Let's take a fresh look at accounting
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IN recent years there has been a growing awareness that company profits, declared in the accounts, may have been illusory.
Inadequate provision for depreciation has always been a way to "rig" a declared profit figure. At a time of rampant inflation it can be argued that some of the biggest companies in Britain have not really made anything like the profits shown in published statements of the annual accounts.
The road haulage industry is particularly vulnerable to the ravages of inflation. Haulage rates are with great difficulty raised in line with increased costs when the situation really calls for the rates to rise faster than current cost increases to accrue the funds necessary for vehicle replacement. Excessive competition magnifies the difficulty.
An expert committee chaired by Mr F. E. P. Sandilands has recently published a report on inflation Accounting (Cmd 6225, HMSO price £4.25, postage extra). At the request of the Government, Mr Sandilands has prepared a summary of the report; this Brief Guide, also published by HMSO, costs 30p.
The main report is unlikely to be read by many practical businessmen but the summary deserves to be discussed, together with the comments of individual accountants and their professional bodies.
It is frightening to read in Mr Sandilands' Brief Guide under the heading "Stock appreciation" that "in 1974 nearly half the declared profits of companies were due to stock appreciation. Where a company needs to maintain its stocks at a fairly constant level, any holding gain realised on stocks is unlikely to be available for distribution and it is potentially misleading to users of accounts to class such gain as profit for the year."
Just how far a transport organisation may fairly be compared with a manufacturing company in terms of accounting practice is a moot point, but there must be some correspondence. Stocks of tyres, repair materials, stationery, plant, etc, would seem to be comnarable
with the materials used in manufacturing industry. The actual vehicles which provide operating revenues may be related to the plant and machinery in a factory. Less than optimum use, in both examples, is wasteful.
Nightmarish
Transport operators need no reminding of the nightmarish increases in vehicle replacement costs. The destruction, in a motorway fire, of a two-year-old 32-ton artic unit will have a most damaging effect on the profitability of one company I know of, despite the insurance recovery.
The Sandilands committee stressed that the apparent picture of a company's performance given by existing accounting conventions was often misleading and the ability to compare the performance of different companies usefully was significantly impaired, Hence the need for agreement on the way in which existing accounting .practices should be modified.
Inflation, in an everyday sense, means a persistent rise in the prices of goods and services, or a persistent fall in the purchasing power of money. Because neither inflation nor the purchasing power of money can be measured in the abstract, but only in relation to price changes in specific items of goods and services paid for with money, inflation does not affect all individuals and companies the same way.
The rate of inflation depends, in fact, upon the selection of goods and services purchased. Hence a key point of Sandilands: "A company's accounts should show the effect of inflation on that particular company's operations."
There are three major categories of company gains, says Sandilands: A holding gain (or loss) is the difference between the value to a company of an asset at any point of time and the original cost. Such gains may be realised or unrealised.
An operating gain (or loss) is the difference between a company's sales revenue and the "value to the business" of the inputs generating this sales revenue. How do you define "value to the business"? Sandilands says the value is the loss the company would suffer if it were deprived of the asset in question. Generally, this would equal the cost of replacing the asset in its existing condition. This agreed, assets should be valued in the balance sheet by reference to their current replacement cost, allowing for depreciation where appropriate, and taking any holding gains arising to a fixed asset revaluation reserve.
Property assets should be revalued at regular intervals. Sandilands make a point which would be greatly welcomed in road transport, namely, that the Government Statistical Service should publish price indices for capital expenditure on plant and machinery specific to particular industries. Such indices would be used unless a company could devise a more precise valuation,
During inflation asset "values" rise, measured in money terms (pounds) so most companies experience an increase in holding gains. But these are different from operating gains and the two should be shown separately in the accounts.
Outmoded
Conventional accounting, based on historic costs, is useful where it is desired to measure a company's performance in terms of costs-incurred, and when prices are stable. Today, in Britain, conventional accounting has surely outlived its usefulness.
Sandilands argues that it is a serious deficiency not to show in the accounts the unrealised holding gains arising through inflation. Many companies have realised this and show assets (particularly property assets) at a "valuation" in their accounts. But as there is no consistency of treatment of such valuations it has become increasingly difficult to compare the accounts of different companies in a meaningful way.
When historic.cost accounting methods lump together holding gains with operating gains as "profit for the year " the accounts fail to give the necessary information required by users.
Depreciation. using historic cost methods, spreads the cost of an asset over its useful life. Inflation does not affect the method since inflationary increases in the price of an asset subsequent to the purchase do not affect purchase cost. But if, owing to inflation, the monetary value of an asset rises after its purchase, a conventional historic cost depreciation provision will not fully reflect the value of the asset consumed during the accounting year.
Professional accounting bodies in the UK have urged that a supplementary statement should be attached to the basic accounts of companies showing the figures converted into figures of current purchasing power (CPP) at the date of the account, using changes in the Retail Price Index (RPI) to reflect changes in the purchasing power of money. Sandilands says the use of the RPI—a wideranging index of consumer goods and services—will often give a misleading indication of the effects of inflation on individual companies. Moreover, the CPP method involves the problem of a new unit of measurement—units of current purchasing power.
New system
Sandilands recommends that a new accounting system, to be known as Current Cost Accounting, should in future form the basis •of companies' published accounts. The main features of this system are : (i) The accounts will continue as at present to be drawn up in monetary units (pounds).
(ii) The accounts should show the "value to the business" of the company's assets at the balance sheet date.
(iii) Profit for the year should consist of the company's operating gains, and should exclude all holding gains. Extraordinary gains may be shown as profit but should be distinguished from operating gains.
(iv) Accounts drawn up in this way should become the basic published accounts of companies. In addition the net book value of assets and depreciation for the year on a historic cost basis should be shown in notes to the accounts.
Although this may seem the merest commonsense, it will take some time for the new system to be fully established. One of the major changes is that the figure for depreciation in the profit and loss account should be a proportion of the figure of the "value to the business" of assets shown in the balance sheet, rather than a proportion of their cost. And profits made from Stock appreciation should be removed from the P and L account and taken to a reserve, by means of a "cost of sales adjustment" in the P and L account.
Advantages
Among the advantages seen for the Current Cost Accounting method may be mentioned the following: 1. Comparative returns on capital employed of different companies may be more accurately assessed than is possible with existing methods.
2. The clear separation in the accounts of holding, operating and extraordinary gains will lead to a clear distinction being made between gains due to a company's productive efforts and gains due to luck or skill in the timing of purchases of assets during a period of inflation.
3. The new system is evolutionary; the "revaluation" of property assets is already widespread, •and many companies -are aware that windfall gains from stock appreciation etc are illusory in terms of profit.
The inflation accounting debate is now international. American authorities have recommended that accounts should bear replacement cost data in notes to their accounts. Australia and South Africa are considering proposals similar to those made by the Sandilands committee.
Accountancy bodies will have to make the running in putting through the necessary changes in accounting methods and they will have to do a lot of reeducation within the profession. British accountants are now looking to the Government to start the ball rolling. In view of Common Market membership it would make much sense for common accounting methods to be agreed throughout the EEC. While they are about it, member Governments should align their company laws ! Probably that will be done in the next century.