Robert McBurney, C.P.A., is assistant professor, Department of Economics and Business Administration, North Carolina State University at Raleigh.
How many daily decisions, involving how much money, are based on the information produced by accounting procedures and summarized on balance sheets and income statements? It is impossible to even guess at such a number. We do know that millions of private investors, as well as businessmen, institutions, financial analysts, editors, attorneys, legislators, bureaucrats and others use this information for a multitude of purposes. The news media grind out a constant barrage of propaganda about private business, using published financial statements as a primary source of data. Legislatures construct laws, particularly tax laws, guided by the same data.
The purpose of this paper is to examine the effects of inflation on a single accounting practice that largely invalidates the net income reported on financial statements of most companies. In other words, countless decisions are made every day, including the horrendous business of structuring confiscatory tax law, on the basis of misleading numbers. This victim of inflation is the accounting principle of calculating depreciation based on historical (original) cost.
This theory, in brief, is that an expenditure for any asset (primarily buildings and equipment) whose life extends beyond one year requires special treatment. That is, it is necessary to allocate the original cost of that asset over its estimated useful life so that each year’s operations receive a proportionate charge or expense for the use of the asset. This procedure creates a charge that is analogous to rent paid for the use of similar assets.
Monetary Stability
The concept of depreciation is clearly rational and cannot be seriously criticized in its theoretical framework—which also, and most importantly, assumes a stable monetary unit. The validity of accounting results, insofar as depreciation is concerned, thus depends on a monetary environment relatively free of significant inflation or deflation. But we have, in fact, witnessed persistent inflation for decades. How does this monetary instability affect accounting conclusions? It is obvious that the magnitude of the investment in depreciable assets and their estimated length of useful service are critical factors. In most of our industry today, such investment in long-lived assets is tremendous. Thus, the related depreciation accounting is economically fallacious.
Let’s consider a very simple example. Suppose that in 1960 a company invested $10 million in a building whose life was estimated at 40 years for accounting purposes. This meant an annual depreciation of $250,000. Assume the replacement cost of the building today is estimated at $20 million, which is “inflation” of only slightly over 4% annually. What should the depreciation be at today’s cost? If the company had been renting the building, the rent charge would be much higher today than in 1960, yet the depreciation remains at the same 1960 level and will continue at that amount until the year 2000. The problem, of course, like so many of our difficulties, is caused by inflation.
For illustration of this adverse impact of inflation, let us assume that the $250,000 depreciation allowance is equal to 5 per cent of the total yearly income of the company and that net earnings before income taxes are $1 million. If income taxes take $500,000, this leaves $500,000 for stockholders either as dividends or for reinvestment in the business. However, if the depreciation is based on replacement cost and is thus doubled to $500,000 a year, only $750,000 will be left for taxes, dividends and reinvestment.
A Cost to be Paid
It seems reasonably clear that the full depreciation on replacement cost is an expense that someone will have to stand. Will it be covered by a reduction in the taxes of the company? Or will it continue to be borne entirely by stockholders? Upon the answer depends the life of that company and the lives of the savers behind it. But it is certain that the inadequate allowance for depreciation now appearing on the books results in higher taxes and the dissipation of capital.
Although this example is pointedly oversimplified, it nevertheless illustrates the essence of the problem. United States industry is not now able to replace its capital assets under present depreciation accounting and increasing price levels. Thus, many financial statements grossly overstate profits: Of course, the accounting profession has long been aware of this and continually proposes adjustments. Congress has thus far refused to allow the necessary corrections in accounting techniques for tax purposes. To do so would obviously reduce corporate profits and corporate taxes. This adjustment would largely negate the windfall taxes generated by inflation policy. But as we can see, such taxes are in effect consuming capital at a rapid rate, which must ultimately result in decreasing productivity and an ever-lower standard of living for all. Perhaps we have already reached this point in the United States.
This is not to suggest that the ravages of inflation on the economy can be cured by any mere change in accounting techniques. But it does suggest that inflation has incapacitated the business compass of profit-and-loss accounting. Thus far, most of the discussion within the accounting profession has centered on how to change accounting practices to accommodate increasing price levels. This approach will require a constant stream of opinions and endless accounting adjustments. In the final analysis, such efforts will be fruitless.
What is the prospect? The lesson of England seems clear enough. Our industry may also become impotent with worn-out, obsolete equipment. The replacement capital will have long since been dissipated by the government to finance various welfare and pump-priming programs. Our course is clear. All of us, and especially the accounting profession, must devote our full energy and imagination toward curbing the government’s inflationary monetary policy.
