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PRICE LEVEL CHANGES AND FINANCIAL ACCOUNTING MEASUREMENT

Research Papers in Economics - RePEc:wpa:wuwpot:0410009 - 2004-10-23

Stanley C. W. Salvary, Canisius College

The strong hold that certain themes have on the mind of the scientist
helps to explain his[/her] commitment to some point of view that may in
fact run exactly counter to all accepted doctrine and to the clear
evidence of the senses. Of this no one has spoken more eloquently and
memorably than Galileo when he commented on the fact that to accept
the idea of a moving earth one must overcome the strong impression
that one can "see" that the sun is really moving. [Holton 1973,59]

ABSTRACT

Debates on inflation have subsided, but the issue is not dead. Debates on this issue are as
perennial as the grass; as soon as there are continuous and significant increases in the level of
prices, the debates will be resumed with much vigor. Therefore, the issue has to be addressed
in spite of the cessation of debate at this time. Many arguments have been presented that
under conditions of changes in the general level of prices financial statements are irrelevant
and uninterpretable. According to the argument for change, a real (constant) money measure
of performance indicates that management is failing to maintain its physical stock of capital.
The nominal money measure is considered to be the problem, since it cannot provide a
constant measure of the physical quantities. Attempts have been made to alter financial
accounting information in order to measure the impact of inflation on a business enterprise to
assist the firm in making its investment decisions and the firm's shareholders in making their
investment and consumption decisions. However, in great part these attempts have not
withstood the test of relevance and interpretability. Given the functioning of a surplus-
oriented money economy, the argument in support of accounting for changes in the general
level of prices is examined in light of the following questions: What is it that is entrusted to
management? Is it a physical stock or a financial stock of capital? Does a firm seek to
accumulate a physical stock or a nominal money stock? Are the suppliers of money-capital
concerned with physical flow prediction or with nominal money flow prediction? This paper
simply sets out to examine the issues and reveal the fallacy of the argument in support of
alteration of financial accounting information in the absence of monetary dislocation.

1 - INTRODUCTION

In periods of rising prices, financial accounting information has been criticized on

the grounds that it reflects a number of dated dollars while the value of the dollar is
changing. According to Hughes, Liu, and Zhang (2004, 731), “[I]nflation creates an
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earnings illusion as an artifact of the mismatching of expenses based on allocations of

historical costs with current revenues in determining earnings. This mismatching distorts
mappings of aggregate earnings and book values into equity value such that value-relevant
information is lost.” The literature is replete with criticisms and studies offering support
for such criticisms (e.g., JofA [1982,90-92]; Mosich and Larsen [1982,134]; Chambers
[1975a]; Niehans [1978,127]).1 The withdrawal by the Financial Accounting Standards
Board (FASB) [1986] of its requirement for inflation accounting does not signify closure
on this issue. As soon as the general price level rises to what would be considered too
high to be ignored, this issue will be revisited and debated. While accounting for price
level changes is not on the FASB's agenda, this area of research is much too vital to be
ignored/abandoned.

This paper seeks to demonstrate that, given recoverable cost as the measurement
property in financial accounting [Salvary 1985;1989;1992;1997;1998a;1998b], in the
absence of monetary dislocation or any collapse of the monetary system, information,
contained in financial statements which are prepared using nominal money as the
measuring unit, is relevant and interpretable in an inflationary environment. Monetary
dislocation means the loss of confidence which brings about a repudiation of paper money.
This condition is termed "a crisis of doubt" by Bresciani-Turroni [1937,172]. When full
repudiation is reached, the economy is reduced to a barter system. Myddleton's [1984,20]
argument ("What is the point of maintaining 'money capital' when the value of money is
falling fast?") is related to the "crisis of doubt" and not to the normal economic
circumstances observed in the UK and the US. Germany in 1918-1923 has been the
classic example of monetary dislocation; there have been milder cases of the German
experience in Poland, Austria, Hungary [Bresciani-Turroni 1937; Sargent 1982;
Holtfrerich 1986], and, in recent times, Russia where the US dollar remains the preferred
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means of saving [Vasiliev 1994,134; Sachs and Woo 1994,127]. The situation in each
country has to be examined to determine if the "crisis of doubt" exists. If it does exist then
adjustments have to be made to correct the measuring unit - nominal money. Although the
"crisis of doubt" was not present in the US, it was the German experience [Sweeney
1927;1928;1930;1931;1935] which constituted the basis for Sweeney's [1936]
recommendation in the US of stabilized (real terms) accounting.
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The analysis in this study leads to the conclusion that, in the absence of monetary
dislocation or collapse of the monetary system, nominal money--the measuring unit used
by accountants--is not defective under general economic conditions. This paper examines
the alternative views of the manner in which price level changes occur and the means for
addressing the alleged defect in financial accounting measurement. (There is no attempt to
summarize the various arguments for and against the various methods advanced to deal
with inflation.) In this study, what is at issue is the justification of inflation as a financial
accounting measurement issue. Since one cannot talk about inflation without talking
about prices and price level changes, the following section sets the stage for further
analysis of the issues identified with inflation by examining the characteristics of the price
system and price level changes.

2 - THE PRICE SYSTEM AND PRICE LEVEL CHANGES

In the normal operations of the economic system, owing to the proper functioning
of the price system, the net effect of specific price changes of all goods and services
produces change in the general level of prices. Such a change is not to be confused with a
change in the general level of prices due to the simultaneous and proportional rise in the
prices of all goods and services. A change in the general price level caused by the net
effect of the realignment of specific prices is a phenomenon entirely different from that of
a change in the general price level caused by the failure of the monetary system .
Historically, the debate on inflation accounting revolves around the nominal money
measure employed in financial accounting. Some economists have insisted that inflation
presents a financial accounting measurement problem, and some accountants have
accepted it as such. Inflation is defined by these economists as the persistent increase in
the general price level due to increases in the prices of goods and services [Trevithick and
Mulvey 1975,1; Griffiths 1976,10]. In this setting, the money measure would be
defective. Accountants, who subscribe to this position, proceed to find an index with
which to adjust financial statements. In reality, while there exists a sustained increase in
the general price level, all prices do not move in the same direction although the net effect
is an increase/decrease in the general price level. In this latter situation, price changes give
rise to windfall profits or losses. In general, the prices of goods and services are shaped by
forces independent of the money unit; accordingly, a change in the exchange ratios (the
nominal amount of money representing exchange relationships among the various
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commodities) is not a defect of the measuring device [Salvary 1993,155-161,168-171;1996;

1997,94-98;1997/1998,101]. Change in the exchange ratios does produce a behavioral
effect on consumption patterns of individual consumers. However, the producer (firm)
is not affected in the same fashion as the consumer, because the firm is merely a conduit
in a money augmentation process (e.g., profit-seeking enterprise). The producer, who
is always confronted with specific price changes, attempts to maximize nominal
dollars/pounds/francs (be it an attempt to maximize the hypothetical real rate of return).
Chambers [1975b, Part 1, Section 10] maintains that: "... changes in particular
prices and changes in the general level of prices influence one another, [therefore] the
effects of both should be brought into account. One cannot be considered in isolation
from the other. Whatever the outcome, it cannot be said whether any part of the result is
due solely to managerial judgements or solely to accidental unforeseeable factors.
Managers may be expected to use their best judgements at all times. Only the results in
aggregate will indicate with what effect firms have been able to meet the conditions
through which they have passed." As per Chambers [1975b], the cause of the change in
the price level does not really matter; what matters is the aggregate effect - the change in
the general price level has to be adjusted for in the financial statements. Given the
foregoing, the following question needs to be answered: Are financial statements
unadjusted for price level changes relevant under changing conditions in the money,
commodity and labor markets? The answer to that question, which is developed in the
later analysis, is based upon the fact that an increase in the general price level due to the
net effect of changes in specific prices is different from an increase in the general price
level due to a simultaneous increase in all prices.
It must be emphasized that: (1) a price system signals changes in the demand and
supply conditions of the various goods and services provided by the economic system, and
(2) the function/purpose of price level adjustments is to enable the conversion from a
measurement using a price system to a physical quantity system - in order to the determine
the change in physical output. It should be quite clear that if prices are held constant, then
the price system cannot be functional. Accordingly, this paper argues that the manner in
which the price level change is brought about does matter [Salvary 2002, 40-41], and
when changes in the general price level are the result of the net effect of changes in
specific prices, adjustments of enterprise accounts for general price level changes are
misguided and misleading.
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Organization of the Remainder of the Paper

The rest of this paper is divided into six parts. The next section presents Inflation:
Its Cause(s) and Measurement; that section is followed by The Financial Reporting Issue.
The succeeding section focuses on Consumption, Production, and Financing. The section
that follows is a discussion of Financial Accounting, The Measurement Property, and The
Capital Market. Next comes A Critique of Current Cost Accounting and Constant Dollar
Accounting. The final section is the Summary and Conclusion.

3 - INFLATION: ITS CAUSE(S) AND MEASUREMENT

Probably the most accepted definition in the literature of inflation is that it is "a
persistent tendency for the general level of prices to rise" [Trevithick and Mulvey 1975,1;
Griffiths 1976,10]. In spite of a persistent increase in the general level of prices, there are
yet some items (e.g., microwave ovens, calculators, cameras, watches) whose prices have
fallen considerably over the last few decades. The reason for inflation accounting is
provided by the monetarists, who maintain that the rise in the general price level is due to
the simultaneous increase in the prices of goods and services brought about by a
mismanagement of the money supply. If changes in the general price level occur in this
fashion, then inflation accounting is on firm grounds and current financial accounting
measurements have to be adjusted unless there is a currency devaluation to correct the
inflated values.
The chief monetarist [Friedman 1980,254-255] maintains that inflation (wherever
it exists) is always a monetary phenomenon.3 This statement is based upon the quantity
theory, which has the neutrality of money as its most fundamental assumption. That is an
increase in the money supply can only have one effect--an increase in the price of goods
and services. So by definition, inflation is a monetary phenomenon. However, much
empirical evidence has been amassed and presented in the economics literature which
contradicts Friedman's hypothesis. A monetary cause of inflation would be true in an
economy in which paper money was replaced by precious metal as the medium of
exchange; but even then, it has been shown that only in limited and in infrequent situations
has this condition been fulfilled [Brenner 1971,74; Gould 1965,94-96,108,109]. It has
been clearly pointed out that, while an increase in the money supply can accommodate or
accentuate a rise in the price level, changes in the general price level is not a monetary
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phenomenon [Ball 1964,69,77; Cairncross 1975,67-69; Hansen1951; Harrod 1973,82;

Hawtrey 1950,Chap.1; Holtfrerich 1986]. It is to be found in a barter economy [Fuller,
1980,6-7]; in which case the entire set of exchange ratios are realigned, thus, redistributing
exchange (purchasing) power among the members of that society. Inflation is attributable
to non-monetary factors [Dow and Seville 1988,240].
Demand and supply conditions in the money, commodity and labor markets change
over time producing changes in the price structures. Consumers then react to this change
in prices in a manner conducive to the maximization of their consumption given their
budgetary constraints. In a market economy, money adjusts (viz: velocity of money and
credit) to the demands of the economy. However, where banks exist as economic
regulators monetary policy enters the picture. Through the use of monetary policy, which
is not an inherent attribute of money, the economy is forced by central bankers to adjust to
monetary policy [Griffiths 1976,5; Pippenger 1982,549].
Although monetary policy may produce a change in the exchange ratio (nominal
money vis-a-vis commodity), such a change is not itself a problem of inflation: "if
everyone's income and assets rise proportionally and in step with the price level ... [they
are] fully 'indexed'" [Fuller 1980,8]. In this situation, no segment is worse off than before;
thus, it is fairly obvious why governmental policy in some countries would provide for
income indexation [McCallum 1983,416-418]. Inflation as a consumer problem is present
as a problem when everyone's income and assets do not rise proportionally. Given this
background, inflation can be defined as persistent changes in relative prices which
produce a sustained change in the general level of prices in an economy to the detriment
of some members of that economy. Given this definition, inflation, which can be
accentuated (aggravated) by monetary policy such as unrestrained consumer credit and an
ad hoc interest rates policy [Harrod 1973,97], is caused by the realignment of prices given
changing demand and supply conditions [Salvary, 1997/1998]. The monetarist model is a
special and rare case. Changes in the general level of prices do not follow the monetarist
model. An increase (decrease) in the general price level is a result of the net effect of the
realignment of the prices of all goods and services in the economy.4 Some prices go up
and some go down, while others remain unchanged.

One might expect that a change in the value of money brought purely by an
expansion in the circulating medium would have similar effects on all prices;
whereas, in fact, prices of different commodities and services moved at
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different speeds and, in one or two instances, even in the opposite direction
[Gould 1965,95].5

An increase in the general price level is due to the fact that the prices which go up in the
general basket of goods and services outweigh those that go down; the reverse holds true.
Therefore, some consumers would be better off; some would be worse off; while others
would be unaffected by the realignment of prices. Since: (a) the firm is faced with specific
price changes for the items in its portfolio of productive assets and (b) the producer is not
identical with the financier/consumer, then the general price level adjustments when
applied to financial accounting measurement are not meaningful and are uninterpretable.6
As opposed to the erosion of business real (physical) capital brought about by the
declining value of money, a more explicit view of inflation is the rising cost of living.
Quite clearly and unequivocally, the impact of inflation is on end consumers. The use of
paper money, which has no intrinsic value, permits a measurement of this impact, viz:
consumer price index (CPI). However, each consumer is affected not by the general price
level index (CPI), but by the changes in the prices of the goods and services entering into
his/her individual (and separate) budget equation.
As attributed to Koopmans, if a money illusion exists it is due to individual price
changes that affect the individual's demand function for commodities. The general price
level has no direct relevance. Therefore, to stabilize money in its accounting function it is
necessary to stabilize only the prices of the specific goods entering the separate budget
equations of every one of the individuals in the economy and not the average price level as
expressed in some index [Botha 1959,154-155]. The foregoing position is reinforced by
Von Wieser [Botha 1959,155], who maintained that money will remain 'stable' with
respect to the individual consumer if and only if the prices of the goods which he[/she]
buys do not change. However, the stabilization to every individual of money in its
accounting function could only be carried out if all prices were kept constant over time.
To accomplish that end would require that the price forming process itself be eliminated.
Any measure of the impact of inflation should be based on its effect on end
consumers by relating their incomes to the changes in the specific prices that affect their
specific baskets of goods and services. Apparently, the most important information, which
an individual household would like to get about price changes, is information on how the
price changes have affected the specific individual household's standard of living
[Eichhorn 1978,19]. The cost-of-living index compares the individual household's budget
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of the base period with the smallest budget needed in the comparison period in order to
satisfy that level of utility (standard of living), which was at best possible with the base
period's budget [Eichhorn 1978,20]. Given what is included and what is omitted at
different points in time, this index is much too general to satisfy the needs of the
individual consumer. However, individuals are cognizant of their nominal money incomes
and the nominal money prices of goods and services which enter into their individual
baskets of goods and services.
Arrow [1974,20-22] maintains that while efficiency can be achieved through the
price system, the price system is indifferent to the individual's position; consequently, a
just distribution of income is not prescribed by the price system in any form or fashion. It
is most unfortunate that in the inflation debate, paper money is considered the villain for a
problem which is inherent in the price system.
3.1 - Nominal Money, Purchasing Power, and Financial Accounting

The desire for change in financial accounting measurement in periods of rising

prices is due to a concern for the preservation of purchasing power. However, it is
important to note that purchasing power resides in commodities and not in nominal
money. The purchasing power of a commodity is measured by a scale: nominal money
[Steuart 1767,408-413]. Thus, money is only a reference frame for expressing the
purchasing power of commodities. Furthermore, the transference of price (a measurement)
to commodities does not in turn transform the commodities into the scale [Salvary 1996].
There are several factors that prevent commodity money from effectively transferring
purchasing power over time. Some commodities are perishable (e.g., fish, vegetables);
others which are not perishable may no longer be demanded (e.g. buggy whips); those that are
still in demand are affected by the changes in technology and taste. The ability to transfer
purchasing power over time is unique to nominal money. In light of that situation,
Davidson [1972,62] maintains that money is "a vehicle for transferring purchasing power
over time." Accordingly, any adjustment of the money value assigned in an exchange
transaction (i.e., price) produces an alteration of the signal generated by the system. “Such
information alteration could reduce the informedness of agents [individuals]” [Salvary
1997/1998,99].
Myddleton [1984,20], in strict adherence to Gynther's view ("... money means
something different to every entity, especially through time.”): (1) confuses purchasing
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power with money; and (2) finds fault with the Sandilands' Report by accepting Gynther's
view as an interpretation of the Sandilands Committee's position. Since purchasing power
is an attribute of commodities and not of money [Salvary 1993,156-157], the position
taken in the Sandilands Report [Myddleton 1984,20] (“The ‘purchasing power’ of money
is not an attribute of money quantifiable without a knowledge of what money is to be spent
on.”) is valid.

4 - THE FINANCIAL REPORTING ISSUE

Proponents of inflation accounting maintain that currently financial accounting

information reflects measurement with money values from the past; thus, the nominal
money as a measure of organizational performance is seriously flawed. It is held that the
measurement unit (nominal money) causes erosion of capital to escape the attention of
business managers [FASB 1986,2; Mosich and Larsen 1982,497-498; Morgenstern
1963,66; Business Week 1979,108-112], and that this condition is responsible for the
inability of business firms to replace assets internally [Niehans 1978,127; FASB
1979,para.124]. To correct the alleged deficiency in financial accounting information (i.e.,
to reflect the impact of inflation on the firm), the firm’s operating performance should be
reported using constant dollar and/or current cost accounting.

4.1 - Financial Performance Measurement Vs Financial Planning Management

The alleged financial accounting deficiency in an inflationary period is based upon
the premise that: (1) past prices are irrelevant to current production (e.g., Parker [1975,
512-524]), and (2) the future cost of replacing assets will be greater than the present cost
of assets that are in use (e.g., [Niehans1978; FASB1979]). The recommended solution to
the problem of future financing needs is to alter the financial measure of performance in
order to ensure the availability of internal financing for future asset replacement, which
may or may not occur. While the cost of capital is related to the raising of capital, the two
are not the same. The cost of capital affects the measurement of performance; however,
the amount of capital raised does not enter into a determination of operating performance,
it constitutes the denominator in arriving at the periodic rate of return. Unequivocally, at
times money-capital is simply not available either in the desired quantity or at the desired
cost; to counter such an uncertainty, managerial policy has been to retain sufficient
earnings to satisfy future needs.
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While the concern for future financing is sound, the issue of self financing has to
be kept separate from the measurement of financial performance. As noted by Haavelmo
[1960,156]:

It is essential to realize that these effects cannot be “deflated away” by reckoning

in constant dollars, or the like. Actual or prospective changes in money value of
[physical] capital enter in a very real way into investment decisions and may affect
the volume, a well as the structure, of [physical] accumulation.

Measuring current financial performance is distinct from managing future

financial planning. Since the premise (financial self-sufficiency--the firm should retain
earnings to satisfy possible future asset replacement) is embedded in managerial
accounting considerations (financial planning), the solution for possible shortfalls of
internal funds for future financing needs should be addressed within the framework of
managerial accounting (ex ante projection) and not be directed to the functions of financial
accounting (ex post measurement). In the deliberations of the Sandilands Committee
[1975,107], full and explicit recognition was given to the distinction between ex ante
projection and ex post measurement by the Institute of Chartered Accountants in England
and Wales in 1949 with Recommendation N. 12 and reaffirmed in 1952 with
Recommendation N. 15: "any amount set aside to finance replacements (...fixed or current
assets) at enhanced costs should not be treated as a provision which must be made before
profit for the year can be ascertained but as a transfer to reserve [an appropriation in the
US]". Unlike the UK standard setters, the US standard setters do not recognize the ex ante
projection/ex post measurement distinction.
Since the FASB [1979, paras.138,139] is concerned with the prediction of cash flows
(which can be distributed as dividends), it is understandable why future financing needs (a
decision criterion) is given precedence over actual money outlays (the measurement
property) associated with a plan in progress. Nevertheless, the question as to which course of
action (alternative - what set of productive assets and which set of goods and services) should
have been (be) chosen by management is a managerial accounting decision problem and
not a financial accounting measurement/reporting problem.7 After carefully considering
its opportunity cost, once the firm decides to stick to its production plan, it is unlikely that
information concerning the constant dollar value and current cost of the firm's assets can
assist users in the prediction of the cash flow from the firm's current production plan.
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It is important to note that: (1) both standard-setting bodies (the UK standard

setting body and the FASB) recommended current cost; and (2) changes in specific prices
do not constitute a deficiency in the measuring unit - nominal money. Accordingly, it is
understandable why Johnson and Storey [1982,131], in agreement with Sprouse [1978],
have stressed that "current cost accounting" is incapable of reflecting anything about the
effects of inflation (changes in the general level of prices) because current cost accounting
deals with specific price changes and not with changes in the general level of prices. They
maintain that inflation occurs only when money loses value; that is, when all prices of
goods and services rise simultaneously.
There are three important points which need to be emphasized. (1) As a direct
consequence of the social evolutionary process, the capital market emerged to
accommodate the financing of large scale operations; thus, the burden on the individual
and invariably the inability of the individual to raise the massive amounts of financial
capital were eliminated. (2) Keynes [1930,301] identified windfall profits as the
increment in wealth (the increase of nominal money flow) belonging to entrepreneurs who
have been able "to dispose of their output at an enhanced price." (3) Public finance
theorists have argued that intergenerational equity should be observed; that is present
generations should not be required to bear the cost of benefits to be enjoyed by (underwrite
the consumption expenditures of) future generations [Herber 1971,546-552]. The
arguments for inflation accounting as presented oppose windfall profits and
intergenerational equity. Evidently, if accountants were to match future costs with current
revenues, future shareholders would benefit at the expense of existing shareholders. Given
the use of replacement cost, reported income would be lowered, consequently, the
accounting rates of return would be lowered. Therefore, any shareholder selling shares
would be losing value and the shareholder buying the shares would be the beneficiary in
such an unintended wealth transfer. As can be understood from the perspective of the
misinformation, the naive investor hypothesis does not apply.

5 - CONSUMPTION, PRODUCTION, AND FINANCING

In the existing economic system, one hears talk about real wages. The underlying
reality is that real wages are a function of nominal money wages. Evidently, the role of
nominal money in the economic system cannot be overemphasized. Individual wage-
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earners can only resist changes in (and hence determine) money wages but cannot
determine their real wages, since that is a function of commodity prices [Keynes 1936,10-
15]. So for the purposes of planning in a money economy, the relevant criterion is that
which mobilizes the economy by effectuating allocation decisions: relative prices as
expressed in nominal money. This sentiment is shared by some early scholars:

[M]oney is a most powerful agent in the distribution of wealth; and those who, in a
country where all exchanges are practically effected by money, continue the attempt
to explain the principles of demand and supply, and the variations of wages and
profits, by referring chiefly to [physical quantities] hats, shoes, corn, suits of
clothing, etc., must of necessity fail. [Malthus 1827, 60]

[I]t is the nominal or money price of goods ... which finally determines the prudence
or imprudence of all purchases and sales, and thereby regulates almost the whole
business of common life in which price is concerned, we cannot wonder that it
should have been so much more attended to than the [physical quantity] real price.
[Smith 1776, 86]

In the social setting, two distinct phenomena exist: consumption (an end) and
production (a means to the end). In a surplus-oriented economy, the means of production
have to be financed and the process of production has to be organized. It is quite clear that
in the consumption and production decisions, the importance of nominal money cannot be
overemphasized [Arrow and Hahn 1971,356].
Three groups are important in a production oriented society: (1) the consumers,
whose consumption (W) make production (O) a necessary phenomenon; (2) the financiers,
those who supply the money-capital (savings) to finance (F) the means of production; and
(3) the producers (the firms), those who organize production (O). The three participants
are faced with three different but interdependent decisions:

Consumer: What basket of goods and services is to be selected for the current period?
Producer: What should be produced? When and How should it be produced?
Financier: How should the existing money savings be allocated among the yield
opportunities in the given period?

The consumer attempts to maximize his/her consumption given personal taste (Tc),
specific prices that affect his/her basket of goods and services (Sp), and his/her budget
constraint (Ic). The producer (the firm) attempts to maximize profit from production (O)
given consumer demand (Dc) and factor prices (Pf) subject to the constraint of the
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availability of money capital (Ma). The financier attempts to maximize the return (E) on
his/her money savings (Ms) for a given risk (R) of default. The financier ventures to
maximize after tax yields (nominal money returns) to optimize/satisfy consumption and
financial wealth accumulation. (Financial institutions are financiers but they are not of
themselves consumers.) The producer (the firm): (a) is in business to make money and not
to hold productive assets, and (b) is always confronted with changes in the specific prices
of the factors of production. The firm adjusts price and quantity of its output in its attempt
to maximize profit. In this setting, inflation (a sustained increase in the general level of
prices) only affects the consumers.
Though the three participants are necessary for a production-oriented market
economy, their objective functions are not identical. There is interdependence but no
substitutability among these optimizing functions. All participants seek to optimize the
use of the nominal money at their disposal. Additionally, there is a difference between
consumption and production. Also, organizing production--the investing function--differs
from the financing of production--the savings function [Keynes 1936,21]. While the
producer is involved in an active process (the acquisition and deployment of factor
combinations), the financier is involved in a passive process (the transfer of money
savings in exchange for a claim instrument against future production). To assume that the
roles of production and financing are interchangeable (alternative modes of conduct) is to
assume that society can function without production and can survive exclusively on the
basis of financing activities.

6 - FINANCIAL ACCOUNTING MEASUREMENT AND THE CAPITAL MARKET

Financial accounting is an administrative information science [Salvary

1985;1989;1992]. It provides for an observational report with measurements based upon
concepts which correspond with the structures and regularities of the system (the nature of
the firm, the role of time, planning, investment plans, contracts, the means for the
settlement of obligations, the posting of nominal money prices) from which it abstracts.
The entity is engaged in a cash flow process and the measurement property identified in
this process is recoverable cost. This process is captured by the accrual basis financial
accounting. It begins with: (a) financing, (b) investing - acquisition of productive assets,
(c) transformation of inputs into the consumable product, (d) distribution of the product,
(e) realization of the vendible value (a receivable established), and ends with (f) collection
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of the realized value. (The foregoing description of the process is modified for financial
and service enterprises.)
The pricing of the cash flow is entirely different from the measurement of the cash
flow. Financial accounting is concerned with the measurement of the cash flow; whereas,
the raison d'etre of the capital market is to enable financiers to place a price on existing
cash flows to reflect changes in the supply and demand for money. It must be emphasized
that in a money economy cash flow is the primary concern of financial accounting
measurement since the rate of return on financial capital--value productivity--dominates
physical productivity, and the flow of physical quantities is a secondary (but an important
control) function of financial accounting. Agreement exists on the need for financial
accounting information; however, there is the issue of how should the sacrifices and
benefits be measured?
It seems logical that the basis for the investment decision should constitute the
basis for the measurement of the sacrifices and benefits. The firm invests nominal money
in a plan based upon the recoverability of the nominal money invested; hence, the
measurement property is the estimated recoverable cost [Salvary 1985;1989;1992].
Investment decisions of the entity are directly linked to the recoverable cost property. The
entity’ cash flow from operations is a function of the estimated recoverable cost and the
markup on the entity's output, which is a function of supply and demand in the commodity
market. Given the estimated recoverable cost of operating assets and the firm’s expected
rate of return, a prediction of the expected cash flow from operations can be made.
Prediction is always complicated by the need to predict the component parts of net
revenues. The prediction is further complicated by the fact that many firms do have assets
stated at amounts in excess of their recoverable amounts; a condition which usually leads
to the "big baths"--massive subsequent write-offs. However, the firm has to be judged in
terms of the plan(s) which it present(s) to the financiers.
Financial accounting information as outlined above permits the firm to be judged
in context of its decisions. The entity's plans are presented in nominal money terms. At
any point in time, if financiers do not like the plan(s), they can liquidate their position.
However, it must be remembered that not all firms are publicly traded. So the functioning
of financial accounting is independent of the presence or absence of a capital market. An
analysis of the production decision in a money economy follows.
 15

6.1 - Production in a Money Economy

A money economy introduces the ability to store purchasing power in nominal
terms. In a surplus-oriented money economy, the production process is motivated by
monetary exchanges to accumulate money (store uncertain purchasing power). Following
Boulding [1950,106,112] and Georgescu-Roegen [1971,216], it is asserted that the firm is
concerned with the accumulation of a stock of money. Profit (or loss) emerges as a
consequence of the production process; it is the difference between inflows of money into
the commodity market representing consumption decisions (the revenue stream from
consumer demand) and the portion of the nominal money investment in production
consumed by consumer demand a given period.
Production involves a risk. Generally, producers expect that the total selling price
(S) of their goods or services would cover: (a) the total money outlay (C) to produce the
goods or services, plus (b) a reward (P) for organizing production. In managerial
accounting, this condition is represented by a budget: P* = S* - C* (* = Expected). The
inherent risk is that the expected selling price may not eventuate. The actual situation--P/L
= S - C, where P (profit) or L (loss) as experienced by the producer is reported in the
firm’s income statement as prepared in financial accounting. The producer's subsequent
evaluation (reconciliation of actual and expected performance via managerial accounting),
as reflected by equations (1), (2), (3) and (4), would reveal that a random (an unplanned)
factor (U) has entered the picture. S*, C*, S and C are in nominal terms/dollars.

(1) S = S* + U1 (-k< U1 <k) where k < ∞

(2) C = C* + U2 (-k< U2 <k) where k < ∞
(3) P ≥ P* when U1 ≥ O, and U2 = or < O
(4) L = P* + U1 - U2 where U1 < 0 and U2 > 0, when (-U1 + U2) > P*

Management presumably selects the best among competing alternatives in order to

optimize the nominal money output given the nominal money input. Profit or loss is a
consequence of the managerial decision in an uncertain environment. The general
opposition to the role of nominal money in the current debate on financial accounting
cannot be reconciled with economic reality and entrepreneurial expectations [Salvary
1990,218-221].8 The argument for physical comparability (constant dollar) ignores the
fact that all firms do not have the identical cost (supply) curve [Christ 1958,350-351]9
because they make decisions in anticipation of a future they perceive somewhat
 16

differently. Therefore, the timing of their actions (nominal money flow decisions) reflect
the differences in anticipation. Subsequent to their money outlays, some firms (with
incorrect timing decisions) will be forced out of the industry because their supply curves
will effectively eliminate them from the market [Von Mises 1949,286-291; Kaldor
1966,34-50; Marshall 1927,808]. Their departure will be precipitated by the inability to
recover money invested in production given the new (unanticipated lower) market prices
for their output--cash flows generated by the real (physical) assets are insufficient to
recapture the nominal money invested in those real (physical) assets.

6.2 - Real Assets, Cash Flows and Security Market Prices

Current accounting measurement in financial reports is considered flawed due to
two issues are addressed below.

(1) In an inflationary environment, a firm whose nominal profits are constant from
year to year suffers a decrease in real profit.

(2) The real rate of return is the return to determine the viability of an investment.

Issue #1: In the normal operation of the firm, management pursues a cash flow
plan which is financed in the capital market by money savers. Having obtained the
necessary financing, management sets in motion the production process with investments
in productive (nonmonetary) assets at the initial state based upon the firm's desired rate of
return and the expected net revenues. The nonmonetary assets take on no other
significance than merely as stores of financial capital to be released in the production
process [Salvary 1997,94-96]. The financiers arrive at a price of the firm's (producer's)
expected earnings--the cash flows expected to be derived from the firm's operation, but
they do not place a value upon the firm based upon the replacement cost or realizable
value of the physical assets which are in the possession of the firm.. (Disclosure of proven
reserves for oil companies, backorders, and other similar disclosures facilitate projections-
-they provide information on the future availability of inputs necessary for continued
output.) The assets (monetary and nonmonetary) are simply means to an end; they are
cash flow generators and not ends in themselves. In this case, the capital market prices
estimated future earnings (cash flows expected to be generated during the change from
nonmonetary asset form to a monetary claim), and financial accounting measures actual
current earnings (cash flows) [Salvary 1998,34-39].
 17

As measured in financial accounting, earnings/profit Ep consists of two elements

[Salvary 1992,241]: (1) a current cash flow component (Ecf) (earnings realized in the form
of cash - current cash flow) plus (2) a future cash flow component (Eff) (earnings realized
in the form of credit - an accrual of estimated discounted future cash flow):

(5) Ep = Ecf + Eff .

If producers' earnings are adjusted by a price index then the adjusted earnings information
would result in distorted market prices for securities--claims against producers' future
earnings. This condition holds since in an inflationary period each financier, in his/her
valuation (pricing) model, makes an adjustment to the rate of discount (Rn) by which the
future earnings (cash flows) would be discounted to compensate for any difference
between what is perceived to be the 'real' rate of interest and the 'nominal' rate of interest.
The valuation model is presented in equation (6):
k
(6) Mst0 = RV(Rn) + Σ (En)(Rn)-1 (t = index; n = number of periods)
-1
n=0

In this model, Ms is the present value of an investment stream (security market price). RV
is the residual value at the end of the holding period. En is the stream of estimated future
earnings (cash flows). Rn is the risk adjusted discount factor. Rn is periodically adjusted
by the financier to compensate for the specific effect of changes in the price level on the
financier. En is the financiers projection based upon current earnings (cash flows) as
provided in financial reports. Since Rn, which is financier specific, is already adjusted for
changes in the price level, if current earnings (cash flows) are adjusted by the Consumer
Price Index, then market price distortion will ensue.
Issue #2: The real rate of interest (return) is defined as the nominal rate of interest
(return) less the rate of inflation [Cohen, et. al. 1987,15,29]. Essentially, the real rate of
return is an inflation-adjusted return [Waggoner 1994,3B]. There are problems with
financial accounting measurements. However, assuming that the measurements are
proper, if what is needed is a measure of the real accounting rate of return, then this can be
arrived at by simply subtracting the "rate of inflation" from the accounting rate of return.
The number arrived at by adjusting a host of different items in the financial statements by
a host of different scalars cannot be meaningfully interpreted.
 18

Indubitably, inflation is a problem for many members of society, but to ascribe the
failure to arrive at the impact of inflation on the business enterprise as a deficiency of
financial accounting is erroneous. The error occurs as a result of the illegitimate
substitution of roles (the producer is considered synonymous with the multiplicity of
shareholders who constitute the financier/consumer). Assuming that general price level
adjusted data validly address the information need of one shareholder who is the sole
owner of the corporation, then the substitution of the financier with the consumer is valid.
In that case, the measurement of the impact of inflation on the business firm (limited to an
adjustment of the earnings amount only) is identical to the impact on the
financier/consumer. However in the case of the publicly held corporation, since the
purchasing power of a sum of money is investor/consumer specific, how can any measure
of a firm's purchasing power units be meaningful to so many varied investors with entirely
different consumption patterns (different baskets of goods)? This point is accentuated by
Tobin [1978,246]: "It is not in fact possible to invest in the GNP Deflator or to hoard the
basket of goods, services, and taxes valued by the Consumer Price Index."
The foregoing analysis provides a suitable basis for evaluating the performance of
the firm and the relevance or irrelevance of financial accounting measurement in an
inflationary environment. At this stage the recommended approaches to measuring the
impact of inflation will be explored.

7 - CURRENT COST ACCOUNTING AND CONSTANT DOLLAR ACCOUNTING

Current Cost Accounting, the alternative approach recommended by the FASB to

provide information on the effects of inflation, deals with specific price changes and does
not provide information on general price level changes. Since specific price changes do
not constitute a necessary or sufficient condition for inflation, current cost accounting is
not inflation accounting.10 Furthermore, the concern for measuring performance by
adjusting for current cost, which is a physical quantity approach, reflects implicitly an
assumption that production is timeless, and therefore, production and consumption occur
simultaneously.11 The main method of accounting for the preservation of purchasing
power - constant dollar accounting - will now be evaluated.

7.1 - Constant Dollar Accounting

Under the definition of inflation as the simultaneous increase in all prices, then the
 19

unit of measurement--money--is not stable; as such, it is necessary to hold the unit of

measurement constant in order to measure. The difference between the unadjusted
measurement and the adjusted measurement would constitute the impact of inflation.12
Changes in prices alter the physical relation underlying nominal money
(dollar/pound/franc) values. A lack of interperiod correspondence between physical
quantity flows and financial volume flows emerges. To preserve the physical
quantity/financial flow relationship, the use of constant dollar accounting is advocated.
The measurement obtained by holding the unit of measurement constant (adjusting for
price level changes) is termed constant dollar accounting. The argument for inflation
accounting is capsulized by Niehans [1978,127]:

Provided consumption in a given period is never an inferior good, money

illusion will distort present consumption upward at the expense of future
consumption. Resources are used up that would have been necessary to
maintain the capital required to provide for the hoped-for future consumption.
In future periods the individual will thus be disappointed to find that money
income is insufficient to buy the hoped-for consumption bundle; he [she] is left
with an inefficient allocation of consumption over time. ... for the accountant it
appears in the form of a firm that determines its profit distributions in such a
way that capital, in money terms, just remains intact. Such a firm will later
find that its owners have actually dissaved consuming capital in the guise of
profits.

The above passage reveals a misapplication of a social income concept (physical capital
maintenance) in measurement of business income [Salvary 1997,100; 1979,366-369].
If conventional financial accounting measurement causes management to be
uninformed, then one would expect that empirical research on: (a) bankruptcy would
reveal that financial statements adjusted for price level changes would be good predictors
of firms that go into bankruptcy, and (b) dividend policy would reveal that firms are
unaware of their future financing needs. The empirical evidence does not support such a
contention. The empirical study by Norton and Smith [1979] concluded that general price
level adjusted financial statements are no better predictors than conventional financial
statements in the prediction of bankruptcy.13 The empirical evidence [Meyer and Kuh
1959; Brittain 1966; Rumelt 1974] on the role of dividend policy in the investment
decision contradicts the assertion that management is unaware of its financing needs by
paying out capital, needed for the replacement of assets, in the form of dividends. Then
 20

what is the significance of information reflecting the preservation of the physical

quantity/financial flow relationship - the maintenance of productive capacity?

7.2 - Current Cost Accounting - Maintenance of Productive Capacity

The maintenance of productive capacity is only one possibility inter alia of
management's decision. Since the rate of return on money invested (rather than the type
of physical capacity) is the prime investment criterion,14 shareholders cannot be construed
to be concerned with the maintenance of physical capacity; and less concerned would be
creditors since their stake is in the recoverability of their money advanced to the borrowers
rather than the commitment of their funds anew to new investment projects. The decision
whether financial capital should be retained to enable the maintenance of productive
capacity (physical capital) or returned to shareholders in the form of dividends is a
managerial decision.15 It is not a concern for financial accounting.
The problem in this area of what should be maintained financial (money) capital
(Kf) or real (physical) capital (Kp - referred to as economic capital) is attributable to the
carryover from the classical economists in the analysis of a subsistence (corn) economy
[Salvary, 1993;1997/1998,101-102]. Apparently, it is from this corn analysis that the
Hicksian consumption definition of income is derived. Upon recognizing the fruitless
debates caused by uses of his definition of income (1939 - Value and Capital) in an
unintended manner, Hicks [1942,133] lamented and emphasized the limitations of his
definition of income. The caution by Hicks is not surprising since the Hicksian definition
may have been derived from John Stuart Mill's [1830,88-89] and James Mill's [1844,75-
84] definitions of social income. According to those definitions, the purpose of
maintaining physical capital as a nation was the preservation of the individual laborers.

The net social produce of a country is whatever is annually produced beyond

what is necessary for maintaining the stock of materials and implements
unimpaired, for keeping all productive labourers alive and in condition for
work and for just keeping up their numbers without increase [Mill 1830,89].
(Emphasis added.)

The distributable income concept [Vancil and Weil 1976,58] which is directly
related to the concept of distributable operating flow [Revsine 1973,Chap.V] is a
derivative of John Stuart Mill's [1830] and James Mill's [1844] consumption model which
applies to society as a whole. This consumption model, called by any other name:
 21

"distributable income" or "sustainable income", is the rational for the FASB's espousal of
current cost as one approach to addressing the inflation issue:

Erosion of physical capital (or erosion of operating capability) may be regarded

as the failure to retain sufficient financial resources to acquire the assets
needed to maintain the capacity of the enterprise to provide a constant supply
of goods and services. The concept of physical capital erosion may be linked
to a concept of distributable income where distributable income is defined as
the amount of cash that may be distributed without reducing the operating
capacity of the enterprise. The information on current cost income from
continuing operations required by this Statement provides a basis for users'
assessments of distributable income [FASB 1979,para.124]. (Emphasis added.)

In a market economy motivated by a concept of surplus (profit), there is no basis

for the replacement of physical assets simply to produce a constant supply of goods and
services. Replacement constitutes an investment decision which must satisfy the criteria
for investment. It must be stressed that: (1) perpetuation of the firm is not a social
imperative, and (2) nominal dollars are advanced by financiers and nominal dollars are
returned to them. It seems logical that financial capital should be maintained.
The term distributable operating flow, which underscores the physical capital
maintenance concept, is defined as: "that amount of resources that can be distributed to
16
owners without constricting the level of physical operations" [Revsine 1973,126]. In
defense of physical capital maintenance, Revsine [1982] argues from the framework of
national policy. Revsine [1982,83-84] maintains that: (1) the firm will be paying taxes on
income determined under the financial capital maintenance approach which would not be
income under the physical capital maintenance approach; and (2) income so determined
could not be exempt from income taxation because it would be conceptually inconsistent
to argue that income exists but it should not be taxed.
From a national policy standpoint (John Stuart Mill [1830] and James Mill [1844]),
it is the individual taxpayer whose sustainable income has to be considered. Yet, there is
no argument for the determination of the individual's taxable income on the basis of the
physical maintenance concept (determining taxable income by maintaining the ability to
acquire the preceding year's basket of goods and services). The individual's taxable income
is based on the current period's expenditures unadjusted for changes in the level of prices.
Unequivocally, in a surplus economy in which what is capital and what is
 22

consumable are entirely different, the maintenance of physical capital (productive

capacity) by the firm is inappropriate as a financial accounting concept for determining
periodic performance--profit measurement. In financial accounting, a distinction is made
between prices and recoverable money outlays. All prices eventually become past prices;
however, past prices are not recorded in financial accounting. For example, when a firm
acquires a productive asset, it is the money outlay or its equivalent that is recorded in
financial accounting provided that such amount does not exceed the net present value of
the investment. Once an investment has been made, the amount recorded for the asset
represents the estimated present value of the investment (the estimated recoverable
amount), which can be equal to or less than the actual money outlay [Salvary 1992,246].
(This fundamental accounting measurement rule has been violated frequently in current
practice, e.g., World Com, Qwest, etc.)
A risk, which is inherent in any profit-oriented undertaking, exists that the actual
present value may differ from the estimated present value. Nevertheless, the money outlay
constitutes a storing of services and provides the basis for determining input cost. As
these stored services (e.g., money commitments in capital goods) are used up, they
constitute the current cost to the firm. Use of current replacement cost would constitute a
substitution of future cost in lieu of actual current cost (the stored future services--planned
cost which flows with the gestation of the plan). Under the current replacement cost
approach, accountants would be matching future costs with average revenue.
Self-sufficiency of internal financing is being peddled under the pretence of getting
a better matching of costs and revenues. This approach is simply the usurpation of the
function of the capital market. One may say why should the capital market be the source
of future financing? To answer this question would lead to a discussion of the evolution of
the capital market, which is beyond the scope of this paper. Briefly however, the history
of society reveals the existence of an evolutionary process of adaptation which is oriented
toward the maximization of the social welfare. Various institutions have been introduced
by society at various points in time in its attempt to be efficient and effective in executing
social exchanges. Clear examples of the social welfare maximizing adaptive process are
the firm, money, a money economy, and the capital market [Salvary 1997, 90-92].

8 - SUMMARY AND CONCLUSION

Business firms are always confronted with specific price changes in the cost
 23

(nominal money prices) of the factors of production, and factor costs constitute the basis
for output price determination. The firm, except it be a monopoly or enjoy an oligopolistic
situation, has to price in accordance with market demand conditions. A nominal price is
set for its output based upon a desired rate of return on nominal money invested. It is only
after the cash flow (the nominal money flow) has been determined that one can determine
the financial capability of the firm. Since each production plan: (a) is unique to its market
condition at a given time and place, and (b) is expressed in nominal money terms, the
return on finance as used in the production plan should be measured in current nominal
dollars. This position does not negate individual financiers/consumers from assessing their
consumption preferences in real terms; that is establishing measures that reflect the
manner in which individually they are affected by changing prices vis a vis their
expectations of nominal returns (cash flows) from their investment portfolios. However,
for the producer/firm, a constant dollar measure cannot be useful for a nominal dollar
(cash) flow system. The firm's performance can be measured and judged only in terms of
the cash flow (nominal dollars) generated by the alternative chosen.
How the many shareholders' consumption will be affected by rising prices given
the shareholders' (as consumers) individual baskets of goods and services is a different
question from how changes in specific factor prices affect a firm's profitability and cash
flow. Unfortunately, in the absence of monetary dislocation, adjustment of financial
accounting information of business enterprises for general price level changes will not
enable a meaningful assessment of an individual's situation; it will only distort the
information which purports to portray the financial condition and performance
measurement of business enterprises.
Accounting is not a subset of economics! While an understanding of economics is
very important, accountants should cease and desist from all attempts to convince
themselves that accounting is a subset of economics. A price system signals changes in
the demand and supply conditions of the various goods and services provided by the
economic system and the function/purpose of price level adjustments is to enable the
conversion from measurement using a price system to a physical quantity system - the
determination of change in physical output. If prices are held constant, then the price
system cannot be functional. Accountants have to focus on the further development of
accounting theory and avoid the substitution of economic theory for accounting theory.
 24

ENDNOTES

1 A very well organized argument against inflation accounting has been presented by Stickney and Green
[1974]; however, that very insightful work has not attracted much attention in the literature.

2 The situation in Russia became more accute on August 17, 1998, when the The Russian Government
devalued the ruble [Edwards, 1999,199].
3 For a similar view of this situation, see Von Mises [1949,254].

4 For a good discussion on the role of expectations, see Hicks [1942,117].

5 This condition exist because there are 'economies of scale', 'learning curves', and 'dynamic adjustment
costs' [Gort and Konakayama, 1982, 1114,1115,1118].
6 For a comparative exposition on the information content of earnings, see Wilson [1987].

7 For an in depth view of this position, see Friedman [1958;1969].

8 The work of Vining and Elwertowski [1976,702,703,707] provides some support for this position.

9 For a similar finding, see Challis [1965,137].

10 For a very good discussion of this point, see Johnson and Storey [1982,131].

11 In this regard, Machlup [1935,582] maintained:

Only [in the case of the stationary state of an economic system] ... may maintenance of capital,
including replacement of particular items of plant, be conceived as part of the production of the
output consumed at the same time. But any theory of economic change and any theory of capital
has to regard the time element as its integrant part. The production of a definite quantity of
output can be done with or without full maintenance of the instruments necessary for its
production. Therefore, the output of consumable services is not dependent upon the simultaneous
input of productive services used for maintenance or replacement of plant; the productive services
used for maintenance or replacement of plant are not a part of the production of services
consumable at the same time, but at later moments of time; there is a time interval between the
input of services and the "dependent" output of services ... [Footnotes omitted].
12 If costs and selling prices vary at different rates, then the inflation accounting methodologies (viz: historical
cost/constant dollar, replacement - current cost/constant dollar) are not interpretable Boussard [1984,164].
13 Baran, Lakonishok and Ofer [1980,22-35] concluded that business earnings as adjusted for general price
level changes are superior to the conventional measure of earnings. Samuelson and Murdoch [1985,706-
710] have strenuously contested the position of Baran, et al.
14 Despite limitations of current financial accounting information given the acceptance of accounting
standards as simply alternatives when more than one method exist, ". . the ROI measure contains, or is
correlated with, information that stock market participants deem important as to profit performance
[Jacobson 1987,477]."
15 Mill [1844,223] has emphasized that profit after it is realized becomes part of capital and is then subject
to whatever use intended on the part of management.
16 For a variation of this position, see Revsine [1970].
 25

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