cost.” It bears a constant relationship to the unrecovered capital-value at the beginning of each year. The imputed cost is the amount of capital which is deemed to be re covered in the receipts of each year. It is also the main ingredient in Keynes* "user cost” of equipment, since it represents the reduction in the present value of the asset which is attributable to its use each year. In contrast, the same data under the usual accounting interpretation would appear as follows: EXHIBIT 2 Expenses (Costs) Net Book Value Year Revenue Current Depr. Return at Year-end 0 1 #15,000 # 5,000 I 3,659 2 15,000 5,000 3,659 3 15,000 5,000 8,659 4 15,000 5,000 8,659 5 15.000 5.000 , _ L 6J.2 _ ,295 ,341 34,636 1.341 25,977 1.341 17,313 1.341 3,659 1.341 -0- $75.000 $25.000 $43.295 $6.705 2For example ($44,518)1.04) = $1,781; ($36,299) 143 The above is based upon the so-called "straight- line" depreciation formula. The net return is not a con stant percentage of undepreciated machinery "value," as is the case in the economic approach. Furthermore, the im puted cost is based on historical rather than on the oppor tunity cost, and this results in a total increase of $1,223 in net return. The capital gain adjustment of this amount is thus merged into the net return. If the net expected receipts varied from year to year, the accountant might use an "output" or "production" method for depreciation, charging in proportion to the variations in net receipts. Such a solution, which is logical within its limitations, would not eliminate the inherent characteristic of the customary accounting treat ment of depreciation: namely, the failure to reflect the internal rate of return which is implicit in the cost of the investment and the net receipts schedule. Accounting theory, however, provides the means to do this, as indi cated in the next schedule below: (.04) 3 $1,452; and so on 144 EXHIBIT 3 Expenses {Costs) Net Book Value Year Revenue Current Depr, Return at Year-end 0 #43,295 1 #15,000 # 5,000 # 7,^35 #2,165 35,460 2 15,000 5,000 0,220 1,772 27,232 3 15,000 5,000 0,630 1,362 10,594 4 15,000 5,000 9,070 930 9,524 5 15.000 _ 5,000 9,524 476 -0- irjuppo #21*000 |6.,.ZP5. The above treatment reflects the internal rate of return of 5%, The net return each year is 5% of the book value at the beginning of that year. In concept, it is exactly like the "economic” treatment in Exhibit 1, the only difference being that the latter is based on an "opportunity” rate of The use by accountants of depreciation methods based on the showing of some constant relationship between net return and capital value is suggested in some textbooks under the heading of "compound interest" methods. The use thereof in practice, however, appears to be virtually non existent, Depreciation based on the opportunity rate of return principle is not a generally recognized procedure among accountants, even as a theoretical proposal* The failure of accountants to recognize the oppor tunity-cost approach to asset valuation and the interrelated process of cost calculation makes the whole question of risk and uncertainty almost entirely irrelevant in any 145 discussion of accounting procedures, since the foundation of opportunity cost is the expected future net receipts from an investment. The accountants explain their adher ence to historical cost for purposes of asset valuation by reference to the uncertainty concerning the eventual returns to a capital outlay, and it is true that the basis for accounting recognition of any asset "value" is the assumption that such asset is a source of future reven ue, either directly or indirectly. The entire range of economic analysis using the concepts and distinctions of general dynamic uncertainty, oligopolistic uncertainty, and certainty equivalents, however, is inapplicable in the face of the accountants’ arbitrary solution to the problem. The foregoing does not mean that the question of expectations is totally unrelated to what accountants do. When the latter separate their historical cost data into "asset" and current "expense" categories and use the latter to compute periodic profit, they base everything on the expectations of future net receipts. Nothing is done, however, to reflect the varying degree of certainty with which such expectations may be held. Even though it may appear that certain key elements in accounting costs are hopelessly divergent from the economic approach, accounting costs are still relevant to several phases of the economists’ theory of the firm; and 146 further evaluation is in order* The special problems which appear to require discussion pertain to imputed costs, joint and common costs, linearity in costs, the cost func tion, and selling (distribution) costs* Imputed costs* The weaknesses of accounting in the area of depreciation have already been suggested, espe cially with respect to the straight-line method. This expediency results often in "cost” figures which do not bear any reasonable relationship to the economic effects of using plant and equipment. In particular, it may lead to the assignment of costs to the wrong segment of pro duction. When equipment loses its economic usefulness solely as a consequence of use and not through obsoles cence, depreciation should be computed so as to vary with the volume of physical production* To treat depreciation in this case as a fixed cost results inevitably in charg ing the cost to the output of the wrong period, judged by either economic or accounting standards. In general, the greater the lag between an original investment and the realization of revenue attributable thereto, the more indefinite and careless are the account ant fs imputations. To a great extent, they tend to be dismissed as mere "bookkeeping" formalities, completed pri marily to obtain income tax deductions. It is very doubt ful if accounting depreciation figures ever reveal anything 147 significant about the results of operations. For economic purposes, they are virtually barren. Cost accounting, of course, entails other imputa tions in addition to depreciation, but it is the relative ly long-lived and expensive investments that give rise to the most material shortcomings in accounting procedures. Joint and common costs. The treatment of these costs by accountants is inadequate. The greatest weakness arises from the accountant*s insistence on allocating all joint costs to individual products. For economic purposes, true joint costs ought not to be assigned to separate units of product. The danger is especially insidious in the case of joint costs arising from explicit expenditure outlays of a current nature. These costs do vary in rough proportion to the aggregate output of joint products as a group, but as a group only. The allocation of such costs to indivi dual products will yield production cost figures which, on paper, vary with output. Since, however, an economically meaningful cost is one that has a cause and effect rela tionship with its product, and would presumably be saved if the latter were not produced, such joint cost data would be misleading for almost all purposes. The possi bility of deceptive results is greater in such cases be cause, as we have said, some joint product costs may actually vary with total output in the aggregative sense* The allocation of joint costs of a fixed nature, whether they are implicit or explicit, to individual pro ducts may also be deceptive* The results depend upon the method used and other circumstances* Certain techniques, the details of which are omitted, result in the assign ment of varying proportions of fixed, joint costs to in dividual products. That is, the relative proportions of a total fixed cost which is assigned to the respective pro ducts might be different at different levels of output, using some standard formulas of cost accounting. This would invariably create misleading impressions concerning the manner in which costs of the individual products vary with output. Other methods commonly in use would result in the same relative amounts of such cost being charged to the separate products regardless of the level of output, and hence would have a neutral effect with respect to the apparent fluctuation of total costs of a product with out put • It would seem that even on the simplified assump tion that cost is a function of output only, the verifi cation of the equality of marginal costs and revenue would necessarily entail the examination of separate data for the different joint products. The possibility that account ing costs will reflect accurately the economic sacrifices 149 of the individual products can be seen to be very question able. Linearity in costs. In Chapter IV, pages 104-5, it was explained that the unit cost assigned in the case of mass-produced, homogeneous products is usually the simple arithmetic mean of the entire production cost of an arbi trary period. The effect is to give an appearance of linearity to the "cost of finished product sold” figure which is found in the income statement, since the indivi dual units of output in any period of production are assigned equal costs. The extent to which such accounting procedures tend to result in an artificially linear relationship between volume and total costs depends in part upon the length of the "period" adopted for bookkeeping purposes. It depends in part, too, upon the extent to which errors are made in distinguishing between fixed and variable costs, but the problem to be examined here relates to the more subtle consequences of periodic accounting practices. Such periods tend to vary between one and twelve months in length; and the longer the interval, the greater is the tendency toward the illusion of unvarying unit costs. Some companies, probably the larger ones in general, make cost reckonings monthly, and changes in the production function and in the market may be better reflected in the unit cost3 assigned to finished product. This, however, is not entirely effective for the following reasons. First, there is the rather common use of "average-cost” methods for inventories. For example, the "costs" trans ferred from finished stock inventory to the cost of fin ished product sold account for any given month may actually represent a cross section of the costs imputed to all finished product on hand at the moment, and the same pro cedure may be used with respect to raw material costs transferred to work in process. Again, even though the company may make monthly cost reckonings for most purposes, it is almost the universal custom to define fixed costs in terms of one calendar year. That is, the fixed costs imputed to one year are the cost of all production accom plished during that period, and all units produced bear an equal portion thereof. For a concrete illustration, suppose that the firm were to adjust its output level materially at the end of each of the first three months of the accounting year. The marginal analysis would require knowledge of the total economic costs for the output of each separate monthly period. Average costs based upon annual aggregates would be worthless in this case, and that would be true both of the explicit and imputed costs. 151 In summary, accountants customarily deal in aggre gates of production costs covering as much as one year. This period is probably greatly in excess of the time- intervals at which many firms are able to adjust their volumes of output in response to changing conditions. As a consequence, accounting unit costs reveal little, and may actually be misleading, ivith respect to the economic effects of such adjustments. The cost function. The remarks in this section are intended specifically to include the explicit costs of accounting, which have thus far received relatively little criticism, as well as the implicit type. While the former type does not appear, as we have said, to diverge seriously in concept from the explicit costs of economists, there are faults and shortcomings in actual applications. The problems of determining the precise relationship between total output and total monetary "cost,” even in the relatively simplified accounting sense, are severe% and it seems to be generally the case that once he gets beyond the relatively clear connections, such as exist in, for example, the case of the so-called "direct” labor, the ac countant tends to become less and less willing to attempt precise assignments of costs to product. A characteristic tendency of the members of this profession to shun imputa tions and conjecture may cause them to be less effective 152 than the difficulties really warrant* The combination of joint products, fixed costs, unused capacity, and imper fect markets presents, however, a formidable barrier to the most determined cost accountant*3 As was implied in Chapter IV, the objective evidence of the extent to which accountants feel unable to analyze their data is found in the appearance on published income statements of such meaningless categories as "administra tive" or "general" expenses* Selling costs* It is evident that accountants do not generally separate production and selling costs in a way which is meaningful for economists* An examination of the quotation from Professor Blocker (page 116) reveals this tendency clearly. Storage, transportation, collec tion, and packing costs are not of the kind which ordinar ily "alter the demand curve" for a product, except, of course, to the extent that any "production" cos£ may con tain an element of this characteristic. In addition, accountants are much too prone to make use of the so- called "administrative expense" category, which is simply 3For verification of this appraisal of cost ac counting, see Cost Behavior and Price Policy (New Yorks National Bureau of Economic Research, 194-3)• This is a study prepared by a group of accountants and economists. 153 a group of costs that they do not feel capable of identi fying as either production or selling items, in spite of the fact that in theory all costs pertain either to pro duction or to selling. It is true that some of the more thoughtful accounting writers do much better than the usual performance in dealing with selling costs. Devine, for example, says; Selling costs differ from production costs in that the former are incurred with the expectation of chang ing demand conditions and the latter represent the effort necessary to shape the physical product. In pure competition demand is practically infinite for the individual firm at the going price, and selling costs are not a problem for individual consideration. If the product is sold in imperfect competition, the cost of differentiating the physical product from competing articles is a production cost, while the cost of spreading information about the real or fictitious differences is considered a selling cost.** Unfortunately, the clear understanding of the prin ciple for differentiating between production and selling costs demonstrated by this writer (overlooking the ques tionable statement about the cost of differentiating physi cal product) is still rare among even the better writers; and one can only infer that the situation in actual prac tice is no better, given the propensity of practice to lag behind the suggestion of academic authors of textbooks. ^Carl Thomas Devine, Cost Accounting and Analysis (New York; The Macmillan Company, 1950), p. 6$6. 154 Where imperfect competition exists, accounting data thus are faulty with respect to selling costs. The analy sis of the processes whereby the firm adjusts its output requires that true selling costs be separated, so that they can be studied in association with revenue while true pro duction costs are associated with the physical volume of production. The reason for this is that selling costs are thought by many economists to relate not only to volume, but also to unit price, so that they should not be simply added to total production costs and treated as a function of output volume. Instead, economists often prefer to treat them as direct deductions from revenue. Whether the economists’ analysis of selling costs in connection with any theory of the firm is correct or not, it still remains a fault on the part of accountants that they do not make their data adaptable to such economic purposes. The accounting treatment of selling costs appears often to be relatively crude as compared with that of pro duction costs, and this is apt to be manifested in a tend ency to treat selling cost expenditures as immediate current costs, without sufficient inquiry into the possi bility that an investment in a capital asset has been made. This reluctance to capitalize selling efforts arises appar ently from the fact that the "asset” acquired is not tangi ble, as is machinery, and not supported by a legal right 155 to future benefits, as would be prepaid insurance premiums, for example. Regardless, however, of the practical diffi culties which would be involved, some effort to capitalize and then amortize selling costs would seem to be indicated in some cases. Even though selling costs should receive attention and treatment as conscientious as that usually given pro duction costs, it is still improbable that they will be made very useful for purposes of economic analysis so long as accountants do not recognize the economic definition of selling cost and do not understand their relationship to revenue under conditions of imperfect competition. There is additional reason why selling cost data derived from accounting records may not be useful for the economic purpose under consideration here. Unlike the case of production costs, the allocation of selling costs to the revenue of a specific period can not ordinarily be accomplished objectively. It is often possible to trace production costs to a given segment of output by observa tion of physical relationships, but selling costs can not usually be so associated with revenue. One can rarely say with certainty that any stipulated outlay for sales effort produced any given volume of sales or was influen tial in maintaining any level of price. The probable consequences of this are somewhat more 156 serious than might be assumed at first glance* If account ants can not obtain information independently, the need to find some solution may lead them to turn to management for an indication of how selling costs relate to gross income* How, for example, should the costs of a long-range adver tizing campaign be amortized? If the advice of the sales manager is accepted, the result is apt to be imputed sell ing costs which simply reflect the intentions, or the hopes, of management* The value of such accounting data with respect to an analysis of the firm would be question able* In some cases, to use them to draw inference about the results of operations of the firm would entail cir cularity of reasoning* Even if all of the foregoing faults are overcome, one further difficulty will always be present* As indi cated in Chapter IV, if the product itself is not defined as the "object of costing," the accountant may adopt any of numerous bases for imputing selling costs to periodic revenue; and the basis chosen may not be the same as that implied in the particular hypothesis which is being test ed* Moreover, the usual Income statement does not reveal the basis for accounting for selling costs. To summarize, the limitations of accounting costs for use in economic analysis arise in part from the differ ent philosophies of the two professions, in part from 157 practices that seem to be explainable only by an unaware ness of the consequences, and finally from a human inabil ity to comprehend and measure complex interrelationships above a certain level of difficulty* The first type of limitation is found in the accountants* approach to imputed costs and their response to uncertainty* The second kind of difficulty is illustrated by the manner of dealing with joint costs, the method of computing periodic unit costs, and the treatment of selling costs* The third deficiency is revealed in an imprecise association of cost with physi cal output* We turn now to the consideration of accounting costs in relation to those theories of the firm in which econo mic cost is an important criterion* It is apparent that the chief issue that has divided economists, at least with respect to cost, is the question whether the outcome of business policy is the equation of marginal cost to mar ginal revenue, or, instead, the recovery of "full-average" costs* A secondary issue that we have seen is that be tween the traditional marginal analysis and the modern linear-programming criterion of maximization* Marginal cost analysis* Before accounting costs can be appraised with respect to their appropriateness for the marginal analysis, the question of the assumed vari ables must be settled* Gordon states that the most simple 158 assumption, and the one which appears to be implicit in the writing of many economists, is that the entrepreneur maximizes profit by making adjustments of output only. He then says: In much of modern price theory, cost and revenue are made single-valued functions of output only. Changes in the "data"— factor costs, production techniques, quality of product, etc.— are handled by shifting the curves, where the direction and amount of shifting are assumed to be given rather than as something to be explained. Price theory does not ignore the possibility of shifts in the relevant functions, but the marginal analysis is applied only to movements along the assumed func tions.5 For the moment, it will be assumed that the theory to be tested is based on the most simplified assumption, that in which cost and revenue are assumed to be function ally related only to output. Even under this simplifying assumption, it is evident that accounting cost data would very rarely reveal the functional relationship between total cost and output that would be needed in order to test the hypothesis that the level of output attained by the firm tended to be at the point of equality between marginal revenue and cost, as these variables are defined by econo mists. ^Robert A, Gordon, "Short-Period Price Determina tion in Theory and Practice," The American Economic Review. (June, 1948), p. 266. The principal basis for the foregoing conclusion is the fact that accounting data do not ordinarily reveal opportunity costs, but instead are burdened with carelessly assigned historical costs. It is conceivable that, in a given case, all capital outlays might be made at a figure corresponding to fisherTs capital value and that no changes would occur subsequently with respect to expectations or to the opportunity rate of discount. If the accountant were then to compute depreciation in such a way as to re flect an internal rate of return {see Exhibit 3» page 144), the resulting cost figures would constitute a fairly suitable approximation of economic imputed costs. If, in addition, the other crudities in cost accounting were at a minimum, accounting cost data could reveal approximately the total short-run economic sacrifice at the various attained outputs. This, to repeat, would constitute an exceptional situation in the real world. Accountants may object to these conclusions and offer their "direct-costing” procedures, previously ex plained, as a suitable measure of marginal costs. Aside from some doubt as to what exactly the criter ia are for identifying a "direct" cost, it is clear that this procedure is not the complete solution to the problem of the lack of economic significance of conventional cost data, especially with respect to marginal cost computation. It is true that direct costing prevents the charging of many "misleading" cost accounting data to production* How ever, the wholesale restrictions under which only clear- cut variable costs are allowed to reach finished product probably tend to cause the omission of many imputed costs which are a necessary component of marginal costs* Given the usual carelessness with respect to maintaining the distinction between common and joint costs, there is a very great possibility that, in actual practice, all common costs will be omitted from the "direct" cost total* This is patently wrong because if the relative proportion of different goods produced is optional, there are almost cer tain to be some costs which are assignable to an Indivi dual product on a responsibility or sacrifice basis* Similarly, in view of customary accounting practices, di rect costing may omit depreciation of a kind which is a function of usage. It is true that, within the range of a given level of fixed cost, marginal costs depend entirely upon the variable element. This, however, does not dispose of the problem of the economic characteristics which are lacking in accounting statistics, and even if "direct" costs are based upon a correct separation of fixed and variable costs, maximum economic profit can not be identified with out using economic methods in computing imputed costs. 161 In view of the above conclusions, it appears to be unnecessary to consider extensively the potential use of accounting data where additional variables might be postu lated in a theory of maximization* The procedures that accountants use are most nearly in harmony with the simple assumption that cost is a single-valued function of physi cal output only; and we have seen that even on that assump tion, accounting costs fail to indicate periodic economic sacrifice. It is not to be expected then that they would prove to be even as well suited for more complex models* The above restriction means that no consideration will be given to the otherwise important question of the construction of a marginal cost curve which takes into ac count the possibility of using varying combinations of input factors, purchased in imperfect markets, to attain a given level of output* The possibility of adding one other variable, however, is considered and discussed under the heading of "selling costs*" Furthermore, the questions of subjective versus objective interpretation and static ver sus dynamic analysis become largely irrelevant in view of the basic deficiencies of accounting costs in this area. As a rough tendency, however, accounting costs may be said to be relatively more appropriate for the objective inter pretation and the static analysis. As was pointed out in the case of revenue, accounting reports never reveal marginal costs directly. The accounts of the firm can show at best only the total costs at various attained rates of output. The shortcom ings of cost accounting procedures lie in their failure suitably to provide even that limited kind of information. Programming. Linear programming has been charac terized in Chapter III as an alternate criterion of maxi mization in the short-run "profit" theory of the firm* If the proponents of linear programming are correct, the cost curves of most modern industrial concerns will have a different appearance from the smooth and continu ous lines of the traditional analysis. The cost curve de picting the effects of adopting different levels of out put, and designating the level of maximum profit, will be discontinuous and segmented. The total cost curve may, in some cases at least, be a smooth line over a limited range of output; but it will eventually exhibit a discontinuous shift to a higher level. Thus the linear programming analysis reflects an important economic hypothesis that added applications of variable factors will not continue to result indefinitely in increased output unless the so- called fixed factors are likewise increased.^ ^Apparently, the writers in linear programming assume that the firm can increase certain expenditure-type costs, which are fixed over given ranges of output, without If It is assumed that the firm manufactures only one product with a given set of facilities, the points brought out in the discussion of marginal costs would suffice for linear programming. Within the range of any segment of a curve based on this type of analysis, the principles of marginalism are as applicable as ever. The shortcomings of accounting costs would be as great in one case as in the other. The situation where linear programming offers a solution to maximum profit which can not be obtained throqsfr the marginal analysis is that in which the firm may use certain facilities for more than one product. This is essentially a common-cost situation in which limited facil ities may have alternate uses. As a short-run problem, then, the firm is free to select the product-mix which is the most profitable; and each product is limited by the ■ extent to which the other is manufactured, plus an addi tional limit placed by the absolute capacity of the pro- 7 cess. Increasing the physical facilities. Such an addition is not considered to be an increase in capacity, and linear programming is still said to be a short-run analysis. 7See William J. Baumol, "Activity Analysis in One Lesson," The American Economic Review. XLVTII (December, 1953), pp. 837-73; and Dorfman, Samuelson, and Solow, op. cit•, pp. 133-3&* In real situations, there would be many cases in volving both types of constraints that we have just dis cussed: namely, that production can not be expanded be yond certain limits on the basis of a given level of fixed expenditures and that two or more products may compete for the use of limited facilities in some processes* The general principles would not, however, be altered in the more complex case* Our only concern with linear programming is with respect to the requirements which it places upon account ing, particularly as contrasted with the marginal analysis* The significant characteristic of the linear-programming analysis is not the assumed existence of limited capaci ties, which is present in any short-run theory, but rather the existence of a situation which makes it impossible to define the condition of maximum profit without weighing the relative contributions to profit of various products (a comparison which includes selling prices as well as costs) where they compete for the use of facilities* All of the deficiencies of accounting costs relative to the marginal analysis pertain with equal force to linear programming* The simplifying assumption of a linear rela tionship between volume and contribution to profit does nothing to modify the shortcomings thereof* Moreover, the additional information needed requires internal cost data 165 which are not ordinarily available other than to those personally connected with the firm. It may be of some interest to consider the proced ure that would be involved in the special case where all of the needed data were available* To "test" the theory of profit maximization would require that the actual quan tities of various products manufactured during the test period be scheduled. Each occasion involving any change in costs, sales prices, or volumes of output would require the solution of difference equations to determine whether the firm had adjusted to the combination of outputs yield ing maximum profit (under the linear-programming criter ion). In the case of imperfect markets, as we have said before, the linearity assumption must be dropped, and the so-called "nonlinear-programraing” analysis substituted therefor.0 This would entail the use of cost functions of a complexity which we have said would not be considered in this dissertation. Average cost. One important difference between what is loosely termed "marginalism" and "average-cost" ^See Dorfman, Samuelson, and Sdlow, op. cit., Chap. 6. 166 policy is as followsl The former refers to a short-run formula for determining the best use of a given set of productive resources* It does not necessarily provide a "profit" at all; a minimum loss may be the outcome of equating marginal costs and revenues* With the exception of the hypothesis attributed to Fellner (pages 77-7&), theories relating to average costs imply no maximization of any sort, but instead imply the recovery of some mini mum amounts* Economists who offer the "average-cost" hypothesis sometimes stipulate that the amount which is recovered is the accounting cost* If not stated explicitly, the assump tion seems often to be implied* If this is the case, there is little left to be said* Accounting statements usually reveal the facts as to the actual recovery of such costs, and the qualitative aspects of accounting costs would be irrelevant* The recovery of accounting costs is commonly offered as a counterproposal by those who assume that the entre preneur can not determine his economic marginal costs and therefore falls back on accounting costs as the only cri teria available. If, however, the opposition to the tradi tional theory is based on a belief that the firm management prefers to practice moderation and to strive only for a "fair" profit over cost, then the outcome which the theory 167 implies might reasonably be the eventual recovery of all monetary cost outlays plus a specified addition for "pro fit o" It is not always made clear by writers in economics what is meant by "average costing" or "full-average cost ing*" Where the word "full" is appended, it is probable that the theory implies that costs arising from past commitments are recovered; otherwise they may not be included in the assumption. Moreover, the costs supposedly recovered may or may not include some allowance for "pro fit," In view of the possible ambiguities and varieties in meaning in this kind of theory, it may serve our pur poses better simply to review some of the characteristics of accounting costs. The relevancy of such data to any given version of average-price pricing theory will then depend on exactly what is implied in the hypothesis. As a preliminary to the evaluation of accounting costs when used for the purposes under consideration, it may be useful to see what the accountant himself considers to be the purpose of his periodic computation of profit. The writers in this subject frequently point out that the only time when one can know with certainty the complete results of the firm’s operations is on the occasion of the final winding up and liquidation. Then, it is asserted, one can finally determine a total profit or loss. Meanwhile, the convention requiring the calculation of profit at arbitrary time intervals forces the adoption of devices which are, for the most part, purely expedient. |One is obliged at the end of each period to divide trans actions and investments into parts and to estimate profits on the basis of unfinished ventures. The accrual conven tion and the system under which historical costs are imputed to periodic revenue are the results of the account ant's responsibility to provide periodic profit figures under what he regards to be artificial conditions. Accountants are not always very articulate in explaining their work, but the following seems to be a correct explanation of what the practitioner has in mind. He sees himself as having to deal with two streams of mone tary units; revenue flows in and costs flow out. There is no conceptual problem in measuring the eventual outcome of any single venture or the aggregated results of all of the ventures of the firm. But the periodic profit requirement makes it necessary to cut nearly every stream into seg ments to be assigned to an appropriate period. Such assignments are accomplished by the various procedures which have been described elsewhere, but the principal characteristic of the accountant's work in this area is the almost complete absence of the subjective imputations made by economists. The accountant feels with respect to his own ver sion of periodic profit that it represents the most defen sible index of the progress of the various ventures in which the firm engages. There is a paradox in this because it is apparent that when the accountant talks of any final "accurate" reckoning, he means total money received less total money paid out. Thus the total profit over the life of the firm is simply total net cash receipts not counting owners* contributions or withdrawals. How ever, in computing his periodic index (profit) of the pro gress of the firm, the accountant refuses to accept peri odic net cash receipts as an index of anything. He insists, instead, that the entire scheme of adjustments and his own type of imputations, described in Chapter IV, are the only correct procedures. Thus, aside from various deviations^ that always occur in practice, the definite tendency of accounting income measurement is as follows. The total reported "profit" over the entire life of the enterprise is equal to the net money flows other than those of a capital 9ln some cases, departures from this underlying objective may be serious and material. However, it would be impractical to digress into a discussion of the numer ous technical circumstances which lead sometimes to the violation of the basic principle— that reported costs are based on historical monetary outlays. 170 nature* Money invested in the firm, plus accounting pro fit, less dividends paid, less all money paid to liquidate owners’ investments, is supposed {according to the usual intention) to equal zero* The entire effect of the various devices that the accountant uses to "improve" his profit reporting is intended to be upon the periodic figures but not upon the final total* This is true because historical costs (actually monetary expenditures) are, with minor exceptions, the bases for the measurement of all periodic "expenses," and actual realized monetary income is the final criterion for the measurement of revenue* One writer, in fact, suggests that the accrual of revenue and cost has the perfectly rational objective of eliminating the effects of sporadic variations in cash movements, to the end that accounting profit is made a better index of the trend of the financial fortunes of the firm.10 Boulding, with reference to profit making, sayss It is a process whereby the asset structure grows in many dimensions, in some dimensions faster than others and in some dimensions perhaps the quantity of the assets may even be declining* Accounting is the attempt to reduce this multi-dimensional 10Morris A. Copeland, "Suitable Accounting Conven tions to Determine Business Income," The Journal of Accountancy. LXXXVII (February, 1949), pp* 167-111, 171 phenomenon to a simple linear scale of dollars.^ Elsewhere, the same author mentions the use of the dollar as a numeraire to reduce "the heterogeneous mass of physical assets" to a "homogeneous financial state- 12 raent," In one respect, statements of this sort may be misleading. They tend to misrepresent the kind of imputa tions which accountants make. It is important to keep in mind that the net increase in money is the ultimate meas ure and limit of total accounting profit. Data concerning the real assets of the firm are analyzed primarily for the purpose of Imputing segments of the flow of monetary costs and revenue to the production of arbitrary time periods and not to impute money "values" to real assets or to real 13 costs. J Historical accounting costs, as we have seen, tend eventually to equal monetary cost outlays. While the evi dentiary value of any single-period profit figure based on such costs is difficult to assess, it can be said that HBoulding, The Skills of the Economist, p. 52. 12Ibid.. p. 51. 13For an enlightening discussion of this subject, see C. Reinhold Noyes, "Certain Problems in the Empirical Study of Costs," The American Economic Review. XXXI (September, 1941), pp. 473-£2. 172 the historical accounting cost is basically correct for this type of theory. In saying that, we assume that the economic theory refers to a relatively long-run tendency allowing time for the recovery of money invested in long- lived assets. The fundamental accounting policy under which all monetary cost outlays are supposed to appear eventually as a cost deduction from revenue (an expense) means that what may be called "sunk" costs are included in the period profit calculations, and 3uch costs are often inextricably merged with those representing current expenditures. Under the opportunity principle, many accounting costs would be measured at zero. This sort of situation may frequently exist, for example, in the case of certain selling (distribution) costs. The effects of past adver tizing outlays, for instance, may carry over into later periods, but such benefits usually have no opportunity value once the outlay is made. Most of the characteris tics of accounting costs which make them unsuitable for measuring economic marginal costs do not appear, however, to be 30 important when viewed in relation to the type of theory now under consideration. Even the failure to deal realistically with joint and common costs and selling costs, the faults with respect to the identification of fixed and variable costs, and the inadequate work done in 173 assigning costs to periods become much less important* They may, in fact, be of no consequence at all in the testing of a very general hypothesis that the firm tends eventually to recover all cost outlays plus, perhaps, a specific amount of profit* The longer the period of time over which the situation is viewed, the more closely will aggregated accounting costs tend to equal total monetary outlays* When one considers the possibility of testing an average-cost pricing hypothesis by reference to individual accounting periods, the problem becomes difficult. Unless it is assumed that the theory refers to the actual recorded accounting costs, the probable meaning of periodic average cost to economists appears very uncertain. One further problem should be examined. The fail ure of accountants to adjust for changing price levels (excepting the use of the inadequate "LIFO” device) means that certain costs, particularly depreciation, may not correspond to the cost which is postulated in a theory of the firm. If it is hypothesized that the firm recovers such amounts as will maintain its purchasing power, then depreciation costs which happen to be based on outlays made in a period of different general price levels could not be the costs implied in the theory. Accountants in recent years have debated the feasibility of adjusting their cost data in a period of marked inflation, and one difficulty which is seen is that of selecting a suitable Ik price index to be used in adjusting historical costs* In actuality, the question is not especially important for purposes of studying the firm. It is not very difficult to adjust recorded accounting costs for price-level changes. In many cases, even the costs revealed in the condensed published statements can be adjusted approxi mately through the use of any index which is deemed appro priate under the circumstances. Contrary to what might be inferred, the use of a standard cost system {described on pages 126-27) does not ordinarily result in the adjustment of recorded historical costs to reflect changes in the general price level* This is true in spite of the common use of the phrase "current standard costs" to describe a system which is widely employed* Profit Some problems which are met in connection with accounting profit have their origins in the ambiguous definitions discussed in Chapter II, Certain subtractions 14-See William A, Paton, "Depreciation—Concept and Measurement." The Journal of Accountancy. CVIII (October, 1959), pp* 38-E37 175 from revenue may be treated as "costs" from one point of view, but be a part of "profit" from another. It has been suggested in the previous discussion of "average-cost" pricing that "costs" might be expected to include some "normal" profit. By this was meant some logically price-' determining return representing a payment for entrepre neurial services to the owners of the enterprise or some return to those who advance capital, neither being explic itly recognized in the "costs" total, or possibly a return to a capitalized monopoly advantage, not explicitly recognized. The only question here is the content of accounting "cost" with reference to such concepts. As was explained in Chapter IV, accounting "profit" usually includes all of the residual "return" which is deemed to inure to the bene fit of the proprietary investors. That is, "profit" is computed from the point of view of the latter. Typically, such profit may contain what perhaps should be imputed as interest, rent, and salaries— when the proprietary inter ests furnish factors in the form of capital, property, and personal services, in addition to the assumption of risks. It was also pointed out that some accountants advocate the exclusion of interest on long-term capital from the category of "cost," preferring to treat this as a 176 distribution of "profit."1^ Finally, it was explained that accountants do not customarily capitalize monopoly advantages, or otherwise recognize their existence, unless the advantages have been paid for explicitly* The general consequence of the foregoing is that the accountant’s "profit" is apt to include a number of elements that the economist would classify as a "cost," and the latter might very well mean to include such ele ments in the "average cost" figure which he postulates as a pricing objective. It would, however, be relatively easy to adapt conventional accounting average cost to the economic definition* Returns attributable to monopolistic advan tages, imputed interest on stockholders* investment, and the like can be added to the accountant's cost. This would, of course, reduce recorded "profit," and the remainder could, presumably, be interpreted as "pure pro fit." Given the faults in accounting procedures, however, this figure would not be a suitable measure of the econo mists' "pure" profit. Some further characteristics of accounting profit 15when this is done, it is ordinarily not difficult to adapt the figures to the more conventional treatment if one wishes to do so. 177 are as follows! It does not correspond with any economic version because the accounting treatment of revenue and cost does not so correspond* Thus the economic rate of return on either the total assets or on the proprietors* equity is not attainable from accounting data. Periodic accounting profit data can not be used to reveal the inter nal rate of return, primarily because the straight-line method of depreciation is used in inappropriate circum stances, as previously explained. These are flaws which, unfortunately, can not be corrected by a relatively simple adjustment as can certain other imperfections which have been mentioned* Interest It is convenient to separate loan financing into two classes. One is the explicit arrangement which is supported by instruments such as notes, bonds, and the like. The other is the informal loan which is implicit in any situation where goods or services are received ,fon credit.” In that connection, all of the so-called "current liabilities" which appear on a balance sheet represent a form of loan financing. In connection with the formal loan, two questions need to be considered. First, do accounting reports reveal the consequential explicit data needed to infer the total amount of interest paid? Second, what are the 173 characteristics of the imputations which are made by- accountants? It is generally true that one may obtain all of the data needed to compute the effective rates and amounts of interest paid on formal loans, although the information is found for the most part on balance sheets rather than on income statements. All that is required is the principal amount, the schedule and amount of the periodic nominal interest payments, the original proceeds of the loan, and the dates of issue and redemption. Thus, it may be possi ble to draw proper inferences even though good procedures have not been followed. The accountant usually recognizes that he must separate the interest element from capital repayments in all payments that service the loan. He recognizes, too, that there should be a reasonable allocation of interest charges to the financial periods over which the loan amor tization takes place. These two objectives are, of course, inseparably related problems. At its best, the accounting treatment of formal contract loans is very well done. Actuarial principles are used to the end that the interest cost which appears on the income statements is a constant percentage of the amount of unpaid principal which appears on the balance sheet as a liability at the opening of the period. Such unpaid balance as it appears at the end of 179 the period will always be the discounted value of the remaining payments„ using the compound interest rate which is implicit in the contract. As in the cases of other accounting principles which are recommended in the better textbooks, crude treat ment is often found in practice. Similarly to deprecia tion, a "straight-line” interest compilation is often employed, the effect of which is an equal periodic interest cost figure for each contract. The situation with respect to informal financing is entirely unsatisfactory. An unknown quantity of implicit interest cost is buried in other cost categories in, probably, virtually every income statement. When a firm receives goods or services on credit and is not charged interest explicitly, it seems reasonable to suppose that the cost is higher than it would be in the case of a cash purchase. Accountants rarely attempt to separate any implied interest charge in such cases, with the results explained above. Furthermore, explicit interest costs may find their way into the cost of manufacturing, where it becomes completely merged with other costs. In view of the importance of interest cost in several phases of the theory of the firm, these faults should be considered serious. ISO II. THE BALANCE SHEET In view of the forms which the theory of the firm has taken, there appear to be four general methods for valuing assets that merit extended discussion* They are (1) immediate liquidation value, (2) unrecovered historical cost, (3) replacement cost, and (4) opportunity cost* It is presumed that a study of balance sheets exhibiting the foregoing "values" with respect to the assets of the firm would yield significant evidence either in support or refutation of the various economic theories relative to the firm. Immediate liquidation ("cash") values relate to all theories in which uncertainty is an element, including the special situations discussed in connection with imper fect markets and the theory of games. Liquidation values are also highly relevant to Boulding's "homeostasis of the balance sheet," since one of the important elements of this theory is, apparently, the ratio of liquid assets to total assets. Replacement cost is sometimes suggested as a basis for asset valuation and depreciation calculation whereby accountants could improve their procedures and give their statements more economic content.However, replacement James L. Dohr, "What They (Economists) Say About Us (Accountants)," The Journal of Accountancy. XCVI .131 costs are more economically significant than historical costs in one special sense only* Replacement costs indi cate what the firm must recover in its operations if it is to maintain its capital in terms of purchasing power* Historical costs indicate what must be recovered in order to maintain capital in the literal dollar sense* That is the only difference between the two. By deducting depre ciation based on unadjusted historical cost, ’ •income" in Hicks* first sense (page 12) may be computed* The use of the replacement cost for such purpose is in harmony with Hicks* second definition. As concerns the balance sheet, the exhibition of unamortized costs as asset "values" is appropriate for theories of the firm which postulate the recovery of "full average cost," and which do not imply any maximization objectives. The only meaning that such values seem capable of imparting is that they indicate, very roughly, what the firm will have to recover in the future in order to attain its assumed objectives. Balance sheets containing such data are, however, probably of little significance with respect to theories which emphasize income and profit objectives* (August, 1953), PP* 167-75. 182 Capital values derived by discounting expected net returns at an opportunity rate of return have a close logical relationship to the traditional profit-maximiza- tion theory, and to all of the alternate interpretations thereof* The use of the best alternative investment oppor tunity to establish the "cost" of an investment seems clearly to establish that fact* The maximization of such capital value i3 the counterpart of maximizing profit; stnd, in every way, the opportunity approach to "value" is the relevant one for the traditional theorist* Accounting balance sheets tend, as we have indicated in Chapter IV, to exhibit "values" of only the first two types mentioned above* Accountants have no interest in preparing statements designed to reveal capital values in accordance with Fisher’s formula* There appears to be somewhat more tendency on the part of theoretical account ing writers to regard replacement cost with favor. The reasons for this are clear. Replacement cost may be regarded as merely a justifiable rectification of his torical cost, occasioned, perhaps, by the obvious effects of inflation; and an estimate of replacement cost requires no reference to expected future income or implied recog nition of unrealized revenue* Replacement costs are not, however, in actual general use at present* Balance sheets, as they appear in practice, are 183 fairly suitable for theories involving liquidity in general* However, the accounting profession has always postulated the Mgolng-concern" assumption in all asset valuations® This means that no "cash” values appear for assets that would not be liquidated in the normal course of operations. As a result, one can not look to account ing statements for data which might be relevant to all aspects of models incorporating uncertainty. Perhaps the greatest fundamental deficiency of the accountant’s balance sheet, in terms of economic signi ficance, is its failure to suggest the overall worth of the firm as an organized unit. When individual assets are combined into a producing and selling unit, there may be a return, if the firm is successful, which can not reason ably be attributed to any individual asset and will certainly not be reflected in the cost thereof. The accountant’s attitude toward this situation has been mentioned at numerous points. As matters now stand, the only occasion when one is apt to see an accounting asset total bearing some significant relationship to the earning power of the company would be shortly following a sale of an established enterprise or a financial reorganization. The lack of comparability, caused by accidents in the histories of their ownership, between organizations which are otherwise similar constitutes a seeming weakness 134 in accounting balance sheets; and, of course, the same condition will have repercussions in the income statements* This criticism must not, however, be carried too far* A different financial history may imply different objectives of management, and the accountant may be doing only his logical duty when he shows different results for firms which have similar technological characteristics but dissimilar financial histories. Everything depends upon what kind of theory is being evaluated. The theory of average-cost pricing, for example, does not appear necessarily to imply that the firm will recover any monop oly return not actually purchased. The existence of this "going-concern" value creates another difficulty, involving opportunity-cost calcula tions. We shall not consider here the logical procedures or the mathematics that might be employed to attribute the total net receipts to the individual assets thought to contribute thereto, since accountants do not attempt to do so and are unlikely to change their policies in the pre dictable future. It must suffice to say that no attempt to place accounting assets on an opportunity-cost basis can be carried out successfully in the usual piecemeal manner in which accountants are accustomed to attack asset valuations. Turning to more favorable possibilities, accounting balance sheets have the potential to be of relatively great significance for theories of "homeostasis• " Perhaps the most important fact is that such theories refer, by nature, to objective ex post situations. That is, the alleged tendency of the firm to maintain a certain pre ferred asset and/or liability structure, without regard to profits, is something that must be judged true or false by reference to accomplished results; and thus ex post data are directly relevant. Furthermore, the lack of economic characteristics found in accounting assets may not be so important with respect to theories involving ratios and comparisons. The tendency, for example, of the firm to maintain inventories at a certain arbitrary level can be studied, and perhaps verified, by reference to a consistently used yardstick, such as historical cost, just as appropriately as by reference to some other unit of measurement• In connection with what has just been written, the accountant’s treatment of inventories is possibly the most unsatisfactory thing that is done with regard to any single class of asset; yet several important economic theories concerning the' firm involve this asset. Since inventories represent goods not yet sold (unrealized revenue), historical cost is the traditional basis for the valuation thereof on the balance sheet. If this principle were 136 carefully maintained by accountants, an analyst could, by the use of a knowledge of turnovers, mark-ups, and price movements in the industry, make satisfactory use of account ing data with respect to inventories and cost-of-goods- sold figures* The accounting profession has, however, habitually indulged in experiments with inventory figures in ways which have often reduced them to statistical absurdities. It is impossible to- believe that the pub lished inventory figures of many corporations can convey anything intelligible to economists. It would serve no purpose to attempt to describe in detail the manipulations to which inventory figures have been subjected on different occasions, but a general observation may be enlightening. Much of the impulse to tamper with inventory figures seems to rise from a reluc tance to be content with the concept that inventories are simply unrecovered costs. The accountant wants also to say something about the realizable value of this important asset; yet he will not make an open break with the cost convention. The results are involved formulas which incor porate too many diverse objectives and accomplish only confusion. III. THE FUNDS STATEMENT The concept of liquid funds appears in the theory of the firm in connection with the hypothesis that the firm maximizes the flow of such resources, as an element in game theory, and as a part of the theories of Boulding. The accountant’s funds statement is designed to indicate the sources and uses of funds by the firm, and to give an insight into the internal operations by tracing the flow of purchasing power, instead of costs, through the organ ization. That sort of information, however, does not furnish any measure of liquidity or of a preference for liquid assets. Furthermore, neither the funds statement nor income statement appears to provide any data through which one could judge whether the firm "maximizes" the flow of funds. Absolute flows can be measured fairly well by the funds statement, but criteria for maximization are lacking. Perhaps the most useful service of this statement could be in the detection of tendencies toward the so- called "homeostatic" patterns of growth, since the instru ment does reveal the sources from which capital is obtained.^ Aside from the foregoing, the funds statement may -^Edgar 0. Edwards, "Funds Statements for Short- and Long-Run Analyses," The Journal of Business of the University of Chicago. "XXV TJuly, 1955TTPP.T55=74. 188 possibly be of some service in the clarification of details about which the income statement or balance sheet is not clear. The exact proceeds of a bond issue, for example, would appear in this statement. Furthermore, the data contained in this report are not subject to imputations to any major extent, as are those in the income statement. This statement as it is customarily prepared by accountants (Appendix C) is not entirely satisfactory for even the limited uses implied above. The emphasis is on the "net working capital," which, as the statement shows, is the margin of the so-called "current" assets over the analogous liabilities. The composition of this net working capital is very questionable, and the concept in general is of doubtful usefulness. When economists mention "funds," it appears that they have in mind money or money equivalents. That is, the concern seems to be with the flow of resources which protect the solvency and maintain the flexibility of the organization. Some of the elements of working capital in the funds statement are questionable in that respect. Inventories do not fit the concept at all, and the "receivables" are not always a source of immediate liquid resources. The conventional organization of this report has certain peculiarities that detract from its usefulness to the layman. Short-term liabilities are a source of funds; 1S9 yet they are treated as a component in the accountant’s concept of funds. This treatment can result in misleading reporting. For example, if the firm should purchase equip ment and issue short-term notes in settlement thereof, the transaction would be treated as funds applied to the acquisition of equipment. Under the accounting reasoning, the increase in notes payable would result in decreasing net working capital, and hence would constitute an expend iture of "funds." In actuality, of course, no outlay of liquid resources is involved in this case until the notes are paid in money. Again, the "working capital provided by current operations" figure merges both cash and credit sales revenue, and credit sales are not an immediate source of money. Potentially, all of the "sources” of funds in Appendix C are deceptive, since any one of them might have given rise to some assets which do not represent liquid resources. Finally, the funds statement would appear to be of little value in verifying a theory that the firm maximizes the flow, or turnover, of liquid funds. In addition to the questionable definition of "funds" implied in the statement, the theory, as we have said, lacks a criterion of maximization. The latter statement is true, at least, to the best of this writer’s knowledge. CHAPTER VT SUMMARY AND CONCLUSIONS The purpose of this study was that of exploring a potential contribution which accounting can make to econo mic theory* The economic area chosen was the theory of the firm, and the specific problem selected pertained to the verification ex post of certain hypotheses implied in the principal forms that this theory takes. To state the matter differently, theories of the firm of the type which were examined in this dissertation contain assertions, or perhaps only implications, that certain measurable consequences will follow as a result of the operations of the business firm* It was found that many important theories of the firm, some of which are subject to varying interpretations as to their exact meaning, are so formulated that the results of operations are susceptible of measurement in monetary terms. These criteria of measurement are monetary costs, revenue, and capital value. Since accounting deals in the same vari ables, the possibility was thought to exist that account ing data could be used to verify many important hypotheses relative to the firm and the results of its operations. Accounting statements were evaluated for the pur pose of determining their usefulness for testing the 191 so-called "traditional" theory of profit-maximization, the alternate hypothesis that the firm recovers only "full-average cost," theories relating to the tendency to maintain a certain financial structure— the "homeostasis" of the balance sheet, and the theory that cash flows are maximized instead of the flow of economic "profit," The conclusions are that accounting data are weak as measures of marginal cost, and hence for use in testing all theories in which such costs are a principal criter ion, The weakness stems from differences in philosophy between accountants and economists, accounting procedures which result in inaccurate assignment of costs to individ ual products and periods, the averaging of costs over excessively long periods, and, finally, a general inability and reluctance to trace out the more obscure relationships between costs and product. The average costs of accounting appear to correspond much more closely to their economic counterpart. Two of the faults found in connection with marginal costs are not regarded as shortcomings with respect to average costs. These are the failure by accountants to adopt the econo mists* philosophy of opportunity cost and the practice of computing averages over relatively long intervals. Other discrepancies, however, are almost as serious with respect to average as they are to marginal cost. It was noted, however, that the "full-average cost" which the firm is asserted to recover through its pricing policies is appar ently intended by some economists to mean the literal accounting cost. To the extent that this is true, any criticisms of accounting costs are meaningless and to point them out would serve no useful purpose. This does not mean that accounting data can not be used to test the hypothesis that the firm recovers just the average account ing costs, but it does mean that the qualitative charac teristics of accounting data have no bearing on their ability to "test" the hypothesis. For all cases where the exact meaning of "average cost" is not specified in the theory, it is not possible to evaluate accounting cost data. The principles and philosophy upon which accounting average costs are computed were, however, discussed at some length. How well these costs would correspond to those which the firm is supposed to recover as a result of an "average-cost pricing policy" would depend upon the implications in the individual hypothesis. The accountants funds statement was found to reveaL roughly the results of operations in terms of the flow of liquid resources through the firm, but such accounting exhibits adopt a definition of "funds" which is not entirely in harmony with what economists seem to have in mind when writing about liquid funds. 193 The accounting balance sheet was judged to be only moderately effective in revealing preferred asset ratios of various kinds, although there is sufficiently good classification to enable the researcher at least to iden tify the assets which represent liquid resources. This is important in view of the fact that the alleged preference for a certain ratio of liquid resources is the foundation for many "non-profit" theories of the firm. It is not, however, the policy of accountants to emphasize liquida tion values for assets in general, and this is a short coming with respect to this kind of analysis. The most unsatisfactory aspect of the accountant's balance sheet is connected with certain deficiencies in his approach to costs. The economic definition of capital- value, based on the discounting of expected net returns, never appears as such on accounting balance-sheets. This means tha^ the version of the "profit" theory which adopts the maximum present worth of future profit streams as its criterion can not be verified by reference to accounting asset "values." With regard to the discovery of any tendency to maintain certain ratios and structural patterns, accounting assets and liabilities may perform fairly satisfactory service, inasmuch as relationships can be detected even though the absolute amounts may be imperfect in some 194 respects. The areas in which accountants could improve their product without giving up any of their practices which they regard as essential and justified are as follows: The differences between common and joint costs and those between production and selling costs could be given recognition without in any way interfering with any reason able accounting objectives. The failure to trace out the line of relationship between cost and physical output, it goes without saying, is a source of possible Improvement, but the barriers to this must be acknowledged. There is no way of prescribing exactly what might be accomplished, since the deficiencies take many forms. In connection with this last question, it must be pointed out that there would be no advantages in having cost data which are based on more complex relationships than are implied in the theory itself. We refer here to the simplified assump tions in the marginal analysis described earlier (page 15*). The possibilities of amending accounting practices in the area of the opportunity-cost principle involve more difficulties. A complete application of this prin ciple would require that the future net receipts attri butable to an investment be computed when the asset is acquired and that an immediate gain, or loss, be recognized 195 if the present value of the investment is found to deviate from its actual money cost* The difficulties in making the estimates suggested above are, of course, well known* There are, however, more fundamental problems involved* It may, perhaps, be possible for accountants to overcome their present reluc tance to depart from "actual cost" as the initial valuation of the investment, although even that is very doubtful. But the really impossible requirement would be the subse quent revaluation in response to changes in either expected income or the appropriate discount rate. Industrial cost accounting involves the aggregation of diverse costs of widely varying kinds, including depreciation, into undifferentiated totals and the transfer of such figures from department to department, including the frequent splitting up of an accumulated cost of production figure for allocation to different products and different depart ments. All such costs are investments, and remain such until finished product is sold. To attempt continual readjustments of capital values under such circumstances , would create fantastic practical problems, and involve procedures that accountants strongly oppose on principle. There are two steps that might be taken to over come, in part, the deficiencies arising from the failure of accounting to adopt the opportunity-cost principle. 196 First, the recognition and use of an internal rate of return, based on historical cost and requiring no con stantly recurring capital adjustments, would provide far more significant depreciation figures for testing theories of the firm than does conventional practice. Furthermore, such data would be more useful to management, and hence would not require unreasonable modification of established practices. Accountants usually meet suggestions of this sort with the statement that they do not have the advance knowledge respecting revenue which the theoretical econo mist can assume as given. It is true that future revenue is difficult to estimate, but any depreciation method that is adopted must be based upon some sort of assumption con cerning the future course of the business of the firm. The second possibility is that of a comprehensive periodic revaluation of the enterprise as a whole, such as actually is done (and properly accounted for) on certain occasions when the entire organization is sold or is sub jected to a major financial reorganization. This would require the creation of a master-valuation asset, of the type which accountants usually call "goodwill.1 * The main points in favor of such a plan would be (1) that the estimation of future net receipts for the organization as a whole is probably more feasible than for an individual investment and (2) that the amortization "cost" of such 197 : ! an asset would not have to be carried through the intricate; cost accounting records, which could be left alone to per- : i form their function of supplying controls over departmental; performance in the manner to which cost accountants are I !accustomed. This suggestion is similar to the capitaliza-; tion of monopoly advantages which was mentioned in Chapter ; ill (pages 27-23}. It not, however, based upon the same philosophy, since it is not aimed particularly at placing a value on such advantages, but rather on bridging the gap between economic enterprise value and historical costs of individual assets. The basis for offering the foregoing suggestions is solely that the procedures are entirely feasible from a technical point of view. Recognized accounting principles j i and techniques are clearly adaptable to these proposals. We shall not, however, attempt to assess the possibilities > ; i that accountants generally will ever be able or willing to put such procedures into effect systematically and con tinuously. Certain other accounting procedures which are disadvantageous as concerns the theory of the firm are not apt to be changed. The policy of computing average cost over arbitrary and relatively long financial periods is one 3ii£h practice. The accrual convention, which obscures the flow of monetary receipts and outlays, is regarded by accountants as one of the refinements of their art, while "cash” accounting is universally depicted in textbooks as a crude and inadequate method* With regard to improvements in accounting for the distributive shares, professional accountants have already shown a constructive interest in more clearly identifying the residual "profit" figure which is left to the ownership group* There seems to be little probability, however, that the imputed elements, such as interest, will ever be identified as a regular procedure* This sort of accounting is in conflict with the accountant?s dislike for what he regards as specula tion and departure from the objective "facts*" BIBLIOGRAPHY 200 A. BOOKS Allen, R. G. D* Mathematical Analysis for Economists* London: Macmillan and Co*, Limited, 195jH 548 pp. _______ . Mathematical Economics. Second edition. New Andrews, P. W. S* Manufacturing Business. London: Macmillan and Co., limited, 194^ 3?!>8 pp. Baumol, William J. Economic Dynamics. Second edition. New York: The Macmillan Company, 1959. 396 pp. Blocker, John G. Cost Accounting. Second edition. New York: McGraw-Hill Book Company, Inc., 1946. 733 PP» Boulding, Kenneth E. Economic Analysis. Third edition. New York: Harper & Brothers, 1955. 905 pp. ______• A Reconstruction of Economics. New York: John Wiley & Sons, Inc., 195(57 311 pp. _______• The Skills of the Economist. Cleveland: Howard Allen, Inc., 1956. 193 pp. and W. Allen Spivey. Linear Programming and the Theory of the Firm. New York: The Macmillan Company, I960. 227 pp. Bray, F. Sewell. Four Essays in Accounting Theory. London: Oxford University Press, 1953. 94 pp. Buchanan, Norman S. The Economics of Corporate Enter prise. New York: Henry Holt and Company, 1940. 483 pp. Chamberlin, Edward Hastings. The Theory of Monopolistic Competition. Seventh edition. HarvarcT Economic Studies, Vol. XXXVIII. C ' * ' Harvard University Press, 1956. 350 pp. Clark, J. Maurice. Studies in the Economics of Overhead Costs. Chicago: the University ofChicago Press, York: St. Martin* . 612 pp. i§23. 502 pp. 201 Coppock, Joseph D. Economics of the Business Firm* New York: McGraw-Hill Book Company, Inc., 195^ 366 pp. Davenport, Herbert Joseph. The Economics of Enterprise. New Yorks The Macmillan Company, 1929* 544 pp. Dean, Joel. Managerial Economics. Englewood Cliffs, New Jersey: frentice-Hall, Inc., 1951* 621 pp. Devine, Carl Thomas. Cost Accounting and Analysis. New York: The Macmillan Company, 1950. 752 pp. Dorfman, Robert. Application of Linear Programming to the Theory of the iFirm. Berkeley, California: Univer sity of California Press, 1951* 96 pp. Paul A* Samuelson, and Robert M. Solow. Linear Programming and Economic Analysis. New York: McGraw- Hill Book Company, Inc., 1956. 527 pp. Doyle, Leonard A. Economics of Business Enterprise. First edition. New York: McGraw-Hill Book Company, Inc., 1952. 343 pp. Due, John F. Intermediate Economic Analysis. Third edition. Homewood: Richard P. Irwin, Inc., 1956. 566 pp. Eiteman, Wilford J. Price Determination: Business Prac tice Versus Economic Theory! Bureau of Business Research. Ann Arbor: University of Michigan, 1949. 96 pp. Feliner, William. Competition Among the Few. New York: Alfred A. Knopf, 1949. 326 pp. Fisher, Irving. The Nature of Capital and Income. New York: The Macmillan Company, 1919. 427 pp. ______• The Theory of Interest. New York: The Mac- millan Company, 1930T 566 pp. Friedman, Milton. Essays in Positive Economics* Chicago: The University of Chicago Press, 195^. 328 pp. Gilman, Stephen. Accounting Concepts of Profit. New York: The Ronald Press Company, 1^39. 635 pp. 202 Hart, Albert Gailord. Anticipations. Uncertainty, and Dynamic Planning. New Yorks Augustus M. Kelley, Inc., 1951#98 pp. Hicks, John R* Value and Capital* Oxfords The Clarendon Press, 1939*33i pp. Johnston, J* Statistical Cost Analysis. New Yorks McGraw-Hill feook Company, Inc., I960. 197 pp. Keynes, John Maynard. The General Theory of Employment. Interest and Money. New York: Harcourt, Brace and Company, n.d. 4&3 pp. Knight, Frank H. Risk. Uncertainty and Profit. New Yorks Kelley k Mi liman, 1957* 361 pp. Koopmans, Trailing C. Three Essays on the State of Econo mic Science. New Yorks McGraw-Hill Book Company, Inc., 1957. 231 pp. Lewis, W. Arthur. Overhead Costs. New Yorks Rinehart & Company, Inc., 1949. 200 pp. Lutz, Friedrich and Vera. The Theory of Investment of the Firm. Princeton, New Jerseys Princeton University Press, 1951. 253 pp. Machlup, Fritz. The Economics of Sellers* Competitions Model Analysis of Sellers* Conduct. Baltimores The Johns Hopkins Press, 1952. 562 pp. Mack, Ruth P. pie Flow of Business Funds and Consumer Purchasing Power. New Yorks Columbia University thress, 1941. 400 pp. Marshall, Alfred. Principles of Economics. Eighth edi tion. Londons Macmillan and Coo, Limited, 1936. 671 pp. Mill, John Stuart-. Principles of Political Economy. Revised edition. Volume Tl. New Yorks The Colonial Press, 1699. 460 pp. Paton, William Andrew. Accounting Theory. New Yorks The Ronald Press Company, 1922. 508 pp. 203 Penrose, Edith Tilton. The Theory of the Growth of the Firm. Oxford: Basil Blackwell, 1959. 272 pp. Schumpeter, Joseph A. The Theory of Economic Development. Harvard Economic Studies, Vol. XLVI. Cambridge: Harvard University Press, 1949. 255 pp. Shubik, Martin. Strategy and Market Structure. New York: John Wiley & Sons, Inc., 1959. 3$7 pp. Solomons, David (ed.). Studies in Costing. London: Sweet & Maxwell, Limited, 1952. 643 pp. Taussig, F. W. Principles of Economics. Third edition revised. New York: The Macmillan Company, 1928. Vol. I, 545 pp. Vance, Lawrence L. Theory and Technique of Cost Account ing. Brooklyn: The Foundation Press, Inc., 1952. 612 pp. Vatter, William J. The Fund Theory of Accounting and Its Implications for Financial Reports. Chicago: The University of Chicago Press, 1947- 124 pp. B. PERIODICALS Alchian, Armen A. "The Rate of Interest, Fisher’s Rate of Return over Costs and Keynes* Internal Rate of Return,** The American Economic Review. XLV (December. 1955), pp. 93^=43^ _______. "Uncertainty, Evolution, and Economic Theory," The Journal of Political Economy. LVIII (June, 1950), pp. 211-21. Anton, Hector R. "Depreciation, Cost Allocation and In vestment Decisions." Accounting Research. VII (April. 1956), pp. 117-34.------------ ---------- Bauer, P. T. "Notes on Cost," Economica, new series, XII (May, 1945), pp. 90-100. Baumol, William J. "Activity Analysis in One Lesson," The American Economic Review. XLVIII (December, 195$), ■ pp. 837-73. 204 Beckett, John A* "A Study of the Principles of Allocating Costs," The Accounting Review. XXVI (July, 1951), pp. 327-33. Bedford, Norton M. "Accounting Measurements of Economic Concepts," The Journal of Accountancy. CIII (May, 1957), pp. 56-62, _______• "A Critical Analysis of Accounting Concepts of Income." The Accounting Review. XXVI (October, 1951), pp. 526-377” Bell, Carolyn Shaw, "Elementary Economics and Deprecia tion Accounting," The American Economic Review. L (March, I960), pp. 154-58. Benninger, L, J, "The Traditional Vs. the Cost Accounting Concept of Cost." The Accounting Review. XXIV (October, 1949), pp. 387-91. Bierman, Harold Jr* "Measuring Financial Liquidity," The Accounting Review. XXXV (October, 19o0), pp. 623- Bishop, Robert L. "Cost Discontinuities, Declining Costs, and Marginal Analysis," The American Economic Review. XXXVIII (September, 1948)^ pp. 607-17* Blodgett, Ralph H. "The Value of Economics for the Accountant," The Accounting Review. XVIII (October, 1943), pp. 324-30. Bodenborn, Diran. "A Note on the Theory of the Firm," The Journal of Business. XXXII (April, 1959), pp. 165- 174. Bornemann, Alfred. "Accounting Profits: An Institution," The Journal of Political Economy. LI (April, 1943), pp. 166-68. Boulding, Kenneth E. "Implications for General Economics of More Realistic Theories of the Firm," The American Economic Review. XLII (May, 1952), pp. 35-44. "Professor Tarshis and the State of Economics," The American Economic Review. XXXVIII (March, 1948), pp. 92-102. 20 5 _. "The Theory of the Firm in the Last Ten Years " The American Economic Review. XXXII (December. 1942). pp. 791-802. _• "The Theory of a Single Investment," The Quar terly Journal of Economics. XLIX (May, 1935), pp. 475- 494 • Bray, F. Sewell. "An Accountant7s Comments on the Sub jective Theory of Value and Accounting Cost." Economica, new series, XIII (November, 1946), pp. 295- ______ • "Accounting Dynamics - I," Accounting Research. ^TT January, 1954), pp. 133-53* . "Accounting Dynamics - II," Accounting Research. VI (January, 1955), pp. 26-37. _______ . "Accounting Dynamics - III," Accounting Research. VI (January, 1955), pp. 267-80. _______ . "Accounting Dynamics - IV," Accounting Research. VII (January, 1956), pp. 52-68. _ "Capital Changes," Accounting Research. VII (October, 1956), pp. 3SO-92. Break, George F. "Capital Maintenance and the Concept of Income," The Journal of Political Economy. LXII (February, 1954), pp. 48-62. _. "Capital Maintenance and the Concept of Income - A Reply," The Journal of Political Economy. LXIV (December, 1956), pp. 534-35. Brems, Hans. "A Discontinuous Cost Function," The Ameri can Economic Review. XLII (September, 1952), pp. 577- 5^6. Carson, A. B. "A Fund-Change-Statement Approach to the Calculation of Inflationary Distortion in Conventional Income Measurement," The Accounting Review. XXIX (July, 1954), pp. 373-32. Chambers, R. L. "Blueprint for a Theory of Accounting," Accounting Research. VI (January, 1955), pp. 17-25. 206 Chenault, Lawrence R. "Business Behavior and the Theory of the Firm," The Accounting Review. XXIX (October. 1954), pp. 645-51. Cole, William Morse, "Theories of Cost," The Accounting Review. XI (March, 1936), pp. 4-9. Committee on Cost Concepts and Standards. "Tentative Statement of Cost Concepts Underlying Reports for Management Purposes," The Accounting Review. XXXI (April, 1956), pp. 1S2-93. Cooper, VI0 W. "A Proposal for Extending the Theory of the Firm," The Quarterly Journal of Economics. LXV (February, 1951), pp. $7-109. ______ . "Theory of the Firm: Some Suggestions for Revision," The American Economic Review. XXXIX (December, 1949), pp. 1204-22. Copeland, Morris A. "Suitable Accounting Conventions to Determine Business Income," The Journal of Accountancy. LXXXVII (February, 1949), pp. 107^X1: Corbin, Donald A. "Capital Maintenance and the Concept of Income - A Comment," The Journal of Political Economy. LXIV (December, 1956), pp. 52S-33* Davidson, Sidney. "Depreciation and Profit Determination." The Accounting Review. XXV (January, 1950j, pp. 45-57. Davis, Richard M. "The Current State of Profit Theory," The American Economic Review. XLII (June, 1952), pp. 245-64. Dein, Raymond C. "The Future Development of Accounting Theory," The Accounting Review. XXXIII (July, 195$), pp. 3$9-40U7 Devine, Carl Thomas. "Cost Accounting and Pricing Poli cies," The Accounting Review. XXV (October, 1950), pp. 3$4-$9« ______. "Depreciation and Income Measurement,V The Accounting Review. XIX (January, 1944), pp. 39-47. 207 . "Loss Recognition," Accounting Research. VI TTanuary, 1955), pp. 310-2?^ "Research Methodology and Accounting Theory Formation," The Accounting Review. XXXV (July, I960), pp. 3#7-99. Dixon, Robert L. "Cost Concepts: Special Problems and Definitions," The Accounting Review. XXIII (January, 194&), pp. 40-43. Dohr, James L. "What They (Economists) Say About Us (Accountants)." The Journal of Accountancy. XLVI (August, 1953), pp. 167-75* Dorfman, Robert. "Mathematical, or ’Linear,* Programming: A Nonmathematical Exposition," The American Economic Review. XLIII (December, 1953), pp. 797-825. Doyle, Leonard A. "Uses of Cost Data for Production and Investment Policies," The Accounting Review. XXV (July, 1950), pp. 274-^2. Earley, James S. "Marginal Policies of ’Excellently Managed5 Companies." The American Economic Review. XLVI (March, 1956), pp. 44r7^ "Recent Developments in Cost Accounting and the ’Marginal Analysis’," The Journal of Political Economy. LXIII (June, 1955), pp. 227-42. Edwards, Edgar 0. "Funds Statements for Short- and Long- Run Analyses," The Journal of Business of the Univer sity of Chicago. XXV (July,""19^21, pp. 156-74. Eiteman, Wilford J. "The Equilibrium of the Firm in Multi- Process Industries," The Quarterly Journal of Econom ics . LIX (February, 1945)» pp. 280-36. "The Least Cost Point, Capacity, and Marginal Anal ysis: A Re.ioinder." The American Economic Review. XXXVIII (December, 194^7, pp. 899-WT» and Glenn E. Guthrie. "The Shape of the Average Cost Curve," The American Economic Review. XLII (December, 1952), pp. 832-JWl 203 Engelman, Konrad. "In Search of an Accounting Philosophy," The Accounting Review. XXIX (July, 1954), pp. 333-90. Enke, Stephen. "Biological Analogies in the Theory of the Firm: Comment," The American Economic Review. XLIII (September, 1953)* p. 603* _______• "On Maximizing Profits: A Distinction Between Chamberlin and Robinson," The American Economic Review. XLI (September, 1951), pp. 566-7$. ‘ _______. "Profit Maximization Under Monopolistic Competi tion," The American Economic Review. XXXI (June, 1941), pp. 317-26. Fellner, William. "Average-Cost Pricing and the Theory of Uncertainty," The Journal of Political Economy. LVI (June, 1948), pp. 249-52. Fetter, Frank A. "Reformulation of the Concepts of Capi tal and Income in Economics and Accounting," The Accounting Review. XII (March, 1937), pp. 3-12. Froehlich, Walter. "The Role of Income Determination in Reinvestment and Investment," The American Economic Review. XXXVIII (March, 1948), pp. 78-91^ Gabor, Andre and I. F. Pearce. "The Place of Money Capital in the Theory of Production," The Quarterly Journal of Economics. LXXII (February, 195°), pp. 537-57* Garner, S. Paul. "Historical Development of Cost Account ing," The Accounting Review. XXII (October, 1947), pp. 385^9. Gibbs, George. "New Cost Accounting Concepts,”/The Ac counting Review. XXXIII (January, 1958], pp. 96-101. Gordon, Myron J. "Scope and Method of Theory and Re search in the Measurement of Income and Wealth," The Accounting Review. XXXV (October, I960), pp. 603-13. _______. "The Valuation of Accounts at Current Cost," The Accounting Review. XXVIII (July, 1953), pp. 373- 334. 209 Gordon, R. A. "Short-Period Price Determination in Theory and Practice.” The American Economic Review. XXXVIII {June, 1943), pp. 2o5-8S7 Groaf, J. de V. "Income Effects and the Theory of the Firm.” The Review of Economic Studies. XVIII (1950-51). pp. 79-557 Griffith, Donald K* "Weaknesses of Index-Number Account- ing,” The Accounting Review. XII (June, 1937), pp. 123- 132. Hatfield, Henry R. "What They Say About Depreciation.” The Accounting Review. XI (March, 1936), pp. 13-26. Hepworth, Samuel R. "Direct Costing - The Case Against,” The Accounting Review. XXIX (January, 1954), pp. 94- 99. Hildreth, Clifford. ”A Note on Maximization Criteria," The Quarterly Journal of Economics. LXI (November. 1^4677 pp. '156-537----------------- Homburger, Richard H. "Measurement in Accounting," The Accounting Review. XXXVI (January, 1961), pp. 94-99. Horngren, Charles T. and George H. Sorter. "*Direct* Costing for External Reporting," The Accounting Review. XXXVI (January, 1961), pp. 84-93* Hurwicz, Leonid. "Theory of the Firm and of Investment," Econometrica. XIV (April, 1946), pp. 109-36. Husband, George R. "The Entity Concept in Accounting," The Accounting Review. XXIX (October, 1954), pp. 552- 557 Hylton, Delmer P. "Should Financial Statements Show •Monetary* or •Economic* Income?" The Accounting Review XXVI (October, 1951), pp. 503-6. Johnson, Charles E. "Inventory Valuation - The Account ant’s Achilles Heel," The Accounting Review. XXIX (January, 1954), pp. 15-26. 210 Johnston, J. "Statistical Cost Functions; A Re-apprais al," The Revue of Economics and Statistics. XL (Novem ber, 195ST7PP- 339^5tn Kaldor, Nicholas* "The Equilibrium of the Firm," The Economic Journal. XLIV (March, 1934), pp. 60-757“ Kendrick, H. W. "The Relationship of Cost Accounting to Income Determination," The Accounting Review. XXIII (January, 194#), pp. 35-39. Knight, Frank F. "Capital, Time, and the Interest Rate," Economica. New Series, TIJ (August, 1934), pp. 257- 286. Lanzillotti, Robert F. "Pricing Objectives in Large Companies," The American Economic Review. XLVTII (December, 195#), pp. 921-40. Lawrence, V/. B. "Cost Accounting Versus the Pricing System," The Accounting Review. XX (April, 1945), pp. 177-82. Lawson, Gerald H. "Joint Cost Analysis as an Aid to Management— A Further Study." The Accounting Review. XXXII (July, 1957), pp. 431-337“ Lemke, B. C. "Is Manufacturing Cost an Objective Con cept?" The Accounting Review. XXVI (January, 1951), pp. 77-79. Lerner, Abba P. "User Cost and Prime User Cost," The American Economic Review. XXXIII (March, 1943), pp. 131-32. Lester, Richard A. "Equilibrium of the Firm," The-Ameri can Economic Review. XXXIX (March, 1949), pp. 478-84. _. "Marginalism, Minimum Wages, and Labor Markets," The American Economic Review. XXXVII (March, 1947), pp. 135-4#. • "Shortcomings of Marginal Analysis for Wage- Employxnent Problems," The American Economic Review. XXXVI (March, 1946), pp. 6J^2l Littleton, A. C, "Concepts of Income Underlying Account ing," The Accounting Review. XII (March, 1937), pp. 13- 22. 211 _______• "Contrasting Theories of Profit," The Accounting Review. XI (March, 1936), pp. 10-lg. . . . ■ _____• "The Logic of Accounts," The Accounting Review, XXX (January, 1955), pp. 45-47* _______ • "Significance of Invested Cost," The Accounting Review. XXVII (April, 1952), pp. 167-73* Lutz, Friedrich A. "The Criterion of Maximum Profits in tfeie Theory of Investment," The Quarterly Journal of Economics. LX (November, 1945), pp.56-77. Machlup, Fritz. "Marginal Analysis and Empirical Re search." The American Economic Review. XXXVI (September. 1946), pp. 519^54: _______ ♦ "Rejoinder to an Antimarginalist," The American Economic Review. XXXVII (March, 1947), pp. 14&-54* Mackenzie, D. H. "Contemporary Theories of Corporate Prof its Reporting," The Accounting Review. XXIV (October, 1949), pp. 360-6W7~ Mann, Everett J. "Cash Flow Earnings— New Concept in Security Analysis," The Accounting Review. XXXIII (July. 195S), pp. 423-26. Marchal, Jean. "The Construction of a New Theory of Prof it," The American Economic Review. XLI (September. 1951), p p ' : 549-65. Margolis, Julius. "The Analysis of the Firm: Rationalism, Conventionalism, and Behaviorism." The Journal of Busi ness, XXXI (July, 1956), pp. 1S7-99. “ _______ . "Traditional and Revisionist Theories of the Firm: A Comment," The Journal of Business. XXXII (April, 1959), pp. 175=82. Marple, Raymond P. "Direct Costing and the Uses of Cost Data," The Accounting Review. XXX (July, 1955), pp. 430=35. Mason, Perry. "*Cash Flow* Analysis and Funds Statements," The Journal of Accountancy. CXI (March, 1961), pp. 59- 72. 212 Mattessich, Richard. "Towards a General and Axiomatic Foundation of Accounting." Accounting Research. VIII (October, 1957), pp. 328-55. Mautz, R. K. "Accounting for Enterprise Growth," The Accounting Review. XXV (January, 1950), pp. 81-88. Means, Gardiner C. "Looking Around: Is Economic Theory Outmoded?" Harvard Business Review. XXXVI (May-June, 1958), pp. 27 et seqq. Moonitz, Maurice. "Adaptations to Price-Level Changes," The Accounting Review. XXIII (April. 1948). dd. 137- 147. _______ • "Inventories and the Statement of Funds," The Accounting Review. XVIII (July, 1943), pp. 262-66. _. "Reporting on the Flow of Funds," The Accounting Review. XXXI (July, 1956), pp. 375-85. _______ . "The Valuation of Business Capital: An Account ing Analysis," The American Economic Review. XLI (May, 1951), pp. 1 5 7 ^ ______and Carl L. Nelson. "Recent Developments in Accounting Theory," The Accounting Review. XXXV (April, I960), pp. 206-17. Morrison, Lloyd F. "Some Accounting Limitations of State ment Interpretation," The Accounting Review. XXVII (October, 1952), pp. 490-95. Moss, Morton F. and Wilber C. Haseman. "Some Comments on the Applicability of Direct Costing to Decision Mak ing," The Accounting Review. XXXII (April, 1957), pp. 184-93. Murad, Anatol. "An Uncertainty Theory of Profit: Com ment," The American Economic Review. XLI (March, 1951), pp. 164-69. Neilsen, Oswald. "Direct Costing— The Case ’For1," The Accounting Review. XXIX (January, 1954), pp. 89-93. Norris, Harry. "Notes on the Relationship Between Econo mists and Accountants," The Economic Journal. LIV (December, 1944), pp. 375-83. 213 _______. "Profit: Accounting Theory and Economics," Economica, new series, XII (August, 1945), pp. 125-33. Noyes, C. Reinhold. "Certain Problems in the Empirical . Study of Costs," The American Economic Review. XXXI (September, 1941), pp. 473-92. Oliver, Henry M. Jr. "Marginal Theory and Business Behav ior," The American Economic Review. XXXVII (June, 1947), pp. 375-83. Paton, William A. "Depreciation— Concept and Measurement," The Journal of Accountancy. CVIII (October, 1959), pp. 38-43. _______. "Distribution Costs and Inventory Values," The Accounting Review. II (September, 1927), pp. 246-53. ______ . "Valuation of the Business Enterprise," The Accounting Review. XI (March, 1936), pp. 26-35. Penrose, Edith Tilton. "Biological Analogies in the Theory of the Firm," The American Economic Review. XLII (December, 1952), pp. &04-19. , ____. "Biological Analogies in the Theory of the Firm: Rejoinder," The American Economic Review. XLIII (September, 1953), pp. 603-09* Perry, Kenneth W. "Accounting and Economics Reciprocally Indebted," The Accounting Review. XXXIII (July, 1958), pp. 450-54. _______. "Statistical Relationship of Accounting and Economics," The Accounting Review. XXX (July, 1955), pp. 500-506. Raby, Wm. L. "The Two Faces of Accounting." The Account ing Review, XXXIV (July, 1959), pp. 452-61. Read, W. H. "Cost Accounting Concepts," The Accounting Review. XXIII (January, 1948), pp. 28-31. Reder, Melvin W. "A Reconsideration of the Marginal Productivity Theory," The Journal of Political Economy. LV (October, 1947), pp. 455-58. 214 Robbins, Lionel, "Remarks Upon Certain Aspects of the Theory of Costs," The Economic Journal. XLIV (March. 1934), pp. 1-13. Robinson, Romney. "The Rate of Interest, Fisher*s Rate of Return over Costs and Keynes* Internal Rate of Return: Comment," The American Economic Review. XLVI (December, 1956), pp. 972-73* Rolph, Earl, "The Discounted Marginal Productivity Doctrine," The Journal of Political Economy. XLVII (August, 1939), pp. 542-56. Ross, Myron H. "Depreciation and User Cost," The Account ing Review. XXX? (July, I960), pp. 422-2$. Ruggles, Richard. "The Concept of Linear Total Cost - Output Regressions." The American Economic Review. XXXI (June, 1941), pp. 332-35. “ Schaefer, Hadley P. "The Distribution Cost Problem," The Accounting Review. XXXIII (October, 1953), pp. 625-31. Schiff, Michael. "Distribution Cost Analysis: A Service to Management," The Journal of Accountancy. CV (Febru ary, 1953), pp. 37-41. Schwartz, Eli. "Theory of the Capital Structure of the Firm," The Journal of Finance. XIV (March, 1959), pp. 13-39. Silcock, T. H. "Accountants, Economists and the Valuation of Fixed Assets," The Economic Journal. LIX (September, 1949), pp. 343-59. Solomons, David. "The Integration of Accounting and Economic Studies." Accounting Research. VI (April. 1955), pp. 106-11. Sorter, G. H. and George Benston. "Appraising the Defen sive Position of a Firm: The Internal Measure," The Accounting Review. XXXV (October, I960), pp. 633-40. Sprouse, Robert T. "The Significance of the Concept of the Corporation in Accounting Analyses." The Accounting Review. XXXII (July, 1957), pp. 369-73. 215 Staehle, Hans, "The Measurement of Statistical Cost Functions! An Appraisal of Some Recent Contributions," The American Economic Review. XXXII (June, 1942), pp. 321-33. Stanford, Clement L. "Cost Minimization and Control as a Function of Cost Accounting," The Accounting Review. XXIII (January, 1943), pp. 31-34- Staubus, George J. "Payments for the Ude of Capital and The Matching Process," The Accounting Review. XXVII (January, 1952), pp. 104-13. _______. "The Residual Equity Point of View in Account ing," The Accounting Review. XXXIV (January, 1959), pp. 3-13. _______. "Revenue and Revenue Accounts," Accounting Research. VII (July, 1956), pp. 234-94. Stigler, George. "Production and Distribution in the Short Run," The Journal of Political Economy. XLVTI (June, 1939), pp. 305-27. _______. "Professor Lester and the Marginalists," The American Economic Review. XXXVII (March, 1947), pp. 154-57. Stockfisch, J. A. "The Relationship Between Money Cost, Investment, and the Rate of Return," The Quarterly Journal of Economics. LXX (May, 1956), pp. 295-302. _______. "An Uncertainty Theory of Profit: Comment," The American Economic Review. XLI (March, 1951), pp. 169-75. Storey, Reed K. "Cash Movements and Periodic Income Determination," The Accounting Review, XXXV (July, I960), pp. 449-54. _______. "Revenue Realization, Going Concern and Measure ment of Income," The Accounting Review. XXXIV (April, 1959), pp. 232-33. Straus, Everet. "Cost Accounting and Statistical Cost Functions," The American Economic Review. XXXV (June, 1945), pp. 43^32. 216 Striker, M. "The Accountancy of J. M. Keynes," The i Accountant. CXXVIII (June 27, 1953), pp. 756-60. Suojanen, Waino W. "Accounting Theory and the Large Cor poration," The Accounting Review. XXIX (July, 1954), pp. 391-96. Taggart, Herbert F. "Cost Accounting Versus Cost Book keeping." The Accounting Review. XXVI (April. 1951). pp. 141-51. Thirlby, G. F. "The Subjective Theory of Value and Accounting tCostf," Economica, new series, XIII (February, 1946), pp. 32-49. Van Lierde, Paul A. "Price-Level Changes and Capital Con sumption Allowances." The Journal of Business. XXXII (October, 1959), pp. 370-62. Vatter, William J. "Cost Accounting and Statistical Cost Functions," The American Economic Review. XXXV (December, 1945), pp. 940-42. _______ . "Limitations of Overhead Allocation," The Accounting Review. XX (April, 1945), pp. 163-76. Vickers, Douglas. "On the Economics of Break-Even," The Accounting Review. XXXV (July, I960), pp. 405-12. Weinwurm, Ernest H. "Improving Accounting Measures for Management: The Concept of Homogeneity in Accounting Data," Accounting Research. VIII (July, 1957), pp. 262- 269. Weston, J. Fred. "The Profit Concept and Theory: A Restatement," The Journal of Political Economy. LXII (April, 1954), pp. 152-70. "An Uncertainty Theory of Profit: Rejoinder," The American Economic Review. XLI (March, 1951). pp. 175-81. Whittaker, Edmund. "Realism and Cost Accounting," The Accounting Review. XXI (January, 1946), pp. 13-19. Yang, J, M. "The Valuation of Intangibles," The Account ing Review. II (September, 1927), pp. 221-31. 217 C. PUBLICATIONS OF LEARNED SOCIETIES AND OTHER ORGANIZATIONS Bain, Joe S. "The Theory of Asset Valuation Implied by Accounting Principles," Proceedings of the Twentieth Annual Conference of the Pacific Coast Economic Association - 1941. pp. 53-56. Seattle: University of Washington Press, 1942. Changing Concepts of Business Income. A Report Prepared by the StudyvGroup on Business Income. New York: The Macmillan Company, 1952. Cost Behavior and Price Policy. New York: National Bur eau of Economic Research, 1943. Doyle, Leonard J. "Most Profitable Product Volume - Taking Account of Costs and Competition," N.A.C.A. Bulletin. XXX (February 1, 1949J, pp. 634-52. Farrell, M. J. "Deductive Systems and Empirical General izations in the Theory of the Firm," Oxford Economic Papers. new series, IV (February, 1952), pp. 45-49. Fellner, William J. "Uncertainty and Idle Balances," Proceedings of the Twentieth Annual Conference of the Pacific Coast Economic Association - 1941. pp. 40-45. Seattle: University of Washington Press, 1942. Friedman, Milton. "Comment" on "Survey of the Empirical Evidence on Economies of Scale" by Caleb A. Smith, Business Concentration and Price Policy. Princeton: Princeton University Press, 1955. pp. 230-33. Gabor, Andre and I. F. Pearce. "A New Approach to the Theory of the Firm," Oxford Economic Papers. new series IV (October, 1952), pp. 252-55^ Hall, R. L. and C. J. Hitch. "Price Theory and Business Behavior," Oxford Economic Papers. No. 2 (May, 1939), pp. 12-45. Harrison, G. Charter. "The Practical Economist's Profit and Loss Statement," N.A.C.A. Bulletin. XXX (December 15, 1943), pp. 443-56. 213 Harrod, R. F. "Price and Cost in Entrepreneurs' Pol icy," Oxford Economic Papers. No« 2 {May, 1939), pp. 1-11* Jastram, Roy W. "Theoretical Notes on Advertising: Its Place Among Competitive Policies of the Firm," Pro ceedings of the Twentieth Annual Conference of the Pacific "Coast Economic Association~7 7L94i. p p. 35-39. Seattle: University of Washington Press, 1942. Kempster, John H. "Break-Even Analysis— Common Ground for the Economist and the Cost Accountant," N.A.C.A. Bulletin. XXX (February 15, 1949), pp. 7llr2ff.“ LeMaster, Eustace. "The Accountants' Provision for Depre ciation and its Effects on Prices," Proceedings of the Eighteenth Annual Conference of the Pacific Coast Economic Association - 1939. pp. 34-36. Eugene, Ore- gon: The Koke-Chapman Co., n.d. Littleton, A. C. Structure of Accounting Theory. Ameri can Accounting Association, 1953* • Lorig, Arthur N. "The Capitalization Principle and Depreciation Charges," Proceedings of the Eighteenth Annual Conference of the Pacific . Coast Economic Assoc iation - 1939. p p . 30-34. Eugene, Oregon: The Koke- Chapman Co., n.d. Manrara, Luis V. "We Are Dragging Our Anchor - The Drift from Historical Cost," N.A.C.A. Bulletin. XXXI (November, 1949), pp. 243-252. Mason, Perry. "Depreciation Policy in Periods of Declin ing Output," Proceedings of the Eighteenth Annual Conference of tKe pacific Coast Economic Association - 1939. ppT*"35-337 Eugene, Oregon*: The koke-Chapman Co., n.d. Paton, W. A. and A. C. Littleton. An Introduction to Corporate Accounting Standards. American Accounting Association, 1949. Vatter, William J. "Does the Rate of Return Measure Business Efficiency?" N.A.A. Bulletin. XL (January, 1959), pp. 33-43. 219 _______. "Tailor-Making Cost Data for Specific Uses," N.A.C.A. Bulletin, XXXV (August, 1954), pp. 1691-1707. Wilson, T. "The Inadequacy of the Theory of the Firm as a Branch of Welfare Economics," Oxford Economic Papers, new series, IV (February, 1952), pp. l$-44. D. ESSAYS AND ARTICLES IN COLLECTIONS Backer, Morton. "Determination and Measurement of Busi ness Income by Accountants," Handbook of Modern Accounting Theory. Morton Backer, editor, itfew York; Prentice-Hall, Inc., 1955. Pp. 209-47. Bain, Joe S. "Price and Production Policies," Vol. I of k Survey of Contemporary Economics. Howard S. Ellis, editor. 2 vols. Philadelphia: The Blakiston Com pany, 1946. Pp. 129-73. Benninger, Lawrence J. "Cost and Value Concepts," Hand book of Modern Accounting Theory. Morton Backer, edi tor. New York; Prentice-Hall, Inc., 1955. Pp. 275- 301. Clapham, J. H. "The Economic Boxes: A Rejoinder," Read ings in Price Theory. Chicago: Richard D. Irwin, Inc7,T952. Pp. 139-142. . "Of Empty Economic Boxes," Readings in Price ~ Theory. Chicago: Richard D, Irwin, Inc.,“T952. Pp. 119-30. Crum, William Leonard. "Corporate Earnings on Invested Capital^" Readings in the Theory of Income Distribu tion. William Fellner and Bernard F.' Haley, editors. Philadelphia: The Blakiston Company, 1946. Pp. 57l- 595. Devine, Carl T. "Asset Cost and Expiration," Handbook of Modern Accounting Theory. Morton Backer, editor. New York: Prentice-Hall, Inc., 1955. Pp. 329-57. Gordon, Robert A. "Enterprise, Profits, and the Modern Corporation," Readings in the Theory of Income Dis tribution. William Fellner and Bernard-F. Haley, edi tors! Philadelphia: The Blakiston Company, 1946. Pp. 556-70. 220 Haley, Bernard F. "Value and Distribution," Vol. I of A Survey of Contemporary Economics. Howard S. Ellis, editor. 2 vols. Philadelphia: The Blakiston Com pany, 194#. Pp. 1-4#. Hart, Albert Gailord. "Risk, Uncertainty, and the Un profitability of Compounding Probabilities," Readings in the Theory of Income Distribution. William Fellner and Bernard F. Haley, editors. Philadelphia: The Blakiston Company,r!946. Pp. 547-57. Knight, Frank H, "Capital and Interest," Readings in the Theory of Income Distribution. William Fellner and Bernard F. Haley, editors. Philadelphia: The Blakis ton Company, 1946. Pp. 3#4-417* _______ • "Profit," Readings in the Theory of Income Dis tribution. William Fellner and Bernard F. Haley, edi tors. Philadelphia: The Blakiston Company, 1946. Pp. 533-46. Lange, Oscar. "A Note on Innovations," Readings in the Theory of Income Distribution. William Fellner and Bernard F. Haley, editors. Philadelphia: The Blak iston Company, 1946. Pp. 181-96. Machlup, Fritz. "On the Meaning of the Marginal Product," Readings in the Theory of Income Distribution. William Fellner and Bernard F. Haley, editors. Philadelphia: The Blakiston Company, 1946. Pp. 159-74. Papandreou, Andreas G. "Some Basic Problems in the Theory of the Firm," Vol. II of A Survey of Contemporary Economics. Bernard F. Haley, editor. 2 vols. Home wood: Richard D. Irwin, Inc., 1952. Pp. 183-222. Pigou, A. C. "Empty Economic Boxes: A Reply," Readings in Price Theory. Chicago: Richard D. Irwin, Inc., 19527 Fp. 131-39. Robertson, D. H. "Those Empty Boxes," Readings in Price Theory. Chicago: Richard D. Irwin, Inc., 1952. Fp. 143-59. Scitovsky, Tibor de. "A Note on Profit Maximization and its Implications," Readings in Price Theory. Chicago: Richard D. Irwin, Inc., 1952. Pp. 352-5#. 221 Viner, Jacob. "Cost Curves and Supply Curves," Vol. II of Readings in Economic Analysis„ Richard V. Clemence, editor. 2 vols. Cambridge, Massachusetts: Addison- Wesley Press, Inc., 1950. Pp. 3-35. Wheeler, rJohn T. "Economics and Accounting," Handbook of Modern Accounting Theory. Morton Backer, editor. New York: Prentice-HalX, Inc., 1955. Pp. 41-76. APPENDIX 223 APPENDIX A THE X CORPORATION BALANCE SHEET DECEMBER 31, I960 Assets Working Capital; Current Assets ................. $100,000 Current Liabilities -40^000 $ 60,000 Plant and Equipment; Cost . . . . . . . . . . ...... $700,000 Less! Accumulated Depreciation • • 180.000 520,000 Other Deferred Costs: Prepaid Insurance . . .............. $ 500 Prepaid Rent •««<«•••••« 1,500 Raw Material Inventory ............. 8.000 10,000 Investments; Land - c o s t .........................$ 13,000 Securities - c o s t ............ . . • 100.000 113.000 Total Assets $703.000 Equities Long-term Debt; Bonds Payable - 4$ Mortgage • • • • $ 50,000 Bonds Payable - 4.5$ Debentures • • 100.000 $150,000 Stockholders* Equity: Capital Stock ........... ..... $368,000 Retained Earnings - Appendix B . . . 185.000 553.000 Total Equities $703.000 224 APPENDIX B THE X CORPORATION STATEMENT OF INCOME AND RETAINED EARNINGS YEAR ENDED DECEMBER 31, I960 Revenue from Sales $800,000 Cost of Finished Product Sold ................ 500.000 Gross Margin .................................. $300,000 Dividend and Interest Income .......... 4.000 $304,000 Expenses: Selling •••••••••••••• $40,000 General and Administrative • • • • • 10.000 50.000 $254,000 Losses: Settlement of Personal Injury Suit , $10,000 Factory Expenses Assignable to Unused Capacity ............. 30.000 40.000 $214,000 Income Taxes 104.000 Net Income before Bond Interest Requirements • $110,000 Bond Interest..................... 6.000 Net Profit to Stockholders ••••• ........ $104,000 Balance of Retained Earnings at January 1, I960 131.000 Total Profits Available for Distribution to Stockholders ••••••••••.. $235,000 Dividends Paid in I960 ..................... 50.000 Balance of Retained Earnings at December 31, 1960- Appendix A .......... $185.000 225 APPENDIX C THE X CORPORATION FUNDS STATEMENT YEAR ENDED DECEMBER 31, I960 Sources of Fundss Net Income before Bond Interest - Appendix B . . ........ $110,000 Adds Deductions not Reducing Working Capital............... 64.000 Working Capital Provided by Current Operations.................... $174,000 Net Cash Proceeds from Sale of L a n d ........ 10,000 Increased Borrowing from Bondholders . . • • . 60.000 Total Funds Received during Year .......... $244,000 Applications of Fundss New Investment in Plant and Equipment $173,000 Dividends Paid................ 50,000 Bond Interest Paid ••••••..• 6.000 Total- Funds Expended ................. . . . 234.000 Net Increase in Working Capital ............... $ 10,000 Balance of Working Capital, January 1, I960. . . 50.000 Balance of Working Capital, December 31, I960 - Appendix D . . . ....................... $ 60.000 226 APPENDIX D THE X CORPORATION SCHEDULE OF WORKING CAPITAL DECEMBER 31, I960 Current Assets; Cash................................| 300 Commercial Bank Deposit............. 4,200 Trade Accounts Receivable* • $30,000 Less: Estimated Bad Debts. 4.500 25,500 Notes Receivable-60 days •*.*.. 10,000 Inventory of Finished Product-cost • 60.000 Total Current Assets #100,000 Current Liabilities: Trade Accounts Payable .••*..• $20,000 Salaries and Wages Payable......... 2,000 Taxes Payable..................... IS . 000 Total Current Liabilities 40.000 Working Capital $ 60.000
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Parker, William Mcfadden
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The Usefulness And Limitations Of Accounting Reports For Testing The Theory Of The Firm: An Appraisal
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Economics
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