Reviewed by Catharine M. Lemieux Indiana State University
The FASB series, “Financial Accounting Concepts,” states that the objective of accounting should be to provide informa-tion for business decisions rather than to describe economic events. In contrast Bodenhorn states, “that the primary concern of the accountant should be to measure the variables which economists have identified as the most important in describing the performance of an economy, and the entities in the economy” [p. 1]. In this book Bodenhorn develops a model of a simple economy based on economic theory and constructs an accounting model appropriate for this economy.
The economy in this model consists of a firm and a person who is both a laborer and a consumer. The individual, labeled Crusoe, maximizes a known welfare function subject to a wealth constraint and the firm maximizes profit subject to a known production function. Three groups, firm, household, and society, comprise the economy. Although this is a simplified view of the real world, Bodenhorn states that, “if an accounting principle gives a poor description of a simple Crusoe model, I find it very difficult to believe that it will provide a reasonable description of a more complicated model” [p. 4].
The author draws four conclusions from this economic model: (1) the sum of the value of individual assets of the firm is equivalent to measuring the value of the firm, (2) the appropriate price index to use for deflating values is a general price index, (3) the current value of real capital corrected for changes in the price index is the appropriate measure of capital maintenance, and (4) the only way to measure income is to measure wealth.
The accounting model consists of a balance sheet that measures wealth and an income statement that measures financial and productive income. The sum of financial income is zero for the economy so national income equals national product or productive income. Because welfare and production functions are known there is no risk in Crusoe’s world. Flow accounts are closed to balance sheet accounts but in this system, debit entries do not increase asset accounts and reduce liability accounts. Debits are defined as anything that increases inventories and are positively signed. Credits decrease inventories and are negatively signed. Liabilities are viewed as negatively signed assets. This enables the same accounting procedure to be used for all accounts.
Allocations, such as depreciation, do not affect income or balance sheet variables because what is closed to the balance sheet accounts is the value added by production. Allocations merely explain the sources of the productive income. Firms do not generate income but do generate product for the society. Production income is transferred to shareholders. In this model wealth is defined as the market value of economic instruments and income is defined as the increase in wealth plus consump-tion. GAAP procedures measure value added directly and plug inventory while this procedure calls for measuring balance sheet values at market and plugging value added. FASB has supported GAAP procedures and Bodenhorn claims that this, “may well inhibit the evolution of accounting into an empirical discipline for the rest of this century” [p. 27].
The final section of this book attempts to extrapolate the conclusions from the first two sections to the real world. The first assumption that is relaxed is the existence of a government. This creates two problems: (1) the future tax liabilities which must be recorded on the firm’s balance sheets no longer balance, and (2) the value of economic instruments is no longer explicitly defined. To solve this problem the productive value of economic instruments could be used for balance sheet purposes with the resulting complication being that inappropriateness of these values for private decision making.
The second assumption that is relaxed is the addition of banks and financial institutions to the economy. These firms differ from the production oriented firm in the economy because their assets are primarily financial and they do not charge fees for services but instead reduce the interest rate on borrowed money. This causes this type of firm to appear to have a negative income because their purchases of productive resources exceed their sales. To correct this problem productive income is ad-justed so that it equals a risk-adjusted normal rate of return on productive assets.
The final chapter extends these results to business accounting. Although the model suggests that the ideal accounting scheme would be based on current market prices, Bodenhorn allows that it would be possible for Crusoe to use historical cost, service-potential or market price as a basis for valuation. However, there are disadvantages to using either historical cost or service-potential valuation methods. The problems with service potential valuation is that the future is difficult to predict and there is no theoretically correct way to allocate future cash flows to various productive instruments.
Historical cost valuation will give the correct measurement for total assets, but it is difficult to allocate purchases of inputs and interest costs to the sale of particular productive instruments. One possible solution is to define projects in an attempt to associate purchases and sales with individual projects rather than individual assets. An additional problem with cost valuation in the real world is the existence of profit, an impossibility in the economic model. One possibility of recognizing profit is to compare actual costs and recoveries to “standard” costs and recoveries obtained from projections based on previous information. Variances would be an indication of the need to revalue assets at market prices.
Bodenhorn constructs a simple example using his Crusoe economy and comparies traditional business accounting proce-dures to the results obtained using his accounting model. Problems with the allocation of depreciation, labor, and interest expenses cause differences in balance sheet values under the two systems. Bodenhorn’s example supports the view that GAAP systematically underestimates interest costs of productive assets due mainly to the use of historical cost valuation of assets. Income would also be distorted due to these allocation differences. This leads Bodenhorn to conclude that, “GAAP are fatally flawewd” [p. 280].
The ideas presented in this book call into question much of existing accounting standards and practices. The controversy begins with differences in the basic objective of accounting. Bodenhorn’s contention that accounting should measure vari-ables important for describing the performance of an economy is very different than the objectives of the accounting profession as stated by FASB. The desire to construct an accounting system where aggregation of individual and firm income statements and balance sheets would be consistent with aggregate meas-ures in the national accounts, lead the author to start with a basic economic model of a simple economy and derive an accounting system that would fit this model. If William D. Hall, former Arthur Andersen partner, is right and the accounting profession does have an “urgent need” for a usable conceptual framework, then this book is a step in that direction. The conclusions of this exercise have important implications for the future direction of the accounting profession.
