Chapter 5: Postulates, Principles, and Concepts

Instructor Manual

CHAPTER HIGHLIGHTS
Chapter 5 starts with an analysis of ARS 1 (by Moonitz) and ARS 3 (by Sprouse and Moonitz), which were sponsored by the APB at its inception. While the shortcomings of these documents are discussed in depth, viewing them within the historical context presented in Chapters 5 and 6 is far more important. For example, ARS 1 and ARS 3 say little, if anything, about user objectives. However user objectives did not begin to make an impact upon accounting theory until much later in the 1960s. The numerous concepts that have arisen on an informal basis as a result of the needs of accounting are examined next. We have used a somewhat arbitrary, but hopefully useful, classification scheme. We presume that students are generally familiar with these concepts. Our main purpose is to assess how important we believe these concepts will be in the future, particularly in light of the development of a conceptual framework. The chapter closes with a review of the equity theories of accounting. These are essentially deductive and normative types of theories that attempt to explain the relationship between the enterprise and its owners. These theories today take a back seat to empirical research findings in accounting. Nevertheless, they are still useful in terms of assessing certain accounting models.

QUESTIONS

Q-1

Do you think the broad principles of ARS 3 are really principles as that term is used in science?

A principle might be termed as an enduring truth in science. Unlike diamonds, however, they may not last forever. In ARS 3, principles are more like rules that are presumed to be useful, though other potential alternatives might be present depending upon factors such as costs and user needs. Such factors, however, were not considered in the early 1960s.

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Q-2

Assuming all other things equal, it is possible that the lower-of-cost-or-market method can result in any given year in higher income than would be the case under the same inventory costing method without the use of lower-of-cost-or-market. If so, then lower-of-cost-or-market cannot be classified as a conservative method. Do you agree with this statement? Discuss.

The first statement is true because beginning inventory may be lower as a result of a lower-ofcost-or-market write-down. If the ending inventory write-down is less than the beginning inventory write-down, a higher income will occur under lower-of-cost-or-market than would be the case without it. However, we would still classify it as conservative. Cumulative income must be equal or lower using lower-of-cost-or-market and the balance sheet valuation of assets is equal or lower in any given year. Therefore, we believe it is conservative in terms of the definition given in the chapter.

Q-3

Why is it that postulates stemming from the economic and political climates as well as the customs and viewpoints of the business community would not serve as a good foundation for deducing a set of accounting principles?

There is a strong probability (as evidenced by the A and B postulate groups) that these types of postulates will be so bland that they will simply be too insufficient to serve as meaningful bases for deducing meaningful principles (or conclusions).

Q-4

Using different studies at different times it still appears to be the case that financial executives have a higher threshold for materiality than either certified public accountants or financial analysts who, in turn, have a higher materiality threshold than users. Why do you think this ordering exists?

Since financial executives are responsible for preparing financial statements, the higher mean for materiality judgments gives them a greater latitude for error by declaring an item as being nonmaterial. Financial analysts as users and certified public accountants as auditors (who, at some point, might be subject to a lawsuit) would prefer lower materiality thresholds.

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Q-5

Do you think that the so-called equity theories of accounting are really theories in the scientific sense? If so, how would you classify them?

Deductive logic appears to have been implicitly used in determining them. Real rigor was never used in setting down the premises and deducing the consequences therefrom. Hence, while they have been pragmatically useful, they probably stop short of being theories in the scientific sense. Rigorously derived conclusions using just deductive logic would qualify as theories in the scientific sense. Hence, we believe the problem is lack of rigor as opposed to type of methodology employed.

Q-6

Why do you think the equity theories are less important today than they were, say, 50 years ago?

Empirically testable hypotheses are much richer in terms of providing insights than the deductively derived equity theories. The equity theories provide interesting outlooks, but they are simply too narrow in scope to provide extensive insights into complicated problems. However, they do have their uses. See the discussion of stock options in Chapter 12.

Q-7

Four postulates (going concern, time period, accounting entity, and monetary unit) were discussed as part of the basic concepts underlying historical costing. Can any of the principles discussed under the same general category be deduced or logically derived from these postulates?

This question does present some interesting possibilities for discussion. We believe that these postulates are too broad and general to serve as a foundation for the development of accounting principles without the addition of some very specific objectives that pertain to defining users and their information needs.

Q-8

How does agency theory (Chapters 2 and 4) differ from the equity theories discussed in this chapter?

Agency theory is much richer in scope than the equity theories. Agency theory is concerned not only with owners but also with managers and other parties such as lenders. The firm itself is simply the connecting link among these parties. Agency theory is rich enough to allow empirical testing of the hypotheses, whereas the equity theories do not appear to allow such testing. One

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reason is that the firm itself is, behaviorally speaking, a purely passive entity. Hence, the equity theories appear to be deductive statements that cannot be further extended or tested.

Q-9

Does the entity theory or the proprietary theory provide a better description of the relationship existing between the large modern corporation and its owners?

The entity theory provides a better description of this relationship because stockholders are largely absentee owners in the large modern corporation. The firm is indeed separate from the owners.

Q-10

Why has the entity theory fragmented into two separate conceptions?

There is a duality, as noted in the text, relative to the interpretation of the owners equity accounts. This ambiguity is most strongly highlighted in the difference between capital stock and retained earnings. The former was seen more strongly as pertaining to the owners, whereas the owners had a less solid claim on retained earnings. As a result, some anomalous situations can easily arise, such as stock dividends being interpreted as income to the owners because they result in a transference from retained earnings to capital stock. The newer interpretation, which puts the entity in a stronger position, is much less ambiguous, because all of the owners equity accounts belong unequivocally to the firm.

Q-11

Of the nine so-called principles shown in Exhibit 5-1, which do you think are the most important in terms of establishing a historical costing system?

This is an open-ended question that should generate good discussion. In our opinion, realization and matching are the most important because they define the essence of the expense-revenue approach, as discussed in the Conceptual Framework Discussion Memorandum and SFAC No. 3. Sterlings 1967 paper on conservatism makes a provocative case for conservatism. The rest of the principles are far less important.

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Q-12

What is the difference between owners equity accounts representing shareholders claims as equity holders versus shareholders interests as owners?

The conception of owners equity accounts representing shareholder claims is much weaker than owners equity accounts representing ownership interests. Shareholder claims probably go no further than the right to receive dividends when declared by the board of directors, the right to vote at annual meetings, and the right to buy shares when new issues are floated (and this is not even totally clear) as well as the right to sell shares..

Q-13

Postulates are supposed to be tight enough to prevent conflicting conclusions being deduced from them. Is this the case with ARS 1?

Definitely not, because an exit value systemnot to mention a general price-level adjustment could just as easily have been deduced from it.

Q-14

Is it fair to categorize ARS 1 and ARS 3 as failures?

No, it is not fair. ARS 1 and ARS 3 should be seen in the historical context in which they arose. After years of putting out brushfires, it was suddenly decided to go to a more conceptually rigorous approach. User objectives had not yet surfaced. The practicing arm of the profession was simply too provincial to accept anything but historical cost. So Moonitz and Sprouse were akin to an advance scouting party performing a historically necessary task.

Q-15

How do the imperative postulates (group C) differ from the other two categories of postulates?

They go beyond mere description, which appears in the A and B group, because they use terms such as should, which indicate value judgments.

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Q-16

Distinguish among the terms realized, realizable, and realization.

Realized and realizable are terms referring to the assets that have been received or will be received as a result of the firms revenue recognition function. Realized means that either cash has been received or a legitimate claim (accounts receivable) is in place. Realizable refers to the ability to convert assets already held into known amounts of cash or claims to cash. Certain types of holding gains on assets are realizable in terms of replacement cost exceeding historical cost (see Chapter 13). Realization refers to the point when revenue is earned and either cash is received or claim to assets arises. Realization has been supplanted by recognition. The latter refers to the point when assets to be received as a result of performing the revenue function are realized or realizable, and the performance of the revenue function is substantially accomplished.

Q-17

How does conventional retained earnings differ from entity equity under the Anthony conception of the entity theory?

Entity equity would be less than retained earnings to the extent, if any, of unpaid dividends on both preferred and common stock.

Q-18

What inconsistencies does Merino see in the proprietary theory at the turn of the twentieth century before the advent of entity theory?

According to Merino, proprietary theorists wanted to focus upon absentee owners and the large profits that they presumably made. At the same time, however, proprietary theorists were also proponents of conservatism, which would tend to minimize the measurement (or calculation) of income.

Q-19

Why is earnings-per-share calculation an example of the residual equity of a firm being broader than merely its current common shareholders?

Earnings-per-share takes into account convertible bondholders on the basis that the bonds have been converted into common stock in fully diluted earnings-per-share and in primary earningsper-share if the convertible bonds are a common stock equivalent.

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Chapter 5: Postulates, Principles, and Concepts Q-20

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Why is the residual equity theory more in line with recent research in finance than entity and proprietary theory?

This is because preferred stock has been viewed as debt leaving the common stock as the sole residual equity component. Hence, common stock and residual equity are one and the same. While the modern view of the corporation holds to entity theory with debt and equity merely being different legal approaches to raising capital but the finance view does maintain a sharp difference between debt and equity because of the absolute need to meet interest payments but not dividends.

Q-21

Why do you think that securities markets more rapidly reflect bad news than good news?

Bad news has a tendency to jolt us more than the possibility that our fortunes will be increasing. Benjamin Franklin stated it in somewhat the following terms: nothing forces our concentration more than the fact that we may be hung for our actions.

Q-22

Why do you think that operating ratios (return-on-assets) are more sensitive to the combined effect of immateriality items than would be the case with solvency ratios (debt-to-equity and current ratios)?

It is quite likely that profitability ratios involve relatively smaller numbers income numbers than solvency ratios which are most likely dealing with relatively larger numbers.

Q-23

At present time, the U.S. federal income tax code allows corporations to deduct interest expense but not cash dividends paid to stockholders. Does the tax code tie in with any of the equity theories?

Yes. The tax code is definitely proprietarily oriented. Dividends are not tax deductible on the grounds that they are not expenses but are instead distributions of income whereas bond interest is tax deductible. Making both tax deductible would tie in with the more narrow view of the entity theory but more importantly lead to increased issuances of stock.

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Q-24

Why does it make sense to define materiality from the users perspective?

It is the user who is making the decision; therefore, materiality from his/her perspective is what is important. The problem arises, however, as the user groups become more diverse. What may be material to one user may not be material for another.

Q-25

What similarities are there between materiality and disclosure?

Accounting information is considered material if its omission or misstatement affects decisionmaking process of any reasonable individual relying on the information. Materiality helps accountants determine when that information is material and should, therefore, be disclosed. The difficult aspect of both materiality and disclosure is determining how much is too much or too little. Neither has universally accepted criteria to apply; professional judgment is required.

Q-26

Discuss how the concept of conservatism may be changing as viewed by Watts.

Watts, Ross (2003a). Conservatism in Accounting Part I: Explanations and Implications, Accounting Horizons (Sept. 2003), pp. 207-221. FASB has been working to eliminate accounting conservatism to attain "neutrality of information. So, the adage of anticipating no profit, but anticipating losses may be withering. Rather than being a strength of the accounting paradigm, it may be viewed as a weakness, distorting accounting information.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS

1. Assume the following for the year 2000 for the Staubus company: Revenues $1,000,000 Operating expenses Cost of goods sold $400,000 Depreciation 100,000 Salaries and wages 200,000 Bond interest (8% Debentures sold at maturity value of $1,000,000) 80,000 Dividends declared on 6% Preferred Stock (par value $500,000) 30,000 Dividends declared of $5 per share on Common Stock (20,000 shares outstanding a par value of $100 per share) 100,000

(a)

Determine the income under each of the following equity theories: Proprietary theory Entity theory (orthodox view) Entity theory (unorthodox view) Residual equity

(b) Would any of your answers change if the preferred stock is convertible at any time at the ratio of 2 preferred shares for 1 share of common stock?

(a) Revenues Operating Expense Operating Income Other Revenues and Expenses Bond interest Preferred dividends Common dividends Net Income

Proprietary $1,000,000 700,000 300,000

Orthodox Entity $1,000,000 700,000 300,000

Unorthodox Entity $1,000,000 700,000 300,000

Residual Equity $1,000,000 700,000 300,000

80,000

$220,000

---$300,000

80,000 30,000 100,000 $ 90,000

80,000 30,000 $ 190,000

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Critique A Statement of Basic Accounting Postulates and Principles by a study group at the University of Illinois (it should be on reserve or otherwise made available to you). Your critique should cover, but not be restricted to, the following points: a. How do the definitions of postulates, concepts, and principles differ? b. Are the examples of postulates, principles, and concepts consistent with their definitions? c. Does this set of postulates, principles, and concepts provide a legislative body with a useful framework for deriving operating rules?

The Illinois Study Group did a study entitled A Statement of Basic Accounting Postulates and Principles, which appeared in 1964, shortly after ARS 1 and ARS 3. Postulates were defined in the Statement in much the same way they were defined in ARS 1as underlying assumptions that are viewed as being valid. Further discussion appears to make it clear that postulates are intended to be descriptive in nature. However, it also is made clear that other propositions will be deduced from them. Concepts, according to the Illinois Study Group, are formed primarily through observation, but they may also be derived deductively. Included among many of the concepts are basic elements of accounting, which were defined in SFAC No. 3. It appears that concepts generally arise outside of the theory process, though they would obviously be part of theoretical formulations. Principles were defined as basic propositions which express significant relationships in accounting; they indicate in a broad sense those actions which will best accomplish the objectives of accounting. It appears that they are largely, but not totally, deduced from the postulates. To some extent, the concepts play a mediating role in terms of determining the principles. It does not appear that all of the items in the Illinois Study Group effort are totally consistent. For example, a principle of the system is recording, which states that a complete record of all activities resulting in changes in assets and equities should be made. The statement is a tautology (though an imperative one). This could easily be restated (by eliminating the imperative) as a postulate. The measurement principle also contains strong elements of the monetary unit postulate as expressed in ARS 1: enterprise data should be expressed in such monetary terms as will facilitate their use by the various interests in an enterprise. The concepts consist of a number of definitions that have a hierarchical order, though none appears to be expressed. Income results from the way terms such as assets, revenues, realization, and income are defined and implemented. There are numerous other criticisms that could be made of this statement. We would conclude by saying that the resulting concepts and principles are too thin upon which to build a meaningful system of standards. It is, nevertheless, important to stress that this study was very much in the mainstream of activity when it appeared. It is relatively easy to find fault 40 years 7th edition Page 10 of 13

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after the fact. The intellectual effort that went into this and similar projects should not be forgotten.

3.

List and briefly discuss as many areas as you can in which an accepted method or technique is conservative, including why it is conservative.

The examples that will be used here, in following the chapter definition, will be relative and will therefore compare alternatives. We will also cite other reasons that may underlie the situation. The classic example is lower-of-cost-or-market, which is conservatism in its purest form. This technique is still applicable to inventories, but since SFAS No. 115, it no longer applies to marketable equity securities. Research and development costs (SFAS No. 2) must be expensed. By requiring immediate write-off, however, verifiability may be improved since everyone now would be using one easily measurable method. Computer software development costs follow research and development. The presumed higher probability of recoverability of costs in software development clearly stamps this as being conservative. SFAS No. 19s attempt to allow only successful efforts by oil and gas producers is conservative. As with research and development costs, however, verifiability would be improved by allowing only one method. Only loss contingencies (SFAS No. 5) are recognized (provided they are probable and can be reasonably estimated), whereas gain contingencies are not recognized. The dilutionary effect of stock options, even if they are not yet exercisable, are recognized in earnings-per-share calculations (APB Opinion No. 15). SFAS No. 87 requires the use of future salary projections for pension expense measurements, rather than current salaries. The presumed purpose is to help users predict future cash flows, though the linkage is rather tenuous. There may be a trade-off, since the pension obligation per se is not in the body of the balance sheet (which is definitely not conservative). Similar to SFAS No. 87 is SFAS No. 106, concerning other postretirement benefits, which requires the use (and estimation) of future medical costs. The FASB is on safer grounds here, because future medical costs are not executory relative to firm and employee, as are future pension costs. Unrealized future losses are more frequently recognized than unrealized future gains in APB Opinion No. 30, which discusses discontinued segments.

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Recognition of deferred tax assets were more restricted than recognition of deferred tax liabilities in SFAS No. 96, but they are now on an even footing in SFAS No. 109. Discontinued operations (APB Opinion No. 130) anticipate future losses but not future gains. Impaired asset writedowns (SFAS No. 121) are recorded but not asset writeups.

4.

A few years ago both Halliburton Corporation, a large construction company, and its auditor, Arthur Andersen, were chided for allowing Halliburton to book a percentage of cost overruns that Halliburton has attempted to collect from customers after projects are completed but before both agreed settlements with customers and, of course, collection thereof. The practice of trying to collect cost overruns in the construction industry is certainly not uncommon. Until 1998 cost overrun collections were not booked until received. Since that time Halliburton began guessing how much of a disputed surcharge would ultimately get paid and crediting itself in advance. Required: (a) Is there a case that can be made for allowing Halliburton to book these overruns? What arguments, if any, support Halliburtons accounting methods? (b) What situations should prevent Halliburton from booking these overruns prior to collection?

This question is based on an article by nationally syndicated columnist Michael Kinsley. a. The strongest case for allowing Halliburtons approach is that (a) the work is completed and (b) it is an industry practice to attempt to collect cost overruns. It is also to Halliburtons advantage that they are attempting to estimate portions that will be collectable assuming that the collectable portion is a legitimate estimate rather than an attempt to pump up current earnings. This practice may also provide a better matching since revenues would be recognized in the period when the project is completed rather than a later period. Notice the similarity of this situation to bad debts expense measurement. The principal problem would be an inability in each individual situation to accurately assess the amount of the collectable portion of the cost overrun. Bad debts, of course, are based on broad experiential factors. At its worst, this practice could devolve into an attempt to manage earnings (Chapter 12).

b.

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CRITICAL THINKING AND ANALYSIS

1.

How permanent do you think the postulates and principles underlying historical costing will be?

Like everything else, some degree of change is bound to occur. The postulates may stay around but how much influence they will have is another matter. We have already mentioned that going concern leads to a logical dead end. Accounting entity will be important but the actual concept itself may change. For example, an increasing number of firms now have strategic alliances with each other without affecting ownership. We wonder if there will be some recognition of this on the balance sheet. While the monetary unit still appears to be stable, it is possible that current values will be enhanced on the balance sheet even though significant verifiability problems still exist with unique items of plant and equipment. Among the principles, conservatism may decline in importance. Disclosure and materiality will most likely gain in importance. How verifiability will change, particularly as current values grow in importance is hard to say. We believe uniformity or some variant of it will grow in importance. If all of these factors hold, comparability will also grow in importance. That leaves the two pillars of historical costing: recognition and matching. Traditional rules of recognition will probably expand. Recognizing unrealized gains and losses on trading securities provides an example. Matching will probably also be modified. Impaired asset write-downs, although an example of conservatism, provides a possible approach. This analysis is simply our view. Many other approaches and modifications are possible. This question might make an excellent term paper project for the course.

2.

If you could relate materiality, disclosure, and conservatism to types of measurements (nominal, ordinal, interval, and ratio scale), how would you do so?

Materiality would likely be a nominal measure. Is it material, yes or no? If an item is material, to what extent do you disclose (in financial statements only, notes only, both financial statements and notes). These would likely be interval metrics. Conservatism could be measured using a ratio measure, perhaps the ratio of number of material items disclosed to the number of questionable material items. Alternatively, use monetary amounts rather than number of items. From managerial accounting, you get what you measure. Discuss the behavioral aspects of reporting how conservative a set of financial statements might be using such ratios.

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