Copyright by
Jerold L. Parmer
1973
A CRITICAL ANALYSIS OF THE ENTERPRISE THEORY
TO DETERMINE ITS IMPLICATIONS
IN ACCOUNTING
by
JEROLD L. PARMER, B.B.A.. M.B.A.
A DISSERTATION
IN
BUSINESS ADMINISTRATION
Submitted to the Graduate Faculty
of Texas Tech University in
Partial Fulfillment of
the Requirements for
the Degree of
DOCTOR OF BUSINESS ADMINISTRATION
/ 7 73
ACKNOWLEDGEMENT
I wish to express my sincere appreciation to Dr. Frsuik
J. Imke, chairman and director of this dissertation, for his
encouragement and assistance.
I gratefully acknowledge the
helpful criticism of the other members of my committee. Professors Samuel W. Chisholm, William P. Dukes, and Doyle Z.
Williams.
Their comments and suggestions resulted in many
improvements.
Finally, to my wife, Polly Ann, I give a special thanks
for helping to bear the moods of composition and study.
CONTENTS
ACKNOWLEDGEMENT
ii
LIST OF TABLES
vj
I.
II.
III.
INTRODUCTION
J
Background of the problem
Objectives
Scope and methodology
Significance of the dissertation
Organization
^
1
'
i
S
COMPARISON OF THEORIES OF EQUITY
IJ
Proprietary theory
•
Legal foundation
Control, risk, income
Entity theory
.....
Position of management
Distinction between owners and
corporation . . . . . . . . . . . . .
Productive economic unit
Fund theory
Operational viewpoint . . . . .
Deemphasis of net income
.
Commander theory
Summary
IJ
Ij
li
IS
2C
RESIDUAL EQUITIES
3*;
21
22
2f
27
2$
31
3^
Nature of residual equities
l"/
Flow of receipts
hi
Position of stockholders
^2
Significance of balance sheet
k^
Expense or distribution of earnings
4*
Interest payments
i^]
Income taxes
4^
Dividends
5]
Residual equity in a cooperative
5;
Sources of capital
5]
Effect on theories of equity . . . . . . 5I
Summary
'
6(
• ••
111
IV. ENTERPRISE THEORY
V.
62
Evidences of social concept . . . . . . . . .
An activity concept
Operationalism
Examination of concept
Development of the theory
Enterprise concepts of profit
Enterprise concepts of assets . . . . .
Enterprise concepts of revenue and
expense
Enterprise concepts of equity
Summary
62
65
69
7^
7^
79
85
88
91
9^
EXAMINATION OF VALUE ADDED CONCEPT
95
Comparison of asset flows
96
Circular flow effect
96
Value added concept of income
99
Limitations of proprietary and entity
theories
100
Social accounting for the nation
101
National income accounting
101
Examples of value added income
statements
103
Comparison of accounting and economic
concepts of value added
I06
Advantages of value added concept . . . IO9
Value added taxes
Ill
Method of taxation
...Ill
Advantages
113
Disadvantages
115
Summary
117
VI.
STATEr/IENTS OF OPERATIONS
119
Comparison of funds and income statements . .120
Background of statements
120
Algebraic comparison of statements . . . 122
Direct comparison of statements . . . . 126
Analysis of funds statements
133
Funds as cash
133
Funds as net quick assets
137
Funds as net working capital
139
Comparison of funds statements
1^2
Flow statements and the enterprise theory . . 1^6
Asset flows for investors
1^9
Asset flows for long term debt holders . 153
Asset flows for short term creditors . . 155
Asset flows for regulatory agencies . . 156
Asset flows for management
159
Summary
I61
iv
VII.
SUMMARY AND CONCLUSIONS
I63
Summary
163
Relationship of asset flows and
profitability
165
Relationship of enterprise theory to
economic theory
I68
Allocation of revenues among factors
of production
170
Conclusions
173
Viewpoint with respect to management . .175
Nature of assets
176
Nature of capital
177
Nature of income
177
Emphasis of concepts
178
BIBLIOGRAPHY
I83
LIST OF TABLES
1.
Comparisons of Theories of Equity
35
2.
Concepts of Net Income
83
3.
Consolidated Business Income and Product
Accounts, 1965
107
4.
Hypothetical Firm, Comparative Balance Sheets
128
5.
Hypothetical Firm, Comparative Income Statements
129
6.
Hypothetical Firm, Comparative Changes in Capital
130
7.
Hypothetical Firm, Comparative Funds Statements,
Funds as All Assets Minus All Liabilities
Hypothetical Firm, Comparative Funds Statements,
Funds as Cash
Hypothetical Firm, Comparative Funds Statements,
Funds as Net Quick Assets
Hypothetical Firm, Comparative Funds Statements,
Funds as Current Assets Minus Current
Liabilities
8.
9.
10.
131
I36
I38
1^1
11.
Hypothetical Firm, Comparisons of Funds Statements 1^3
12.
Hypothetical Firm, Relationship of Net Income
to Value Added
158
Comparisons of Proprietary, Entity, and
Enterprise Theories
180
13.
VI
CHAPTER
I
INTRODUCTION
Background of the Problem
The corporation csone into existence as a vehicle for
the conduct of joint ventures.
It has grown both in size
and in importance from simple entities with a few people
acting jointly to huge complex organizations.
Originally,
liquidation of the venture with distribution of the assets
to the owners was expected.
permanent.
Now, the corporation is more
Corporate charters are granted in perpetuity.
Liquidation of the corporation is considered the exception
rather than the expected.
Corporations conduct a much larger volume of business
than any other type of business organization, including proprietorships and partnerships.
The corporation is generally
recognized as the prime business institution in the United
States.
Other forms of business entities exist but the cor
poration is the representative type of business entity in
the United States economy.
Edward Ziegler, The Vested Interests (New York: The
Macmillan Co., 1964), p. 4.
During the nineteenth and twentieth centuries, various
theories concerning the ownership or equities of business
organizations evolved.
etary theory.
The first of these was the propri-
The central idea of this theory is, as the
name implies, that the business is an extension of the owner.
In this scheme, assets represent things owned by the
proprietor, and liabilities are debts owed by the proprietor
This concept provided a satisfactory explanation of business
firms when businesses were small, and the owner personally
conducted or oversaw the operation of the business. Thus,
the proprietary theory is often associated with individual
proprietorships and partnerships and carries a connotation
of personal involvement by the owners.
Near the beginning of the twentieth century, the corporation began to replace the proprietorships as the dominant business organization.
The emergence of the corpora-
tion brought the recognition of the separation of ownership
and management, with the owners no longer personally conducting the operations of the business. It became difficult
to rationalize that the corporation was an agent for the
stockholder, and criticism of the proprietorship began to
arise. An alternative explanation of business ownership,
the entity theory, evolved.
The entity theory adopts the
viewpoint of the entity rather than the viewpoint of the
owners.
In this theory, accounting statements report the
accomplishments of the business.
The firm views funds
received from both stockholders and long term debt holders
as being commingled.
Both sources provide funds for the cor
duct of business.
The entity theory is generally accepted as the underlying assumption in financial reporting.
The corporation is
representative of the theory, as the corporation has a distinct separation of the business entity and the stockholder
owners.
Yet, the theory has equal application to other form
of business organizations.
For example, when the entity the
ory is accepted, the emphasis on reporting for an individual
proprietorship is on the business entity which is separate
from the individual per se.
The accounting reports show the
results of the business itself and not the status of the assets and liabilities of the owner.
While the entity theory recognizes a separation of the
owners and the business, the status of the corporation has
continued to change.
The concept of the corporation is now
much broader than just an institution in its own right.
Man
agement has come to consider itself responsible not just to
the stockholders but to all of the participants of the firm.
The idea that management has responsibilities to many groups
and even to society as a whole can be seen in a survey of th
literature.
Ezra Soloman states that in this newer ideology
profit-maximization is regarded as unrealistic, difficult, i
appropriate, and immoral.
In its place is a constellation o
objectives including service, survival, personal satisfactio
2
and satisfactory profits.
This economic change has placed increased responsibilities on accountants.
The accountant in the past has been
concerned with assisting owners to evaluate business operations.
John C. Greer states that the accountant now must
accept a broad social responsibility. Accounting reports
are the basis for significant decisions and policies in economic, social, and political matters as well as business affairs.^
Accounting thought has continued to change, also. The
entity theory has been attacked by the proponents of the
proprietary theory on the grounds that the entity theory
constitutes fiction. This attack includes the following
points. First, all business transactions must be conducted
by some person; thus, there must be a personal relationship
involved.
Secondly, a corporation is a mere legal concept;
a corporation, per se, does not possess ambitions, goals, or
even the ability to act. George R. Husband states that the
active agents of a free enterprise society are natural persons.
Free enterprise society is conducted to accomplish
their purposes.
Ezra Soloman, The Theory of Financial Management (New
York: Columbia University Press, 1963)1 P* I6.
-'w. A. Paton and A. C. Littleton, An Introduction to
Corporate Standards, intro. by Howard C. Greer (Chicago:
American Accounting Association, 19^0), p. v.
George R. Husband, "The Entity Concept in Accounting,"
The Accounting Review (October, 1954), pp. 552-63.
There is an even broader basis for the attack on the
entity theory.
If the position of the investor has become
amalgamated with the position of the other contributors of
factors of production, then, logically, accounting reports
should not be addressed to stockholders but to all interested
parties and the public in general.
Other theories that have been advanced in the literature are the residual equity theory, the funds theory, the
commander theory, and the enterprise theory.
None of these
theories has gained significant acceptance.
The residual equity theory is a compromise between the
proprietary and entity theories.
The primary point is that
while the business is the center of accounting activity, as
in the entity theory, income of the business is considered
to accrue to the owners or stockholders as in the proprietary theory.
The primary advocate of the funds theory is William J.
Vatter.^
In this theory the accounting unit is defined in
terms of a group of assets and a set of activities or functions for which these assets are employed.
assets is called a fund.
This group of
The entire notion of equity or
ownership is abandoned, and assets are accounted for in
terms of the restrictions placed upon them.
The applica-
tion of the fund theory is most apparent in the area of
^William J. Vatter, The Fund Theory of Accounting and
Its Implications for Financial Reports (Chicago: The University of Chicago Press, 194?).
governmental accounting, but the concept carries over in financial accounting in other fields.
The enterprise theory is a broad social concept of a
business enterprise.
The enterprise theory emphasizes the
effects of business operations on all of its participants
and in its broadest sense upon society as a whole.
This
broad, social responsibility is consistent with increased
reporting responsibilities recognized by Greer.
This in-
crease in reporting responsibilities provides the impetus
for the examination of the enterprise theory.
The enterprise theory recognizes that assets flow into
and from the firm.
This flow of assets concept is consis-
tent with the view of asset flow in economic theory
flected in the circular flow diagram.
re-
The enterprise the-
ory emphasizes that all factors of production are important
in the productive process.
No one factor is more important
than the other factors of production.
If a business entity
operates for the benefit of all interested parties, then a
broader concept than either the proprietary or the entity
theories is implied.
If a firm is to be analyzed on the basis of social considerations, then the traditional type of income statement
is not adequate.
assets.
The enterprise theory emphasizes flow of
This flow includes the disbursements that a firm
makes to the various elements of production.
A relevant
measure of income reflects the increase in value of a firm's
product during the productive process. A statement showing
this increase is a statement of value added.
Objective
The enterprise concept of the firm is not well defined
nor have its assumptions and limitations been thoroughly examined.
The thesis of this dissertation is that the enter-
prise theory represents a more viable and more relevant explsination of the structure and behavior of a business firm
in today's environment than either the proprietary or entity theories.
The objectives are to determine if the enter-
prise theory provides a better theory upon which to build
accounting principles and to define the assumptions and limitations of the theory.
Scope and Methodology
The thesis is posed that the enterprise theory represents a more viable, relevant explanation of a business firm
in today's environment. Comparisons and contrasts of the
proprietary, entity, funds, commander, and residual equity
theories are made in order to show how they are related. A
snythesis of these theories is used to develop the enterprise theory.
The enterprise theory is then contrasted to
the proprietary and entity theories. The enterprise theory
is developed in order to derive logical conclusions to aid
in the development of sound accounting principles.
8
A survey of existing literature, including books, periodicals, and unpublished materials, provides the basic information for the study.
From this survey, facts and assump-
tions needed to develop the theory are selected.
Based on
these facts and assumptions, the enterprise concepts are developed .
The concepts serve as a basis for the development of
statements to illustrate the application of the enterprise
theory to a hypothetical firm.
The concepts and the illus-
trations are the basis for the testing of the thesis.
Significance of the Dissertation
A conclusion is made that the enterprise theory does
provide a more viable and more relevant explanation of the
structure and behavior of a business firm in today's environment than either the proprietary or entity theories.
This
conclusion has an effect on both accounting theory and financial reporting.
It is shown that business operations are conducted
through transactions which cause assets to flow into and
from the firm.
This flow of assets, as observed by the en-
terprise theory, between the firm and its participants is
consistent with the conduct of business operations as viewed
in economic theory as illustrated by the circular flow diagram.
The nature of net income is examined in the light of
the flows of assets. It is shown that the firm per se cannot have net income as all receipts of the firm must equal
the disbursements of funds over the life of a business. Thus,
net income is an ambiguous term.
In order for the term to
have meaning, asset flows from the firm and the recipients
of those assets must be defined.
This view of net income is
nearer the meaning of net income as used in economic theory.
Through the ideas of asset flows of a firm and the defining
of net income, the enterprise theory contributes to an integration of the accounting and economic disciplines.
Organization
The first chapter of the dissertation provides an orientation to the various theories pertaining to corporate
stock ownership.
This chapter also serves an an introduc-
tion of the enterprise theory. Chapter II compares the proprietary, entity, funds, and commander theories and shows
that all are related and that the differences in the various
theories are due to the differences in emphasis. The third
chapter deals with residual equities and their effect upon
the various theories. The effect of residual equities in
cooperatives is examined. A full chapter is devoted to residual equities as their effects have significant implications to all other theories. The fourth chapter presents
the development of the enterprise theory.
The concepts of
the theory are developed and the nature of assets, capital.
10
and income in the enterprise theory is examined.
The fifth
chapter shows that asset flow concepts and value added statements are common to both the enterprise theory and economic
theory.
In the sixth chapter, asset flow concepts are ex-
amined and an assumed firm is used to exemplify various asset flow concepts.
Chapter seven contains the conclusions
and recommendations.
CHAPTER II
COMPARISON OF THEORIES OF EQUITY
There are several theories regarding ownership of equities of a business.
Each of these theories interprets the
operations of the business from a particular viewpoint.
De-
bate exists as to which of these theories provides the best
basis on which to construct accounting theory.
The propri-
etary, entity, funds, and commander theories are discussed
in detail in this chapter.
Proprietary Theory
Selection of the accounting unit to be included in a set
of accounts and financial statements serves to define the
scope or boundaries of a given accounting entity.
Transac-
tions coming within these boundaries must be recorded.
In
order to develop consistent accounting principles, it is important to determine the underlying accounting theory to be
used in recording the activities of the accounting unit selected.
The proprietary theory was the forerunner of all
theories and is illustrated by small businesses in which the
owner is active in the conduct of the business affairs.
These
small businesses include proprietorships, partnerships, and
small corporations.
However, the proprietary theory can be
11
12
extended to apply to a large, diverse corporation.
In a small business organization, the owners are often
personally involved in the conduct of the business operations.
In such a case, there cannot be a separation of own-
ership and management; they are the same.
However, as a
business grows, both in size and in scope of activities, it
is impossible for the owners to be personally involved; therefore, duties and responsibilities must be delegated to others.
In the corporate form the persons that perform these
duties are the officers and directors.
Stockholders elect the members of the board of directors, who in turn select the corporate officers.
However,
the stockholders retain the final authority to terminate or
change the board of directors.
The proprietary theory views
these directors and officers as employees for the owner stockholders.
Thus, the stockholders or owners have ultimate au-
thority with management acting as an agent to conduct the
owners' business.
The proprietary view of management has been influenced
by the legal position of management.
Legally, the powers of
management are considered as powers in trust which are used
in managing the corporation for the benefit of the stockholders.
The following quotation is an example:
. . . all powers granted to a corporation or to the
management of a corporation, whether derived from statue
or charter or both, are necessarily at all times exercisable only for the ratable benefit of all shareholders
13
as their interests appear.
The view by a prominent advocate of the proprietary theory emphasizing managements' relationship to the stockholders
was expressed as:
The corporation might well be viewed as a group of individuals associated for the purpose of business enterprise, so organized that its affairs are conducted
through representatives.2
Stockholders are less active in the control of many
corporations today.
Management must exercise a wider range
of control. More typically, as long as the affairs of the
corporation run smoothly and profitably, the stockholders
are unlikely to terminate or change the management group.
Legal foundation
The law recognizes two theories, the fiction theory and
the association theory, in regard to the creation and authority of corporations.^ The fiction theory holds that the law
of the land is the source of authority for a corporation.
The association theory recognizes a union of persons as the
source of authority and the laws as a regulatory power. Parallels exist between the fiction theory of law and the entity
Adolf A. Berle, Jr. and Gardner C. Means, The Modern
Corporation and Private Property (New York: The Macmillan
Co., 1933). p. 248.
2
George Husband, "The Corporate Entity Fiction and Accounting Theory," Accounting Review (September, 1938), p. 24l.
^Arthur T. Roberts, "The Proprietary Theory and the Entity Theory of Corporate Enterprise" (unpublished Ph.D. dissertation, Louisiana State University, 1955), P« 12.
14
theory of accounting and between the association theory and
the proprietary theory.
From the association viewpoint, it
may be stated that the corporation is in the position of a
trustee who uses the corporate assets for the benefit of the
stockholders.
One writer expressed this view of the association concept of corporations:
No matter how real and distinct the corporate entity
may be in the rights and duties attached to it, it is
never an inconsistency to say that the corporation is
always an association of individuals acting as a unit
in the group name.^
The proprietary theorists emphasize that the corporation holds assets in trust for the stockholders.
If the
corporation is acting as a trustee in regard to the corporate assets, it follows that the owners would have a net
value view of assets.
The emphasis is upon the remaining
value after deducting all debts against the assets.
This
approach is consistent with the formula used by proprietary
theorists, that assets - liabilities = capital.
In this equation, assets - liabilities = capital, capital represents the residue in the assets after the liabilities have been deducted.
This view emphasizes the distinc-
tion between owners and creditors.
Under the proprietary
theory, only the owners' equity is considered capital.
4James Carter, The Nature of the Corporation as a
Legal Entity (Baltimore: John Hopkins University, 1919) i
p. 36.
15
Control, risk, and income
Ownership may be defined in terms of control, risk, and
income.^
In a small unincorporated business, little contro-
versy exists over the owners having the greatest share of all
these elements.
In a corporation with a separation of duties
and functions, the owner stockholders do not clearly possess
the greatest combination of the three essential elements.
The common stockholders have the right to vote in the
selection of the directors of the corporation, and, in turn,
the directors select the corporate officers.
Thus, the stock-
holders have a voice in management and in the control of a
corporation.
In recent years, the position of ownership has
generally changed from active to passive with the growth in
size of the industrial corporation.
However, the stockhold-
ers still have ultimate control through their legal right to
elect directors.
As indicated in an earlier paragraph, stock-
holders usually acquiesce and allow the encumbent management
to remain unless the stockholders become particularly dissatisfied.
In contrast with the weakening position of stockholders
in the control of corporate activities, an increase has occurred in the influence of long term creditors in the management of corporations.
First, there is a tendency to give
^Roberts, p. 180.
Berle and Means, pp. 66-8.
16
7
creditors representation on the board of directors. Next,
control is shifted to long term creditors in numerous provisions of indenture agreements between borrowing corporations
and long term creditors. Examples include maintenance of
specified working capital, provisions for replacement of
fixed assets, provisions relating to sinking funds, restrictions on future indebtedness, and restrictions of dividends.
The question of control appears to revolve around the difference between active day to day control and final ultimate
control through voting rights.
In regard to the element of risk, the stockholders are
the first risk bearers as all losses must be fully absorbed
by the stockholders' equity before other parties suffer losses.
However, it is not uncommon that the stockholders' in-
vestments are insufficient to absorb all losses. Further,
the concept of limited liability tends to curb the magnitude
of loss that a stockholder may incur. Thus, the stockholders may be the primary risk takers, but they are not absolute as others must absorb losses also.
From an economic point of view, both long term creditors' and stockholders' investment positions depend upon the
earning capacity of the enterprise, and both are subject to
some risk.
The following statement reflects such a view:
So long as the earnings are liberal, bondholders
and stockholders share in the harvest. Both classes
'^Arthur Stone Dewing, The Financial Policy of Corporations (New York: The Ronald Press, 1953). P- 188.
17
of securities are good investments and receive money
from the same source—the earnings of the corporation.
But when earnings are small the stockholder receives
nothing although the bondholder may be paid—often to
the serious distress of the company. When, however,
the earnings decline further the payment to the bondholder, too, is stopped. . . . Bondholders thus assume
economic risks which do not differ very much from those
of stockholders owners.°
However, the proprietary theory takes a different view
of capital, emphasizing a difference in nature. From the
proprietary view, a purchase of stock by an investor represents ownership of the corporation's assets, whereas bondholders make loans to the corporation.
This view is repre-
sented by the following statement:
The holders of capital stock own the equity in the assets which remain after the debts of the corporation
are paid. Capital stock, therefore, means proprietorship, ownership or per cent control of the business.
A share is a fractional interest in the equity of a
corporation.°
The proprietary theorists would thus state that stockholders take more risks as they are the first in line for
losses, the most unsecured.
However, it is not feasible to
say that stockholders are the only risk takers.
In regard to income, the purchase of a bond implies relative safety of principal and a satisfactory return.
In
contrast, the stockholder has no enforceable claim on the corporation until a dividend is declared or liquidation occurs.
Q
Benjamin Graham and David L. Dodd, Security Analysis
(New York: McGraw-Hill Book Co., 1951). P- 38.
^Birl E. Shultz, The Securities Market and How It Works
(New York: Harper and Brothers Publishers, 1942), p. 59«
10
Graham and Dodd, p. 38.
18
The distinction between bondholders and stockholders
is based more on a legal viewpoint than on an economic viewpoint.
Stockholders actually are concerned with reasonable
security of principal and assurance of income much in the
same terms as bondholders. The following statements are illustrative t
By the very investment in common shares, the stockholder acknowledges himself as a joint heir to the fortunes and misfortunes of the business. He risks his
capital on the skill with which his directors meet the
hazards of an ever changing economic scene. But he is,
so far as large publicly held corporations are concerned, an investor. His capital is entitled to a return, providing his corporation efficiently performs
economically desirable services for society. And as
an investor he wants to count on his return; and to comply with this demand from its shareholder, the corporation must conserve some of the large earnings in rich
years to fill out the dividends during the lean time of
poor earnings. Perhaps it is wrong and at variance with
the economic conception of the common shareholders'
contribution to industry to count on some degree of
regularity in the dividend disbursements. But he does.
And unless he can, he will not invest in the corporation's shares, and the corporation will suffer because
of the greater difficulty in obtaining capital.^^
Although the law still maintains the conception
of a sharp dividing line recognizing the bondholder as
a lender and the stockholder as a quasi-partner in the
enterprise, economically the positions of the two have
drawn together. Consequently, security holders may be
regarded as a hierarchy of individuals all of whom have
supplied capital to the enterprise and all of whom expect a return from it.^
Many companies have recognized the fact that a regular
dividend policy provides the corporation with a loyal group
^^Dewing, p. 798.
12
Berle and Means, p. 279.
19
of stockholders.
There are many similarities between con-
tracted interest paid on bonds and regular payments of dividends on stocks.
The elements of ownership-control, risk, and income
have been found to some degree in both long term creditors
and the stockholder owners.
The proprietary theory regard-
ing ownership is based primarily on a legal viewpoint, i.e.
a legal distinction between the creditors and the owners.
If one accepts the idea that the stockholders own the
business and dominate management, then, logically, the business organization is a method of doing business for the owners.
The stockholders are the nucleus, and all other par-
ties are instrumentalities to be used for the benefit of the
stockholders.13
-^ One implied objective of the business from
the proprietary viewpoint is the maximization of profits for
the owners.
The proprietary concept emphasizes personal relationships.
Persons own property and conduct transactions.
En-
trepreneurs are real live people conducting business operations for an expected profit.
Conduct of business opera-
tions would be viewed as a series of exchange transactions
between persons.
Entity Theory
It is impossible in a large corporation with hundreds
^^Roberts, p. l8l.
20
of stockholders for the stockholders to take an active part
in the administration of the corporation.
As a result, a
separation of management and ownership has evolved.
The ac-
tive participation of owners has lessened such that the owners now have only an indirect relationship with management.
Position of management
The proprietary view of management is that management
is completely dominated by the owners, or that management
is a representative of the owners.
a different viewpoint.
The entity theorists take
They regard the business organization
as an institution in its own right, separate and distinct
from the owners.
The following quotes are illustrative:
According to the entity theory, the business is regarded
as an operating unit which has an existence separate and
distinct from its natural owner or owners.^^
The business undertaking is generally conceived as an
entity or institution in its own right, separate and
distinct from the parties who furnish funds.^5
While the proprietary advocates consider management as
an instrument in the hands of the owners, the entity advocates regard the owners as secondary to management.
The
owners are suppliers of funds, similar to creditors.
One writer expressed the view of the entity theory with
respect to the position of management thus:
14
Walter G. Kell, "The Equities Concept and Its Application to Accounting Theory" (unpublished Ph.D. dissertation, University of Illinois, 1952), p. 46.
•^W. A. Paton and A. C. Littleton, An Introduction to
Corporate Accounting Standards (American Accounting Association, 1940), p. 8.
21
Although management performs the function of managing
the corporate affairs, with authority delegated by
stockholders, some consider management as an entity in
itself rather than an employee of the stockholders.
The part owners previously played in the corporation
has been taken over by management. Therefore the divorce of ownership and control seems to indicate the
entity theory or a managerial approach to corporate
enterprise theory.^^
Management plays an influential part in the conduct of
affairs of a corporation. With the growth of corporate businesses, the authority of professionaJ. managers has increased
because of the efficiencies and abilities which these managers have developed.17' In some cases, management can help to
effect their perpetuance. Yet, it must be remembered that
the stockholders always have ultimate authority through voting control. While there has been a definite lessening of
control by stockholders over management, final control has
not lapsed.
Distinction between owners and corporation
From the entity line of reasoning, the corporation is a
separate and distinct entity with the emphasis on the corporation. There is a real distinction between the stockholders,
who are considered as the owners of the corporation, and the
18
corporation, which is regarded as the owner of the assets.
Arthur T. Roberts, "The Proprietary Theory and the Entity Theory of Corporate Enterprise," abstract of unpublished
Ph.D. dissertation. Accounting Review (July, 1956), p. 449.
17
'Roberts, Ph.D. dissertation, p. 25.
18
Dwight A. Pomeroy, Business Law (Cincinnati, Ohio:
Southwestern Publishing Co., 1931), p. 49.
22
Under the entity concept, the entity owns all of the
assets and owes all of the suppliers of funds, stockholders
as well as creditors. This interpretation is represented
by the formula, assets = liabilities + net worth, used by
the entity theorists.
Certain definitions of the term assets seem to emphasize the entity point of view. Examples are:
Things owned are given the title "assets." Such items
may be more completely defined as anything of monetary
value owned by a specific individual or firm regardless of whether it is material or immaterial. . . . It
is not sufficient that properties be in the possession
of a firm to be considered assets. They must be owned
by the firm.^^
The factors acquired for production which have not yet
reached the point in the business process where they
may be appropriately treated as "costs of sales" or
"expenses" are called "assets."^^
These definitions emphasize an entity approach. Part
of the emphasis from this approach is placed on the contribution that assets make to production. Further, the emphasis is on total assets, not net assets after debt claims,
as in the proprietary concept.
Productive economic unit
From a professional manager's point of view, the business organization is regarded as a productive economic unit
rather than as a method of doing business. The entity point
of view implies a managerial point of view.
19
^George K. Husband and 01in E. Thomas, Principles of
Accounting (New York: Houghton Mifflin Company, 1935)» P* 17.
20
Paton and Littleton, pp. 25-6.
23
From the entity view, the stockholders' possession of
corporate stock does not represent ownership of the corporate assets, but is evidence of a bundle of rights.
The
stockholders have rights to share in profits, rights in distributions in a liquidation, rights to attend stockholders'
meetings, and rights to vote on corporate policies and the
selection of the board of directors.
All of these rights
are indicative of the ownership position.
In the entity theoiy, the liability claims of the creditors and the equity claims of the stockholders are claims
against the assets collectively.
This view of capital is
consistent with a managerial viewpoint.
Funds from credi-
tors and from stockholders are considered commingled.
The entity view of capital is similar to the view of
capital as used in economics and finance.
The economics
capital is defined in terms of a fund of value which may be
embodied in the physical tools of production.
The financial
management point of view is concerned with all resources, or
assets, and the various creditors' and owners' claims to the
resources and the associated earnings.
When viewed from an entity viewpoint, net income would
involve a change in the total assets rather than a change in
a stockholder's account.
Income is the increase in total
assets which results from the excess of proceeds recovered
over the associated outlays.
Emphasis is on the change of
liabilities and equity, not just on the change of owners'
equity.
24
The following definitions of income illustrate the entity viewpoint:
Net business income may be defined as the amount by
which the equities of the proprietors, and all others
furnishing capital and entitled to participate in income , are increased as a result of successful operations.^^
Under the entity or managerial approach, income is
thought of as representing the net monetary reward derived from all sources by the skillful conduct of the
enterprise. Under this view, it makes no difference
who furnished the resources. They may be stockholders, bondholders, or other parties.^^
From the entity viewpoint, all gains belong to the corporate enterprise.
The stockholders are paid a return on
their capital investment. The stockholders do not possess
a legally enforceable claim against the corporation. When
a stockholder invests in a firm, he receives a bundle of
rights, the rights to receive declared dividends, rights in
liquidation, and other rights. However, if the stockholder
wishes to regain his original investment, he is forced to
sell his stock to a third party.
If a corporation consists
of a method of conducting business, as indicated by the proprietary theory, the stockholder would not logically have
to wait for a dividend; he would have a valid claim through
ownership.
In the area of the distinction between cost and distribution of profits, the entity and proprietary theories come
21
W. A. Paton, Essentials
York: Macmillan Co., 1949). p.
22
G. H. Newlove and S. P.
(Boston: Heath and Co., 1951).
of Accounting (rev. ed.; New
78.
Gamer, Advanced Accounting
p. 392.
25
into sharp focus.
From a proprietary view, all payments to
an outsider, such as wages, tajces, and interest, are costs.
They represent a reduction in the net equity of the owners.
However, under the entity or managerial viewpoints, there is
no distinction between payments to outsiders and payments to
debt and equity holders.
pense.
All disbursements represent an ex-
From this view, dividends are not distributions of
income but represent costs of operations to the business,
similar to interest.
The entity theory places emphasis on the business entity as the center of the business activity.
Various elements,
management, capital, employees, and suppliers, contribute
their respective factors to the business organization.
Busi-
ness operations emphasize productivity in which the various
factors are blended into a final product.
All parties except
management are considered as external to the business.
Fund Theory
A strong criticism of both the proprietary and entity
theories is presented by William J. Vatter,
Vatter expresses
satisfaction with the proprietary theory in regard to single
proprietorships and partnerships.
However, the proprietary
theory has shortcomings in regard to corporations.
Indivi-
dual proprietorships have a limited life but corporations
have a continuous life.
The entity theory avoids this pro-
blem by focusing attention on the business rather than on
26
the owners of the business. The entity theory, in turn, is
inconsistent, primarily because of the personalization of
the entity.^^
Vatter indicates that continuity involves a great deal
more than mere corporate existence.
It includes assumptions
that (a) the existing pattern of economic organization, including legal rules and social attitudes, will remain unchanged; (b) the operations reflected in accounting statements will be continued in substantially the same terms as
in the past; that is, the line of products, the geographical
scope of market coverage, and the general patterns of sale
effort will persist; (c) the economic and technological factors which are relevant to the operations will continue to
exert their influence in a substantially unaltered fashion;
and (d) the techniques and the forms of managerial effort
will be carried over into the future.23-^
In addition to Vatter's criticism of continuity, he
states other criticisms. First, the entity theory requires
valuation at cost.24 Vatter does not believe that valuation
at cost permits full disclosure as accounting has grown be25
yond using any "single-valued" or general purpose theory. -^
William J. Vatter, The Fund Theory of Accounting and
Its Implications for Financial Reporting (Chicago: The University of Chicago Press, 1947). p. 5*
^^Ibid.
24
"^^Ibid.
^^Ibid., p. 7.
27
Another criticism made by Vatter of the entity theory is
that its terminology does not possess an operational content.
For example, Vatter defines assets as service poten-
tials rather than property owned, equities as restrictions
on assets rather than claims or rights, and revenue and expense as basic flows rather than specific effects of individual transactions.
Operational viewpoint
The fund theory completely abandons a personalistic
point of view and emphasizes an operational viewpoint in
dealing with accounting problems. In the fund theory, the
basis of accounting is neither a proprietor nor a corporation.
The unit for which records are kept and reports are
made is defined in terms of a group of assets. This group
of assets is called a fund, with a meaning similar to the
meaning in the term sinking fund.
The proprietary theorists view equities as net worth of
owners; the entity theorists view equity as claims against
assets.
In the fund theory, equities are viewed as restric-
tions on the use of assets of the fund, which places condi26
tions under which the fund can be operated.
The view is
expressed by Vatter that claims do not arise against assets
but against persons. Assets are used to satisfy claims, but
these claims lie in the field of property rights, not in the
^^Ibid., p. 19.
28
property itself. ' Further, liabilities as shown on the
balance sheet represent future obligations to pay. The legal obligation does not arise until the due date of the instrument; thus, the items on the balance sheet represent anticipated legal liabilities, not real ones.
Liabilities
as shown on the balance sheet represent specific restrictions.
From the fund viewpoint, the term equity does not
encompass either claims or rights. Rather, it is a restriction on the operation of the fund.
It is from this viewpoint
that the equation, assets = restrictions, is derived.
From the fund viewpoint, retained earnings represent
restrictions by the fact that all assets are subject to specific restrictions or by the overall restriction of being
part of the fund. Appropriations of retained earnings are
more clearly interpreted by the fund theory than by any of
the other theories. Appropriations represent restrictions
by the management of the assets for a specific purpose, such
as plant expansion or repayment of bonded indebtedness. All
of the items on the right hand side of the balance sheet represent restrictions on the use of assets.
In regard to assets, Vatter emphasizes that assets are
not monetary or financial in character. Vatter states:
Assets are economic in nature; they are embodiments
of future want satisfaction in the form of service
^"^Ibid.
2^Ibid.
29
potentials that may be transformed, exchanged, or
stored against future events.29
This concept of assets is compatible with the process of accrual and deferral and eliminates the need for the idea that
costs attach."^
Expense, according to the fund theory, is
the draining off or the release of converted services of assets, even if they are not revenue producing.
Because of
the joint services nature of many expenditures, expenses cannot be measured by a transactions approach.
As it is impos-
sible to trace all of the effects of a particular transaction, expense must be measured in terms of flows rather than
by transactions.^31
Revenue, in the fund theory, is observed by the addition of new assets.
This addition may be in the form of cash
but does not necessarily have to be.
A distinctive feature
of revenue, from other asset increasing transactions, is that
the new assets are completely free of restrictions, other
32
than the residual equity restriction.^
Deemphasis of net income
In the fund theory, the concept of income has become impersonalized.
The theory does not require, but may use, the
concept of net income.
^^Ibid. , p. 17.
^Qlbid.
^^Ibid. , p. 24.
^^Ibid. , p. 25.
The fund theory emphasizes the idea
30
that a business operates to perform a service. Financial
reports, then, are more in the nature of statistical summaries emphasizing sources and applications of funds.
The fund theory also emphasizes the fact that the fund
is created for some purpose; that is, it is to be operational.
The holding, converting, and delivering of services are
the objectives of a fund.
Financial reports should be tailored to the needs of the
group to which the report is addressed rather than having a
single all-purpose statement. While it is impossible to enumerate all parties that may be interested in the financial
reports of a firm, Vatter identifies three specific groups:
33
management, social control agencies, and investors.-^-'
Management places the greatest demand of all parties on
the accounting system.
The accounting system must facilitate
the managerial process. This process includes wide ranges of
collection of data, of communications, of control suid internal check, and as an aid in various problems of policy and
34
strategy.^
Secondly, various governmental units depend upon accounting summaries in taxation, regulation of prices,
protection of creditors, and other public interest matters.
Trade and other associations use accounting data to inter3*5 Thirdly, present and prospective
pret developments.-^^
^^Ibid., p. 9.
^^Ibid., p. 8.
^^Ibid.
31
investors and creditors rely on accounting data as a basis
for their decisions. The accounting reports must be adapted
by each group to fill its specific needs.
Vatter emphasizes the distinction between the fund theory and conventional accounting:
1.
2.
3.
4.
5.
6.
The fund, not some person connected with it, is
viewed as an entity.
Valuation, so far as fund accounting is concerned,
is a minor issue; the absence of income emphasis
is largely responsible for this, but the impersonalness of the entity notion obviously contributes
to this point of view.
Equities, or whatever the right-hand balance sheet
items are called, are viewed as restrictions upon
assets, not as legal liabilities; this is true not
only as to surplus but also with respect to appropriations and commitments.
The segregation of long-term from short-term items
is maintained in somewhat more definite ways when
fund accounting is employed. The funding of capital assets, long-term investments, and the like is
common practice in institutional practice.
Fund accounting for institutions and government
agencies embraces certain procedures in reporting
operating data, and there are some differences between financial and institutional concepts of revenue and expense. These differences, however, are
largely matters of valuation or of the degree to
which the accrual basis of accounting is followed.
One of the distinctive features of fund accounting
is the absence of emphasis upon "net income" and
related notions of "profit," "operating margins,"
and the like.36
Commander Theory
The proprietary theory emphasizes ownership of assets
by the.proprietor; the entity theory stresses that the corporation owns the assets of the business. The commander theory emphasizes control over assets rather than the ownership
^^Ibid. , pp. 42-3.
32
of property.
The unit for which records are kept is a human
being or a small group of human beings.
These persons have
power to deploy resources under their economic control but
of which they do not necessarily have legal ownership.-^^ Bte.ny
times references are made to the business, the club, or a department as a separate social, economic, or legal entity.
There is a tendency to think of these units as engaging in
activities.
However, it is persons who conduct activities
on behalf of other human beings.-^
The function of control
can only be exercised by humans and should be used as a view39
point in accounting activities.-^^
Investors have control over their own resources, but
they do not have control over assets transferred to a business in which there is a separation of ownership and management.
Investors exercise control over dividends after they
are distributed to them.
Control over the company's re-
sources is exercised by a hierarchy of commanders.
Every
manager has limited control over certain assets with a very
few commanders having general command over all of the com,
40
pany's resources.
Accounting reports are useful in that they are used by
37
-^'Louis Goldberg, An Inquiry Into the Nature of Accounting (Iowa City: American Accounting Association, 1965). p. l63«
^^Ibid.
^^Ibid.
^^Ibid., p. 165.
33
commanders in their control of resources.
Louis Goldberg
states:
. . . accounting records are kept, statements are prepared, and records are analyzed, by people on behalf
of people for the benefit of people.
The adoption of the commander theory does not change
the double entry methodology or the scope of activity.
The
theory emphasizes that reports should be addressed to people.
It may be noted that this address is similar to the idea expressed in responsibility accounting.
From the viewpoint of the commander theory, the balance
sheet becomes a statement dealing with the resources with
which a commander has been entrusted.
The commander con-
trols these resources but does not necessarily own them.
The
balance sheet is a statement of accountability, with the manager in a fiduciary role.42
The income statement is a summary and a measure of the
events during a period of time.43
^ These events have been
initiated not by an artificial entity but by real persons.
The income statement is a summary of the expenditures the
44
commander has made and the accompanying results.
The proprietary theory appears to be a special case of
^^Ibid., p. 167.
42
"^Ibid. , p. 171.
^^Ibid.
44
^^Ibid., p. 172.
34
the commauider theory, one in which both ownership and con5 The entity theory can also
trol are lodged in one person.4*^
be reconciled to the commander theory. Where a commander
has control over many assets, he may wish to limit or define
his responsibilities into separate entities. Thus, he may
consider each area a distinct entity but without conceding
an artificial personality.
Summary
The more salient features of each of the theories are
presented in Table 1. Each of the theories exajnined presents a different approach to the understanding of a business entity. Each theory provides a different interpretation, depending upon the viewpoint taken.
The proprietary theory represents the view of the owners. As such, management oversees the business in his behalf.
The owner views assets as belonging to him and views capital
as the remaining assets after all liabilities are deducted.
Income, then, is the increase in assets to which the owner
has claim.
The overview of the concept is that the business
is an extension of the individual and the corporation is a
method of conducting business.
In the entity theory, the viewpoint of the firm is assumed.
Thus, definitions reflect the entity view. Manage-
ment is not an employee of the owners but is one of the
^^Ibid., p. 173.
35
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36
elements of production in its own right.
Assets are owned
by the business, and capital encompasses funds contributed
by both debt holders and equity holders.
increase in all assets.
Net income is the
The emphasis of the entity concept
is that the business entity is separate from the owners and
as such management is separate from ownership.
The funds theory does not view the firm from either the
owner's or the entity's standpoint.
impersonal.
Rather the concept is
Assets are not defined in terms of ownership
but in terms of service potentials.
restriction on the use of assets.
cept of net income is deemphasized.
Capital represents a
In this theory, the conEmphasis is placed on
the source and the application of various funds.
The em-
phasis of the concept is that a business is operational in
nature and that funds constitute a segregation of assets
of a specific purpose.
The commander theory emphasizes that all business is
conducted for the benefit of natural persons.
Thus, a
commander is one that has assets under his control.
The
commander of a business is responsible for the assets of
the firm regardless of the ownership of those assets.
CHAPTER III
RESIDUAL EQUITIES
In the prior chapter an examination was made of the
proprietary, entity, funds, and commander theories. In
all theories of equity there is a person or group of persons that possess a residual claim to the assets of the entity. The understanding of the claims that accrue to these
residual claimants is significant to the understanding of
the various theories regarding equities. An examination
is made in this chapter of the nature of these residual
equities and the relationship of residual equity to the
various equity theories. An examination is also made of
the nature of residual equity in a cooperative enterprise.
Nature of Residual Equity
George J. Staubus developed a concept of accounting to
investors based upon residual equities.
In this context,
Staubus defined residual equity as:
. . . a residual equity is a right to receive any service that the entity is capable of providing in excess
George J. Staubus, A Theory of Accounting to Investors
(Berkeley: The University of California Press, 196I), p. 19-
37
38
of those required to satisfy the definite enforceable
rights of related parties.^
Staubus indicates that in a business firm this right
typically resides in the owners; in a corporation these owners are the common stockholders.
If, hov/ever, the normal re-
sidual equity is eliminated by loss, the next ranking equity
holders, preferred stockholders or unsecured creditors, become the residual equity holders.^
The essential element of
Staubus' concept is that the rights of all claimants of a
business are enforceable in a given order.
The order fol-
lows the legal sequence of secured liabilities, unsecured
liabilities, preferred stockholders, and common stockholders.
Staubus shows that investors need information related
to the potential future cash receipts from the investment
relationship.
These future transfers of money from the firm
to the investor depend upon (a) the firm's ability to disburse cash for this purpose, (b) the legal status of the investor's expectations, and (c) the management's willingness
4
to pay the investor.. Of these items, the legal status of
the investor's expectation is the more significant for the
purpose of comparing the residual equity theory to the other theories.
^Ibid.
^Ibid.
4
George J. Staubus, "The Residual Equity Point of View
in Accounting," Accounting Review (January, 1959). p. 7.
39
Through algebraic manipulation, Staubus reaches several
conclusions.
First, for an investor that is concerned with
his position in the case of liquidation, the equation becomes:
Present cash balance plus future cash receipts minus
future cash disbursements to higher ranking equity
holders equals cash balance that will be available to
satisfy the investor in question (and lower ranking
equity holders),5
It is significant to note that the same equation would
be used by all claimants in a liquidation, but the amount
of cash available to each would be different, depending upon his rank as a claimant.
Another equation from the viewpoint of a long term lender that is expecting periodic payment is presented:
The period's cash receipts minus the period's cash disbursements that rank higher than his claim equal the
net cash receipts available to pay him (and lower ranking claimants) a periodic return.°
This equation assumes that payments for operating purposes , such as materials and wages, must be made if the firm
is to continue in business. All of these views of the cash
equation carry the idea of a sequence or order of obligations,
which in turn present the residual equity viewpoint.
Staubus emphasizes the significance of residual equity
in this manner:
From the point of view of investors as a group, the
special significance of the residual equity is that
it is a buffer to all of them (except residual equity
^Ibid. , p. 9.
^Ibid.
40
holders) and is a claim senior to none. It is also of
great significsuice to the residual equity holders as a
measure of their claim. The residual equity is the one
item on the balance sheet in which all investors have
a strong interest; it is a common meeting ground, a focal point agreeable to all.'^
Flow of receipts
Staubus' theory of accounting to investors is couched
in terms of flows of cash to claimants of the finn.
The
theory is not one of division of profits but one of priority of -claims.
This emphasis on cash helps to explain the
rise in importance of the use of funds statements.
Even
though there is a distinction between funds, generally defined as current assets minus current liabilities, and cash,
it is closer than the relationship between profits and cash.
Continuing the idea of the priority of various claimants to the assets of a firm, the claims of common stockholders will next be examined.
The stockholder's posses-
sion of corporate stock does not represent ownership of property but is evidence of a bundle of rights.
Generally, it
is accepted that the stockholder has the right to share in
the profits when a dividend is declared, the right to share
in assets in liquidation, the right to attend stockholders'
meetings to vote on corporate policy and the selection of
the board of directors, and, in cases, the preemptive right
to share in additional stock issuances.
"^Ibid. , p. 10.
41
Dividends are regarded as the distribution of profits
to the shareholders of a corporation.
of this distribution is emphasized.
The contingent nature
First, profits and as-
sets must be available before a dividend may be declared by
the directors.
Secondly, just because a corporation has re-
tained profits, the directors will not necessarily declare
a dividend.
The stockholder does not possess a claim until
the dividends are declared.
It is to be noted that the dis-
cretion lies with the directors, not with the stockholders.
The second right enumerated above is the right to share
in assets in liquidation.
However, if one accepts the going
concern concept, then liquidation is an exception and not the
expected.
The life of a corporation is normally not limited
by legal contract.
Yet, even where corporations are termi-
nated, the assets that are distributed to the stockholders
are the residual assets.
The claims of other parties must
be satisfied first, with the remaining assets being returned
to the stockholders.
The right of the stockholder to vote does provide a
deterrent power to the stockholder.
The effectiveness of
this deterrent pov/er is often questioned, particularly in
the case of large, diverse corporations.
Related to this
question of control is the preemptive right, the right to
share in future stock issuances in order for a stockholder
to maintain his proportionate position of control and of
ownership.
The preemptive right is often eliminated in pub-
lic corporations for purposes of operating convenience.
42
Position of stockholders
From the above line of thought, David H. Li states that
stockholders are left with one right, the right to receive
dividends when and if declared £uid that even this right is
o
conditional.
Li states that a stock issue is in essence a
variable annuity contract with a perpetual life and transferrable rights, with its principal represented by the offering price and annuity payments represented by dividends.^
Li continues that from this line of reasoning business
capital supplied by stockholders does not represent equity
of the stockholders but rather equity of the corporation.
As long as there is no due date for a stockholder's claim
for refund of his capital contribution, there can be no present value in the claim.
tually no claim.
Without a due date, there is ac-
A conclusion from this line of thought
is that stock price, then, is not a reflection of book value
but a capitalization of future dividends.
Li points out, however, that for a corporation to survive in an expanding economy, the corporation must grow.
For a corporation to grow, the corporation must attract additional capital, and this growth requires the honoring of
o
David H. Li, "The Nature of Corporate Residual Equity
Under the Entity Concept," Accounting Review (April, 196O),
p. 261.
^Ibid.
^Qlbid.
^^Ibid.
existing financial responsibilities, including the payment
of dividends to stockholders. A corporation may survive in
the short run without the payment of dividends, but in the
long run the corporation must honor its responsibilities.
The corporation's self interest requires an eventual payment of dividends.12
Li concludes that retained earnings represent accumulated income of the corporation and are an additional equity
of the corporation.13
^ This view is consistent with the view
expressed by Husband in regard to the entity viewpoint:
Viewed as a legal entity income earned by the corporate
endeavor is the property of the corporation, per se.
The extent that such income is retained in the business
it in effect becomes the corporation's proprietary interest in itself. To consider it otherwise, as when
it is treated as part of the book value of the stockholder's equity, is to imply acceptance of the agency
or representative point of view.l^
Staubus point out three distinct ways in which the residual equity concept differs from the proprietary concept. -^
First is the fact that creditors can become residual equity
holders.
This occurs in an abnormal situation in which the
owner's equity has been reduced to such an extent that the
general creditors become residual equity holders. Secondly,
every accounting entity has a residual equity.
In all
^^Ibid., p. 262.
^^Ibid., p. 263.
14,George R. Husband, "The Entity Concept in Accounting,"
The Accounting Review (October, 195^). p. 55^*
^^Staubus, "The Residual Equity Point of View," p. 8.
44
businesses, government organizations, or non-profit institutions, there is always some one or some group that possesses
a claim to the residual assets. Third, preferred stockholders
are usually considered as owners; however, they do not qualify as residual equity holders. A preferred stockholder, except for those possessing participating rights, possesses a
preference to dividends but does not share in the residual
of the earnings or in the assets in liquidation. Preferred
stockholders' claim to dividends is fixed in amount. To argue that such stockholders possess a claim to retained earnings is to imply that all fixed claimants, including creditors , have a claim to retained earnings.
Significance of balance sheet
In the residual equity concept, it is natural for a particular claimant to be aware of prior claimants in predicting his potential for receiving cash from a firm. However,
it is equally desirable to observe all claims that rank below his claim for all of these lower ranking claims provide
a margin of safety or a buffer.
The retained earnings of
the firm, thus, are a buffer for all claimants and provide
a measure of assurance to everyone that possesses a claim
against the firm.
From this viewpoint, it can be stated
that all claimants hold a claim to retained earnings. Emphasis is placed on all claimants, not just the common stockholders who have an interest in retained earnings, as the
size of retained earnings has a direct impact on the quality of all claims.
^5
As all claimants of a firm possess an interest in retained earnings, the accounting for retained earnings is importsuit. If retained earnings are misstated, then two possibilities exist. First, assets may also be misstated. If,
for example, assets are overstated, then retained earnings
would be overstated, thus overstating the quality of every
claim held by a creditor or stockholder.
Secondly, if re-
tained earnings are misstated, then some claim of the firm
may be misstated.
If accrued interest is not reported on a
statement, then a claim, interest payable, would be understated and retained earnings would be overstated.
If a claim
is misstated, the dual effects are an improper ranking of
claims and a misstatement of the quality of all claims
through misstated retained earnings. It is for this reason that all claimants look to the income statement, as it
represents the periodic changes in their buffer, retained
earnings.16
Expense or Distribution of Earnings
Residual equity is defined by Staubus as the right to
receive assets in excess of those required to satisfy prior
claims.
The concept of residual equity has implications for
the various theories regarding corporate equities. Transactions involving payment of interest, dividends, and income
^^ibid.
46
taxes will be examined to determine if they represent an expense to the corporation or a distribution of earnings under
the various theories.
Robert T. Sprouse made an analysis of transactions involving payments of interest, dividends, and income taxes under four separate concepts of the corporation. '^ The four
concepts are (1) the concept of the corporation as an association of common stockholders who are the owners of the corporate assets and obligors of the corporation, i.e., the proprietary theory; (2) the concept of the corporation as a separate and distinct entity existing and operating for the benefit of all long-term equity holders, i.e., the entity concept; (3) the concept of the corporation as a social institution, i.e., the enterprise concept (which is discussed in detail in the next chapter), and (4) the term corporation as
merely indicating a prescribed set of legal relations, i.e.,
operating under various state and federal regulations including federal income tax regulations.
If income is defined as an increase accruing to an investment in a corporation over a period of time, then beginning investment must be defined to determine the associated
income.
However, Sprouse indicates that investment in a cor-
poration must be defined in terms of one's concept of the
18
corporation.
In the association of common shareholders
17
"^'Robert T. Sprouse, "The Significance of the Concept
of the Corporation in Accounting Analysis," Accounting Review (July, 1957). p. 370.
^^Ibid., p. 372.
47
concept, investment would be common shareholder's contribution and any undistributed earnings. In the concept of the
corporation as a separate and distinct entity, investment
would include contributions from bondholders, other longterm obligations, preferred shareholders, and common shareholders.
In the concept of a corporation viewed as a social
institution, all sources of capital represent investment in
the enterprise. From a legal viewpoint, the total of stated
capital, paid-in capital, and retained earnings represent investment .
Interest payments
In the corporation viewed as an association of common
shareholders, the proprietary concept, interest payments
19
must be considered as expense. ^
In this concept the com-
mon shareholders are considered the beneficial owners, and,
from their viewpoint, interest payments represent a payment
to an outsider.
Interest payments must be deducted from rev-
enues to find the increases due to the common shareholders.
In the concept of a corporation as a separate entity
operating for the benefit of long term equity holders, interest charges on long-term debt are not properly expenses.
Bond proceeds in this concept represent investment, and interest payments represent a distribution of a contracted
^^Ibid.
20ibid.
20
48
share of corporate income. Paton and Littleton expressed
this idea:
To management the bondholders' dollars and the money
furnished by the stockholders become amalgamated in
the resources subject to administration, and the net
income of the enterprise consists of the entire amount
available for apportionment among all classes of investors. Interest charges, from this standpoint, are
not operating costs but represent a distribution of
income, somewhat akin to dividends. -^
Sprouse points out, however, that this concept leads to
a difficult question during periods in which operating losses
have occurred, and there are no earnings retained from prior
periods.22 Since interest payments are contractual, payments
are legally obligated.
It appears that such accumulated los-
ses by the corporation cause a reduction in the capital contributed by shareholders. This idea, that stockholders do
not have a claim even to their own contributions, is the same
as expressed by Li in an earlier paragraph. Thus, Li concluded that equity paid in by stockholders appears to be
owned by the corporation.23
-^
In the concept of the corporation as a social institution, the enterprise concept, interest charges represent a
cost for the use of capital supplied by bondholders.24 In
this concept, interest is the return to a factor of production
21
W. A. Paton and A. C. Littleton, An Introduction to
Corporate Standards (American Accounting Association, 1940),
pp. 43-44.
22
Sprouse, p. 373.
^ \ i , p. 261.
24
Sprouse, p. 373.
49
similar to wages and rents. However, it is pointed out that
dividends are also a return to suppliers of capital; thus, interest and dividends appear to be of the same nature as wages
and rents. Either all are expenses or all are a distribution
of earnings.
From a legal viewpoint, bonds are considered a liability and thus constitute a deduction in computing corporate net
income.2*-5^ Interest charges are deductible and thus constitute
an expense for federal income tax purposes.
Income taxes
Income taxes, unlike payroll and property taxes, are
contingent in nature.
It is because of this contingent na-
ture that they are analyzed under the various concepts of a
corporation. From the viewpoint of a corporation as an association of individuals, income taxes represent payment to
others and are clearly an expense.
Their contingent na-
ture does not alter this interpretation.
Salary bonuses pro-
vide an example; they are contingent in nature but are generally recognized as an expense.
From the entity viewpoint, the state and federal governments are not corporate investors. Thus, any payment to
them constitutes an expense to the entity.
this idea:
^^Ibid.
2^Ibid.
Paton expressed
50
Taxes are a somewhat anomalous element in business finance. Taxes are coerced; their amount largely outside
of the control of management; they do not follow price
trends closely; they can hardly be said to measure the
value of services received and utilized in production.
Taxes, therefore, are not strictly congruous with ordinary expenses. However, taxes are clearly a deduction from or charge against revenues in the process of
determining net income.27
From the viewpoint of a social institution, a corporation furnishes products to society at a cost that provides a
fair return to all factors of production including the suppliers of capital.
In such a case there is no economic pro-
fit for the corporation.
Sprouse points out that this is
the position of the various state and federal agencies that
regulate the operations of various public utility companles.28
Analogous to this concept of regulating the profits of
public utility companies is the concept of excess profits
tax. Excess profits taxes carry the connotation of taking
away from corporations those profits derived from the blood29
shed of war. ^ From this viewpoint income taxes can be considered a distribution of profits to the members of society.
However, this idea assumes that the incidence of taxation
falls on the corporation and cannot be shifted forward in
the form of higher prices.^30
'William A. Paton, Essentials of Accounting (rev. ed.;
New York: The Macmillan Co., 1949) . p. 99.
^^Sprouse, p. 374.
^^Ibid.
30lbid.
51
From a legal viewpoint, income taxes appear to represent an expense.
From the idea that investment in a corpo-
ration is represented by stated capital, paid-in capital
and retained earnings, taxes constitute an expense to be deducted to determine the increment to be added to retained
earnings for the period.
For federal income tax purposes,
state income taxes constitute a deduction.
However, federal
income taxes are not allowed as a deduction in the computation of federal income tajces.
Dividends
A dividend is generally considered to be a pro-rata distribution of the corporation's earnings to the stockholders.
If the corporation is viewed as an association of owners,
corporate earnings are viewed as belonging to the owners. A
dividend, thus, is a payment to the shareholders of something they already possess.
Under the proprietary concept,
income belongs to the shareholders at the time it is earned.
Thus, a dividend is logically interpreted as a reduction of
investment or a partial liquidation of the corporation.
From the viewpoint of a corporation as operating for the
benefit of all long term investors, payments to both the bondholders and to shareholders are viewed as a distribution of
31 It should be pointed out, however, that Sprouse's
profits.-^
definition of an entity operating for the benefit of long
^^Ibid.
52
term investors does not exactly coincide with other entity
concepts.
From a strictly managerial viewpoint, all pay-
ments by the firm constitute an expense.
The view of the corporation as a social institution requires the treatment of preferred dividends as well as divi32
dends on common stock as an expense.^
All payments for production costs under this concept are considered as an expense. However, this leads to the unusual conclusion that
dividends should be accrued in the absence of actual dis33
bursement.-'^
It is interesting to note that dividends are permitted
as a deduction for federal income tax purposes in certain
situations.
The situations include cooperative associations,
regulated investment companies, and dividends on preferred
stocks in certain public utilities and certain bank and trust
34
companies."^
From a legal viewpoint, the payment of dividends constitutes a distribution of earnings.
The viewpoint of many
state statutes is one of protecting creditors, and a deduction of dividends to stockholders is not permitted in the
computation of net income.
From the analysis made by Sprouse, it becomes clear that
the magnitude of net income to be reported is dependent upon
^^Ibid. , p. 377.
^^Ibid.
^^Ibid.
53
the viewpoint of the corporation that is taken. Further,
the proper treatment of interest, income tajces, and dividend
pgiyments is effected by the viewpoint of the corporation that
is assumed.
In George J. Staubus' article, "The Residual Equity
Point of View in Accounting," three broad categories or
groups that have an interest in accounting reports are recognized.
The three groups are managers, investors, and gov-
emmental agencies.^-^ Even though Staubus recognizes the
three groups, he places emphasis on the needs of the investor in his residual equity view.
If Staubus' view of accounting is assumed, then it logically follows that the revenues of the firm's operations go
to whoever is holding the residual equity claim, whether he
be supplier, creditor, or stockholder.
This view in turn
seems to imply the social concept of the corporation, that
all parties in the production process have a claim to the
revenues of the firm. From this viewpoint, a cooperative
association's capital structure will be examined.
Residual Equity in a Cooperative
A cooperative is a method of conducting business which
may be engaged in most any line of business activity. A cooperative may be defined as an association or corporation organized and operated to make a profit, not for itself but to
^^Staubus, "The Residual Equity Point of View," p. 4.
54
36
enhance the economic status of its patrons.-^
Often cooper-
atives are associated with the agriculture industry. Their
use is, in fact, much broader, effecting many industries.
Many businessmen conduct transactions with firms that are
true cooperatives. Examples include Associated Groceries
which serve smaller retail grocery stores, the REA Express
which is operated for the joint benefit of the railroad com37
panies, and the Associated Press.^'
The accounting process for a cooperative business, in
general, follows the process required in the conduct of a
similar type of non-cooperative business. However, the net
income of the firm, or the net margin as called in a cooperative, is a return to patrons rather than a return to the
suppliers of capital. Additional records must be kept to
facilitate the allocation of these returns to the patrons.
Studies of the financial statements of cooperatives indicate a variety of sources of capital and a multitude of reporting practices. This multitude of reporting practices in
turn has led to variances in classification and confusion in
terminology."^
Because of this reporting problem, excep-
tions to most descriptive procedures used by cooperatives
^ W. L. Bradley, "Accounting in Cooperative Business
Enterprise," Handbook of Accounting Methods. ed. by J. K.
Kassuter (3rd ed,; Princeton: D. Van Nostrand Company Inc.,
1964), p. 300.
^"^Ibid. , p. 301.
^ Robert L. Dickens, "Accounting for Cooperative Equity," The Cooperative Accountant (Fall, I967). p. 4.
55
can be found.
However, an analysis of the source and nature
of capital and of net income will be conducted even though
many exceptions do exist.
Sources of capital
Two basic approaches to capitalization of cooperatives
are recognized: fees may be charged to prospective members
or stock may be sold.
This approach gives rise to a classi-
fication dichotomy: stock and non-stock cooperatives. When
membership fees are charged, there is generally no return
39 Also, non-stock cooperatives may
earned on these amounts.^
be organized by the issuance of capital certificates. These
certificates may be of various denominations: $25. $50, $100,
and so on. These certificates usually bear interest, may or
may not have due dates, and usually have no voting rights.40
In cooperatives that issue stock, either preferred stock
or common stock may be issued. V/hen preferred stock is issued, the stock generally has no due date, is often subject
to retirement by the board of directors, generally carries
an interest rate of approximately eight percent, and usually
42
has no voting privileges.
Common stock issued by a cooperative may or may not receive interest. Usually one member
has one vote regardless of the number of shares held. Common
^'^Ewell Paul Roy, Cooperative: Today and Tomorrow (2nd
ed.; Donville, 111.: The Interstate Printers and Publishers,
Inc.. 1969). p. 333.
^Qlbid.
^^Ibid.. p. 331.
56
stock and preferred stock may be divided into various classes
with each class having different par values, interest rates,
42
and voting rights.
From the above description of the sources of capital of
a cooperative, it is easy to understand why confusion arises
in terminology.
Many of these sources of capital have char-
acteristics that are more closely associated with debt than
with capital.
Many of the instruments have a limited life
or are subject to recall by the directors.
The return to
these instruments is often fixed, and the word interest is
used often.
IVIany of the instruments carry no voting rights,
and those that do are often limited to one vote per member
regardless of shares owned.
However, most of these ideas
are consistent with the idea that the return to capital
should be limited.
The basic concept of a cooperative is
that the net income, or net margin in cooperative terminology, is returned to the customers.
In connection with the capital provided from outside
sources, plans using a concept of revolving, retained earnings are often used by cooperatives.
V/hen this concept is
used, the net income for the year is divided into two parts.
The first part is used to provide a cash return to each patron.
This portion, returned to the stockholder in cash, is
typically twenty percent of the net income for the fiscal
period as this percentage meets one of the requirements for
^^Ibid.
57
exemption from federal income taxation.
The second portion,
eighty percent, is distributed to the patrons in the form of
debt or equity certificates.
The distribution of both items,
cash and certificates, must be on the basis of patronage with
the cooperative.
The cash provided from operations but not
returned to patrons, the eighty percent, can be used to retire capital provided earlier.
Thus, all capital instruments,
such as preferred stock and capital certificates, may be retired.
When this plan is carried to its ultimate conclusion,
capital of a cooperative becomes a pool of rotating, outstanding allocations of net income.
This concept of rotating capital was expressed by Robert L. Dickens after conducting comprehensive research on
cooperative equity as:
It is generally expected, and sometimes established by
contract, that this capital will be rotated out of the
cooperative. Thus, most of the capital of most cooperativeSjuhave many, if not all, of the attributes of
debts.^-^
The preceding statement led Dickens to make a recommendation that cooperatives should attempt to reflect the basic
distinction between debt and equity for balance sheet report44
ing purposes.
This recommendation further led Dickens to
observe: "This will result in some cooperatives showing very
little or no equity on their balance sheet."45
43
^Dickens, p. 23.
44.
Ibid.
"^^Ibid.
58
The idea of a balance sheet without an equity section
is unusual.
The omission indicates that capital is not nec-
essarily essential.
Cooperatives have traditionally main-
tained a heavy debt to equity ratio in favor of debt. Presumably, one reason has been the access to borrowings at
relatively low interest rates from the federal government.
Further, as the return to capital stock is fixed at a low
rate, there is little incentive to hold stock. From this
view it becomes logical that equity capital is little more
than a thin buffer to facilitate long term borrowing. Patrons , not the stockholders, are the claimants to the residual equity.
A second observation is made from a viewpoint reflecting Staubus' residual equity theory.
Staubus' theory indi-
cates that a priority of claims exists against a business
based on legal priority.
In this concept the distinction
between debt and equity is arbitrary; the only meaningful
classification is on the basis of legal priority.
This view
is also expressed by Dickens as: "The basic nature of a cooperative enterprise creates a blurring of the distinction
46
between debt and equity in the financial statements."
Effect on theories of equity
A cooperative is designed to enhance the economic position of the patrons who are the final
^^Ibid., p. 14.
residual
equity
59
claimants, not the stockholders.
The stockholders possess a
claim that is essentially equal to debt, perhaps on a subordinated basis.
Dickens' empirical study indicates that some
cooperatives should correctly publish a balance sheet without
an equity section.
The proprietary theory appears difficult to defend in
light of the preceding.
The stockholders, as owners, appear
to possess a very inferior position.
Their only claim is
for a limited return on a very subordinated basis.
tity theory is also difficult to defend.
The en-
The cooperative
does not function to benefit the long term suppliers of capital, neither debt nor equity.
Likewise, the firm itself
cannot be considered the primary beneficiary.
Staubus' residual equity concept deemphasizes the distinction between debt and equity, and it in turn emphasizes
a priority of claims according to their contract.
Vatter's
funds theory also deemphasizes the distinction betv/een debt
and equity.
The funds theory is reflected by the equation,
assets = restrictions.
Both of these theories appear to have
some validity in the cooperative enterprise.
The cooperative operates to enhance the economic position of the patrons by an earlier definition.
This enhance-
ment is accomplished by the net income of the firm being allocated to the customers on the basis of patronage.
This
implies a social concept, or the enterprise theory.
It has
been shown that the cooperative does not operate for the primary benefit of the stockholders.
60
Summary
The proprietary theory views assets as belonging to the
owners and the debts as being owed personally by these same
owners.
Net profit is considered to accrue to the owners.
In the entity theory, the assets are recognized as being owned by the business.
The business also owes all debts.
Retained earnings are considered to belong to the business
until they are distributed to the stockholders.
In the residual equity theory, the business is recognized as owning the assets.
The credit side of the balance
sheet is viewed as a series of claims which are ranked by
legal priority in their claims to these assets.
Net income
is considered to accrue to the residual equity holders.
The
residual equity holder generally is the common stockholder
except in those cases where the net income is needed to satisfy the claims of prior claimants.
In the social concept, all receipts go to the factors
of production.
All factors of production have a claim
against the firm, presumably in a legal priority as in the
residual equity theory.
As all factors are to share in the
proceeds, the distinction between expense and distribution
of profits becomes blurred.
In a cooperative, the residual claimant is not the equity holder but is in fact the patron customer.
In such a
case, the equity holder appears to be the lowest ranking
creditor.
In the theories of owner equities, proprietary,
61
entity, and residual equity, the implication is that a successful business operates to the enhancement of the investors.
This is not the case of cooperatives, as their re-
wards are returned to the customers, not to the investors.
CHAPTER IV
ENTERPRISE THEORY
The enterprise theory is developed in this chapter. The
first part of the chapter is concerned with the ideas of an
activity concept and the ideas of operationalism.
Both of
these ideas are used in the development of the enterprise
theory.
Next, the enterprise theory is developed, includ-
ing an analysis of the underlying assumptions. Part of the
development of the theory is a synthesis using concepts from
the other theories of ownership equities. An examination of
the various concepts of profit using the enterprise theory
is conducted.
Finally, the nature of assets, revenues, ex-
penses, and equities is examined from the enterprise viewpoint.
Evidences of Social Concept
Chief Justice Marshall gave a legal definition of a corporation in 1819 that has become classic: ". . .an artificial being, invisible, intangible, and existing only in the
contemplation of the law."
Since that time economic changes
•1
Trustees of Dartmouth College v. Woodard, 4 Wheat.
(U.S.), 518 (1819).
62
63
have occurred that have institutionalized the corporation.
The corporation today is commonplace in the conduct of business.
Many people think only of such firms as IBM and Gen-
eral Motors as representative of the United States economy.
While such firms may be the leaders, many thousands of firms
2
of lesser size and stature exist. Yet, all of these firms
possess a certain permanence. All of the participants of
these firms, employees, management, creditors, and stockholders, may change; yet, the corporation will remain. In
essence, firms have become permanent and participants are
transitory.
George 0. May made the following statements in regard
to the changes in the American economy:
Looking at the problem broadly, we have an economic system that is materially different from that of 1913 when
the first income tax laws of the present series were
first enacted. Today our business is, to a great extent,
conducted by large corporations, the management of which
cannot be governed wholly or even mainly by the desires
of nominal owners. As Oswalt W. Knauth has pointed out
in a recent article entitled "Group Interest and Managerial Enterprise" in the Journal of Industrial Economics,
Vol. I, April, 1953, "the primary concern of management
groups is to maintain the flow of production. In order
to do so, the groups have to consider constantly their
relations with customers, suppliers, labor, government,
and creditors, as well as the stockholders,3
Especially significant in the develooment of the corporation has been the role of management. Management no longer
Richard F. Jassen, "Appraisal of Current Trends in Business and Finance," Wall Street Journal (Feb. 26, 1973). p. 1.
-^George 0. May, "Stock Dividends and Concepts of Income,"
The Journal of Accountancy (October, 1953). P» 431.
64
is regarded merely as the representatives of the stockholders, but, instead, management has become the custodian of
the enterprise objectives of survival and growth.4 In the
public eye, management represents the corporation; however,
it should be noted that the corporation exists apart from
its participants. The objectives of the firm itself must
be different from the objectives of its participants, such
as management and stockholders.-^
The concept of the corporation has become much broader
than just an institution in its own right. This idea is expressed in an article by Oswalt W. Knauth and is the article
referred to by George 0. May in an earlier paragraph:
Subject to all of these pressures, management has
become less and less to consider itself responsible to
its owners and more and more to accept responsibility
for the corporation as a whole. It does not oppose the
demands of other parties in the interest of the owners,
but on the contrary, attempts to satisfy them all—dividends for stockholders, high wages and good conditions
for employees, friendly relations with government, an
approving public, customers who will return for future
purchases. In a sense, such a point of view might be
interpreted as enlightened self-interest of management,
or enlightened stockholder interest, but typically it
goes beyond that in interest of performance."
This economic change and the increased responsibilities
of accountants have been recognized.
Howard C. Greer states:
4Waino W. Suojanen, 'Accounting Theory and the Large
Corporation," Accounting Review (July, 1954), p. 393.
^Ibid.
Oswalt W. Knauth, "Group Interest and Managerial Enterprise," The Journal of Industrial Economics (April, 1953).
p. 89.
65
In a changing economy, accounting has been undergoing a change. From a convenient mechanical device
privately applied to the measurement of the status and
results of a business enterprise, it has grown into an
important medium for the public expression of the important facts about our vast and complex commercial and industrial society. Where the accountant once was concerned merely with assisting the owners of a business
to evaluate its operations in money terms, he now must
recognize a broad social responsibility. His findings,
and the manner in which he sets them forth, have become
the basis for significant decisions and policies, not
only in business affairs, but in economic, social, and
political matters as well.7
An Activity Concept
It has been claimed that the majcimization of profits is
the basic objective of a business. More recently this concept has come under criticism and is at times rejected altogether.
The attacks on the maximization of profit seem to
stem from three avenues. First, the maximization of profit
is based on an assumption of a static competitive economy.
Today's economy is dynamic rather than static, and pure competition appears to be a special case rather than the dominant method.
Secondly, there is evidence that many firms are not interested in profit maximization.
Some firms prefer smaller
but more certain income. Also, the question arises as to
whether firms maximize short-run profits or long-run profits
'W. A. Paton and A. C. Littleton, An Introduction to
Corporate Accounting Standards, with an Introduction by Howard C. Greer (Chicago: American Accounting Association,
1940), p. V.
66
Thirdly, the maximization of profits requires that businessmen have knowledge of marginal revenues and marginal costs.
It is doubtful that most businessmen have access to this sophisticated information.
Joel Dean, in supporting the idea of satisfying or acceptable level of profits, states:
Many firms, and particularly the large ones, don't operate on the principle of profit maximization in terms
of marginal cost and revenue but rather set standards
or targets of reasonable profits.°
Dean indicates several reasons for limiting profits, which
include to discourage potential competitors, to restrain wage
demands of organized labor, to maintain good customer will,
to maintain pleasant working conditions, to maintain good
public relations, to restrain the zeal of antitrusters, and
g
to maintain liquidity and avoid debt.^ Dean also indicates
that profit standards can be formulated in aggregate dollar
terms, as a percentage of sales, or as a return on investment.
They can be formulated for individual products or for
the combined product line of the firm.
The concept of an acceptable level of profit takes into consideration the conflicting interests of the participants in a business organization. Each participant may possess objectives that are in conflict with the objectives of
o
Joel Dean, Managerial Economics (Englewood Cliffs, N.J.:
Prentice-Hall, Inc., 1951), p. 28.
^Ibid., p. 29.
^^Ibid., p. 34.
67
other participants.
For example, stockholders may desire a
policy that would ensure them large dividends.
Management
may have an objective of long term growth of the firm, or an
objective to preserve liquidity.
The idea of satisfactory
level of profits provides a compromise for those responsible
for making decisions and those influenced by the decisions.
The maximization of profit concept stresses the point
that a business organization is a method of doing business
and should be conducted for the benefit of the owners.
The
adequate level of profit concept seems to consider a business organization as a productive economic unit that is operated for the benefit of the group rather than in the interest of the owners.
The activity concept is, thus, devel-
oped that a business organization is an association of activities and as such is a method of conducting -business for
all participants, including owners.
This activity concept of a business appears to be consistent with the concept of a firm as recognized by Vatter.
Vatter defines assets in terms of service potentials.
He
then views the firm as an operating unit where the acquisition, holding, and conversion of services are the functions
of the business.
Related to this activity concept of a business firm
are the twin goals of survival and growth of the firm.
The
^^William J. Vatter, The Fund Theory of Accounting and
Its Implications for Financial Reporting (Chicago: The University of Chicago Press, 1947), p. 18.
68
entrepreneur is cbncerned with the conditions necessary for
the firm's survival, the conditions under which the participants will continue to contribute their activities in the
future•
This idea of survival and growth is recognized by Herbert Simon when he indicates that the entrepreneural group
is mostly interested in conservative values.
He indicates
that the entrepreneur as an economic man may be interested
in profits and not in size and growth, but further indicates
that this is not a serious objection as size and growth are
often related to profits.
Simon further indicates that most
entrepreneurs are interested in non-material values such as
prestige and power as well as profits.
He indicates that
this attachment to conservative objectives is even more characteristic of the professional managerial groups who exercise
13
active control of most large business enterprises. ^
Rothchild seems to support this survival idea in his discussion of duaopoly and oligopoly.
In his article, "Price
Theory and Oligopoly," Rothchild observes businessmen in a
14
struggle for position.
He is of the opinion that most oligopolists' desires are to entrench themselves in a secure
12
Herbert A. Simon, "Rational Behavior and Organizational Theory," Trends in Economics (University Park: Pennsylvania State University, 1955), P* 94.
^^Ibid., p. 117.
14
•^ K. W. Rothchild, "Price Theory and Oligopoly," Economic Journal (September, 1957), pp. 309-10.
69
position which will enable them to "hold what they hold."
The emphasis, then, is on the survival of the business
organization as a method of doing business for the owners
and other participants. For a business to survive, it must
induce all of its participants to continue to participate.
This is accomplished by distributing monetary or other rewards in order to satisfy the participants' personal objectives. -^ There is no one ultimate solution to the distributions of these inducements to the participants. One possible
solution may be for owners to receive the majority of the rewards and other participants very little. The opposite solution would be for the owners to receive little reward and the
other participants to receive the majority.
Perhaps, the
logical compromise exists such that all participants receive
some reward for dealing with the firm.
Operationalism
The concept of operationalism is related to the activity concept developed in the previous section. The basic idea
of operationalism is that an object may have a different meaning or have different characteristics in different environments.
The emphasis in operationalism is what the object does
rather than on what the object is. While it is unproven, the
^ H . N. Nammer, "An Activity Concept of the Business
Enterprise and Its Implications in Accounting Theory" (unpublished Ph.D. dissertation. University of Illinois, 1957),
p. 77.
70
use of operationalism is assumed to have been developed from
the concept of relativity in physics.
In explaining the
concept of operationalism, Norton Bedford states:
Essentially, operationalism is an attempt to clarify
the meaning of a concept by insisting that the proper
definition of a concept is not to be found in what men
say or even think it to be. Rather, the meaning of a
concept lies in the operations performed by its measurements, including a specification of the areas in
which it is useful.^7
The idea of operationalism leads to a conclusion that
objects have two definitions, one stressing what an object
is and another stressing what an object does. Henry Margenau points out that concepts have two definitions, a formal
18
one and an operational one.
He states:
. . . it is necessary . . . that every accepted scientific measurable quantity have at least two definitions,
one formal and one instrumental. It is an interesting
task to show how some sciences fail to become exact because they ignore this dual character of the definitory
process. Omission of operational definitions leads to
sterile speculation . . .; disregard of formal (or conrg
stitutive) definitions leads to that blind impiricism. ^
This idea of an operational definition is complementary
to the activity concept of a firm.
Both emphasize the firm
as a place of activity. Although Vatter does not mention an
activity concept or operational definitions, he provides an
Norton M. Bedford, Income Determination Theory: An
Accounting Framework (Reading, Mass.: Addison-Wesley, 1965),
p. 68.
^"^Ibid.
^®Ibid., p. 7.
^^Ibid.
71
excellent operational definition of a firm:
Every accounting unit is aimed at the fulfillment of
some purpose, for which the services embodied in assets are of importance. The acquisition, holding,
conversion, and delivery of these services to the parties at interest is the operation of the unit.20
Norton Bedford develops an operational concept of net
income.
An operational definition of net income emphasizes
the needs of the users of the concept.
Thus, different per-
sons may have different definitions of net income, depending
upon their needs.
From this operational approach, Bedford
states that an ideal concept of income to meet the needs of
contemporary society includes:
1.
2.
3.
It should be useful to the varying purposes to
which people put the concept of income.
It should be measurable in the normal sense of
measurement.
It should also provide some conformity with a variety of satellite concepts of income, so that the
relationship of one concept to another will be understood. 21
Bedford proceeds to develop an operational concept which
includes the following six steps:
acquisition of money ser-
vices, acquisition of services, utilization of services, recombination of acquired services, disposition of services,
and the distribution of income.
Through these six steps and
the use of symbols, Bedford can define various concepts of
net income.
Bedford indicates that if someone wants to know what operational income truly means, he must examine the manner in
^^Vatter, p. 18.
^^Bedford, p. 75^
72
which it is computed and not rely on what someone says has
been measured.
If different measurement methods are used,
operational income would then reflect different constitutive
meanings.
Because of the fact that business operations and
accounting measurements do vary, the constitutive meaning of
22
operational income must vary.
Bedford identifies some of the various groups to whom
income may be reported asi
1• Economic entity income, which refers to the increase
in assets from all types of operations
2. Total equity-group income, which is entity income
plus gifts to the entity
3. Total original-stockholder group
4. Total present-stockholder group
5. Total original junior-stockholder group
6. Total present junior-stockholder group
7. Managerial entity income, which is the balance of
the increase in assets from all operations after
all equity holders have been paid for use of their
funds. . . • over the life of the corporation—
since legally all income accrues to equity holders
it may be contended that this type of income will
be zero.^-^
Bedford indicates that payments to both stockholders and
to creditors for the use of funds represent distributions of
income.
In addition, there is the conceptual problem of
which distributions to the stockholders and creditors are
distributions of earned assets and which are distributions
of contributed capital.
Bedford states that there is no in-
herent reason why distributions to stockholders should reduce
retained income rather than contributed capital.
^^Ibid., p. 181.
23 Ibid., p. 183.
The fact is
73
that companies distribute assets to creditors and stockholders. 24 This idea appears to be the same idea expressed by
Staubus in his concept of residual equity; any distribution
reduces equity holders' claims to the remaining assets. Bedford further indicates that distributing earned assets before
contributed assets is a fiction and amounts to a LIFO prin2*5
ciple of e q u i t i e s . ^
Before concluding Bedford's discussion of operational
i n c o m e , two additional quotes from his book appear to have
inference to the enterprise theory.
F i r s t , Bedford s t a t e s :
O p e r a t i o n a l i n c o m e , in another constitutive m e a n i n g ,
may b e considered more of a social concept than a m e a sure of individual o r group r i g h t s , f o r it may be held
to reflect the economic contribution which a n entity
has made to the economy in which it operates.^°
This concept of income is only one of many concepts of
operational income.
It does represent a broad concept and
reflects a social point of v i e w .
Bedford also states:
The theory that w a g e s paid to labor represent a d i s t r i b u t i o n of i n c o m e , that labor is n o t a commodity b u t is
a p a r t i c i p a n t in the collective enterprise of big b u s i n e s s just a s stockholders a r e , and that the cost of l a b o r should n o t be deducted in computing income m a y well
be a n emerging concept to which accounting theorists
should direct a t t e n t i o n . B u t f o r the present it is foreign to the accounting n o t i o n of business income.27
^ ^ I b i d . . p.
184.
^^Ibid.
^ ^ I b i d . , P- 180.
^•^Ibid., P. 78.
74
From these points of view, that operational income reflects a social point of view and that wages represent a distribution of income, the enterprise theory will be developed.
Examination of Concent
Development of the theory
In prior chapters it was shown that in many ways funds
invested in a firm by both long term creditors and by stockholders are similar.
Management looks at funds from both
sources as commingled; both provide resources to the firm.
From an economic point of view, returns to both long term
creditors and stockholders depend upon the esirning capacity
of the firm.
The following quote is repeated for emphasis:
So long as earnings are liberal, bondholders share in
the harvest. Both classes of securities are good investments and receive money from the same source—the
earnings of the corporation. . . . Bondholders thus
assume economic risks which do not differ very much
from those of stockholder owners.^"
This likeness of long term debt and capital stock leads
to the following question.
Do returns to debt and capital
constitute cost or distributions of income to a corporation?
If they are costs, is it not rational for a profitable organization to consider minimizing costs and retire all loans
and capital when possible from proceeds of operation?
This
retirement appears logical if the return to loans and capital is greater than the revenues derived from their use.
?8
Benjamin Graham and David L. Dodd, Security Analysis
(New York: McGraw-Hill Book Co., 1951), p. 38.
75
If, on the other hand, distributions to creditors and
stockholders are not costs, does it follow that they are distributions of profits?
What is the difference between these
distributions for capital and distributions to employees for
wages, to management for their efforts, and to the providers
of other resources?
It follows that there is a similarity;
all are costs of production.
It is relatively easy to see a similarity in long term
debts, particularly if refinancing is contemplated, giving
a perpetual effect and equity capital.
Is there an inherent
difference between the position of holders of long term debt
and the holders of current liability?
The strongest argument
indicating such a difference would seem to be that providers
of long term funds look to operating income for a return,
while providers of short term funds expect to be repaid from
current assets.
In rebuttal, it is pointed out that the term current is
arbitrarily defined as a one year period or one operating cycle, whichever is longer.
There is no real distinction in
liabilities due within a year and those due one day later.
Further, it is entirely feasible that certain firms may be
able to repay long term debts from their present cash position.
Likewise, certain firms may not be in a position to re-
pay current debts with current assets.
More realistically,
all debt holders possess a claim against a firm in accordance
with their legal priority.
It seems logical to conclude that
76
short term creditors provide funds for a firm's operations
just as long terra creditors provide funds.
If this idea, that all factors are inputs to production,
is pushed to its limit, the conclusion must be that all contributors of factors of production become claimants of the
firm.
This is precisely the idea advanced by Staubus in his
residual equity theory.
In essence, all receipts by the firm
provide an increase in assets and in claimants' rights. All
disbursements of a firm constitute a reduction in assets and
in claimants' rights.
Net income for a business is generally determined by deducting expenses for a period from the receipts of the period.
If, however, all payments are defined as distributions
to be paid to the factors of production, the idea of expense
is eliminated.
nues.
The equation becomes income is equal to reve-
However, a revenue is an increase in assets with a cor-
responding increase in rights of some claimant when viewed
from a residual equity viewpoint.
Thus, a firm is a place
of activity which has revenues, increases in assets and rights
to assets.
The enterprise concept places emphasis on activi-
ty and views the firm as a productive economic unit that is
operated for the benefit of the group rather than for the
particular benefit of the owners.
In line with this view of a corporation, Vatter states:
Viewed realistically, the corporation is a conglomeration of personalities, resources, conditions, and relationships; and this conglomeration is but faintly if at
all recognized in the corporate "person." In this frajnework wages are not merely cost of production; they are
77
at the same time a distributive share of the general
proceeds from operations; interest and dividends are
other shares in the same set of proceeds; the distinctions between "costs" and "distributions of income" are
no longer so sharp as they might have appeared under
other circumstances.29
Throughout the life of a business, all receipts of a
firm will be disbursed to the factors of production. This
occurrence is true whether such words as expense, costs, or
distributions of earnings are used to identify the amounts
paid to these factors. If throughout the life of a business
all receipts are to be disbursed to the factors of production, the concept of profit for a firm is eliminated. There
may be excess of receipts over disbursements in a given time
period but not during the life of the firm. For any period
less than the life of a business, any retained earnings or
deficit appears to be in the nature of an under or over payment to the factors of production.
The only alternative is
to define retained earnings as a firm's equity in itself.
If complete certainty in regard to all business operations could be assumed, then a firm could provide desirable
products to its customers at a cost, including a fair return
to the factors of production, in which case there would be
30
no corporate net income, or economic profit.-^ But this assumption is filled with pitfalls. It is presumed that
^^Vatter, p. 10.
^^Robert T. Sprouse, "The Significance of the Concept
of the Corporation in Accounting Analysis," The Accounting
Review (July, 1957), p. 374.
78
certainty means complete knowledge which eliminates risk. In
such a case, debt and equity would have the same meaning, i.e.
there would be no risk and both would be providers of capital
on an equal basis. Further, if perfect knowledge were available, there would be no need for inventories. Thus, as soon
as a product were produced, it would be sold, providing receipts for immediate distribution to the factors of production.
The concept of profit can thus be eliminated for a firm
operating in certainty within any time period. Also, the
concept of a profit to the entity is eliminated to a firm
over its full lifetime even if operating with risks. However, as firms do not operate under certainty, must have
fixed equipment, and must maintain inventories, the use of
capital is necessary.
The enterprise concept emphasizes that
capital must compete with all other factors of production for
a return. Also, the fact that the stockholders are the residual equity holders means stockholders are the last in line to
receive a return.
The growth in size and complexity of the corporate form
of business organizations, the rise in mass production, and
the increase in competition all result in the development of
the idea of the going concern.
The going concern concept im-
plies that a firm is expected to remain in business, that
liquidation is the exception rather than the rule. The acceptance of this idea has led investors to change in attitude.
79
They now often look at the earning power of a company, rather than its financial position, as a basis for granting credit.
Therefore, the productivity of assets has come to be
considered as the firm's main attribute. This productivity
of assets recognizes an activity concept of a firm and provides an operational viewpoint as stressed in earlier paragraphs .
Enterprise concepts of profit
Bedford indicates that the concept of profit should be
broad enough to facilitate a variety of net income computations in such a manner that the relationship of one computation to another can be understood.
Thus, net income for each
of the various participants can be computed. Each of the computations of net income should, however, remain a part of the
overall net income concept.
The enterprise theory emphasizes an activity or flow
concept. Also, the enterprise theory does not emphasize one
factor of production over other factors. The contributors
of capital do not occupy a more imminent position than do the
providers of other factors of production.
The disbursement
of the firm to each of these factors of production constitutes income to that factor.
Thus, a separate computation
of net income can be made for the various participants of
the firm to reflect their net income.
If the distributions to each group of participants are
labeled net income to that specific group, it logically
80
follows that the summation of the various net incomes to specific groups provides a broader concept of net income. This
broader concept of net income reflects the total of the receipts acquired by a firm in its conduct of business activities.
This total of receipts also reflects the value of
goods and services provided.
The assumption is made in ac-
counting and economics that the exchange price reflects the
value of the exchanged item; this assumption is particularly
valid of transactions made at arm's length. From a social
viewpoint, then, the total receipts of a firm must reflect
the total value of the goods that are transferred from the
firm.
At this point, two possibilities appear. First, a firm
may sell its products at exactly the cost of the factors of
production.
In this case there is no excess or deficiency
to accumulate in retained earnings of the firm. Actually, in
the present methods used in accounting, any excess or deficiency is defined as belonging to stockholders. This point
is recognized by Vatter:
. . . the residual owner stands the losses and reaps
the gains after contractual rights of other parties
have been satisfied. But it is the notion of residual
equities that establish the equality of assets and equities, not a duality of property, or a notion that "property must be owned by someone."31
The second possibility that exists is for a difference
to occur between selling price and the cost of the factors
^^Vatter, p. 20.
81
of production.
If there is an excess of receipts over costs
of production, this increase must have occurred because of
the operation of the firm.
This increase is akin to the idea
of synergism: the total is greater than the sum of the parts.
Synergism leads to the value added concept of income. As the
term value added implies, this concept reflects the increase
in value of products as the result of the productive process.
Hendriksen defines value added net income as:
In economic terms, value added is the value of the output of an enterprise less the value of the goods and
services acquired by transfer from other firms. Thus,
all employees, owners, creditors, and governments
(through taxation) are recipients of the enterprise income. This is the total pie that can be divided among
the various contributors of factor inputs to the enterprise in the production of goods and services. How this
pie is divided is usually subject to contractual agreements and bargaining.32
A conceptual problem arises as to the proper allocation
of this increase in value, brought about through production,
among the various firm participants. Should this increase be
distributed only to employees, owners, creditors, and governments; or should it also be distributed to the suppliers of
raw materials, to suppliers of intangibles, and to suppliers
of plant equipment?
Conceptually, perhaps, all participants
of the firm should receive a distribution.
However, this dis-
tribution would cause never ending problems of allocations,
reallocations, and re-reallocations among ever widening circles of suppliers. Economic theory holds that four basic
^ Eldon S. Hendriksen, Accounting Theory (rev. ed.; Homewood, 111.: Richard D. Irwin, Inc., 1970), pp. I50-I.
82
factors of production exist.
bor, capital, and management.
These factors include land, laEconomic theory also holds
that these four elements share in the distribution derived
from the increase in value of goods in the productive process.
In many cases, employees, owners, and governments do
share in the net income of the firm.
Employees often have
bonus arrangements, tax rates of governments are most often
on a progressive basis, and owners may receive an increase
in dividends.
In an indirect way, the argument can be ad-
vanced that creditors with a fixed rate of interest share in
increased profits through a reduction in risk,
Further, since
the factors of production are participants of the firm on a
continuing basis, allocations of future shares are always
subject to renegotiation.
In essence, these groups share in
the receipts provided by the productivity of the firm.
Chap-
ter V is devoted to further analysis of the value added concepts.
Hendriksen summarizes several concepts of net income and
shows the interrelationships.
All of these concepts appear
to have relevance to the enterprise theory.
The summary is
presented in Table 2.
As shown in Table 2, the value added concept of net income reflects the definition stated earlier.
The recipients
of this type of income are employees, owners, creditors, and
governments.
A narrower concept is that of enterprise net
83
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84
income.
In the enterprise concept, interest charges, income
taxes, and true-profit sharing distributions are not determinants of enterprise net income; but they are distributions
of net income. This concept reflects the 1957 statement of
the American Accounting Association.-^-^ This concept also separates the financial aspect of the corporation from the operating.34
-^
Net income to investors reflects the income that would
accrue to stockholders and holders of long term debt. This
income would include interest on long term debt, dividends
on preferred and common stocks, and the undivided remainder.
This concept also separates the operating income from the financing activities. Net income to shareholders is similar
to net income to investors minus interest charges and profitsharing distributions.-^^ Net income to residual equity holders would be the net income to shareholders less preferred
dividends.
It would accrue to current and potential common
stockholders unless priority payments cannot be met.-^
In summary, the enterprise theory recognizes distributions to all participants as sharing in the proceeds of the
33
^^Committee on Accounting Concepts and Standards, Accounting and Reporting Standards for Corporate Financial
Statements and Preceding Statements and Supplements (CoTumbus, Ohio: American Accounting Association, 1957), p. 5*
34
-^ Hendriksen, p. 151.
^^Ibid., p. 152.
^^Ibid., p. 153.
85
firm.
One interpretation of this broad concept of net in-
come is the value added concept of net income.
This value
added concept is a social concept which recognizes employees,
owners, creditors, and governments as the beneficiaries of
the income of the enterprise.
Other related concepts of in-
come provide more restrictive definitions of net income which
are useful for specific purposes.
Enterprise concepts of assets
It was stated in an earlier chapter that the definition
of assets under the proprietary theory emphasizes the debt
paying ability of the assets.
In the proprietary theory, the
owners of the business are assumed to own the assets and to
be personally liable for the debts of the firm.
From the own-
ers' viewpoint, the requirements of ownership and value of assets are necessarily important.
This proprietary concept of assets could be expected
from the way that business was conducted.
In the past, many
business operations consisted of a single venture.
Liquida-
tion rather than the going concern was the primary characteristic of business activity.
Consequently the major problems
of accounting centered around the debt paying ability of the
37
enterprise.-'^
The view of assets that emphasizes debt paying ability
is subject to criticisms.
-^'Nammer, p. 154.
First, this view of assets
is
86
based on a liquidation view of assets rather than a going
concern view.
Thus, it misses an important attribute of as-
sets, an attribute that emphasizes the role that assets play
in production.-^
Another criticism of this concept of assets is that the
concept is too narrow to recognize many perfectly good assets such as prepaid insurance, organization costs, and deferred charges.
tion is assumed.
In these cases, value is lacking if liquidaFurther, in the case of certain mortgaged
property, legal title or ownership may rest with the mortgagee, not with the business.
From the entity point of view, certain definitions of
assets emphasize the function that assets serve in production.
The emphasis on assets, then, is as a factor of pro-
duction, not on debt paying ability.
This shift in emphasis
is further reflected by changed economic conditions.
The
rise of the corporate form of business, the rise of mass production, and the increases in competition have resulted in
39
the development of the going concern concept.^^ In this
context, the productivity of assets or the earning power of
the corporation replaces the concept of liquidation values
of assets as a measure of debt paying ability.
Both of the foregoing concepts of assets emphasize a descriptive definition.
^^Ibid., p. 155.
39 Ibid., p. 157
An operational definition of assets
87
emphasizes the functions assets play in production.
From
this viewpoint, assets serve two purposes: (1) they are the
means for furthering the enterprise activities to meet the
corporate objectives, and (2) they are the means of paying
4o
all claims of the participants of the firm.
This concept is expressed by Vatter as:
Contrary to most popular notions, assets are in essence
neither physical, legal, nor even financial phenomena.
It may at times be convenient to talk of assets as if
they were physical, legal, or financial things; but this
convenience is achieved at the expense of exactness of
expression.41
Vatter proceeds to define assets as:
Assets are economic in nature; they are embodiments of
future want satisfaction in the form of service potentials that may be transformed, exchanged, or stored
against future events.42
The service view of assets stems from economics.
This
view defines assets from the point of view of the enterprise
and emphasizes an asset's main attributes, productive purposes, and satisfaction of participants' claims.43
Vatter indicates that the services concept of assets may
be objectionable because it is a protean concepti it may have
44
different meanings to different people.
Things are not always the same when viewed from many different perspectives.
^^Ibid., p. 158.
^^Vatter, p. 17.
^^Ibid.
43
•^Nammer, p. 159.
^\atter, p. 18.
88
However, this is the very idea that Bedford emphasized as important.
It is the element that makes a concept operational.
Vatter recognizes his definition of assets as operationas as he states:
The service concept of assets is operational in the
strictest sense; quite apart from the financial means
of expressing and carrying on business transactions,
every accounting unit is aimed at the fulfillment of
some purpose, for which the services embodied in assets are of importance.45
The services embodied in asset form are the essence of
asset definition. A frame of reference must be established
on the grounds of operational significance.
Enterprise concepts of revenue and expense
If a business is a mixing place for all of the factors
of production, then one factor should not logically occupy a
position of greater importance than the others. As noted
earlier, the distinction between an expense and a distribution of profit has become blurred.
This blurring occurs as
all distributions of the firm are payments to some factor
of production.
Conceptually, if all factors of production are partners
in production, logically, no one factor is due a return until
all factors are paid a return. As goods are sold, the total
value added to the products can be computed. At this time,
all of the factors of production would participate in the
distribution of the proceeds.
'^5Ibid.
89
This idea can produce some unusual results.
First, in-
ventories would be virtually costless, for factor inputs would
have no costs.
They would only share in the proceeds.
This
reduction of inventory costs lessens the need for capital.
Secondly, there would be no fixed costs for the finn.
All
factors of production would share in the proceeds of the
firm; therefore, expenses are completely variable with proceeds.
Following this line of reasoning, a sale is really the
exchange of one asset, finished goods, for another asset,
generally money and generally of a greater value.
This ex-
change would create an increase in assets and an increase in
the equity side of the balance sheet.
It seems that income
is a positive increase in assets and in equity.
From this
viewpoint, an expense would be a negative change in assets
and in equity.
The idea that distributions to the factors of production
are not to be made until a sale is made imposes a practical
limitation upon the acceptance of the enterprise concept.
First, it might be difficult to entice the suppliers of various factors to participate in the firm with the prospect of
facing a long waiting period before payment is received.
Next, each of the suppliers in reality becomes an investing
partner in the firm.
It is one thing to sell goods to a firm
and quite another to share in the risks as an investor.
Third-
ly, this idea leads to the awkward position that the firm cannot record expenses until after a sale is made.
90
In reality, this situation is avoided by the fact that
most factors of production contribute their inputs on the basis of a contractual amount.
Each factor receives a stipu-
lated amount and supposedly does not share in further proceeds of the firm.
Thus, the residual equity holder posses-
ses the final elastic claim on revenues.
Even though there is only one final residual equity holder, there are methods of arbitrage at work in the present system.
These methods enable many factors of production to
share a second time in the earnings of the firm.
Labor
unions often look to reported net profit and retained earnings in wage contract negotiations.
further share in net profits.
They are attempting to
Income bonds and convertible
debentures provide other examples.
At the same time, cove-
nants in bond indentures provide a restrictive device on the
residual equity holders.
All types of bonus arrangements
and incentive plans are direct examples.
The value added concept indicates that the four basic
factors of production—land, labor, capital, and management—
share in the revenues of the firm.
Thus, this concept im-
plies that the providers of goods and services that are outputs of other firms should not share in the redistributions
of a firm's earnings.
This concept implies that the value
was added by the four basic factors of production; thus,
they should be the recipients of this income.
91
Enterprise concepts of eaui-bv
In the proprietary concept, capital is defined as the
residual after deducting the claims of all participants other than the owners from the total of assets.
This approach
emphasizes legal owners as the only source of capital# and,
as such, only the owners' equity is considered as capital.
A criticism that can be made against this approach is that
this definition emphasizes only one attribute of capital:
capital as a claim or right.46
In the proprietary concept, only the stockholders are
considered the true owners.
This concept is based on a le-
gal distinction between owners and creditors.
Such a legal
distinction overlooks the economic fact that all factors of
production contribute to the operation of the firm.
From a managerial or an entity viewpoint, capital is
defined as the total of all assets. Following this entity
line of reasoning, the enterprise is an end within itself,
and stockholders as well as creditors are suppliers of cap47
ital. ' Thus, emphasis is placed on all assets used in operations regardless of the source of these assets. Again,
the entity view of capital stresses only one attribute of
capital: capital is the assets with which the firm operates.
The proprietary approach emphasizes capital as a claim
or right.
The entity theory emphasizes capital as the total
r
Nammer, p. 163.
47 Ibid., p. 164.
46
92
of assets.
Thus, an adequate definition of capital should
meet three requirements.
First, the definition should em-
phasize all of the attributes of capital, the asset, and the
equi-ty effect.
Secondly, the definition should be based on
economic assumptions rather than legal definitions of ownership.
Thirdly, a definition should maintain a distinction
48
between assets and capital.
There are two mathematical formulas that are used by the
proprietary and entity theorists to show the relationship of
assets, liabilities, and equities for balance sheet presentation purposes.
First, the proprietary theorists use the for-
mula: assets - liabilities = net worth, or in symbol form,
A - L = C.
This formula recognizes a legal distinction be-
tween liabilities and capital.
quantities.
As such, L and C are unlike
The formula, thus, emphasizes the net assets,
or the liquidation values of assets, to which the owners have
a claim.
On the other hand, the entity theorists present a formula which states: assets = liabilities + capital, or in sumbol form, A = L -h C.
This formula emphasizes that the total
of assets is equal to the total claims of creditors and of
owners.
As such, a distinction is maintained between assets
and claims.
These entity theorists maintain that it is im-
proper to deduct liabilities from assets, as they are unlike items.
^^Ibid., p. 165.
93
It has been indicated earlier that even though the stockholders are considered to hold a final elastic claim to income, they do not always receive that income.
They do not
necessarily receive benefit of this income because of the arbitrage operations of the other factors of production which
receive a second distribution of net income.
From the enterprise viewpoint, then, a formula for balance sheet presentation is represented as: assets » equities +
retained earnings.
In this context, equities are the rights
or claims of all participants of the firm.
These amounts
tend to be fixed in amount and include the regular or recurring dividends that are paid to stockholders as well as the
amounts due other participants.
Retained earnings, then, re-
present a buffer that is subject to future claims of all of
the equity holders.
A = E
In symbol form the equation becomes:
+ RE.
Criticism of this formula possibly includes the objec-
tion that there is an inherent difference between creditors
and stockholders.
The rebuttal is that there is an inherent
difference from a legaJ. viewpoint but not from an economic
viewpoint.
Further, there is a body of knowledge which deals
specifically with computing the cost of capital, including
stock, and with minimizing that cost to the firm.
An alternative definition of retained earnings that has
been offered is that retained earnings represent the proprietary interest that the corporation holds in itself.
Another
94
thought from this viewpoint is expressed by Ladd. He indicates that the earnings of a firm required for growth and
4Q
expansion may not be earnings at all. ^ However, these comments do not alter the enterprise theory formula: A = E + RE,
but merely offer alternative explanations.
Summary
The activity concept views the firm as an association
of activities with emphasis on the operation of the firm for
the benefit of all of the firm's participants. This activi-ty concept is consistent with the ideas of operationalism as
represented by Bedford.
These concepts provide a basis of
analysis of the firm based on operational definitions.
The enterprise theory views a firm, then, from the standpoint of the firm's operations rather than from a static or
descriptive viewpoint.
Theoretical analysis of the firm
shows that all suppliers of the factors of production are
partners in the productive process. Practical limitations
prevent firms from conducting operations in strict accord
with the enterprise concept. However, many alternative practices are followed that the results of the operations of the
firm approximate the results of operations of a firm as envisioned by the enterprise theory.
"owight R. Ladd, Contemporary Corporate Accounting and
the Public (Homewood, 111.: Richard D. Irwin, Inc., 1963),
p. 60.
CHAPTER V
EXAMINATION OF VALUE ADDED CONCEPT
The enterprise theory includes the assumption that all
factors of production are partners in the productive process.
The value added concept of income views the contributors of
the factors of production as the income recipients of the
firms.
Economic theory includes the concept of a circular
flow diagram of economic activity.
In the first part of
this chapter a comparison of assets flows is conducted to
show the similarities of the flows as represented by the circular flow diagram and by the enterprise theory. Economic
theory also includes the concept of measuring the value added
to products during the productive process. Value added by
production constitutes a part of the asset flow as represented by the flow diagram of economic activity.
The use
of value added estimates becomes the basis of computing the
gross national product of the nation. The second part of
this chapter includes a discussion to show the relationship
of added value to the enterprise theory.
The final part of
the chapter includes an examination of the value added concept as a basis of taxation.
95
96
Comparison of Asset Flows
Circular Flow Effect
The circular flow diagram of economic activity portrays
the flow of resources into a firm and the flow of finished
products from the firm.
This diagram shows that individuals
furnish the factors of production to business firms. These
factors of production are defined in economics to include
land, labor, capital, and management. This diagram also
shows that output of the business firms is transferred from
firms back to individuals as consumers. This constitutes a
circular flow; resources flow from individuals to the firm
and goods and services flow from the firm to individuals.
This circular flow of resources and goods constitutes a
flow of real goods and service as defined in economics. This
flow of real items is matched by a flow of money, which constitutes a second circular flow between individuals and the
firm.
This money flow moves in the opposite direction from
the real flows. Thus, resources, or factors of production,
flow from individuals to the business and money flows from
the business to individuals. Also, output of goods and services flows from the firm to individuals and money flows from
individuals to the firm.
Therefore, the flow diagram re-
flects two complete flows. One flow represents real goods
and services and the second flow represents money. A flow
97
diagram of economic activity is presented for illustration.
Money
Income
(Wages. Rents, Interest. Profits)
\Economic Resources (Land. Labor. Capital)
Individuals
\ /
i
•
\
1 Firms
Output of Goods and Services
Money Expenditures
The enterprise theory views the firm as a mixing place
where the various factors of production are blended together
to create a product.
In this process, all of the factors of
production are regarded as partners in the productive process.
With this idea, that all factors are partners, the receipts of the firm are available for distribution to the various factors of production. Each distribution represents a
return to the respective factor for its contribution to the
productive process. This distribution of receipts to the
factors of production is precisely the idea advanced by the
circular flow diagram of economic activity.
While economic theory acknowledges certain shortcomings,
or limitations, of the circular flow diagram,it is generally
accepted as descriptive of a capitalistic economy. The capitalistic economy is characterized by the private ownership
For a fuller discussion of the circular flow concepts
of economic activity see Campbell R. McConnell, Economics:
Principles, Problems, and Policies (3rd ed.; New York: McGrawHill Book Co., 1966), pp. 53-7.
98
of property, or other resources, and the freedom of individuals to conduct business activities of their choice. Self2
interest is the driving force of such an economy.
It can be seen from the diagram of economic activity
that individuals furnish the factors of production to the
firm.
In return the firm pays salaries, rents, interest,
and profits to the individuals for these factors. This diagram emphasizes that all receipts of the firm are returned
to individuals, not just a portion or a part of the receipts.
If all receipts of the firm are disbursed to the factors
of production, then an equation can be developed that revenues are equal to expenses over the life of the firm. Economic theory recognizes four basic elements in the productive
process.
ment.
These elements are land, labor, capital, and manage-
The returns to these productive factors are identified
as rents, wages, interest, and profits. Economic theory accepts as an identity that receipts of a firm equal rents,
wages, interest, and profit.
The enterprise theory also accepts that over the life of
the business all receipts of the firm are equal to its disbursements.
The equality of flows is expanded and emphasized
in Chapter VI of this study.
However, the enterprise theory
does recognize that an excess or deficiency of receipts over
disbursements may occur in a given time period covered by an
accounting report.
^Ibid., p. 56.
99
Value added concept of income
Economic theory recognizes four basic factors in the
process of production, which include land, labor, capital,
and management.
It is the payments to only these four ele-
ments that economic theory includes in the computation of
value added to production.
The reason for excluding other
payments is that the value added computation attempts to
measure the increase in value during production, not the total cost of the product.
A firm makes many disbursements to acquire the inputs
to the productive process. These disbursements may be divided into two groups. One group of disbursements is to individuals for the four basic factors of production. The
other group includes payments to other firms for their products.
Thus, the output of any firm is the total of the
payments made to other firms and the payments made to the
four basic factors of production. As the value added computation attempts to measure the increase in value during
the productive process, only payments to the four basic factors are counted. A computation of total value would include payments to both firms and individuals.
The circular flow diagram, then, includes the payments
to the four factors of production and thus represents only
the value added to production.
If the flow diagram included
products from other firms and the related payments, then the
diagram would reflect the total value of output rather than
increased values of output.
100
The value added by a firm,then, represents only a part
of the total cost of a product. Likewise, the circular flow
diagram represents only a part of the total asset flows of a
firm.
If the cost of inputs of products from other firms
were included, the total cost of products would be computed
and total flow would be shown.
Limitations of proprietary and entity theories
In Chapter II of this study, a comparison was made of
the proprietary, entity, and other theories. It was shown
that the proprietary theory view of the firm emphasizes the
viewpoint of the owner. Thus, assets are considered as owned
by the stockholders, and capital is a net worth concept. In
this view capital is the residual in assets after the claims
of debt holders are deducted in which the stockholder possesses a claim.
In this theory the distinction between a
creditor and an owner is significant. This distinction is
based on legal concepts.
In the analysis of the entity theory in Chapter II, it
was shown that the corporation possesses legal title to the
firm's assets. The stockholder possesses stock of the corporation which is evidence of a bundle of rights. Thus, the
entity theory places emphasis on the legal concept of ownership.
Both the proprietary and entity theories emphasize certain legal concepts. The enterprise theory in contrast emphasizes the productivity of the firm and the related asset
101
flows.
Productivity and the asset flows, both, emphasize
economic concepts. Thus, the views of the enterprise theory
are more closely associated with the views of economic theory than are the views of either the proprietary or entity
theories.
Social Accounting for the Nation
National income accounting
The value added concept of net income is a common ground
on which accountants and economists can meet. Traditionally,
accountants have been concerned with the measurement and analysis of net income of one firm, or a microeconomic approach
to the measurement of net income. Economists usually are concerned with the aggregate results for an entire industry or
community or the macroeconomic approach.-^
From the overall approach of economists, techniques have
been developed to measure the output of the United States as
a whole. This measurement results in the national income figures for the country. Annual estimates of national income
have been made by the Department of Commerce since 1933. The
Department of Commerce issues a monthly publication. The Survey of Current Business, which reflects this national income
data. Annual summaries of national income and its components
3
^Mary E. Murphy, "Social Accounting," Modern Accounting Theory (Englewood Cliffs, N. J.: Prentice-Hall, Inc.,
1966), p. 485.
102
4
are published in the July issue each year.
The general approach of the national income figures follows the value added
concept.
In 1947 the Department of Commerce established the following definition of value added to be used in the calculation of national income:
Value added by manufacture is calculated by subtracting the cost of material, suppliers, and containers,
fuel, purchases, electric energy, and contract work
from the total value of shipments. In that it approximated the value created in the process of manufacture, value added provides the most satisfactory measure of the relative economic importance of given industries available in the Census of Manufactures.5
The Commerce Department issued a supplement in 1951
which provides a detailed discussion of the conceptual framework and the statistical sources and, methods underlying the
United States national income statistics. In 1954 an additional supplement was issued which enlarges the discussion
of sources and methods by which statistics are compiled.
The final product of many firms often becomes an input
into other firms. It is for this reason that the Department
of Commerce has taken a value added approach to national income determination.
If a summation of the output of all the
firms were taken, then many products would be counted more
than once. Thus, it is only the additions, or the value
^Ibid., p. 488.
^U. S. Department of Commerce, Bureau of the Census,
Census of Manufactures, Vol. I (1947), p. 20.
^Murphy, p. 489.
103
added, that are counted as items progress through multiple
processes to become a final product. Economic analysis recognizes "two basic approaches to the determination of the value through production. One approach is to deduct the cost
of the items which are outputs from other firms from revenues of the firm.
The term products is used to denote these
items and includes such things as merchandise, supplies, advertising, and utilities. The second approach is to aggregate the costs incurred by a firm for factors of production
that are not products of other firms. The term non-products
is often used to denote these costs which include wages, salaries, interest, and profits.
Examples of value added income statements
An individual firm is assumed to illustrate the value
added concept. A traditional income statement for the Hypothetical Firm, a merchandising concern, is as follows:
HYPOTHETICAL FIRM
Income Statement
Sales
Cost of merchandise sold
Gross profit
Operating expenses:
Sales & office salaries
Depreciation
Utilities
Supplies
Repair
Advertising
Property taxes
Interest
Net income before taxes
Income taxes
Net Income
$20,000
12.000
8,000
$2 ,000
1 ,000
200
300
500
600
200
400
$
5,200
2,800
700
2.100
104
The first approach to the determination of value added
is to deduct from sales all of the product costs of other
firms:
HYPOTHETICAL FIRM
Value Added Statement
Sales
Cost of products purchased:
Merchandise sold
Utilities
Supplies
Repair
Advertising
Property taxes
Depreciation
Value added by firm
$20,000
$12,000
200
300
500
600
200
1,000
14.800
5,200
The second approach to the determination of value added
is a direct summation of the non-product costs. A further
assumption is made that of the $2,100 net profit shown in the
conventional statement a cash dividend of $1,000 was paid.
HYPOTHETICAL FIRM
Value Added Statement
Distributions to factors:
Sales & office salaries
Interest
Income taxes
Dividends
Undistributed profits
Value added by firm
$ 2,000
400
700
1,000
1,100
5.200
These illustrations reflect the value added by one firm.
As the analysis shows, the amount of value added by both approaches is the same amount. The national income figures are
essentially a summation of the value added amounts of the individual firms. There is no attempt to consolidate the income statements of all firms; the national income aggregates
are derived through estimation and other statistics.
105
While both approaches render the same amount of value
added, there are certain conceptual problems that cause difficulty.
Debates exist as to whether depreciation and indi-
rect taxes, which include property, excise, and luxury taxes,
should be considered to be products purchased from other
firms or to be non-products originating within the firm.
Strict application of the logic of the value added concept
indicates that these amounts should be considered as payments for products purchased from other firms. This logic
is particularly applicable to depreciation. Depreciation
purports to measure the amount of a fixed asset used up in
production. A similar case is presented for indirect business taxes as these taxes are considered as payments for
7
governmental services consumed in the productive process.
Many times, however, these items can be found as components of value added rather than being considered as a product purchased from other firms. The primary reason for such
inclusion appears to stem from the fact that neither depreciation nor indirect taxes accurately measure what they supposedly represent. Depreciation estimates vary widely.
A
strong argument can be advanced that indirect business taxes
are not an accurate measure of the benefits a firm receives
from the government.
Consequently, an inaccuracy occurs re-
gardless of the approach taken. Since theoretically they
^Chandler Morse, Basic Concepts of Private and Social
Accounting: an Economic Approach (Deposit, N. Y.: Valley
Offset, Inc., 1954), p. 7^.
106
should be excluded from value added, this approach seems the
o
better alternative.
Comparison of accounting and economic
concepts of value added
The illustration of the amount of value added in the
preceding illustrations was for one firm. The national income figures represent a summation or estimate of the value
added of all the firms in the economy.
However, the format
of the national income account is divided into two sides. The
left side reflects disbursements made to the various factors
of production in the economy.
This left side is often re-
ferred to as the disbursements side.
The right hand side of the income statement reflects
the receipts of all business firms in the economy. A conceptual difference between this income statement and the traditional income statement of an individual firm is that the
national income statement must balance. This balancing necessitates two additional items to be shown on the receipts
side of the balance sheet. These items are the net change
in inventories and business investment in productive assets.
There are also certain terminology changes to reflect disbursements to factors of production for the entire economy.
A national income account for I965 is presented in skeletal
form in Table 3.
^Ibid., p. 74.
107
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The fact that the national income statement balances reflects the tautology that receipts must equal disbursements,
or in symbol form: R = D.
This income statement and the equa-
tion both reflect the circular flow diagram of economic activity.
It is because of this balancing feature that the in-
ventory adjustment and capital investment accounts must appear on the receipts side of the income statement. An increase in inventories is considered a forced additional investment by stockholders. An increase in the capital assets
of the economy is likewise considered an additional investment.
The logic, however, of including the net inventory change
in the income statement goes deeper. As the national income
statement purports to show the income of the nation, then an
increase in inventories should be included.
This constitutes
a conceptual difference in the national income figures and
the value added figures in the illustration of value added
for an individual firm.
If this logic were applied to the
individual firm, an increase or decrease in the inventories
should be reflected in the value added statements.
Similar logic applies to the investment in productive
assets.
If such assets are purchased from other firms, then
their value has been included in the national income from
the other firm's output. However, if productive assets originate from within a firm, then these assets should be included in the value added figures of the firm.
109
Advantages of value added concept
As indicated earlier, the enterprise theory places emphasis on a flow or on the activity of the firm. From a social viewpoint, the operations of the firm should not be assessed in terms of the net income provided to only the ownners; rather, the assessment should be on the basis of the
contribution of the firm to society as a whole. It is in
this area that the traditional income statement is found
lacking.
The traditional income statement emphasizes re-
turns to stockholders; thus, it reflects income only from
the viewpoint of the investor. The value added income statement measures the flow of income and its division among all
factors of production.
The value added concept of income reflects the productive processes of the firm.
In doing so, the emphasis is
placed on production rather than on the point of sale as being the proper point to recognize revenue. This is entirely
logical if it is truly the productive process that adds utility to products. The traditional procedure of recognizing
revenue at the point of sale is defended on the basis of conservatism.
It is statistically possible to follow this con-
servative procedure and perhaps even wise to do so. It
should be recognized that to do so, however, has the effect
of imputing the value added to a product to a period in which
9
the sale occurs rather than to the process of production.
°Waino J. Suojanen, "Accounting Theory and the Large
Corporation," Accounting Review (July, 195^), p. 396.
110
Both methods, reporting income as units are produced
and as sales are made, result in the same income over time.
Actually, both the value added concept of income and the traditional income statement report the same amounts over time.
However, the value added concept views income as the return
to many factors, and views income more broadly than does the
traditional income statement.
The value added concept of in-
come gives recognition to the fact that there is a flow of
product in one direction and a flow of income in money terms
in the opposite direction.
This concept of income recognizes
that the rights of stockholders, as well as other participants, are subordinate to the firm itself. This concept recognizes management's responsibility of preserving the enterprise by mediating the claims of its various participants.
The enterprise concept imputes value added in the period of production, and the conservative accounting practice
imputes value added to the period of sale. The difference
is not an impossible hurdle to overcome. Accounting statements can handle the data either way, thus constituting an
alternative but acceptable choice of method.
There are many
alternative acceptable choices presently available, including methods of depreciation and methods of inventory valuation. All report the same income over time.
The rise of the value added concept of income could be
adopted with or without the change relating to inventory
^^Ibid., p. 398.
Ill
valuation.
This method would provide more data than is pre-
sently available in the income statement. These statements
could be readily consolidated by the Department of Commerce.
The consolidation would give comprehensive and up-to-date information about the economy.
This information would be more
accurate for government regulatory purposes.
Waino W. Suojanen indicates an urgency of adopting such
a concept from his statement:
If "managerial prerogatives" are not interpreted in
terms of social responsibilities, and the power of
the enterprise reflects itself in predatory behavior
realized upon assumptions derived from individual property rights rather than social property rights, then
the enterprise system can Ippk forward to even more
direct government controls.^^
Value Added Taxes
Method of taxation
The concept of a tax on the value added during processing originated over four decades ago. However, serious consideration of such a tax appears to have begun in 1949. At
that time a group of United States tax experts and a number
of Japanese economists and government officials recommended
12
a tax on value added for use in postwar Japan.
This proposal was never put into effect in Japan. The value added
tax (herein after called the VAT) is, however, the primary
^^Ibid., p. 398.
^^Clara K. Sullivan, The Tax on Value Added (New York:
Columbia University Press, I965), p. 126.
112
method of taxation in the European Economic Community. -^ Also, the state of Michigan adopted in 1953 the Michigan Busii4
ness Activities Tax which follows the value added concept.
The VAT is a compromise between a sales tax and a turnover tax.
The turnover tax existed in many of the common
market countries of Europe, and is a sales tax levied each
time a good or service is sold, or turned over, as it passes
5 This
through the manufacturing and marketing process.1*-^
turnover tax is also referred to as a cascade tax. The cascade tax was at one time the primary source of tsLX revenue in
the European countries.
The cascade tax has the fault of
building up, getting fatter on itself, as goods move from
16
raw materials suppliers to ultimate consumer.
The basic feature of the VAT, then, is to implement a
tax on a product but to allow a deduction for all factors
of production on which the tax has been previously paid. The
effect is to levy a tax on the amount of value that a firm
has added to its product. An example will illustrate this
feature. A wholesaler purchases a product from a manufacturer for $200 plus VAT of $20 (assuming a 10 percent rate
on net sales).
The article is then sold to a retailer for
^-^Ula K. Motekat, "The Value Added Tax," Massachusetts
CPA Review (April, 1972), p. 18.
^^Sullivan, p. 298.
^^Motekat, p. 18.
^Russell Boner, "Tax on 'Added Value' Concept in Europe
Produces Price Spiral, Second Thoughts," Wall Street Journal
(October l4, I969). p. 30.
113
$300 plus VAT of $30. The journal entries to record these
transactions are:
Inventory (or purchases)
Prepaid VAT
Cash (or accounts payable)
To record purchases of goods
Cash (or accounts receivable)
Sales
Liability for VAT .„
$200
20
$220
330
300
30
To record sale of goods '
The net liability of the wholesaler is the $10 difference
between the liability of $30 and the prepayment of $20. The
tax paid by each firm is levied on the difference between the
product's selling price and the cost of its purchases which
have been taxed in prior firms. The overall revenue effect
for the taxing entity, however, is the sum of the taxes collected from all the firms through which a product passes.
This sum equals the amount that a sales tax would produce
18
at the point of final sale.
Advantages
The VAT is computed by multiplying the difference between the sales price and the prior taxed inputs by the tax
rate.
For a deduction to be allowed on purchases of materi-
als, proper supporting evidence must be available. If a prior tax has not been paid, a deduction is not allowed. This
method is claimed as one of the advantages of the VAT system.
^"^Motekat, p. 20.
18.
Ibid.
114
Enforcement of the VAT is then very efficient. Firms must be
able to prove the payments of prior taxes to obtain a deduction.
Taxable transactions and allowable deductions are easily defined in the VAT tax. The German law uses only 13,000
words to define taxable and non-taxable transactions, to
show deductions as allowed or denied, and to give the collection procedures. The Internal Revenue Code and related materials of the United States contains approximately 2,440 pages
of the Code, 1,152 pages of Regulations, 20,4000 Revenue Rulings, 33,300 Tax Court and Board of Tax Appeals decisions,
and 30,600 Federal Court decisions.•'•^
It is also argued that the VAT provides greater rewards
for efficiency and larger fines for inefficiency.
The VAT
is a constant rate on the value added where the income tax
is a progressive tax on a residual. Under the VAT system,
20
an unprofitable firm continues to raise revenues.
Invest-
ment incentives such as the investment credit can continue
to operate under the VAT system. A credit can be given
against a tax liability, or a cash payment can be made outside a tax system.
The VAT system can also be substituted for excise taxes.
'^Finding the Answers to Federal Tax Questions (New
York: Commerce Clearing House, Inc., 1973), P- 5.
^^Motekat, p. 21.
^^Ibid.
115
The duplication of enforcement of separate taxes could thus
be eliminated.
Different VAT rates can be applied to differ-
ent products. Consumer expenditures can be stimulated or reduced by appropriate changes in the VAT rates.^^ This stimulation or reduction would give more flexibility in the regulation of the economy.
The VAT system can be used to encourage or discourage
imports and exports. If imports are discouraged, the credit
for any prepaid tax can be either limited or denied. This
limitation has the effect of increasing costs, and the sales
price must be increased.
The opposite is also true; an in-
crease in the VAT credit reduces costs and encourages imports.
This system also works to encourage exports. If a
credit is given for prepaid VAT to an exporter, or if he is
not taxed on the value added, the cost of the product is lowered. Thus, an exporter can compete more effectively in a
foreign market.23
-^ This effectiveness has been one of the
foremost arguments for the adoption of a VAT system in the
United States.
Disadvantages
One disadvantage of the VAT system is that businesses
must switch from a cash to an accrual basis of accounting.
This change is necessitated to obtain a matching of the prepaid VAT on purchases with the VAT liability that arises at
^^Ibid.
^^Ibid., p. 22.
116
24
the time of sale.
Another effect of the VAT is to accel-
erate tax payments. Most countries require VAT reports and
payments to be made monthly.
The present tax system of the
United States is based on a quarterly reporting system and
generally allows more time between the time revenues are received and the time that taxes are due.^ However, this appears more as a policy matter than an absolute advantage or
disadvantage.
The VAT system does complicate the state and local sales
tax system.
If both are levied, a question arises as to
which comes first. The sales tax has been one of the primary sources of state and local tax revenues. The adoption
of a value added tax would mean that both federal and state
and local taxes would be derived from the sale of products.
This tax base could foster political differences between the
state and federal governments.
Further, economists point out that a VAT, like all sales
taxes, is regressive in nature. Thus, persons with a low or
moderate income will pay more tax in relation to their income
than will persons with higher incomes.
There are several advantages and disadvantages to the
VAT system.
The strongest endorsements for such a system
appear to be its simplicity to administer and its flexibility to encourage exports. The primary disadvantage appears to
24
"^^Ibid.
^^Ibid.
117
be its regressive nature.
It should also be noted that, con-
ceptually, value added should be based on production. However, as a practical expediency, all value added taxes are
based on sales.
Summary
A close relationship exists between the circular flow
concept of economic activity and the enterprise concepts.
Both concepts emphasize the flows of productive factors into
the firm and finished goods from the firm.
Both concepts view
the firm as a place of activity and as such both concepts emphasize the productivity of the firm.
When emphasis is placed on the productivity of the firm,
the most relevant measure of this productivity is the value
added to products. Economic theory shows that a direct computation can be made by a summation of the payments made to
the four basic factors of production.
The factors include
land, labor, capital, and management. As the enterprise theory is a broad social concept of the firm, the value added
statements better reflect the productivity of the firm than
does the traditional income statement. The value added statement shows returns to the four basic factors of production,
and the income measures the return to stockholders only.
The value added approach to the measurement of productivity is also the basis of the computation of the national
income.
The use of such a concept by individual firms would
118
greatly facilitate the computation of the national income aggregates .
Many countries use value added during production as a
basis of taxation.
This type of tax has many advantages and
is discussed as a possibility for use in the United States.
CHAPTER VI
STATEMENTS OF OPERATIONS
The American Institute of Certified Public Accountants
recommends the preparation of three statements to show the
results of operations. These three statements are the balance sheet, the income statement, and the statement of the
changes in financial position.
The balance sheet, or posi-
tion statement, and the income statement, which is a statement of operations, have long been recommended.
In 1971 the
publication of statements of changes in financial position
was recommended.
The relationship between the income statement and the
statement of changes in financial position is examined in the
first part of this chapter.
operations.
in many ways.
Both statements are reports of
It is shown that these statements are similar
It is also shown that these statements are
but two of a variety of statements of operations that can be
developed, depending upon the viewpoint of operations that
is assumed.
The enterprise theory is a broad theory that recognizes
viewpoints of different participants of the firm, including
those of investors, regulatory agencies, and managers. The
latter part of this chapter presents operating reports based
119
120
on the viewpoints of these three groups.
Comparison of Funds and Income Statements
Background of statements
In the middle ages, the single venture was the dominant
form of business organization.
The major problems of account-
ing were concerned with the ability of the firm to pay its
debts.
Credit was granted on the basis of the financial con-
dition of the borrowers. Thus, emphasis was placed on the
debt paying ability of assets.
An important shift occurred in accounting thought in
the late 1920's and early 1930's. This shift placed emphasis on the providing of financial information for investors
and for stockholders rather than for creditors and for management.
The rapid growth of ownership of corporations fos-
tered this change.
Hendricksen states that this emphasis of reporting to
stockholders led to the following changes in accounting
thought:
(1) a deemphasis of the balance sheet as a statement of
values, by adhering more closely to the going-concern
concept as opposed to liquidation, and by looking at the
balance sheet as a link between two income statements
rather than the reverse; (2) the increased emphasis on
the income statement and a uniform concept of income;
(3) the need for full disclosure of relevant financial
information, by presenting more complete financial statements and increasing the use of footnotes; and (4) an
^Eldon S. Hendricksen, Accounting Theory (Homewood, 111.:
Richard D. Irwin, Inc., 1970), p. 58.
121
emphasis on the consistency in reporting, particularly
with respect to the income statement.2
Liquidation becajne the exception rather than the rule.
Creditors thus began to look to the earning power of the firm
rather than to its financial position as a basis for granting
credit.
Firms now use assets to produce income and as going-
concerns do not commonly use non-cash assets to settle liabilities.^ Emphasis continues to be placed on the income statement.
Today, the net income figure from the income statement
is often regarded as the most important single figure in the
financial statements.
The accrual basis of accounting is commonly used for reporting purposes. This basis makes use of accruals, which
represent the allocation to the current period of expected
future receipts and disbursements for services, and deferrals, which represent the allocation to current and future
periods of past services and disbursements for goods and services.4 These allocations of accruals and deferrals cause
differences to exist between the reported net income amount
and the net changes in the firm's cash balance.
During the 1950's, an emphasis on cash flow appeared.
This term was used with many different meanings. This usage
^Ibid., p. 59.
% . M. Nammer, "An Activity Concept of the Business Enterprise and Its Implications in Accounting" (Unpublished
Ph.D. dissertation, University of Illinois, 1957), p. 157.
4Hendricksen, p. 237.
122
led to the publication by the AICPA in 1961 of Accounting
Research Study No. 2 by Perry Mason dealing with cash flow
and funds statements. The AICPA recommended the discontinuance of the terminology "funds statement" in APB Opinion 19.
effective in September 1971. However, the "funds" will be
used in this study to be consistent with reference material.
Research Study No. 2 states:
The funds statement is not a supporting schedule to the
balance sheet, the income statement, and the statement
of retained earnings, although it is technically based
upon the same accounting data and "ties in" to these
financial statements. It is, instead, a complementary
statement, an important report in its own right, which
presents information which cannot be easily obtained
or cannot be obtained at all, from the other financial
statements. It contributes materially to the financial
aspects of the answers to such questions as . . .5
The income statement and the funds statement both reflect
changes caused by operations; yet, they show different information. These similarities and differences will be examined.
Algebraic comparison of statements
Research Study No. 2 indicates that the income statement
and the statement of changes in financial position are based
upon the same data; yet, they are designed to answer different questions.
Income statements are prepared from the point
of view of the stockholders or owners. This statement is designed to show the increase or decrease in claims that accrue
to the owners of the firm.
However, specifically excluded
^Perry Mason, Accounting Research Study No. 2 (New York:
AICPA, 1961), p. 49.
123
from this statement are the contributions and withdrawals
of the owners. Thus, the income statement cannot show all
changes in capital of a firm.
To show all changes in capi-
tal requires an additional statement, a statement of changes
in capital.
While there are several definitions of funds, the basic
intent of the statements of changes in financial position is
to show the sources and uses of those funds. The four accepted definitions of funds include funds as cash, funds as
net quick assets, funds as working capital, and funds as all
financial resources.
A more direct comparison can be made of the income statement and the statement of changes in financial position
through symbolic notation using algebraic operation. First,
the statement of changes in financial position can be derived
in the following manner:
The balance sheet may be represented as:
Assets = Liabilities + Capital
or
A = L -I- C
(Equation l)
If assets and liabilities are divided into current and
non-current portions, the balance sheet becomes:
CA + NCA = CL + NCL + C
(Equation 2)
By subtracting current liabilities from each side, the
^Ibid., pp. 51-5.
124
equation becomes:
(CA - CL) -f NCA = NCL -I- C
(Equation 3)
By substituting working capital (WC) for current assets
minus current liabilities, the equation becomes:
WC + NCA = NCL -I- C
(Equation 4)
By subtracting non-current assets from each side, the
equation becomes:
WC = NCL -f C - NCA
(Equation 5)
A comparison of working capital for consecutive years
yields:
19x1
WC =
NCL -I- C - NCA
19x2
V/C =
NCL -t- C - NCA
AWC = ANCL •*- AC - A NCA
(Equation 6)
Equation 6 shows that the change in working capital must
be equal to the change in non-current liabilities plus the
change in capital minus the change in non-current assets.
The changes in any of the categories may be either positive
or negative.
The minus sign before the change in non-current
assets indicates that an inverse mathematical relationship
exists between the change in working capital and the change
in non-current assets.
Examination of equation 6 reveals that any increase in
funds must come from an increase in non-current liabilities,
from an increase in capital, or from a decrease in non-current assets. All sources of funds, then, are related to one
of these three changes. The reverse is also true. All uses
125
or applications of funds must be from decreases in non-current liabilities, from decreases in capital, or from increases
in non-current assets. Equation 6 then represents the sources
and the uses of funds in symbolic notation.
Symbolication will be used to derive a combined income
statement and other changes in capital. Again, the balance
sheet is represented as:
A = L -f C
(Equation 1)
By subtracting liabilities from each side, the equation
becomes:
A - L = C
(Equation 7)
By comparison of consecutive years, the equation becomes:
19x1
A - L = C
19x2
A - L = C
AA - AL = AG
(Equation 8)
Equation 8 indicates that the change in capital can be
explained in terms of the changes in assets minus the changes
in liabilities.
The income statement as traditionally pre-
pared, however, excludes the contributions and withdrawals
of the owners. Thus, equation 8 reflects the combined statement of net income and the statement of other changes in capital. A point to be emphasized from both equation 6 and equation 8 is that the change in any balance sheet account or
group of balance sheet accounts can always be explained in
terms of the changes in the remaining balance sheet accounts.
126
The combined income statement and statement of changes
in capital, represented by equation 8, and the funds statement, represented by equation 6, show the changes in consecutive balance sheets. Both statements reflect changes or
flows of the firm's assets and claims to assets.
The commonly used definitions of funds include funds as
cash, net quick assets, working capital, and all financial
resources.
Funds could be defined as all assets minus all
liabilities.
If this definition is used, then, equation 8
would reflect the sources and uses of those funds. The equation states that the changes in the net of assets and liabilities can be explained in terms of the changes in capital.
If viewed as a funds statement, increases in capital represent sources of funds and decreases in capital represent uses
of funds. If viewed as an income statement, increases in assets over liabilities represent income and decreases of assets over liabilities represent losses. Equation 8 then represents both a funds statement and a combined statement of
income with other changes of capital. This indicates that
an income statement and a funds statement are reflecting the
same information.
This point will be further developed
through the analysis of comparative statement.
Direct comparison of statements
A comparison of operating statements will be made for
the Hypothetical Firm for a period of four consecutive years.
Comparisons are presented in Tables 4, 5, 6, and 7 of balance
127
sheets, income statements, changes in capital, and funds
statements using a definition of all assets minus all liabilities.
The following assumptions are made for the vari-
ous years:
12x1
1.
Capital stock is sold for $20,000.
2. A building is purchased for $10,000.
3.
No other operations are conducted.
19x2
1.
Net income for the year is $2,100 as reflected by
the income statement.
2.
This income statement is the same as used to illustrate the value added statement in Chapter V.
3. An increase occurs in the balances of accounts receivable, inventories, and account payable.
1. A net loss of $800 occurs as reflected by the income statement.
2.
$5,000 was borrowed on a long term note, and the
proceeds were used to secure a permanent investment of XYZ Corporation stock.
19x4
1.
No business operations are conducted.
2.
The permanent investment is sold at a $1,000 gain.
3.
The building is sold for its book value.
4.
The firm is completely liquidated.
128
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132
Examination of the funds statements and the changes in
capital statements shows their similarities. First, the increases of changes of capital and the total sources from the
funds statement are identical for each year and for the four
years in aggregate. Secondly, the same observation holds for
the total of withdrawals in the changes in the capital statements and for the total of uses in the funds statement. These
totals are in agreement for each year and for the four years
in aggregate. When funds are defined as all assets minus
all liabilities, the funds statement shows all changes in
the capital accounts.
The funds statement and the combined statement of income
and changes in capital reflect the same information for the
Hypothetical Firm.
The funds statement has netted into one
figure, the effect of many transactions. The funds statement
may be rearranged to show both the receipts of funds and the
disbursement of funds from operations. This rearrangement is:
HYPOTHETICAL FIRM
Funds Statement
(Funds Equal All Assets Minus All Liabilities)
Year Ended 19x2
Sources
Sales
Uses
Merchandise sold
Salaries
Depreciations
Utilities
Supplies
Repairs
Advertising
Property taxes
Interest
Income taxes
Increase in funds
$20,000
1
$12,000
2,000
1,000
200
300
500
6oo
200
400
700
17.900
$ 2.100
133
This arrangement of the funds statement is identical
to the single step income statement in this period in which
there are no other transactions affecting capital. A single
step income statement and a multiple step income statement
are identical except for the format or arrangement of the
data.
The direct comparison of the income statements with the
funds statements for the Hypothetical Firm leads to the sajne
conclusion as reached by the algebraic comparison. The funds
statement, when funds are defined as all assets minus all liabilities, and the combined statements of income and changes
in capital present the same data. Net income, then, can be
defined in terms of funds. Using this approach, net income
is the flow of all assets minus all liabilities which increases the claims of stockholders. This conclusion is reinforced by observing that the funds statement becomes a single step income statement when all of the asset flows are
shown rather than being netted into one figure, net income,
as shown on the funds statement.
Funds, however, may be defined in many ways.
If one
definition of funds is equivalent to net income, what are
the meanings and implications of other definitions of funds?
Analysis of Funds Statements
Funds as cash
Cash is the most narrow or restrictive definition of
13^
funds.
It is defined to mean literal cash, either undepos-
ited or as demand deposits in banks.
Cash provides the me-
dium of exchange for most business transactions. Its importance is widely accepted.
Hendricksen states:
In the final analysis, cash flows into and out of a
business enterprise are the most fundamental events
upon which accounting measurements are based and upon
which investors and creditors base their decisions.
Cash attains its significance because it represents
generalized purchasing power which can be transferred
readily in an exchange economy to any individual or
organization for their own needs in acquiring goods
and services desired by them and available in the
economy.8
Cash is the accepted medium of exchange. Receipts and
disbursements of a firm are normally made in cash payments.
Staubus* theory of residual equity, which was examined in
Chapter III, recognizes this importance of cash. Staubus
develops equations dealing with cash flows to show an investor's right to cash in liquidation, showing the payment available to long term lenders, and other equations dealing with
cash receipts and disbursements. It was shown in Chapter III
that Staubus* theory of residual equity is not one of division of profits. Conversely, Staubus* theory deals with the
flows of cash and priority rankings of claimants to the assets of a firm.
The importance of cash receipts and disbursements is
sharply focused in the analysis technique often referred to
7
'Mason, p. 51•
8,
Hendricksen, p. 238.
135
as discounted cash flows. This technique has several variations , but its essence is always to find a current value of
future inflows and outflows of cash. This technique is not
a net income concept; in fact, allocations of expenses such
as depreciation to various periods are strictly forbidden.
The analysis measures the flow of cash and discounts its value to the present.
The change in the cash account can be explained in
terms of the changes in all of the other balance sheet accounts.
This equation is»
A Cash = AL + AC - ANon-cash-accounts
(Equation 9)
It was shown earlier that net income is a flow of all
assets minus all liabilities that increase the claims of
stockholders.
Cash flow is a flow of funds also. An in-
crease in cash, then, constitutes a flow of one asset which
is subject to the claims of all creditors and stockholders.
However, there is a legal order in the payment of claims of
a firm.
Thus, to a party holding an immediate claim against
the firm, an increase in cash constitutes an increase in
funds with which to satisfy the claim. An increase in cash,
then, is income to a holder of an immediate claim.
The funds statement, with funds defined as cash, is
presented for the Hypothetical Firm in Table 8. The funds
statement reflects the point made by Staubus that the firm
has receipts and disbursements of cash. Any party conducting business with the firm would evaluate his probability
136
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137
of receiving payment by observing the firm's flow of cash and
considering his ranking in the priority of payments. For example, a stockholder, a residual claimant, would not expect
the declaration and payment of a dividend if the firm's cash
position was deteriorating.
Funds as net auick assets
Another definition of funds is that of net quick assets.
This definition includes cash on hand, cash in the bank,
short term receivables, temporary holdings of marketable securities , minus short term payables as funds. This concept
Q
of funds is not widely used, however.^
This concept of funds
is slightly broader than the cash concept and recognizes certain items as being virtually equal to cash.
Items excluded
from quick assets are inventories and short term prepayments,
such as prepaid insurance. A comparative funds statement using a definition of net quick assets for the Hypothetical
Firm is presented in Table 9»
The change of funds, when funds are defined as net quick
assets, can be stated in algebraic form.
This equation is:
AQA = ANon-quick liabilities -f AC - ANon-quick assets
(Equation 10)
This formula recognizes sources of funds as increases
in non-quick liabilities, as increases in all capital accounts, and as decreases in all non-quick asset accounts.
^Mason, p. 53•
..•g^.-TEMB-^.
138
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139
Uses of funds include decreases in non-quick liabilities, decreases in capital, and increases in non-quick assets.
Funds as net working capital
The working capital definition of funds is the most
widely used of all definitions of funds. This definition
views current assets minus current liabilities as funds. Hendricksen states that several advantages of defining funds as
current assets minus current liabilities have been suggested.
These advantages include:(1) this concept of funds is readily articulated with the income statement and balance sheet;
(2) it follows traditional definitions used in financial reporting and is therefore more understandable; (3) it tends
to concentrate more on infrequent transactions rather than
transactions resulting from regular operations; and (4) it
has been proposed as a means of presenting the general liquidity of the firm.-*-^
Hendricksen states several disadvantages of using the
net working capital concept of funds. Many significant interfirm transactions are not disclosed. For example, an increase in inventories financed by short term borrowing is
not disclosed.
The acquisition of plant and equipment ac-
quired by issuance of stock is not included.
Thus, (1) the
funds statement does not disclose structural changes in the
financial relationships of the firm and (2) it does not
Hendricksen, p
140
disclose major changes in policy regarding investments in
current assets and short term financing.
The working capital concept reflects the going concern
concept. Current assets show those resources available to
discharge current liabilities. Current liabilities show
those obligations due within the coming year. A firm must
meet its current obligations to remain in business. Holders of current liabilities possess a priority claim against
the firm.
The offsetting of current assets and current li-
abilities implies that current liabilities must be paid first
with the remainder of current assets available for other uses.
The funds statement shows, then, the sources and uses of
funds not required for routine operations.
Comparative funds statements using a working capital definition for the Hypothetical Firm are presented for illustration in Table 10. These statements reflect the major receipts and uses of the non-current funds such as the issuance of capital stock, the borrowing of long term debts, and
the liquidation of the firm's common stock.
It should also
be observed that the effects of operations for each period
are netted into two figures, net income and depreciation. The
emphasis of the statement is on the availability of funds for
uses other than current operations. Thus, an increase in
working capital constitutes a type of income for all noncurrent claimants of the firm.
^^Ibid.
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Comparisons of funds statements
Four definitions of funds have been presented. A comparative funds statement reflecting these four definitions
for the year 19x2 for the Hypothetical Firm is presented in
Table 11. These definitions include funds as all assets minus all liabilities, as working capital, as net quick assets,
and as cash.
The broadest of the definitions is funds as all
assets minus all liabilities. When a funds statement is prepared using this broad definition, the measurement and valuation of aJ.1 asset accounts and of all liability accounts affect the amount of net income for the period and, hence, the
increase of funds for the period.
From the broad definition of all assets minus all liabilities, each definition of funds becomes successively more
restrictive.
The working capital definition of funds is cur-
rent assets minus current liabilities. The computations of
the change in net working capital require the measurement of
only current items. Thus, any measurement errors made in
computing the balance of non-current assets and non-current
liabilities have no effect upon the accuracy of the funds
statement when using a working capital concept. Therefore,
the inaccuracy of measurement of such items as depreciation,
depletion, amortization of leasehold, amortization of intangible assets, income tax allocations, and pension expenses
12
has no effect upon the accuracy of this funds statement.
•'•^George J. Staubus, "Alternative Asset Flow Concepts,"
Accounting Review (July, I966), p. 404.
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144
A comparison of the funds statement using the working
capital definition and the all assets minus all liabilities
definition for the Hypothetical Firm reveals the only difference to be the inclusion of depreciation as a source in the
working capital definition. Depreciation constitutes a deduction on the income statement and reduces net income. Thus,
the addition of depreciation to the net income amount eliminates the effects of depreciation from the working capital
funds statement.
The items that must be measured accurately
for the working capital funds statement to be accurate are
all of the current accounts, both assets and liabilities.
The next most restrictive definition of funds is the net
quick asset definition. Net quick assets include cash, short
term receivables, temporary holdings of marketable securities, minus current payables. Thus, the measurement problems
of all other balance sheet accounts have no effect upon the
accuracy of the net quick asset funds statement. The accuracy of the measurement of inventories, prepayments, and deferred items does not affect the net quick flow.
Comparison of the net quick funds statement with the
working capital funds statement shows sources to be identical in both statements. However, the net quick assets statements show the increase in inventory as a use of funds. This
increase constitutes an additional investment from a net
quick asset point of view. However, the accuracy of measurement does not affect net quick asset flows. Regardless of
1^5
the accuracy of the measurement of inventories, the same
amounts are used in the computation of cost of merchandise
sold on the income statement and for the changes in nonquick assets in the funds statement. Staubus emphasizes
this point by the following statement*
To the extent that we are dissatisfied with the inventory measurement in accounting we may lean toward the
quick-flow concept rather than working flow.13
The most restrictive of all definitions of funds is
the cash flow definition. As indicated previously, cash is
taken literally and includes only deposited and undeposited
cash.
Thus, the changes in cash can be accounted for in
terms of the changes in all of the other balance sheet accounts, which include the changes in accounts receivable and
accounts payable. The accuracies in the measurement of receivables and related allowances have no effect on the accuracy of cash flows. Comparison of the cash flow statement
and the net quick asset funds statement confirms this point.
Increases in a long term liability constitute a source. Also, increases in accounts receivable constitute a use of
cash, just as the increases in any other asset constitute a
use of cash.
Each of the successive definitions of funds has been
more restrictive in terms of assets. At one extreme is a
definition of funds as all assets minus all liabilities. The
change in these funds measures the profitability of the firm.
^^Ibid., p. 403.
146
This flow of funds measures the increase in claims that accrue to stockholders. At the other extreme is the definition of funds as cash only.
This flow measures the change
in cash and constitutes income to the current claim holders.
The flow of cash and near-cash assets constitutes a flow of
funds and is generally referred to as liquidity. Between
these flows is the working capital definition of funds which
is current assets minus current liabilities. This flow measures the increase in net current items and constitutes income to all non-current claim holders. The conclusion from
this analysis is that net income is a flow of funds which
enhances the claim of relevant claim holders.
Flow Statements and the Enterprise Theory
Statements for the four definitions of funds for the
Hypothetical Firm have been presented for the four year life
of the firm.
In each case it was shown that the total of
funds received over the life of the firm is always equal to
the uses of funds over the life of the firm regardless of
the definition of funds that is used.
The enterprise theory
emphasizes that assets must equal the equities or claims of
all holders plus retained earnings.
Comparative statements using the four different definitions of funds for a single year, 19x2, is presented for comparison in Table 11. With the definition of all assets minus all liabilities as funds, the change in funds is the net
147
income of the period.
process was used.
Thus, the full accrual and deferral
However, with each successive definition
of funds that was discussed, a partial elimination of the accrual and deferral process was effected. Finally, with the
cash definition of funds, all accrusLls and deferrals were
eliminated with only the flows of cash remaining.
Several advantages and disadvantages of these flow concepts were summarized by Staubus:
1.
If we substitute working flow for earnings we may
gain by omitting our crude measurements of depreciation, depletion, amortization, and provisions
for deferred liabilities; but we must recognize the
disadvantage of completely ignoring capital consumption costs and the portions of pensions, income
taxes, etc. that are not paid currently.
2.
If we substitute quick flow for working flow, we
may gain by eliminating dependence upon the valuation of inventories, prepayments, and deferred credits to revenue, but we expose the resulting net
flow figure to the problems of mismatching of cost
with revenues by failure to defer them when appropriate.
3.
If we substitute cash flow for quick flow we may
gain by avoiding the problem of the valuation of
receivables, but we lose the contribution to matching resulting from the use of the accrual method
of recognizing revenues and costs.
4.
To reverse the substitution, if we switch from cash
flow to quick flow we gain better matching of costs
and revenues through the use of the accrual technique, but must accept the problem of valuation of receivables.
5.
If we substitute the more refined concept of working
flow for quick flow, we gain the better matching by
short term deferrals of merchandise costs, prepayments of services, and revenue received in advance,
but take on the measurement difficulties relating
to these deferrals, especially inventory valuation.
6.
If we switch to earnings from working flow, we improve the relevance of the flow concept to investor's
[ l!~ 11 > M T '
148
interests by providing for long-lived assets and for
long-term delays in the payments of some costs, hut
we must face up to the related measurement problems,
especially depreciation.1^
Accounting data is often evaluated from different points
of view.
Staubus recognizes three points of view including
the view of owners, of managers, and of the entity.^^ Robert
Sprouse indicates that accounting data for a corporation can
be analyzed from four points of view including (1) as an association of common shareholders, (2) as a separate and distinct entity operating for the benefit of all long term equity holders, (3) as a social institution, and (4) merely indicating a prescribed set of legal restrictions.
William J.
Vatter recognizes three broad areas in which accounting reports have different significance. The areas include demands by management, needs and desires of social control
agencies, and information for credit extension and invest17
ment.
The remainder of this chapter relates the several
asset flow concepts to the needs of three groups: investors,
regulatory agencies, and management.
^^Ibid., p. 4o6.
-^George J. Staubus, "Payments For the Use of Capital
and the Matching Process," Accounting Review (January, 1952),
p. 104.
Robert T. Sprouse, "The Significance of the Corporation in Accounting Analyses," Accounting Review (July, 1957).
p. 370.
^'''william J. Vatter, The Fund Theory of Accounting and
Its Implications for Financial Reports (Chicago: University
of Chicago Press, 1947), p. 9-
149
Asset flows for investors
An investor in common stocks of a firm is a holder of
residual equity.
He possesses the residual claim in the as-
sets remaining after deducting all prior claims, including
those of preferred stockholders and holders of debt. Common
stockholders, then, are interested in the retained earnings
of the firm, as retained earnings purport to show the residual that will pass to the common stockholders. An investor
is interested in the retained earnings of the firm and the
recent changes to those retained earnings.
From this residual equity view, the changes in all assets and all liabilities are important. As shown in the preceding paragraphs, the change of all assets minus all liabilities is the net income of the firm. The change in the valuation of a building is just as significant as a change in
the valuation of inventories or receivables. All of these
changes would affect net income. In regard, Staubus says:
Thus, the monotary-nonmonetary dichotomy and the currentnoncurrent distinctions need not be emphasized. Even
the difference between assets and liabilities may be
played down once we recognize the difference in mathematical sign applicable to them when they merge into a
net asset concept.1°
However, a stockholder is also interested in the cash
flow of a firm if he expects a cash transfer from the firm
at any point in the future. Future cash balances can be projected by combining present cash balances, future receipts,
18Staubus, "Alternative Asset Flow Concepts," p. 406.
150
and future disbursements.
Past recurring cash flows provide
a reference point for the prediction of future flows. Thus,
cash flow information is also significant to the investor.
Liquidity is important in order for the firm to pay dividends in the near future.
Investors in common stock are in-
terested in the short term liquidity of a firm as well as the
long run profitability.
In the long run all costs, includ-
ing depreciation, must be covered; therefore, profitability
is vital.. Thus, the relationship of liquidity and profitability of a firm is significant to an investor. There is
a close relationship between liquidity and profitability in
the long run but not in the short run. This point is made
by Moonitz.
That is to say, over the long pull, a profitable concern will also be solvent, although the reverse proposition, namely that a solvent concern will also be
profitable is manifestly not true. Over a short period of time, however, profitability and solvency are
almost independent of each other.19
Because of the close relationship between solvency and
profitability in the long run, Staubus states:
The common stockholder is almost certain to be more interested in predicting profitability than liquidity,
and an accurate earnings statement is likely to be far
more important to him than a cash flow statement or even
a working flow or quick flow statement.^
Profitability and solvency are related in the long run.
It follows that net income implies the availability of cash
^Maurice Moonitz, "Reporting on the Flows of Funds,"
Accounting Review (July, 1956), p. 378.
Of)
"^staubus, "Alternative Asset Flow Concepts," p. 407.
—
^
"
^
-••'"•
-
••
151
with which to pay dividends in the long run. The ability to
pay a dividend does not necessarily imply that a dividend
will be paid.
It was shown in Chapter IV that the objec-
tives of the firm often include survival, growth, and liquidity.
The objectives of management may be different from
the objectives of stockholders.
When net income and the retained earnings of a firm are
used to predict future values of stock, the analyst is making certain assumptions. Net income is equal to the change
in all assets minus the change in all liabilities. Thus, if
an analyst makes a prediction of future net income based on
past net income, he is assuming that inflows of assets to
the firm and the outflows of assets to all claimants prior
to stockholders will be recurring.
This is the same point
emphasized by the enterprise theory. The enterprise theory
indicates that all claimants of the firm possess a claim
against the firm*s assets. The residual equity theory indicates that the claimants of a firm possess a claim in a
given order, and in that order the common stockholders'
claims fall last.
Retained earnings of a firm are normally shown on the
firm's balance sheet as part of the stockholders' equity.
From the enterprise point of view this is improper.
It has
been shown that all claimants possess a claim to the assets
of the firm.
It has also been shown that stockholders pos-
sess only one legally enforceable claim which is to dividends
152
after they have been declared.
Retained earnings are the
excess of asset inflows over all fixed claims, or liabilities, of the firm.
The only ways in which stockholders can
receive assets equal to retained earnings are to declare dividends of such amounts or to liquidate the firm at exactly
the book values shown on the balance sheet.
Of the two ways in which stockholders of the firm could
receive assets equal to retained earning, both appear illogical.. First, receiving these amounts through liquidation is
illogical by definition.
The income statement, which shows
all asset flows of the period, is based on the going concern
assumption.
Secondly, the anticipation of dividends equal
to retained earnings involves a problem of liquidity.
It is
more logical to analyze cash flow statements for potential
dividends than to consider merely that retained earnings will
pass to stockholders.
It has been shown that net income is equal to the change
in all assets minus the change in all liabilities, and that
retained earnings represent the excess of asset inflows to
the firm over fixed claims to those assets. The fact that
earnings have accumulated in a firm implies nothing about
how the related assets will be used.
The logical conclusion
is that retained earnings represent unspecified claims that
are against the firm; as such they should not be shown as
part of stockholders' equity.
The conclusion, then, is that investors and potential
153
investors are interested in the profitability and the liquidity of the firm.
Of the two items, profitability ap-
pears to be more significant, as profitability implies liquidity in the long run. However, a third element that an
investor should evaluate is managements' intent to pay dividends to the stockholders.
Asset flows for long term debt holders
Present and potential bond or other long term indebtedness holders are interested in both liquidity and profitability.
However, the analysis of debt securities takes a
slightly different emphasis on liquidity and profitability
than does the analysis of common stocks. Two points appear
pertinent. First, since the securities are being held for
long term, the holders are concerned with profitability.
Secondly, since the securities are fixed claims, the holders are not directly interested in the firm's profitability
beyond that required to satisfy their claim.
Profitability is important to long term debt holders,
but not to the extent that it is important to a stockholder. Long term debt holders make a trade-off away from profitability toward increased liquidity.
Debt holders are con-
cerned with liquidity because their return, interest, and
often the maturity of their obligations occur annually. Thus,
long term debt holders are concerned with the firm's ability
to meet its fixed obligations under the most adverse conditions that are forseeable.
n I —
- • •"
15^
Long term debt holders are interested in the firm's income statement which indicates the general liquidity in the
long run and are interested in the firm's working capital
statements, which indicate the recurring flows to non-current claimants. One other approach which long term debt
holders might take is to calculate the net recurring flows
before interest, preferred dividends, and income taxes to
21
which these debt holders would have a claim.
The state-
ments of the Hypothetical Firm will be used to illustrate
this point for the year 19x2. The approach is to begin with
the working capital statements and increase net income to
show the recurring flows available for interest payments
to long term debt holders.
HYPOTHETICAL FIRM
Funds Available For Interest Payments
19x2
Sources
Net Income
Depreciation
Interest
Income Taxes
Uses
Increase
$2,100
1,000
400
700
$4,200
-0$4,200
This statement indicates that the increase in the Hypothetical Firm's ability to meet its interest payments totaled
$4,200 in the year 19x2. A long term debt holder would be interested in the trend of these funds over a period of years,
^^Ibid., pp. 407-8.
155
just as a stockholder is interested in the trend of net income over a period of years.
Asset flows for short term creditors
Short term creditors, employees, suppliers of materials
and of services, and others expect cash payments from a firm
in the very near future. Each of these providers of goods
and services must predict the firm's ability to make a cash
payment at a specific time in the very near future. Thus,
quick flows and cash flows are more relevant than net in22
come.
These short term creditors are more concerned with
the firm's flow of cash than of the firm's flow of fixed assets.
Employees and short term suppliers are more directly
concerned with the liquidity of the firm than with the profitability of the firm in the short run. However, employees
and suppliers of goods and services do have a secondary interest in the long run profitability of the firm. Because
employees normally expect increases in salaries, employees
do have an interest in the increase in all asset flows. Management and employees may also have a direct interest in
these long-term increases in all assets because they can
participate through exercise of stock options and through
bonus arrangements.
The enterprise theory holds that all participants of
the firm share in the net income of the firm.
^^Ibid., p. 409.
Included are
156
employees, managers, suppliers, short term creditors, long
term creditors, and stockholders. The foregoing analysis
has shown that stockholders, long term creditors, and managers have a direct interest in the net income of the firm.
Generally, these participants have a secondary interest in
liquidity.
The foregoing analysis has also shown that em-
ployees, suppliers, and short term creditors have a primary
interest in liquidity of the firm and a secondary interest
in the profitability of the firm.
This secondary interest in the long-run asset flows of
the firm by employees, suppliers, and short term creditors
is reinforced if the going concern assumption is made. This
assumption states that the firm is expected to remain in
business which indicates that the firm will continue to need
employees, suppliers, and other participants.
It is con-
cluded that all participants of the firm have an interest in
the liquidity and the profitability of the firm. At one extreme is a group with primary interest in profitability and
a secondary interest in liquidity. At the other extreme are
participants with a primary interest in liquidity and a secondary interest in profitability. All participants of the
firm have some interest in both profitability and liquidity
under the going concern assumption of accounting.
Asset flows for regulatory agencies
Four asset flows of cash, net quick assets, net working
capital, and all assets minus all liabilities have been
157
examined in the preceding analysis. However, there are other asset flows that are relevant to different parties. The
concept of value added was examined in a prior chapter. In
this examination it was shown that the value added concept
reflects the productive processes of the firm.
The value
added concept assesses the contribution that a firm has made
to society.
Value added was defined as the sum of payments made by
the firm for the factors of production that are not products
of other firms. The term non-products is used to denote the
costs which include such items as wages, salaries, interest,
and profits.
It is noted that profit, or net income, is one
of the elements of value added, while the other elements of
value added, wages, salaries, and interest, appear as expenses on the income statement. Essentially, the value added
statement views part of the items of the income statement as
components of value added and part of the items as expenses.
There are two approaches to the computation of value added.
One approach is to deduct the cost of all products from
sales, leaving the value added.
The second approach is a
direct summation of the items which constitute value added.
The statements in Table 12 emphasize the relationship of value added to net income.
The statement of relationship of net income and value
added shows that the value added statement is a special arrangement of the income statement.
Since net income is a
158
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flow of all assets minus all liabilities, the value added
statement is also a flow. The value added statement is part
of the flow between consecutive balance sheets of a firm.
The advantages of the use of the value added statements
were developed in a previous chapter.
It was shown that the
Department of Commerce develops estimates of national income
using an added value approach.
The issuing of value added
statements by individual firms would facilitate the compiling of the national income data.
The use of the value added method of reporting also provides for the possibility of a value added tax, or VAT. The
advantages of the VAT include efficiency of collection and
incentives for firms to operate efficiently.
It was shown
that appropriate changes in the VAT rate gives flexibility
in the regulation of the economy.
The enterprise theory holds that all of the factors of
production are partners in the productive process. The value added concept of income views the various factors of production as the income recipients of the firm. From this
point of view, an assessment of a firm's contribution to
society as a whole can be made for value added statement.
Asset flows for management
It has been shown that participants external to the
firm are interested in the firm's profitability and its liquidity.
Investors in common stock have a primary interest
in profitability and a secondary interest in liquidity.
160
Employees, suppliers, and short term creditors have a primary interest in liquidity with a secondary interest in profitability.
Each of these parties logically uses an asset
flow concept to reflect its objectives.
The firm, however, must be concerned with its relationships with all groups of participants. Part of a statement
by George 0. May is repeated for emphasis:
The primary concern of management groups is to maintain
the flow of production. In order to do so, the groups
have to consider constantly their relations with customers, suppliers, labor, government, and creditors, as
well as stockholders.^3
External groups are making analyses ranging from liquidity to profitability, depending upon their particular interest. Logically, then, management must be concerned with all
of these analyses made by external groups in order to deal
effectively with each of these groups. Management should
have available a full range of asset flow statements for internal use. Both internal and external parties need similar
information to conduct negotiations.
However, the range of statements from profitability to
liquidity has another implication, particularly in regard to
internal decisions as to the use of corporate funds. The various uses of funds compete with each other. Examples include
capital expenditures, payments of dividends, and retirement
of debt. Each proposed use of funds will have its particular
^-^George 0. May, "Stock Dividends and Concepts of Income," The Journal of Accountancy (October, 1953), P« ^31•
I6l
effect upon both profitability and liquidity.^^
A successful investment in a capital expenditure will
generally increase profitability in the long run but will
reduce liquidity in the short run. An alternative investment of the same amount could have different effects on
both liquidity and profitability.
Similar investments could
have the same profitability in the long run but have different effects upon liquidity in the short run.
Cash dividends can be expected to reduce both the profitability of the firm and its liquidity. Retirement of debt
or stock constitutes another possible use of funds. Each
such decision should be based upon the projected results on
the firm's profitability and its liquidity.
Profitability
in the long run is the desired end of the firm, but this
must always be balanced against the required liquidity in
the shorter run.
Summary
The enterprise theory views the firm as a productive
economic unit operated for the benefit of many different
participants in the firm, including employees, suppliers,
creditors, management, and stockholders. Each of these participants has a particular need for financial information
from the firm.
Thus, a report addressed to the needs of
24
Staubus, "Alternative Asset Flow Concepts," p. 409.
162
employees is as significant as a report addressed to the
needs of a stockholder.
The going concern assumption ac-
cents the relationships that exist between the continuing
participants of the firm. All participants have an interest in the long run profitability of the firm.
Analysis of the various asset flow concepts reveals
that net income as traditionally defined is a flow concept
of assets with claims to those assets accruing to stockholders. When this broad concept of asset flows is used,
the concept carries the connotation of profitability. Other asset flows enhance the claims of other parties and can
be considered as income to those parties. A flow concept
of only cash or near-cash items carries the connotation of
liquidity and measures the increase in assets from which
current claimants will be paid.
CHAPTER V I I
SUr/IMARY AND CONCLUSIONS
Summary
Evidence indicates that an assumption of an acceptable
level of profits is a more realistic assumption than is the
maximization of profits of a business firm.
This evidence,
as indicated in Chapter IV, includes: the attachment of conservative objectives by professional managers, the concern
of management to maintain the flow of production, and the
desire for friendly relations with customers, suppliers, employees, government, creditors, as well as stockholders. The
acceptable level of profit concept provides a compromise for
the conflict of self-interests of the many different groups
of participants of a firm.
If a firm is not operating for the maximization of the
profits for the owners, it must be operating for the benefit
of all groups.
Thus, the rejection of the maximization of
profits concept implies that a firm operates for the benefit
of many groups.
If a firm operates for the benefit of many
groups, then a broader, more comprehensive viewpoint of the
firm must be accepted.
This broader, more comprehensive
viewpoint is better represented by the enterprise theory of
163
164
the firm than by either the proprietary or entity theories.
It was shown in Chapter III that the distinction between
expenses and distributions of profits for a firm is arbitrary.
This distinction is dependent upon the viewpoint of each of
the participants of the firm.
To stockholders all payments
to all other participants are expenses. Management may view
dividends to stockholders as an expense, particularly in minimizing the cost of capital of a firm. Employees view payments to other parties as an expense when these payments prohibit the employees from receiving a pay increase. It was
shown in Chapter IV that a corporation is a conglomeration
of personalities, resources, conditions, and relationships.
It was stressed that wages, interest, dividends, and other
disbursements are two-fold in nature. They are costs of
production, and, at the same time, they constitute a distributive share of the general proceeds of production.
As reflected in Chapter III, Staubus developed a concept of accounting based upon residual equity which emphasizes the flows of cash.
This concept of residual equity
recognizes all participants of the firm as possessing claims
in a legal priority. Again, in this concept the distinctions
between expenses and distributions of income become blurred.
All disbursements represent a distributive share of the general proceeds of operations.
An analysis of various asset flow concepts was made in
Chapter VI. It was shown that the change in all assets and
165
all liabilities of a firm reflects the flow which is generally recognized as net income. However, this usage of net income implies certain assumptions. First, even though a change
or flow of assets has occurred, this increase in claims, or
profits, accrues to the stockholders only if the stockholders are the residual equity holders. Secondly, an increase,
or profit, does not necessarily provide liquid assets with
which the firm can make payments to stockholders.
Relationship of asset flows and profitability
If the flow of assets includes only one asset, cash,
minus the change of all other assets and if the claimants
are defined as all of the firm's claimholders, a different
concept of profit emerges. In such a case, cash flows become significant.
In both concepts of profit, the asset
flows have been defined and the claimants have been defined.
Each method of defining profit is equally logical. Since
payment in cash is the usual method of operation, the flows
of cash are relevant. Use of this definitive approach allows many definitions of profits; in each case the asset
flows must be defined and the recipients of these flows must
be defined.
Thus, profit may be defined as any flow of, or
change in, a firm's assets that increase or enhance the claim
of a participant or group of participants of the firm.
Profitability, then, is an ambiguous term.
It has mean-
ing only when the viewpoints of a specific group are assumed.
Asset flows as reflected by the various definitions provide
166
statements that reflect the increase and, hence, the income
that accrue to claim holders. For example, the funds statement, using a working capital definition, reflects the flows
of current assets which cause a change in the claims of all
non-current claimholders. An increase in working capital enhances the value of the claims of both long-term debt holders and stockholders and constitutes net income to this group
of claimants.
The defining of income in terms of asset flows and the
acceptable level of profits concept imply that a business
organization is a productive economic unit which is operated
for the benefit of many participants. As shown in Chapter IV,
the productivity of a firm's assets has come to be considered
the firm's main attribute. The enterprise theory emphasizes
this activity viewpoint of the firm.
The enterprise theory
views the firm as an association of activities and as such
is a method of conducting business for all participants of
the firm.
If the productivity of a firm's assets is a primary attribute of the firm, then non-liquidation or continuity of
the firm must be assumed.
The assumption of a going-concern
is often used in accounting.
The use of this assumption jus-
tifies the presentation of assets on financial statements at
cost rather than at a liquidation value. Yet, the assumption of continuity of a firm, or of a going-concern, has a
deeper implication.
If the firm continues to conduct business
167
along the lines of past operation, then it will continue to
need the same participants as in the past. Thus, employees,
suppliers, management, creditors, stockholders, and others
all have an interest in the firm.
The enterprise theory is directly applicable to the
large modern corporation that must consider the effect of
its actions on various groups and even upon society as a
whole.
Such a corporation must have an omni, or many, di-
rected viewpoint.
In such a setting, ownership does not
carry the special significance as it does in the proprietary
and entity theories. Rather, the uniqueness of the enterprise concept is the assumed corporate objective of growth
and development in the interest of society.
The analysis of the enterprise theory, in Chapter IV,
indicates a similarity between long-term debt and corporate
stock.
The analysis also shows that any distinction between
long-term debt and short-term debt is arbitrary. Further,
a likeness among payments to employees for labor, payments
to suppliers for products, and payments to debt holders was
identified.
All of these payments are made to acquire the
factors of production for the firm to operate. All of these
payments constitute flows of assets from the firm. These
flows of assets constitute an enhancement of the claims of
the participants.
If all of the payments made by a firm constitute a flow
of assets from the firm to acquire a factor of production.
168
it logically follows that these factors of production are all
essential in the productive process. If all of the factors
of production are required for the firm to operate, there is
no apparent reason that one factor should take precedence
over the other factors in the reporting of operations for a
firm. All factors are important.
The analysis in Chapter IV shows that over the life of
a business the receipts of a firm must equal the disbursements of the firm.
The analysis in Chapter VI showed this
also to be true regardless of whether receipts are defined
as cash, as net quick assets, net working capital, or as all
assets minus all liabilities.
Over the life of a business,
then, it is impossible for the firm, per se, to have a profit or a loss.
This reaffirms the earlier statement that
profits must be defined in terms of flows of assets which
enhance the claims of participants.
Relationship of enterprise
theory to economic theory
This concept that a firm has flows of assets to its participants is amenable to an idea expressed in economic theory. Economic theory views a firm as a place where flows of
factors of production into the firm and flows of products
from the firm occur.
This idea is often expressed in the
form of a circular flow diagram of economic activity. This
same idea of flows of assets is reflected by the enterprise
theory.
169
Economic theory describes business activities in terms
of flows of assets into and from the firm.
Profits as de-
fined in economic theory carry a meaning unlike the meaning
of profit as defined in accounting. Economic theory defines
profit as an excess, or greater than required amount, that
is paid to a factor of production.
Thus, economic theory
defines large returns to capital as being composed of two
parts.
The first part is a return required to prevent a dis-
investment of capital. The second part is an excess paid to
the providers of capital.
The enterprise theory does not define profits consistently with economic theory, but a similar idea is relevant.
The enterprise theory views business operations as a place
where flows of assets occur, coinciding with the view of asset flows in economic theory. Likewise, the enterprise theory recognizes that the flow of assets, or the payment, to
a particular factor of production may include an excess. It
is logical that this excess could be paid to any factor of
production, not only to the providers of capital. Thus, similar ideas of excess payments exist in both economic theory
EUid in the enterprise theory.
The only point of difference
is that the enterprise theory defines profit as a flow to a
factor of production. Economic theory defines profit as an
excess amount paid to a factor of production.
The economic
definition of profit appears to possess a normative content.
The enterprise theory defines profit as a flow of assets
170
to a specific group of participants. Economic theory provides a refinement which is applicable to the enterprise theory.
This refinement is the computation of the value added
to products during the productive process. The essence of
the value added computation is to divide the payments made
for the factors of production into two groups. One group
includes the payments made to other firms for the output or
the products of the production. The second group of payments
is to the factors of production which are not products of
other firms. These payments include disbursements for salaries, for income taxes, for interest, and for returns to owners.
This flow constitutes a flow of assets to a specific
group and, therefore, constitutes a profit or income to that
group.
The advantages of using the added value method of re-
porting to regulatory agencies was examined in Chapter V.
Allocation of revenues among
factors of production
The concept of the enterprise theory has been developed
as a broad, social concept based upon asset flows to all of
the firm's participants.
It has been shown that all partici-
pants of the firm are partners in the productive process and
that all participants have a continuing interest in the firm,
especially if the concept of continuity of the firm is assumed.
Traditional accounting thought holds that the factors
of production, except stockholders for the use of capital.
171
are reimbursed according to a fixed, or at least a determinable, contract.
The remainder or residual is assumed to ac-
crue to the providers of capital. The enterprise theory limits this fixed and remainder idea of asset flows. It is acknowledged that most factors of production are reimbursed according to a fixed or determinable contract. However, as
shown in Chapter IV, many arbitrage methods exist whereby
the effects of these fixed or determinable contracts are mitigated.
Examples of these arbitrage methods include bonus
arrangements for employees and management, escalator clauses
in employment contracts, the setting of interest rates to reflect elements of risk, and any increase or change in raw material prices by vendors. Even when a contract is absolute
for a given period of time, renegotiations include an element
of the expectation of the future. This renegotiation process
is a constant reshuffling process which affects the flows of
future assets to the various elements of production. Thus,
the concept of a residual passing to stockholders is applicable to past periods; but all future receipts of the firm
are subject to an allocation among the factors of production.
This is consistent with the idea used in differential analysis—that past asset flows constitute a sunk cost but future
asset flows may be altered to achieve a desired effect.
The enterprise theory emphasizes a flow of assets to
all of the participants of the firm.
It has been shown that
these participants include, but are not necessarily limited
172
to, the following groups: employees, management, suppliers,
short and long term creditors, stockholders, and even customers. Analysis has also shown that,over the life of a
business firm, the receipts of the firm must exactly equal
the disbursements of the firm.
However, for any arbitrary
shorter period such as an accounting period, these receipts
and disbursements will not necessarily be of equal magnitude.
Traditional accounting theory holds that this differ-
ence, which constitutes retained earning, belongs to the
stockholders.
Thus, retained earnings are normally shown
as part of the stockholders' equity on the balance sheet.
Analyses in Chapter IV and VI have shown that these
retained earnings will not necessarily flow to the stockholders.
The only two ways that these retained earnings
could pass to the stockholders are through dividends or
through liquidation of the firm.
Both of these methods
conflict with the objective of the firm of growth and survival.
Rather, retained earnings are more in the nature of
a residual, created by positive asset flows that are held
in abeyance, which will at a later date be disbursed to a
claimant in regard to the priority of his claim.
While the enterprise theory holds that retained earnings will not necessarily pass to stockholders, this does
not imply that capital is unnecessary.
Rather the enter-
prise theory recognizes all factors of production are important, including capital. Economic theory recognizes
173
some firms as labor intensive and some as capital intensive.
Economic theory also shows that the returns to each factor
is logically determined on a marginal basis dependent upon
the productivity of the factor.
The enterprise theory views all elements of production
as partners and views retained earnings from asset flows as
held for the benefit of all elements of production. Thus,
the balance sheet logically reflects that assets are equal
to the claims or equities of all participants plus the unallocated retained earnings. Therefore, the equation becomes: A = E -f RE. This view emphasizes that retained earnings can be used to the benefit of all claimants of the finn
and even implies a concept of continuity of retained earnings.
Conclusions
It is concluded that the enterprise theory represents
a more viable and more relevant explanation of the structure
and behavior of a business firm in today's environment than
either the proprietary or the entity theories. It has been
shown that the enterprise theory is very broad in viewpoint
and can be used as a frame of reference to support adequately accounting theory.
The enterprise theory concedes that the proprietary theory may accurately represent the point of view of the owners.
Likewise, the entity theory may accurately represent the
17^
point of view of the firm per se. However, the enterprise
theory is broader and thus constitutes an overview of both
the proprietary and entity theories. It is also recognized
that the enterprise theory is more directly applicable to
large corporations which acknowledge their responsibilities
to many diverse groups, and which have distinct separation
of management and ownership.
Both the proprietary theory and the entity theory place
emphasis upon legal distinctions.
The proprietary theory
emphasizes the legal distinction between a creditor and an
owner.
The entity theory emphasizes a legal distinction of
ownership--that the corporation owns the assets and the stockholders own their stock which represents a bundle of rights.
The enterprise theory does not deny these legal distinctions nor does it emphasize them. Conversely, the enterprise theory emphasizes flows of assets into and from the
firm.
This emphasis of flows is closely related to economic
theory, particularly as reflected by a typical flow diagram
of economic activity.
Thus, through this emphasis on asset
flows, the bond between accounting theory and economic theory is strengthened.
Both the enterprise theory and the
economic theory recognize that all factors of production
share in the revenues of the firm.
The sharing of revenues by all factors of production,
however, points out a limitation of the enterprise theory.
The theory does not indicate the method of allocation of
175
revenues among the various factors. The concept of residual
equities states that once a claim is determined, it must be
paid in accordance with legal priority.
The question of al-
location is not answered by the enterprise theory, per se.
It is recognized that the question of allocation of resources
in the productive process is the topic of microeconomic theory.
While the enterprise theory states that the factors of
production share in the revenues of the firm, this sharing
among the various factors will not necessarily be on an equal
or proportionate basis. Rather, it is more logical from a
microeconomic view that the factors will share in regard to
their contribution to production or on a marginal basis.
The implications of the enterprise theory for accounting are far reaching.
The enterprise theory emphasizes the
firm as a productive economic unit and recognizes the viewpoints of its different participants. A contrast of the enterprise theory with the proprietary and entity theories
will be shown for five areas. These areas include: (1) viewpoints with respect to management, (2) the nature of assets,
(3) the nature of capital, (4) the nature of income, and
(5) the emphasis of the concepts.
Viewpoint with respect to management
The proprietary and entity theories view the function
of management quite differently.
The proprietary view holds
that management represents an agent for the stockholder. In
176
this regard, he possesses authority delegated to him. He
may be regarded as a special employee. From the entity
point of view, management is independent of the stockholder.
Management is responsible for the conduct of the cor-
porate affairs.
This contrast can be presented by the fol-
lowing statements:
From the proprietary point of view, management is an
agent for the stockholders.
In the entity theory, management is an element in its
own right.
The enterprise point of view ignores the legal question
of whether management is subject to the control of the stockholders.
Rather, the enterprise theory views management as
one factor in the process of production.
In this view, all
factors are important and make their special contribution.
This position is represented by the following statement:
In the enterprise theory, management is one of the many
factors of production.
Nature of assets
The nature of assets from a proprietary and an entity
viewpoint is represented by the following statements:
In the proprietary theory, elements of ownership and
value are the primary characteristics of assets. Emphasis is on the debt-paying ability of assets.
The entity theory emphasizes the function assets serve
in production. Thus, the primary characteristic of an
asset is its productivity.
The enterprise theory recognizes the attributes of assets as viewed by both the proprietary and the entity theories.
177
However, the enterprise theory defines assets in terms of
their service potentials.
As shown in Chapter IV, the en-
terprise theory adopts the service potential definition as
stated by Vatter:
Assets are economic in nature; they are embodiments of
future want satisfactions in the form of service potentials that may be transformed, exchanged, or stored
against future events.
Nature of capital
The nature of capital claims in both the proprietary
and entity theories is represented by the following statements:
In the proprietary theory, capital is the owners' claim
that is the residue in assets after all liabilities
have been deducted.
From the entity view, capital is equal to total assets
regardless of whether the sources are from stockholders or creditors.
The enterprise theory's view of capital is closely related to the view as presented by the entity theory.
How-
ever, the enterprise theory does view retained earnings as
a buffer subject to the future claims of all equity holders.
Capital is defined as:
In the enterprise theory, capital is equal to total assets regardless of whether the source is stockholders,
creditors, or earnings. This total is divided into two
parts, that to which stockholders and creditors have
specific claim and that which remains unallocated.
Nature of income
The essence of the proprietary and entity definitions
of income is stated as:
178
From the proprietary viewpoint, income is the increase
that results from completed transactions with outsiders.
The emphasis is on the claim against asset increases.
From the entity viewpoint, income is the increase in
total assets that results from all sources.
The enterprise theory views income as an arbitrary term
that must define an asset flow to a specific claimant to have
meaning.
The enterprise definition is reflected by the fol-
lowing statement:
Over the life of a firm, all receipts must equal disbursements; therefore, the firm, per se, cannot have
income. The term income is used in regard to asset
flows to specific claim holders.
Emphasis of concepts
Each of the three theories presents a distinct viewpoint
of the firm.
The proprietary theory places emphasis on the
view of proprietors and as such the corporation is only a legal vehicle for the conduct of business activities.
The en-
tity theory places emphasis on the continuity of the firm
and on the separation of ownership and management.
The en-
terprise theory does not emphasize either the proprietor or
the entity.
The enterprise theory emphasizes, rather, the
flow or the conduct of the business activity and the effect
of these activities upon all of its participants.
The em-
phasis of these three concepts can be stated:
The proprietary theory views the firm or the corporation as a method of doing business.
The entity theory emphasizes the separation of ownership and management.
179
The enterprise theory emphasizes the conduct of business
activities and the effect of these activities upon its
participants.
A summary of the theories, proprietary, entity, and enterprise, is presented in Table 13. Analysis of this summary
reflects the viewpoint of each of the theories.
In the pro-
prietary theory, ownership is emphasized and, as such, manaigement is considered an agent for owners; assets are owned
by the stockholder; etc.
In each item, definitions are
framed in terms of the stockholder.
The entity theory emphasizes the viewpoint of the firm.
Thus, management is independent of owners and is responsible
for the conduct of operations of the firm; capital is a total of funds provided to the firm, etc.
The emphasis is on
the entity.
The enterprise theory assumes neither a proprietary nor
an entity view.
Rather, the enterprise theory views the firm
as a place of activity with emphasis upon changes, or productivity, between the firm and all of its participants, including society as a whole in its broadest sense.
Acceptance of the enterprise theory leads to the following recommendations:
1,
The term net income, or profitability, should be
deemphasized.
The accepted connotation of this
term is an increase in claims that accrue to the
stockholders.
Accounting serves too broad a pur-
pose for such a single use approach.
Rather, var-
ious flows of assets and the related claims of
180
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181
specific groups should be emphasized.
This recom-
mendation has been partially implemented by the requirement that statements of operations include a
statement of changes in financial position.
2.
Accounting study should place a greater emphasis on
the understanding of the various flow concepts of
assets.
This emphasis would provide an excellent
pedogogical tool in accounting education.
This em-
phasis on flows would alert users of financial
statements that a firm has many flows of assets,
not just the one reflected by the income statement.
3.
The feasibility of compiling value added statements
for regulatory agencies should be investigated.
The
usefulness of such statements would be advantageous
to regulatory agencies, but this should be weighed
against the increased effort of preparing such
statements.
4.
The enterprise theory and economic theory both emphasize flows.
Further study and effort should be
made to bring these two disciplines closer together.
5.
Accounting statements should reflect the enterprise
theory where appropriate.
Specifically, retained
earnings should not be shown as part of stockholders' equity on the balance sheet.
182
In conclusion, it is significant to state that the enterprise theory is not strictly an accounting theory.
As
developed in this dissertation, it has implications to economic theory and could be used as a device to unite the two
disciplines.
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