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A note on accounting during inflation
034EGA, The Int..ll of Mgrnt Sci., VoL 3, No. I, 1975
A Note on Accounting During Inflation CYRIL T O M K I N S University of Strathclyde, Glasgow (Received June 1974)
The paper suggests that the extensive debate over the question of whether to use a consumer price index or a specific index (or replacement costs) to adjust historic accounts is approaching the problem in the wrong way. There are several relevant concepts of income which should be reported and the relevant index differs according to the income concept reported. It is proposed that companies should publish figures for four different concepts of income and that, where specific indices are required, these should be specific to each company.
IT IS to be regretted that the A c c o u n t i n g S t a n d a r d s Steering C o m m i t t e e 1 in E n g l a n d and W a l e s did n o t c a r r y out the p r o p o s e d study o n the f u n d a m e n t a l objects a n d principles o f p e r i o d i c financial statements f i r s t - - b e f o r e issuing ED8.1 It is h o p e d that the Inflation A c c o u n t i n g C o m m i t t e e will call for an extensive study o f financial r e p o r t i n g a n d published accounts. W i t h o u t clearly identifying the objectives o f financial r e p o r t i n g a n d considering a wide range o f m e t h o d s by which these objectives m i g h t be satisfied, it m a y transpire t h a t modifications represent mere ' t i n k e r i n g ' with the system when radical change is needed. H o w e v e r , p e n d i n g such a study, it is still possible to m a k e suggestions based u p o n the existing f r a m e w o r k o f published accounts. G i v e n the urgency o f i n t r o d u c i n g an a c c o u n t i n g m e t h o d which reflects the i m p a c t o f inflation, it is i m p o r t a n t t h a t an interim m e t h o d s h o u l d be devised. This note offers some outline suggestions which c o n t r a s t m a r k e d l y with ED8. These suggestions are n o t claimed as c o m p l e t e l y new t h i n k i n g on the subject, but represent the i The Accounting Standards Steering Committee (ASSC) was formed by the Institute of Chartered Accountants in England and Wales to consider key areas of accounting practice. Initially proposed recommendations are issued in the form of exposure drafts for comment by interested parties--thereafter, a standard recommendation for practical application is published. Exposure Draft 8 (EDS) was such an exposure draft and after consideration and discussion the ASSC was about to issue a recommended standard when the Government of the day indicated that it was not satisfied that the matter had been discussed adequately. The ASSC made a compromise whereby a 'provisional standard' was issued along the lines of ED8 pending the report of a Government Committee--the Inflation Accounting Committee. 87
Tomkins--A Note on Accounting During Inflation author's personal views which inevitably reflect some of the previous literature. The note only deals with the information requirements of shareholders, although it is believed the needs of other interested persons are not greatly different. The main point of this note is to argue that published accounts should clearly identify four different income concepts and that use of both general and specific price indices are necessary. The four income concepts will be called: (i) current operating earnings (ii) operating income earned for the year ended . . . (iii) distributable funds (iv) net earnings for ordinary shareholders. Despite the use of four income concepts, the extra accounting work involved is not extensive--all figures being derived by adjustments to conventional final accounts.
1. Shareholders' information needs Corporate financial theory tells us that managers have primarily to take two major decisions: (i) the capital investment decision (ii) the decision involving the method of financing investment. This decision also contains within it the question of dividend policy because this is unavoidably linked with the decision regarding the retention of earnings. Shareholders, therefore, want to see first whether the rate of return on investment, measured before charging any financing costs, is adequate. It does not matter whether managers will decide in future to modify the nature of their business operations. A calculation of ROI (return on investment) on this basis provides a guide to the rate of return e a r n a b l e / f the company stayed in the same business with the same mix of inputs and sales. Any projected changes should be communicated to shareholders by notes to the accounts with outline estimates of their effects on profits. This line of argument was first put forward by Gynther. z Secondly, shareholders want to judge whether managers are financing their investments by a suitable mix of debt and equity. This also involves a consideration of their needs for dividends.
2. Consideration of R 0 1 RO! does have an undesirable property for its use may lead to the limitation of the scale of investment and only accepting a few projects with high rates of return. However, ROI is a widely accepted performance indicator and this note 2 A view put forward in a paper on inflation accounting presented to the Annual Conference of the Association of University Teachers of Accounting, held in Edinburgh in 1973. 88
Omega, Vol. 3, No. 1 assumes that, at least for the time being, ROI will still be a measure required by investors. The relevant ROI which gives a guide to future profitability is calculated by dividing current operating earnings (measured before any deductions for interest, dividends and taxation 3) by the current cost of replacing the assets used in the business. Both numerator and denominator are discussed in turn. (i) The current operating earnings numerator Ignoring forecasts of the future, the best guide to future operating earnings in the same line of business is the operating earnings for the last year in terms of current values. Hence to compute current operating earnings, sales revenue should be restated at year-end prices and all costs restated at year-end replacement costs? For practical application it is suggested that expenses be ~ o u p e d and each group adjusted by reference to a quarterly index based on the firm's own invoice data and constructed by the company's accountant who should provide clear evidence for figures in his calculation. This index could be checked for reasonableness by the company auditor with little difficulty. It should be noted that depreciation would be charged on the replacement cost (or original cost adjusted by special index) of the fixed assets by use of the straight line or other conventional method. No backlog of undercharged depreciation should be deducted in the calculation of operating earnings as this would distort the use of the figure for projecting future earnings. Finally for income concepts (i) and (ii) no adjustment should be made to operating earnings for gains or losses on monetary liabilities and assets. These gains/losses arise largely through financing policy and not operating policy. (ii) The investment denominator This should be the sum of fixed assets and working capital. All physical assets should be restated at year-end replacement cost (or original cost adjusted by a special index); money-assets and liabilities (investments, debtors, cash, creditors) should be unadjusted. In the adjusted balance sheet the ordinary shareholders' equity (issued share capital and reserves) should be the residual after such adjustments. 3. Comparison of R O I over a series of years While a calculation of ROI using current operating earnings and assets all valued at year-end prices may be the best guide to future profitability, investors may be interested in comparing how ROI has varied over a series of years. A different form of ROI should therefore be calculated for all years including the 3 It might also be measured net of tax by some analysts, but this need not be specifically recognised in the published accounts. The author has pointed out elsewhere the defects of replacement cost accounting from the viewpoint of measuring an income function for internal decisions regarding price and output policy but this is rather a different question to that considered here. 89
Tomkins--A Note on Accounting During Inflation last one. For each year's ROI the numerator would be the operating income earned for the year e n d e d . . . This would simply be operating earnings before financing charges and tax expressed at average prices for the year. In the denominator the company's average assets held in the period should also be respecified at average prices for the year. These adjustments to average prices could be achieved by use of the same price index data used in section 2 above. There still remains the question of whether ROI's earned in previous years should be scaled up to indicate the ROI trend calculated in real terms. This is quite unnecessary because one is calculating the trend of a ratio. If required, comparisons over time of changes in cost structure, profit margins, etc., can also be made in terms of ratios which largely cancel out the effect of inflation. This is not meant to imply that investors should not inspect trends of earnings per share; the point is that, so far, this note has been concerned with measuring only the operating efficiency of the business. The relevant income concept of EPS (earnings per share) calculations is not a form of operating earnings as discussed in section 5 below.
4. Consideration of capital structure and distributable funds In this note distributable funds are defined as operating income earned for the year e n d e d . . . (as previously defined) less prior financing charges (interest on debt and preference dividends) but before depreciation. Distributable funds so defined provides an approximation to the total cash funds generated for distribution as dividend or retention to finance replacement or new assets. Note that in this case there is no necessity for an assumption that the company will stay in the same line of business. As the company could decide to distribute all of the distributable funds and finance repayment of debt or investment by external funds, shareholders would be interested in seeing how the real value to the shareholder of those distributable funds changed over time. Hence, it would be quite acceptable to adjust previous years' distributable funds by a general price index so that they could be compared, in real terms, with the figure for the current year. Only the distributable funds figure itself should be adjusted, not the cost and revenue components. When announcing distributable funds figures the company should also specify the amount which it feels should be retained to finance retirement of debt and investment, obviously, the company will take into account likely costs of assets in the future. It would be desirable for the company to go further and show the predicted sums needed for investment and debt repayment over the next, say, 4 or 5 years. Shareholders could then judge whether the company's current dividend and financing policy is suitable. They see clearly what sum is needed, what is available internally and they know their own requirements for dividends. [n addition to adjusting the stream of distributable funds by a general index, 90
Omega, Vol. 3, No. 1 it would also be useful to adjust the stream of dividends declared by a general index to show how the real consumption value changed over time.
5. Holding gains and losses So far no mention has been made of adjustments for holding losses or gains on monetary assets and liabilities. It is argued in this note that a fourth concept of earnings, called net earnings for ordinary shareholders should be highlighted in the accounts. Net earnings for ordinary shareholders should be defined as operating income earned for the year (after depreciation) less interest, preference dividends, taxation and also less any loss (plus any gain) on money assets (liabilities). This income figure would be appropriate for use in calculating the yield for ordinary shareholders EPS or the P/E ratio. Consider first, long term debt raised by the company at 10 per cent. This 10 per cent includes an element to compensate for the lender's estimate of the effect of future inflation. If his estimate turns out to be too low, he loses, and the ordinary shareholders gain. When they want to borrow, managers can, therefore, try to increase returns for ordinary shareholders by finding lenders who expect a lower rate of inflation than management expects to occur. T h e real cost of finance, from the ordinary shareholders' viewpoint, is the amount of interest paid less an allowance for the fact that both interest and the capital~sum at maturity will be paid in 'depreciated pounds'. This deduction does not provide an immediate sum of distributable cash but it does represent a clear gain for the shareholders. (It does not necessarily mean that in any one year shareholders would want the company to borrow money--this depends on the comparison of interest rates charged to the company, shareholder time preference rates and investment opportunities the value of which to the shareholder are also partly determined by his own expectations about inflation. These shareholder preferences in aggregate are, of course, shown by the cost of equity calculation--the required yield on ordinary shares.) As debt interest costs must be adjusted, so allowance must also be made for the changes in value of any money investments held by the company. Interest received on fixed interest debt should be adjusted by the loss incurred through inflation. An adjustment for net quick assets should similarly be calculated if material. It is suggested that all these gains and losses on money assets and liabilities should be shown in a separate section of the income statement, s A general price index should be used to calculate the gains and losses. Gains to the shareholders, through the company holding debts can only be converted to real value terms for them using a general purchasing power index. Furthermore a time series of net earnings for ordinary shareholders' figures should be converted to real terms by use of a general index. It could be argued that adjustments to quick assets are operating gains and losses rather than financing cost-adjustments. 91
Tomkins--A Note on Accounting During Inflation 6. Shareholders' total investment in the company Shareholders will be interested in discovering whether the value of their investment in the company has been maintained in real terms. The value of their investment is the higher of the market value of the company's shares or the liquidation value of the company after meeting prior charges. It is suggested that estimates of both figures be given as at the end of each year. The historic stream of figures should again be adjusted by a general price index. 7. Conclusions regarding wholly U.K. companies It is essential to distinguish between four different income flow concepts in company published accounts: (i) current operating earnings (ii) operating income earned for the y e a r . . . (iii) distributable funds (iv) net earnings for ordinary shareholders. The operating earnings concepts are needed for judging operating efficiency in terms of the ROI earned in the industries in which the company currently operates; a distributable funds concept is needed to allow shareholders to evaluate the current financing and dividend decisions; the fourth concept is required to calculate P/E ratios and shareholder yields on investment. All four different concepts of income are required and each has different implications as regards the type of price index which should be used. Specific indices (replacement costs) are relevant for (i) and (ii); a general price index is involved in calculations for the others although they also have operating income earned as a basis and to that extent also make use of specific indices. It is not suggested that existing historic accounts be replaced at this stage-but that an income statement (showing concepts (i), (ii), (iii) and (iv)) and a balance sheet, as described in 2(ii), be published as supplementary statements. Finally operating income earned for the year as defined in this paper would be a suitable basis for taxable profits. 8. ED8 and multi-national companies Many large companies in the U.K. have activities overseas. The weakness of ED8 is particularly clear in these cases. Under ED8 it appears that accounts for activities in all countries are to be consolidated and then restated in terms of the rate of general price changes in the U.K. The resulting figures must surely defy any rational interpretation. It would be far better to restate operating earnings for each country in terms of specific indices applying to each country. Then consolidated figures for income concept (i) and (ii) above could be calculated. (This, of course, begs the question of the appropriate exchange rate for translation purposes--which again underlines the need for an extensive study on 92
Omega, Vol. 3, No. 1 wider aspects of financial reporting.) Distributable funds and net earnings for ordinary shareholders might also be consolidated in the same fashion, using general price indices appropriate to each country. Even then notes would be needed to indicate any limitations regarding the transfer of funds back to the U.K. The series of net distributable funds available for distribution to U.K. shareholders would be converted to real terms using the U.K. general price index.
CONCLUSION This note has attempted to marry what is theoretically desirable with the necessity for restricting the amount of additional work required for accountants. A full-blooded replacement cost accounting system would cause extensive change in company accounting systems whereas the proposals suggested here are simple to achieve and should provide a good approximation to the information which theory tells us is needed by investors both for the evaluation of the company as a business entity and for the assessment of earnings for shareholders. It could be implemented with little prior training; in fact it would not be much more complex to operate than the very rough and ready proposals of ED8.
93
G
A Note on Accounting During Inflation CYRIL T O M K I N S University of Strathclyde, Glasgow (Received June 1974)
The paper suggests that the extensive debate over the question of whether to use a consumer price index or a specific index (or replacement costs) to adjust historic accounts is approaching the problem in the wrong way. There are several relevant concepts of income which should be reported and the relevant index differs according to the income concept reported. It is proposed that companies should publish figures for four different concepts of income and that, where specific indices are required, these should be specific to each company.
IT IS to be regretted that the A c c o u n t i n g S t a n d a r d s Steering C o m m i t t e e 1 in E n g l a n d and W a l e s did n o t c a r r y out the p r o p o s e d study o n the f u n d a m e n t a l objects a n d principles o f p e r i o d i c financial statements f i r s t - - b e f o r e issuing ED8.1 It is h o p e d that the Inflation A c c o u n t i n g C o m m i t t e e will call for an extensive study o f financial r e p o r t i n g a n d published accounts. W i t h o u t clearly identifying the objectives o f financial r e p o r t i n g a n d considering a wide range o f m e t h o d s by which these objectives m i g h t be satisfied, it m a y transpire t h a t modifications represent mere ' t i n k e r i n g ' with the system when radical change is needed. H o w e v e r , p e n d i n g such a study, it is still possible to m a k e suggestions based u p o n the existing f r a m e w o r k o f published accounts. G i v e n the urgency o f i n t r o d u c i n g an a c c o u n t i n g m e t h o d which reflects the i m p a c t o f inflation, it is i m p o r t a n t t h a t an interim m e t h o d s h o u l d be devised. This note offers some outline suggestions which c o n t r a s t m a r k e d l y with ED8. These suggestions are n o t claimed as c o m p l e t e l y new t h i n k i n g on the subject, but represent the i The Accounting Standards Steering Committee (ASSC) was formed by the Institute of Chartered Accountants in England and Wales to consider key areas of accounting practice. Initially proposed recommendations are issued in the form of exposure drafts for comment by interested parties--thereafter, a standard recommendation for practical application is published. Exposure Draft 8 (EDS) was such an exposure draft and after consideration and discussion the ASSC was about to issue a recommended standard when the Government of the day indicated that it was not satisfied that the matter had been discussed adequately. The ASSC made a compromise whereby a 'provisional standard' was issued along the lines of ED8 pending the report of a Government Committee--the Inflation Accounting Committee. 87
Tomkins--A Note on Accounting During Inflation author's personal views which inevitably reflect some of the previous literature. The note only deals with the information requirements of shareholders, although it is believed the needs of other interested persons are not greatly different. The main point of this note is to argue that published accounts should clearly identify four different income concepts and that use of both general and specific price indices are necessary. The four income concepts will be called: (i) current operating earnings (ii) operating income earned for the year ended . . . (iii) distributable funds (iv) net earnings for ordinary shareholders. Despite the use of four income concepts, the extra accounting work involved is not extensive--all figures being derived by adjustments to conventional final accounts.
1. Shareholders' information needs Corporate financial theory tells us that managers have primarily to take two major decisions: (i) the capital investment decision (ii) the decision involving the method of financing investment. This decision also contains within it the question of dividend policy because this is unavoidably linked with the decision regarding the retention of earnings. Shareholders, therefore, want to see first whether the rate of return on investment, measured before charging any financing costs, is adequate. It does not matter whether managers will decide in future to modify the nature of their business operations. A calculation of ROI (return on investment) on this basis provides a guide to the rate of return e a r n a b l e / f the company stayed in the same business with the same mix of inputs and sales. Any projected changes should be communicated to shareholders by notes to the accounts with outline estimates of their effects on profits. This line of argument was first put forward by Gynther. z Secondly, shareholders want to judge whether managers are financing their investments by a suitable mix of debt and equity. This also involves a consideration of their needs for dividends.
2. Consideration of R 0 1 RO! does have an undesirable property for its use may lead to the limitation of the scale of investment and only accepting a few projects with high rates of return. However, ROI is a widely accepted performance indicator and this note 2 A view put forward in a paper on inflation accounting presented to the Annual Conference of the Association of University Teachers of Accounting, held in Edinburgh in 1973. 88
Omega, Vol. 3, No. 1 assumes that, at least for the time being, ROI will still be a measure required by investors. The relevant ROI which gives a guide to future profitability is calculated by dividing current operating earnings (measured before any deductions for interest, dividends and taxation 3) by the current cost of replacing the assets used in the business. Both numerator and denominator are discussed in turn. (i) The current operating earnings numerator Ignoring forecasts of the future, the best guide to future operating earnings in the same line of business is the operating earnings for the last year in terms of current values. Hence to compute current operating earnings, sales revenue should be restated at year-end prices and all costs restated at year-end replacement costs? For practical application it is suggested that expenses be ~ o u p e d and each group adjusted by reference to a quarterly index based on the firm's own invoice data and constructed by the company's accountant who should provide clear evidence for figures in his calculation. This index could be checked for reasonableness by the company auditor with little difficulty. It should be noted that depreciation would be charged on the replacement cost (or original cost adjusted by special index) of the fixed assets by use of the straight line or other conventional method. No backlog of undercharged depreciation should be deducted in the calculation of operating earnings as this would distort the use of the figure for projecting future earnings. Finally for income concepts (i) and (ii) no adjustment should be made to operating earnings for gains or losses on monetary liabilities and assets. These gains/losses arise largely through financing policy and not operating policy. (ii) The investment denominator This should be the sum of fixed assets and working capital. All physical assets should be restated at year-end replacement cost (or original cost adjusted by a special index); money-assets and liabilities (investments, debtors, cash, creditors) should be unadjusted. In the adjusted balance sheet the ordinary shareholders' equity (issued share capital and reserves) should be the residual after such adjustments. 3. Comparison of R O I over a series of years While a calculation of ROI using current operating earnings and assets all valued at year-end prices may be the best guide to future profitability, investors may be interested in comparing how ROI has varied over a series of years. A different form of ROI should therefore be calculated for all years including the 3 It might also be measured net of tax by some analysts, but this need not be specifically recognised in the published accounts. The author has pointed out elsewhere the defects of replacement cost accounting from the viewpoint of measuring an income function for internal decisions regarding price and output policy but this is rather a different question to that considered here. 89
Tomkins--A Note on Accounting During Inflation last one. For each year's ROI the numerator would be the operating income earned for the year e n d e d . . . This would simply be operating earnings before financing charges and tax expressed at average prices for the year. In the denominator the company's average assets held in the period should also be respecified at average prices for the year. These adjustments to average prices could be achieved by use of the same price index data used in section 2 above. There still remains the question of whether ROI's earned in previous years should be scaled up to indicate the ROI trend calculated in real terms. This is quite unnecessary because one is calculating the trend of a ratio. If required, comparisons over time of changes in cost structure, profit margins, etc., can also be made in terms of ratios which largely cancel out the effect of inflation. This is not meant to imply that investors should not inspect trends of earnings per share; the point is that, so far, this note has been concerned with measuring only the operating efficiency of the business. The relevant income concept of EPS (earnings per share) calculations is not a form of operating earnings as discussed in section 5 below.
4. Consideration of capital structure and distributable funds In this note distributable funds are defined as operating income earned for the year e n d e d . . . (as previously defined) less prior financing charges (interest on debt and preference dividends) but before depreciation. Distributable funds so defined provides an approximation to the total cash funds generated for distribution as dividend or retention to finance replacement or new assets. Note that in this case there is no necessity for an assumption that the company will stay in the same line of business. As the company could decide to distribute all of the distributable funds and finance repayment of debt or investment by external funds, shareholders would be interested in seeing how the real value to the shareholder of those distributable funds changed over time. Hence, it would be quite acceptable to adjust previous years' distributable funds by a general price index so that they could be compared, in real terms, with the figure for the current year. Only the distributable funds figure itself should be adjusted, not the cost and revenue components. When announcing distributable funds figures the company should also specify the amount which it feels should be retained to finance retirement of debt and investment, obviously, the company will take into account likely costs of assets in the future. It would be desirable for the company to go further and show the predicted sums needed for investment and debt repayment over the next, say, 4 or 5 years. Shareholders could then judge whether the company's current dividend and financing policy is suitable. They see clearly what sum is needed, what is available internally and they know their own requirements for dividends. [n addition to adjusting the stream of distributable funds by a general index, 90
Omega, Vol. 3, No. 1 it would also be useful to adjust the stream of dividends declared by a general index to show how the real consumption value changed over time.
5. Holding gains and losses So far no mention has been made of adjustments for holding losses or gains on monetary assets and liabilities. It is argued in this note that a fourth concept of earnings, called net earnings for ordinary shareholders should be highlighted in the accounts. Net earnings for ordinary shareholders should be defined as operating income earned for the year (after depreciation) less interest, preference dividends, taxation and also less any loss (plus any gain) on money assets (liabilities). This income figure would be appropriate for use in calculating the yield for ordinary shareholders EPS or the P/E ratio. Consider first, long term debt raised by the company at 10 per cent. This 10 per cent includes an element to compensate for the lender's estimate of the effect of future inflation. If his estimate turns out to be too low, he loses, and the ordinary shareholders gain. When they want to borrow, managers can, therefore, try to increase returns for ordinary shareholders by finding lenders who expect a lower rate of inflation than management expects to occur. T h e real cost of finance, from the ordinary shareholders' viewpoint, is the amount of interest paid less an allowance for the fact that both interest and the capital~sum at maturity will be paid in 'depreciated pounds'. This deduction does not provide an immediate sum of distributable cash but it does represent a clear gain for the shareholders. (It does not necessarily mean that in any one year shareholders would want the company to borrow money--this depends on the comparison of interest rates charged to the company, shareholder time preference rates and investment opportunities the value of which to the shareholder are also partly determined by his own expectations about inflation. These shareholder preferences in aggregate are, of course, shown by the cost of equity calculation--the required yield on ordinary shares.) As debt interest costs must be adjusted, so allowance must also be made for the changes in value of any money investments held by the company. Interest received on fixed interest debt should be adjusted by the loss incurred through inflation. An adjustment for net quick assets should similarly be calculated if material. It is suggested that all these gains and losses on money assets and liabilities should be shown in a separate section of the income statement, s A general price index should be used to calculate the gains and losses. Gains to the shareholders, through the company holding debts can only be converted to real value terms for them using a general purchasing power index. Furthermore a time series of net earnings for ordinary shareholders' figures should be converted to real terms by use of a general index. It could be argued that adjustments to quick assets are operating gains and losses rather than financing cost-adjustments. 91
Tomkins--A Note on Accounting During Inflation 6. Shareholders' total investment in the company Shareholders will be interested in discovering whether the value of their investment in the company has been maintained in real terms. The value of their investment is the higher of the market value of the company's shares or the liquidation value of the company after meeting prior charges. It is suggested that estimates of both figures be given as at the end of each year. The historic stream of figures should again be adjusted by a general price index. 7. Conclusions regarding wholly U.K. companies It is essential to distinguish between four different income flow concepts in company published accounts: (i) current operating earnings (ii) operating income earned for the y e a r . . . (iii) distributable funds (iv) net earnings for ordinary shareholders. The operating earnings concepts are needed for judging operating efficiency in terms of the ROI earned in the industries in which the company currently operates; a distributable funds concept is needed to allow shareholders to evaluate the current financing and dividend decisions; the fourth concept is required to calculate P/E ratios and shareholder yields on investment. All four different concepts of income are required and each has different implications as regards the type of price index which should be used. Specific indices (replacement costs) are relevant for (i) and (ii); a general price index is involved in calculations for the others although they also have operating income earned as a basis and to that extent also make use of specific indices. It is not suggested that existing historic accounts be replaced at this stage-but that an income statement (showing concepts (i), (ii), (iii) and (iv)) and a balance sheet, as described in 2(ii), be published as supplementary statements. Finally operating income earned for the year as defined in this paper would be a suitable basis for taxable profits. 8. ED8 and multi-national companies Many large companies in the U.K. have activities overseas. The weakness of ED8 is particularly clear in these cases. Under ED8 it appears that accounts for activities in all countries are to be consolidated and then restated in terms of the rate of general price changes in the U.K. The resulting figures must surely defy any rational interpretation. It would be far better to restate operating earnings for each country in terms of specific indices applying to each country. Then consolidated figures for income concept (i) and (ii) above could be calculated. (This, of course, begs the question of the appropriate exchange rate for translation purposes--which again underlines the need for an extensive study on 92
Omega, Vol. 3, No. 1 wider aspects of financial reporting.) Distributable funds and net earnings for ordinary shareholders might also be consolidated in the same fashion, using general price indices appropriate to each country. Even then notes would be needed to indicate any limitations regarding the transfer of funds back to the U.K. The series of net distributable funds available for distribution to U.K. shareholders would be converted to real terms using the U.K. general price index.
CONCLUSION This note has attempted to marry what is theoretically desirable with the necessity for restricting the amount of additional work required for accountants. A full-blooded replacement cost accounting system would cause extensive change in company accounting systems whereas the proposals suggested here are simple to achieve and should provide a good approximation to the information which theory tells us is needed by investors both for the evaluation of the company as a business entity and for the assessment of earnings for shareholders. It could be implemented with little prior training; in fact it would not be much more complex to operate than the very rough and ready proposals of ED8.
93
G