management accounting

MANAGEMENTACCOUNTING

PUBLISHED BY THE NATIONAL ASSOCIATION OF ACCOUNTANTS/ FEBRUARY 1973

THE BUSINESSMAN'S ROLE

PRICE -LEVEL CHANGES AND COMPANY WEALTH

INTERNATIONAL TAX MANAGEMENTCMA: FIRST EXAMINATION

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NAA'sManagement Advisory Service

Isn't For Sale .. .(But a Lot Of People Are Buying It!)

For the disadvantaged, needy person wanting to establish hisown small business properly, confidential accounting andfinancial management advice is available from a number ofNAA Chapters . .. without charge.

This advisory service is provided by volunteer managementaccountants, corporate treasurers, controllers, financialexecutives and CPAs with membership in NAA.

The purpose of the advisory program is to make the smallbusinessman aware of his financial management needs and toget him started in the right direction.

NAA does not do the detail work. Carrying out of advice mustbe accomplished by competent employees or qualifiedprofessionals. NAA advisors withdraw once the business issuccessfully under way. The problem is, there are still a lot ofareas, where help is needed, not now being served by an NAAChapter Socio- Economic Committee.

If you'd like to start one —or otherwise help out — contact:

• Your local Chapter President

• ROBERT F. CLAIRMONTSocio-Economic Program

National Association of Accountants919 Third AvenueNew York, N.Y. 10022(212) 759 -3444 or 371 -9124

Participation is not limited to NAA members. Anyone whowould like to join the NAA Socio- Economic Program is alsoinvited to contact us.

PRESIDENT'S PERSPECTIVE

ImprovingFinancial ReportingA great deal of concern has been expressed in recent yearsabout financial reporting and disclosure. Auditors have comeunder fire for attest ing to statements later viewed as misleading.Corporate accountants and company management have alsoreceived their share of criticism for information deemedmisleading and for omission of material facts. Financial publicrelations consultants are now the latest group to fall under SECscrut iny. In the landmark Pig 'N Whist le injunction and consentdecree the concept of liability was extended to financial publicrelations counselors, placing on them the obligation ofinvestigat ing facts received from management , as well asinvestigation of management's creditability.

A positive effort to improve financial reporting to the presshas been launched in recent months by the Public Relat ionsSociety of America. Its local chapters have held seminars ondisclosure requirements and account ing principles, which weredeveloped in cooperation with one of the Big Eight account ingfirms.

Although the seminars principally involved CPAs and financialpublic relations consultants, it was apparent in many cases therewas a lack of communication between P -R consultants andin -house accounting staff. Corporate accountants were notheld legally responsible in this particular instance but in light ofthe recent public crit icism it would seem that at the veryminimum they have a professional responsibility to improvetheir working relationship with all the other parties involved infinancial reporting.

The inter - disciplinary approach to financial reporting, asillustrated by the discussion seminars between P -R consultantsand CPAs, is a significant new development and one which canonly lead to bet ter communications. Management accountantscan inaugurate similar efforts to improve disclosure and thusbolster the public's faith in the basic integrity of the privateenterprise system.

ROBERT BEYERPresident, 1972 -73

MANAGEMENT ACCOUNTING /FEBRUARY 1973

2


15 THE BUSINESSMAN'S ROLEBy Robinson F. BarkerA review of the problems facing business today and the role the businessman mustplay in contributing to public policy.

Cover: 17 PRICE -LEVEL CHANGES AND COMPANY WEALTHCMA test scene inManhattan was By Russell J. Petersen

duplicated at 21 other Changes in price levels may affect the purchasing power of a company and thereforesites across the its comparative wealth. In this article, the author describes a procedure for the

country. See p. 61. measurement of gains or losses resulting from price -level changes.

21 CONTROL AND MANAGEMENT OF INDIRECT EXPENSESBy Harold E. SharpIndirect expenses are of prime concern to buyers for governmental agencies andprivate companies. In this article, the author reviews various aspects of the subjectand illustrates the approaches used to best allocate these costs in order to remaincompetitive.

26 ACCOUNTING CHANGES: WHY CPAs MUST CONFORMBy George D. Cameron, III; Ralph W. Gudmundsen, Jr.; and Jack R. BallDespite the natural urge to resist change in financial statements, management shouldconsider why the change is necessary and why the CPA insists on it. The authors feelthat the CPA must make these changes and they give three reasons why.

29 A SYSTEMS APPROACH TO CASH FLOW DETERMINATIONBy Walter J. Thrun, Sr.The author presents three questions that budget administrators should ask to obtaininformation for an investment decision. He shows how to answer them with asystems concept.

An award-winning article: Certificate of Recognition

32 THE 'MAKE OR BUY' DECISIONBy Jim MadisonThe cost analysis of "make or buy" decisions can best be made using a mathematicalmodel. In this article, the author discusses suc h a model and offers an example wherethe firm's capacity to produce is the determining consideration.

35 A CASE FOR CURRENT -COST REPORTINGBy Arthur E. CarlsonThe author asserts that data for reporting purposes must take cognizance of the factthat future orientation is a prime requisite of accounting information for decisionmaking purposes. He reviews three sets of current standards to substantiate hisassertion.

38 CONTRACT TERMINATION AND UNABSORBED OVERHEADBy Paul M. TruegerAlthough it is generally agreed that the overall public interest is best served by givingthe Government the right to halt activities and related costs which are determined tobe unproductive, this author believes that the Government should move to help the

el

contractor to extricate himself from the cancelled project and to compensate himequitably for the financial consequences.


FEBRUARY 1973

41 ASPR: SOME SUGGESTED CHANGESBy Douglas G. CordermanAccording to the author, defense contract accounting procedures do not alwaysconform to generally accepted accounting principles. To remedy the situation, he

proposes a number of changes.

45 BUSINESS COMBINATIONS: POOLING OR PURCHASE?By David J. RetzWhen two corporations decide to combine, the accounting methods used to effectthat combination will be subject to conflicting interpretations. In this article, theauthor presents a strong case for the "purchase method" over the "pooling of

interests" method.

47 INTERNATIONAL TAX MANAGEMENTBy Ernst K. BrinerInternational corporations face special tax problems in terms of United States taxesand the taxes of other countries. An insight into some of these problems is offered

in this article.

53 NAA TESTIFIES ON FORECASTSText of MAP statement on forecasts at SEC hearings.

55 ELECTIONS '72Mid - Missouri's "Kit" Bond, who was elected governor of his state, leads list of NAAmembers who ran and were elected to public office last November.

57 THE GAMES ACCOUNTANTS PLAYWith magnifying glass and trenchant wit, Prof. Briloff dissects the anatomy of recentfinancial reports; finds "Hot Pants" accounting and "Inflated Bosoms."

61 CMA EXAMINATIONS HELD FOR FIRST TIMEInitial Certificate testing program attracts many; questions and unofficial answers toPart 1 are offered for future guidance.

DEPARTMENTS1 PRESIDENT'S PERSPECTIVE6 LETTERS to the editor

14 DATA SHEET items of interest for the businessman

52 BOOKS for the management accountant59 CHAPTER /MEMBER NEWS all about chapters and members60 TIME OFF the l ighter side of the ledger

Views expressed herein are authors' and do not represent Association policy unless sostated. Reprints of articles appearing in any issue of MANAGEMENT ACCOUNTING are availa-ble from NAA's Reprint Department.

MANAGEMENT ACCOUNTING /FEBRUARY 1973 3

COMMENT

Is There A Forecast In Your Future?

Corporate financial management may soon be faced wi th an addi-tional annual reporting problem— forecasting. It appears that the Se-curities & Exchange Commission may permit, if not require, compa-nies to include in their annual financial reports, predictions of nextyear's profit status.

Some companies seem to believe the SEC will require such fore-casts, and because of this belief one company included in an unusual1972 "preliminary" annual report (dated Dec. 28) estimates for 1973.The company's (Fuqua Industries, Inc.) Chairman, J. B. Fuqua, saidof the forecast, "While we are not fully convinced of the merits ofmaking public projections of future earnings, if this is the kind ofmusic we will have to march to, we are willing to lead the band."

At the SEC hearings in November and December, some testimonywas favorable to forecasting in annual reports, but most financialgroups were opposed to mandatory forecasts while in favor of volun-tary forecasts. Because of such great opposition, some observersbelieve required forecasting will not come about.

NAA is involved in the forecasting. issue through the Committeeon Management Accounting Practices. The MAP Committee sug-gested the SEC permit forecasting if companies so desire but shouldnot require forecasts because of the problems which could resultfrom presentation of such predictions. (See page 53 for text of thestatement.) The Financial Executives Institute took a similar position.

Since forecasting soon may become a reality, NAA members shouldstay abreast of developments as reported in newspaper and magazineartic les . MANAGEMENT ACCOUNTING has pr inted art ic les On forecasting

and undoubtedly will print more. NAA invites you to participatedirectly in the forecasting issue through letters to MAP and MANAGE-MENT AC CO U NT IN G Or t h r o u g h s u b m i s s i o n o f articles discussingthe ramifications and feasibility of forecasting.

C o m i n g U p i n MANAGEMENT ACCOUNTING

Everyone compla ins about r i sing heal th care cos ts ; in "Hospi t al Cos tControls , " Isaac Smal ls does something about i t . . . Seeking sophis-ticated pricing guides? Al J. Betley provides them with "Contribut ionPricing" . . . Sett ing work standards for profess ionals requires re-sourcefulness, ski l lfully di splayed in "Controll ing Professional Man-

power Costs" by J. Kent Oehm . . . In "The Investment Credit,"Will iam A. Cole and Stephen H. Wales, Sr., discuss appl ications ofthe five Investment Credit Acts passed since 1962.


VOL. LIV NO. 8 FEBRUARY 1973

Published monthly, for members only, by theNATIONAL ASSOCIATION

OF ACCOUNTANTS919 Third Avenue, New York, N.Y. 10022

rnonpo

dR =EXECUTIVE DIRECTORWilliam M. Young, Jr.

DIRECTOR OF PUBLICATIONSJames D. Collier

MANAGING EDITORErwin S. Koval

SENIOR TECHNICAL EDITORAlbert Cohen

FEATURE EDITORRobert F. Randall

ASSOCIATE EDITORSDonald StabileKathy Williams

EDITORIAL ASSISTANTSDebbie VoutsasLucile Lawrence

CIRCULATION MANAGERRaymond Goldstein

B o

Secondclasspostage paid at New York, N.Y.,and at additional mailing offices. To ensureuninterrupted mail service, please notify usimmediately of any change of address. Sendpresent address label and new address, in-cluding Zip number, to Member RelationsDept., NAA, 919 Third Ave., New York, N.Y.10022. Allow six weeks for change. Price $1.25per copy. Single subscriptions available onlyto NAA members, libraries, and college -levelaccounting students. Subscription rates, peryear: NAA members, $10.00 (included in an-nual dues); libraries, $9.00, college students,$5.00.

ADVERTISING REPRESENTATIVES

Mead Irwin Associates, 520 Fifth Avenue, NewYork, N. Y. 10036, (212) 986 -9781.E. W. Carlson, Union Trust Building, Pitts-burgh, Pa. 15219, (412) 471 -1410.

James K. Millhouse, 919 N. Michigan Avenue,Chicago, ill. 60611, (312) 641 -6625.

WESTERN STATESRoy McDonald Associates, Inc.

Dallas, Tex. —(214) 637 -2444Denver, Colo. —(303) 825 -3325Houston, Tex. —(713) 529 -6711

Los Angeles, Calif. —(213) 483 -1304Portland, Ore. —(503) 292 -8521

San Francisco, Calif. —(415) 397 -5377Copyright © 1973 by the

Nat ional Association of Accountants

MANAGEMENT ACCOUNTING/ FEBRUARY 1973

NewNCR18=22Designed for the business office, with features for business problems.

Now, NCR brings you a new, low- pricedone - memory calculator especially designed for officefigure work. The new NCR 18 -22 has all the featuresto do the kind of jobs you encounter every day inbusiness.

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The keyboard is not cramped. Extra long "zero"bar extends to the left of amount keys for natural handpositioning. Arithmetic function keys and memorykeys are spaced so anyone can operate the 18 -22

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When you see the NCR 18 -22, we're sure you'llagree it's the ideal display calculator for your businessneeds at a price you can afford. Only $279.For more information call your nearest NCR BranchOffice or NCR Office Products Dealer. Or write OfficeProducts Division, Dayton, Ohio 45409.

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Letters TO THE EDITOR

Will Accountants Recognize Social Changesand Adapt . . . 3

I read with interest the article, "Pilots of Social Progress," byMr. Robert Beyer in the July 1972 issue of MANAGEMENTACCOUNTING. It is true that accountants in public and corporateaccounting practices have historically had a role in corporate socialresponsibility and that the role has expanded considerably duringthe last twenty years. There is little doubt that future socialchanges will have even greater influences on the profession ofaccountancy. The real question appears to be whether accountantswill be able to recognize social changes and adapt to them.

Social changes have resulted from expanding technology, declineof the family unit, greater educational opportunities, failure ofthe market mechanism, and political philosophies. Whether thesefactors represent root causes of social change or are results ofintensified human interaction is difficult to determine. However,the effects of these factors can be seen in attitude changes towardmanagement and accounting, as well as in the quantity and sophis-tication of accounting data required to satisfy social demands.

Causes of social change are primarily external to the businessorganization. In many instances, a positive business response tosocial demands has resulted, principally due to government coer-cion. Some social groups have expressed antagonism towards busi-ness management and accountants because certain social needsand changing attitudes have not been recognized. Many corpora-tions would not have invested in pollution controls, engaged inminority employment, or used good accounting and reportingpractices if it were not for government intervention.

Accountants and professional accounting organizations need torevise their perspectives of the accountant's service role and rela-tionship to social progress. Social progress is people- oriented, andsince accountants generally have had little training in the behav-ioral sciences, any reference to the accountant as a pilot of socialprogress may be misleading. Social progress will occur becauseelements in society change. The role played by accountants insocial progress will depend on their ability to recognize and respondto social changes and causal factors.

Elliot SlocumDepartment of Accounting

Georgia S ta te UniversityAtlanta, Ga.

A Giant Step Forward

As I was reading the article by William J. Sullivan of Youngs-town State University in the August 1972 Issue Of MANAGEMENTACCOUNTING, I discovered that through his system of budget re-porting to department heads on a monthly basis, he has takena giant step forward in solving the age -old problem of com-munications between financial personnel and others in an organi-zation.

As most of us know, a budget, in order to be effective, mustbe communicated so that adequate planning can be done. Ade-quate communication means an understanding of the budget byall concerned and frequent reporting on the budgetary progress.Once the budgetary or financial division of an organization under-stands all other facets of the organization, and once all nonfinan-cial people in an organization understand budgetary responsibility,

one of the problems that has plagued financial officers for yearswill have been solved.

It seems that Youngstown State University through its budgetofficer, William J. Sullivan, has reminded us again that there ismore to finance than facts and figures, and that communicationis essential to productive, workable relations between persons inany organization.

Jeffery W. BarryPresident —Walsh College

of Accounting and Business AdministrationTroy, Mich.

Listening Is a Two -Way Operation

"The Auditor Should Be Welcomed Into the Data ProcessingFamily ..." This concept, mentioned in Harry L. Brown's article"Auditing Computer Systems" (September 1972), represents achallenge to both the auditor and data processing personnel.

Mr. Brown pointed out that the auditor has more to offer thanjust "checks and balances." The auditor for years has been a"systems analyst." The auditor has the ears of top management,a corporate overview, access to all company information and knowsthe value of good controls. With this background the auditor hasmany things to offer in designing a system. One wonders why,with all of this going for him, the auditors have not been moreinvolved in the design of major systems. He suggests that dataprocessing personnel listen to the auditor. I suggest that the listen-ing is a two -way operation. However, being a "member of thefamily," he does link his experience factor as an auditor and hiscontrol concepts to data processing operations. This closer tie tendsto expedite the solution of problems of control in the design stages.

Ken PenderThe Detroit Edison Co.

Detroit, Mich.

Re: Information Services

I feel that I would be remiss in my duty if I did not reporton the excellent service that I received from your Mr. DonaldMackenzie, the Manager of your Technical Information Service.

Mr. Mackenzie gave himself entirely to a problem which Isubmitted to him for his assistance. 1 am sure that if prospectivemembers knew of his devotion to duty, and that of the nationalstaff, they would not hesitate to join our Association.

I am more than pleased to call at tention to the high class of"service" that Mr. Mackenzie gives on behalf of the Association,and he deserves every consideration.

Joseph de AmbrosisMember -at -Large

Winnipeg, ManitobaCanada

A Very Useful and Timely Article

Mr. Pagano's article in the September 1972 issue of MANAGEMENT


Toshi*,ba would Ii0kea few words wi6th

all 0111ietti* Dm24 users.There'll come a time when your old faithful friend —the

Olivetti D-24—is going to conk out on you.When that sad day comes, you're going to be looking for

a new calculator.We hope you'll take a look at us— Toshiba. Why? For one

very good reason. The keyboard and operation of the ToshibaBC -1216P Electronic Printing Calculator is almost identicalto the Olivetti D-24.

The advantage of this is obvious. You won't have to spendhours getting familiar with a new machine.

In addition, the Toshiba is electronic whereas the Olivettiis electro- mechanical. So the Toshiba is faster and quieter.

The Toshiba is also smaller and lighter (it weighs only15.4 pounds). Plus it has other convenient features like anadd -mode, a true credit balance, and red and black print -out.

So if your Olivetti is a little shaky, look into a Toshiba.It's a tough little calculator with a familiar face.

For more details about the Toshiba BC -1216P writeToshiba America, Inc., 41 -06 DeLong St., Flushing, N.Y.11355 or call(212) 939 -7400.

W T O SI n T o u ch

R I B Aw i t h T o m o r r o w

The Toshiba BC-1216P


ACCOUNTING titled "The Line Manager 's Role In Bakery Opera.tions" is a very complete discussion of line functions in a bakeryoperation. He correctly identifies the primary objectives of theline manager as "efficient production output" and "high qualityof merchandise."

His statement that the line manager must work closely withthe Scheduling Department indicates one very important and veryessential consideration. The line manager should not be burdenedWith the responsibility for production scheduling in addition todirect production responsibilities. For greatest efficiency, a sched-uling function or department distinct from the line functionshould be maintained. The overall line responsibility for produc-tion setup, production runs, packaging, production reporting, andmaterial and supply usage reporting is essentially a completeoperation.

James D. PascoeAccounting Manager

Fred Sanders Co.Detroit, Mich.

Software Costs — Expense or Capital Expenditure

Software associated with a data processing facility, regardlessof whether purchased or developed with in -house capabilities, posesa serious accounting question. From both an accounting theoryand a management information standpoint, what is the properaccounting treatment for the costs of such software? This questioncomes to light because the IRS has changed the rules governing

the method of accounting for software costs for tax purposes.The IRS originally took the position that software, when pur-

chased together with hardware, should be depreciated over a five -year period. Left unclear was the problem of what a purchaserof software should do when his systems engineering and program-ming services were purchased separately from his hardware. TheIRS has since changed its position. Its latest ruling provides thatcompanies obtaining software either bundled with new equipment,purchased separately from an equipment supplier or softwarehouse, or developed in- house, have the option of either expensingit during the year of purchase or capitalizing the costs with sub-sequent amortization over a five -year period. The IRS also askedthat companies be consistent in their accounting for software, andif a company wishes to change from one method to another fora new purchase, permission must be obtained from the IRSCommissioner. It appears that by changing i ts ruling, the IRShas taken a "middle of the road" position and left the accountingfor software costs to the discretion of the companies using dataprocessing equipment.

One cannot argue with the fact that a tax advantage wouldaccrue to a company that expensed i ts software costs. From anaccounting theory standpoint, it seems that an asset has beenacquired and should be capitalized and depreciated. It is a knownfact that the hardware cannot operate without software, i.e., theprograms to perform the various data processing operations,whether for accounting analyses or other types of managementinformation needs, depend on software for implementation. If thehardware must be capitalized and depreciated, why shouldn't thesame rules apply to the software?

Continued on page 28

Vir niaris

f0rlOVerSwho will love Richmond

too during Garden Week in Virginia. . .

Educational, Historical &BeautifulFor information write to: APR I L 26-28,1973

MR. CHARLES D. SANDS7104 Wheeler Road

Richmond, Virginia 23229 HOTEL

RICHMOND, VIRGINIA

MID - ATLANTIC REGIONAL CONFERENCE■ Richmond Chapter of

■

NATIONAL ASSOCIATION OF ACCOUNTANTS


Stake it to aailas

.. md11 do the rest!The Texas Council has helped prepare an exciting program for the1973 Annual International Conference for you and your family— one as big as Texas itself.Your trip to Dallas will span the excitement of a real Texas Rodeo,where big prize money is at stake, to a sample of the life style of

the sophisticated super -rich.

If you have never attended an informal Texas Chuck WagonDinner, then this is your chance. (Of course you'll have a chance todress -up at the Annual Dinner.)

Children of all ages rave about the Six Flags of Texas, which isacres and acres of fun and Texas history.

Plan now to attend one of the best National Association ofAccountants' Annual International Conferences ever. If you havenever attended before — don't miss this one!

Speakers and topics for the Technical Program and details about thecomplete schedule at the Big "D" in '73 will be in the mail shortly.

■ NATIONAL ASSOCIATION OF ACCOUNTANTS

■� � NqlCONFER�N� �

0).

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�WORLD LEADER

GENERAL � ELECTRIC IN INFORMATIONSERVICES

If you can't attend ourC "Effective Cash

Management" in New York,March

1 2 m 1 6 , 1 1 1 1 1 1 1 1 1 1

New York /March 12- 16 /Statler- Hilton /13 Courses

Developing and Using Standard Costs (Mon. /Tue.)

Flexible Budgeting & Performance Reporting (Wed. /Thu. /Fri.)

Effective Cash Management (Mon. /Tue.)

Economic Evaluation of Capital Expenditures (Thu. /Fri.)

Accounting Information for Pricing — Policies and Decisions (Mon. /Tue.)

Management Accounting for Banks (Thu. /Fri.)

Management Accounting for Executives & Managers (Mon. /Tue.)

Management Accounting for Hospitals (Mon. /Tue.)

Data Processing— Concepts & Techniques for Managers (Mon. /Tue. /Wed.)

Computers and Internal Control (Thu. /Fri.)

Management Science for Budgeting and Profit Planning (Mon. /Tue.)

Linear Programming: Accounting Applications (Thu. /Fri.)

Marketing Fundamentals for the Management Accountant (Thu. /Fri.)

12 MANAGEMENT ACCOUNTING/ FEBRUARY 1973

u1s rhow about' n St. LoMarch 26 -30?

St. Louis /March 26 -30 /Chase -Park Plaza /6 Courses

Developing and Using Standard Costs (Mon. /Tue.)

Flexible Budgeting & Performance Reporting (wed. /Thu. /Fri.)

Direct Costing & Contribution Accounting (Thu. /Fri.)

Effective Cash Management (Mon. /Tue.)

Economic Evaluation of Capital Expenditures (Thu. /Fri.)

Data Processing— Concepts & Techniques for Managers (Mon. /Tue. /Wed.)

RegiSter nowfor New York or St. Louis

Spring'73C E P

Continuing Education Program

Write or call: CEP RegistrarNational Association of Accountants919 Third Avenue, New York, N.Y. 10022(212) 759 -3444

MANAGEMENT ACCOUNTING/ FEBRUARY 1973 13

Data Sheet FEBRUARY 1973

Disclosure of Accounting Policies and Tax Discrepancies Proposed by SEC

New disclosure proposals by the Securities & Exchange Commission would affect reportingof accounting policies use0and reporting of Federal taxes in earnings reports. Under the SECproposal, companies would be required to submit in reports to the agency "a summary ofsignificant accounting policies to be included in the financial statements either separately oras the first note." "Under certain circumstances and where significant" a company would haveto include an estimate of the dollar impact on net income of use of the principle followedas compared to an alternative acceptable principle. Such disclosure would be required whena company uses more than one accounting principle in reporting similar types of transactions,when it changes its accounting policy within the past two years, or when the principle usedis not the prevailing principle used by companies in the same industry. An accounting changeregarded as "significant" by the agency is one that affects net income by at least 5% or affectsthe improvement or worsening of earnings by more than 25 %, as compared to the prior period.The agency also wants to see improved disclosure of the reason why total income tax expensereported by the company differs from the amount which would result from multiplying thestatutory United States Federal corporate income tax rate by the income before tax.

Take Joint Responsibility for Disclosure, SEC Chief Accountant Urges Auditors

Speaking before the N.Y. State Society of CPAs, SEC Chief Accountant John C. Burton urgedthe auditors to take joint responsibility with corporate management for what is disclosed infinancial statements. If the financial statement which the auditor is attesting to is not preparedas he would prepare it, then he should so note that fact in his report and not tuck it awayin a footnote, Mr. Burton advised. He told the Society members that the costs would be muchhigher if they let the potential liability from shareholder lawsuits prevent them from innovatingand improving their functions.

AICPA Expands Washington, D.C. Staff

In recognition of the increasing impact of the Federal Government on the accounting profession,the American Institute of CPAs has expanded its staff in the U.S. capital. In announcing thenew direction in Washington, Gilbert Simonetti, Jr., vice president — government relations, ac-knowledged the influence of government in the past, on a number of matters of great significanceto the accounting profession. The Institute will concentrate on developing a more effectiverelationship with Congress and the Executive Branch by working "toward becoming a positivesource of advice on public policy relating to accounting, auditing, financial controls, taxationand . . . related m at ters. . . . "

Big Demand for Accounting and Financial Executives Seen in 1973

There will be a 20% increase in corporate demand for accounting and financial executives thisyear, according to a nationwide survey of 475 major corporations conducted by Boyden As-sociates, Inc., an executive search firm. This was the largest increase by job category projectedby the survey. The biggest demand for accounting and financial executives with minimum salariesof $25,000 will be in the East and Southeast. The firm noted that the demand for multinationalexecutives is also rising. "The executive with international experience and expertise in marketing,sales, finance and general management is being sought in almost every corner of the globe,"says Frederick M. Linton, president of Boyden Associates.

CASB Secretary Says MAP's Statement on Contract Costs the Only One Available

One quote you may have missed. Speaking before the Federal Government Accountants Assn.,Arthur Schoenhaut, executive secretary of the Cost Accounting Standards Board, said, "The NAAhas a subcommittee of its Management Accounting Practices Committee that interfaces withthe staff of the Board. The MAP Committee has made some constructive suggestions in thepast and, in fact, developed a statement of contract cost concepts which was published inthe March 1972 issue of MANAGEMENT ACCOUNTING. Although one can find fault with the state-ment of contract cost concepts, it is the only such statement available, and it emanates froman authoritative group."

14 MANAGEMENT ACCOUNTING /FEBRUARY 1973

THE BUSINESSMAN'S ROLEOf All Our Institutions, Business Is The Only One That Society

Will Let Disappear

By Robinson F. Barker

In our free enterprise system, business traditionallyhas been held responsible for the supply of goods andjobs, for costs, prices, wages, hours of work, and forstandards of living. Today, business also is being askedto take on the responsibili ty for the quality of lifein our society. The expectation is that business —inaddition to its traditional accountability for economicperformapce and results — should assume responsibilityfor the health of society. Not only is business beingasked to solve those social problems that have defeatedothers, but i t is expected to anticipate them and toprevent their emergence in the first place.

This challenge does not, of course, come as a com-plete surprise. For some time, there have been businessleaders who have heeded Thomas Paine's warning:"Those who expect to reap the blessings of freedommust, like men, undergo the fatigue of supporting it. "'These are the men who share the concern voiced bystudents and others that not all in our nation haveparticipated in the most prosperous economic era inthe history of man. More important, these same busi-nessmen have begun to take steps to try to mitigatethe problem.' Similarly, the business community rec-ognizes and is working on other associated social prob-lems. The nation's top scientists and engineers —amongthem representatives of industry— working under theauspices of the National Academy of Engineering andthe National Academy of Sciences, have begun totackle the problem of assessing technology. Their goalquite simply is to create a mechanism —now lackingin the economy— whereby the broad social effects ofexploiting and restricting a technological developmentcould be considered and effectively expressed.

Good Business Or Good Citizenship?

More and more the distinction traditionally drawnbetween corporate citizenship and corporate businessis becoming less and less delineated. Are companytraining programs for school dropouts good businessor good citizenship? Does a large corporation's massivestudy of the effects of automation on society mostsignificantly serve the company planners or the com-munity at large? Is the sponsorship of an art showsound advertising or does it fal l under the headingof culture? If you're a pragmatist, as most businessmenare trained to be, the answers are irrelevant. It isactivity itself which is important.

Obviously, a great deal more activity is required.

In many areas we have merely begun to scratch thesurface and in others —if we subject ourselves to objec-tive self - analysis —we have not accomplished even that.We still have to substitute deeds for words if we wishto plead innocent to the charge of preaching andpromising while running in place. There is however,concrete evidence that the first steps —the most impor-tant in any journey —have been taken and others willfollow.

However, it is not that simple. Business does notoperate in a vacuum. While it does have a distinctimpact on society, distinct capabilities and charac-teristics, and distinct opportunities, business is notalone. Other institutions such as the university, thehospital, the government, the military, and labor playa role, and as such must be held fully as accountableas business for the quality of life in our society. Justas we now recognize that government does not offera panacea for society's problems, we also must recog-nize that business of and by itself will produce nomiracles.

The Problem of Environment

Consider the problem of environment. Business doesnot have the capability to solve the problem by itself.Even the most stringent self - policing will result innothing better than a diffused, disorganized overallapproach. This is an area that is responsible only toenlightened government regulation which accuratelyreflects the demands of the total populace.

Too often, I'm afraid, we tend to ignore the com-plexity of the problem in a search for easy solutions.Take the case of electric utilities. How many of ourpower demands are we willing to sacrifice in the nameof preserving the environment? Before answering,however, pause to consider that the makeup of manyof our power plants today was determined by govern-ment regulations responding to a public plea for powerat the cheapest cost.

Again, business' efforts in an area such as housingwill be governed by the attempt to update buildingcodes at the local level and the efforts of unions inthe building trades to cooperate. Nor can business beexpected to unleash the technology and capability that

'Thomas Paine, The American Crisis IV, September 12, 1777.' Members of the National Alliance of Businessmen, an organization re resentingsome 47,500 American industrial companies, during the past four and one -halfyears found jobs for approximately 1,000,000 disadvantaged persons. Of thisgroup —made up of those formerly considered chronically unemployed becauseof their environment and lack of education —some 500,000 were still on the jobafter six months. Pittsburgh Office of the National Alliance of Businessmen.

R. F. BARKER

is Chairman of theBoard, PPG Industries,Inc., Pittsburgh, Pa.He is a graduate ofHarvard College andthe AdvancedManagement Programin the HarvardGraduate School ofBusinessAdministration. Mr.Barker serves asdirector to severalprivate and publicinstitutions.

This article is adaptedfrom a speech to thePittsburgh Chapter inOctober 1970, andwas submittedthrough that chapter.


"What many

. . . fail to

recognize isthat business

is ... an organof innovation."

exist to solve the problem under a property tax struc-ture that harnesses the profit motive in reverse bymaking it more profitable to let buildings decay thanto improve or replace them.

Similarly, can business attempts to help solve theproblems of the hardcore unemployed and minoritygroups be effective unless accompanied by a similareffort on the part of unions in their membership andlicensing practices?

None of the foregoing comments are to imply inany way that it is not clearly in the self - interest ofbusiness and businessmen to accept this responsibilityfor the quality of life in our society and to build itinto the vision of business executives. Three immedi-ate reasons come to mind to support such a move.First, the consequences for neglecting this area areso very great. Second, there is the obvious and moreimportant fact that a healthy business and a sicksociety are not compatible. Healthy businesses requirea healthy, or at least a functioning, society. The healthof a community is a prerequisite for successful andgrowing business. Finally, the quality of life in oursociety should be a tremendous business opportunity.It is, after all, the job of business to convert the needsof society into profitable business opportunities —toconvert social change into constructive innovation.And it is a poor businessman who thinks that innova-tion refers to technology alone. The major industriesof the nineteenth century resulted, to a very largeextent, from the conversion of the new social environ-ment —the industrial city —into a business opportunityand into a business market.

Business . . . An Economic Institution

Yet, one must wonder if the demand that businesstake responsibility for the quali ty of life has beencarefully thought through by its advocates. Business,for example, cannot accomplish these tasks by behav-ing like anything but what it is, an economic institu-tion that acts in terms of economic rationality, aninstitution that must be motivated by profit incentivesin order to function efficiently. Profitability mustremain the yardstick of business whether its activitiesare concerned with the quality or quantity needs ofsociety.

This is a pressing point, and one, I suspect, thatis not fully recognized. For example, businessmen oftoday cannot help but be struck by the lack of under-standing regarding the profit motive. It may well bethat the greatest failure of businessmen is their inabil-ity, or lack of effort, to educate others about theoperation and meaning of the profit system. You asaccountants, better than anyone, should understandthe system. Yet how many of you go home eachevening and complain about the rat -race? Is it anywonder that most wives can't go beyond naming thecompany their husbands work for in answer to a re-quest to describe what their husbands do for a living?Or is it surprising that so many of the youth in ourcolleges —sons and daughters of businessmen —swearthat business and industry is the last place they wantto end up. It is readily apparent, and becomes moreso each day, that while as a nation we reap the benefitsof our economic system, we have little understandingof it.

An Organ of Innovation

At a time when increasing numbers of individualsand groups are demanding that business accept moreresponsibility— because of its demonstrated ability tomanage and get things done —there is underway alsoan attack at the very foundations of business —profitand competit ion. What many unfortunately fail torecognize is that business is predominantly an organof innovation. Of all social institutions, it is the onlyone created for the express purpose of making andmanaging change.

Specifically, business has an advantage where gov-ernment, for example, is weak. Business can abandonan activity. Indeed, it is forced to do so if it operatesin a competitive market. There is a point beyondwhich even the most stubborn businessman cannotargue with the market test , no matter how rich hemay be. (Even Henry Ford had to abandon the ModelT when it no longer could be sold.)

Of all our institutions, business is the only one thatsociety will let disappear. Attempts to close a uni-versity or a hospital, no matter how superfluous andunproductive they might be, create a storm of protest.

Precisely because business can make a profit, it alsomust run the risk of loss. This risk, in turn, goes backto a second strength of business: It alone among allinstitutions must pass the test of performance. Nomatter how inadequate the test of profitability, it isa test nonetheless for all to see.

Support for an obsolete hospital in a communityis usually based on the argument that it will one daybe needed again. Advocates for even the poorest uni-versity contend that it is better than none. The com-munity is easily moved by a sense of "moral duty"to save either institution. The consumer, however, isunsentimental. He is unmoved when he is told thathe has a duty to buy the product of a company becauseit has been around a long time. The consumer alwaysasks: "And what will the product do for me to-morrow?" If the answer is "nothing" he will see itsmanufacturer disappear without the slightest regret.And so will the investor.

This is the strength of business as an institution.And it is the best reason for keeping it under privateownership. The argument that the capitalist shouldnot be allowed to make profits is a popular one. Butthe real role of the capitalist is to be expendable. Hisrole is to take risks and, sometimes, to take losses asa result. This is a role that the private investor, ratherthan the public one, is much better equipped to dis-charge. Business is the one institution that, from thebeginning, has adapted to change, the one institutionthat has proved its right to survival again and again.This is what business is designed for, precisely becauseit is designed to make and to manage change.

The Proper Role of Government

For many years people have expected miracles ofgovernment because it was widely believed that gov-ernment would produce a great many things for noth-ing. It could eliminate wicked private interests andthe dirty profi t motive. It could solve many of ourproblems by dividing the wealth as opposed to the



PRICE -LEVEL CHANGESAND COMPANY WEALTHThe Funds Approach To The Measurement Of Net Monetary Gain Or Loss

By Russell J. Petersen

During a period in which there is a change in thegeneral price level, a company may experience a changein its wealth in the form of reduced or increasedpurchasing power. In certain circumstances this impactcan be material, particularly for companies that holdlarge net monetary positions during periods of signifi-cant changes in the general price level. The purposeof this article is to describe a procedure for the mea-surement of general price -level gains and losses, whichis an amplification of material contained in ARS No.6 and APB Statement No. 3.'

Approach

The general procedure to be described may beviewed as a problem in estimating price- stabilized netmonetary fund flows during a specific time period.Accountants have become experts at measuring andreporting other fund flows when the fund is definedas cash, net working capital, or net quick assets. Aswe will illustrate, they also may develop a funds state-ment to report the flow of net monetary magnitudes(during a specific time period) using the same conceptsand procedures which are appropriate for the develop-ment of the more classical funds statements. Themeasurement of net monetary gains and losses in-volves, in essence, the measuring of price- stabilizednet flows to determine a computed net magnitudeat the end of the t ime period. Comparison of thiscomputed magnitude with the actual net monetaryposition will yield the period gain or loss.

ExampleThe financial statements of the Durham Fabric

Shoppe, Exhibit 1, are used to illustrate the principalideas in this procedure. In addition to the financialstatements, the following information is required inorder to complete the analysis.

1. Depreciation expense for 1971 was $500 and isincluded in cost of sales.

2. Assets disposed of during the year were depre-ciated to a net 20 percent salvage value. Theywere sold on March 31, 1971, and all new assetswere acquired on June 30, 1971.


3. Bonds were redeemed on March 31, 1971, at theirbook value at that time. They were six percent,$5,000 face value bonds.

4. Preferred stock valued at $2,000 was redeemedon June 30, 1971, in exchange for notes payable.

5. Cash dividends of $100 were declared on June30 and December 31,1971.

6. The company maintains its investment in itsunconsolidated subsidiary account on an equitybasis. The subsidiary declares and pays cash divi-dends on September 30 of every year.

7. Prepaid expenses are entirely salesmen's supplies.8. The company sold patents which cost $450 for

book value on September 30,1971.9. Interest is paid on December 31 of each year.

10. Sales, purchases, and selling expense have beenrealized or incurred evenly throughout the year.

In addition to the above information, the generalprice -level index data is assumed to be as follows:

Date GNP Conversiondeflator factor*

12 -31-70 120.0 1.0503 -31-71 122.0 1.0336 -30-71 124.0 1.0169-30-71 125.0 1.00812 -31-71 126.0 1.000Average(1971) 123.0 1.024

*ConversionEnd of period index

factorIndex of time of monetary flow

Average CF (1971) — 126.0— 1.024

123.0

MEASUREMENT O F N ET MO NETARY FLOWSThe Monetary Gain /Loss Computation Work -

paper, Exhibit 2,reflects the complete computationalprocedure from which we will derive the ComparativeFunds Statement illustrated in Exhibit 3. Essentially,there are two principal steps required to complete the

Reporting the Financial Effects of Price -Level Changes, ARS No. 6, AIOPA,New York 1963.— Financial Statements Restated forCentral Price -Level Changes.APB Statement No. 3, AICPA, New York. 1969.

R. J. PETERSEN

is an AssistantProfessor at theGraduate School ofBusiness, DukeUniversity. He is alsoa CPA and holds a B.S.degree from OregonState University, anM.S. degree from theUniversity of Oregon,and a Ph.D. degreefrom the University ofWashington.

17

workpaper. The first step involves the usual adjust-ments to the financial information to obtain estimatesof the gross monetary flows which have occurred dur-ing the accounting period. The procedure for this partof the analysis is similar to that followed in the deter-mination of fund flows when the funds are definedas net working capital or net quick assets. A discussionof the reclassification and elimination entries whichwould be appropriate in the Durham Fabric Shoppesituation is set forth below. Each step is keyed toappropriate entries appearing in the reclassificationand elimination columns of the workpaper. Comple-tion of this stage of the analysis is then achieved byextension of the effect of each reclassification or elim-

Exhibit 1FINANCIAL STATEMENTSDURHAM FABRIC SHOPPE, INC.

STATEMENT OF FINANCIAL POSITION12 -31 -70 and 12 -31 -71

Assets

12 -31 -70 12 -31 -71

Current assets:Cash $ 2,400 $ 1,800Accounts receivable 1,700 1,500Inventory 5,200 6,700Prepaid expense 200 300

$ 9.500 $10,300Property, plant and equipment $ 8,300 $ 8,100

Less: Accumulated depreciation 2,600 2,500Net $ 5,700 $ 5,600

Investment in unconsolidatedsubsidiary $ 5,350 $ 5,100

Patents $ 1,200 $ 650Total assets $21,750 $21,650

EquitiesCurrent liabilities:

Accounts payable $ 4,150 $ 9 1850Current income tax payable 350 -0-Dividends payable 10_0 -0-

$ 4,600 $ 9,650Long -term liabilities:

Bonds payable $ 4,750 $ -0-Notes payable -0- $ 2,000

$ 4,750 $ 2,000Owners' equity:

Preferred stock $ 7,000 $ 5,000Common stock 3.200 3,200Paid in surplus 600 600Retained eamings 1,600 1,200

$12,400 $10,000Total equities $21,750 $21,650

INCOME STATEMENT12 mos. ended 12 -31-71

Sales $8,235Cost of sales 7,200

Gross margin $1,035Selling expense 1,450Patent amortization 100

Operating income $(515)Interest expense -bonds 65Income tax expense -0-Gain on disposal of assets 150Income from unconsolidated subsidiary 250

Net loss $(200)

ination entry to the "Unadjusted monetary flows"column of the workpaper.

PRICE -LEVEL ADJUSTMENTOF THE MONETARY FLOWS

The reader should note that each of the itemsappearing in the "Unadjusted monetary flows," debitand credit, columns of the workpaper represent grossmonetary values during different price -level periods.which existed at the time the flows occurred. Accord-ingly, they represent measurements made at differentmonetary values during different price -level periods.The adjustment process, therefore, involves the trans-lat ion of these flows to a common dollar value, inwhich case one must know the date that each suchflow occurred together with the general price -levelindex which existed on that date.

For certain kinds of monetary flows, this informa-tion is not always available; therefore, accepted prac-tice has been to use the average index values for flowswhich are presumed to occur evenly during the period.For example, the sales amount is assumed to occurevenly throughout the period, and the general price -level adjustment factor is the average index for theperiod.

The last step in the analysis involves the generalprice -level adjustment of the monetary flows. In thisexample, the financial statements have been preparedas of December 31, 1971; therefore, the price -leveladjustments will reflect the monetary flows at thegeneral price level which existed at that t ime. Forinstance, the problem data tell us that the companyacquired new assets on June 30, 1971, when the generalprice -level index' was 124.0. The appropriate conver-sion factor for this price level is 1.016 and is appliedto the monetary flow of $550 to arrive at an estimateof the monetary flow measured in December 31, 1971,of $559. This same procedure is applied to adjust allof the flows. Note that the opening balance of netmonetary assets also must be adjusted to year -enddollars. This amount is entered on the workpaperunder the column heading entitled "12 -31 -71 Com-puted net monetary assets."

MEASUREMENT OF NET

MONETARY GAIN OR LOSSThe numerical data which have been extended to

the "Adjusted monetary flows" columns representgross monetary flows measured at the general pricelevel which existed December 31, 1971. Adding the netflow of ($3,161) to the price- stabilized opening bal-ance of net monetary items yields an estimate of the"Computed net monetary position" at December 31,1971. In this example, the amount so determined is($8,674) and can be thought of as a "best estimate" ofthe net monetary position which should exist at theyear end if the wealth posit ion of the company hasnot been affected by movements in the general pricelevel during 1971. In this example, however, the netmonetary position at December 31, 1971, is ($8,350).Therefore, i t can be seen that the best est imate ofthe net effect on the wealth of Durham Fabric Shoppe

The indexes used in this example are hypothetical. Under an actual analysisof this kind the GNP deflator is probably the hest measure of movements inthe general price level and is suggested in APBS No, 1.


DZDOm

r

mZ

Dn

n

OC2

ZO

mm

c

D

co

vw

tD

Exhibit 2MONETARY GAIN /LOSS COMPUTATION WORKPAPER

12 -31 -70 12 -31 -71

Dr Cr Dr Cr

Monetary ass ets/ l i ab i l i t i es

Cash $ 2,400 $ 1,800

Ac c ounts rec e i vab le 1,700 1,500

Ac c ounts payab le $ 4,150 $ 9,650

Curren t i nc om e tax payab le 350 -0-

Di vi dends payab le 100 -0-

Bonds payab le 4,750 -0-

Notes payab le -0 - 2,000

12 -31 -70 $ 5,250

12 -31 -71 $ 8,350

Net c ha nge

D r Cr

Net $ 3,100

Nonm oneta ry i tem s

Inven to ry 5.200 6,700 $ 1,500

Prepa id expens e 200 300 100

Propert y, p l an t 8 equ ipm ent 8,300 8,100 200

Ac c um ula ted deprec i a t i on 2,600 2,500 100

Investm ent i n s ubs id ia ry 5,350 5,100 250

Patents 1,200 650 550

Pre fe rred s toc k 7,000 5,000 2,000

Com m on s toc k 3,200 3,200

Pa id i n s u rpl us 600 600

Reta i ned earn i ngs - beg inn ing 1,600 1,600 400

$20,250 $20,250 $ 4,100 $ 4,100

Dividends 6 -30-71 100

Dividends 12 -31 -71 100

Sales

Cost of s a les

Deprec i a t i on expens e

Se l l i ng expens ePaten t am ort i za t i on

In te res t expens e

Gain on di s pos a l of as s e ts

Inc om e f rom s ubs id i a ry

8,235

6,700

500

1,450

100

85150

250

$29,885 $29,885

Reclas si f i ca ti on

en t r i es

Dr Cr

(6 )1 ,500

(5) 100

(2) 750(1) 500 (2 ) 600

(3) 250

(4) 100

(6)1,500(1) 500

(5) 100(4) 100

(2 ) 150

(3) 250

Unad jus ted

m oneta ry f l ow s

Dr Cr

$ 3,100

$ 550

450

2,000

100

100

8,235

8,200

1.550

85

12 -31 -71

12 -31 -71 Co m p ut ed

Conve rs i on Ad jus ted ne t m one ta ry

fac to rs m onet a ry f l ow s ass ets

Dr Cr

1.050 $(5 ,513)

xxx $ 3,161 (3 ,161)

1.016 $ 559

1.008 454

1.016 2,032

1.016 102

1.000 100

1.024 8,433

1.024 8,397

1.024 1,587

1.000 85300 1.033 310

500 1.008 504

$12,585 $12,585 $12,862 $12,862

Com put ed ne t m o net a ry po s i t i on $ (8 ,674)

LESS: Ac t ua l ne t m onet a ry pos i t i on (8 ,350)

NOTES: Net m onet a ry ga in $ 324

(1) Deprec i a t i on expens e does no t repr es en t an app l i c a t i on o f m oneta ry a s s e ts and there fo re i s e l im ina ted .

(2 ) The re m a in i n g ne t c red i t c han ge i n the ac c um ul a ted d eprec i a t i on ac c o unt re f l ec ts the am o unt o f dep rec i a t i on p revi ou s l y tak en o n a s s e ts d i s p os ed o f du r i ng th e ye ar . Ac c ord i ng l y,

one c a n de te rm ine the c os t o f as s e t d i s p os a l s as fo l l ow s .8X = 600, X = $750. Th i s en t ry, there fo r e , s im p l y e l im in a tes the nonm on eta ry e f fec t o f thes e d i s pos a l s and m eas ures

the i n f l o w to the m oneta ry as s e t g r oup o f $ 300 w h i c h oc c urre d as a re s u l t o f th i s t ran s ac t i on .

(3 ) W hen a c om pany m ain ta i ns i t s i nvestm ent i n an unc ons o l i dated subs id ia ry on an equ i ty bas i s, the en t ry m ade by th e ac c oun t an t t o re c ord the c om pa ny' s s har e o f the u nc on s o l i d a ted

subs id i a r i es ' ne t i nc ome i s a nonm oneta ry t rans ac t i on . Ac c ord i ng l y, the e f fec t o f th i s t rans ac t i on i s e l im ina ted .

(4 ) Pa ten t am ort iza t i on i s a nonm oneta ry t rans ac t i on . There fo re , i t s e f fec t i s e l im ina ted .

(5 ) P repa id expens es , under th i s c i rc u m s tanc e , repres en t p repaym ents o f i tem s w h i c h w i l l u l t im ate l y be c l as s i f i ed as s e l l i ng expens e . Ther e fo re , i n o rd er to es t im at e t he ne t m one ta ry

f l ow , the ne t c han ge i n the p repa id as s e t ac c oun t i s a dded to t he s e l l i n g expens e ac c oun t .

(6 ) Trans fe r o f t he ne t c hang e i n th e i nve n to ry ac c oun t w i l l res ta t e c os t o f s a l es to an am o unt re f l ec t i ng purc has es dur i ng the p er i od . S inc e pu rc ha s es a re ac h i eved by e i th er i nc ur r i ng

Il m oneta ry deb t o r g i vi ng s om e m oneta ry as s e t , they repres en t app l i c a t i ons o f the ne t m o neta ry fund .

Exhibit 3COMPARATIVE FUNDS STATEMENT

Unadjusted AdjustedNet monetary positions January 1, 1971 $(5,250) $(5,513)Net monetary flows from operations:

Sales $ 8,235 $8,433

Less:Inventory purchases $, 8,200 $8,397Selling expenditures 1,550 1,587Interest expenditures 85 85

(1,600) (1,636)

Other monetary sources:From asset disposals $ 300 $ 310Distributions from subsidiary 500 504Sale of patents 450 454Monetary gain NA 1,250 324 1,592

Applications of monetary amounts:To retire preferred stock $ 2,000 $2,032Investment in plant 550 559Dividend accruals 200 (2,750) 202 (2,793)

Net monetary position— December 31, 1971 $(8,350) $1.350L

of movements in the general price level during 1971is a gain of $324.

COMPARATIVE FUND S STATEMENT

The Comparative Funds Statement, Exhibit 3, re-flects the data generated on the Monetary Gain /LossComputation Workpaper. The reader should note thatthe statement reports the flow of monetary amountsmeasured on an unadjusted (mixed dollar) basis andat the price level which existed at the end of 1971.Certain characteristics of the general price -level ad-justment procedure are probably best reflectedthrough a review of the data presented in these state-ments. The reader should take particular note of thefollowing interesting points which are illustrated onthese statements:

1. The opening net monetary position measured onthe two bases is different because the adjusted dataare stated in dollar values which existed at the endof the year while the unadjusted amount reflects

the same net monetary position measured inDecember 31, 1970, dollar values.

2. The adjusted -funds statement reflects a monetarysource which is labeled "monetary gain." Thisamount is the monetary gain measured on theMonetary Gain /Loss Computation Workpaperand reflects the company's net increase in purchas-ing power which it experienced during 1971 as aresult of changes in the general price level.

Conclusion

The procedure outlined in this paper is an amplifi-cation of procedures explained by others in ARS No.6 and APBS No. 3. However, the advantage of theapproach developed in this article is that it recaststhe measurement of general price -level gain or lossin a form which is a direct extension of the usualfunds -flow measurement procedure. Therefore, ac-counting practitioners will find that the mastery ofthis procedure involves only a simple application oftechniques previously learned. ❑


CONTROL ANDMANAGEMENTOF INDIRECT EXPENSESThe Control And Management Of Indirect Expenses Is One Of

The Most Important Contributions The Management Accountant

Makes Toward The Profit Objective Of His Company

By Harold E. Sharp

It is common today for buyers representing both gov-emmental agencies and private companies to obtaindetailed cost estimates from the seller for the purposeof establishing a price for his various products andservices. Because the subject of overhead is generallytoo complex to be readily understood by most buyers,they base their purchase decisions on the size of theoverhead rate. It is, therefore, important for the sellerto find answers to the following questions: "Is a lowrate better than a high rate ?" "Does a more efficientcompany have low overhead rates?' "Do lower over-head rates mean lower total costs ?" The answers arenot easily determined. In order to please the customer,and to remain competitive, many companies havedeviated from the academic approach of classifyingdirect and indirect costs. The trend has been to reclas-sify many indirect costs as direct, under the assumptionthat whenever a cost can be charged direct it is morereasonable to do so. Some companies also attemptto reduce their overhead expense rate through ac-counting reclassifications. An example of this is dem-onstrated below:

Companies A and B have the same facilities, basicexpenses, and produce the same products. CompanyA is 10 percent more efficient than Company B inthe areas of direct and indirect labor. However, Com-pany B has reclassified 20 percent of its indirect laboras direct. A comparison of costs and rates before andafter the accounting change is illustrated by Exhibit1. The example shows that before the accountingchange, Company B was the high cost producer, buthad a lower overhead rate. After the accountingchange, Company B's total costs did not change, butthe overhead rate dropped considerably.

Indirect Expense Rates

The development of indirect expense rates as a partof the company's estimating and accounting proce-dures permits it to: (1) estimate its rates so that it

can bid on new work and plan internal operations;(2) record and allocate expenses to the various workorders as actual costs are incurred; and (3) at the endof each fiscal year (shorter periods may be used), closeits books and make final adjustments to accuratelyreflect the period's costs. These three processes resultin the following types of rates:

BIDDING RATESBidding rates are used for estimating the price for

work to be performed in the future. They are estimatesusually based on historical costs modified by estimates(statistical and /or direct) to reflect anticipated futureconditions.

BILLING RATESBilling rates are interim overhead rates used to

allocate overhead expenses to the various work ordersor other cost objectives during the company's fiscalyear. Actual overhead rates may fluctuate widelythroughout the year because of seasonal fluctuationsof expenses and workload changes. Overriding theseconditions is the fact that at the close of the fiscalyear overhead charges to all work performed duringthe year will be adjusted to reflect the final overheadrate. The billing rate thus represents the company'sbest estimate of what the final rate will be for thefiscal year.

The cycles which billing rates normally follow are:(1) At the beginning of the company's fiscal year thebidding and billing rates will probably be the same;and (2) Periodically, based on experience and othercurrent data (as it becomes known), the rates fordistributing indirect costs will be revised to be asrealistic as possible. Each time the billing rate is re-vised, all overhead costs allocated to the specific costobjectives during the current fiscal year are adjustedto equal the revised rate.

FINAL OVERHEAD RATES

Final overhead rates are the rates established at the

H. E. SHARP

is CorporateAdministrativeContracting Officer atthe Lockheed AircraftCorp., Burbank, Calif.He holds a B.A.degree in Accountingfrom California StateCollege at LosAngeles, and has beenan Instructor at theU.C.L.A. GovernmentContracts Program.

This article wassubmitted through theSouthwest LosAngeles Chapter.


". . . somecompanies

establish a

number of

indirect

expensePOWs."

close of the company's fiscal year after all expensesare in and accruals, as appropriate, are made. Theseare the final rates which will be used to allocate indi-rect expenses to all work orders or other cost objectiveswhich incur costs of the type included in the baseused to allocate indirect costs. The following exampleillustrates the effect of adjustment from interim ratesused for allocating costs during the fiscal year to reflectthe allocation of the final rates for the fiscal year.In this case, direct labor cost is used to allocate manu-facturing overhead.

Rate AmountDirect labor (base) $5,000,000Applied overhead 118% 5,900,000Actual overhead 121% 6,050,000Adjustment (increase) to

work orders 3% 150,000

The $5,900,000 of applied overhead is the amountapplied to work orders by use of interim billing ratesof 118 percent. The overhead expense actually experi-enced during the company's fiscal year was $6,050,000,or 121 percent. The three percent difference, $150,000,represents the addit ional cost to be applied to thespecific cost objectives.

Indirect Expense Pools

For purposes of controlling and estimating, over-head expenses are generally classified as fixed, semi -variable, and variable expenses in relation to somebase. Some of the more typical categories to be foundin a manufacturing plant follow:

FIXEDRentTaxesInsurance (property)UtilitiesCommunication

SEMI - VARIABLE

PensionsEmployee insurance

Exhibit 1COMPARISON OF OVERHEAD RATEBEFORE AND AFTER ACCOUNTING CHANGE

Company A Company B

Before AfterDirect labor $900 $1,000 $1,200

OverheadIndirect labor $ 900 $1,000 $ 800Other expenses 1,000 1,000 1,000

Total overhead $1,900 $2,000 $1,800

Total cost $2,800 $3,000 $3,000

Overhead rate 211% 200% 150%

Vacation & sick leavePayroll taxAccountingMaintenance

VARIABLE

Indirect laborTrainingSuppliesRecruitment expense

Fixed expenses usually do not vary much unlessmanagement decides, for example, to increase or de-crease facilities and other capital equipment. Semi -variable expenses usually relate to payroll orientedexpenses that have fixed limits, and do not vary pro-portionately to the payroll. Variable expenses usuallyvary directly with the base to which they are applied,such as payroll cost, or labor hours. In many cases,management decisions can vary the amounts to beexpended without a direct relationship to the base.Indirect expense is thus allocated to the various costobjectives by the application of a rate which is devel-oped by relating total indirect expenses for the yearto a base. To account for these costs, some companiesestablish a number of indirect expense pools.

The number of expense pools established by theaccounting system determines the number of differentrates the company must manage and use in estimatingthe prices of its products. From a management aspect,the smaller the size of each pool the better visibilitymanagement has in controlling indirect expenses.Some companies use a large number of small pools,usually at the departmental or burden center level,and therefore have many different overhead rates. Thefollowing list is an example of an organization withmany pools:

ENGINEERIN G EXPENSE PO OLS

Advanced technologies 110%Systems engineering 115%Design engineering 117%Material engineering 116%Analytical support 120%Laboratories 150%Test operations 175%Engineering shops 165%Logistics 105%Training 112%

TEST SITES EXPENSE POOLS

Eastern test range 100%Western test range 115%Happy island 90%Go -Go mountain 95%Boondock haven 105%

MAN UFACTURING EXPEN SE POO LSDevelopment machine shop 210%Development sheet metal 195%Development assembly 180%Processing & plating 250%Heat treating 220%Production machine shop 160%Production sheet metal 155%


Production subassembly 140%Production final assembly 130%Tool design 120%Tool fabrication 170%Planning 115%

G & A EXPENSE POOLSContract & administration 10%Research & development 2%

The disadvantage of having many small overheadpools and rates is that fluctuations in the allocationbase (i.e., direct labor dollars) causes the rates to varysignificantly. This in turn makes forecasting realisticrates a difficult task. When business is slack for acertain department, its rates are high, and it is moredifficult to estimate prices for new business. Also, theaccounting for historical costs, and cost distributions,are more complex and t ime consuming. In order toavoid these difficulties, many companies prefer to usea small number of large pools, such as the following:

cerning the formation of the company's rate structure. "AnotherThe various methods of structuring rates do not change

method oftotal plant costs, but they do influence the cost dis-tribution. Exhibit 2 shows a comparison of costs and handling theserates between an aircraft and spacecraft company.

A comparison of the cost of a unit of labor and expenses is tomaterial between the two companies is demonstrated

charge thema s follows:

to specialAircraft Spacecraft

Engineering accounts ..."Labor $ 5.00 /hr. $ 5.00 /hr.Overhead 6.00 (120 %) 4.50 (90 %)G & A 2.00 (40 %) .95 (10 %)

Total $13.00 /hr. $10.45 /hr.

ManufacturingLabor $ 3.00 /hr. $ 3.00 /hr.Overhead 4.80 (160 %) 3.90 (130 %)G & A 1.20 ( 40 %) .69 ( 10 %)

Total $ 9.00 /hr. $ 7.59/hr.

SERVICE AND OPERATIONAL POOLS Material $10.00 ea. $10.00 ea.Engineering Overhead 120% Material burden

—

2.00 (20 %)Test Sites 103% G & A

—

1.20 (10 %)Manufacturing Overhead 162% Total $10.00 ea. $13.20 ea.General & Administrative 12%

When large pools are used, the effect of fluctuationsin the base at the lower departmental levels do notcause significant variations in the rates. Managementof expenses in this case is done by accumulating ex-penses at a lower tier department or burden centerlevel, combining these expenses into one larger burdencenter. This method is simpler, because the rates arefewer and are more stable.

Because many expenses are not easily identifiableto an operational pool for which rates are established(i.e., engineering, manufacturing), it is expedient tofirst charge the costs to service pools and periodicallyallocate the service pools to the operational pools.Types of service pools would be: (1) facilities and plantmaintenance, which include many occupancy typeexpenses, and (2) plant services which includes officesupplies, reproduction, transportation, etc.

Another method of handling these expenses is tocharge them to special accounts within each of theoperational pools and then to periodically make allo-cations among the operational pools. For example,heat, light, and power could be charged to manufac-turing and then allocated to engineering and otherpools. It is also a common practice to use a combina-tion of both methods. In any event, the results willbe substantially the same, with the reason for the useof different methods being primarily one of preference.

Types of Indirect Rates

Factors that influence the structure of indirect ratesare (1) the nature of the business (e.g., aircraft versusspacecraft) and, (2) the overhead expense base (e.g.,direct labor dollars versus direct labor hours).

NATURE OF BUSINESSThe marketing tendencies of a company tend to

influence management and accounting decisions con-

The aircraft company allocates all indirect expenseson the basis of direct labor dollars. General and ad-ministrative expenses are allocated on the basis of totaldirect labor dollars ($16,000 + $40,000 — 40 %). Thisis designed to avoid charging indirect costs to directmaterial costs. Spare parts constitute a sizeable portionof an aircraft company's sales and are composed pri-marily of purchased parts. Therefore, by not allocatingindirect expense to material costs, the company cankeep its spare parts costs low and competitive. Salesof complete aircraft are based on total sales price, andadvanced design features, therefore, rates do not sig-nificantly influence the company's competitive posi-tion. Also, when there is a mix of commercial andmilitary aircraft, an allocation of general and adminis-trative expense on the basis of total costs cause dispro-portionate burdening of commercial work. This isbecause engines are usually furnished by the Govern-ment and not included in the cost base.

The spacecraft company allocates part of its indirect

Exhibit 2COMPARISON OF COSTS AND RATES:AIRCRAFT COMPANY VS. SPACECRAFT COMPANY

Aircra ft Spacecraft

Cost Rate Cost RateEngineeri ng di rect labor $ 10,000 $5.00 /hr. $ 10,000 $5.00 /hr.Eng ineer i ng overhead 12,000 120% 9,000 90%Manufac tur i ng d i rec t labor 30,000 $3.00 /hr. 30,000 $3.00 /hr.Manufac tu r i ng overhead 48,000 160% 39,000 130%Material & subc on t ract i ng 60,000 60,000Mater i al bu rden 12,000 2 0 %

General & adm ini strati ve 16.000 40% 16,000 10%

Total cost $176,000 $176,000

MANAGEMENT ACCOUNTING/FEBRUARY 1973 23

"Indirect labor,

payrollexpenses, andfringe benefits

usually relateto direct labor

dollars."

expense to material and subcontract direct costs. Gen-eral and administrative expenses are allocated on thebasis of total costs (direct labor, overhead, mate-rial /subcontracting and material burden) which pro-duces a lower rate ($16,000 + $160,000 — 10%). Theprinciple sales of the company are in the form of itsengineering capabilities; therefore, the cost of an engi-neering hour must be competitive. Although the com-pany does get involved in hardware production, sparessales are low, and the company is usually 'locked in"on its products because of its engineering capabilities.

OVERHEAD EXPENSE BASEOverhead expenses are commonly distributed as a

percentage of direct labor dollars; however, some firmsuse a percentage rate based on direct labor hours. Thisis shown by the following examples:

Expense Base RateEngineering Direct labor

overhead dollars 120%Engineering Direct labor

overhead hours $6.00 /hrMaterial handling Direct material

expense & sub - contractdollars 12%

G &A Total costs 10%G &A Direct labor

dollars 50%G &A Direct labor

hours $1.10 /hr

The percentage methods have the following advan-tages and disadvantages:

Advantages1. Fluctuations in expense dollars do not "appear"

to affect the rate significantly, for example:

Before Afterchange change

Overhead expense $1,200,000 $1,240,000Direct labor dollars 1,000,000 1,000,000Direct labor hours 200,000 200,000Rate — percent 120% 124%Rate — dollars per hour $6.00 /hr. $6.20 /hr

A four percent increase appears less significant thana 20 cent per hour increase.Since direct labor dollar escalation trends are sig-nificantly higher than for overhead trends, theeffect of adverse fluctuations in either the directlabor or overhead expense will tend to be offsetby the difference in escalation trends.Percentages are easier to compare between depart-ments or companies than are the rates per hour.

Disadvantages1. If most of the overhead expense items are not

directly related to direct labor dollars, but ratherto direct labor hours, headcount, floorspace, orsome other identifiable relationship, then the useof percentages for management purposes is mis-leading.

2. Since direct labor rates normally escalate at a

higher rate than other costs, judging fluctuationsof other expenses in relation to direct labor dollarswill result in distortions.

Forecasting Indirect Expense Rates

Forecasted rates are used for bidding and cost man-agement purposes. However, there are two significantproblems in forecasting: (1) determining the futuresales in terms of units to be used for establishing thebase for each indirect expense pool (i.e., direct labordollars, cost of sales, etc.), and (2) the cost of futureexpenses (i.e., labor, material, taxes, etc.). Commonly,seat -of- the -pants forecasting is done by starting withthe current rates and adjusting them for knownchanges, such as tax increases, union agreements, etc.,and ignoring the sales base and the other effects offuture costs. Today, most major concerns attempt tobe more exacting in their estimates.

Forecasting the base of each indirect expense poolrequires a determination of future sales, based on firm,as well as anticipated business. The value of futuresales can be developed on a bottom -up or top -downbasis. Bottom -up estimates are used when hardwarequantities for current products are estimated (i.e.,number of airplanes, missiles, etc.). Then manhoursand materials can be estimated using statistical meanssuch as learning curves and other historical costs andproviding for anticipated escalation trends. Bottom -upestimating, although more exacting, is time consumingand the least preferred methods by most people. Top -down estimates usually consider cost escalation in agross manner. The base for each overhead pool (i.e.,engineering direct labor, etc.). is usually determinedon a statistical basis.

Forecasting expenses applicable to each overheadpool is relatively easy once a base is established. Ex-penses are usually estimated statistically by relatingthem to some base such as labor dollars, labor hours,square feet, etc. Regression analysis or correlationtechniques may be used to determine these relation-ships at various sales levels. For example, indirect labordollars can be correlated to direct labor dollars ad-justed for differences caused by inflation. In turn,indirect labor dollars can be determined for the fore-casted direct labor dollars. Adjustments must be madefor escalation (inflation) of future costs, union negoti-ations, changes in law, and other known or anticipatedchanges. The use of new facilities can cause an increasein occupancy costs per man, or square foot. Someanalysts tend to estimate all expenses as a percentageof the base they are using. Although this relationshipmust be made in analyzing the composit ion of thetotal overhead rate, it is not a logical relationship forestimating expenses. Indirect labor, payroll expenses,and fringe benefits usually relate to direct labor dol-lars. Supplies and services may relate to manhours orheadcount. Occupancy costs may relate to area orheadcount. Another essential factor to consider is theoperating ratios of expenses that management mayestablish as goals, for controlling indirect expense.

Conclusion

The control and management of indirect expensesis one of the most important contributions the man-agement accountant makes toward the profit objective


of his company. There are many methods which canbe used to accomplish this. In the final analysis, therate structure selected, the methods used for allocatingcosts to profit objectives, and the methods used forpreparing forecasts of indirect expenses, should bethose methods which give the most reasonable resultsin the circumstances. To attain the most reasonable

THE BUSINESSMAN'S ROLE

Continued from page 16

business concept of multiplying it. Historically, wehave had an inclination to create administrative andeven regulatory agencies which carried within them-selves the seeds of inertia and perpetuity. No soonerare they called into being than they become ends inthemselves, acquire a vested right to grants from thetreasury, and achieve immunity to political direction.What often occurs is that they end up defying publicwill and public policy rather than implementing it.

The proper role of government is that of the centralinstitution in the society of organizations. Businesscannot replace it as such, nor should it. We need anorgan that expresses the common will and the commonvision; yet one that enables each organization to makeits own best contribution to society while continuingto express common beliefs and common values.

Idealistically, the role of government has beenlikened to that of a symphony conductor. The conduc-tor himself does not play an instrument nor does hehave to know how. His job is to know the capacityof each instrument and to evoke optimal performancefrom each. His job is to lead.

This is the lesson that business has learned —thedistinction between governing and doing. In businesstoday, this separation is achieved through decentrali-zation. Yet, the term is misleading. It implies aweakening of the central organ, the top managementof a business. Actually, decentralization oftenstrengthens top management by freeing it to manage.

We have heard much criticism of our system. And,while much of it has been warranted and has serveda useful function, a good bit of it is based on an idyllicview of a perfect past and a myopic view of an imper-fect present. Many of our problems are not problemsof failure but of inaction. It is only now— because wetake for granted that the economy can provide forall our physical needs —that we are becoming conscious

results, due consideration must be given to (1) thesize of the company, (2) the type and complexity ofthe product being manufactured, (3) the competitiveatmosphere in which the company operates, (4) theavailability of resources and comparative costs of ad-ministering the system, and (S) the degree of controland management information necessary.

of our shortcomings in respect to the quality of life.This consciousness, I might add, may be the mostimportant factor in rectifying our shortcomings.

The Role of the Businessman

To do his part, the businessman must assume atleast four important roles in the area of public policy.

1. A role of leadership —He must display the courageof his convictions. If his firm has developed safetyglass or a safe car, he must —when necessary —takethe lead in upgrading minimum standards.

2. A role of positive action —He must take the lead.No longer will complaints about government re-strictions or general public apathy suffice. Not onlymust the businessman strive for closer cooperationwith government and other institutions in society,but he must compete and voluntarily take on thosetasks he is better equipped to perform.

3. A role of concern —He must devote himself toproviding opportunity, not aid or charity, to thosegroups in society bypassed to date. He must giveweight to social as well as commerical factors inmaking his plans and decisions.

4. A role of education —He must proselytize outsideof the board rooms and comfortable associationsof manufacturers. For only by increasing the man -in- the - street's insight into the role of free marketsas the basis of economic order will the businessmangain the understanding and cooperation he needsto succeed in accomplishing these larger tasks.

Conclusion

Above all, in contributing to public policy, may wehope that business will display the confidence andaggressiveness that once was the hallmark of mostAmerican institutions —the belief that anything can bedone and that the way to correct a wrong is not toapologize but to take action.

"... one of

the most

importantcontributions . .


G. D.CAMERON, III

is a Lecturer inBusiness Law at the

University ofMichigan, Mr.

Cameron, who is amember of the Bar,

State of Michigan,holds B.A. and M.A.

degrees from KentState University and aI.D. /LL.B. degree from

the University ofMichigan where he is

currently a DoctoralCandidate in Political

Science.

This article wassubmitted through the

Western WayneChapter.

ACCOUNTING CHANGES:WHY CPAs

MUST CONFORMIt Would Be Naively Simpl ist ic To Ascr ibe Al l Changes In

Accounting Principles To Business Evolution

By George D. Cameron, III;Ralph W. Gudmundsen, Jr.; andJack R. Ball

Whenever the Accounting Principles Board of theAICPA issues an opinion calling for changes in cor-porate financial statements, management prepares fora confrontation with the independent CPA. Manage-ment knows he will insist on changes in the publishedfinancial statements to make them conform with thenew opinion. This concern over financial statementchanges is understandable, particularly if the changeswould have an unfavorable effect on the financialstatements. Despite this urge to resist change in finan-cial statements, management should consider whychange is necessary and why the CPA must insist onit.

Accounting principles evolve to cope with changesin the ways business is conducted. This evolutionappears clearly in the development of such techniquesas single proprietorship accounting, partnership ac-counting, joint venture accounting, corporate account-ing, fiduciary accounting, and cost accounting. Yet itwould be naively simplistic to ascribe all changes inaccounting principles to business evolution. The CPA,primarily through professional associations, has ef-fected deliberate changes in accounting principles.This area of change is the chief concern of this article.Further, only those factors which might help manage-ment better undtsrstand the reasons for deliberatechange are of concern here. Some of the principalfactors that management could well ponder includethese traits of CPAs:

1. Professional outlook2. Code of ethics3. Professional liability

Professional Outlook

In the practice of professions, deliberate changeborn of research and study guards against decadence.As experience with established principles accumulates,changes are found to be needed in the applicationsof principles and in the principles themselves; newprinciples emerge generating additional waves of

change. In its interest in developing and refining prin-ciples, accounting conforms with the experience ofother professions.

Management has much to lose by successfully op-posing statement changes borne on the tides createdby the evolution of accounting principles. The useful-ness of the CPA's opinion to management rests almostentirely upon the confidence of the public in thepublic accounting profession. Without the public'sconfidence, the CPA's opinion of management 's fi-nancial statements would become meaningless to thirdparties, and the statements would suffer substantialloss of credibility. To maintain the public's confidencein his opinion and thereby maintain the value of hisopinion to management, the CPA must insist that thetides created by the evolution of accounting principlesbe allowed to run their course in the financial state-ments. Management should be assured that the evolu-tion reflects changes in business practices or genuinelybetter understanding of business practices. The CPA'sconcern for deliberate change from study and researchis no phony exercise or indulgence in professionalsnobbery; changes are needed and expected of theprofession.

Code of Ethics

CPAs are guided in their practice by a code ofprofessional ethics, a voluntary assumption of self -dis-cipline advising the public that the profession willprotect (or attempt to protect) the public interest.

However, the code of ethics applicable to CPAs hasa unique characteristic; it requires him in his histori-cally primary service, the attest function, to place thepublic interest above the interest of his client. Inattesting financial statements, the CPA is responsibleprimarily to third parties who may read his report.Thus, his professional ethics take on more than usualimportance.

In view of the importance of the code of professionalethics to the CPA, management should consider thatin discharging his responsibility to third parties, hemust evaluate the fairness of management's financialstatements in the light of generally accepted account-ing principles. In connection with this rule, manage-ment should remember that whenever the APB speaks,


"generally accepted accounting principles" are auto-matically generated. Thus, as a matter of professionalethics, the CPA must keep abreast of APB opinions.If management's statements are based on accountingprinciples that conflict with a new APB opinion, hemay have to insist on changes in order to render anunqualified opinion or a report free of distractingdisclosures.

Professional Liability

While financial statements are basically the repre-sentations of management, the CPA has a professionalliability for the information contained in the financialstatements on which he reports. His primary respon-sibility (hence liability) for the statements is to thirdParties, not to management. To understand this posi-tion, management would benefit from a thoroughreview of the development and nature of the CPA'sliability.

CHANGES IN JUDICIAL MOODWhile the body of law dealing specifically with

"accountants" has been slow in developing, parallelsmay be drawn to the legal rules covering other profes-sions and suppliers of services. The late 1950's and1960's have seen a drastic shift in legal thinking insofaras the liability of suppliers of goods or services isconcerned. The old rule of caveat em¢tor (let thebuyer beware) has been repudiated, both legislatively(e.g., the Uniform Commercial Code) and judicially.The trend is distinctly in favor of extension of legalprotection to the consumer, the customer, the client.

Another drastic shift in the "rules of the game"worth noting at this point concerns "privity." Brieflyput, "privity" means "relationship" (based on a con-tract between plaintiff and defendant). It was usedby manufacturers to deny warranty liability on theirproducts where the product had passed through thehands of at least one independent middleman. Butthe concept of "privity" as a prerequisite to recoveryagainst a manufacturer of defective goods has met allbut unanimous judicial repudiation.

Thus far, however, .relevant reported court casesindicate that privity of contract remains a key variablein the professional liability of the CPA. Whereas heis liable for fraud both to his client and to third partieson much the same basis, his liability for negligenceand /or breach of contract will differ, depending onwho is suing and on the nature of the action brought.It is difficult for a third party to mount a successfulbreach of contract action against a CPA unless theplaintiff can show a clearly intended "third partybeneficiary" situation, i.e., unless the CPA's reportswere clearly intended for the plaintiff's benefit. Evenif such a plea is successful, its inherent limitation fromthe plaintiff's point of view is that recovery usuallywould be limited to the amount paid for the (defec-tive) services rendered; the third party also would haveto prove he suffered "special damages" which werewithin the contemplation of the parties to the contractwhen they made it. All in all, this would be a difficultcase to prove.

Presently, a majority of jurisdictions continue todistinguish between the CPA's liability for negligenceto his client and his liability for negligence causing

harm to third parties. While he is clearly liable tohis client for the consequences of his negligence,

.. as to third parties —even those who theaccountant knew or should have known wererelying on his audit — liability can be foundedonly upon fraudulent conduct, and proof ofmere negligence will not suffice. "'

In the case just cited, the court noted a "developingtrend" of cases holding accountants liable to thirdparties 2 but indicated that the plaintiff had not provedthat Colorado courts were ready to accept this newtheory of liability. Nevertheless, the beginnings of atrend are surely there. In the light of developmentsin other areas of the law, it seems only a matter of

'time until the CPA's liability for "mere" negligenceis extended to third parties, just as the liabil ity ofmanufacturers has been.

SIGNIFICANCE OF THE CHANGESWhat meaning has all of this to the CPA? It means

that he will be held more closely by the law to strictstandards of quality performance. In cases of grosserror or blatantly sloppy work, punitive damages arepossible. Some different types of legal liability towhich CPAs have been subjected are:

1. Liability to employer or person in privity for dam-ages which result from his failure to employ thedegree of knowledge, skill, and judgment usuallypossessed by members of that profession.

2. Liability for false or inaccurate reflection of finan-cial conditions presented by certified statements.

3. Liability for failure to discover defalcations orfraud because of lack of compliance with properaccounting procedure.

4. Liability for loss or damage due to erroneous adviceor lack of due care of property.

5. Liability to third parties for false financial state-ments where the CPA has reason to believe thatstatements are incorrect and that said statementwill be relied upon.'

Perhaps the key question from the individual CPA'spoint of view is: "How careful do I have to be toavoid legal liability ?" Phrased another way, his prob-lem is to gain advance knowledge of the standard bywhich he will be judged and then to hold to thatstandard. In this regard, the existence of the APB'sstandards may be considered as boon or bane, depend-ing on one's point of view.

APB PRONOUNCEMENTSIn the pronouncements of the APB, the accounting

profession has some generally accepted and generallyknown national standards of practice. The medicalprofession, for example, does not have any such na-tional standards, and medical opinions of "good prac-tice" vary even more widely than those of accountants.The CPA, therefore, has a more reliable gauge forhis day -to -day practice than does the medical doctor.With some national standards as a guide, the CPA

'Stephens Industries, Inc, v. Haskins and Sells, 438 F.2d 157 (19711.

[bid., p. 360.' American Jurisprudence, Second Edition, Vol. 1. The Lawyers CooperativePublishing Co.. New York, 1962, p. 365.

1. R. BALL

is a Quality ControlSupervisor for BendixAerospace SystemsDivision, Ann Arbor,Mich. Mr. Ball holds aB.A. degree inChemistry from TexasTechnological Collegeand an M.B.A. degreefrom Eastern MichiganUniversity.

R. W. GUDMUNDSEN

is on the Staff, Ernst &Ernst, Detroit, Mich.Mr. Gudmundsenholds a B.B.A. degreefrom the University ofMichigan.


"In addition to

potential legal

liability, there

is also pressure

from private

and

governmentregulatory

agencies."

has less chance than a medical doctor of being sub-jected to liability simply because of "luck of the draw,"i.e., due to the professional opinions of the expertswho testify in his case.

On the other hand, the APB pronouncements maypresent a legal hazard for the individual CPA whodoes not abide by them. If observing APB opinionsconstitutes sound evidence of good practice, departingfrom them might in i tself constitute a prima faciecase of bad practice. No CPA would lightly assumethe heavy burden of justifying the use of accountingprinciples that conflict with those supported by theAPB. Hence, his insistence to management that theirfinancial statements conform to the pronouncementsof the APB stems to a large extent from the pressureof potential legal liability.

THE AUDITING ASPECTIn addition to potential legal liability, there is also

pressure from private and government regulatoryagencies. Public accounting firms have been accusedof fai ling to protect the "third party" public fromdistortion, misrepresentation, and fraud in the finan-cial statements of their clients. In defense, indepen-dent auditors claim that their primary responsibilitiesare to assure that the statements are presented inaccordance with "generally accepted accounting prin-ciples" and that the amounts presented are reasonable.The auditing firms do not guarantee that the client

LETTERS to the editorContinued from page 8

Software for various applications are not consumableitems, and should not be treated as office supplies.Once developed, they remain static and are used toperform specific functions on a repetitive basis. How-ever, it is recognized that some changes to existingsoftware may be necessary because of changing formanagement information requirements or systemsdesign. In such cases, the normal accounting treatmentfor asset improvements, maintenance and disposalsshould be applied.

The data processing facilities of an organizationform a service type organization that provides therequired services for the various operating entities ofthe organization. Therefore, looking at software costsfrom a management viewpoint, it would seem thatmanagement would be interested in knowing what partof the total cost of operating the data processingfacility is attributable to software. In addition, man-agement should be interested in the most equitablemethod of distributing the cost to "customer- users"of the services. Should they be treated as part of thegeneral overhead that is distributed to all "cus-tomer- users" of data processing services, or should theybe charged to the specific "customer- user" for whomthe software application was developed?

Let me cite an example where software costingabout $200,000 was developed to perform a specificapplication for a "customer- user" as part of the overallaccounting and management information system. Thetotal cost was charged to the "customer- user" in oneperiod although the application developed will be used

has accounted accurately for every penny earned andspent. Even if an audit of such scope as to justifysuch a guarantee were possible, the cost of such anaudit would not be economically feasible to the client.Thus, a CPA must rely instead on sample tests ofthe data on which the client's statements and schedulesare based. When his examination, based on such sam-ple procedures, does indicate a need for change inthe financial statements, he would be foolhardy notto insist on such changes as the condition for anunqualified opinion.

Conclusion

This article has emphasized three reasons why theCPA from time to time must insist on changes infinancial statements. First, he is a professional practi-tioner and as such seeks to improve his service bydeliberate changes in theory and practice born ofresearch and study. Second is the need for him torespect the profession's ethics; the majority of CPAsare bound ethically in their attest function to treatthe interests of statement readers as paramount. Fi-nally, the need for him to consider his professionalliability was discussed. The APB pronouncements werefound to be a potential legal shield when statementsconform with APB pronouncements but a strong po-tential legal hazard when they do not. Hence, he ismotivated strongly to insist that the statements onwhich he reports conform with APB opinions. M

on a repetitive basis. This method, in lieu of capitaliz-ing the cost and depreciating over an estimated life,will have the effect of distorting the data processingservices charged in future periods. This same situationwould be true for all other software costs whetherpurchased or developed in -house and charged to the"customer- users" in the same manner. On the otherhand, if such costs were charged to general overheadand distributed to all "customer- users," they may ormay not be charged with the cost that is directlyattributable to them.

From an accounting standpoint, it appears that themost appropriate method of accounting for softwarecosts would be to capitalize such costs and depreciatethem over their useful life. If developed for a specific

j "customei- user" include, as part of the servicescharged, an increment for the depreciation. If theapplication developed is not for a specific "cus-tomer- user," the depreciation attributable to themwould be charged to overhead and distributed to allusers of data processing services.

As previously stated, a tax advantage would accruefrom treating software costs as expense rather thancapitalizing them. However, I believe that it is equallyimportant (1) from an accounting standpoint, to rec-ognize when an asset has actually been acquired, and(2) for costing purposes, to provide management withmeaningful operating cost data for data processingactivities. It would be interesting to know whatmethods various organizations are using in accountingfor software costs.

Frank M. ZappacostaWashington, D.C., Chapter

Alexandria, Va.


A SYSTEMS APPROACHTO CASH FLOWDETERMINATIONIt Should Be Remembered That Unless Accurate Projections Are

Made Of Expected Cash Benefits It Makes Little Difference

Whether The Expected Cash Flow Is Discounted At Five Percent

Or Twenty -Five Percent

By Walter J. Thrun, Sr.

The bulk of research in the capital budgeting processhas been directed to choosing the discount rate. Themajor concern appears to be whether to use the firm'sborrowing rate —its marginal cost of capital or thestockholders' opportunity costs —or a non - default rateas found on existing government securities. Thoughthe discount rate is an important part in an investmentevaluation, it should be remembered that unless accu-rate projections are made of expected cash benefitsit makes little difference whether the expected cashflow is discounted at five percent or twenty -five per-cent. Some firms compensate for the uncertainty in-herent in cash projections by increasing the calculateddiscount rate, but risk and the time value of moneyshould not be pooled by employing a "risk inflated"discount rate. What must be recognized and acceptedis the need for a more accurate measure for establish-ing the expected cash flow from the investment.

There are three questions that the budget adminis-trator should ask in the capital budgeting process toobtain the information needed for a decision: First,is there really a need for another machine of the typerequested by the production personnel? Second, if abottleneck does really exist and the new machine isneeded, what are the operating cash benefits associatedwith the acquisition of the machine? Third, how muchcan the firm afford to spend to relieve the bottleneckand still provide the required return on investment?

These questions will be presented in order andanswered with the aid of an illustrative example. Theexample will cover an application for a simple machineshop operation. This application is similar to otherindustries with process operations in that the productspass through common operations. Consider, for exam-ple, that there are only a couple of operations thatare performed on a raw casting to transform it into

a finished pipe fitting. In fact, there are generally justfour basic steps to be performed. They are:

1. Grind gates and /or clean parting line as required.2. Ream interior and tap thread.3. Turn and chamfer exterior and chase thread.4. Test for porosity by water submersion.

In a shop that machines pipe fittings it is typical that100 percent of all castings are ground and /or deburred;100 percent of all fittings are reamed and tapped; 60percent of all fittings are turned and chased; and 40percent of all fittings are tested for porosity.

Question One

The problem begins with the production managerrequesting a new automatic chucking machine. There-fore, question number one is: Do we really need an-other chucker? To answer this question objectively isnot as simple as it may first appear; conventionalmethods will at best underestimate the cash benefitsmade available by acquiring additional chuckingequipment. The problem adds dimensions when oneremembers that all the fittings that pass through thechucking operation will have passed through thegrind /deburr operation and 60 percent of the fittingswill subsequently pass through the lathe operation.If scheduling does not enter as a decision variable,then unnecessary idle grinding capacity may result orcreate a bottleneck at the lathe. So then, the problembecomes one of optimization with the cash flow infor-mation being provided as a by- product. Here's howit works:

A linear programming optimization equation is setup. This equation is a function of the total shopcapacity, individual machine constraints, and the cur-rent cash margin realized per product. The latterparameter is perhaps the most significant. Instead of

W . I. THRUN, SR.

Orange CountyChapter 1972, is anAdministrativeManager for AmericanMetal Climax, Inc.,Tulsa, Okla. He holdsB.A. and M.B.A.degrees fromCalifornia StateUniversity. Mr. Thrun,who wishes to thankMr. William R.Anderson for histechnical assistance,was awarded aCertificate ofRecognition for thisarticle (1971 -72).

This article wassubmitted through theOrange CountyChapter.


" . . . profit

maximization

is the usual

'name of the

game' for the

business

entrepreneurs

30

considering each of the factors of production individ-ually, the overall effect is consolidated by subtractingthe variable cost from the selling price with the resultbeing the variable cash profit realized for each product.Inasmuch as profit maximization is the usual "nameof the game" for the business entrepreneurs, this isthe logical parameter for the optimization equation.We will assume that the proposed equipment is equalin performance to the existing chucking machines,hence its advantages are limited to providing addi-tional available hours. A faster machine could beincorporated into the problem, but then the problembecomes more sophisticated and the purpose of thispresentation is to describe a concept, not to expoundon software applications.

This problem can be represented mathematicallyby the cash profit maximization equation for a shopthat machines pipe fittings as shown in Exhibit 1.

The coefficients of the maximizing equation acrossthe top of the table represent dollars of cash profitrealized per thousand of the respective products. Eachof the constraint equations represents a machine centeras follows: equation (1), three grinder /deburrers; equa-tion (2), two automatic chuckers; equation (3), twoturret lathes; and equation (4), one water tester.

Now let us take a close look at the equations inExhibit 1. Consider product X,. It can be noted thatthis product passes through or utilizes all machinecenters except the water tester. If the time coefficientsof X, were added, the result would be .5097 standardhours to produce one thousand fittings 1.26 to 1.75lbs. requiring four cutting elements. In other words,the coefficients of the machine constraints tell howmany standard hours are required for each productto pass through each machine center. Let's look atit in another way. Consider the machine center whichconsists of turret lathes. Proceeding across the row itis noted that products X „ X,, X;, and X, pass throughthis machine center. Adding the coefficients of eachof the variables in this row will indicate how manystandard hours of lathe tiine are required if one thou-sand of each of the aforementioned products are pro-duced. It can be noted that the chucking machinescenter is constrained by 1,040 total available hours.

Exhibit 1CASH PROFIT MAXIMIZATION EQUATIONS

Maximize profit:

This is simply the hours provided from two machinesper month considering a three - shift, five -day workweek.

At this point, all we need to know is the actualproduction for each product during several precedingmonths. This enables us to find the monthly averageand then determine if there is a bottleneck at thechucking machines. This procedure is carried out asfollows:

Production Time required Total chuckingto ream and hours required

tap 1,000 units

X, = 205,504 .1558 32.02X, = 346,816 .1643 56.98X; = 92,649 .2703 25.04X, = 15,734,086 .0088 138.46X; = 25,126,900 .0064 160.81X, = 10,442,246 .0364 380.10X- = 12,843,081 .0192 246.58

1,039.99

By multiplying the "Production" of each productby its respective "Time required to ream interior andtap 1,000 units" we can determine "Total chuckinghours required." It is clearly evident that there is abottleneck at the chucking centers as there are 1,040total available chucking hours and 1,039.99 were re-quired for present production. There is no room toexpand. Also at this point the present level of variablecash profit can be determined by substituting the"Production" figures into the profit maximizationequation in Exhibit 1.

Question Two

Now the second question concerning the operatingcash benefits associated with the acquisition of anadditional chucking machine can be tackled. The inputinformation required at this point is extremely impor-tant. The product managers trust advise the limit orextent of each product that can be sold within theexisting pricing structure. The significance of this willbe realized by considering that to change the pricingstructure would affect the operating cash profit rea-

$185.03X, + $213.20X, + $276.06X , + $10.58X , + $4.34X , + $30.25X , + $9.83X , Profit

Subject to equipment constraints:(1) .1267X , + .1341 X , + .1140X , + .0041 X , + .0024X , + .0129X, + .0068X, _< 1,560 hours

(2) .1558X , + .1643X , + .2703X , + .0088X , + .0064X , + .0364X , + .0192X,

< 1,040 hours(3) OX , + .2113X , + .1963X , + OX, + .0118X , + .0568X , + OX

,

< 1,040 hours(4) OX , + OX, + OX , + OX, + .0104X , + .0112X , + .0101X

,

< 520 hours

Where the variables represent the following products:X, - Fitting, 2.51 to 4.00 lbs. requiring five cutting elementsX, - Fitting, 1.26 to 1.75 lbs. requiring four cutting elementsX, - Fitting, 4.01 to 5.00 lbs. requiring five cutting elementsX, - Fitting, .51 to .75 lbs. requiring four cutting elementsX, - Fitting, .26 to .50 lbs. requiring two cutting elementsX, - Fitting, .51 to .75 lbs. requiring six cutting elementsX, - Fitting, .51 to .75 lbs. requiring three cutting elements


Exhibit 2PROJECTED PRODUCTION ADDITION

Time to ream Total Time to Totaland tap thread chucking water test water

Production for 1,000 units hours 1,000 units test hoursX,

— 205,504 .1558 32.02 -0- -0-X, = 375,000 .1643 61.61 -o- -0-X, = 100,000 .2703 27.03 -0- -0-X, = 16,000,000 .0088 140.80 -0- -0-X, = 25,126,900 .0064 160.81 .0104 261.32X6 = 10,442,246 .0364 380.10 .0112 116.95X,

=

14,032,385 .0192 269.42 .0101 141.73

1,071.79 520.00

Total variable cash profit per month with this production is $877,727.43.

lized per product and our optimization equation (seeExhibit 1) would no longer be valid. This is not tosay that the concept being presented could not handlea price change. It can, but this requires changing thecash margin on those products affected, just anothercomplication that would not enhance the understand-ing of the basic concept.

The product managers provide their marketing limi-tations as shown below:

X, = 205,504346,816 < X, < 375,00092,649 < X, < 100,000

15,734,086 < X, < 16,000,00025,126,900< X, < 30,000,000

X, = 10,442,24612,843,081 < X, < 15,250,000

The incorporation of the proposed chucking ma-chine is accomplished by changing equation (2) toreflect the change of the availability of 520 more hours,i.e., from 1,040 to 1,560:

The rest is left to the computer. The results aregiven in Exhibit 2.

It can be seen that production was not maximizedon all products even though there is now ample chuck-ing capacity. The answer is that another bottleneckwas reached and sure enough, by examining the watertest time used in Exhibit 2 it is noticed that the watertest time is now the limiting factor.

Observe also the changes in the mix (within theconstraints) and the new value of the profit functionof $877,827.43. The profit has increased $22,542.37 permonth from the profit found in Exhibit 1. Accordingto the present concept then, the $22,542.37 is attribu-table exclusively to the proposed chucking machineand is, therefore, the relevant cash flow associated withthe investment.

Question Three

Now, we are ready to consider question slumber

theee, i.e., how much can the company afford to spendto relieve the chucking bottleneck and still providethe required return on investment.

Assuming that the company requires a 10 percentreturn on its investments, that a chucking machinehas a five -year economic life, and a 50 percent cor-porate tax rate:

X BE = [ (CF — PXBE) (t) ] x (IF)

Where:

X BE = Cost that the proposed asset cannot exceedto provide the required return

CF = Cash flow from operationsP = Percent of proposed asset to be depreciated

annuallyt = Applicable tax rateIF = Interest factor for the required rate of

return over the economic life of the pro-posed asset.

Then:

X aE _ ($270,508.44 — .2X BE) (.50)] x (3.962)

= $383,811.22

Conclusion

At this point, all three questions have been an-swered. It was determined that there was a bottleneckin the chucking area, the cash flow associated witha new chucking machine was isolated, and the break -even point to relieve the bottleneck was computed.As one might suspect, the foregoing is actually a dy-namic process. As soon as the next bottleneck isreached, the whole process starts over again until thepoint is reached in which the incremental cash benefitscannot be equated favorably with the cost to relievethe bottleneck. ❑

". all three

questions have

been

answered."


J. MADISON

is a ManufacturingCost Accountant with

Tektronix, Inc.,Beaverton, Ore. Mr.

Madison holds a B.S.degree in Business

and Technology fromOregon State

University and ispresently workingtoward an M.B.A.

degree at PortlandState University.

This article wassubmi t ted through the

Portland Chapter.

THE 'MAKE OR BUY'DECISIONTaken In Aggregate, 'Make Or Buy' Decisions Can Have A

Critical Long -Range Effect On The Firm's Operating

Characteristics

By Jim Madison

The "make or buy" decision is basically one of deter-mining which alternative is economically most desira-ble and most effectively utilizes the firm's resources.Individually, these decisions may or may not producea significant impact on the firm's operation-, however,taken in aggregate, they can have a critical long -rangeeffect on the firm's operating characteristics. Thesedecisions can affect the firm's production methods andcapacities, available working capital, cost of bor-rowing funds, and competitive position. Therefore,before the "make or buy" decision can be made, thefirm must establish a goal with respect to the natureand extent of its production facilities. The firm alsomust define the manufacturing processes that arecongruent with its overall company goals and stra-tegies. With these basic considerations established, thefirm can proceed to an analysis of the cost, quality,and quantity considerations of the individual "makeor buy" decisions.

Although cost and quantity considerations are thefirst to come to mind, quality sometimes will be thedetermining factor in the "make or buy" decision. Forexample, some of the reasons quality is used as acriterion for buying are as follows:

1. The supplier's experience makes him better suitedfor producing the desired quality.

2. The research activity of a progressive supplier en-ables the firm to "keep up with the times."

3. The cost of developing expensive productionmethods and processes which may or may not becongruent with the firm's goals are avoided.

4. Large investments in inventories having a high riskof obsolescence can be reduced.

However, when there is no significant difference inthe quality of the product (make or buy), cost andquantity considerations will govern. These consid-erations can best be approached from the firm's salesforecast. Once the sales forecast has been established,then such techniques as economic order quantity (buy)

and economic manufacture quantity (make) can beused to determine what quantities of component partswill be necessary to support the forecasted sales. Thisin turn leads to the analysis of such items as proficiencyof labor, adequacy of facilities (capacity), and technicaland administrative support.

A Mathematical ModelThe cost analysis can best be made using a mathe-

matical model. However, before developing the model,certain assumptions must be established. First, thefirm must have and maintain adequate planning andsales forecasting techniques which will predict reliablefuture demands for the firm's product and conse-quently component parts. Second, the firm must takeinto account the fact that it has limited resourcesavailable to invest in different strategies. Third, theremust be an adequate capital budgeting system whichevaluates potential investment rates of return andcompares them with returns available from alternativeuses of the firm's resources. Each of these assumptionshas a direct impact on the "make or buy" decisionwhich will influence greatly the final decision.

The basic model used in the cost analysis is onedeveloped by Mock and Miller.' Since the model ispredictive in nature, the expected value of each in-fluencing variable must be taken into consideration.The five influencing variables are:

Quantity —The future demand for component partsas determined by forecasting techniquesVariable Manufacturing Costs —Raw materials,labor, and overhead items that tend to vary withproductionPurchase price of component partsInvestment to buy— Inventory handling and carry-ing chargesInvestment to make —Any necessary additionalcapital equipment, investment in both work -in-process and finished goods inventory, and inventoryhandling and carrying charges

Edward Mock and David Miller, 'The 'Make or Buy' Decision under Unmr-tainty," journal of Systems Management, May 1970.


Exhibit 1ASSUMED (MAKE OR BUY DECISION) VARIABLES

Materiel Labor plus Price Invest. Invest. DiscountDemand unit Cost var. O/H per unit to make to buy rate at 15%

Year (D) (M) (L + VOH) (P) (I M ) (1 e) (r)Y„

—

— — —

$1,000—

—

Y,

2,500 $.20 $1.50 $3.50 400 $500 .870Y

,

3,000 .20 1.55 3.65 300 400 .756Y

,

4,000 .25 1.75 3.75 500 300 .658Y

,

4,500 .25 1.80 3.85 600 300 .572

The "make or buy" model may be expressed bythe equation:

CS = D (P) — D (M + L + VOH)

Where:CS is the cost savings in the accounting period.

Dis the demand in units for that period.Mis the raw material unit cost.L is the labor cost per unit.

VOH is the variable overhead cost per unit.P is the purchase price per unit.

The expected cost savings in a period are equal tothe demand for components in that period times thepurchase price minus the variable cost of the compo-nents if made in- house. The incremental investmentfor the period is equal to the investment to makeminus the investment to buy and is given by theequation:

K = I m —I B

Where:K is the incremental investment.I M is the investment to make.I B is the investment to buy.

capacity available to meet new future demand for fouryears into the future. Exhibit l lists the variables whichare assumed to apply. With these variables established,the cost savings, incremental investment, and thepresent value of the (make) savings based on the firm'sminimum acceptable rate of return of 15 percent canbe calculated (see Exhibit 2).

Thus, if the firm utilizes its future excess capacityas given in this case and makes the component partsneeded, there will result a savings of $16,323 overpurchasing the same component part from a vendor.This is, of course, based upon the fact that the firmis willing to accept 15 percent as a minimum returnon its investment.

As a second assumption we wil l consider the casein which the sales forecast indicates that the firm nolonger has adequate production facilities (capacity) toproduce the necessary component parts during thenext four years. To rectify this situation and continuemaking the parts will require an additional capitalexpenditure of $20,000. It also is estimated that thisadditional expenditure will reduce variable operatingcosts by 10 percent. Given these conditions, the varia-bles, demand, purchase price, and raw material costsremain the same as before. The labor and variableoverhead figures now become:

YearThe mean of the inflows or outflows for that period Yis equal to the expected cost savings minus the invest- Y!ment costs: Ya

Y,Y, = CS — K

When it is discounted to its present value by a rateof return equal to the minimum acceptable return(r) for the firm, the inflow or outflow is equal to:

PV i = (1 + r ) -i Y i

The final step in this model is to sum the presentvalues for each time period which results in the presentvalue of the mean inflows or outflows.

Example

The following example illustrates how capacity con-siderations will affect the "make or buy" decision.First, we will assume that the sales forecast, the eco-nomic manufacture quantity, and the present facilityutilization are satisfactory and the firm has adequate

L + VOH1.351.401.581.62

and the new investment strategy becomes:

Year Make I M Buy I B

Yo $21,000 $ 0Yr 400 500Y2 300 400Ya 500 300Y, 600 300

Placing these new variables into the formula will giveus the new annual cost savings (to buy), the new annualincremental investment cost, and the new presentvalue of the net savings based on the same minimumacceptable rate of return equal to 15 percent (seeExhibit 3).

In this case, based on the revised assumptions, thefirm would be $2,089 better off to purchase the com-

" . . . thismodelanalyzes justthe cost aspect

of the 'makeor buy'decision . . . "


"The results ofthis examplecan be used

to draw con-clusions . . . "

Exhibit 2COST SAVINGS FOR MAKE DECISIONBASED ON ADEQUATE CAPACITY

Incremental Mean inflow CashCost savings investment or outflow flow

Year (CS) (K) (Y i) (PV )Y

a

—

$1,000 $1,000 $(1,000)Y

,

$4,500 (100) 4,600 4,002Y

,

5,700 (100) 5,800 4,385Y

,

7,000 200 6,800 4,474Y

,

8,100 300 7,800 4,462Expected net present value of the positive (make) inflows = $16,323

Exhibit 3REVISED COST SAVING FOR BUY DECISIONBASED ON INADEQUATE CAPACITY

Incremental Mean inflow CashCost savings investment or outflow flow

Year (CS) (K) (Y i) (PV i)Y — $21,000 $21,000 $(21,000)Y $4,875 (100) 4,975 4,328Y

,

6,150 (100) 6,250 4,725Y 7,680 200 7,480 4,922Y

,

8,930 300 8,630 4,936

Expected net present value of positive (buy) inflows=

$ (2,089)

ponents from an outside vendor than to acquire theadditional capital investment needed to increase ca-pacity. It should again be pointed out that this modelanalyzes just the cost aspect of the "make or buy"decision and oftentimes the factors of quanti ty orquality will outweigh the final decision.

Conclusion

The results of this example can be used to drawconclusions and to demonstrate the usefulness of the"make or buy" analysis. The first case illustrates thesavings a firm might experience if it manufactures itsown component parts, providing there is excess pro-duction capacity to produce the component parts andit is congruent with the firm's goals. The second caseillustrates the situation in which the firm increasesits production facilities to increase the capacity ofcomponent part manufacturing. In this particular casewhere the component parts can be purchased from

an outside vendor, an increase in capacity would proveto be costly.

By looking at both cases together, certain limitationsto the "make or buy" decision are observed. In bothcases, the analysis assumes that the firm's operatingconditions are static. This situation is in fact not true,and oftentimes many "make or buy" situations developsimultaneously, making their effect cumulative. Eachdecision causes changes to the firm's operating situa-tion. Many such decisions will change substantiallythe set of operating conditions upon which each deci-sion is based, nullifying any computations and com-parisons based on that set of conditions. To reducethe effect of these limitations. the "make or buy"decision always should be reviewed by some controlentity within the firm. Without this review process,all elements of planning, control, and coordinationwith respect to the firm's goals are lost, which againis detrimental to the firm's long -range survival. F-1


A CASE FORCURRENT -COSTREPORTINGIt Appears That If Accounting Information Is To Be Of Primary

Usefulness To The Decision Maker, It Must Take On A Larger

Degree Of Future Orientation

By Arthur E. Carlson The American Accounting Association set consistsof:

Economic decisions are numerous and diverse, and ifeconomic information is to be communicated for pur- 1. Relevanceposes of decision making, then the nature of these 2. Verifiabilitydecisions must be identified. A few of the more typical 3. Freedom from biascases might include: 4. Quantifiability I

1. The determination of the price for a product or The AICPA set consists of: A. E. CARLSON

a service St. Louis Chapter 1952,2. The determination of which product to push in 1. Relevance is Professor of

a multi - product line 2. Understandability Accounting at

3. The determination of which sales territory to ex- 3. Verifiability WashingtonUniversity. He holds

ploit 4. Neutrality an Ed.B. degree from4. The determination of the optimum site location 5. Timeliness the University of

for a new plant or warehouse 6. Comparability Wisconsin, an M.B.A.

5. The determination of quality of performance by 7. Completeness = degree from Harvard

an employee or associate University, and aPh.D. degree from

From the traditional set of generally accepted ac- NorthwesternNo pretense is made that this l isting more than counting principles, the following subset can be devel- University. Dr. Carlson

scratches the surface of possible decision - making areas, oped: is Past President of

but there can be little doubt of the heavy future the St. Louis Chapterand a Past National

orientation they evidence. Although data on past 1. Accrual Director.events may enter into the information filtration pro- 2. Adequate disclosurecess, they do so chiefly to fill in the continuum, along 3. Consistency

This article waswith present conditions and future possibilities (or 4. Conservatism

submitted through theprobabilities in many instances). It appears that if 5. Matching St. Louis Chapter.accounting information is to be of primary usefulness 6. Materialityto the decision maker, it must take on a larger degreeof future orientation. If future orientation is a prime requisite of account-

Three Sets of Standardsing information for decision - making purposes, thendata for reporting purposes must take cognizance of

At least three sets of standards or qualities of ac- this requirement. For that purpose, then, current -costcounting information may be viewed in historical data do a better job of satisfying the future orientationperspective. They are: requirement than do historical -cost data. A review of

the three sets of standards outlined above (which are1. The American Accounting Association set2. The AICPA set I

A Statement of Basic Accounting Theory, American Accounting Association,

3. Selected generally accepted accounting principles (Chicago, now Sarasota, Fla.), 1966, p. 7.

subsetBasic Concepts and Accounting Principles Underlying Financial Statements ofBusiness Enterprises, APB Statement No. 4, AICPA, New York, 1970, p. 10.


" . . . i t isessential that

the term'current cost'be defined."

by no means mutually exclusive) should help substan-tiate this assertion.

Current CostFirst, however, it is essential that the term "current

cost" be defined. It is used in this discussion as asurrogate for "replacement cost to the user of theresource," and would necessarily involve the determi-nation of liability values as well. Current -cost informa-tion, it is suggested, can best be derived by applyinggenerally accepted price indices to historical -cost datafor specific types of assets. It seems reasonable to assertthat current -cost reporting would provide useful infor-mation for the decision maker(s) in a single firm,even if no other firm were to adopt this approach.However, the usefulness of the method would bemaximized if there were general use by the businesscommunity, as well as general acceptance of specificindices for specific purposes and general agreementon a set of rules for index application, since com-parability thus would be enhanced.

THE ST AND ARD O F RELEVAN CE

The standard of relevance (found in both the AAAand the AICPA sets) suggests that information pre-sented to the decision maker should influence hisdecisions in some positive manner. Does the presenta-tion of historical -cost information alone fulfill thisstandard? It frequently does not because one or moreof the figures given are obsolete; and in addition, itmay mislead those who do not recognize the obsoletefigure or figures. Historical -cost information can beuseful: (1) as a base for observing trends; (2) as a meansof satisfying legislative requirements (such as tax lia-bilities); or (3) as a means of discharging stewardshipresponsibilities. But, historical -cost information needsto be augmented by conversion to current -cost equiva-lents in order to satisfy the needs of the decision makerfor relevancy in financial reporting.

THE STANDARD OF UNDERSTANDABILITYThe standard of understandability (found only in

the AICPA set) suggests that the decision makershould receive accounting information to which he canrelate. Most users are oriented primarily to the mostrecent price level. Even those users who recognize thetrue character of historical -cost information do notpossess the requisite knowledge to properly adjust suchinformation to reflect current conditions. And, it isnot sufficient simply to apply a general price indexto all classes of assets indiscriminately. Specific indicesmust be used to adjust particular classes of assets whosebehavior departs substantially from the general normover time. This cannot be done by just any decisionmaker, whoever or wherever he may be.

THE STANDARD OF VERIFIABILITYThe standard of verifiability (found in both the

AAA and the AICPA sets) suggests that the same basicset of accounting data should be susceptible to useby unrelated practitioners (preparers of reports) whocan be expected to arrive at fairly similar results, andthat it can be found by practitioners to compare withevidence in order to reassure investors. Verifiabilityis one of the prime attributes of historical -cost infor-

mation and its importance cannot be denied. But itseems appaient that reliable indices (such as the GNPImplicit Price Deflator, the Wholesale Price Index,etc.) can be prepared and disseminated by reliableagencies independent from both user and practitioner.If such indices then were applied uniformly accordingto generally accepted rules, it would seem that thestandard of verifiability still could be maintained.

THE STAN DARD OF NEUTRALITYThe standard of neutrality (or, "freedom from bias,"

as the AAA calls it) suggests that accounting informa-tion should not reflect in the process of its develop-ment the biases of anyone likely to be using it fordecision making. The use of historical costs tends tobuild in biases because some persons with knowledgeof current conditions possess an advantage over otherswho lack such knowledge. It is to be hoped that theuse of current -cost information would tend to diminishsharply this advantage and would more closely ap-proach the standard of neutrality.

THE STANDARD OF QUANTIFIABILITYThe standard of quantifiability (found in the AAA

set) need not pose any greater problems of quantifica-tion in the development of current information thantraditionally have been experienced in the measure-ment of historical costs once the ground rules havebeen developed and agreed upon.

THE STAN DARD OF TIMELIN ESS

The standard of timeliness (AICPA) refers not onlyto promptness in the publication of financial state-ments, but also may be interpreted as requiring relativecurrency of reported information. It would seem bydefinition that, for the most part, current -cost infor-mation should be more timely than historical -costinformation. And, while the quantification of current -cost information may consume more t ime than thequantification of historical -cost information, the ubiq-uity of computer -based accounting systems shouldreduce this time differential to relative insignificance.

THE STANDARD OF COMPARABILITY

The standard of comparability (AICPA), like itsolder counterpart consistency, concerns year -to -yearcomparisons within a single firm, comparisons betweenfirms in the same industry, and inter - industry compari-sons. Consistency and uniformity of accounting prac-tices lead to comparability of results. Throughout thehistory of the accounting profession, consistency anduniformity have been difficult to control. The uni-versal adoption of current -cost reporting, followingagreed -upon rules of index use and application, wouldnarrow severely the range of alternative choice ofaccounting method and remove much of the existinglack of comparability.

THE STANDARD OF COMPLETEN ESSThe standard of completeness (AICPA), like its

older counterpart adequate disclosure, suggests thatthe information presented to decision makers shouldbe sufficient or adequate to meet their needs. Tradi-tional financial statements are replete with examplesof inadequate disclosure, especially in the Owner's


Equity section of the Statement of Financial Position.A financial statement confined to historical -cost pre-sentation is further inadequate in its encompassmentof recent events that have influenced the conduct ofthe business — current -cost information would do amore adequate job of reporting.

Traditional Concepts

The traditional accrual concept generally is recog-nized as essential to the complete accounting systemof all but the simplest of businesses. The accrual basisof accounting represents the traditional approach tothe extension of historical cost information by therecognition of economic events before any cash set-tlement. The use of current cost information extendsthe "distant early warning" line even farther by en-compassing significant economic events not recognizedthrough the use of historical costs. This tends to pro-duce additional refinement in the determination ofincome.

Even the advocates of historical cost reporting havecome to recognize the declining importance of thetraditional standard of conservatism. The adoption ofcurrent -cost reporting procedures would serve merelyto hasten its demise since many of the standardsalready discussed are clearly of greater overall impor-tance.

It has been asserted by several writers that thematching concept is the most important of the tradi-tional accounting concepts and standards. Its objectiveis to match current costs and current revenues asprecisely as possible. Current costs have considerableinfluence on current sales prices of products and ser-vices and reflect the true current expirations of re-source values. Thus the use of current -cost informa-tion in the preparation of financial reports clearlyshould improve the matching process and diminishthe reasons for attempted manipulations in the timingof transactions.

The traditional concept of materiality should applywith equal force to the use of current -cost information.Many detailed adjustments of cost information neednot be made when the effects of specific price changesare of minor importance, both with respect to theasset valuation problem and with respect to the incomedetermination problem.

Some Objections to Current -Cost Reporting

This discussion would not be complete without areconsideration of some of the objections to current -costreporting that have been raised (or are likely to beraised) by accounting scholars. Most of the notionsthus far presented evolved from the deliberations ofthe AAA Task Force on Accounting Objectives' dur-ing November and December 1971, which built itsreport upon the 1966 AAA report titled "A Statementof Basic Accounting Theory." But it is well to lookto the other side of the question.

It might appear that the advocacy of current -costreporting presumes some sort of panacea for the prob-

' Consisting of the author, Professor Raymond C. Dein, University of Nebraska;Professor Anelise N. Mosich, University of Southern California; and ProfessorLawrence L. Vance (Chairman), University of California, Berkeley. Professor Deinsubmitted a written dissent from the majority report of the Task Force.4 Such as specification of the use of averages of beginning -of -year and endof -yearindices for updating sales, purchases, and ending inventory figures, and for develop-ing the amounts of purchasing power gains and losses.

lems faced by the decision maker. Traditional financialreports have not proved to be completely adequateinputs to the decision - making process, and it wouldbe most presumptious to assume that current -costreporting would solve this problem once and for all.But, if current -cost reporting can increase the informa-tion content of financial statements, (or reduce redun-dancy, whichever is to be preferred) it certainly be-comes a step in the right direction.

It might be asserted that current costs are not futurecosts and therefore do not solve the problem of thefuture orientation of most decisions. But we alreadyhave observed the complete lack of future orientationinherent in historical -cost information. Time is acontinuum, and what is really needed is a cyberneticapproach to information identification, measurement,and communication. Since we still may be several yearsaway from this type of information system, however,it is believed that current -cost reporting moves usfarther along the continuum than historical-cost re-porting and closer to the realization of the "totalsystems concept."

While it has been asserted earlier in this article thathistorical -cost (or acquisition cost) information aloneis not sufficient input for wise decision making, thecorollary notion that current -cost information aloneis sufficient input should not be inferred and doesnot follow. Current -cost information must be usedin financial reports in a manner that will make thislimitation clear to the user. The most appealing ap-proach would seem to be to state the acquisition costof each asset either parenthetically (as is done nowwith lower of cost or market inventory presentations)or in a series of appended footnotes. But primary focusstill would be on current -cost information.

It must be acknowledged that historical -cost infor-mation will continue to be relevant as the basis forspecific current -cost determinations and must continueto be available where specific legislation requires itsuse. This leads naturally to the notion that currentcosts are really the present -day fulfillment of historicalcosts and become necessary inputs if decision makersare to keep pace with dynamic economic develop-ments. Therefore, arguments can be advanced eitherfor keeping accounts on an historical -cost basis andmaking index adjustments only for statement purposesat statement dates, or for making index adjustmentswithin the accounting system but recording the pricelevel increases (or decreases) in separate accounts forthose containing acquisition costs. Careful specifi-cation of the use of indices' and the use of computer -based accounting systems should reduce considerablythe effects of time lags on the conversion from anhistorical -cost framework to a current -cost frameworkof reporting.

It also must be acknowledged that difficulties existin estimating the effects of specific future environ-mental changes on the future course of any businessenterprise. But, difficulties also exist in estimating thelives of depreciable assets booked at acquisition costs.And, the LIFO inventory method was developed inan effort to bridge the gap between historical costsand current costs.

A case can be made for a standardized approachContinued on page 44

"... current

costs arereally thepresent -dayfulfillment ofhistorical

Costs . . ."


P. M. TRUEGER

New York Chapter1948, is head of his

own company ofAdministrative and

AccountingConsultants. He writes

and publishes amonthly newsletter"Administrative and

Accounting Guide forDefense Contracts,"

and is the author of abook on the same

subject.

CONTRACT TERMINATIONAND

UNABSORBED OVERHEADIf The Government Defaults In Its Obligation, The Overhead

Cost Must Be Charged Against Other Work Which Neither

Caused It Nor Received Any Benefit Therefrom

By Paul M. Trueger

Standard contract clauses provide that the Govern-ment may terminate its contracts either because thecontractor has defaulted or for its own convenience.The latter action has little direct analogy in the busi-ness world; however, it is generally agreed that theoverall public interest is best served by giving theGovernment the right to halt activities and relatedcosts which are determined to be unproductive. Theremaining problem in this area, and it is a significantand complex one, relates to the Government's obliga-tion to mitigate the harm it has done to its contractorby terminating for convenience. In its broadest con-text, this obligation is twofold. The Governmentshould (1) move quickly and effectively to help thecontractor to extricate himself from the cancelledproject and find his way back to other activities, and(2) equitably compensate the contractor for the finan-cial consequences of the termination action.

A contract termination settlement should generallyinclude payment to the contractor for: (1) costs in-curred on the terminated contract, (2) a reasonableprofit thereon, (3) costs continuing after terminationwhich could not reasonably be avoided, and (4) ex-penses of settlement. Continuing costs fall into severalcategories. For example, there are production andengineering costs of ongoing operations that, if haltedabruptly, would damage the work in process or wouldotherwise be detrimental to the Government's interest.There are also costs which continue just because thereis no way of cutting them off. In the unanimous viewof the defense industry, as well as in the judgmentof very many (although sometimes silent) DOD of-ficials, the Government is equally responsible, in botha moral and legal sense, for all reasonable costs at-tributable to its action in terminating a contract forits convenience.

Unabsorbed Overhead

Those of us who can remember the mass termi-

nations of World War II find it difficult to understandthe basis for questioning continuing costs, includingunabsorbed overhead, to the extent reasonable andtraceable to the termination. Few questions wereraised about this cost in principle at that time andthe Joint Termination Regulation (JTR) specificallyrecognized that some costs and expenses just couldnot be discontinued immediately and, where reason-able attempts had been made in this direction, they"should not be denied merely because they were in-curred after the effective date of termination."

Some twenty years later, noting the absence ofexisting authoritative DOD regulations on this subject,the Defense Industry Advisory Council (DIAC, prede-cessor to IAC) specifically recommended an additionto the Armed Services Procurement Regulation(ASPR) to recognize continuing fixed overhead ex-pense after termination for the convenience of theGovernment. The ASPR Committee refused to takeany action on this recommendation in July and De-cember 1965.

In February 1971, however, the Defense SupplyAgency (DSA) proposed a revision to ASPR statingthat: "the cost of idle facilities and idle capacity orany form of unabsorbed overhead is not allowable asa direct charge to a terminated contract." As the ASPRCommittee people studied this proposal, they foundlittle in the way of definitive, authoritative precedent.Specific, clear -cut ASBCA or court cases were difficultto come by, and the study group grudgingly carne tothe conclusion that unabsorbed overhead claims tendto be negotiated between the contractor and the con-tracting officer without resort to formal appeals.

The study group expressed concern about what itthought were signs of increasing claims for unabsorbedoverhead, and its failure to identify policy pro-nouncement allowing or disallowing unabsorbed over-head as a termination cost . The DSA, on the otherhand, offered the view that the increasing claims forunabsorbed overhead might be attributable to theASPR revision to 15- 205.12 in May 1967. This ASPR


paragraph previously contained sharp limitations onthe allowability of costs of idle facilities and idlecapacity. The aforementioned revision described thesecosts as including "maintenance, repair, housing, rent,and other related costs, e.g., property taxes, insurance,and depreciation," and stated that they would beallowable under a number of circumstances, includingwhere "...they were necessary when acquired andare now idle because of

...termination ..."

Costs Continuing After Termination

The term "unabsorbed overhead" (or "unabsorbedburden," used interchangeably) has several connota-tions in accounting and business. In discussing thiscost in connection with termination settlement pro-posals, we refer to that portion of indirect costs whichwould have been absorbed by, or charged to a specificcontract if i t had not been terminated. The termi-nation action makes this portion unabsorbed initiallyand its disposition must be determined. Logically, inour judgment, inasmuch as this overhead became un-absorbed as the direct result of the Government'saction in terminating a contract, it should be paid(absorbed) by the Government and considered a costof the termination. If the Government defaults in itsobligation, the overhead cost must be charged againstother work which neither caused it nor received anybenefit therefrom. In effect, of course, this cost wouldcome out of the contractor's profit or "hide."

ASPR 15- 205.42(d) and (e), respectively, explain thebases for specifically allowing loss of useful life ofspecial tooling, special machinery and equipment, andrental costs under expired leases. Most of industry'sproblems in this area arise because many DOD officialsrecognize the specific allowances cited in subpara-graphs (d) and (e) but ignore the more comprehensiveprovisions of subparagraph (b), cited below, which issignificant and persuasive:

"15- 205.42(b) Costs Continuing After Termi-nation. If in a particular case, despite all rea-sonable efforts by the contractor, certain costscannot be discontinued immediately after theeffective date of termination, such costs aregenerally allowable within the limitations setforth in this Part, except that any such costscontinuing after termination due to the negli-gent or willful failure of the contractor to dis-continue such costs shall be considered unal-lowable."

We note that there is no regulatory support fordisallowing unabsorbed burden. To the contrary,ASPR 15- 205.42(b) would appear to constitute reas-onable indication of an intent to reimburse all con-tinuing costs which the contractor could not halt.

Contract Appeals

Relatively few appeals involving unabsorbed over-head ever reach the Armed Services Board of ContractAppeals (ASBCA). One of the exceptions that provesthe rule was reflected in the following case.' Accordingto the Board, the contractor claimed: "entitlementto the entire continuing overhead, from the date oftermination until the contemplated date of comple-


tion, the amount of which is $84,733. The TerminationContracting Officer (TCO) disallowed in its entiretyappellant's claim for unabsorbed overhead but deter-mined that certain indirect expenses could not beimmediately discontinued and allowed appellant$9,588." As explained in a footnote to the decision,"This figure was computed by the TCO using ap-pellant's unabsorbed overhead figure

..." We found

both the basic statement and the related footnoteunclear.

Further, research disclosed that the TCO testifiedas follows:

"In deciding the amount of money to allow thecontractor for the continuing indirect costs Iused the contractor's settlement proposal of$57,000, approximately, for the fiscal year 1967,and I divided that by 1/6, allowing approxi-mately $9,500 in total settlement for the con-tractor's claim of unabsorbed overhead, orcontinuing indirect costs as indicated in myunilateral decision."

The point of interest here, it seems to us, is thatthe Board's decision has been interpreted by some asclearly establishing that unabsorbed overhead is notallowable. This is understandable in the light of someof the Board's comments, e.g., "The TCO disallowedin its entirety appellant's claim for unabsorbed over-head. . . " However, the above -cited statement attestsa different picture. Other portions of the hearingfurther suggest that the Government did make anallowance for unabsorbed overhead so that the disputeseems to have involved the amount rather than theprinciple. More importantly, the hearings revealed thatthe decision to make this allowance for continuingindirect expense was actually initiated by a DODSettlement Review Board and passed on to the TCOfor implementation.

In a previous case, involving the Fairchild StratosCorporation, the Board's decision with respect to un-absorbed overhead contained the following:

"Before reaching the question posed by theparties, we must determine whether unabsorbedoverhead is a continuing cost reimbursable underthe contract. Our research has uncovered nocases in which the question of unabsorbed over-head had been considered under a terminationfor convenience clause of the type included inthis contract. In connection with the partialtermination for convenience of a fixed pricesupply contract, this Board has refused to allowrecovery of unabsorbed overhead." Z

The Board cited its ruling in Fairchild Stratos, whenit reached the Technology, Inc, decision, and impliedthat it reflected a precedent for disallowing unab-sorbed overhead. The Fairchild Stratos case was anextremely complicated one, and the ASBCA decisionwas long and involved.

The Navy partially terminated an engine contract

' Appeal of Technology, Incorporated, ASBCA 14083, June 1971.I

Fairchild Stratos Corporation, ASBCA No. 9169, on Motion for Reconsideration,68.1 BCA par. 7053 (Recon. den.).

"The term

'unabsorbedoverhead'. . .has several

connotationsin accountingand business,"

39

". . . westrongly

endorse the

recommen-dations of

industry asso-

ciations . . . "

and several months later the Air Force completelyterminated all of its contracts. The latter action, lead-ing to the ultimate shutdown of the contractor's plant,understandably occupied most of the contractor's at-tention. The Fairchild -Air Force termination set-tlement, which did not go to dispute, apparentlyincluded an assumption by the Government of a con-siderable portion of the continuing costs. A similarprocedure with the Navy, however, could not beagreed upon and became the basis for this appeal.

It is important to note that the Board's views oilthe financial consequences of the termination aresubject to various interpretations. It framed a questionas to whether Fairchild was entitled to an equitableadjustment because of the partial termination. Ineffect, it seemed to be considering the effect of thecontinuing costs, including unabsorbed overhead, onthe remaining portion of the contract. The Board'sanswer to its own question was:

"If, by a rational means, a method is found forcalculating the monetary effect upon appellantof the partial termination of the contract, andif the application of that method shows anincrease in cost, then appellant is entitled toan equitable adjustment."

We find here an obvious parallel to the problemof unabsorbed overhead under a contract terminatedin its entirety. In the case of the partial termination,the Board found no pain in compensating the contrac-tor by an upward adjustment in price for the remainingengines. In the case of a complete termination, theonly comparable financial relief is through reim-bursement of the costs which could not be ab-sorbed.

A third case' which does not involve a substantialdollar amount, does, however, offer several points ofinterest. The contract that was entered into by AdamBarr's Son on July 23, 1969, required construction workin connection with the Stewart Air Force Base, New-burgh, N.Y. On September 18, 1969, the contractorwas directed to suspend work for a 30 -day period atwhich time approximately 20 percent of the total jobwas completed. Thereafter, the suspension was ex-tended for an additional 44 days. However, on No-vember 24, 1969, the entire contract was terminatedfor convenience due to a decision to close the Base.

As a result of the foregoing, a settlement proposalwas submitted which included, in addition to thenormal cost amounts, such items as: (1) full overheadand profit that would have been realized if the con-tractor had completed the contract, (2) loss of an-ticipatory earnings computed at $250.00 per day causedby the termination and the bond associated therewith,(3) costs of preparing the case for appeal to the Board,and (4) interest expense.

Initially, the Board ruled on the loss of anticipatoryprofits negatively by placing this item in the category

of consequential damages, which were not allowablesince they were not incurred costs applicable to thecontract terminated.

With respect to the contractor's claim for the costof preparing the case and interest expense, the Boardmade reference to a prior ruling,' and made the com-ment that "such requests for relief are traditionallydenied."

As to the loss of overhead absorption and profitthat would have been earned had the contract goneto completion, the contracting officer limited thisamount to the percentage of work actually completedto the date of the receipt of the aforementionedsuspension of work that was approved by the Board.However, the Board further recommended the allow-ance of an additional amount of overhead incurredduring the 67 -day suspension period prior to the re-ceipt of actual termination notice which was compara-ble to continuing overhead on a standby basis. Thislat ter amount was computed on a daily absorptionbasis. In addition, the Board also suggested the allow-ance of a lump sum for settlement type expenses thatwere to be distinguished from those incurred in prose-cuting the appeal.

It is to be noted here again that some contractorsare including in their settlement proposals lump sumamounts representing unabsorbed overhead that wouldhave been recovered had the contract gone to comple-tion. Obviously, such total numbers, predicated on atotal overall computation, are having difficulty withthe Board since they do not represent costs of a directnature applicable to the terminated contract. Timeand again we find contractors appealing items of asophisticated and complex nature and computing themon a lump sum basis rather than using detailed preciseformula computations. Naturally, the total basis doesnot make much of a headway with the Board; but,it tends further to set certain precedents in principlethat are difficult to overcome in future similar appealactions.

Conclusion

The views of individual Government auditors, con-tracting officers, settlement review boards, boards ofcontract appeals, Federal courts, etc., in specific situa-tions are impossible to predict. For this reason westrongly endorse the recommendations of industryassociations to revise ASPR to establish unequivocallythe acceptability of appropriate unabsorbed overheadand all other reasonable costs which can be tracedto the Government's action in terminating a contractfor its own convenience. Until this action is taken,it is our judgment that contractors should continueto assert such claims, where applicable, because theyare clearly supportable by accounting and businesslogic, as well as equity. ❑

i Adam Bart s Son, ASBCA 15178. dune 1971.{ ]cco Industries, Inc.. ASBCA Nos. 15061 and 11131.


ASPR: SOMESUGGESTED CHANGESThe Termination For Convenience Clause Of ASPR Is An

Outmoded Concept That Is Costing The Government Millions

Of Dollars While Disguised As A Cost Savings Device

By Douglas G. Corderman

The "bible" for the defense contract accountant isthe Armed Services Procurement Regulation, abbre-viated as ASPR. Section 8 of the regulation deals withterminations; Section 15, which is of particular con-cern, deals with the basic question of cost allowability;and Section 3 includes regulations on ContractorsWeighted Average Share.

Problems with Termination for Convenience

Sections 8 and 15 consider the termination of aGovernment contract. Section 8 discusses terminationprocedures, and Section 15- 205.42 treats the allowabil-ity of termination cost. The one fault in this treat-ment, however, is that ASPR allows the Governmentto terminate a contract at its convenience.

In the normal commercial business world, if a con-tract is terminated by the buyer before performanceis completed, the seller is entitled to a variety ofremedies which essentially guarantee the seller's abilityand right to a "full" profi t on the job rather thansimply the prorated profit on the work accomplishedup to the point of termination. The Government hasrevised these normal contracting rules to give itselfan "extra" advantage.

In reality, however, a good case can be made thatthe advantage to the Government that arises fromhaving a termination for convenience clause is morethan offset by the disadvantages. The impact of thisclause in general terms is to:

1. Dry up private financing, particularly long -termloans or debt arrangements

2. Require the government to provide capital assetsunder facility agreements

3. Force contractors into short -term, high -cost leasingarrangements

4. Increase administrative costs excessively in thesettlement of terminations

5. Prevent or limit modernization of equipment andplants

6. Increase the probability of poor procurement prac-tices by providing government procurement agen-cies an escape clause from bad procurements

Lower profits of defense contractors and limitequity financing

COST TO CONTRACTORS

Such provisions, in which the Government can can-cel a contract at its convenience, keep the normallyprudent lender from providing funds. When funds areprovided, they are always at high -risk rates, furtherdriving up the cost of doing business with the Govern-ment. Few contractors can afford to make a sizableinvestment in facilities on a long -term commitmentbasis and must turn to the Government or to leasingcompanies.

The cost of administering termination settlementsis excessive for the value received. Whole sections ofcompanies and government agencies are involved indescribing, accounting for, and disposing of terminatedinventory. Many others work out the problem on apart -time basis. These costs can come to or exceed10 percent of the negotiated value of the termination.

Too many contracts are started and then cancelled.Several billion dollars are wasted each year on itemsprocured and then cancelled. Since these actions se-verely impact contractors' sales and profits, equityfinancing is very difficult to obtain.

Further, the effective management of a companywith a major termination is almost impossible withlayoffs, bumping, idle plant capacity, morale, andpublic relation deteriorations. Many of these costs arechargeable to the termination claim and, therefore,are passed along to the Government.

COST TO THE GOVERNMENTThe Department of Defense today has a major

investment in the machinery of terminations. Eachof the Defense Contract Administration Service Re-gional ( DCASR) offices has a Termination Branchwith a varying number of Termination ContractingOfficers (TCO). In total, DCASR has approximately60 TCOs in 17 branches. Each DCASR office alsohas price analysts, production and technical specialists,administrative contracting officers, legal staffs, financeexperts, and many others, including DCASR top man-agement personnel, involved on a part -time basis withterminations.

D . G . C O R D E R M AN

is Vice President ofAdministration ofElectronics and SpaceDivision, EmersonElectric Co., St. Louis,Mo. Mr. Cordermanholds an A.B. degreefrom DartmouthCollege and a 1. D.degree from HarvardLaw School.


"What shouldthe rule be

regarding

interestallowabihty ?"

While statistics are not readily available on themanhours expended by the Defense Contract AuditAgency on terminations, there is no doubt that thetotal dollars are very substantial.

Each of the Army, Navy, and Air Force procuringagencies also has staff members who participate interminations on a full -time or part -time basis. All ofthe major aerospace companies have full -time termi-nation staffs and both they and the smaller defensecontractors have a great many employees engaged intermination assignments on a part -time basis. Whileit is impossible to know the true cost of personnelinvolved in defense contract terminations, there islittle doubt that it is in the tens of millions annually.

Another indication of hidden costs partially attribu-table to the existence of a termination for convenienceclause is the amount of money invested in governmentreal property. As of June 30, 1970, the Departmentof Defense had $6 billion invested in industrial realproperty and $12 billion invested in plant equipment.While the Defense Department could not withdrawcompletely from investments of this magnitude, undercertain conditions this investment could be reducedsubstantially. If members of industry were askedwhether they would purchase the government facili-ties in their possession if the termination for conve-nience clause were eliminated and if interest weremade allowable, in a large number of cases the answerwould be affirmative.

Viewed another way, the carrying costs alone of $18billion of DOD owned industrial real property andplant equipment, at a six percent annual interest rate,equals the total contract price of items terminatedin fiscal year 1970, $1.095 billion.

This money does not represent savings to the Gov -emment arising from termination. This figure is theprice of the various items terminated as contained inthe contract or as estimated when unit prices are notavailable. Since some terminations occur shortly afterwork begins and others occur immediately before de-livery, it seems fair to assume that the average ter-mination occurs halfway through a contract. If atermination is partial, the contractor is entitled toan equitable adjustment of the price for the continu-ing portion of the work. In addition, a contractoralways is entitled to recover settlement expenses.Combining these factors, a reasonable estimate indi-cates that an amount equal to two - thirds the contractprice of items terminated yields no benefits to theGovernment.

Terminations are expensive in terms of the person-nel structure the present system has allowed to de-velop. Termination "savings" tend to be more thanoffset by "wasted" expenditures. The termination forconvenience clause does impact the defense industry'sability to obtain financing.

Cost Allowability

Over the years, the original ASPR Section 15 rulesfor cost allowabilities have been modified andamended hundreds and hundreds of times —until whatremains is a nightmare of confusion to the noviceaccountant who first discovers this whole new account-ing world and an illogical, unfair set of guidelines tothe experienced practitioner. In particular, many items

of cost that are accepted as allowable by the account-ing profession generally, and by the Internal RevenueService, are deemed to be unallowable when chargedagainst a defense contract. Still, it does seem thatcertain of these disallowances are totally inappropriatefrom the viewpoint of both accounting theory andnormal business practice.

INTERESTUnder the terms of ASPR clause 205.17, interest

is unallowable as a cost to be charged against a Gov-ernment contract. This clause defines interest as in-cluding "interest on borrowings (however represented),bond discounts, (and) costs of financing and refinanc-ing operations." The theory behind this clause is thatto allow interest would give an unfair advantageto firms that are under - financed and must resort toborrowing, as opposed to other contractors who areable to finance a contract from their own resources.Moreover, the theory is that the Government can"borrow" at a better interest rate than contractors soit is better for the Government to provide contractworking funds through the progress payment routethan for a contractor to borrow money and then chargethe borrowing costs to a contract.

The first argument above fails because it ignoresthe fact that most companies have both debt andcapital financing rather than one or the other, so thehypothetical "black and white" situation rarely exists.Instead, the majority of companies finance contractspartly with retained earnings. Moreover, not to allowinterest favors companies with a substantial net worth,as opposed to the company that lacks financing. Italso penalizes both the small business and the strug-gling company on the way up as they competewith the corporate giants in the defense business.

While it may be true that the Government can raisefunds more cheaply than a private firm, this assertionis by no means clear. For it assumes that the Govern-ment always raises funds at the best going rate in themoney markets and, therefore, no one can do betterand many will do worse. However, if considerationis given to the Government's internal administrativecosts in processing funds to a contractor, the full costsof Government financing may well turn out to begreater than simple contractor borrowings. In anyevent, the "real truth" will never be known becauseof the great difficulty in determining the applicabilityof the various Government administrative costs in-volved.

A more valid issue is the question of can (and will)the banks and other lenders provide the necessaryfunds. Defense contractors are hardly the most popularof borrowers in today's money markets. Frequentlythey are required to pay more than another borrowerbecause of the high- risk /low -profit nature of theirbusiness. In other cases, any kind of financing simplyis not available.

The real question, notwithstanding the above, is"What should the rule be regarding interest allowa-bility?" By all normal and reasonable standardsthe answer must be, "Interest should be allowable."

Interest expense is recognized as an allowable ele-ment of cost in all commercial contracts. Almost everycontractor has interest expense. Not to allow interest


penalizes the small business more than it damages thelarge business. This result is opposite the normal gov-ernment position of favoring small business.

CONTRIBUTIONS AND DONATIONSThe ASPR provision (ASPR 15- 205.8) relating to

cost allowability of contributions and donations isshort and specific; they are unallowable.

When this provision was first drafted and includedin the regulation, it perhaps had limited merit. Afterall, the Government has a duty to its taxpayers notto allow contractors to increase defense costs throughexcessive generosity to favorite charities. But eventsover the past 25 years have demonstrated clearly thatthe prohibition has missed its mark. The problem isnot the occasional contractor who perhaps might at-tempt excessive and improper charitable donations.The problem today is the almost mandatory require-ment of all contractors that they support their localUnited Fund and other charitable organizations.

In a very real sense, the resulting contractor expend-itures are not an optional item for the DOD contrac-tor. He must give if he is to continue to be a respectedand responsible member of the business community.When his employees need help from a United Fundor other charitable agency, they receive it. How canthe employer not aid these very same organizations?Contributions and donations are recognized as legiti-mate business expenses by every authority, includingthe IRS.

BAD DEBTSASPR (Section 15- 205.2) states, "Bad debts, includ-

ing losses (whether actual or estimated) arising fromuncollectible customers, accounts and other claims,related collection costs, and related legal costs, areunallowable." This regulation is founded on the pre-mise that the Federal Government always pays its bills.Thus, a defense contractor should have no bad debtsthat are the responsibility of the Government.

This premise is faulty for two reasons. While theGovernment may pay all its bills, sometimes primecontractors on government contracts do not pay theirobligations. Since this bad debt clause generally ispassed down to the subcontractor level by the primecontractors, a subcontractor of a bankrupt prime con-tractor can be left holding the bag. As with most ofthe unallowable items of Section 15, it is typicallythe small business that suffers most since a smallbusiness is more apt to be a subcontractor rather thanprime contractor.

Even if the Government pays i ts bills, in manyinstances there are controversies over the amount due.The Armed Services Board of Contract Appeals(ASBCA), which has been established to hear mattersin dispute on Government contracts, handles in excessof one thousand cases a year, and the majority ofGovernment contract claims are resolved without re-sort to the ASBCA. In addition, there are alwayscollection and legal costs and these costs must be paidby the contractor. Thus, the Government has it withinits power to delay payment of a just debt, causinga contractor to incur added expense and then not torecognize these additional costs. Somehow, this ap-pears to be unfair and improper.

ADVERTISINGOther than advertising for employees, procurement

of scarce items, and the disposal of scrap and surplus,advertising is prohibited by ASPR 15- 205.1. This de-termination is based on the Government's desire toavoid paying for extensive high pressure advertisingcampaigns directed at influencing the awarding ofcontracts. The theory is that the Government receivesenough information as part of the normal proposalcycle to make proper award determinations and, there-fore, not only is advertising expensive, it is unnecessary.

This approach ignores everything preached by theadvertising industry and on which American industryhas been based. Advertising builds awareness of com-panies and products. Companies frequently get theopportunity to bid and obtain orders as a result ofbuyers reading their advertising. This spreads overheadcosts and lowers prices. And this is true in govern-ment contracting as well as commercial business.

Advertising helps build reputation. A well -knowncompany is more apt to be a well- thought -of company.This helps in attracting and retaining employees. Ithelps in raising capital. And it helps in convincingcustomers that you can do their job.

If total freedom in advertising is anathema to Gov-ernment regulations establishers, at least partial costallowability seems in order. Advertising is a real andnecessary cost of doing business (even with the Gov -emment), and it pays for itself.

ENTERTAINMENTASPR 15- 205.11 provides for total prohibition of

.entertainment costs including "costs of amusement,diversion, social activities, and incidental costs relatingthereto, such as meals, lodging, rentals, transportation,and gratuities . . ." In theory, this regulation keepsgovernment contractors from improperly influencingcontract awards and performance of government per-sonnel. However, there are other government regu-lations specifically prohibiting government personnelfrom accepting contractor paid entertainment of anysort. Thus, the prohibition in ASPR against entertain-ment is redundant as regards its original purpose.

We find here a situation where the business worldin general accepts customer entertainment as a normalbusiness practice, even when done on a very broadscale. The IRS accepts entertainment expense as legit-imate and requires no documentation if the expenseis under $25. Yet the Department of Defense refusesto acknowledge the acceptability of even one dollarof such cost. Excessive entertainment in governmentcontract circles would clearly be out of order, butrecognizing lunches and dinners and other entertainingcosting under $25 in total as acceptable business seemsto be in keeping with the way American business isusually done. No government buyer or inspector isgoing to be influenced improperly for $25. The regu-lation is out of tune with the world of today.

Contractors Weighted Average Share

In December 1966, the DOD issued Defense Pro-curement Circular Number 50 which introduced a newconcept into accounting for defense contractors. Con-tractors Weighted Average Share (CWAS) is nowcovered by ASPR Section 3 -1000. The CWAS concept

"Advertising is

a real and

necessary costof doing

business ..."


"Unfortunately,

the CWAS

concept neverhas gotten off

the ground."

is based on the premise "that a contractor who acceptshigher risk contracts has a greater financial motivationto exercise prudent business judgment in the perform-ance of such contracts." Accordingly, a contractor whoaccepts these higher risk contracts is to be given areward in the form of reduced government controls.

At the time the CWAS concept was introducedthere was great hope by those in both industry andthe Government that it would develop into an effec-tive technique for government contract management.Unfortunately, the CWAS concept never has gottenoff the ground. The problem with CWAS is not thatthe concept is deficient; rather, the difficulty is thatCWAS application has been severely restricted to onlythe most obvious cases —items such as salaries andwages, fringe benefits, materials, training expenses, andrecruitment costs.

CWAS is not applicable to stock options, certainrental costs, various taxes, termination costs, plantreconversion costs, and precontract costs; nor is it

A CASE FOR CURRENT -COST REPORTING


to value estimation. And, it would appear that theuniform application of standard indices agreed uponin advance by the accounting profession would ac-complish this goal and thereby provide a closer ap-proximation to reali ty than now is achieved by themore traditional procedures.

Conclus ion

There is much evidence that the consolidatedfinancial statements of conglomerates can gloss overmany important considerations and that the use ofcurrent costs in financial reporting would not cure allof this illness. Also, the consolidation of foreign sub-sidiaries in an era of floating currencies and shiftingexchange rates further complicates the financial re-porting problem. It would be naive to suggest thata switchover to current -cost reporting on the part ofthe American financial community necessarily wouldsimplify this. But how much should be expected froma reporting procedure when the fundamental problemstems from the quality or character of input data?

applicable to any of the many items of normal businessexpense that ASPR deems unallowable. Moreover,while CWAS appears to have application to al l themany surveys DOD conducts on contractor compensa-tion programs, procurement systems, accounting pro-cedures, estimating systems, and the like, it never hasbeen authorized for such usage. Thus, a good ideaatrophies and costs remain higher than necessary.

Summary

The termination for convenience clause of ASPRis an outmoded concept costing the Government mil-lions of dollars while disguised as a cost savings device.Section 15 cost principles should be updated to con-form to modern business practices as recognized andaccepted by the IRS. However, CWAS is an imagina-tive, practical, new approach to managing DOD con-tracts. Its use should be expanded at every opportu-nity. The cost saving to the Government as well asto industry can be substantial.

These matters need attention, but current -cost report-ing can have litt le or no more influence upon themthan historical -cost reporting has had to date.

To summarize, the use of current -cost informationin financial statements would seem to satisfy (or atleast not contradict) almost any set of accountingobjectives that has been or could be developed. And,while current costs do not provide complete informa-tion about the future, they seem to move farther alongthe continuum of time than historical costs are capableof moving. Much of the reverence for the use ofhistorical -cost data stems from tradition and longexperience.

It is natural to fear the unknown. But the resolutionof most of the doubt concerning the efficacy of current -cost data never will take place unless and until thereis general acceptance by the financial community(accountants, financial analysts, etc.), specific rules forthe application of indices are developed, and current -cost reporting is given a fair tr ial in practice. Onlythen will it be possible to face squarely many of thequestions that can be only matters of conjecture atpresent.


BUSINESS COMBINATIONS:POOLING OR PURCHASE?One Must Consider That The Fair Value Of What Is Received Is

Equal To That Which Is Being Surrendered

By David J. Retz

When two corporations decide to combine, whetherthrough merger or acquisition, the accounting methodsused to effect that combination will be subject toconflicting interpretations. Essentially, in a merger,when the pooling of interests method is used, thebalance sheet and income statement items of theconstituent companies are added together includingprior period earnings. In an acquisition, or purchase,the acquired company is considered to be identicalto that of a tangible asset. The earnings of the newentity (Company A and Company B combined) arepresented as of the date of acquisition.

Reasons for Combining

Ignoring accounting methods for the moment, sev-eral reasons are given for a merger or an acquisition.The acquiring company or dominant one often citesthe following: (1) a need to diversify its product line,(2) a need to improve its competit ive position, (3)a need to obtain superior management and /or tech-nical abilities, or (4) a need to invest excess funds.On the other side, the acquired firm uses the followingreasons: (1) a need for additional financing for vitalexpansion, (2) a need to expel the threat of tech-nological product changes in the future which can beachieved by joining a larger corporation, (3) a needfor suitable management after the retirement of a keyexecutive, or (4) a need to be acquired after a longperiod of depressed operations. The real reason, how-ever, and a valid one, is increased profitability.'

The guiding purpose of the American capitalistsystem is primarily to make profits and consequently,all actions of corporations have as their goal profitswhether they are part of long or short -term plans.Admittedly, the theoretical difference between thepurchase and pooling of interests methods is whetheror not two companies are joining together equally.Undoubtedly, if it is a purchase one company mustbe the dominating one. If two companies are of equalstrength, neither one in reality wants to join or sellitself to the other. Rather, one must want somethingthat the other has, and in most cases, the dominantcompany has expertise and money while the acquiredone has a salable product or service along with plane,property, equipment, etc.

At the present time both methods are imperfect.However, the purchase method has more theoreticalsupport than the pooling method and can be perfectedsomewhat more with stricter regulation from withinthe profession.

Pooling of Interests

In a pooling of interests, one of the corporationsinvolved issues its stock to the stockholders of theother corporation in exchange for their stock. Usually,just the common stock is involved, but there are nu-merous cases where debentures and preferred stockare used in effecting the transaction. Also, cash is notused except for the buying or selling of fractions ofshares or to buy out a small stockholder who doesnot wish to convert. The assets, liabilities, and theequity accounts of the two corporations are then addedtogether and no goodwill is recognized.

Validity of the pooling concept lies in the fact thatthe assets belonging to the corporations are not givento the stockholders, and the net assets of the combinedcompanies are not increased in total. Another factoris that the owners are now involved in a new entitysince they did decide on the combination.

The mutual exchange of risks and benefits on behalfof the two ownership groups is similar to the givingup of some interests in one company for those ofanother firm. Such is the case where a new corporateentity results from the combination of two corpora-tions. The functions of the two companies become"integrated" at the high management levels at firstand then, numerous changes take place at other levels.Even the liabilities, production and operations, as wellas the marketing policies will change.

Another requirement for the pooling to take placeis that cash, except for the negligible amount men-tioned previously, cannot be used to effect the combi-nation. However, there is not much difference in termsof liquidity between cash and stock. Stock can bereadily sold for cash and this reasoning is self - evidenton a balance sheet where "marketable securities" isshown beneath the "cash" account. The addition ofaccount balances would, in the end, have the samevalue whether or not stock were used to effect thecombination. Believers in pooling, do not want to

, James E. Meredith, Jr., "Accounting's Contribution to the Selection of BusinessInvestments,- Management Accounting, April 1968.

D. J. RETZ

is an AccountingSenior at RiderCollege and a memberof the AccountingClub. He is also aresident dormitorysupervisor and hopesto pursue a career inpublic accounting.

This article wassubmitted through theTrenton Chapter.


"More work is

involved, butthe benefits to

be derivedwould be

worthwhile."

acknowledge this effect since the use of cash wouldmake the combination similar to a purchase of an asset.In this respect, the validity of the pooling conceptseems weak and its consistency, in respect to otheraccounting concepts, is questionable.

Pooling is said to have been "developed within theboundaries of the historical -cost system and is compat-ible with it." = While the statement is true, the degreeof compatibility that exists is subject to argument.Historical cost can be carried to an extreme and thisis done in pooling. For example, assume that a newcorporate entity is formed as the result of a pooling.The accounts of the two original corporations are notrevalued. The question is, why should they not berevalued? If an asset is bought by a firm for $1,000,it is recorded at that amount. If the firm now combineswith another firm, the asset remains on the books at$1,000 (assume no depreciation). However, acting asa middleman, why should the firm not add a cost tothe asset? If this cost of the "middleman" is notconsidered in the merger, why should the cost of theoriginal middleman be accounted for in the cost ofthe asset?

Of course, it is easier to compare the earnings ofthe new firm if the accounts are combined at theirhistorical cost. But, if the accounts are not reasonablystated at a fair value, the comparison is not valid.Negotiations before the transaction are not basedsolely upon the number of shares to be exchanged,but rather on the value of the two companies (valuebeing the worth of present net assets and future earn-ing power) in terms of dollars. Those amounts arethen converted by using the market value of the stockand making adjustments for temporary effects.

Also, ignored by the pooling method is goodwillwhich is always an integral part of the negotiations.It should, therefore, be acknowledged and accountedfor in the new or surviving entity.

After the merger has been accomplished, the ac-counts of the two previously separate entities arecombined. The financial statements are presented asif the pooling of interests took place on the first dayof the accounting period, even though it could haveoccurred on the last day. This can and does distortthe income statement that is subsequently issued. Itseems that a better method of financial reportingwould be to present separate statements for each firmfor the partial period before the combination, andthen a combined statement for the period beginningwith the date of the combination. More work is in-volved, but the benefits to be derived would be worth-while.

Expenses incurred during the merger period are tobe deducted from income in the first period of thecombination. This is contrary to present day account-ing concepts. When a firm is organized, its relatedorganization costs are amortized over a period of fiveyears or less. This is done even though benefits fromthe organization are experienced for the l ife of thebusiness. When a pooling occurs, the costs are notspread out, al though the amounts involved in bothcases may be approximately equal. For instance, ex-

2 APB Opinion No 16, "Bus111— Combinations," AICPA, New York, 1970,P. 291.' Ibid.. p. 2s7

penses, such as registration fees, costs of furnishinginformation to stockholders, fees of finders and con-sultants, and salaries and other expenses of employeeswho are involved with the merger activity are similarto those of starting up an organization.

Purchase Method

In contrast to the pooling of interests method, acombination can also be accounted for by the purchasemethod. The purchase method is based on the condi-tion that there is a dominani company which acquiresa subordinate company on the same basis that an assetis purchased. The most voiced objection to the pur-chase method is from proponents of the pooling ofinterests method who feel that goodwill should notbe recognized.

In addition to maintaining that any combinationis actually an acquisition, those who favor the purchasemethod believe that the transaction is a bargainedone. In other words, negotiations take place on eachside. There is an estimation of the value of the netassets and future earning power of the subordinatecompany. The excess of the purchase price paid overthe recorded (after revaluation) value of the net assetsis accounted for as goodwill. Whether the combinationis effected by cash or stock is of no great importancebecause one must consider that the fair value of whatis received is equal to that which is being surrendered.

Basic principles are followed by the purchasemethod. First, the assets and liabilities are shown attheir bargained values. These items also include newassets and liabilities, if any, incurred directly as a resultof the combination. In addition, the fair value ofconsideration which was received for the stock issuedis shown. When, the net income is computed for thenew firm, the expenses are based upon the newlyrecorded figures rather than ones recorded by theprevious owner. Another principle followed is that theretained earnings of the corporation are not fused withthose of the acquired company.'

At first glance, there are numerous defects withthe method. However, they can be eliminated withsome self - imposed control. It has been said that itis difficult to measure the fair value of the business.This is nonsense since both sides during negotiationshave an idea of what each is worth, regardless of theaccounting method to be employed.

The argument against the revaluing of assets of onlythe acquired firm and not those of the acquiring firmhas little justification. When a firm purchases an assetit is recorded at a cost, which is reasonable and neces-sary to get the asset where one wants it and in thecondition one wants it. At this time, the companythat purchases the asset does not revalue all otherassets which it has. The probable reason for the oppos-ing point of view is that the purchase method doesnot produce as high an income after the combinationis effected as the pooling method.

Just as abused, if not more so, as the treatmentof acquisition costs is that of goodwill. Goodwill isprobably the most voiced objection to the use of thepurchase method. The proponents of the poolingmethod say that goodwill is not exactly determinableand therefore should not be acknowledged. Regardless



INTERNATIONAL TAXMANAGEMENTAn International Company Requires Constant Exchange Of

Information Between Parent And Subsidiaries To Gain The

Advantage Of Any Possible Legal Tax Benefits Which Can Be

Ascertained And Included In The Overall Tax Planning

By Ernst K. Briner

Prior to January 1, 1963, the earnings of Americancontrolled foreign corporations (CFC) were not taxeduntil dividends were paid to the parent companies.After that date, controlled foreign corporations weresubject to the Revenue Act of 1962. The RevenueAct was introduced because it was possible for certaincompanies to avoid taxation by selling products manu-factured in the United States to their CFC subsidiarieslocated in low tax rate countries which then resoldthe products at higher prices to worldwide markets.According to the Act, if the taxable base companyincome is less than 30 percent of the total income,none of the current year foreign income (not yetremitted) is taxed in the United States. If the taxabletype income is more than 70 percent of total income,all of the income (Subpart F income) is taxed. If thetaxable income is between 30 percent and 70 percentof the total income, then the exact amount of taxabletype income is taxed (dividends, interest, royalties, andvarious miscellaneous types of income generally aretaxable). Thus, the income of a CFC must be carefullyanalyzed so that the taxable income and the non -taxa-ble income can be distinguished.

The 30 -70 Test

In order to ascertain whether income meets the"30 -70" test, it is necessary to group the CFC's salesincome. It is also necessary to group, on a separatebasis, income originating from commissions, serviceand rentals as follows:

All income from material manufactured by thecontrolled foreign corporation is non - taxable.(Non -base company income)

2. The portion of profits from sales, consumption ordisposition inside the country of incorporation of

material purchased from a related company forresale without further processing is non - taxable.The remainder is taxable in the United States.

For profits resulting from material purchased froman unrelated company for resale without furtherprocessing, the portion from sales, consumption ordisposition inside the country of incorporation isnon - taxable. The portion of profits from sales out-side the country of incorporation to unrelatedpersons is non - taxable, the remainder (sale to re-lated companies outside the country of incorpo-ration) is taxable. (Base company income)

It is here that good tax management comes in toplay since it is essential that the various exceptionsare properly applied. It is particularly important thatincome not subject to United States taxes be properlyreported to the parent so that exemption from taxeswith respect to foreign income be obtained. Mostmultinational companies have designed special formswhere detailed breakdowns of base company andnon -base company income are shown. It should alsobe noted that foreign taxes paid by CFC's may beoffset against the United States tax when the earningsof the CFC are subject to the United States tax, andthat the total taxes can be further reduced by a mini-mum distribution of dividends from CFC's to theparent company.

Good Tax Management Is Essent i a l

Because of the very far reaching effects that infor-mation submitted by CFC's to their parent companieshave, it is mandatory that the tax papers and taxreceipts be verified by someone not connected withthe actual preparation. Additionally, attention shouldbe given to how the foreign taxes themselves arehandled. It is interesting to see that profit planning,the establishing of short -term and long -term cash fore-

a

E. K. BRINER

Member -at -Large1970, is TaxManager— Europe forDow ChemicalEurope, S.A., Zurich,Switzerland. He hashad commercialtraining in Zurich andin London where heattended the RegentPolytechnical College.Mr. Briner holds adegree in Accountingfrom the Associationof InternationalAccountants, GreatBritain. At the timethis article was inpreparation, Mr. Brinerwas active in forminga chapter inSwitzerland.


"'Mostindustrialized

countries haveconcluded

double

taxa tiontreaties with

other

countries."

casts, and the generation of source and applicationof funds statements have become some of the mosttime consuming key functions of controllers andtreasurers. All expansion programs depend on theseestimates. It is therefore surprising that one of theavenues which some large international companies stilltend to treat rather lightly is taxes. It is evident thatan international company requires constant exchangeof information between parent and subsidiaries to gainthe advantage of any possible legal tax benefits whichcan be ascertained and included in the overall taxplanning.

International Taxes

It is virtually impossible for any person to knowall of the tax laws. An American company operatingin all States will be subject to every Federal, Stateand local taxing jurisdiction. A small country likeSwitzerland "enjoys" 25 different cantonal income taxlaws and one Swiss Federal income tax law. Never-theless, the tax laws of some countries show a certainsimilarity, but only on a very broad basis. Any attemptto put the various countries into groups is thereforevery difficult and the results would be very debatable.Moreover, it depends upon which aspect the groupingis made, since the tax systems of some countries mayshow similarities but vary widely from the legal pointof view. The following are some possible though in-complete groupings:

ASSESSMENT GROUPING

GLO BA L METHO D. The following countries have similarassessment methods:

Group a Group bAustria DenmarkBelgium NorwayFrance SwedenGermanyLuxemburgNetherlands

SC HEDULAR ME THO D . The following countries differen-tiate between various kinds of income:

GreeceIndiaItalySpain

BR ITISH ME THO D . The United Kingdom employs itsown schedular assessment method (Schedules A toF —with different cases under Schedule D).

W O R L DW ID E (UN LI M I TE D ) ME TH OD . The United Statesemploys the worldwide method.

LI M ITE D ME TH O D . Switzerland exempts under certainconditions income received by a holding companyfrom its subsidiaries.

FISCAL GROUPING

CLASSICAL SYSTEM. Corporation taxes are levied at asingle rate. Dividends are then taxed as shareholder's

income at normal rates in the following countries:

LuxemburgNetherlandsUnited Kingdom (and most British Commonwealthcountries)United States

SPLIT TAX RATE SYSTEM. Corporation taxes are leviedat two different rates, i.e., depending on whether profitis distributed or retained, in each of the following twocountries:

AustriaGermany

TAX C R EDIT (I MP UTA TI ON ) SYSTEM. Corporation taxesare levied at one rate and imputed credit is grantedto the shareholder in the following countries:

FranceBelgiumUnited Kingdom (beginning April 1, 1973)Germany (intends to switch in 1974)

YIE LD ON CAPITAL SYSTEM. The corporation tax ratedepends on the yield on capital employed (the higherthe capital, the lower the tax rate). This system isin use in Switzerland.

LEGAL GROUPINGThe tax laws of various European countries were

greatly influenced by private law. Certain Anglo-Saxonregulations, e.g., the taxing of worldwide income andthe granting of foreign tax credits were establishedin order to avoid double taxation. Thus, they havean impact on International taxation. In general, how-ever, they may be grouped as follows:

Continental EuropeanAnglo -SaxonIberian

Local Tax Problems

A number of local tax problems are fundamentallyt he sa me since the y a r e t ru ly of a n in terna tiona l na -tu re . Some of the fol lowing situa tions wil l , t herefore ,

a lways confront the t ax mana ger.

DOUBLE TAXATION TREATIESMost industrialized countries have concluded dou-

ble taxation treaties with other countries. A numberof advantages can be gained by properly following theregulations contained in the treaties. Under certainconditions the withholding tax on dividends can bepartially returned to the payee. It is, however, to beobserved that the processing of claims for such returnsby the tax authorities takes some time and it is there-fore, essential to lodge any such claim at the earliestpossible date. Much bank interest can be gained ifthe claim is speedily processed.

MERGERS AND ACQUISITIONSOF FO REIG N COMPANIES

Mergers and acquisitions (also restructuring) usually


require a ruling for exemption of United States taxes.Exemption from local taxes can sometimes also beobtained as long as i t can be proved that the trans-action was in the interest of the local economy (e.g.,Germany, Spain). Sometimes past losses can be carriedforward to future tax periods if the merging companywill continue to manufacture the products of theabsorbed company.

LEGAL STRUCTURE OF LOCAL FO REIGNCOMPANY

In certain countries, or in a particular type of in-dustry, it might be preferable to operate through thevehicle of an American branch. This is particularlytrue where there are considerable start -up expensesand where it is very doubtful whether a reasonablereturn on investment can be obtained within the nextfive years or so, but where nevertheless, for technicalor prestige reasons, an operation must be opened.Losses can sometimes be written off directly in thebooks.

CAPITAL ST RUCTURE OF A CFCIn a number of countries there are rules requiring

companies to keep their capital investment equal toa certain ratio with respect to indebtedness. If it iscontended that there is "thin capitalization," then thedifference will be treated as hidden capital and mightbe subject to a capital stamp tax of one or two percent.In some countries this consideration is not evenbrought into account when the capital investment isactually increased by new capital injection. In thesecases the stamp tax is automatically levied.

In some countries (e.g., Germany) there are alsospecific rules requiring an increase in capital when 50percent or more of the paid -in capital has been lostthrough operational difficulties. In addition, Ger-many—to quote one example —has a split tax rate. Thedistributed earnings are taxed at a lower rate thannon - distributed earnings. However, this benefit ispartly lost due to the fact that on capital conversionof retained earnings there is no stamp tax whereason cash injections there is.

TAX PAYMENTSIn most countries, taxes must be paid in advance.

Usually the payments must be made on a quarterlybasis. The first payment on account is normally basedon the preceding year's results. It is very importantthat the payments properly reflect the company'sapproximate liabilities on the year -to -date taxableprofits. If this is not the case, i .e., if the companymakes payments on account which are based on a lowerearned profits for the preceding year, then, apart fromthe additional tax which will be due, there will beinterest and fines to be paid.

In certain countries there is a very close coordinationbetween sales tax authorities and the income tax peo-ple. Any increase in the payment of sales tax is usuallyreported to the income tax people who are thus awareof these substantial changes. It is obvious that thereverse might also happen, inasmuch as the currentresults may not correspond to the preceding year'sresults. In which case, the recovery of excessive pay-ments is usually very time consuming. Also, some tax

authorities will not effect cash refunds but credit theexcess to future tax liabilities.

INTER - COMPANY PRICINGInter - company pricing (Section 482) and related

matters should also be verified since the tax authoritiesof most major countries pay special attention to arm'slength transactions for inter - company sales as well asinter - company services. It is, therefore, mandatory thatthe setting up of international service pools whichrender know -how for technical service, data processing,systems work, site planning, etc., must be of ultimateand direct benefit to the respective local organization.The criterion is usually that pooling of resources andbrains results in improved production, increased sales,better efficiency and avoidance of trouble when start-ing up a new plant.

It is obvious that the streamlining of work willbenefit, not only the respective local company byincreasing its efficiency, but ultimately the local taxauthorities will benefit since usually more profits aregenerated by the taxpayer if better methods are in-troduced. Needless to say that documentation, timerecords, etc., of service pool staff should be availableat the offices of the company rendering the particularkind of service. The allocation of the charges is usuallymade on actual cost basis plus a mark -up of five toten percent and the proportionate shares depend onthe individual sales, accounts receivables, number ofpersonnel and other allocation factors. The allocationof charges should be verified by an independent audi-tor since most tax authorities will insist on proof thatservice was given at arm's length and that it was alsoa bona fide one.

PROVISIONS TO RESERVESWH ICH ARE NO T T AX EXEMPTED

It is not unusual for various reserves (e.g., reservefor severance pay or staff indemnities) to be set upwith provisions which are fully taxable. Permanentrecords should be kept of these taxed reserves sincea second tax might have to be paid.

ROYALTY AGREEMENTSFrequently royalties that are payable by a licensee

to the licensor are reduced by a value added tax. Thisprocedure is usually caused by an oversight of thelicensee who is not aware that he should pay the fullamount. The amount which he will have to pay forthe value added tax is a creditable item and will beconsidered as being a prepayment for his value -addedtax liabilities and constitutes no additional cost.

TAX UNITYThe full integration beyond the border depends on

three criterions: financial integration, economical in-tegration, and managerial integration. Only if all threepoints can be proven is there a chance that the parentor other related company can offset the value -addedtax paid by one of its related companies as a prepay-ment of tax paid by the local company.

TAX DECLARATIONSTax declarations must always be reviewed properly.

It is not unusual that a company might have declared

"In most

countries,taxes must bepaid inadvance."


" . . . the tax

managershould

preferablywork with a

checklist . . . "

too little which will later result in not only heavytaxation, but most likely there will also be interestand possibly fines levied. If a company has declaredexcessive fiscal profits, e.g., by adding back reservesalready taxed, etc., it will have difficulty obtainingcredit or a refund of the excess paid. In some countriesit may take as much as three years to receive eithera credit or a refund.

Conclusion

Proper planning is necessary and this must be donein close concert with the top management. Therefore,the tax manager, should preferably work with a checklist, such as the following:

1. Request tax projections from the respective con-trollers whereby the non tax - exempted itemswould be enumerated. Likewise timing differencesdue to accelerated depreciation, etc., should beshown.

2. Management should work out some minimumdividend distribution plan so that at year -end thegroup of companies can take advantage of anyUnited States tax concessions.

3. In a less developed country it might be preferableto operate through a less developed country cor-poration (LDCC) in order to qualify for a muchlower effective United States tax rate.

4. Find avenues for bona fide reduction of the taxa-ble profit (accelerated depreciation, inventorywrite -offs, etc.).

5. Check the local company's tax declarations.6. Examine the local tax assessments and advise

management of the non deductibility of certainitems so that corrective measures can be taken.

7. Verify that unjustified tax assessments are con-tested.

8. Verify that all relevant papers (tax returns, etc.)and tax receipts (photocopies) are forwarded tothe parent company in order to obtain foreigntax credits.

9. See that the American management is cognizantof major changes in local tax legislation so thatcorporate policy, as e.g., for future investments,cash flow, dividend remittances, minimum divi-dend distribution, etc., can be formed accordingly.

10. See to it that local personnel discharge their taxliabilities properly since in many countries theemployer will be held responsible for the employ-ees' personal tax liability.

11. See to it that value -added tax credits are fullytaken up as advance payments as long as the taxis incurred within the group members. Relatedcompanies —but domiciled outside the EEC —canunder certain conditions debit the value addedtax to a related company which is domiciled inthe respective country where the value added taxarose. The local company can then utilize thisdebit as an advance payment toward its own valueadded tax liability and thus grant a credit to therelated non - resident company.

12. Check the variance if the effective tax rate ofa CFC differs much from the official average rate.Perhaps some special investment benefits werededucted from the tax payments and no entrieswere made for the timing differences.

BUSINESS COMBINATIONS: POOLING OR PURCHASE?


of the difficulty of its determination or its intangibil-ity, goodwill does exist, and therefore, in some mannerit ought to be accounted for if one is paying morethan the fair value of an asset (in this case, an entirecompany is being considered an asset). In the purchasemethod the recognition of goodwill is permitted; yet,there is a problem of amortization and the amountof goodwill to be recorded.

"Accounting for Goodwill, ARS No. 10," states fourfairly specific treatments for the asset. They are briefly:(1) retain the cost indefinitely, (2) retain the cost butpermit amortization, (3) retain the cost but requireamortization, and (4) deduct the cost of goodwill fromstockholders' equity at the date of acquisition.' Amor-tizing the future superior earning power seems prefera-ble to charging it to stockholders' equity or leavingit on the books indefinitely. another reason for non -amortization, is that the "goodwill value is not con -smned or used to produce earnings in the same manneras various property rights." ` This is totally inappro-priate, since few assets, if any, really depreciate, de-plete, or amortize in the same manner. Goodwill maythus be misconstrued to be the perfect asset. In otherwords, it does not lose value through the passage of

time. If this were so, it would be the "ideal" assetin which to invest. Actually, it does lose value overa period of time even though the period cannot beprecisely spelled out.

Conclusion

The accounting methods for combinations aredefinitely weak and need to be strengthened. Untilthe profession begins to review some of its practicesit is doubtful that financial statements present thetruest picture possible to the reader.

The pooling of interests method, due to i ts fun-damental but irrational justification for existence,should be eliminated. Its only "advantage" is that itlets a combined company show a larger income becauseexpenses, such as depreciation, are based on very con-servative historical costs rather than the real cost. If,for example, the assets of the acquired company wererevalued, most likely upwards, the depreciation ex-pense would be greater, current income would belower, and therefore, taxes paid would be lower. Theaccounting profession should be concerned with accu-rate financial reporting as a whole and not over em-phasize tax considerations. ' APB Opinion No. 17, "Intangible assets," AICPA, New York, 1970, pp. 336337.' Ibid.. p. 337.


NOWNINIIISI/NINE WORLD

is

your Association, use it!

Books FOR THE MANAGEMENT ACCOUNTANT

COST ACCOUNTING: ANALYSIS AND CONTROL

Third Edition

Gordon Shillinglaw

Richard D. Irwin, Inc., 1818 Ridge Rd., Homewood, 111. 60430,1972, 789 pp., clothbound, $16.35.

The author's goal in this third edition revision is to emphasizethe universality of cost accounting concepts. Major changes includea new chapter dealing with the behavioral aspects of budgetaryplanning and reporting systems and a major expansion of thecoverage of short -run optimization models. Included in CMAexamination reading list.

READINGS IN COST ACCOUNTING BUDGETINGAND CONTROL

Third Edition

William E. Thomas, Jr.

South - Western Publishing Co., 5101 Madison Rd., Cincinnati,Ohio 45227, 1968, 879 pp., clothbound, $9.15.

A compilation of readings in cost accounting and budgeting origi-nally sponsored back in 1955 by the American Accounting Associa-tion with the present editor. The criteria for selection of the articleswere quality and coverage.

BENEFIT COST ANALYSIS 1971

Arnold C. Harberger et al., Editors

Aldine - Atherton, Inc., 529 S. Wabash Ave., Chicago, Ill. 60605,1972, 485 pp., clothbound, $20.00.

This book represents the first attempt to provide an annual volumein benefit cost analysis. The authors have collectively attemptedto choose some of the most significant and relevant work of 1971.

GRANTS ADMINISTRATION

William Willner and Perry B. Hendricks, Jr.

National Graduate University, 1630 Kalmia Road N.W., Wash-ington, D.C. 20012, 1972, 278 pp., clothbound, $12.50.

This volume has been prepared to offer assistance in the diversefield of grants and contracts with federal agencies, but i t maybe equally useful with state, county and city governmental agenciesas well as with other non -profit institutions and foundations. Whilethe grantee is the principal point of focus, the grantor has notbeen ignored.

BASIC AUDITING PRINCIPLES

Fourth Edition

Arthur W. Holmes and Wayne S. Overmyer

Richard D. Irwin, Inc., 1818 Ridge Rd., Homewood, 111. 60430,1972, 434 pp., clothbound, $14.65.

This book provides a relatively short course in auditing. To showthe terminal visible audit product, an audit report is presentedin the first chapter. Each chapter presents audit objectives, appli-

cable internal control features, auditing principles, standards andprocedures, concluding with financial statement consideration forproper and adequate disclosure in reporting.

MANUAL OF COST REDUCTION TECHNIQUES

Magnus Radke

McGraw -Hill Book Co., 1221 Avenue of the Americas, New York,N.Y. 10020, 1972, 259 pp., clothbound, $15.00.

This work is conceived as a basic guide, offering suggestions andmethods useful to the managements of firms about to introducesystematic short term cost reduction. It is intended as a workprogramme for division managers and cost reduction executives.

MANAGING THE RESOURCE ALLOCATIONPROCESS

Joseph L. Bower

Division of Research, Graduate School of Business Administration,Harvard University, Soldiers Field, Boston, Mass. 02163, 1970, 363pp., clothbound, $8.00.

Four case histories, following investment projects from their incep-tion deep in the organization to a final decision by the corpora-tion's top management, consti tute the core of the study. Theyprovide unique insight into the forces that shape the resourceallocation process in action.

HANDBOOK OF MODERN OFFICEMANAGEMENT AND ADMINISTRATIVE SERVICES

Carl Heyel, Editor -in -Chief

McGraw -Hill Book Co., 1221 Avenue of the Americas, New York,N.Y. 10020, 1972, 1172 pp., clothbound, $29.50.

A comprehensive handbook providing broad reference and prac-tical information on such subjects as: planning and schedulingoffice work, hiring, training, deployment, office work measurement,and standards.

1972 -73 DIRECTORY OF OFFICE SALARIES FORU.S. AND CANADA

Administrative Management Society, Willow Grove, Pa. 19090,1972, 40 pp., paperbound, $30.00.

This survey presents weekly salary data for 12 clerical jobs and7 data processing jobs considered to be the most common forall types and sizes of companies. It is based on salary rates ineffect Feb. 2, 1972.

MANAGING EDUCATIONAL COSTS

Philip H. Coombs and Jacques Hallak

Oxford University Press, 200 Madison Ave., New York, N.Y. 10016,1972, 288 pp., clothbound $7.50, paperbound $1.95.

The aim of this book is to provide those directly responsible formanaging education with a clearer understanding of the natureand behavior of educational costs in relation to educational results.


NAA TESTIFIESON FORECASTS

Committee On Management Accounting Practices Tells SEC Hearings

That Forecasts Should Be Permitted, But Not Required, In Financial Statements

Because Of The Many Problems Inherent In The Process

The National Association of Accountants, through itsCommittee on Management Accounting Practices,presented its position to the Securities and ExchangeCommission on the matter of including Forecasts incompany financial reports.

The SEC conducted public hearings on the subjectfor approximately three weeks. On December 12, 1972,Dudley E. Browne, Chairman of the MAP Subcom-mittee on Forecasts, testified before the Commission.Mr. Browne, who is a consultant to (and former SeniorVice President of) Lockheed Aircraft Corporation,stressed that, because of the multiplicity of problemswhich are inherent in the process, the SEC shouldnot require management's inclusion of forecasts infinancial statements. For the benefit, however, ofthose companies whose managements believe them-selves capable of presenting forward estimates withreasonable expectation of accuracy, and who considersuch information to be significant to interested par-ties, the SEC should relax its present rules and permitdiscretionary use of forecasts. Other members of theMAP Subcommittee on Forecasts are Robert f.Dona -ehie, E. W. Kelley, and Robert A. Morgan.

The following "Statement to the Securities andExchange Commission Regarding Forecasts," whichwas submitted to the SEC prior to Mr. Browne's oralpresentation, contains the official views of NAA.

In regard to the publication of forecasts, the Commit-tee on Management Accounting Practices, speakingfor the National Association of Accountants, wishesto reiterate and expound upon its position previouslyput forth to the American Institute of Certified PublicAccountants Accounting Objectives Study Group.

We believe that certain forecasts, or forward es-timates, are desirable in some circumstances, and en-courage their discretionary use at the option of man-

agement where the likelihood of materially misleadingthe reader is not great. Corporate managements havea clear responsibility, as stewards of business enter-prises, to think in terms of future direction, and planaccordingly. In this respect, forecasting of future activ-ity assumes an importance second to none in themanagerial process.

Because forecasts and projections of various kindsare prevalent throughout the business and financialcommunity, and some are utilized by certain groupsin making investment decisions, there would seem tobe little conceptual justification for not includingpertinent forecast data in financial reports. It is inthis light that we have stated that the publicationof forward estimates of material aspects of the com-pany with statements of the basic underlying assump-tions is highly desirable, but at the discretion of man-agement. However, before a mandatory requirementshould be imposed, significantly more study and re-search work needs to be done. NAA's research studiesrelative to planning, budgeting, and the like have beendirected toward internal management functions. In ouropinion, forecasting for the benefit of outsiders in-volves many practical difficulties which require carefulconsideration prior to requiring the mass of Americanindustry into a course of action for which many maynot be ready.

Some of the areas which we believe need furtherstudy are the following:(1) Format should we talk in terms of revenues, ex-

penses, cash flow, earnings per share, etc.? If wewish to minimize problems and still provide readerswith information of value, it would probably be bestto think more in terms of "trends" and "ranges"than to attempt greater precision.

(2) Disclosure of Assumptions—it would appear thatfull and open disclosure of all relevant underlying


"The extent of

practicalproblems

created by aforecasting

requirementmust be

recognized."

assumptions is necessary for presenting forecasts ina meaningful manner. Of even greater concern iswhether a user of a forecast will retain the informa-tion relating to underlying assumptions. The impor-tance of assumptions lies in the knowledge thatdeviations therefrom signify a need for forecastrevision. An obvious difficulty in this process is thelikelihood, in some cases, of thereby disclosing po-tentially damaging information to competitorsabout new product development, marketing andpricing strategies and other such data usually con-sidered to require confidentiality.

(3) Time Period what time period should the forecastcover? What criteria is appropriate in terms ofacceptable accuracy? How does the time periodrelate to the product cycle? It is, of course, truethat the longer range used for the forecast, thegreater the potential for error and, in the long run,the greater will be the error factor.

(4) Revisions—with what frequency should forecastsbe reviewed and updated, and how does the productcycle affect the timing of revisions? Frequentchanges would probably be confusing to a reader,and yet, changing circumstances might demand revi-sion for the forecast to have any real value.The question at hand is whether forecast informa-

tion directed toward investors, or potential investors,is the logical derivative of a mechanism utilized prin-cipally for guidance of business managers. A differen-tiation should be recognized between management'sfunction of taking business risks in guiding operationson the one hand, and the investor's role in appraisinginvestment risk. In the latter situation, it might wellbe considered that management's historical record isof greater value than its ability to prognosticate. Itis certainly true that forecast information is availableand forms the basis of many investor decisions. Inmany situations, the forecasts are prepared by outsiderswho speculate based on data supplied by management.In other cases, corporate management has, throughthe media, hazarded a guess as to earnings. In neitherinstance is the same ring of authenticity accorded theseforecasts as would be to those made by detailingrevenues and expenditures within the framework ofan annual report or SEC filing. In the former instances,there is, or should be, an understood element of riskin acceptance of the forecasts.

The extent of practical problems created by a fore-casting requirement must be recognized. The rangeof accuracy would vary widely depending upon indi-vidual competence and characteristics of the company,industry, and type of market, as well as the currenteconomic circumstances surrounding the company and

its industry. Furthermore, these capabilities are con-stantly changing. A large organization with a stablemarket would undoubtedly perform better than acompany which has not achieved a level of maturity,and is concerned, perhaps, with future actions of aforeign government. Similarly, a monopolistic situa-tion, such as exists with a utility, would create lessof a problem than a monopsony (one buyer with manysellers) such as in government contracting. Disclosureof all relevant assumptions not under managementcontrol could produce estimates so fraught with errorpotential as to be virtually meaningless. Despite wishesto the contrary, the possibility always exists that es-timates within acceptable ranges cannot be madewithin a desired level of probability.

From a behavioral viewpoint, presenting forecastscould well foster, on the part of management, a ten-dency to take actions which would be contrary to thebest interest of the organization solely to come outon target. Requiring a forecast, in many cases, wouldnot only create hardships, but would ask for thatwhich, of necessity, is of dubious value at best andin fact may be misleading to the reader.

Another matter of concern relates to the very natureof financial accounting. It should be generally under-stood that historical financial statements contain es-timates and sometimes arbitrary allocations, repre-senting the informed judgment of management. Adanger inherent in the usage of forecasts might bean inclination by unsophisticated readers to lose sightof the subjective aspects of the financial statementsbecause of the emphasis on estimation in the forecast.

To conclude, we think that in certain instances,when management has significantly better than usualexpectations of excellent foresight, when all basicunderlying assumptions are recited, and when manage-ment believes information of this nature is particularlyimportant for an investor to make an informed deci-sion, only then should forecasts be included in finan-cial reports. The degree of sophistication in accountingpractice has come far over the years, but, in our opin-ion, has not reached the point at which forecastsshould be made mandatory. We do believe the currentrestriction should be relaxed, thereby permitting theuse of forecasts, if desirable. We do not believe thatthose forecasts which are incorporated in reportsshould be attested to by independent public account-ants for all the reasons noted herein. We believe suchattestation would be so limited, and that the possi-bility of the users' misunderstanding so great, as toindicate that attestation could lead to greater loss ofconfidence therein than any correlary increase in reli-ability in the forecasts.


ELECTIONS '72Mid - Missouri's 'Kit' Bond, Who Was Elected Governor Of His

State, Leads List Of NAA Members Who Ran And Were Elected

To Public Office, According To Association Survey

The youngest governor ever elected in Missouri andits first Republican Governor in 28 years, ChristopherS. Bond, 33, set a number of records as a result ofhis successful race for the state's top executive post.

Mr. Bond, a lawyer, was elected state auditor in1970. The same year he joined the National Associa-tion of Accountants, affiliating with the Mid - MissouriChapter.

Although he was elected to the most prominentoffice in 1972, a number of other members also wereelected to offices at the state and municipal levels,according to a survey by MANAGEMENT ACCOUNTING.At least four were elected to their state legislatures,while other public- spirited members. ran for officesranging from seats on the city council and board ofeducation to county commissioner.

The commitment to public service demonstratedby the members who won their races, and also by thosewho lost theirs, is not unusual for NAA'ers. For manyyears accountants and others affiliated with localchapters have been very active in community affairs,often as a result of their membership and the incen-tives in the chapter competition. However, one hasto look no further than a general willingness to helptheir communities to find the common root for theinvolvement of members in public affairs.

In pulling off his record victory, Governor Bondhad help from President Nixon's landslide vote in theState of Missouri. But much of it was also due tohis own appeal. Young, articulate and handsome, "Kit"Bond stressed the need for new faces and a changein the government of the state. "There is one overrid-ing issue in this campaign." he told voters. "Who canbring real change to Missouri's state government ?"

During his campaign, he called for a strong CivilService, a code of ethics for state officials, and strictcontrols on lobbyists and campaign spending. As oneof the newest and youngest governors in the Republi-can party, he will be closely watched and evaluatedfor possible national office.

'Elect an Accountant'

Wayne H. Traub, who won a two -year term ascounty commissioner, minced no words about his

Candidate "Kit" Bond, a member of Mid -Missouri Chapter, campaigns for the governorship.

MANAGEMENT ACCOUNTING/FEBRUARY 1973 55

Elections 1972NAME OFFICE CHAPTER

Christopher S. Bond Governor Mid - MissouriJohn Cox State Senator Bangor- WatervilleJoseph Dennis Councilman North Jersey ShoreSteve T. Grammen Board of Education WheelingAlbert J. Hanson Councilman— Princeton

HightstownJames P. Irwin City Auditor— Wheeling

Martins Ferry, OhioVincent Moore State Senator WichitaRaphael J. Musto State Representative Pennsylvania NortheastRobert D. Reisman Trustee— New York

Irvington, N.J.Donald F. Smith School Board Member Daytona BeachEdward Smith Board of Education ColumbiaWayne H. Traub County Commissioner Lansing - JacksonCaesar Trunzo N.Y. State Senator Long IslandE. Jack Umland City Councilman Mpls.— NorthstarRalph Ziegler Treasurer— Saginaw Valley

Carrollton Township

background. At the bottom of his campaign flyer isthe exhortation, "Elect an accountant to the board."In addition, at the top of his list of accomplishmentsand other relevant data is the phrase "UnderstandsFinance, Taxation."

Did this emphasis on his financial experience con-tribute to his election? Mr. Traub is not sure but itdid put his opponent on the defensive because he feltcompelled to protest that a financial background wasnot required for a county commissioner. Mr. Traub,treasurer of Lee Stamping & Machine, Inc., was askedby the local party committee to run for the officeeven though he had never run for a public officebefore. He is currently serving as treasurer of theLansing- Jackson Chapter.

Mr. Traub will be one of 15 county commissionerswho run Hillsdale County in Southern Michigan. Thecounty board holds two meetings a month, Mr. Traubsaid, but each commissioner is also assigned to oneor more committees, so he looks forward to spendingquite a bit of his free t ime on county business. "Itwill be very interesting," he says. He would like toserve on a committee dealing with either budget ortaxation but committee assignments are made on thebasis of seniority and not on the basis of proficiencyor experience in a particular area.

The three NAA members elected to the upper housesof their state legislatures are Vincent Moore of Wichita(Kansas) Chapter, John Cox of Bangor - Waterville (Maine)Chapter, and Caesar Trunzo of the Long Island-Suf-folk (N.Y.) Chapter. Mr. Moore was reelected to atwo -year term in the Kansas legislature.

Although he served eight years as councilman of theTown of Islip on Long Island, Mr. Trunzo has never helda state -wide office before. He won election as New YorkState senator in his third campaign for the post. Hisinvolvement in government and community affairs firststarted when he moved to Brentwood, Long Island, accordingto the new state senator. "Community service just naturallyflowed into politics;' he says.

HANSON REISMAN

TRAUB TRUNZO

At one time he held a financial position in a localcorporation, and at the same time served as a council-man for the town of Islip. When this office waschanged to a full -time position, he had to make adecision whether to continue in private industry orpursue a budding political career. "I'm not sorry Imade that decision," he noted in recounting his choiceof public service.

When he campaigned early last year, he could boasta long list of accomplishments and service in commu-nity organizations. For example, he was treasurer ofthe Brentwood Youth Activities, treasurer of theBrentwood Little League and is still treasurer of theIslip Town Republican Committee. He also belongsto several community, fraternal and church - relatedorganizations.

Welfare reform and tax reform were two of theissues Mr. Trunzo campaigned on, but he also is inter-ested in issues such as recreation and conservation.He would prefer to serve on the Committee on Fi-nance when he goes to Albany in order to put hisfinancial background and training to good use.

One Night a Week Plus . . .

"Much to my surprise I've enjoyed it thoroughly,"Albert J. Hanson says when asked about his electionas councilman for the borough of Hightstown, N.J.Mr. Hanson, who is assistant controller with McGraw -Hill, Inc., was asked by his local party to run for theoffice. He was asked to run primarily because of hisfinancial background since the vacant spot had beenheld by the councilman in charge of budget and fi-

nance.Initially, the post will take at least one night a week

of his t ime, Mr. Hanson says. But during the earlypart of the year when the budget is being put together,



THE GAMESACCOUNTAPLAYWith Magnifying Glass And Trenchant

Prof. Briloff Dissects The Anatomy Of

Financial Reports; Finds 'Hot Pants' Ac

And 'Inflated Bosoms'

A balance sheet is very much like a bikini bathingsuit. What it reveals is interesting; what it concealsis vital.*

If there was a contest for the "Ralph Nader of theaccounting field," a slim, unassuming —but outspo-ken— professor from the City University of New Yorkwould win it hands down. And you can be sure ifthe final tabulations in the contest did not check out,someone would speak up —Dr. Abraham J. Briloffhimself.

In his new book, Unaccountable Accounting,* Dr.Briloff analyzes some recent company fiascos andspotlights the role the auditors played. It is ProfessorBriloff's thesis that accounting is going through anidentity crisis because in a number of celebrated in-stances the auditors did not blow the whistle on theirclient companies. He faults accountants on two counts:for not making sensible rules for the game and fornot rationally interpreting principles already promul-gated.

Most businessmen will recall the examples he citesin his indictment of the accounting profession. Thosewho read Barron's National Business and FinancialWeekly regularly will recognize some of the materialhere and the breezy acerbic style of the author. Ina series of articles for the financial weekly in 1968and 1971, Dr. Briloff zeroed in on some of the ques-tionable practices of companies who had found a gapin GAAP. Specifically, he took aim at the conglom-erates, home - building industry, the leasing industryand land developers.

The pooling ploy has passed its heyday but theauthor shows how it was done at the height of theconglomerate frenzy. Dramatic improvements in the

* Abraham J. Briloff, Unaccountable Accounting. Harper & Row, New York,1972. $9.50.

company's operations could be shown just by includingearnings of the companies acquired during the yearand comparing them with results the year before theconglomerator pooled. It worked for awhile, but thenmany people— including Author Briloff and theSEC — started blowing the whistle.

Another innovative bit of accounting noted by theauthor is that of leasing companies. They inflatedincome by picking up manufacturing revenues imme-diately despite short -term leases, the expenses involvedin re- leasing or selling the equipment, idle capacityand other considerations.

The name of the game was earnings per share andbefore the bottom fell out, a number of companiesexcelled at it. The author mentions names and figures.He has done his homework well and when he concludes"The Emperor has no clothes," often as not he is righton the mark.

The burden of the responsibility for such distortionof accounting lies not with company manage-ments —whom Dr. Briloff seems to expect to takeadvantage of every loophole —but with the CPAs whoattest to the "fairness" of the statements. A CPAhimself, Dr. Briloff has jousted with the companiesinvolved and even with the former top rule- makingbody of the profession —the Accounting PrinciplesBoard. At one time, he was a co- defendant in a multi-million dollar suit brought by a company which hewrote about.

A considerable knowledge of accounting and apenchant for footnote - reading are. prerequisites forreconstructing some of the earnings reports. As Dr.Briloff points out, even some professional accountants


"Lift up your

eyes from

bottom line,"

he tells

analysts.

are unable to understand all the ramifications of somecorporate financial statements.

But with an elan and color that belies the publicimage of fusty accountants and accounting, Dr. Brilofftakes some financial reports apart and puts them backtogether. Here's a sampling of the chapter headings,illustrating a style which will help give the book agreater exposure than if it were written in turgidacadenlese: "Alice in GAAP Land," "A Look at SomeInflated Bosoms and Big Busts," "A House Is Not

a Home."In a final chapter, "Quo Vadis ? ", the author offers

to the groups involved in financial reporting someprescriptions for corrective action. He suggests unlessinvestors, analysts, businessmen and accountants un-derstand the implications of the crisis, "there is littlehope for the survival of the corporation as a formof private enterprise." Challenging the accountingprofession, he insists that "they must share with man-

agement the transcendent commitment to the totalsociety and to posterity; they must manifest a reali-zation that they are professionals, hence with thepresumed commitment to an advancing body ofknowledge, and a commitment to service —and therebyforswear the coloration of a trade profession." Themarch of events has rendered academic a number ofrecommendations directed to the American Instituteof CPAs and the Accounting Principles Board, whichof course has been superseded by an entirely new,independent structure. He also refers to NAA as oneof "the leading spokesmen for my profession."

What Dr. Briloff is doing is sounding a call tointegrity to accountants in public practice and incorporate offices. As such, this book deserves carefulreading and pondering. The crisis may not be as deepand wide as the author believes, but the problemsexist and, as a result, an upheaval is going on infinancial reporting. This book helps to show why.

DR. BRILOFF: CONSCIENCE OF ACCOUNTANCY

One of the most controversial men in the field ofaccounting, Dr. Abraham J. Briloff has been describedvariously as the "Conscience of Accountancy" and the"Avenging Angel of Accounting." The targets of hiscaustic criticism, of course, tend to refer to him inless printable terms.

Dr. Briloff first received widespread attention whenhe drew the eyes of security analysts to the shenanigansgoing on in pooling -ofinterest accounting by con-glomerates. In a speech before the New York Societyof Security Analysts in January 1968, he discussed thedistortions of pooling as exemplified by Litton Indus-tries. The speech brought little attention until almosttwo weeks later when Litton announced its secondquarter earnings would drop by a large percentage.Almost overnight, his career as gadfly to the account-ing world bloomed and with courage and gusto hehas pursued it ever since.

A favorite speaker before the security analysts, Dr.Briloff recently appeared before the Society in con-nection with the publication of his new book, Unac-countable Accounting. He was in top form, inveighingagainst the dubious accounting practices of leasing andland development companies.

ELECTIONS '72

Continued from page 56council members devote a proportionally greateramount of time to township affairs.

A member of the Princeton Chapter, Mr. Hansonis interested in Hightstown's recreational program andin helping solve a growing problem of most growingcommunities — traffic. Another big local matter is edu-cation, and resolving the conflicts— monetary and oth-erwise —will take up a big slice of his three -year termas councilman.

With his right hand sweeping out to make his points,he traced the tortuous financial manipulations of a"growth" company. Enlivening the speech with a dryirony and humorous metaphor, he used such phrasesas "lo and behold," "incestuous circumstances," and"how could this be ?"

A CPA himself and a professor at Baruch College,City University of New York, Dr. Briloff is highlycritical of auditors and even of the American Instituteof CPAs itself. Despite his constant barrage of criti-cism, however, it is obvious that he loves the fieldof accounting and wants its practitioners to maintainthe highest standards of ethics. He exhorts securityanalysts to "lift up your eyes from the bottom line"and "know much, much more about accounting." Hebelives that accountants, especially auditors, will bemore careful in the future if the analysts point outdoubtful accounting practices to the companies in-volved. "The burden is for you to say this won't goon any more or any further," he told the analysts.

Perhaps the major tenet of this accounting icono-clast is capsuled in one of his favorite remarks: "Whatis wrong with my profession is not so much accountingprinciples but the principles of accountants."

If anyone knows the value of time — surely it is anaccountant. Almost daily he is involved with calcula-tions of time value of money. Because of this appreci-ation, a willingness to devote private time to publicservice gratis or for nominal compensation is all themore noteworthy. The members listed above are onlyillustrative of the widespread public service contribu-tions being made at present. Others have served atpublic posts in the past and even more will serve theircommunities, states and countries in the future.


Chapter /Member News

WALKER

Walker Is U.S. Steel President

Wilbert A. Walker, New York, has beennamed president of the United StatesSteel Corp. Mr. Walker, who has beenexecutive vice president since 1967, willassume the new post on March 1. He willalso head the general administration com-mittee.

A graduate of the University of Pitts-burgh, Mr. Walker joined U.S. Steel in1941. A CPA, he was elected in 1949 vicepresident- accounting and director of theformer Carnegie - Illinois Steel Corp., asubsidiary of U.S. Steel. He was namedvice president- accounting of the parentcompany in 1951 and six years later waspromoted to vice president and comp-troller. On September 1, 1970, he waselected chairman of the finance commit-tee. He has been a member of the boardof directors of the steel company sinceDecember 1968.

Emeritus Life Associates

The designation of Emeritus Life Associate ismade available to retired members who havehad 20 years of active service, or ten years ofactive service including five years as an electednational or chapter officer or director. Thoseso designated are relieved from payment ofannual dues. The in tent o f this provision ofthe By -Laws is to recognize the debt which theAssociation owes to members of long standing.

J.BERNARD BROWN, Louisville past pres-ident.FRANK C. CAPISTA, Essex County.

A. L. CHAPMAN, Atlanta Central.ELMER E. CHENOWITH, Washington.HERBERT C. GRIMM, Atlanta Central.WILLIAM D. HAMILTON, Des Moines.ROBERT M. HANISCH, Raritan Valley.HOWARD G. HAYES, Toledo.BENEDICT A. HENN, Detroit.HERBERT M. HOLMES, Hawaii.CHARLES IHRIG, JR., Long Island - Nassau.ROBERT LLOYD, Piedmont- Greensboropast president.RANDALL P. MACDONALD, Albany.EUGENE B. MARTENS, New York.RONALD G. NESTOR, Wheeling past pres-ident.HENRY R. ORTOWSKI, New York.CARL R. RANDOLPH, Lansing- Jackson.GEORGE W. SWANSON, Essex County.EDWIN WALKER, Erie.HOWARD M. WOLCOTT, Cincinnati.

Promotions and New Positions

JOHN RITCHIE, Albany, is now financialvice president of Mohawk Paper Mills.PAUL COWIN, Butler Area, has been pro-moted to secretary- treasurer of ButlerCounty Mushroom Farm, Inc.

THOMAS E. FIRST, Cincinnati, has beenappointed treasurer and chief financialofficer for the E. W. Buschman Co.

JERRY LEE, Columbia, was recently electedvice president and treasurer of DixieRadio Supply Co., Inc.

ANTHONY W. DEFRANCIS, Columbus, hasbeen promoted to secretary- treasurer ofDynamic Security Life Co.. . . ALEX J.GAAL was named controller of SuburbanMotor Freight. . . . THOMAS M. JORDAN,JR., has been appointed vice president ofCitizens Capital Corp.... R. E. WINNERwas named controller for Bernardo San-dals, Inc.

NICHOLAS P. DASCALos, Dayton, wasnamed comptroller of Koehring MasterDivision.

EMERY AUTHIER, JR., Detroit, has beenpromoted to vice president of finance forAmerican Steel Corp.

WILLIAM KEANE, Essex County, has beennamed financial planning manager forHoffman -La Roche.

MICHAEL P. HERMAN, Fort Wayne, Wasnamed treasurer - controller of Dietrich In-dustry.

BERNARD D. CARTER, Jacksonville, hasbeen named controller of Florida Publish-ing Co.

MICHAELJ.CONROY, Knoxville , has beenappointed controller of the Berkline Corp.

ROLAND REED, Lake Erie Central, pastpresident, has been promoted to vicepresident in charge of finance of NorwalkFurniture Corp. . . . DENNIS SWITALSKI isnow controller at Central Security Na-tional Bank.

S. HALE WEGENER, Los Angeles, wasnamed vice president of professional ser-vices of General Appraisal Co., an Ameri-can Appraisal Associates company.

PAUL WARREN, Louisville, has been pro-moted to assistant secretary of GlenmoreDistillers Co.

LARRY L. WALKER, Madison, has beenpromoted to assistant controller for Ray -O -Vac Div., ESB Inc.

SALVATORE G. PASTORE, Morristown, hasbeen appointed project manager for thecorporate development department ofSuburban Propane.

f i

FIRST CARTERCincinnati Jacksonville

ARTHUR DURFEE, Nashville, was recentlyelected treasurer, Myers Truck & Caster.

MAURICE MAYO, Ne w Hampshire , wasrecently appointed corporate controller ofIngersoll Rand Corp.

WILLIAM HOGAN, Ne w H a v e n , has beenpromoted to controller, Cerro Wire &Cable Co., division of Cerro Corp.THOMASJ.GIROIR, New Orleans, has beenpromoted to assistant cashier of the FirstNational Bank of Jefferson Parish. lie isthe son of Philip L. Giroir, the late pastNAA vice president.

MELVIN M. PECHON has been named apartner in the firm of Robbert, Favaloroand Pechon.CHARLES H. JEHLE, Oakland County, wasnamed controller of Karam Bros., Inc. .. . ROBERT J. MILLER was promoted totreasurer of A. J. Etkin Construction Co.DUDLEY SHEFFLER,Ohio- Western Reserve,has been promoted to divisional controllerat Reliance Electric.FRANK SALADIN, Ok la h om a C i ty , was pro-


moted to secretary- treasurer of American L Y L E Z I M M E R M A N , Raritan Valley, is nowTrailer, Inc. with Alpha Metals as corporate controller.

R O B E R T J . TO L T ZM A N , Orange Coast, hasbeen appointed vice president of businessdevelopment for General Appraisal Co.

H E N R Y R. HOARE, Pennsylvania North-west, was recently promoted to controller,Penntech Papers, Inc.

R OB ER T BLA YL OC K, Piedmont - Greensboro,has joined Miller TV Products as vicepresident and controller.

LEWIS G. IFFT, JR., Pittsburgh, has beenappointed general manager, systems, pro-cedures and communications, RegionalService Centers of U.S. Steel Corp.

R I C H A R D A . C ALABR IA , Richmond, hasbeen named controller of Hamilton PaperC o . . . . D A V I D M C K I T TR I C K has joinedJames River Paper Co., as treasurer.. . . K E N N E T H H . W I N S T O N , S R . , has joinedCarmine Foods, Inc., as controller.

W A R R E N D . BAGATELLE, Rochester, hasbeen elected to the board of directors ofMeson Electronics Co.... MARK KOIENwas promoted to treasurer of Opic Corp.

J. R. MORRIS, Sabine, has been namedcontroller of Ideco Division— Dresser In-dustries.

Time OfgpFlRD ROOM

•� i I �

Three St. Louis members have beennamed at the Tretolite Div., PetroliteC o r p . L L O YD N . STANSBER R Y w a s a p -

pointed administ ra t ive ma nager, W I L L I A M

B . SC H R A N D was named controller, andJ O HN F . D A I N S , cost accounting supervisor.. . . R O Y R . H E I M B U R G E R h a s j o i n e d t h e

"ABC" group of banks as vice presidentand controller. He will serve as vice pres-ident of the Brentwood Bank and con-troller, "ABC" Bank Services.

R O B E R T H I N S H A W , San Francisco, has beenpromoted to director, corporate financialservices, Fibreboard Corp.

PA UL P A L M E R , Seattle, has been promotedto chief accountant of Lockheed Ship-building & Construction Co.

D O N A L D B . M C G I N N I S , South Jersey, isnow vice president of finance for the JohnMeyer Div., W. R. Grace Co.

MARVIN MORSE, Tulsa, has joined ArrowTrucking as controller.

D O N A L D W . M A C L E A N , Waterbury, wasrecently promoted to manager of the

r I

uY/ II_

"We've voted in favor of adopting your profit- sharing scheme, Smith.we each of us $20,000."

New Kind of DisclosureAsked in Annual Reports

Amid the ser iou s d iscussions concern-ing financia l disclosure, the Wa ll S tr ee t

Journal recently s truck a lighter note .

I t seems one homebu ild ing compa nyhad the br ight idea of a sking its stock-

holder s wha t they would like to see inits annual r eport . Appa rently obliviousof cont roversies involving such d isclo-

sure issues as forecasts, accountingmethods, a nd deprecia t ion , one stock -

holder 's requ est was simple. He wrote:"J u st t e l l u s you a re ma k ing money."

60

It 's Only $45

You folks

A new member of the Associationgraphically made a point about NAAthat its officers and directors have beenstressing for a number of years.Whether intentionally or not, themember wrote on the check accom-panying his application "Pay to theorder of National Association of Ac-countants only Forty Five . . . dollars."The italics are ours but the use of theadverb would suggest that at least onemember was amazed that the Associa-tion would charge only $45 for all themembership benefits.

Ernst & Ernst Hartford office.

Organization ServiceR O B E R T N . A N T H O N Y , Mass. Route 128,has been named president -elect of theAmerican Accounting Assn. Dr. Anthony,who is the Ross Graham Walker Professorof Management Control at Harvard Busi-ness School, served as Assistant Secretaryof Defense, Comptroller, from 1965 -1968.He was active on the NAA MAP Com-mittee for a number of years.

Two Staff Members Retire

Between them they have more than 52years of service with the Association.That kind of loyalty may be unusualbut it was just part of the daily workfor Mrs. Ma del ine Long, who retiredlast month, and for Miss Evelyn Wil-lett, who retired on December 31.Thousands of NAA members —past andpresent— received mail from Miss Wil-lets, who acted as member corre-spondent for many years and who ex-celled in unraveling member problems.Indeed, Miss Willets monthly fur-nished part of the material forChapter /Member News in MANAGE-M E N T A C C O UN TI N G . T h e name ofMadeline Long is probably not as fa-miliar to NAA members because of thenature of her work; nevertheless sheplayed a vital role in the handling andcontrol of accounts receivables. Bothformer staff members deserve long andhappy retirements but their colleaguesat 919 Third Avenue will miss them.


CMA EXAMINATIONSHELD FOR FIRST TIME

Questions And Unofficial Answers To Part 1 Of First Examination

In Certificate In Management Accounting Program Are Published;

410 Applicants Take Exams At 22 Sites Throughout United States

Over 400 applicants in NAA's new Certificate in ManagementAccounting Program sat for the first examinations which wereheld December 6 -8 at 22 sites in the U.S. Questions and answersto Part 1 of the examination are published on the followingpages; Parts 2, 3, 4 and 5 will be published in subsequent issues.

The Institute of Management Accounting, which was estab-lished earlier this year by the National Association of Account-ants, developed the examination program. The objectives ofthe Institute, according to Dr. James Bulloch, its Director, are"to establish management accounting as a recognized professionby identifying the role of the management accountant and theunderlying body of knowledge; to foster higher educationalstandards in the field of management accounting; and to assistemployers, educators and students by establishing an objectivemeasure, through examination, of an individual's knowledge

and competence in the field of management accounting."There are five parts to the examination, and applicants who

are accepted by the Institute have up to three years to completeall five parts. Successful candidates are awarded the Certificatein Management Accounting. In order to retain the Certificate,holders must continue updating their expertise in the field.The examination will be held annually during the first weekof December.

A complete set of questions and unofficial answers to thefive -part examination, in booklet form, will be available laterthis Spring from the Institute of Management Accounting fora nominal charge.

The success of this first examination is due to the excellentcooperation given by many individuals. Among those who con-tributed to the content of the first CMA examination are:

Prof. Joseph Lane, Jr.Department of Accounting Prof. Elba Baskin School of Business AdministrationUniversity of Alabama College of Business Administration Canisius College

University of North Carolina Buffalo, N.Y.Prof. Gary YamashitaDepartment of Accounting The examination was offered at 22 sites Prof. Clayton GrimstadCalifornia State University— Hayward with the assistance of the following people College of Business Administration

and their universities: University of DenverProf. Larry Peppers Denver, Colo.Prof. John Sauter John BakerProf. William Kimball National Test Supervisor Prof. Harvey HendricksonProf. Roger Hawkins University of Alaska Department of AccountingCollege of Business Anchorage, Alaska Florida International UniversityEastern Michigan University Miami, Fla.

Dean Francis DiLeoProf. James Wheeler College of Business Administration Prof. Anthony MastroProf. Timothy Nantell University of Bridgeport Department of AccountingProf. Edwin Miller Bridgeport, Conn. (Hartford site) George Washington UniversityWayne Bernath Washington, D.C.Larry Madeo Clifford YouseGraduate School of Business Admin. Director of Continuing Education Prof. Catherine MilesUniversity of Michigan Bentley College Department of Accounting

Waltham, Mass. Georgia State UniversityProf. Edward Howle Atlanta, Ga.Prof. Harold Wyman Dean Eugene Kotz Continued on page 72


62

Management Accounting Examination

Examination for the Certificate in Management Accounting Program given by the Institute of ManagementAccounting of the National Association of Accountants, 919 Third Avenue, New York, New York 10022

Examination for Part 1

Managerial Economics and Business Finance

Wednesday, December 6, 1972; 1:30 P.M. to 5:00 P.M.

Questions Estimated Time

Required Number 1 1 hourRequired Number 2 3/4 hourRequired Number 3 or Number 4 (not both) 1/2 hourRequired Number 5 or Number 6 (not both) 1/2 hourRequired Number 7 or Number 8 (not both) 3/4 hour

31/s hours

The time allowance suggested approximates the relative weight assigned each question.

INSTRUCTIONS TO CANDIDATES

1. Place your candidate number at the top of each

answer sheet you submit. Begin each question ona new sheet of paper. Arrange your answers in the

numerical order of the questions. Number all pagesin order. The answer sheet provided for objective

questions is to be considered page 1.

2. Calculations made to support your answers to prob-lem and analysis questions should be legible andclearly referenced to your answers.

3. Answers to questions should be well written.Illegible writing and lack of clear exposition willinfluence the evaluation of the examiners.

FAILURE TO FOLLOW THESE INSTRUCTIONS MAY RESULT IN FAILURE OF WHAT OTHERWISEMIGHT HAVE BEEN PASSING WORK.



QUESTION NUMBER 1— Estimated time 1 hour

INSTRUCTIONS: Select the BEST answer for each ofthe questions below. Your answer is to be marked on theanswer sheet provided. Mark your answer by blackeningthe appropriate answer space with a soft lead pencil. MarkONLY ONE ANSWER for each question. Your gradewill be determined from your total of correct answers.

Sample Question

101. Which one of the following persons is a famouseconomist?

a. Albert Einstein.b. Charles Lindberg.c. Louis Pasteur.d. Jonas Salk.e. Adam Smith.

Answer Sheet

101. a. b ,. ... , ....., c. d e . _

Answer the Following Items

1. The profit- maximizing rule for a firm operatingunder perfect competition is to produce until

a. price equals average cost.b. price equals marginal cost.c. price equals average fixed cost.d. marginal revenue equals average cost.e. marginal revenue equals average fixed cost.

2. The profit- maximizing rule for a monopolist isto produce until

a. price equals average cost.b. marginal revenue equals marginal cost.c. marginal revenue equals average cost.d. price equals marginal cost.e. price equals average variable cost.

3. When output of a product increases at a decreasingrate as uniform sized increments of variable input factorsare added while fixed input factors remain constant inamount, this is an example of

a. economies of scale.b. diminishing marginal utility.c. demand.d. diminishing returns.e. none of the above.

4. Economies of scale are experienced when

a. the law of diminishing returns holds.b. a variable input is added to a fixed factor of pro-

duction.c. the total of all factors are variable and output

grows at a faster percentage rate than input.d. the total of all factors are variable and input grows

at a faster percentage rate than output.e. the total of all factors are variable and both input

and output are growing at the same percentage rate.

5. If total revenue rises in response to a decrease ina product's price, demand elasticity is

a. inelastic.b. unitary.c. elastic.d. perfectly inelastic.e. none of the above.

6. If a government's objective in levying excise taxeson commodities is maximum yield of revenue, this objec-tive is most likely to be achieved by taxing

a. goods with high prices.b. goods with low prices.

c. goods which are price inelastic.d. goods which are price elastic.e. only imported goods.

7. A major coffee - exporting country in South Americaroutinely destroyed part of its coffee crop. This practiceis most likely to have short run economic benefits to coffee

growersa. if coffee has price inelastic demand.b. if coffee has elastic demand.c. if demand for coffee is increasing.d. if demand for coffee is decreasing.e. if demand for coffee is unchanged.

8. The demand curve as seen by a producer in aperfectly competitive economy is

a. sloping downward to the right.b. sloping upward to the right.c. perfectly horizontal.d. perfectly vertical.e. none of the above.

9. An increase in demand for a particular good willgenerally cause its demand curve to shift

a. downward and leftward.b. upward and rightward.c. only if supply shifts.d. only if the price changes.e. none of the above.



10. The short run supply curve for the perfectly com-petitive firm is

a. its marginal cost (MC) curve.b. that portion of its MC curve above the minimum

point on its average cost (total unit cost) curve.

c. that portion of its MC curve above the minimumpoint on its average variable cost (variable unitcost) curve.

d. that portion of its MC curve above the minimumpoint on its average fixed cost (fixed unit cost)

curve.e. that portion of its MC curve above the demand

curve.

11. When the demand curve slopes downward to theright, marginal revenue will be less than price because

a. consumers behave in this way.

b. economic analysis makes this assumption.

c. firms not in perfect competition behave in this way.

d. firms in a monopolistic setting behave this way.

e. the price change as you move to the right alongthe curve applies to all units sold.

12. Which of the following is the clearest statement ofthe law of demand?

a. As income rises, people buy more of all goods andservices.

b. As price increases, the quantity of a good de-manded will fall, assuming all other things equal.

c. As price increases, demand falls.

d. Demand can never exceed supply.e. The higher a person's income, the greater the per-

centage of income saved.

13. A free - market economy allocates its resources pri-marily through

a. central planning.

b. the price system.

c. negotiation.

d. bargaining.

e. none of the above.

14. The short -run equilibrium price under perfect com-petition may not be

a. above average cost.b. above average variable cost.

c. below average cost.d. below average variable cost..

e. above average fixed cost.

15. When an economist speaks of a firm making "zeroeconomic profits" he means

a. that the owners of the firm get a normal rate ofreturn, or the going rate of return, on their invest-ment.

b. that the owners of the firm get a zero rate of returnon their investment.

c. that the firm's price is equal to the low point onits average cost curve (or total unit cost curve)even if the firm is not in perfect competition.

d. that the firm's marginal revenue and marginal costcurves intersect somewhere along the average costcurve (total unit cost curve).

e. that the firm is in short -run equilibrium.

16. One characteristic not typical of oligopolistic indus-tries is

a. the existence of barriers to entry.b. the absence of price competition.

c. price leadership.d. a small number of firms in the industry.

e. easy entry into the industry.

17. The "kinked" oligopoly demand curve describes asituation where a firm expects

a, competitors to follow price decreases but not priceincreases.

b. competitors to follow price increases but not pricedecreases.

c. competitors to follow price increases and decreases.

d. competitors to not follow price increases and de-

creases.e. none of the above.



18. The major objection to monopolies advanced byeconomists is

a. the instability in an industry where there is a singleproducer.

b. the dangerous influence on democratic government.c. the lack of technological progress in monopolistic

industries.d. the tendency to restrict output and charge higher

prices.e. the tendency to form international cartels with

monopolists in other countries.

as

19. Monopsonistic exploitation of labor occurs whena. there is only one producer of a product.b. there is only one employer in a labor market.c. there are many employers in a labor market.d. there are not enough workers in a labor market.e. unions strike a small employer.

20. Tennis rackets and tennis balls may be described

a. inferior goods.b. substitute goods.c. complementary goods.d. derived demand goods.e. none of the above.

21. The demand for bicycle parts is an example ofa. derived demand.b. snob demand.c. artificial demand.d. purely competitive demand.e. none of the above.

22. Let MUA be the marginal utility that the consumergets from good A, MU„ be the marginal utility that theconsumer gets from good B, PA the price of good A, andP„ the price of B. We know that the consumer will increasehis overall utility level (that he obtains from an expenditureof a given size), by spending less on B and more on A if

a. M U A > MUB

b. M U A < MU„

C- MUA MU,tPA < P„

d. MUA MU„PA > PB

e. M U A • PA > MU„ • Pit

23. Net national product is equal toa. national income plus taxes.b. gross national product less depreciation.c. disposable income plus corporate profits.d. gross national product less indirect business taxes.e. none of the above.

24. Which of the following is not included as part ofthe national income statistic?

a. Wages.b. Dividends.c. Personal income taxes.d. Social security payments.e. Rental income.

25. Gross investment for the economy does not includea. new home construction.b. purchases of new equipment by business enterprises.c. changes in inventories.d. construction of a new factory.e. purchases of government bonds.

26. The absolutely crucial requirement for a rising percapita living standard is

a. rising wage rates.b. rising productivity.c. increases in spending.d. increases in the money supply.e. none of the above.

27. The accelerator effect or investment acceleratordescribes the effect of

a. a change in investment when the change in invest-ment is induced by an income change or a changein sales.

b. a change in investment when the change in invest-ment is induced by accelerated depreciation.

c. a change in investment when the change in invest-ment is induced by an interest rate change.

d. any change of investment in inventories.e. any change in investment.

28. The Keynesian multiplier effect is based ona. the instability of aggregate investment.b. the stability of open market purchases by the

Federal Reserve.c. the circular flow of expenditures and income in

the economy.d. the built -in stabilizers present in the federal tax

structure.e. the absence of perfect competition in the auto-

mobile industry.



29. Given a marginal propensity to consume of 75%and equilibrium GNP of $200 billion, a $10 billion de-crease in government expenditures will produce a newequilibrium level of

a. $160 billion.

b. $240 billion.

c. $210 billion.

d. $190 billion.

e. $197.5 billion.

30. A family spends $9,000 out of its $10,000 income.If their income were to rise by $1,000, they would spend$800 of it, for a spending total of $9,800 out of $11.000total income. The family's marginal propensity to save asits income rises from $10,000 to $11,000 is

a. 10 %.

b. 20%.

c. 10.9 %.

d. 8.0 %.


31. In the diagram Y, is the full employment incomelevel. From the information in the diagram it can bedetermined that

Q

YfY

a. the equilibrium income level involves unemploy-ment.

b. the equilibrium income level involves inflation.

c. income will fall.d. income will rise.

e. income is above the equilibrium level.

32. Consider a simple economy with no governmentspending or taxes, and no foreign trade. If the amount ofdesired savings exceeds the amount of desired investment,this means that

a. the level of demand is causing excess inflation.b. the level of demand is causing excess unemploy-

ment.c. income will rise.d. income will fall.e. the accelerator effect has caused a drop in invest-

ment.

33. Continuing inflation would benefit people who area. bondholders.b. on fixed income.c. creditors.d. covered by life insurance.e. none of the above.

34. The federal tax system acts as a built -in stabilizersince

a. tax receipts are fixed over the business cycle.

b. congress changes tax rates whenever the economyexperiences a recession.

C. tax receipts automatically decline during a recession.

d. tax rates automatically decline during a recession.e. the budget is balanced during a period of full

employment.

35. The value of money to a United States citizen is

a. the amount of goods and services it will buy.

b. the gold the government will give you in exchangefor it.

c. independent of the consumer price index.d. determined by the level of the national debt.e. determined by the balance of trade with foreign

countries.

36. The money supply is composed of

a. government bonds and time deposits.

b. time deposits and demand deposits.c. time deposits, paper money, and government bonds.

d. demand deposits and common stocks.e. coins, paper money, and demand deposits.



37. Which of the following statements is correct?

a. In recent years the entire increase in G.N.P. hasbeen inflation; real G.N.P. has not grown.

b. Inflation is defined as a high price level.

c. Unexpected inflation tends to raise the real incomeof debtors.

d. A continuing inflation will eventually cause pricesto begin to increase more rapidly than wages.


38. The analysis of business cycles seems to indicatethat

a. if income remains constant, gross investment willbecome zero.

b. investment spending tends to fluctuate more widelyand play a more active role in initiating incomefluctuations than does consumption spending.

c. if income grows a given number of dollars eachyear, net investment will also be constantly growing.

d. if the marginal propensity to save is high, incomefluctuations will be greater.


39. The "principle of comparative advantage" indicatesthat free international trade can be beneficial to nations,

a. as long as wage levels are not too greatly differentbetween nations.

b. as long as domestic industries are not threatenedby foreign competition.

c. as long as no country is absolutely more efficient inthe production of every good than others.

d. as long as the products imported cannot be pro-duced domestically.

e. even if none of the conditions mentioned in theother answers is fulfilled.

40. The money value of a country's total exports ofgoods minus total imports of goods for a period of oneyear is commonly referred to as the

a. balance of trade.b. balance of payments.c. balance of international indebtedness.

d. net balance on current account.


QUESTION NUMBER 2— Estimated Time 3/4 hour

On March 1, 1972, the National Corporation purchased$100,000 worth of inventory on credit with terms of 1/20,net /60. In the past National has always followed thepolicy of making payment one month (30 days) after thegoods are purchased.

A new member of National's staff has indicated that thecompany he previously worked for never passed up its cashdiscounts, and he wonders if that is not a sound policy.It was pointed out, however, that if National were to paythe bill on March 20 rather than on March 30, this wouldrequire the firm to borrow the necessary funds for the 10extra days. National's borrowing terms with a local bankwere estimated to be at 8 1/i percent (annual rate) with a15 percent compensating balance for the term of the loan.It was the feeling of most members of National's staff thatit made little sense to take out an 8 1/2 percent loan with acompensating balance of 15 percent in order to save 1percent on its $100,000 by paying the account 10 daysearlier than they had planned.

Required:

A. Just in terms of true interest cost, would it be toNational's advantage to take the 1 percent discount bypaying the bill 10 days early if to do this they borrowedthe necessary amount on the above mentioned terms?

B. It has also been pointed out to National that if theydo not take advantage of the cash discount, they shouldwait the entire 60 -day period to pay the full bill rather thanpaying within 30 days. How would your answer to Part Achange if National undertook this policy (i.e. just in termsof interest cost, would it be to National's advantage to takethe l percent discount by paying the bill 40 days earlyif to do this they borrowed the necessary amount on theabove mentioned terms ?)

C. Your answer to Part B indicates that, in relation toPart A, it has become either more or less desirable toborrow in order to take advantage of the 1 percent cashdiscount.

If you said more desirable, explain why, giventhat the only difference is that in Part A, ifNational doesn't take the 1 percent discount, itpays the complete sum at the end of March;while in Part B, it wouldn't pay the completesum until the end of April.

2. If you said less desirable, make a similar ex-planation.



Answer only one question from questions 3 & 4. If bothare answered, only the first will be counted.

QUESTION NUMBER 3 (an alternate to Number 4)—Estimated time 1/2 hour

The Federal Reserve System purchases one million dol-lars of U. S. Government securities on the open market.The securities are sold by the non -bank public. Memberbanks have a reserve requirement of 25 percent for demanddeposits and expand or contract their loans to the legalmaximum at all times.

Required:

A. As a result of the above action, are commercialbank reserves expanded or contracted? By how much?

B. What amount of increase or decrease in the moneysupply will occur?

C. The action is appropriate for one of the two statesof economy described below. For which one is it appro-priate and why?

1. The economy is essentially at full employmentand is experiencing inflation of about 10%annually.

2. The economy has a significant amount of un-employment and is experiencing almost noinflation.


The United States has experienced a deteriorating balanceof payments position during the postwar period, mostnotably during the late 60's and early 70's when it sufferedlarge balance of payments deficits. Because of these per-sistent deficits, the United States recently agreed to devaluethe dollar by raising the official price of gold from $35per ounce to $38.

Required:

A. Discuss the following questions with respect to traderelations between West Germany and the United States.

1. What does it mean to say the dollar has beendevalued?

2. What effects can the dollar devaluation be ex-pected to have on prices of domestic and im-ported goods:

a) in the United States9

b) in West Germany?

B. Discuss the following statement. "The devaluationwas necessary, at least in part, to compensate for the in-flation occurring in the United States."



While most people describe the United States economyas a free enterprise system, it is really a mixed economicsystem in which a significant degree of government regu-lation and intervention may be found in every importantindustry. For businessmen operating in such an environ-ment it is increasingly important that they recognize thepowers of the various agencies set up to oversee the func-tioning of the economy. Several important governmentalregulatory groups are listed below:

a. Interstate Commerce Commission.b. Price Commission.c. National Labor Relations Board.d. Antitrust Division of the Department of Justice.e. Environmental Protection Agency.

Required:

Select any two and describe for each the main areas ofintervention into the business sphere; be sure to outlinethe specific functions the agency performs which haveeconomic consequences.


The United States national debt has grown from about16 billion dollars in 1929 to over 400 billion dollars in1972.

Required:

A. What are the major circumstances that have broughtabout this large growth in amount of debt?

B. There are conflicting arguments as to whether ornot the debt is a burden to the economy. Take either sideof the argument and support it with appropriate points.





The Morton Company is planning to invest $10,000,000in an expansion program which is expected to increaseearnings before interest and taxes by $2,500,000. Thecompany currently is earning $5 per share on 1,000,000shares of common outstanding. The capital structure priorto the investment is:

Debt $10,000,000

Equity . . . . . . . . . . . . . . . . . . . 30,000,000

$40,000,000

The expansion can be financed by sale of 200,000shares at $50 net each, or by issuing long term debt at a6% interest cost. The firm's recent profit and loss state-ment was as follows:

Sales $101,000,000

Variable cost $ 60,000,000Fixed cost . . . . 30,500,000

$ 90,500,000

Earnings before interest and taxes $ 10,500,000

Interest 500,000

Earnings before taxes $ 10,000,000

Taxes (50 %) 5,000,000

Earnings after taxes . . . . . . . . $ 5,000,000

Required:

A. Assuming the firm maintains its current earningsand achieves the anticipated earnings from the expansion,what will be the earnings per share

1. if the expansion is financed by debt?

2. if the expansion is financed by equity?

B. At what level of earnings before interest and taxeswill the earnings per share under either alternative be thesame amount?

C. The choice of financing alternatives influences theearnings per share. The choice might also influence theearnings multiple used by the "market ". Discuss thefactors inherent in choice between the debt and equityalternatives that might influence the earnings multiple. Besure to indicate the direction in which these factors mightinfluence the earnings multiple.


The Conner Company has the following capital struc-ture:

Mortgage Bonds 6% . . . $ 20,000,000Common Stock (one million

shares) . . . . . . . 25,000,000Retained Earnings 55,000,000

Iuu,uuu,uuu

a. Mortgage bonds of similar quality could be soldat a net of 95 to yield 61/2 %.

b. The common stock has been selling for $100 pershare. The Company has paid 50% of earningsin dividends for several years and intends tocontinue the policy. The current dividend is $4per share. Earnings are growing at 5% per year.

c. If the company sold a new equity issue, it wouldexpect to net $94 per share after all costs.

d. The marginal tax rate is 50 %.

Conner wants to determine a cost of capital to use incapital budgeting. Additional projects would be financedto maintain the same relationship between debt andequity. Additional debt would consist of mortgage bondsand 'additional equity would consist of retained earnings.

Required:

A. Calculate the firm's weighted average cost ofcapital.

B. Explain why you used the weighting system youused.

(END)


Certificate in Management Accounting ExaminationUnofficial Solution for Part 1- December 1972


QUESTION NUMBER 11. b 11. a 21. a 31. a2 . b 12.b 22.d 32.d3 . d 13.b 23 .b 33 . e4. c 14.d 24.d 34 . c5 . c 15 .a 25 . e 35 . a6. c 16. e 26 .b 36. e7 . a 17 .a 27 . a 37. c8. c 18.d 28. c 38 . b9 . b 19.b 29 . a 39 . e

10. c 20. c 30. b 40. a

QUESTION NUMBER 2A. The cost of not paying by the 20th day is $1,000.The company pays on the 30th day; thus, it is paying$1,000 to borrow $99,000 for 10 days. The annual interestcost is:

1,000 x 360 or 36.36%

99,000 10

It would be necessary to borrow $116,471 from the bankto satisfy the 15% compensating balance and pay $99,000to the suppliers (99,000 + 85 %). The interest chargesfor the 10 -day period would be $116,471 x .085 x 10/360or $275.00. The interest rate on the $99,000 would be:

275 x 360 = 10.00%

99,000 10

It is to National's advantage to borrow from the bankin order to earn the discount.

B. Waiting 40 days to pay the bill changes the annualinterest cost of the discount to 9.09 %.

1,000 x 360 = 9.09%99,000 40

The interest charges at the bank would be $1,100 (116,471x .085 x 40/360).The interest rate on the $99,000 would be:

1,100 x 360 = 10.00%99,000 40

It is not in National's best interest to borrow from thebank in this case.

C. The reason the borrowing alternative is no longerdesirable is the change in the number of days that theborrowing covered. The $1,000 discount is a fixed charge

for the 40 -day period. The amount of discount is un-changed by the number of days that lapsed between the20th day and the day of payment. The interest chargesvary with the number of days. Changing the borrowingperiod from 10 to 40 days increased the interest chargesfrom $275 to $1,100.

QUESTION NUMBER 3A. Member bank reserves will be expanded by $1,000,000if all the money is deposited.

B. The money supply will increase by $4,000,000. The$1,000,000 deposited will support $3,000,000 in expandedloans for a total change in the money supply of $4,000,000.

C. This action is appropriate for the economy experiencingunemployment and no inflation. The added money avail-able would lead to borrowing for investment and otherexpenditures, thus increasing demand for goods and ser-vices, requiring companies to hire more workers and thusreducing the unemployment.

QUESTION NUMBER 4A. 1. Strictly interpreted devaluation means a rise in the

price of gold. Thus, the change in the gold pricefrom $35 per ounce to $38 per ounce is devaluation.If no other countries revise the value of their cur-rency relative to gold then the devaluation of theU.S. dollar results in its depreciation relative toother currency. This was the objective of devaluingthe U.S. dollar.

A. 2. a) In the United States the prices of domestic goods(assuming no West German components) will re-main unchanged. Imports from West Germany willincrease in price.

A. 2. b) The prices of goods produced domestically inWest Germany will not be affected by the devalua-tion of the U.S. dollar. U.S. goods imported byWest Germany will decline in price.

B. The inflation in the United States has occurred ata faster rate than inflation in our important tradingpartners. Thus, foreign imports become more attractivebecause their prices are not rising as fast as those in theU.S. Also, our exported goods become less attractive tothe foreign markets. The devaluation, assuming othernations do not do the same, will depreciate the valueof the U.S. dollar and, at least temporarily, make importsless attractive and our exports more attractive.


QUESTION NUMBER 5a. Interstate Commerce Commission. The Commissionregulates the activities of interstate common carriers;railroads, water carriers and motor carriers. Its activitieswhich have economic consequences include settingfreight rates, allocating routes, approving change inlevels of service and approving certain capital- raisingtransactions.b. Price Commission. The Commission has the respon-sibility of monitoring the changes in prices of productsunder the current wage and price controls. It considersrequests for price increases in light of price guidelinesand cost factors and grants, modifies or disapprovesthem in accordance with its findings of the facts.c. National Labor Relations Board. The major respon-sibility of the Board is to consider case -by -case applica-tion of labor relations laws. The major issues handledby the NLRB are primarily unfair labor practices andunion certification elections. Its economic consequencesare usually found only with one firm and one union.The accumulation of decisions in similar cases wouldperhaps have a more widespread economic effect.d. Antitrust Division of the Department of Justice. TheAntitrust Division's primary responsibility is to enforcethe provisions of the Sherman and Clayton Acts. Itseconomic function is to preserve competition by enforc-ing antimonopoly laws.e. Environmental Protection Agency. The Agency wasestablished to develop quality standards for air andwater. The enforcement of the standards set has eco-nomic consequences. The consequences appear in theform of added costs of products (e.g., automobile emis-sion control devices) and added plant investment costs(e.g., particle precipitators). It is argued that these costsare a form of value for a previously "free" good suchas air and water.

QUESTION NUMBER 6A. The major circumstances that brought about the largegrowth in the amount of national debt was World WarII. The national debt grew from $40 billion to $260 billionfrom 1939 to 1945. There was also a rapid growth, ap-proximately $100 billion, in the 1960's, attributable tothe Vietnam War and domestic programs of that period.

B. Arguments supporting the debt is a burden.1. The interest payments require large amounts ofmoney, raised from taxes, that could have been spenton other, more important needs.2. The taxes and interest, although collected fromtaxpayers and paid to taxpayers, does shift fundsbetween individuals in the economy.3. The public expenditures causing the debt are inplace of present and future outlays for private goods.Thus, there is an opportunity cost in the form offoregone private goods.Arguments supporting the position that the debt is nota burden.1. When the national debt is compared to the growthand size of our national economy it does not represent

a large burden at all. In 1971 the national debt wasapproximately $400 billion with a national income of$850 billion. The interest charges are about 2'h% ofnational income.2. The debt is owed internally (due to each other);thus is offsetting within the economy.3. The large amount of debt gives the Federal Reservethe opportunity for stabilization through largo openmarket operations.4. The existence of the debt may cause taxpayers toaccept the use of deficit financing more readily forachieving economic stability.

QUESTION NUMBER 7A.

Debt EquityFinanced Financed

Earnings beforeinterest and taxes—present $10,500,000 $10,500,000

Added earnings —expansion 2,500,000 2,500,000

13,000,000 13,000,000Interest 1,100,000 500,000

11,900,000 12,500,000Taxes 5,950,000 6,250,000Net income 5,950,000 6,250,000

Common SharesOutstanding 1,000,000 1,200,000

Earnings Per Share $5.95 $5.21

B. (E.B.I.T. —Int.) (1 —T. R.) = E.P.S.No. of Shares

(E.B.I.T.- 1,100,000) (1 —.50) _1,000,000

(E.B.I.T.- 500,000) (1 —.50)1,200,000

E.B.I.T. = $4,100,000

C. A major factor that is inherent in the choice betweendebt and equity financing is the change in the risk forthe equity holders. If the expansion is financed by debtthe increase in risk appears in two forms. There is in-creased risk of insolvency because the debt requires reg-ular fixed cash outlays for interest and usually for prin-cipal. Equity financing does not incur the legal obligationsfor the regular cash outlays. The other effect is on thevariability of earnings to common stockholders. The fixedcharges against income reduces the amount of incomeavailable to stockholders. The relative variability of earn-ings available to common stockholders increases. Bothof these risks would tend to reduce the earnings multiple.(Note, the market value of a share does not necessarilydecrease with the debt expansion.)


QUESTION NUMBER 8A. Book Value Weighting (In Millions)

AfterTax Weighted

Amt. Proportion Cost AverageBonds 20 209o' 3.42% .68Common Stock 25 25% 9.0 7.20Retained Earnings 55 55% 9.0

100 100% 7.88%

Market Value Weighting (In Millions)Bonds 19 16% 3.42% .547Common &

Retained Earn. 100 84 9.000 7.560119 100% 8.107%

CMA EXAMINATIONS HELD


Prof. Hadley SchaeferUniversity of Michigan — DearbornDetroit, Mich.

Prof. Robert ZimmerGraduate School of Business Admin.University of MinnesotaMinneapolis, Minn.

Madeleine StanleyGraduate School of Business AdminNew York UniversityNew York, N.Y.

Prof. Allan DrebinGraduate School of ManagementNorthwestern UniversityEvanston, Ill.

Earl LittrellGraduate School of Business

The cost of equity capital is:

Dividend + growth or 4.00 + .05 = 9.0%

Price 100.00

B. The weighting to be used should reflect the mix ofcapital the company intends to use (presumably basedupon its understanding of the optimal mix). The problemstates that the company intends to maintain the samerelationship between debt and equity. If that relationshipwas defined as the book value relationship then thatshould be used to calculate the weighted- average costof capital. If the relationship referred to meant the marketvalue weighted - average cost of capital then that rela-tionship should have been used.

University of PittsburghPittsburgh, Pa.

Prof. David WeinerCollege of Business AdministrationUniversity of San FranciscoSan Francisco, Calif.

Prof. Fred MuellerGraduate School of Business ,'Admin.University of WashingtonSeattle, Wash.

Richard NehrbassSchool of Business AdministrationUniversity of Southern CaliforniaLos Angeles, Calif.

Prof. E. M. ShamsedinCollege of Business AdministrationUniversity of South CarolinaColumbia, S.C.

Professor James EdwardsSchool of Business AdministrationSouthern Methodist UniversityDallas, Texas

Assistant Dean Thomas HendricksGraduate School of Business Admin.Tulane UniversitvNew Orleans, La.

Prof. Delmer HyltonDepartment of Business and AccountingWake Forest UniversityWinston- Salem, N.C.

Prof. Earl SpillerGraduate School of Business Admin.Washington UniversitySt. Louis, Mo.

Prof. Richard JohnsDepartment of Business and Mgmt.University of WisconsinMilwaukee, Wis.


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