Wealth, Income, and Intangibles 9781487583507

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WEALTH, INCOME, AND INTANGIBLES

WEALTH, INCOME, and INTANGIBLES by

J.E.SANDS

University of Toronto Press

© 1963 University of Toronto Press Printed in Canada

Reprinted in 2018 ISBN 978-1-4875-8218-0 (paper)

PREFACE

I wish to acknowledge the financial assistance of the Institute of Chartered Accountants of Ontario in initiating this study and of the University of Toronto Press in publishing it. I am indebted also to the American Institute of Certified Public Accountants for its kind permission to use its library facilities. I am most grateful to Professor C. A. Ashley of the University of Toronto for reading the drafts and for providing very wise and valuable counsel. The faults that remain are my own. The book is dedicated to my families, past and present.

Toronto, Canada October, 1961

J.E.

SANDS

CONTENTS

PREFACE

V

1.

INTRODUCTION

3

2.

PREMISES

6

3.

WEALTH

Purpose of Accounting Definitional Requirements Market Value Double-Entry Book-Keeping Consumable Wealth Secondary Wealth Currency Competitive Conditions Intangibles Nature of Intangible Value Accounting Statements of Wealth

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viii

4.

I CONTENTS INCOME

Psychic Income Wealth Income Accounting Entity Beneficial Ownership Accounting Income Realization Concept Matching Concept Intangibles in Income Dollar Values APPENDIX: INCREASE OF SOCIETY'S WEALTH

33

54

5.

MEASUREMENT

56

6.

PRESCRIPTION

82

Entity Wealth Description of Wealth Currency and Secondary Wealth Service Wealth Sale Wealth Intangibles Businesses

General Requirements Treatment of Intangibles Supplementary Considerations Treatment of Tangibles Illustration INDEX

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WEALTII, INCOME, AND INTANGIBLES

1 INTRODUCTION

This study began as an inquiry into the nature and accounting treatment of intangible assets. As a starting point, it seemed logical to obtain a definition of intangibles. There was no satisfactory definition to be found. Intangibles were defined by accounting authorities by listing the things called by that name, but without providing a description of the characteristics that distinguish intangibles from other assets. It seemed logical, then, to go a step further back and to obtain an accounting definition of assets. Once again there was no satisfactory definition to be found. Assets were defined, in effect, as debit balances which appear in accounting statements of financial position, but there is not complete agreement about what things under what circumstances should be represented by the debit balances. Nothing very useful could be done without a definition of assets, so one had to be produced. This eventually broadened the scope of the inquiry into an examination of the entire theoretical structure of accounting. A brief summary of the study at this point may assist the reader in making his way through the subsequent maze. It begins by considering the purpose of accounting, since without a statement of purpose no defensible structure of what accounting theory and practice ought to be can be

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developed. It is held that the primary purpose of accounting for business enterprises has become the production of accurate estimates of wealth and income for management and other purposes, and that this is implicit in current accounting theory and practice. This statement of purpose can be disputed, of course, but only by advancing a different and more acceptable one. If one accepts the purpose of accounting as stated, wealth and income must be defined. The definitions it is held, must accord with commonly accepted concepts, if accounting measurements are to have any general significance. Thus, wealth is defined in brief, as those things that have value, and income as an increase in wealth. Value is defined as value in exchange because, it is held, a concept of value must be adopted which allows of objective measurement, and only value in exchange meets this requirement. Here again one could disagree, but only by proposing different and more acceptable definitions. Wealth as defined, is subdivided into four main categories and several sub-categories according to its fundamental characteristics. The four main categories are consumable wealth, those things that exist in solid form; secondary wealth, claims against others; currency, coins, and bills; and intangibles, conditions of imperfect competition. The nature of income as defined, is considered and compared with concepts of income implied in the application of currently employed accounting conventions. In the course of this review, it is shown that accounting concepts differ from the definitions proposed, for three main reasons: because current exchange values are often ignored, because intangibles are not treated consistently, and because adjustments are not generally made for changing dollar values. The question is then considered, whether and to what extent current exchange values can be determined, and the conclusion reached, that some reasonable estimate of market

INTRODUCTION

/

S

value can almost always be made for consumable wealth, secondary wealth, and currency, but almost never for intangibles. Finally, three recommendations are made. First, since the value of intangibles cannot be measured, they should be omitted from the definitions of wealth and income adopted for accounting measurements. Secondly, in so far as it is possible to do so, current exchange values should be employed in accounting. Thirdly, adjustments should be made to estimates of dollar income in order to arrive at estimates of real income.

2 PREMISES

Purpose of Accounting

Originally the purpose of accounting was simply to keep track of the physical existence of assets and to assign responsibility for their care and maintenance. The phrases "to account for" and "to be held accountable for" still convey this idea. In this early period business enterprise typically was carried on by the single proprietor who knew his business intimately. It was not necessary for his accounting needs to worry about the valuations to be attached to his assets. He needed accounting records only to make sure that none of his assets got lost, stolen, or strayed. There were times, however, when even this early merchant wanted to sum his assets, and in order to do so he had to state them in comparable units. The obvious unit was the unit of money, in which nearly all business assets could be stated, and for want of a better measure of the number of those units to attribute to each asset he used original cost. As the scale of enterprise increased, proprietors found it necessary more and more to borrow money in order to carry on their businesses. Lenders very naturally wanted to know what sort of security there was for their loans. Thus it became important to consider the valuations attached to

PREMISES

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7

assets; unadjusted original cost was no longer completely satisfactory. Lenders, of course, were not concerned about the possibility of assets being understated in value; that would simply mean that they had more security than they thought. What they were concerned with was that assets might be overstated in value. It became the practice, therefore, to state asset values at original cost or market, whichever was the lower. In comparatively recent times the scale of enterprise in most lines of business has increased tremendously. In contrast with the early proprietorship, the fortunes of a modem business enterprise are of concern to many people; shareholders, creditors, management, employees, government, and the general public. Because of this diversity of interests in most businesses, neither the unadjusted cost nor the lower of cost and market approach is satisfactory any longer for the valuation of assets. It can be just as damaging to the interests of most groups to have assets undervalued as to have them overvalued. Shareholders for example, can be led to make bad decisions about investments just as easily by understatements of wealth and income as by overstatements. The interests of all parties can be served adequately only by accounting practices that produce reasonably accurate estimates of wealth and income. Thus the primary purpose of business accounting today is to measure wealth and income as accurately as possible. Accounting still has the additional purpose of keeping track of assets, or providing a record of stewardship, and in the case of non-profit entities such as municipalities this may be its most important purpose. But in so far as the principles of income determination and asset valuation are concerned, and these are the fundamental principles of business accounting, it must be acknowledged that the chief purpose is to produce accurate estimates of income and wealth.

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Definitional Requirements Before principles and procedures can be developed for the measurement of something, that thing must first be defined. Before one can calculate wealth and income therefore, one must first define wealth and income. In order to be useable, these definitions must meet three requirements; they must be universally applicable, they must accord with commonly accepted concepts, and the things defined must be measurable. If accounting is to have any solid foundation, wealth and income cannot be defined differently from one case to another. This does not mean that once defined, there can be no differences of opinion about how they should be measured or about what may be a more reasonable estimate in any particular case. Just as the weight of an object may be measured in various ways and just as it may be estimated at different amounts, so also may the income of a business be measured in various ways and estimated at different amounts. The concept of weight itseH cannot be variable, however, nor can the concepts of wealth and income. This does not mean that wealth and income must be described in any particular way in an accounting statement or report any more than that weight must always be stated in grams. Accounting data are used in many ways, and the design of accounting systems and reports to produce information in the most useful and informative form is an art. But if accounting practices are to be developed logically, they must have a firm starting point. Wealth and income must be defined in accordance with commonly accepted concepts, so that their measurement will have significance. The more widely understood and accepted are the definitions, the more useful will be the measurement. The things defined must be measurable for the obvious reason that the whole purpose of defining them is so that they can be measured.

PREMISES

/

9

Market Value The essence of wealth is value; anything that has value is wealth to the extent of that value, and anything that does not have value is not wealth at all. Unfortunately value cannot be measured in any absolute way; all measurement is relative. In order to measure some property of a thing, one must compare it with something else that has the same property. For example, in order to measure the length of a desk, one must measure it against something else that has physical length. The obvious choice is to measure it in inches, the inch having length and nothing else. The desk length can be translated into or exchanged for so many inch lengths. Similarly in order to measure the value of something, one must compare it with something else that has value. The obvious choice in this case is dollars, the dollar having value and nothing else. The value of the thing being measured can be translated into or exchanged for so many dollar values. Because people have different tastes, widely different dollar prices would be paid, if necessary, by different individuals for the same items of wealth. The absolute value of a thing to any particular individual is completely subjective. If one wants to communicate the value of something, one must use a measure of value in exchange that is objectively applicable. The only such measure that exists is market value. Some things that have intrinsic value have no market value. Good health is extremely valuable to its possessor but by its nature it is not exchangeable. Since no objective valuation can be placed on things that are not exchangeable, they must be omitted in measuring value. The market value of those things that can be exchanged is determined by their scarcity as well as their utility. The less scarce a commodity, the less valuable it is in exchange,

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regardless of its inherent value. Air has no value in exchange, since there is no scarcity of it whatever, although its intrinsic value is infinite. There is usually more than one market value for the same item of exchangeable wealth, because there is usually more than one market in which the item can be traded. Different markets exist because entry to all markets is, to varying extents, restricted. Before one can establish the market value of something therefore, one must decide which market is relevant. For a given individual the relevant market for determining the value of any item of wealth is the one in which he can make the best deal. For a buyer it is the market in which he can obtain the item for the lowest price; for a seller it is the market in which he can sell the item at the highest price. If an individual has to pay $3,000 for a new automobile, that is the relevant amount for him to use in measuring its market value, regardless of the fact that the automobile dealer was able to buy it for less. If he is only able to obtain $1,000 on the sale of his old automobile, that is the relevant amount for him to use in measuring its market value, regardless of the fact that an automobile dealer might have been able to sell it for a higher price. Furthermore, in order that market price should reflect market value, the other party to the transaction must also be acting in his own best economic interests. If an exchange takes place at more or less than the amount that would be determined under such circumstances, then the buyer has made a gift of the difference to the seller or vice versa, and the nominal transfer price does not reflect market value for either party. The degree of competition or lack of it that exists in a market is here of no significance. In the sale of a particular piece of land for example, there could be only one seller but there might be several prospective buyers. The seller would be a monopolist with no competition, but each of the

PREMISES

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11

prospective buyers would have competition. Nevertheless, the price at which the exchange took place would be the market value of the land at the time of exchange. It would not make any difference if prices were set by some authority and were not the result of the free operation of the market forces of supply and demand at all. Regardless of the effect of outside influences on it, as long as the exchange price reflects the best deal that can be made by both buyer and seller, it constitutes market value for them. The number of exchanges of identical things that take place in a market at any one time is not relevant to the determination of market value. In the sale of some commodities, for example hammers, many exchanges take place simultaneously or almost so, while for others, such as pile drivers, only one transaction may take place over a fairly long period of time. An exchange will never take place in any market at a figure in excess of the highest price bid by a purchaser or at a price less than the lowest price asked by a seller. Neither will any seller sell for less than the highest bid price, nor any purchaser buy for more than the lowest ask price. Every exchange therefore takes place between the lowest-price seller and the highest-price buyer when their prices coincide. Whether the highest bid price is being offered by one or several prospective buyers and the lowest ask price is being demanded by one or several sellers at the same time is of no consequence. Market values are constantly changing. They change because tastes or the strength of desires to consume different things change and because the relative scarcities of things change; in the economist's language, because demand and supply change. Thus the price at which a thing is exchanged is its market value at the instant of time at which the exchange takes place but not necessarily at any other point in time. The original cost of that thing reflects its market value at the time it was acquired and nothing else. If the

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market value does not change, original cost continues to be a significant amount because it continues to reflect market value. If market value changes, however, original cost ceases to have any significance whatsoever for the measurement of wealth. The present value of a thing is not the slightest bit greater nor less than the price at which an identical thing can be purchased, regardless of how much more or less its value happened to be at the time it was acquired. Present wealth must be measured by reference to present values. Double-Entry Book-Keeping

The double-entry system was developed for the purpose of keeping track of wealth and is admirably suited to that purpose. Double-entry book-keeping requires that two records be kept of wealth, one showing the form of the wealth and one showing the ownership equity in that wealth. When wealth is invested in a business for example, both the wealth and the ownership are recorded. When the wealth invested is exchanged for other things, it is replaced in the records by those things by means of a double entry. Thus it does not matter how the wealth is used or what it is exchanged for; it must all continue to be accounted for in some way in order to equal the amount invested. The double-entry technique in itself, however, neither produces a continuing record of wealth nor measures income. In order to make the system work, it is only necessary to record exchanges; it is not necessary to record anything that happens to wealth other than by means of exchange. The most obvious example of this condition is that no automatic allowance is made for the fact that some of the things for which wealth is exchanged, such as the services of sales clerks, are used up almost immediately and cease

PREMISES

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13

to remain wealth, at least in their original form. This was recognized from the very beginning of accounting with the result that attempts have always been made to distinguish between things that have a continuing value, or assets, and things that are used up almost immediately, or expenses. Another obvious example is that things that are used up over a long period of time continue to be valued at their original exchange price unless adjustments are made to their recorded values for such things as depreciation. In the early period of accounting when only a record of the physical existence of assets was required this was not overly important, and it is only in comparatively recent times that accounting practices involving the periodic amortization of long-term asset values have been generally adopted. Changes in wealth resulting from gifts or discoveries or favourable circumstances, not involving exchanges, are still not generally recorded in accounting. When new wealth is acquired without exchange in the form of tangible assets such as inventories, properties, plant, and equipment, many accountants record it at estimated current market value but many do not record it at all. When intangibles such as the favourable attitudes of customers are concerned, few if any accountants record their acquistion unless they have been consciously and deliberately purchased. When the exchange value of existing wealth changes, it is usually recorded only to the extent that the values of inventories, short-term investments, and receivables decline. Current accounting practices, therefore, do not usually produce satisfactory estimates of wealth as defined here.

3 WEALTH

Consumable Wealth For society as a whole all value derives from consumption. In order to have value a thing must be capable of being consumed and someone must want to consume it. Uranium had no value until it was discovered how it could be used and people wanted to use it. It has value now because the two necessary requirements, knowledge of use and desire to use, have been met. Consumption must be interpreted broadly. To eat bread is to consume it physically, to drive a car is to consume the services it provides, to attend a play is to consume the services of the actors, to view a work of art is to consume the services of the artist as they are preserved in that work. Consumption may be a very roundabout process. An automobile has value because it provides consumable services. The dies used to stamp out automobile parts have value because the services they perform are ultimately consumed in the services enjoyed by the automobile drivers and passengers. The mining property from which the metal is extracted to make the dies has value for the same reason. Nothing is consumable unless it exists in tangible form. Thus consumable wealth consists of existing inventories of

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15

consumable goods plus existing inventories of things that can be turned into consumable goods plus existing goods that can be used in the production of consumable goods. In other words, consumable wealth consists of inventories and productive equipment. This of course is obvious to anyone familiar with national savings and investment accounts. When one consolidates the wealth of an entire country from the statements of wealth of individual entities, all forms of wealth other than inventories and productive equipment disappear. The only exception arises from foreign trade and this too would disappear if one consolidated the wealth of all countries. Consumable wealth can be and is generally subdivided for business accounting purposes in the ways illustrated in Chart 1. The things that are consumed physically are all forms of inventory whereas the things that are not consumed physically are all forms of productive equipment. Only processed products which are to be sold or used fairly directly in the producing function of a business, as opposed to the marketing, financial and administrative functions, are described as inventories in accounting. Processed products not to be sold or used in production, such as office supplies, are usually labelled either prepaid expenses or deferred charges, while depletable resources are called fixed assets or by some similar name, or deferred charges. The category of deferred charge, although in common use, is CHART 1

Consumable Wealth

Consumed physically

I

Depletable resources

Processed products

Consumed in services

Finite service Infinite service potential potential

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a thoroughly unsatisfactory one, since it does not indicate any specific asset characteristic nor is it consistently used for assets with common characteristics. Describing an asset as a deferred charge is little more informative than calling it a debit. The location of land gives it an infinite service potential. Those things that have finite service potentials are usually subdivided into structures and equipment initially and may be further subdivided according to the types of structures and equipment. All of the things consumed in services are usually described as fixed assets or by some similar name. Occasionally the term "other assets" is used to describe those items of consumable wealth that are not being used in the normal course of the operations of a business but are being held as a form of investment. This terminology is little better than the use of "deferred charge." Secondary Wealth

In most cases, more than one person or group of people has a claim against or equity in the same item of wealth. The ordinary trade creditors of a business, for example, have a claim against all the wealth of that business, to a different extent from, but in the same way as, the proprietors. It is not feasible to subdivide every item of wealth for the claims against or equities in it, and show only that portion of it represented by the extent of his claim as the wealth of each claimant. Instead, for business accounting purposes each item of wealth is attributed in total normally to only one business entity at a time and the extent to which others have an equity in it is recorded separately as a liability of that entity. Indeed, this is the primary advantage of the double-entry book-keeping system; it permits changes to be made in assets without disturbing the record of equities

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in those assets and vice versa. The result is that in order to compute the wealth of a business one must add to its consumable wealth the claims it has against the wealth of other entities. These claims may be described as secondary wealth. For society as a whole they cancel out and have no value, but they do have value for an individual business. Secondary wealth is subdivided for business accounting purposes as shown in Chart 2. Secondary wealth is of four kinds: claims arising from the conscious and deliberate investment of wealth in the purposes of other entities; those arising from the fact that many business exchanges are not completed on both sides immediately and simultaneously; those arising from the necessity of guaranteeing contract performance by depositing wealth with another entity as security; and those arising from the deposit of wealth with other entities for safekeeping. CHART 2 Secondary Wealth

I

Investment claims

Shortterm

Uncompleted trade exchanges

I

Security deposits

I

Safekeeping deposits

I

Long- Receiv- Receiv- Securing Securing Demand Time term able able cash provision deposits deposits in in payment of goods assets services and services

Investment claims include stocks, bonds, mortgages, endowment insurance policies, and the like. These are broken up in accounting into short-term and long-term investments, usually on the basis of intended use. When trade exchanges are not completed immediately and simultaneously on both sides they may give rise to

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claims receivable in assets, such as cash receivable from sales on credit, or to claims receivable in services, such as insurance protection receivable from the payment of premiums. Asset receivables of this kind are usually described as accounts and notes receivable, while service receivables are usually grouped with prepaid expenses or deferred charges. Security deposits may be required in order to secure cash payment for services to be received, as with some public utilities, or to secure the provision of goods and services in accordance with a contractual agreement, as in building construction. The former are sometimes classified as receivables and sometimes as prepaid expenses or deferred charges. The latter are usually regarded as a form of receivable. Safekeeping deposits are made with banks and such institutions as trust companies, and may be either demand or time deposits. Such deposits are not usually distinguished from cash. Currency At one time currency could have been classified as secondary wealth, representing a claim against gold or silver, but no longer. Its value now rests on the fact that it is accepted in exchange for other things. It must, therefore, be considered a separate category of wealth. Currency, like secondary wealth, does not represent value for society as a whole; it is merely a means of exchange. Competitive Conditions All businesses operate in what economists describe as conditions of imperfect competition. It is these conditions

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that give rise to profits; without them no profits could exist. To the extent that conditions of imperfect competition make profits possible to a business, they have value for its proprietors. For purposes of exposition and analysis, economists group conditions of imperfect competition under a few general headings, such as imperfect knowledge ( to the effect that not all prices and methods of production and sale are universally known) and imperfect mobility of resources (to the effect that people cannot move in or out of a market at will and without suffering any loss by so doing). While it is possible to classify them in a few categories, there are in fact thousands, perhaps millions, of individual circumstances or conditions of imperfect competition which impinge on the operation of any business. Imperfect knowledge, for example, includes the lack of complete knowledge on the part of every consumer about the properties of a product and the range of possible alternatives, the lack of complete knowledge on the part of every employee about alternative employment opportunities, and the lack of complete knowledge on the part of the management about alternative production, marketing, and financing methods. Some of the conditions of imperfect competition under which any business operates are favourable to it and some are unfavourable. The lack of complete knowledge of alternative employment opportunities on the part of employees is a favourable condition for a business, while the lack of complete knowledge of alternative operating methods on the part of the management is an unfavourable condition. It is only to the extent that the effect of the favourable conditions under which a business operates outweighs the effect of the unfavourable conditions that it will show a profit. The conditions of competition which affect a business are constantly changing; new circumstances are constantly arising and old ones disappearing. New conditions may be created by a business, either deliberately, as, for example,

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changes in consumer preferences brought about by advertising, or unconsciously, such as changes in consumer preferences arising from the consistent quality of a product; or they may be created entirely independently of the business, for example, by a government subsidy or changes in the policy of competitors or changes in any other product. Most of the conditions that are created, either deliberately or unconsciously by a business, are more closely bound up with and have a greater effect on it than on any other business. For example, the greatest effect of most advertising is to produce greater consumer preference for the product of a particular business, although it may at the same time produce greater consumer preference for that general type of product and less consumer preference for the products of competitors. On the other hand, those conditions that are created independently are usually more general in effect. For example, a subsidy would benefit all firms in an industry. Conditions of imperfect competition may disappear naturally as the result, for example, of an increase in the knowledge of management; or they may be destroyed directly, say by government tariff action; or they may be destroyed indirectly, by the advertising of competitors for example. The effect of some, such as the lack of knowledge by competitors of some productive process, may last a long time, while the effect of others, such as consumer preferences created by advertising, may be short-lived. Some conditions are protected by law indefinitely; for example, a franchise may preserve indefinitely the absence of any other firm in a market. Some are protected for a fixed period of time; a patent preserves for a fixed period the effect of a lack of knowledge of some productive process by competitors. And some are not protected at all; for example, there is no legal protection for a lack of knowledge of alternative employment opportunities by employees. Not only are some conditions favourable to a firm protected by law, some that are unfavourable to it are enforced by law. For example,

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firms are prevented from combining in certain ways to create the effect of a single supplier in a market. Although the lifetimes of those conditions of imperfect competition that are protected or enforced by law may be influenced by that protection or enforcement, they are not entirely determined by it. The competitive advantage protected by a patent will continue after the patent runs out and until such time as competitors begin to use the process that was patented. On the other hand, the value of the condition protected by a patent may disappear long before the patent runs out, if a new process is developed which is superior to the one patented. Furthermore, the existence of legal protection does not in itself make a condition more valuable. The unlegislated absence of competitors in the immediate vicinity may be far more valuable than the patented right to prevent competitors from using a particular process. Not only do new conditions of competition constantly arise and old ones disappear; the influence of those in existence during any period of time is constantly changing. The condition protected by a patent may be an important factor contributing to profits when that condition first arises, but it will probably diminish in importance as other improvements are made in productive processes by competitors. It is not possible to know and enumerate every individual condition of imperfect competition affecting a business. In current accounting practice only a very few are segregated; those legally protected by patents, copyrights, trade marks, franchises, and the like; those arising from large-scale expenditures for such things as advertising and research, whose cost is described as a deferred charge; and those described as organization, financing and development expenses. All those that are not separately distinguished, favourable and unfavourable, are lumped under the single caption goodwill.

Only those conditions that are acquired in an exchange

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transaction are recorded in accounts; in fact, only those that are acquired deliberately in an exchange transaction are recorded. Those that are acquired unconsciously, such as favourable customer attitudes resulting from the efforts of salesmen, are ignored, as are those that arise spontaneously, such as the disappearance of a competitor. The result is that often relatively unimportant conditions are included in accounting statements of wealth, while those that are much more important are omitted. What is more, attempts are sometimes made in accounting practice to assign the full effect of all conditions of imperfect competition to one or a few individual conditions, such as patents, when all of the assets have been purchased together. This practice apparently results from a general distrust on the part of bankers and others of the all-inclusive description of conditions of imperfect competition as goodwill. Intangibles

In current accounting practice conditions of imperfect competition are described, if at all, as intangibles. Patents represent the right to be the only producer of a product and thus to have complete control over the supply of that product in the market for a certain period of time; or else they represent the right to continue for a given period of time the effect of a lack of knowledge among competitors about a productive process. They are granted as a reward to those who invent new or improved products or processes and as an inducement to others. Copyrights are the same as patents in principle, the only difference being that they are granted in respect to such things as books, music, and art, rather than to manufactured products and processes. Trade marks represent the right to distinguish a product

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from that of competitors and thus to create a market in which the producer has complete control over the supply of his own specific product for as long as it is produced. The distinction between products may be no more than the trade mark or name itself but the right is granted as an inducement to the producer to maintain and improve his product's quality, by making the value of that quality, in terms of sales potential, available to him. Franchises represent the right to be the only supplier of a product or service in a particular market. They are granted for varying lengths of time to entities operating in markets where it is thought it would be a disadvantage to the grantor to have more than one supplier. The holder is usually subject to some control by the grantor of a franchise, as part of the agreement between them. Distributorships and licences are forms of franchises. When franchises are granted by the state to profit-making entities to run public utilities for the provision of transportation or similar services, the rates charged by those entities are usually regulated so that their profits or losses will fall within a certain range. In some cases the rate of profit is fixed. However, even if no profit or loss were permitted, the franchise would represent a relevant factor of imperfect competition. Its effect would then be exactly equal and opposite to the net effect of all the other conditions of imperfect competition. There is one other type of legal right which is often described as an intangible but which does not represent a condition of imperfect competition, the leasehold. A leasehold is a claim for the services of a piece of property. It is different in degree only, not in nature, from ownership of property. Both represent the legal right to use property in certain ways, subject to the rights of other individuals or groups. In the case of ownership, the use of the property may be subject to regulation by various levels of govern-

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ment and each may have the right to expropriate the property. In the case of leased property, the lessor also has rights, in addition to those of governments. The services to which a lessee has rights are different from those of an owner of property only in respect of duration, the first being for a limited and the second for an unlimited period of time. The lessee of a particular piece of property may have a competitive advantage because of the favourable location of that property but the same situation would exist if he owned the property. The value of the competitive advantage is part of the value of the property or the leasehold right to its services. To describe a leasehold as an intangible is therefore confusing. Even those who do so usually classify leasehold improvements as fixed assets, and that is how leaseholds themselves should be classified. Advertising expenditures are made for the purpose of distinguishing a firm's product from that of competitors. If the advertising is successful, a condition of imperfect competition favourable to the firm is created or enhanced. Deferred advertising expenses represent that condition. Research expenditures are made for the purpose of discovering new products and processes and thus of producing greater knowledge within a firm than exists within competing firms. Once again, if the research is successful, a condition of imperfect competion favourable to the firm is created or enhanced, and deferred research expenses represent that condition. The effect of superior knowledge created by research can be continued, even though the condition itself disappears, by patenting the product or process developed. Where a patent is not obtained, the continuance of conditions produced by research depends on secrecy. The so-called deferred charge, as indicated earlier, is a catch-all category in which are put a variety of items having no common characteristics. Many deferred charges which appear in conventional accounting statements do not re-

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present conditions of imperfect competition. It is not uncommon, however, to find them all described as intangibles in current accounting practice. The term intangible is used here to mean only conditions of imperfect competition. Deferred advertising and research represent intangibles by this definition. Prepaid insurance premiums, sometimes described as deferred charges, are secondary wealth arising out of uncompleted trade exchanges. Asset development expenses, such as expenditures made to develop mining properties which are sometimes called deferred charges, represent part of the value of the assets for which they are incurred. Heavy expenditures made to move and rearrange productive equipment are sometimes deferred. These may represent an increase in the value of the productive assets themselves, or the creation or enhancement of favourable conditions of competition, or both. Bond discounts, often called deferred charges, are a form of bond equity adjustment. This can best be shown by an example. Suppose that three-year bonds redeemable at $100 are issued for $97. At the time of issue, they represent claims against the assets of the issuing entity of $97 each, not $100, since their market price is $97 and there is no reason why the issuing entity itself could not repurchase them at that price, provided it had the cash available. Ignoring the compounding feature of interest for simplicity, if interest rates do not change over the lifetime of the bonds, their market price will be $98 at the end of the first year, $99 at the end of the second and the maturity value of $100 at the end of the third year. Just as it could have repurchased the bonds for $97 at the time of issue, the issuing entity could repurchase them for $98 after one year, $99 after two years, and $100 at maturity. If, therefore, the bonds are recorded in the accounts at their maturity value, a discount adjustment must be applied against that value, of $3 at the time of issue, $2 after one year, and $1

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WEALTH, INCOME, AND INTANGIBLES

after two years, in order to arrive at correct statements of the bondholders' equity. The annual dollar reductions in discount are adjustments of nominal to effective interest charges. If interest rates change during the lifetime of the bonds, the equities of bondholders and shareholders will change immediately as a result. If interest rates increase, the market price of the bonds and thus the equity of the bondholders, will decrease, while the equity of the shareholders will increase, reflecting the gain to them from having the use of money whose market value has increased. Like most other changes in market values however, a change in interest rates is never reflected in current accounting practice, unless an exchange transaction has taken place. Operating deficits are sometimes carried forward in accounts as deferred charges. In some cases such deficits may have been incurred in creating or enhancing valuable conditions of imperfect competition; for example, losses incurred in waging a price war that is successful in eliminating competitors. Organization, financing, and development expenses are a manifestation of the imperfect mobility of resources. Anyone wishing to enter any business must incur some such costs in order to get started. Thus they are a barrier to the entry of new firms into a market and represent a favourable condition of imperfect competition for those already in it. Over a period of time the organization and financing of businesses in any industry change, so that the value of these factors, like that of others, changes also. A good example is the relative ease of entry into automobile manufacturing during its early years, compared with the virtual impossibility of entry today. When an entity is purchased, the price includes the net value of the consumable wealth, secondary wealth, currency, and intangibles separately distinguished. If the price exceeds this amount, the excess is paid for all those conditions of

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27

imperfect competition not separately distinguished and is designated goodwill. This is true for the goodwill figure which arises on consolidation of the accounts of parent and subsidiary companies as well as for individual companies. Where one company acquires a long-term controlling interest in the shares of another, any amount it pays in excess of the value of the share of the other assets it acquires in that company, it pays for the anticipated earning power of the combination. Short-term speculative purchases of stock usually involve other considerations besides the earning power of the issuing company, but investments sufficiently large and long-term to justify the consolidation of accounts do not to any significant extent. The goodwill that arises on consolidations may pertain in whole or in part to the parent company, although it originates from the acquisition of the subsidiary. For example, the subsidiary may be acquired to eliminate it from the market as a competitor. In any case, it pertains either to the parent or the subsidiary or both and therefore represents value to the combination. The abilities and efficiency of management are usually considered important factors contributing to the profits or losses of an enterprise and therefore a part of the intangible value of a business. They are not intangibles. It is only to the extent that there is a lack of perfect competition in the market for individuals, that profits and losses are produced from their services. If perfect competition existed, everyone would earn precisely what he was worth because his salary, express or implied, would be bid up to that amount but no higher. With an individual's salary set at exactly what he was worth to a business, there could be no profit or loss to that business from the use of his services. In fact of course~ perfect competition does not exist, so that profits and losses result from the employment of human as well as other resources. The so-called personal goodwill which is at-

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WEALTH, INCOME, AND INTANGIBLES

tributed to many small businesses, particularly personal service businesses, is another manifestation of the same condition. To the extent that it represents the superior abilities or business connections of an individual as such and not merely of that individual as a representative of a specific business, it is part of the value of the individual, not of the business. However, if conditions of imperfect competition make it possible for the individual to be employed for less than he would otherwise get, these conditions constitute intangible value to the business in which he is employed.

Nature of Intangible Value Intangible wealth, like secondary wealth and cash, does not represent value for society as a whole. To the extent that someone gains from conditions of imperfect competition, someone else must lose. Intangibles have value only when one is able to make and keep profits. When this ability is restricted-for example, by placing the means of production under the control of the state-as is done in some countries, intangibles, while they may exist, are similarly restricted in value. It should be noted in this connection that the value of intangibles does not depend on profits as such but on the ability to make profits. Members of co-operatives for example, may gain the benefit of intangible value through lower prices of the things they buy rather than through profits. In any case, intangible value depends on the right to make an economic gain and thus, ultimately, on the institution of private property. The total intangible value which attaches to a business does so only for the existing combination of tangible assets, that is, consumable wealth, secondary wealth, and currency

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29

of that business. If tangible assets are removed or if new ones are added to the combination, the intangible value attaching to the combination will change. It may either increase or decrease with a given change in tangibles; increasing the size of a business does not necessarily increase its profitability. All of the intangibles of a business cannot be transferred to different proprietors, therefore, without transferring all of the tangible assets. If only part of the tangible assets is transferred, only part of the intangibles will accompany them. The intangibles that accompany a partial transfer of tangible assets may, however, have a greater net favourable value than those that pertained to the whole. Part of the business of a bankrupt may be taken over and a price paid for it in excess of the value of the tangible assets, because unfavourable conditions are thereby eliminated, leaving a favourable balance. Since any change in the tangible assets of a business produces a change in its intangible value, the intangible value is constantly changing in response to asset exchanges. It may change regardless of the tangible assets, of course, but it cannot remain static while they change. This is not the case where equities are concerned. No change in equities by itself will produce a change in the intangibles attaching to a business. A change in equities may be accompanied by a change in intangibles, such as when the management changes at the same time, but it does not in itself bring about the change. Most stock and bond market transactions, for example, have no effect whatsoever on intangibles. Most intangibles are difficult for the management or proprietors of a business to control. Some, such as patents, are controllable in a legal sense, but their value is not always controllable. When legal protection is not provided, any effective control is often impossible, or possible only with large-scale expenditures on advertising, price wars, and so on. The extent to which intangibles can be transferred

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or sold separately from other assets by one group of equityholders to another is a function of the ease with which control can be exercised over them by the transferors. Thus it is usually difficult to transfer more than a small proportion of the intangibles of a business separately from its other assets and it is never possible to transfer all of them separately. Without the use of tangible assets, present or future, intangibles have no value. They represent conditions in which tangible assets can be used to produce profits, but if tangible assets are not used, no value results. The use of tangible assets does not have to be made by the legal or nominal owners of an intangible, but it must be made by someone. The legal owner of a patent, for example, may not use it in combination with tangible assets himself but may license someone else to do so in his stead. If he never does either, however, it has no value to anyone. Holding a patent to prevent others from producing a product which would compete with one's own is using it with tangible assets, of course, just as applying it directly to production would be. Present intangible value is future tangible value; it becomes tangible in the process of using assets for gain. The effects of favourable and unfavourable conditions impinging on the operation of a business attach to the product of that business, making it more or less valuable than the goods and services that were used to produce it. They may also attach to the other assets of the business and to the assets of other businesses. Favourable customer attitudes towards a particular store may induce people to shop in a certain area and that habit may continue even if the store disappears. If this happens, the original favourable attitudes will have increased the value of the land in the area. The extent to which intangible value ultimately becomes tangible depends on what is done to take advantage of it. It

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might be that there was no drug store in a certain locality. If someone took advantage of this condition to open a drug store, he would gain considerably by it and much tangible value would result. If he opened a cigar store instead, he would also benefit from the lack of a drug store, because with many products drug stores and cigar stores compete. He would not benefit as much from the lack of a drug store in the locality by opening a cigar store, however, as by opening a drug store. Accounting Statements of Wealth To summarize the accounting description of business wealth, the following is a listing of assets arranged in an order commonly found in balance sheets, or accounting statements of financial position, indicating the characteristics of the kinds of wealth included in each asset category. Cash: currency and safekeeping deposits Short-term investments: liquid investment claims against the wealth of other entities Receivables: uncompleted trade exchanges receivable in assets and deposits securing contractual agreements to provide goods and services Inventories: processed products to be sold or used in production Prepaid expenses: processed products to be consumed physically but not to be sold or used in production, uncompleted trade exchanges receivable in services and deposits securing cash payment Long-term investments: investments in non-operating consumable wealth and non-liquid investment claims against the wealth of other entities Land: wealth consumed in services and having infinite service potential

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Depreciable assets: wealth consumed in services and having finite service potential Depletable assets: depletable resources, consumed physically Intangibles: conditions of imperfect competition impinging on the operation of the business.

4 INCOME

Psychic Income Psychic income is the satisfaction one derives from consumption. It is obtained in the act of consumption, not in the receipt of money or in the exchange of money for other forms of wealth. Ultimately the benefit of all wealth must be obtained by consumption, or in psychic income. If someone received money for work he did yesterday and spent that money on food and drink that he consumed today, his psychic income would have been obtained today; if he had died last night he would have obtained no benefit from the money, unless he was a miser; his heirs would, but not he. If someone wanted to measure the value of his psychic income, he would have to measure the exchange value of the things he consumed at the time he consumed them. This is not necessarily the same thing as the value of the things he acquired at the time he first acquired them, and not simply because he might die after acquiring them but before consuming them. The value in exchange of something when it is acquired will not be the same as its value in exchange when it is consumed, if supply or demand or both change in the interval.

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WEALTH, INCOME, AND INTANGIBLES

It is not feasible to measure income by reference to the value of things consumed at the time of consumption. It would not be difficult to determine the value at the time of consumption of something that is consumed all at once, like a bag of peanuts, even though it might not be consumed for a considerable time after acquisition and its exchange value changed during that time. It would be virtually impossible, however, to determine the consumption value of something like an automobile that is consumed gradually over a long period of time. In order to do so one would have to determine its exchange value and the proportion of its total available services used up every time it was used. Wealth Income

For practical purposes income is defined as the acquisition or increase of wealth rather than the consumption of wealth. This income arises from two sources. One source is the combination of assets with other assets and services in such a way that together they have a value in exchange different from the sum of the values that each had individually. For example a manufacturer buys labour, materials, productive equipment, and so on in various markets, combines them, and sells the product in another market at a price different from the sum of his costs. The difference arises from the fact that access to markets is to some extent restricted. It may be described as business operating income. The other source of wealth income is the change in exchange value of individual assets which results from changes in supply and demand. An example is an increase in exchange value of a land holding which arises independently of its being combined with any other specific asset or assets. Income of this sort may be described as capital gain. As a practical matter it is impossible to segregate capital

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gains from business operating income entirely, because the exchange values of individual assets change continuously during the process of combining those assets to produce a product with a greater exchange value. It is impossible to know, for example, precisely how much of the profit on the sale of a product is due to changes in the market value of the raw materials used and how much arises from the process of combining those raw materials. In order to segregate capital gains from business operating income accurately, it would be necessary to determine the current exchange value of every original component of every item of wealth whenever it was sold or consumed in use, and compare it with the exchange value of that component at the time it was acquired. Capital gains can be estimated approximately, however, the accuracy of approximation depending upon how often estimates are made. This can best be illustrated by example. Suppose first that an individual purchases a new car to use as a taxi for $3,000, that he consumes ¼ of its service potential in the first year, and that supply and demand for his kind of car do not change during the year. The result will be that described in Table I and subsequent explanation. TABLE I At purchase Service cost, ¼ of $3,000 After one year

Asset Value $3,000 600 $2,400

The car service cost to be taken into account in calculating the business operating income of the owner will be ¼ of $3,000, or $600, because ¼ of the car's service potential has been consumed. There will be no capital gain, because if supply and demand for such cars do not change, the market

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WEALTH,INCOME,ANDINTANGIBLES

value of one that is ¼ consumed will be ¼ of its original value, or $2,400. Suppose next that supply or demand or both change to the extent that the car is worth $2,550 in the market at the end of the year, instead of $2,400. The result will then be that shown in Table II. The car service cost will still be TABLE II At purchase Service cost,

½ of $3,000

Capital gain After one year

Asset Value $3,000 600 2,400 150 $2,550

Decline in Value $600 (150) $450

approximately ~, of $3,000, or $600, but the car owner will have made a capital gain of approximately $150, the net decrease in his wealth in the form of the car being only $450. The reason the figures are approximate and more frequent estimates produce more accurate results becomes evident in the next example. Suppose finally that ½o of the car's service potential is consumed in the first half-year and ½o in the second halfyear, and that its market value is $2,790 after the first half-year and $2,550 after the full year. The result will be that shown in Table III. The car service cost in the first half-year will be approximately ½o of $3,000 or $300 and the capital gain approximately $90, the net decrease in car value being $3,000 minus $2,790, or $210. In the second half-year the car service cost will be approximately ½ of the %0 of original service potential remaining after the first half-year, or ½ of $2,790, i.e., $310, and the capital gain will be approximately $70, the net decrease in car value being $2,790 minus $2,550, or $240. For the year as a whole

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TABLE Ill

At purchase Service cost,

½o of $3,000

Capital gain After half-year Service cost, ½ of $2, 790 Capital gain After one year

Asset Value $3,000 300 2,700 90 2,790 310 2,480 70 -$2,550

Service Cost

Capital Gain

$300

300 310

$610

$ 90 90 70 $160

--

the more accurate estimate of car service cost is $300 plus $310, or $610, and the more accurate estimate of capital gain is $90 plus $70, or $160. The reason these estimates are more accurate is that they take into account more changes in market values. For most businesses, more frequent estimates take into account changes in the market values of more assets, as well as more changes in the values of individual assets. If estimates were made only every two years, on the average only the values of things that last a year or more would be estimated, whereas if estimates were made every year, on the average the values of things that last six months or more would be estimated. The income earned by an individual in exchange for his services is no different in principle from business operating income. He sells his services for more than they cost him. In fact of course, there is no way of quantifying the cost to an individual of his own services. The value to an individual of his own time is completely subjective. In measuring income to an individual arising from his own labours, therefore, the cost is ignored and his income is considered to be the gross amounts he obtains for his labours.

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It should be noted that part of what is often described as profit in accounting statements is not income as here defined. There is a factor of what is called pure interest on capital, which does not represent a gain to the owners of that capital. Pure interest is that rate which would have to be paid for capital in the absence of any risk to the investors. It results from the fact that on the average people would rather have a dollar today than a dollar at any given time in the future. The rate of pure interest can be approximated from the government short-term treasury bill rate. Pure interest is not a gain to investors because something of equal value is given up by them in return for it, present dollars in exchange for future dollars. In calculating accounting profits, interest on proprietorship capital is usually ignored, with the result that pure interest on ownership investment is included as part of profit. Many reported profits are actually losses if pure interest is taken into account. For many single proprietorships and partnerships, accounting calculations of profit include not only pure interest but also the value of the services of the owners, as well as the income arising from the business. Accounting Entity

Defining income as the acquisition of wealth instead of the consumption of wealth does not in itself solve the problem, described in connection with psychic income, of measuring the value of things consumed at the time they are consumed. Income defined as the acquisition of wealth, or wealth income, differs from income defined as the consumption of wealth, or psychic income, only to the extent that more wealth is acquired than consumed or vice versa. Wealth income for a period, therefore, is simply equal to psychic income for the period plus the increment in wealth

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( or minus the decrement) remaining at the end of the period. The problem is solved by divorcing wealth from individuals who consume it and attributing it to what are described as accounting entities. An accounting entity is simply a bundle of wealth which is being accounted for. Wealth may be added to or withdrawn from the bundle at any time without reference to when it is consumed. Income for an accounting entity for a period then is wealth at the end of the period minus wealth at the beginning of the period, plus the wealth withdrawn and minus the wealth invested from outside during the period. Wealth is not added or withdrawn continuously but at particular points in time, with intervals between. The extent of the wealth added and withdrawn can therefore be determined. A wide variety of accounting entities exist in practice: businesses, municipalities, estates, countries-in short, anything to which anyone wants to attribute and measure wealth and income. Beneficial Ownership

The wealth of an accounting entity is recorded in two ways, as assets and as the equities of those who have claims against the assets. The assets change in nature and amount, and the equities in those assets change, but the equities are always equal to the assets; an accounting entity never has a surplus of assets over equities. An accounting entity as such, therefore, never has income, for any increase in assets is accompanied by a corresponding increase in equities. What is usually described as the income of an accounting entity is the increase in the amount of their claims of a particular group of equity-holders. The wealth of every accounting entity is managed by an individual or group who combines and exchanges it in various ways, usually in an

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I WEALTH, INCOME, AND INTANGIBLES

attempt to increase it independently of additional investment in the entity from outside. Those equity-holders, the value of whose claims are changed by such efforts by the management, may be described as the beneficial owners of the entity. The beneficial owners are not necessarily the same as the nominal owners of an entity. The holder of an income bond is a nominal creditor but a beneficial owner of the issuing company, since the value of his claim depends upon the success of the management in increasing company wealth. The beneficial owners of an entity may and usually do change over time. An obvious example is the continuous transfer of shares in public companies. In addition to this deliberate market exchange, beneficial ownership may move between nominal categories of equity-holders as a result of what happens to the wealth of an entity. For example, the trade creditors of an entity will become beneficial owners, if the management is not successful in maintaining the wealth of the entity at a level sufficient to meet the creditors' original contractual claims.

Accounting Income The concept of income as an increase in wealth has been abandoned for accounting purposes in recent years in favour of a concept of income realization and a notion about matching costs and revenues. 1 The development of the realization and matching concepts appears to be the result of the increasing difficulty of measuring wealth, the increasing financial importance of income as opposed to financial position and the fact that asset valuations usually have rela1See for example Changing Concepts of Business Income, the report of the study group on business income sponsored by the American Institute of Certified Public Accountants and the Rockefeller Foundation (New York: Macmillan 1952), sec. 3.

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tively less effect on statements of income than on statements of financial position. In some cases the application of the realization and matching concepts produces estimates of income not substantially different from the corresponding increases in wealth. When it does not, however, the validity of the practice is questionable, since the notion of income as an increase in wealth is virtually universally held. Indeed a review of accounting literature indicates that the realization and matching concepts were only devised as a means of approximating increases in wealth. Unfortunately in current accounting practice they have tended to become accepted for their own sakes, regardless of their measure of wealth income. Realization Concept

The essence of the realization concept is that no increase in wealth takes place, either in the form of business operating income or in the form of capital gains, without the sale of an asset for cash or for a legally enforceable claim for cash. It is supported on grounds of conservatism; income should not be taken up in the accounts unless there is objective, verifiable evidence to show that it has been gained. In fact, however, this argument is not sufficient to support the realization concept unless one pushes it to the length that no evidence short of a completed sale is sufficiently objective and verifiable, an extreme position indeed. Presumably the reason for being conservative in accounting is to protect the users of accounting data from overstatements of income and asset valuations regardless of the objections to undervaluations. Their primary source of protection is the independent check of management opinions by outside auditors, however, not the use of figures which may represent anything less but not more than current values. A more likely reason for applying the realization concept

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is that it makes record-keeping and auditing much easier. All exchanges must be recorded in accounting in order to make the double-entry book-keeping technique work. Almost all exchanges take place at clearly and easily established exchange prices. On the other hand, no change in value which is not reflected in an exchange transaction needs to be recorded in order to make the double-entry system work, although recording it would not prevent the system from working. Changes in value which are not reflected in an exchange transaction are not quite so easy to establish, although it is usually far from impossible to estimate them with reasonable accuracy. The realization concept represents an attempt to measure increases in economic value by reference to legal notions of change in ownership, but the two are not the same. It produces reasonable estimates of income only where no significant changes take place in asset market values. Its application omits entirely the effect of changes in the value of long-term assets such as plant. Furthermore, it ignores the extent to which intangibles attach to and increase the value of inventories above cost between the time the raw productive factors are acquired and the time the finished product is sold. When there are significant fluctuations in the volume of inventories, as in some types of construction work, this produces a ludicrous result. Consider an example. Assume that a house-building contractor started business on January 1 of last year. During the year he built ten houses having a selling price of $25,000 each, at a cost of $20,000 each. In addition, he incurred selling and administrative expenses of $30,000 during the year. Assume that he sold one of the houses in December of last year and the other nine on January 1 of this year and then went out of business. Applying the realization concept, his records would be as in Table IV. They are manifestly ridiculous. All the work was done and presumably virtually all the value added, or to

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put it another way virtually all the intangibles were translated into tangible value last year, while all that was done this year was to sign the sale contracts for nine of the ten houses. TABLE IV Income for last year Sales Cost of sales

$25,000 20,000 5,000 30,000 $25,000

Expenses Loss Inventory at the end of last year, 9 Sales Cost of sales Profit

X

$20,000

Income for this year 9 X $25,000 9 X $20,000

= $180,000. $225,000 180,000 $ 45,000

There would be no inventory on band at the end of this year.

In addition to producing unreasonable estimates of income under some circumstances, the realization concept nearly always produces understatements of wealth in a period of rising prices and successful operations, since neither increases in the market value of long-term assets such as plant nor the extent to which intangibles attach to inventories during the production and sale processes are taken into account in valuing assets. In the example given above, the value of the inventory of nine houses at the end of last year was much more nearly 9 X $25,000, or $225,000 than 9 X $20,000, or $180,000. The realization concept is not universally applied in current accounting practice. Exceptions are made to varying degrees by different accountants. Most accountants probably support the practice of taking up profits on instalment sales under conditional sales contracts immediately, even

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though legal title does not pass until the last payment is made. Many accountants support the practice of taking up profits on long-term contracts proportionately over the lifetime of those contracts on the basis of degree of completion. Some accountants support the practice of taking up profits on barter exchanges where no tranfer of cash is involved. And a few accountants support the practice of taking up increases in the value of individual assets in some circumstances even when there has been no sale or exchange of any sort nor any immediate prospect of either. In general, however, the position of the accounting profession is that no gain takes place until it is "realized". It is held that to reflect "appreciation" or to take up in the accounts asset value not purchased is to take up "future income" which may never become "actual income". In this connection the notion is sometimes advanced that the gain from an increase in the current market value of long-term assets such as plant is obtained in the following years in which that plant is used, in the form of lower than current market charges to operations. Leaving aside entirely the basic illogic of spreading a change in current market values over several future years, this notion cannot even be applied to the location value of land, since no charges are made against operations in respect of it. Sometimes the "going concern concept" is advanced in support of this idea but the going concern concept simply means that one does not value assets at distress sale prices, not that one must ignore changes in market values. Matching Concept

The matching concept is the idea that costs should be taken into account in measuring income only as the revenues they

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were incurred to produce are "realized". It is an essential companion to the realization concept. If income were measured simply by reflecting the effect on beneficial ownership of all changes in the values of assets and equities other than ownership, there would be no need to worry about matching costs with revenues, but when one takes up revenues only when they are "realized", one must develop a corresponding notion of cost "realization". In addition to being based on an artificial concept of realization, the cost-matching notion suffers from considerable confusion in its application. This is particularly evident in value amortization procedures for long-term assets. These procedures are nearly always mathematical abstractions. Instead of reflecting the extent to which an asset has declined in exchange value, they frequently tend to reflect some notion of intrinsic value which is different from measurable exchange value, and some overriding sense of fairness, which requires that equal physical services should have assigned to them equal costs, regardless of what happens to their market values. The straight-line method is a popular method for calculating depreciation, for example, and the declining-charge method is often supported on the grounds that it tends to equalize the total of depreciation and repair and maintenance charges applicable to an asset each year of its useful life. But equal physical services do not necessarily involve equal costs. The cost of using any asset for a period of time is the extent to which its exchange value declines during that time. Thus the cost of holding and using an asset during the year in which it suddenly becomes obsolete is much greater than the cost of holding and using it to the same extent in the preceding year. The confusion surrounding the matching notion is clearly exemplified in the treatments accorded to goodwill. One

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school of thought holds that goodwill should be written off against income only when it is apparent that there has been a decline in its value-that is, when profits are low. Another school holds that goodwill should be amortized over the periods which are thought to be benefited by it, regardless of the extent of its continuing value-that is, when profits are high. A further illustration of confused thinking in the application of the matching concept is the development of the notion of "deferred credits", which are to be taken into account in measuring income but not in measuring financial position. For example, it is held by many accountants that the matching concept requires the tax expense applicable to the current year to be estimated by reference to current accounting income, not taxable income, when taxable income is less than accounting income but will be correspondingly more in later years. Some of these same accountants, however, hold that the current provision for tax liability need be sufficient only to cover taxes actually levied. 2 In other words, the matching concept is not carried through consistently in the balance sheet. Income is determined by applying the matching concept, while financial position is determined by applying legal concepts. The two, of course, are not the same, with the result that statements of income and financial position will not balance unless a specific balancing figure, described as a deferred credit, is inserted. It is held that this deferred credit has nothing to do with assets, liabilities, or ownership, being required only for the measurement of income. This is an impossibility, because it means that equities are not equal to assets in an accounting entity, whereas assets and equities represent the same thing, simply stated in two different ways. 2See Auditing and Accounting Practices Bulletin no. 10, issued by the Committee on Accounting and Auditing Research of the Canadian Institute of Chartered Accountants, 1954.

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Intangibles in Income A more fundamental weakness in the current accounting concept of income is that wealth is not defined consistently. Sometimes intangibles are included in statements of wealth, or balance sheets, and sometimes they are not. If wealth is defined to include intangibles the translation of existing intangibles into tangible form does not constitute income, because it does not represent an increase in total wealth. Since an increase in the tangible wealth of an entity can only come about through additional investment or through the translation of intangibles into tangibles, this means that no increase in tangible wealth constitutes income. Income then only arises through an increase in intangible wealth. Furthermore, in order to constitute income, an increase in intangible wealth must be acquired either freely or at a cost which is less than its value, since otherwise it does not represent an increase in total wealth. If intangibles are excluded from the definition of wealth, the acquisition of new intangibles is not income because it is not an increase in wealth, but the translation of intangibles into tangibles then is income, because it is an increase in wealth. It is generally agreed by accountants, that when goodwill, or intangible value in general, is acquired in conjunction with the purchase of a group of tangible assets, it should not be written off immediately upon acquisition, except under certain special circumstances; instead it should be included as part of the wealth of the entity. 3 At the same time it is held by virtually all accountants that goodwill should never be recorded as an asset at any other time, nor should any recorded value of goodwill ever be increased. 8See Accounting Research Bulletin no. 43 (1953), chap. 5 and no. 48 (1957), issued by the Committee on Accounting Procedure of the American Institute of Certified Public Accountants.

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Furthermore, it is generally agreed that it is not proper to reinstate goodwill in a statement of wealth once it has been written off, regardless of whether the original write-off was justified in view of the acquisition and continuing value of intangibles attaching to the entity. On the other hand, those specifically distinguished intangibles that are reflected in expenditures for the acquisition or protection of legal rights such as patents, for organization, financing and development and for research and advertising should be set up as assets in accordance with generally accepted accounting practice, whenever they are believed to have resulted in the acquisition of some lasting value or to have made some contribution to earning income in the future. ( Oddly enough, contrary to this general position, it is not apparently accepted practice to record legal rights as assets when they are employed to prevent competitors from doing certain things which are not being done by the entity in question. To be more specific, a patent held by an entity to prevent anyone from producing a product which would compete with its own would not normally be considered an asset, unless the competing product itself was being produced by the entity.) These practices are basically illogical and inconsistent. They indicate to users of accounting data that intangibles are a form of wealth for accounting purposes, that a few forms of intangible value can be and are acquired during the operation of an entity, but that most intangible value is created only when tangible assets are transferred from one group of equity-holders to another. Accounting statements of wealth could be prepared for two identical businesses showing widely different amounts of total wealth as a result of including goodwill for one but not for the other. Accounting statements of wealth for the same business are not comparable when goodwill is included in some years but not in others.

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Those intangibles that are set up initially as assets can be divided into two categories for the purpose of subsequently writing them off, those that appear to have a limited term of existence and those that appear to have an unlimited term of existence. 4 The treatment advocated for the former is consistent with that generally applied to depreciable assets, that is, they should be written off by systematic charges against income over the period benefited, except that where a significant error is discovered in the rate of writeoff, an adjustment may be made to surplus. In practice the period benefited by the competitive advantage represented by a legal right, such as a patent, is usually considered to be no longer than the lifetime of the right itself, or of a similar one which has replaced it, so that although the advantage itself may continue beyond the legal lifetime of the right, no asset balance is carried forward beyond that time either as goodwill or in any other form. The intangibles included in the unlimited term of existence category can be divided into two further types, those that will have some value for a very long but unknown time into the future, such as organization costs, and those that may be relatively short-lived but that are constantly being replaced by others, such as goodwill generally. Little general agreement has been achieved about the accounting treatment of intangibles having unlimited terms of existence beyond the idea that whatever it is, it should be conservative. Some accountants hold that no amounts should be written off unless and until it becomes evident that the intangibles have declined in value, pointing out that the value of goodwill generally, for example, may be maintained by current expenditures. Other accountants advocate writing them off over a relatively short space of time after acquisition, on the grounds that the original value is being 4See Accounting Research Bulletin no. 43, chap. 5.

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used up even though it may be being replaced currently by new value. They hold that new acquisitions should be segregated and treated individually. On grounds of conservatism, however, new acquisitions are seldom set up as assets, except occasionally where they are the result of such things as substantial research expenditures. Furthermore, amounts written off one intangible category are never transferred to another. The effect is that the loss of intangibles is reflected as a decrease in wealth, but the acquisition of intangibles is not reflected as an increase in wealth. 11 In general, current accounting practices suggest a desire to dispose of intangibles in such ways that they will have as little effect on financial reporting as possible. Small-cost increments are written off at acquisition. Large-cost increments are set up as assets and amortized gradually to avoid significant charges in respect of them in any income period. This reflects a tacit general appreciation of the fact that intangible practices are inconsistent and that financial reports are also inconsistent to the extent that they include intangibles. Current practices also reflect financial management considerations to a large extent rather than measurement considerations. Intangible write-offs tend to be made during periods when profits are high and shareholders will "Both practices are approved in ibid., although they are mutually contradictory. The bulletin states "When it becomes reasonably evident that the term of existence of [an intangible having an unlimited term of existence] has become limited ... , its cost should be amortized by systematic charges in the income statement over the estimated remaining period of usefulness." The implication is clear that it need not be written off otherwise. The bulletin also states "When a corporation decides that [an intangible having an unlimited term of existence] may not continue to have value during the entire life of the enterprise it may amortize the cost of such intangible by systematic charges against income despite the fact that there are no present indications of limited existence or loss of value ... , and despite the fact that expenditures are being made to maintain its value." In other words, it may be written off if one so chooses.

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not be upset or inconvenienced by them and they tend to be deferred during periods of small profits or of losses. The attempt is sometimes made to justify current accounting treatments of intangibles on the grounds that accountants are primarily interested in measuring return on investment and therefore should not record goodwill unless it has been purchased. To begin with, this ignores the fact that goodwill is purchased not only when a business as a whole is acquired but continuously throughout the operation of all businesses, by means of sales salaries, public and industrial relations expenditures, and so on; and while most individual increments to intangible value acquired in the course of operations may be insignificant in themselves, they often accumulate to very large amounts. Secondly, the extent of an investment must be measured by its current value, not by the price originally paid for it. When a man invests $1,000 of his wealth in a piece of land and the market value of that land increases to $2,000, his investment in it becomes $2,000. That is the extent to which he holds his wealth in the form of land and, in consequence, the extent to which he foregoes holding it in some other form. Similarly, when the value of intangibles increases, the extent of investment in them increases. The extent of an investment in any asset or combination of assets, tangible or intangible, is the market value of that asset or combination. The rate of return on an investment for any period of time is the increase in the market value of the investment during that period divided by the average market value of the investment during the period, and expressed as a percentage. To measure the average market value of the investment precisely, one would have to calculate the average of an infinite number of investment amounts, since the investment changes continuously and irregularly throughout the period. As a practical matter, for relatively

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short periods of time one can substitute the market value of the investment at the beginning of the period for the average market value of the investment during the period and still produce a reasonable result. But the calculation becomes less and less significant the farther back into the past one goes in order to obtain the market value of investment figure. The argument in favour of current practices described above involves the inclusion in investment of an estimate of intangible value, to the extent that such value is included at all, which is based on a transaction that happened any number of years ago. Thirdly, the investors in an entity do not remain the same and a calculation of the return on an investment in which goodwill was purchased some time in the past is of little significance to an equity-holder who did not make that investment. Finally, it is no more logical or consistent to base rate of return on investment calculations on variable definitions of wealth and income than it is to base wealth and income measurements themselves on such definitions.

Dollar Values

Wealth and income are measured in terms of the unit of currency, in this country the dollar. Unfortunately, however, the dollar is not a constant, its value in exchange changes over time just as the values in exchange of other assets do. If one wants to measure real income therefore, one must allow for this fact. It is a simple matter in principle to adjust estimates of income for dollar value changes, as long as one remembers that the dollar value of any asset changes for two reasons; first, because the value of dollars in exchange for other

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things changes; second, because the value of the other asset in exchange for other things changes. To the extent that the dollar value of a parcel of land for example, changes because of a change in the value of dollars, there is no gain to the owner of the land. To the extent that the dollar value of the land changes because of a change in the value of the land however, there is a gain to the owner. In order to estimate real income, one has only to eliminate the effect of changes in the value of the dollar. To illustrate, if someone has an equity in assets of $8,100 at the beginning of the year and $10,000 at the end of the year and if the value of the dollar itself declines by 10 per cent during the year, his real income for the year, measured in terms of year-end dollars, is $10,000 minus 100/90 X 8,100, that is, $10,000 minus 9,000, or $1,000. The practical difficulty in making such calculations is in finding a satisfactory measure of the change in the value of the dollar in exchange for other things. In order to measure dollar value changes precisely, one would have to have a general price index which took into account the dollar price changes and quantities of all goods and services being traded. For a variety of reasons it is not possible to produce such an index. On the other hand, several indices are produced which individually or in combination could be used to approximate it closely enough for all practical purposes. In current accounting practice little attempt is made to adjust estimates of income for dollar value changes and still less is made to distinguish dollar value changes from real value changes. Depreciation continues to be calculated on historical cost, which in most cases means cost determined at a significantly different price level. The last-in first-out method of determining inventory cost gives effect to price-level changes in the calculation of income to some extent but only by ignoring their effect on wealth, that is, on financial position.

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APPENDIX: INCREASE OF SOCIETY'S WEALTH In the course of the discussion of income, it was stated that an increase in the tangible wealth of an entity can come about only through additional investment or through the translation of intangibles into tangibles. In describing the nature of intangibles, it was stated that intangible wealth does not represent value for society as a whole. The question then arises, how does the wealth of society increase? It is obvious that our standard of living, in both material goods and the time to enjoy them, is improving. For all practical purposes, it can be assumed that the total quantity of matter and energy in existence does not change. What does change is the ability of society to utilize that matter and energy. Wealth is increased by the inventiveness of the human brain in finding new ways to use resources and easier ways to change their form. Given the knowledge of how to use certain things, wealth may be increased further simply by the effects of nature in changing the form of matter and energy. Several examples may be cited, the receipt on earth of solar energy, both directly and in the form of water power, the growth of fruit and nuts on trees and of wool on sheep, and the reproduction of all animal and vegetable species. The ability to acquire more goods more easily, as a result either of improvements in knowledge or of natural changes in resources, makes labour more valuable relative to goods. In the absence of conditions of imperfect competition, however, no such change in relative values can increase the wealth of an accounting entity. Any change in the value of the entity's product, resulting from changes in the relative values of the factors of production, is offset by changes in the amounts that must be paid for those factors. The application of human labour to other resources in order to appropriate them or to change their form does not increase the measurable wealth of society. The amount by which the value of the other resources is increased is equal to the value of the labour expended. By contrast, nothing measurable is given up in return for an idea or for the fruits of nature. The wealth available to later generations is, of course, increased to the extent that their predecessors forego the consumption of that wealth for which they traded their labour and that which was created by nature during their lifetime and still endures. On the other hand, the wealth available to later generations is diminished to the extent that their predecessors consume, as in the burning of coal and oil, wealth for which they did not trade their labour and which was not created by nature during their lifetime. The value of increases in knowledge in producing increased wealth in other forms is obtained as that knowledge is applied.

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The value of some ideas is limited by the fact that they are superseded by better ideas. The value of many ideas, however, like the invention of the wheel, is infinite. Those who produce new ideas seldom get a significant proportion of the value of their ideas. Society provides some reward by creating or enforcing conditions of imperfect competition in their favour, such as patents and copyrights, but most of the value created by innovators is appropriated to the welfare of society as a whole.

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Entity Wealth The first step in measuring the wealth and increase in wealth of an entity is to decide what items of wealth should be considered part of the entity. This is one of the fundamental problems of accounting, at least of business accounting. A business is not always a legal embodiment. A single proprietorship, for example, has no legal status separate from the proprietor; it does not consist of all the wealth of the proprietor and usually involves some wealth that has been contributed temporarily by people other than the proprietor, such as trade creditors. If a business is not a legal entity, its wealth cannot be defined by reference to the legal concept of ownership, since it cannot own anything. Even if it could, things it did not own would sometimes be considered to be its assets. A corporation is a legal entity capable of ownership, but it does not always own all of the things described as its assets. When something is purchased

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asset on the purchase of a going concern may result from the fact that for the time being there are no competitors in the immediate vicinity. It would be difficult to conceive of this condition as a form of ownership. In order to define a business accounting entity it must first be decided which items of consumable wealth and currency should be attributed to that entity. There are two main considerations involved in this decision, control and purpose. In general, consumable wealth and currency are attributed to that business entity whose management has a greater degree of control over them than anyone else, subject only to the prior rights of the state. In many cases this greater degree of control stems from legal ownership but not always. In addition to being under common control, all items of consumable wealth and currency must be devoted to a common purpose in order to be included as part of the same accounting entity. Accounting is utilitarian; items of wealth must have some common purpose in use if their summation is to have any significance. In most cases in practice it is obvious which items are under common control and are being devoted to a common purpose. In the final analysis, however, this is a matter of judgment and cases are sometimes encountered that give rise to legitimate differences of opinion. One example is deciding which subsidiaries of certain holding companies should have their assets reflected in consolidated financial statements. Another is deciding whether the assets involved in some long-term lease contracts should be attributed to the lessee entity. The assignment of consumable wealth and currency to entities automatically determines the other items of wealth attributable to them. To the extent that secondary wealth is taken in exchange or as a substitute for consumable wealth and currency, it is wealth of the entity. To the extent that conditions of imperfect competition impinge on the use of the entity's other assets to make a profit, they also are

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entity assets. The total of the assets so determined constitutes the accounting entity. It should be noted at this point, that not all entity claims are included in statements of assets in current accounting practice. Claims in respect of which no consideration has passed, such as purchase contracts involving both delivery and payment in the future, are omitted. A complete statement of entity wealth, however, would have to include them. Description of Wealth

Intangibles, or conditions of imperfect competition, influence the exchange of all assets, whether individually or in groups. For individual assets, the effect of intangibles is a factor in the market value of those assets. For example, the effect of there being a limited number of automobile tire manufacturers is reflected in the market price of tires. Similarly, for assets in groups, the effect of intangibles on the group is a factor in the market value of the group. The market value of a whole automobile, consisting of many individual components, tires, motor parts, body parts, and so on, reflects the effect of all the conditions of competition in the car market. The effect of intangibles on groups of assets is not the same as their effect on those same assets taken separately, however. Different conditions affect assets in combination from those that affect them individually. The market price of an automobile is not the same as the total of the market prices of all its components plus the cost of combining them. The fact that there are very few car manufacturers influences the price of cars but has little effect on the price of tires in the consumer market. Since assets taken individually have an exchange value different from that of the same assets considered as a group, for the purpose of valuing assets, it must be decided what

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things are going to be considered single units. This decision will determine what portion of the value of a business is considered tangible and what portion intangible. To illustrate, if the owner of a fleet of taxis were to value his cars as so many bodies, so many motors, and so on, the total value obtained would be different from that obtained if he valued them simply as so many cars, since the market conditions affecting the price of cars are not simply the sum of the market conditions affecting car components. The difference between the two valuations applied to the tangible assets would be offset by an equal and opposite difference in the value of intangibles under the two methods of valuation, since the value of the business as a whole would be no different. It would reflect the fact that a different set of intangibles pertains to the purchase and use of motors, bodies, and the rest separately, from those pertaining to the purchase and use of whole cars for taxis. In the final analysis, the decision as to what assets will be considered single units for valuation is also an arbitrary one, and although a fair degree of uniformity in asset description exists in current accounting practice, it still creates some difficulties. For example, land and a building on it may be purchased together at a price quite different from that which would be paid for the land and building if they could be exchanged separately, when the building is a house and the land is a valuable industrial site. The conventional practice is to value land and buildings separately. In this case valuing them at market separately involves an adjustment to their purchase price and a corresponding adjustment to the intangibles of the business. Another such situation arises when parts of a machine are replaced and the replacements cost more than the comparable original parts. If the machine is to be valued as a machine, as is conventional, an adjustment must be made to the cost of the replacement parts. In this case, conditions of competition

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unfavourable to the purchaser exist in the market to the extent that he must pay more for replacement parts than for original equipment. These conditions take effect immediately on purchase of the parts and the difference in price should be written off at once. Currency and Secondary Wealth Since the value of all assets is measured in exchange for currency, the value of an entity's currency is its face amount. Foreign currencies must be translated. Occasionally foreign currency balances exist that are not readily exchangeable for domestic currency. For measurement purposes these can be regarded as secondary wealth claims for currency. All forms of secondary wealth, investment claims, uncompleted trade exchanges, security deposits, and safekeeping deposits, represent claims receivable either in other assets or in services. The other assets and services may not be collectable for a long and indefinite period of time, as in the case of corporation stocks, but ultimately they underlie the value of the secondary wealth. Claims receivable in other assets may represent beneficial ownership of the entity against which the claims exist or they may not. When they do not, their value can be established in one of two ways, either by reference to a market in which similar claims are being traded or by an assessment of their collectability in currency. The value of bonds is usually established by reference to the bond market. The value of trade accounts receivable is usually established by estimating the extent to which they will be collected. Claims receivable in assets other than currency must first be translated into currency values, by determining the value of those other assets in exchange for currency, and then assessed for collectability. When the value of claims for

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assets is determined by an assessment of their collectability, the pure interest factor is usually ignored; their value is not reduced in recognition of the fact that they will not be collected until sometime in the future. When value is established by reference to a market in similar assets, the discount is inherent in the market price. Many asset claims representing beneficial ownership can also be valued by reference to a market in which similar assets are being traded, such as the stock market. When there is no market in such claims, it is because they are all held by one or a very few investors. In these circumstances the claims should be and are usually replaced by the underlying assets in consolidated statements of wealth by the parent entities. The problem of valuing the claims then becomes one of valuing the underlying assets. For th~ minority interests, however, the problem remains one of estimating the market value of a security which has no market. In any case, the value of beneficial ownership claims can only be determined by reference to the value of the underlying assets, when there is no market in those claims. Claims for services consist of things that are currently being traded, such as insurance protection, or things whose price is determined by some authority, such as municipal services, and therefore have a readily determinable market value. Just as with claims for assets, there is always a possibility that the concern against which a claim for service exists will default on it. In a free market that possibility influences the price originally paid for a claim and if the entity against which the claim exists continues to sell claims for the same service it will continue to be reflected in their current market price. If that particular concern stops selling claims against itself, however, a change in the degree of risk of default by it will not be reflected in the market price of a similar service from other concerns. When the price of services is set by some authority, the risk of default does not

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influence the original price, but any subsequent change in the degree of that risk will affect the market value of the service remaining to be received, in the absence of continuing price control. In practice in most cases, changes in the extent of risk of default on claims for services are so slight as to be negligible and are ignored. Service Wealth There are several problems involved in measuring value in exchange which, while they may exist more generally, have particular relevance to the determination of values for those assets that are consumed in providing services. First, there is both a purchase market value and a sale market value for the assets of a business. For service assets, assets in which the concern does not normally trade, the sale market value is almost always lower than the purchase market value, for two reasons. First, a firm that does not deal in a particular kind of asset seldom has the same competitive advantage in its sale as one that does. It does not have a sales organization set up for the purpose of marketing those assets and is not usually in touch with a wide market of prospective buyers. It is not likely, therefore, that the firm can obtain as high a price for service assets as firms that are in the business of selling those assets. Secondly, a firm must incur some costs in selling an asset. When the asset is a service asset the firm will also suffer disposal losses such as removal costs, business interruption losses, and the loss of the productive location value of some assets, reflected in such things as original installation costs. These costs and losses must be deducted from the sale price of an asset to arrive at its sale value. The result is that the net return on sale to a concern that does not trade in

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certain assets is less than the purchase price from one that does. As long as a service asset is in use, its value is its purchase market value; when it is sold, its value is its sale market value. In order to understand why, one must understand the way in which a business combines productive factors. In order to produce maximum profits a firm will attempt to do the following two things. First, it will attempt to combine resources in the optimum proportions, so that the last dollar spent on each factor of production, building space, machinery, employees, and so on produces exactly the same return as the last dollar spent on every other factor. If the last dollar spent on any one factor produced more than those spent on the others, it would be to the advantage of the firm to spend more on that one and less on the others, out of a given total investment. Secondly, a firm will attempt to establish the total amount of its investment in all resources at that level at which the last dollar spent on every resource returns exactly one dollar. As long as an additional dollar of investment would return more than one dollar, taking all costs into account, it would be to the firm's advantage to go on investing. Only when an additional dollar of investment would return less than one dollar would it be to the firm's advantage to stop investing. In so far as it is possible to do so, therefore, a firm will operate with a combination of assets from which the anticipated return, or value to it in combination, from the last one of each type, and therefore from every one considered separately from the rest, is exactly equal to that asset's purchase market value. Over time, the market values of assets change in response to changes in supply and demand, and technology changes as a result of new discoveries and inventions. As a result, a firm's optimum total investment and the optimum distribution of it among different types of assets also change. If

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there were perfect mobility of resources, the firm would change its assets in response to each change in market prices and each change in technology. In fact, of course, there is not perfect mobility; it is often better to continue with a less than ideal combination of resources than it is to incur the costs necessary to overcome the lack of mobility and change the combination. For example, unless there is a substantial change in the market value of a firm's building or the technology relating to it, it is seldom worth the cost of moving to another. It is better not to dispose of an asset until such time as the cost of keeping that asset, in the form of its inappropriateness in combination with the other assets of the business, equals the cost of disposing of it, which is the difference between its purchase and sale market values. Between the time a service asset is purchased and the time it is sold, it tends to become less and less appropriate in combination with the firm's other assets, and its value in combination declines from purchase to sale market value, although at times the process may be reversed temporarily. The value of the asset itself does not decline in this way however, it is the value of the combination that declines. In other words, conditions of immobility in the use of assets pertain to businesses, not to specific assets. To the extent that conditions of imperfect competition pertain to the value of individual assets, they affect the market prices of those assets. As long as a service asset is continued in use, it continues to provide services to the business. The services become embodied in and form part of the value of the product of the business, and are sold in the form of that product. The value of an asset's services is its purchase market value, since the market value of services is reflected in the purchase market price of assets that render those services. Thus it is the purchase market and not the sale market that is

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relevant to the valuation of service assets in use. When a service asset is sold, the unfavourable conditions of competition pertaining to the sale of such assets by the particular firm attach to the specific asset and a net price is obtained for it less than its purchase market value. These conditions do not attach, however, unless and until the asset is sold. This is the essence of the going concern assumption in accounting. The analysis of the effect of immobility on the value of businesses and their assets leads to two further conclusions. First, a business entity seldom benefits to the full extent of a capital gain, for when the value of an individual asset increases, the appropriateness of the existing combination of assets usually decreases and the combination cannot be changed freely. Secondly, the total of intangibles pertaining to any business can never have a net unfavourable effect greater than the difference between the purchase and sale market values of the assets of that business, or the cost of disposing of those assets, arising out of immobility. Because different markets exist for the same items of wealth, there is not necessarily any one market price for an asset that is relevant to all businesses. Two concerns may value the same asset at market at two different amounts. As long as concerns trade in different markets, different market prices will exist for them for the same things. What constitutes the market for a firm depends on that firm. More specifically, it depends on what access to markets is enjoyed by the management of that firm. The fact that a firm may be able to purchase an asset for less than one or more of its competitors does not necessarily mean that it makes a profit to the extent of the difference immediately on purchase. Better access to markets for an asset is a condition of imperfect competition and the firm's profit will be greater than that of its competitors to the extent of the difference, but the condition does not take

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effect unless and until the asset is combined in the form of services with other productive factors so that the product can be sold. No gain is made while the asset remains in the form of an asset, unless its sale market price in that form exceeds its purchase market price plus costs of disposal. Although they are rare, circumstances are encountered in which the sale market price of a service asset as an asset exceeds its purchase market price plus costs of disposal. For example, it is possible that a construction company could build a structure for itself that could be sold on the market for a price that would more than cover purchase and disposal costs. In such a case the sale market value, that is, sales price less costs of disposal, would be the relevant one. The firm would have access to that value immediately, regardless of any conditions of competition that impinged on the use of the asset's services, and only the difference between the ultimate sale market value of the asset's services in combination with other productive factors and the sale market value of the asset itself would reflect the future effect of conditions of imperfect competition. The difference between the current sale value of the asset and the purchaseplus-disposal costs would reflect the past effect of conditions of imperfect competition and would represent an accomplished increase in wealth. It is a simple matter to measure the market value of an asset, if identical assets continue to be exchanged. The price at which identical assets are being exchanged is the market value of the asset in question at the time of the exchanges. Between exchanges of identical assets the market value can be imputed by reference to those that take place at the nearest points in time. When service assets are new, there are usually others being traded that are identical for all practical purposes. As they are used, however, they become more and more different from each other. The market values of assets that

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are unique cannot be known precisely but they can be estimated. It is not overly difficult to estimate the value of an asset if similar assets are being exchanged even though they may not be identical. This is the case with most land and with some types of used equipment, such as cars. An appraiser can estimate the market value of such assets by adjusting the prices at which similar assets are being exchanged for differences between them and the assets in question. The fewer the differences, the fewer adjustments are necessary and the more accurate the estimates may be expected to be. When similar assets are not being traded the problem of estimating market value is more difficult but not insoluble. The value of a service asset is the value of the services it will render. As long as other assets are being exchanged which provide the same services, therefore, the value of an asset can be estimated by reference to their exchange prices, even though the assets may not be similar physically. For example, buildings of a certain type of construction may no longer be built because it has been found more economical to build them some other way. Nevertheless, the market value of a building of the former construction could be estimated by reference to the current cost of acquiring a building of the new construction that would provide the same services. There are three possible sources of difficulty in attempting to estimate the value of assets that are not being traded by reference to the value of assets that are being traded and that provide similar services. The first is to know what services are being provided by an asset; the second is to know to what extent those services remain to be used up; the third is to know the degree of similarity of those services to the services of other assets that are being traded. These, of course, are the problems of determining depreciation. Unfortunately little effort is made in current accounting

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practice to determine accurately the remaining value of assets in use. Most depreciation estimates are simple mathematical amortizations of original cost. Some assets provide more than one kind of service simultaneously. For example, automobiles provide the service of being fashionable as well as the service of transportation. Their value declines as the fashion service is used up as well as declining as the transportation service is used up. The fact that the fashion service is used up rapidly accounts for the rapid loss in the exchange value of a car during the early part of its life. In order to value an asset by reference to the services it provides, therefore, it is necessary to determine what those services are. Fortunately the services provided by most business assets are fairly easily determinable and subject to reasonable estimation by reference to the value of other assets which provide the same or similar services. It is worth noting that where an asset provides more than one service, it is the market as a whole that determines the relative values of the various services, not the individual owners. In the case of the automobile for example, the market may decide that 25 per cent of its value consists of style services and 7 5 per cent consists of transportation services. An individual purchaser may not feel that the style is worth anything but may attribute the entire price of the car to the value of the transportation services he anticipates receiving. Nevertheless once the style services have been used up, the market value of the car will have declined 25 per cent and depreciation will have been suffered to that extent, regardless of whether the individual owner attributes any value to style. What individuals think about value is subjective, only markets produce objective valuations, in the form of values in exchange. In estimating the value of an asset by reference to the value of the services it renders, no allowance need be made for the obsolescence that may in future but has not yet

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occurred. The present value of a service asset is the present value of the services it has to render. If those services become less valuable in the future, that is a loss of the future, not of the present. The extent to which an asset has become obsolete up to the present time is reflected in the current market value of the services it has to render. Improvements in technology make it cheaper to obtain the same services from another asset. In valuing an asset by reference to the services it renders rather than by reference to the cost of replacing it in its physical form, this factor is automatically taken into account. It is difficult to conceive of any productive service that has ever ceased to be produced or for which a reasonably similar service has not been substituted. Certainly many forms of assets cease to be produced regularly and some services may even cease to be provided to ultimate consumers. But it must indeed be a rarity when a service that has been found useful in production loses its usefulness to the extent that it or something similar to it is no longer economical to produce. Gaslights, for example, may not be economical to produce, but the lighting service they provided still is, in the form of electric lights. Horse-drawn cartage vans may no longer be economical to produce, but the transportation service they provided still is, in the form of automotive trucks. The only time a service asset cannot be valued by reference to the sale price of assets rendering similar services is when assets are no longer being produced for that purpose. The only reason for not producing assets which render certain services is that the cost of the services would be greater than anyone would be willing to pay. If such a situation should exist, the value of the asset in question would be indeterminate: the existence of a market value depends upon the existence of a market. If there were no market for such assets or their services, the value of the

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asset would be something less than the current cost of replacing its services but how much less could not be known. There are service assets such as sugar-refining machines that are highly specialized in the services they perform and therefore are not being produced constantly in the way that lathes and drill presses are, but which remain economical to produce whenever the occasion arises. For these assets the most recent exchange price of an asset providing the same or similar services, adjusted for any changes in the market conditions of supply and demand for such assets, should produce a reasonable estimate of market value. It is not reasonable to impute the market value of service assets by reference to the sale market value of their services in the form of a concern's completed product. The selling price of a completed product is made up of the purchase value of all the goods and services included in it plus the value of all the conditions of imperfect competition that attach to it during production and sale. The value of the conditions can be derived by deducting the purchase value of all the goods and services from the sale value of the completed product, but it cannot be estimated with any reasonable degree of accuracy in any other way. Thus the value of an asset's services cannot be approximated by deducting the purchase value of the other goods and services plus the value of the competitive conditions from the sale value of a completed product. Sale Wealth

The market value of wealth that is consumed physically by a business, in the sense of being sold or used up in production for sale, is usually in the range between current purchase replacement or reproduction cost and current sale price less additional costs to complete and sell. Inventories

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I 71

are acquired by purchasing raw materials and by combining them under conditions of imperfect competition with labour and asset services. At the time that the material, labour, and asset service components are acquired, their market value is their purchase price. At the time of sale their market value is the sale price of the product. The difference between their purchase price and their sale price is the value of the conditions of imperfect competition in which the raw materials, labour, and asset services were combined. That value attaches to the inventories in the course of their production and sale. Purchase price plus intangibles equals sale price. Competitive conditions may be unfavourable to a business as well as favourable and in any business one must expect to find some of both. If the favourable conditions outweigh the unfavourable, inventories will increase in value in production; if the unfavourable outweigh the favourable, inventories will decrease in value in production. Between purchase and sale one would normally expect that the market value of inventories would be somewhere between purchase reproduction price and sale price less additional costs of completion and sale, being greater than purchase price and less than sale price if competitive conditions were on balance favourable, and greater than sale price and less than purchase price if they were on balance unfavourable. It is possible, however, that the market value of inventories could fall outside that range. If conditions were generally unfavourable in the early stages of production and salefor example, in the procurement of raw materials, labour, and asset services-but generally favourable in the later stages-for example, in favourable consumer attitudesthe market value of inventories midway through the combining process might fall below the purchase reproduction price even though that were less than the sale price less additional costs to complete and sell.

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Unfortunately for measurement purposes, it is not possible to know the extent to which the value of things acquired changes in stages of the combining process without knowing what all the conditions of imperfect competition are and at what points in the combining process they take effect, and these things cannot be known in the present state of human knowledge. Thus it is not possible to measure precisely the market value of inventories between purchase and sale, where no market exists for them in that form. It is often possible to estimate that value, however. For example, the market value of newly acquired raw materials to which little had been done other than to place them in stock would not be likely to differ substantially from their current purchase price, since it is not likely that any significant condition of imperfect competition could have attached to them up to that time. Similarly the market value of something being made to order for a fixed sale price and almost completed would not be likely to differ substantially from the sale price less completion costs, since it is probable that all of the significant conditions of imperfect competition would have attached to it by then. In general, whenever the uncertainties faced by the management in operating a business are not great, the value of inventories can be approximated by reference to the fact that maximum profits are produced when the last dollar spent on each factor of production produces the same return as the last dollar spent on every other factor. To the extent that they are able to assess the profit producing potential of each factor, the management of a business will purchase it ·relative to other factors in proportion to that potential. For example, if bigger profits can be made by spending more on sales effort than on manufacturing effort, then more will be spent on sales effort. The extent to which the value of an item of inventory has increased from purchase price towards sale price, therefore, is approxi-

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mately the same proportion of the difference between the two as the proportion of the total material conversion and selling costs of that item already spent on it. To illustrate, assume that the data in Table V pertains to a given business. TABLE V Sale price of product Raw material cost Material conversion cost Selling cost Total conversion and selling cost Total cost of product Profit per unit of product

$2

5

$11

3 8

Inventories on hand Raw materials Work in process, including all necessary raw materials, and on the average half converted Finished goods, on the average halfway between the end of conversion and ultimate sale

10

TT 15,000 units 20,000 10,000

Since material conversion cost is %of the total conversion and selling cost incurred, approximately %of the total profit of $1, or 62.5¢ can be assumed to be attributable to conversion effort. Similarly, approximately¾ of the profit of $1, or 37.5¢, can be assumed to be attributable to selling effort. The value of the inventories can be estimated as shown in Table VI. If, because of inventory fluctuations, the assumptions that work in process is on the average half converted and finished goods are half sold are not reasonable, fractions other than a half must be used in calculating the appropriate cost and profit factors. If sales are made before production, selling cost and selling profit must be taken up before production. This method of approximating inventory values relies on two assumptions. One is that the proportions of total

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TABLE VI Raw materials, 15,000 units at $2.00

$30,000

Work in process 40,000 Raw material cost, 20,000 units at $2.00 Conversion cost, 20,000 units at half the total conversion 50,000 cost per unit of $5.00 Conversion profit, 20,000 units at half the total 6,250 conversion profit per unit of 62.5 ¢ $96,250 Total value Finished goods $20,000 Raw material cost, 10,000 units at $2.00 50,000 Conversion cost, 10,000 units at $5.00 6,250 Conversion profit, 10,000 units at 62.5¢ Selling cost, 10,000 units at half the total selling cost 15,000 per unit of $3.00 Selling profit, 10,000 units at half the total selling profit 1,875 per unit of 37.5¢ $93,125 Total value

cost incurred in conversion and selling respectively are not significantly different from those that would be incurred if there were perfect mobility of resources. If they are, as they might be in industries in which heavy capital investment is involved, the presumption that costs are incurred in proportion to their profit potentials is not entirely justified. The other assumption is that the management is able to determine, at least approximately, the relative profit potentials of different productive factors. When the results of expenditures are uncertain, as in some cases of new product development and promotion, the value of the product cannot necessarily be assumed to increase in the same proportions as the various kinds of cost are incurred. Some natural resources present a particular problem in inventory valuation because of the degree of uncertainty involved in their development. As a result of imperfect knowledge about the extent of some natural resources, their

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value may increase immensely in the early stages of development, after very little expenditure has been made on them, and relatively little in later stages of production, although much more is expended on them. For example, a mining property may increase in value from practically nothing to several million dollars as a result of a few thousand dollars worth of exploration and development work. The value of the ore will increase by very little more than the cost of extracting it, although that cost may be substantial. A different approach must be taken to the valuation of this type of asset from that described for processed product inventories. Fortunately for measurement purposes, there is usually a market for resource assets at various stages of their development. For example, there is a market for unproved mining claims, for the raw ore of those that are proved commercially valuable, and for the refined metals. By reference to these market values it is usually possible to impute the value of a natural resource at different stages of its development within a reasonable tolerance. Intangibles

Intangibles cannot be valued with any reasonable degree of accuracy. When a specific asset is not being exchanged, its value can only be imputed by reference to the prices at which similar assets, or those providing similar services, are exchanged. The intangible value pertaining to a business is the effect of thousands of conditions of imperfect competition in a unique combination. There is, therefore, nothing similar for comparison. Even the degree of their similarity to another set of conditions, remote as it might be, cannot be determined. Some conditions might be similar to those of other businesses but there would always be

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many that were not, and the latter might be the more important. Even when a particular intangible or set of intangibles is sold, the exchange price does not necessarily reflect its value in exchange, except momentarily. The value of intangibles is the value of their profit-making potential. But the profit-making services available from intangibles cannot be estimated with any reasonable accuracy. Neither their effective lifetimes as economic factors nor the extent to which they will be exploited during those lifetimes can be known. By contrast, the services to be received from tangible assets usually can be estimated reasonably, so that their exchange prices usually reflect fairly accurately the exchange value of their available services. Lack of knowledge about the future services available from assets is itseH a condition of imperfect competition. Because of it, more or less than the market value of the services of assets is paid for them, resulting in losses or gains on the transactions. An offer to purchase the assets of a business is even less likely to reflect the value of intangibles than a completed exchange. The offeror may want to acquire them for a purpose quite different from that for which they are currently being used, such as to eliminate competition. The offer may be for something less than all the assets of the business, which would mean that not all the intangible factors would be included. And unless a transfer of any asset actually takes place, its value is not reflected by the offer price, even momentarily. The cost of creating conditions of imperfect competition is seldom an indication of their value, even at the time they are created. Many valuable conditions are created entirely independently of the firm they affect and involve no cost to it. The extent to which the intangible value of a business has been created in this way cannot be known. When a firm

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creates intangibles, their cost may be much less than their value; or the cost to a firm to create intangibles may be much more than their value, owing to the lack of knowledge about their available future services noted above. Even if cost were relevant, it would not be possible to determine the cost of creating those conditions that are built up gradually over long periods of time: for example, favourable customer attitudes created by the efforts of salesmen, service policies, and consistent quality of product. In current accounting practice the value assigned to intangibles on the purchase of a business frequently does not even measure their cost correctly. It is arrived at by deducting the values assigned to tangible assets from the purchase price of the business as a whole. Errors and misstatements are often made in the valuation of the tangible assets, for example, by recording them at their cost to the previous owners instead of their current market value, and the price of the business as a whole is sometimes mis-stated as, for example, when the purchase is made for a non-cash consideration such as shares in a company, and the value assigned to that consideration is something other than its current market value. When the net effect of intangibles is unfavourable, it is often assigned to tangible assets to avoid showing a negative figure under the heading of assets. Since the net unfavourable effect of intangibles cannot be greater than the costs and losses involved in disposing of all of a firm's assets, the assignment of an unfavourable amount of intangibles to the valuation of tangible assets amounts to reducing those valuations by part of the cost of disposing of the tangible assets, in spite of the fact that there may be no intention of disposing of them. Even when the net effect of intangibles is favourable, it is sometimes assigned to tangible assets, rather than shown separately, because tangible assets appear more substantial. Finally, part of what is paid for a business and assigned to intangibles is sometimes

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really a hidden cost of management. The management of one concern may pay more for another than it believes the other's assets, tangible and intangible, are worth, in order to gain for itself a non-economic satisfaction of eliminating a competitor, or greater economic power, or larger management fees, or more opportunities to manipulate company assets for personal gain, and so on. Businesses

The value of a business as a whole cannot be determined any more readily than the value of its intangibles. In some accounting texts it is implied that the value of a business can be estimated by projecting accounting estimates of past earnings into the future for a certain period of years and then discounting those future figures to the present at the "normal rate of return" on investment for the industry. To begin with, it is the future not the past that is significant in the valuation of a business. If a business cannot earn income in the future, it has little value, regardless of its record of past earnings. The past is relevant only to the extent that it gives some indication of what may be expected in the future. Since profits arise only out of conditions of imperfect competition, the relevant area for investigation in valuing a business consists of the economic conditions in which that business will compete. Secondly, past performance is gauged by reference to historical accounting measures of income. In current accounting practice the measures do not include all of the relevant figures for the wealth and income of a business. To the extent that they do not, they are misleading. Thirdly, the notion of a "normal rate of return" for an industry is an artificial one. The only rate of interest in-

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volved in discounting future wealth to the present is the pure interest rate. This rate is the same for all investments, since it is not affected by risk. The difference between the pure interest rate and the so-called normal rate of return for an industry arises from the inability to forecast the future. One can never be certain what the future wealth of a business will be; all business investment is to some extent a gamble. Since it is a gamble, business investors want odds. The greater the likelihood that forecast wealth will not be realized, the less they are willing to pay for a chance for it. The greater the likelihood that forecast wealth will be realized, the more they are willing to pay for a chance for it. And if they could be certain what the future wealth of a business would be, they would be willing to trade their present wealth for that future wealth at a rate of discount determined only by their preference for present over future wealth. It is true that some industries by the nature of their operations involve a greater risk of loss of invested wealth than others, and it might be possible to approximate statistically for any given industry the rate of return necessary in the successful firms to compensate for the losses suffered by the unsuccessful firms. In fact, however, the average actual rate of return on investment in some industries is very different from that which would be produced statistically. People are attracted to high odds even though those odds may not be as high as they should be in view of the risk involved. The result is that in some industries, such as mining, the average actual rate of return may be negative. Finally, attributing the income to be gained over a certain number of future years to the present value of a business is basically illogical. Future income is a future gain of wealth. No future gain can be attributed to present value. Wealth cannot come into existence in the future and

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also exist in the present. The notion that future income is present value is based on the application of two different concepts of wealth and income simultaneously. On the one hand wealth is defined to include intangibles, and on the other income, or an increase in wealth, is defined to be the translation of intangibles into tangibles. Existing intangible wealth becomes future tangible wealth, but existing intangible wealth does not include future intangible wealth. Existing conditions of imperfect competition are not the source of all future conditions of imperfect competition. Even if one defined income as the translation of intangibles into tangible wealth, it would not be sound to regard all income to be gained within a certain period as being attributable to existing intangibles. At least some of the tangibles gained in every future year will not be attributable to present intangibles, and on the other hand some of the tangibles to be gained in years an extremely long time into the future may be attributable to present intangibles. The value of a whole business at any time includes its intangible as well as its tangible wealth; the whole is equal to the sum of the parts. The same thing is true of a business as is true of any other combination of assets. The value of the business or combination is not the same as the total of the values of all its components taken separately, unless one includes all the conditions of competition which impinge on the combination. Thus, if one assigns values to the tangible assets only, or to the tangible assets and some but not all of the intangibles, the total value so obtained will be different from the value of the business as a whole, to the extent that intangibles have been omitted. The problem of valuing intangibles remains. The market price of shares in a business is not a satisfactory measure of the value of that business. The price paid for a share in a business, or for a whole business for that matter, only reflects its value at the instant of exchange.

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Inherent in all share prices are estimates of the firms' intangible wealth and as already shown, such wealth cannot be estimated satisfactorily. The fact that share prices may be established by the judgment of large numbers of people does not necessarily mean that the implicit estimates of intangible value are any better. Furthermore, individual share prices are influenced by factors other than the value of the business, by dividend policies, by attempts to gain income by other means than through business ownership such as through directors' fees, by stock manipulations, by inadequate financial data and so on, so that they are not necessarily even an accurate reflection of what would be paid for the business as a whole.

6 PRESCRIPTION

General Requirements

Accounting will be at its maximum utility only if accountants do not attempt what is impossible, do attempt as much as is possible, and make clear the significance of what they do. Not attempting the impossible entails not trying to measure intangibles; attempting as much as is possible means estimating the market values of tangibles and adjusting estimates of income for changes in the dollar unit of measurement; and making clear the significance of what is done means describing separately in financial statements those things that have been determined absolutely, those things that are estimates, and those things whose value cannot reasonably be estimated.

Treatment of Intangibles Since intangibles are not measurable, no accounting statement purporting to be a measure of wealth should include them as assets any more than it should include such things as good health. On the other hand, tangible wealth is sometimes exchanged consciously and deliberately for in-

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tangible wealth and if the double-entry book-keeping system is to work, these exchanges must be recorded. Such in-

tangibles could be written off against income or surplus immediately on purchase, as in fact many of them are. Writing off small amounts does not create any serious problems. But occasionally very large amounts are expended for intangibles which are thought to have continuing value: for example, goodwill purchased along with all the other assets of a business, or large research expenditures. To write these large amounts off immediately and thereby imply that they had no continuing value would be to suggest that the management of the entity had made very unwise or improper expenditures. The problem is how to reflect accountability by continuing to record intangible purchases, while at the same time excluding intangibles from the asset category for measurement purposes. The solution to this problem is to show intangible expenditures, to the extent that they have not been written off, as deductions from ownership equity instead of as assets in statements of :financial position, or balance sheets, making such reports statements of tangible wealth. This practice is already commonly applied by bankers in assessing the credit worthiness of prospective borrowers. More specifically the following procedures are recommended, based on the adoption of the current operating concept of income, and assuming the preparation of corporate statements. All intangible expenditures, whether for goodwill in the purchase of a going concern or for competitive advantages to a business in the course of its normal operations, should be written off against revenues in the period in which they are made. Income is then defined as the increase in ownership equity in tangible assets, allowing for the addition or withdrawal of further investment. When expenditures of a significantly large and unusual nature are made to acquire

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intangibles which it is believed will have a continuing value, the amounts may be added back to the income figure as "current unamortized expenditures for competitive advantage," the term intangibles not being sufficiently descriptive, in order to arrive at the balance transferred to earned surplus. "Accumulated unamortized expenditures for competitive advantage" should be shown in the statement of financial position as a deduction from earned surplus, or if surplus alone is not sufficient, from common share capital and surplus together, in order to arrive at a figure for "ownership equity in tangible assets." If there is not sufficient common shareholders' equity for this purpose, the accumulated unamortized expenditures should be shown as a deduction from the common plus preferred shareholders' equity and if this is not sufficient, from the creditors' equities as well. In short, accumulated unamortized expenditures for intangibles should be deducted from as many forms of equity as are necessary to cover them, in the order in which those equities are available to meet losses of entity wealth. There is one exception that should be made to the method of disclosure just described and that is when a form of surplus other than earned surplus arises simultaneously with the purchase of the intangibles, for example, when a premium is recorded on shares issued for the purchase of assets including goodwill. In this case the unamortized expenditure for competitive advantage should be applied first against the surplus with which it arose. In other words the unamortized expenditures should be applied first against that form of surplus out of which their acquisition was financed, and if financed out of invested capital, first against earned surplus. Accumulated unamortized expenditures for competitive advantage should be written off directly against that form of surplus against which they are first applied in financial

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statement disclosure. If the balance of that surplus is not sufficient for the required write off, the difference may be written off against other forms of surplus. They should never be charged against income, since their entry and amortization in the financial statements has nothing whatever to do with the measurement income defined as an increase in tangible wealth. The current unamortized expenditures added to income do not represent an adjustment to the estimate of income. Their inclusion in the income statement is simply for the purpose of reporting financial stewardship. No strong recommendations can be made concerning the extent to which accumulated expenditures for competitive advantage should be written off in an income period, for the same reason that they cannot be included in assets: their value is not measurable. However, it is not very important how they are written off as long as they do not enter into the calculation of wealth or income. Perhaps the most logical procedure would be to write off expenditures for competitive advantage according to the estimate of their value at the time they are made. Thus if a research expenditure is expected at the time it is made to benefit equally the following five years, it might be reasonable to write it off over those years in equal annual instalments. Whatever the method of amortization adopted, the amount written off each year should be disclosed in the financial statements, so that it can be compared with the accumulated unamortized balance, the current year's addition to that balance and the current year's income, in order to assess the wisdom of intangible expenditures and the effectiveness of management stewardship in respect of them. Where less is paid for a business than the purchase market value of its tangible assets and what is sometimes described as negative goodwill arises, it should be taken directly into income and described as a "gain of tangible

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I WEALTH, INCOME, AND INTANGIBLES

assets on acquisition of the business," or by some similar name. To the extent that a purchaser is able to obtain tangible assets for less than he would otherwise have to pay, as a result of the unfavourable effects of immobility on the seller, he increases his tangible wealth through conditions of imperfect competition; and such an increase is by definition income. Goodwill on consolidation of parent and subsidiary company accounts should be treated in the same way as the intangibles of an individual company. When the circumstances surrounding a stock interest in another company indicate that its assets are not part of the accounting entity of the stockholding business, the stocks should be included in the stockholder's balance sheet as stocks. They should be valued at market as stocks, just as all other assets should be valued in the form in which they are recorded. When the circumstances of a stockholding in another company indicate that the assets of that company are part of the stockholding entity, however, the form of those assets should be shown in consolidated statements. Once again the assets should be valued at market in the form in which they appear. The difference between the value of the stocks and the value of the underlying tangible assets, representing an estimate of intangible value, should be treated as expenditure for competitive advantage. When control over a subsidiary is gained through a gradual acquisition of stock over an extended period of time, the segregation of the stock market value into tangible and intangible factors when consolidation is eventually warranted may produce a figure applicable to competitive advantage that exceeds the amount paid for it when the stock was acquired. In this case the term "estimate of" competitive advantage is more appropriate than "expenditure for" competitive advantage. It is worth noting at this point that in current practice

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when subsidiaries are consolidated but not wholly owned by their parents, the goodwill on consolidation does not represent the full extent of the estimate of intangible value involved in the acquisition of the assets of those subsidiaries. When only eighty per cent of the stock of a subsidiary is acquired by a parent, for example, the goodwill on consolidation is calculated as the excess of the purchase price of that eighty per cent over eighty per cent of the value of the tangible assets. Thus only eighty per cent of the estimate of intangible value implicit in the acquisition of all of the subsidiary's tangible assets is included in the consolidated statements, whereas one hundred per cent of the value of the tangible assets themselves is included. This practice is not logical. If the estimate of intangible value implicit in the market value of stocks is going to be accepted for inclusion in financial statements, it should be the full amount of that estimate. The percentage ownership by a parent of its subsidiary has no bearing whatsoever on the intangibles that pertain to the operation of the combination as a single unit. Since intangibles cannot be valued adequately in a balance sheet, the possibility of disclosing their existence and importance by means of footnotes to financial statements suggests itself. In general, however, such footnotes should not be used. They would require arbitrary decisions concerning which conditions of competition were most important and should be described, decisions beyond the competence of accountants or anyone else in most cases. The users of accounting data should be left to make their own judgments about such matters on the strength of reported tangible wealth and income. It might be suggested that those intangibles that have a separate legal identity or that can be sold separately from the tangible assets of an entity, such as patents, should continue to be regarded as assets and only those that are not separately salable or legally identifiable be eliminated.

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This, however, would require the adoption of a legalistic rather than an economic point of view. From an economic standpoint there is no difference in the nature of intangibles regardless of whether they have a legal identity. In fact the same condition may or may not have legal standing in some cases at the whim of the entity's management. For example, the same competitive advantage may be obtained by patenting a new process or simply by keeping it secret. Furthermore, the effects and therefore the values of different intangibles cannot be segregated and those that are not legally identifiable or salable may be the most important. The definition of what things are wealth for measurement purposes must be applied consistently by including only those things with the same wealth characteristics. One must either include all intangibles or none. By excluding them all, one defines income consistently as the translation of intangibles into tangibles. Supplementary Considerations

There are other considerations which can be advanced in support of the treatment of intangibles described above, in addition to the fact that intangibles by their nature are not measurable. For one thing, intangibles represent wealth only in a restricted sense. They have no value in the ultimate sense of consumable services or claims for those services; they have no value except to a profit-making entity in acquiring tangible wealth. Current accounting treatments of intangibles seem to reflect an intuitive appreciation of the nature of their value. For the most part they are included in balance sheets only when there appears to be little alternative and then they are placed at the end of the list of assets. Unlike tangible assets, virtually never will they be taken into the accounts or their value written up as a result

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of discovery or appreciation or of fortuitous circumstances ( that is, in the absence of a conscious and deliberate exchange transaction), not even when their value may be demonstrable, as in the case of a tariff, and not even to the extent of one dollar. In many cases they will not be included even when purchased deliberately, as in the case of advertising. Furthermore, intangibles have value only for the beneficial owners of a profit-making entity; their only value is in producing income and only beneficial owners share in income. Other forms of wealth have value for all equityholders. Since a business entity is not defined by reference to ownership but by reference to the control and purpose in use of wealth, it is not entirely unreasonable to omit from entity assets a form of wealth which has value only for the beneficial owners of the entity. The beneficial owners are in most cases only a small minority of those who have an equity in an entity's wealth, let alone an interest in its financial condition and operations. Another factor in favour of the treatment of intangibles described above is that it eliminates the current practice of recording transfers of equities as changes in assets. The generally accepted practice is to revise the valuations attached to assets whenever a whole business changes hands, and much effort has been expended in an attempt to establish criteria by which it can be decided whether asset valuations should be changed when a less extensive transfer of equities takes place. 1 The value of a business does not depend on who owns it or how that ownership changes, however. The assets of a business are determined by reference to considerations of control and purpose in use. The value of those assets depends on management access to markets, since that deter1 See, for example, Accounting Research Bulletin no. 48, issued by the Committee on Accounting Procedure of the American Institute of Certified Public Accountants, 1957.

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mines the prices that can be obtained and must be paid. No transfer of equities in itself changes a business accounting entity or its value, it neither creates nor destroys wealth. Transfers of equities should be recorded as what they are; that is, they should be recorded by means of adjustments to the equities, if adjustments in the accounts are required. They should not be recorded as changes in the extent of entity wealth. The gain or loss of equity of one individual or group to another in an entity should not be reflected as a gain or loss of wealth to the entity as a whole. In the treatment of intangibles described above, no change is made to the recorded value of an entity in respect of them when a transfer of equities takes place; any adjustments required are made in the equities themselves. Transfers of equities arising from corporate reorganizations and transfers of partnership equities are no different in the above respects from changes in corporate equities arising from the transfer of company stocks. In this connection it is worth noting that when the members of a partnership change and a goodwill adjustment must be made, in current practice it is often made to the partners' capitals. The logic of the equity treatment of intangibles is particularly evident when less is paid for a going business than the purchase market value of its tangible assets. Treating intangibles as assets then involves the impossible notion of a negative asset. Most accounting concern over the treatment of intangibles is as a matter of financial management; it has to do with dividend policies, capital investment, return on investment, and the like. As a matter of measurement, accountants appear to be little concerned in practice about how intangibles are treated after their purchase has been recorded. Accounting practices suggest a desire to get rid of intangibles

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in such a way as to have as little effect upon the financial reports as possible. The equity treatment of intangibles has advantages from the financial standpoint. To begin with, it reflects the extent of beneficial ownership in a business, since all those who must rely on intangibles for part of their equity are beneficial owners and the extent to which equity-holders rely on intangible value is indicated. By reflecting the extent of beneficial ownership, the equity treatment of intangibles discloses the propriety of dividend payments more clearly. Dividends are paid in tangible assets; they should only be paid out of a surplus of tangible assets. If there is not a sufficient surplus of tangible assets to cover a dividend payment, it must be paid in part out of tangible assets representing capital investment and perhaps even tangible assets representing creditor investments. While it might be legal to pay such dividends, when there were enough intangibles recorded to cover the shortage of tangible asset surplus, the payment would have the effect of reducing the tangible security of senior equityholders, represented by stockholder investment, below the legal capital limit and perhaps even eliminating it completely, making the senior equity-holders dependent on future tangible assets for the payment of their claims This would be made obvious if intangibles were shown as a deduction on the equity side of the balance sheet. Further consideration of dividend practices leads to a recommendation concerning the capitalization of corporations that acquire going businesses having goodwill and other intangibles. When a going concern is acquired in exchange for capital stock rather than for cash, the legal capital amount of that stock should equal only the value of the tangible assets acquired; any intangibles purchased should be represented by an excess of issue price over legal

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capital, or contributed surplus. Whether the shares issued are preferred or common, par or no par, is not important. With an equal amount of surplus available against which the intangibles can be offset, capital stock is represented entirely by tangible assets and the intangibles can be written off without the need to accumulate tangible asset earnings and perhaps force unwanted expansion in order to maintain legal capital. In so far as investment and return on investment calculations are concerned, the equity treatment of intangibles has the advantage that invested wealth and the income from it are defined consistently for all businesses under all circumstances.

Treatment of Tangibles If accounting is to provide adequate measurements of tangible wealth and income, more effort must be devoted to the determination of. tangible asset values. All of the tangible assets of an entity must be included in statements of its total wealth, and they must be valued at estimated market values, regardless of how they were acquired and how much they cost originally. The simple results of asset exchanges, recorded by means of the double-entry technique must be supplemented with the results of changes under contracts not yet consummated by an exchange, and with estimates of the extent to which the market values of all assets and liabilities have changed. The general principles to be applied in the determination of exchange values have been described under the heading of measurement. The specific procedures required depend on the particular case. It would be foolish to minimize the practical difficulties involved in measuring market values. Little has been done by accountants towards developing

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techniques for this purpose and considerable effort will be required. On the other hand, much of the work involved in current accounting practices will be eliminated by the use of market values; for example, detailed allocations of original costs will not be required for inventory valuation. In addition, many of the technical problems of current accounting practice will be eliminated; most consolidation difficulties, for example, will disappear. Even when generally effective methods of establishing market values are developed, it is probable that the market values of some tangible assets will remain indeterminate within a fairly significant range. A rough approximation of market values is still better than no estimate at all, however. Figures for wealth and income that have no relation or an uncertain relation to current values are worse than useless-they are downright misleading. When all tangible asset and other equity amounts have been determined, the residual represents the equity in tangible assets of the beneficial owners of an entity. The increase or decrease in this equity from a previous estimate represents the estimated dollar profit or loss to the beneficial owners for the period between the estimates. It still remains to translate this dollar income into real income. The means of translation were described in connection with the discussion of income. Theoretically, a profit or loss determined in the manner described above should also be adjusted in arriving at real income for the fact that it includes pure interest, which is not a gain. As a practical matter, however, such adjustments can be omitted, because the distinction between pure interest and profit has little significance for most users of accounting data. In accounting for tangible wealth and income, some things can be determined absolutely and some can only be estimated. Changes in wealth arising from exchanges, when

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one side of the exchange is cash or a claim for cash, are absolutely determinable in amount. An exchange involves physical action whose happening can be proved. When one side of the exchange is cash or a claim for cash, the dollar amount of the exchange is established. Changes in tangible wealth resulting from changes in market values can only be estimated. Some can be estimated more closely than others, but they all involve approximations and legitimate differences of opinion can exist concerning any of them. The most important prerequisite for the use of the results of any form of measurement is an appreciation of the limitations inherent in the measurement methods. In accounting statements a clear distinction should be made between absolute exchange transactions and estimates. In income statements, exchange revenues and expenditures should be described first, with estimates following in a completely separate section. In balance sheets, those amounts that are estimated should be clearly labelled and as much information as is feasible within reasonable space limitations should be provided concerning the methods of estimating used. Illustration

The model financial statements in Tables VII and VIII and their attendant explanations illustrate the prescribed treatments of accounting data. A. Included in sales are receipts and receivables arising out of sales for cash, or for claims for cash, occurring within the period. Similarly, purchases and expenses include all payments and payables arising out of purchases of goods and services for cash, or for obligations payable in cash, occurring within the period. Sales and purchases and expenses are defined by reference to the passage of goods

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TABLE VII

A A B

STATEMENT OF INCOME Sales, described Purchases and expenses, described Estimated changes in value Decrease in property, plant and equipment Increase in uncollectable accounts Increase in sales liabilities Increase in inventories Increase in investments

C

D

$100,000 90,000 10,000 $4,000 1,000 1,000 6,000 2,000 1,000 3,000

Estimated dollar increase in net tangible assets Estimated decrease in dollar values Estimated real increase in net tangible assets, in period-end dollars Current unamortized expenditures for competitive advantage Transferred to surplus

3,000 7,000 2,000 5,000 10,000 $15,000

or services. The kinds of sales and purchases and hence their description in the income statement will depend on the nature of the business. As a minimum, those sales and purchases of assets in which the concern does not normally trade, such as plant and equipment, should be shown separately. The operating statements of those non-profitmaking entities for which only accountability and not the measurement of income is important can very well stop at this point. B. Under estimated changes in value are listed all those changes in asset and liability amounts estimated to have occurred within the period but not reflected in sales or purchases and expenses, or in conscious and deliberate creditor and owner investment and disinvestment. These amounts

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will be the differences between the period-end and periodbeginning estimates of each of the asset and liability categories, less those arising from sales and purchases and expenses, except when investment or disinvestment was made during the period in the form of those assets or liabilities. In that case, the estimated changes in value must be adjusted for the investment factor. For example, if owners added to their investment in a business by transferring a piece of real estate to it, the estimated value of the property at the time of investment would have to be deducted from an increase in value of property, plant, and equipment in arriving at an estimate of income. Changes in asset and liability estimates may be described in as much detail as seems appropriate for the particular business in the particular circumstances. C. The estimated decrease in dollar values is deducted from the dollar increase in tangible assets to arrive at the real increase in tangible assets during the period, measured in period end dollar values. D. Current unamortized expenditures for competitive advantage are those large and unusual expenditures made during the period for intangibles which are believed to have a continuing value. No specific mention of income taxes is made in the above statement. Theoretically, income taxes should be considered distributions of surplus, since, by definition, those bodies that levy taxes, the amounts of which are dependent on income, are beneficial owners. In current practice, income taxes are reflected as determinants of income. In so far as accounting reports are concerned, this distinction is not particularly important. Income taxes can be included just as easily in the statement of income (Table VII) or in the balance sheet (Table VIII). The main differences between the prescribed form of balance sheet and those generally currently produced have

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TABLE VIII BALANCE SHEET TANGIBLE ASSETS

E

Consumable wealth, secondary wealth, and currency, described

$100,000

LIABILITIES AND OWNERSHIP EQUITY

E

Liabilities, described Legal capital stock, described G Accumulated change in dollar value of capital stock Capital stock in current dollars Earned surplus $24,000 Balance at beginning of year G Current change in dollar value of surplus 1,000 Balance at beginning of year in current dollars 25,000 F Transferred from income statement 15,000 40,000 FG Expenditures for competitive advantage amortized, in current dollars 12,000 28,000 Balance at end of year FG Accumulated unamortized expenditures for competitive advantage, in current dollars 20,000 Ownership equity in tangible assets H

$45,000 40,000 7,000 47,000

8,000 55,000 $100,000

Footnotes: Descriptions of methods of estimating

to do with contract claims, expenditures for intangibles, changes in the value of dollars, and descriptions of the methods used in making the required estimates. E. Tangible assets and liabilities include claims in respect of which no valuable consideration has passed, as well as those that have been consummated. Tangible assets and liabilities may be listed and grouped in any way that seems appropriate, including the intermixing of asset and liability amounts, as long as it is made clear which are estimates.

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F. To the equity of the beneficial owners, in this case to earned surplus, is added the amount transferred from the income statement. From it is deducted the amount of intangible expenditures being amortized during the period. This amount has no necessary relationship to the current unamortized expenditures for competitive advantage added back to income. To the extent that intangible expenditures still remain to be amortized, they must also be deducted in arriving at ownership equity in tangible assets. G. Each year, adjustments must be made in the balance sheet to ownership equity and expenditure for competitive advantage, in order to compensate for dollar value changes and to state the amounts in current dollars. The net effect of these adjustments will equal the adjustment for dollar value changes included in the statement of income. Periodically, legal action should be taken to transfer the accumulated change in dollar value of capital stock to legal capital. H. The footnotes, which are an integral part of the statements, provide sufficient detail concerning the methods used in making the required estimates to permit readers of the statements to use the data provided intelligently.

INDEX

ACCOUNTING ENTITY, 38-39, 56-58 Accounting principles, 7 Accounting statement of wealth, see Balance sheet Advertising expenditures, 21, 24, 48 Amortization of long-term assets, see Depreciation Appreciation, 44 Assets, see Wealth BARTER, 44 Balance sheet, 31, 48, 58, 83, 87, 92, 94, 96-98 Beneficial ownership, 39-40, 60, 61, 89, 91, 93, 97 Bond discount, 25-26 Buildings, see Structures Businesses, valuation, 78-81

CASH, see Currency Claims, 17-18, 60-62 Conditions of imperfect competition, 18-21; see also Expenditures for competitive advantage; Intangibles Conservatism, 41, 49, SO Consolidations, 27, 57, 61, 86-87 Consumable wealth, 14-16, 57 Consumption, 14, 33-34 Contributed surplus, 84, 85, 86, 91-92 Copyrights, 21, 22 Cost, 11-12, 45

Cost and market, the lower, 7 Currency, 18, 31, 57, 60 15-16, 18, 21, 24-26 Deferred credits, 46 Deficits, 26 Depletable resources, 15, 32; 11ee also Sale wealth Deposits, 17, 18, 31, 60 Depreciable assets, see Fixed assets Depreciation, 13, 45, 53, 67-68 Development expenses, 21, 26, 48 Discoveries, 13 Dividends, 91 Dollar values, 52-53, 93, 96, 97, 98 Double-entry book-keeping, 12-13, 42 DEFERRED CHARGES,

16, 67 Equities, 16, 84, 89-90, 91 Expenditures for competitive advantage, 84, 85, 86, 96, 97, 98; see also Conditions of imperfect competition; Intangibles Expenses, 13, 94, 95 .EQUIPMENT,

MANAGEMENT, 50-51, 90-92 Financing expenses, 21, 26, 48 Fixed assets, 13, 15-16, 32, 59; see also Equipment; Land; Service wealth; Structures FINANCIAL

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Franchises, 21, 23 GIFTS, 13 Going concern concept, 44, 63-6S Goodwill, 21, 26-27, 4S-46, 4748, 49-50, Sl, S2, S6-S7, 8S87, 90 INCOME: accounting, 40-41; business operating, 34; capital gains, 34-37, 65; definition, 4, 8, 47, S4, 83; personal, 37; proprietorships and partnerships, 38; psychic, 33-34; real, 52-53, 93, 96; statement, 94-96; wealth, 3438 Instalment contracts, 43-44, S6 Intangibles: accounting treatment, 13, 21-22, 47-52, 88-89, 90-91; cost, 76-78; definition, 3, 6-7, 22, 32; kinds, 22-28; valuation, 70, 75-78, 80, 81; value, 28-31, S4, 58-60, 65, 88, 89; see also Conditions of imperfect competition; Expenditures for competitive advantage Interest, pure, 38, 61, 78-79, 93 Invention, 54, 55 Inventories, 13, 14-1S, 31, 53; see also Sale wealth Investments, 13, 17, 31, 60 LAND, 16, 31, 67 Leaseholds, 23-24, 57 Liabilities, 16, 97 Long-term contracts, 44 MANAGEMENT, 27-28, 77-78 Market value: estimates of, 4-S, 60-62, 66-70, 72-81; meaning of, 9-12

Matching concept, 40-41, 44-46 Measurement, 9, S4, 93-94 OBSOLESCENCE, 68-69 Organization expenses, 21, 26, 48 "Other assets," 16 PATENTS, 21, 22, 24, 48 Personal goodwill, 27-28 Prepaid expenses, 1S, 18, 31 Price indices, 53 Processed products, 15, 31 Property, plant, and equipment, see P:xed assets Purpose of accounting, 3-4, 6-7 REALIZATION CONCEPT, 40-44 Receivables, 13, 17-18, 31, 60 Recommendations, 5, 82-88, 9294 Research expenditures, 21, 24, 48 Return on investment, 51-52, 7879, 92 SALE WEALIB, 70-75 Secondary wealth, 16-18, 57, 6062; see also Claims Service wealth, 62-70 Stewardship, 7, 83, 85 Stock values, 80-81 Structures, 16, 67 TANGIBLE ASSETS, 28-29, 97 Taxes on income, 46, 96 Trade marks, 21, 22-23 VALUE, 4, 9, 14; in exchange, see Market value; of knowledge, S4, 55; of labour, 54

WEALm, 3, 4, 8, 9, 31-32, 47-48, S4-S5, 56-58, 88