“Take it from me, Harlow, things are going to geta lot
worse before they get better.”

THE NEED FOR INFLATION ACCOUNTING

The recent uproar over the “unconscionable” or
“excess” profits of the oil industry brings into
focus a national problem that is more than just
an aspect of the energy crisis: The U.S. is de-
luding itself about the true state of earnings
and capital accumulation in our economy. We
have been hypnotized by the dollar figures and
have not been looking at performance in terms
of real wealth created or consumed.

The financial accountants attempt to measure
business income through the use of some gener-
ally aceepted conventions that are dignified as
“principles.” They produce figures that purport
to be adequate for the purposes of both invest-
ment appraisal and business decision-making.
In doing so, however, the accountants use a unit
of currency as their standard of measurement.
They ignore the fact that unlike the physical
standards for the meter, liter, or kilogram, no
unit of currency does or can provide a constant
standard of measurement—for anything. Its
worth or purchasing power in the marketplace
is always changing.

Erosion. Now, if financial accounting were only a .
matter of historical score-keeping, such an illu-
sion might be of rather limited consequence.
But when the erosion of capital as a result of in-
flation is completely ignored in the determina-
tion of reported profit, the consequences can be
serious and far reaching. Thus, while the al-
leged “profit” from inflation is an arithmetical
abstraction—neither realized nor realizable by a
going concern—the taxes on the reported in-
come are paid in hard cash. So also are divi-
dends, which are sometimes increased under the
heady influence of higher “profits.” And distri-
butions under profit-sharing or management
bonus plans are hardly likely to be exempt from
the gratifying appearance of greater earnings.
After these disbursements, the real capital left
in the business has suffered severe erosion.
Knowledgeable business administrators, who
are aware of the deficiencies or at least the sub-
tleties of financial accounting, will be guided
and guarded accordingly in their decision-mak-
ing, but there is ample room for the opinion that
most businessmen accept their accountants’
findings as “truth.” Even where there is inter-
nal recognition of the need for appropriate
judgmental interpretation of the figures re-
ported from the accounting process, there is al- |
ways an external public in which such sophis-
tication is not to be expected. Among this public
would be present and prospective shareholders
as well as major suppliers. And it might not be
wholly inappropriate to include also financial in-
stitutions which, indeed, could have a dual inter-
est and responsibility insofar as they may be
both creditors for loans and trustees for private
investment funds.

American accounting always has been unwill-
ing to face up to the inflation issue. Now, at |
last, the situation is getting some recognition.
In a recent pronouncement, the Securities &
Exchange Commission is urging companies to
disclose in their financial reports as much as
] : they reasonably can about the impact of infla-

Except for a grudging oe een tion upon their earnings—as reported. In par-
of inventory accounting that would charge IM ticular, the SEC is asking companies to disclose

ge ied cael Sa et oe oh te in their financial reports the impact of inflation
ast-in, ~ ¥ ’ heer om, ”
on the whole, continued to revere and defend on so-called “inventory profit.

; fas ; 3 And in recognition of the seriousness of the
ee eee pe ee as oo problem, the recently created Financial Ac-

, : ~~" counting Standards Board has put inflation ac-
ee and Ree ae on Be counting near the top of its agenda. Eventually,
real capital that must be preserved and en- it will issue an opinion on whether U.S. Cons
hanced if the business is to he continued as a vi- eed ime oe ie financial results ad- |
able going concern—the very basis upon which Justed for price level changes.
certain accounting postulates are alleged to be
founded. As a result, in times of inflationary in-
creases in price levels—which is nearly always—
conventional accounting accepts and condones
an illusion that, other things being equal, big-
ger figures give rise to greater profits than
would be earned on the basis pf a stable level of

prices.

Ul,