Infation Accounting and Nonfinancial Corporate Prots: Physical Assets pot

JOHN B SHOVEN StanfordUniversity JEREMY I BULOW Massachusetts Instituteof Technology Infation and Accounting Nonfinancial Corporate Physical Prots Assets is THIS ARTICLE the firstof two complementary papersconcerninginflation accountingand nonfinancialcorporateprofits This installmentdiscusses the generalconceptualand practicalissuesin definingan inflation-adjusted measureof profits and examinesthe treatmentof depreciableassets and inventoriesin detail The companion article, to appear subsequentlyin BPEA,will analyzeaccountingpracticesfor financialassets and liabilities, and also aggregateand summarizethe results of both papers The Definitionof Real Corporate Profits It is widelyrecognizedthat inflationof the generalpricelevel and relative distortand cloud the meaningof corporateaccountsand, priceadjustments therefore,also corporatetaxation and the portion of the national income accounts(NIA) that is based on corporatefinancialstatistics.The distorNote: In addition to many participantsin the Brookings panel, a number of others have been most helpful in this research: Henry J Aaron, Solomon Fabricant, John A Gorman, Alvin K Klevorick, Anthony K Lima, Patricia Neade, Joseph A Pechman, PerryD Quick, William H Sprunk, David Starrett, and George J Staubus 557 558 BrookingsPapers on EconomicActivity,3:1975 tion arisesprimarily becauseundercurrentaccountingpracticefirmscarry many physical and financialassets and liabilitiesat originalcost or book value, figuresthat are expressedin dissimilarunits and that may deviate widely from currentmarket value or replacementcost Accountingpractices also differ greatly across firms and between tax and book financial reportsfor the same company.These practicesmay createunnecessary inefficiencies taxation and investment,and increasedifficulty predicting in in or assessingthe cyclical position of the economy Indeed, there has been some speculationthat the recognitionof the 1974-75recessionwas delayed by the distortingeffects of inflationon reportedbusinessstatistics.' The importanceof sucheffectshas increasedgreatlyin the past ten years, as has the rateof changeof generalpricelevels Among a numberof studies analyzingthese issues, severalrecentpapershave concentratedon the impact of inflationon corporateand personalincome taxation.2The Davidson-Weiland the Tideman-Tucker papersevaluatethe potentialimpact of adoptionof inflation-accounting principles recentlyproposedby the Financial AccountingStandardsBoard (FASB).3In contrast,this paper and its sequelaim to beginfrom scratchand developa consistenteconomicdefinition of real corporateprofits and associated accountingprocedures.The individual sources of the inflationarydistortions implied by current accounting practices will be analyzed Estimates of the micro and macro magnitudes involved in moving to inflation-adjusted accounting procedureswill be presented The first issue to be addressedin such a study is the definitionof corporate net income or profits Corporateincome figuresare used for a wide varietyof purposes.They serveas a base for corporatetaxation,as a guide to investment allocation and managementperformance,as an ingredient See, for example, James P Gannon, "Analysts Now Agree Recession's Key Cause Was Rampant Inflation," Wall Street Journal,April 25, 1975 See, for example, William Fellner, Kenneth W Clarkson, and John H Moore, CorrectingTaxes for Inflation (American EnterpriseInstitute, 1975), and three papers preparedfor the Brookings Conferenceon Inflationand the Income Tax System, Washington, D.C., October 30-31, 1975 (scheduledfor appearancein a Brookings conference volume): Sidney Davidson and Roman L Weil, "Inflation Accounting: Some Income Tax Implications of the FASB Proposal"; Edward M Gramlich, "The Economic and BudgetaryEffects of Indexing the Tax System"; and T Nicolaus Tideman and Donald P Tucker, "The Tax Treatment of Business Profits under Inflationary Conditions." FASB, Proposed Statementof Financial Accounting Standards(Exposure Draft), "Financial Reporting in Units of General Purchasing Power" (December 31, 1974; processed) John B ShovenandJeremyL Bulow 559 in the constructionof national income accounts, and as data for determining the functionaland personaldistributionof income No single concept or measure of income will always be optimal for all of these uses While we will focus on a definitionthat we find most appropriatefor income or welfarecomparisons,otherconstructions be describedand the will availabledata necessaryfor their evaluationwill be presentedhere and in the sequel In discussingincome definitions,the initial questionis whose income is being estimated.There are several classes of claimantson the assets and incomeflows of a firm,includingbondholders,banksand othershort-term lenders,and preferred and common stockholders.In our work, profitsare takento be a measureof the increasein real economicpower of the equity holdersdue to their investments.This definitionis consistentwith current accountingpractice and with the tax base of the present corporationincome tax A fundamental choicefacedin definingcorporateprofitsis betweenusing a realizationor an accrualbasis An identicalissue exists in assessingpersonal income The fundamentalquestion is whether assets and liabilities should be carriedon balancesheets at historicalcost or at currentmarket value When is economic power enhanced-at the time the market value of an asset increases(or a liability decreases),or when these changes in value are converted into cash? Present corporate accounting practices adopt a combinationof the accrualand realizationcriteria.Whileaccounts receivableand payable are accrued(that is, treatedas equivalentto cash), otherfinancialassetsand liabilitiesof nonfinancial corporationsare carried at their issue or purchasepricesuntil redeemedor sold, a conventionconsistentwith a realizationprinciple.Land and other real capital assets that and are deemednondepreciable nondepletableare also carriedat purchase price.Real depreciable assetsarewrittendown from originalcost according to a presumptiveschedule of the effects of wear, tear, and obsolescence The depreciationaspect of this policy can be interpretedas an attempt to approximateaccrual accounting for these items, while the original-cost basis is more consistentwith the realizationprinciple.As will be described below, currentaccountingpractice with respect to inventoriedassets in effect gives firms a once-and-for-allchoice between accountingmethods that approximatethe accrual or realization definitions of income The presentaccountingsystem rests on an intendedlogic with respect to the accrual-realization choice, although it has not been implementedas pre- 560 BrookingsPaperson EconomicActivity,3:1975 cisely as it might One of the major tenets of financialaccountingis the going-concern assumption,accordingto which the firm will continuein its particularproductiveactivity indefinitely.4 is in the business of selling It some things and using (not selling) others (like physicalplant and equipment).Sincetheselatteritemsare not going to be sold, theircurrentmarket value is not relevant for the firm This classificationof goods implies accrual accountingon items that the firm sells and a realizationmethod on those that it does not In evaluatingthe accrualand realizationbases, and combinationsthereof, a hypothetical"ideal"economywith universalcompetitivemarketsand no transactionscosts may be a useful tool In such a world (one in which many economists spend much of their researchtime), a realization-based definitionof income would have little justification.Firms or individuals are implicitlyreinvesting unsold assetsand reissuingunredeemed liabiliin ties at each point in time Their incomes should be independentof their choices about whetherto reinvestin the same assets(and liabilities),to exchangeassets, or to consume This sort of logic leads to the Haig-Simons concept of personal income defined as consumptionplus the change in accruednet worth,5and suggeststhat distributionsto equity holders plus the changein accruednet worthbe taken as the corresponding definitionof corporatenet income(that is, profits).In this worldand with this definition of profits, neither depreciationschedulesnor alternativeinventory-valuation policies are needed.All assets and liabilitieswould be carriedon balance sheets at marketvalue and the net worth of the equityholderswould be equal to the value of the firm'sassets less the value of its liabilities(the value of the claims of the prior claimantson the assets of the firm) The componentof profitsreflectingchange in net worth would be determined balance simply by comparingthe end-of-periodand beginning-of-period sheets This definitionof profits includesaccruedcapital gains While we See, for instance, Arthur L Thomas and S Basu, Basic Financial Accounting (Wadsworth, 1972), pp 59-60 Simons suggests that personal income can be estimated as "(a) the amount by which the value of a person's store of propertyrights would have increased,as between the beginning and end of the period, if he had consumed (destroyed) nothing, or (b) the value of rights which he might have exercised in consumption without altering the value of his store of rights In other words, it implies estimate [sic] of consumption and accumulation." Henry C Simons, Personal Income Taxation (University of Chicago Press, 1938), p 49 See also Robert MurrayHaig, "The Concept of Income-Economic and Legal Aspects," in Haig, ed., The Federal Income Tax (Columbia University Press, 1921) John B Shovenand JeremyL.Bulow 561 view this as appropriate an incomemeasure,its use for nationalincome for accounting,whose primarypurposeis measuringcurrentproductiveactivity, may be undesirable The computationof the realratherthan the nominalchangein net worth is best accomplished statingall entriesin the two balancesheetsin units by of commonpurchasing power We follow the conventionof using end-ofperiod(year)dollarsto expressprofits,and for consistencystate dividends paid throughout the year in these units This approach introduces the choice of the appropriatemeasureof changes in purchasingpower of the monetaryunit Argumentscan be made for both the consumerprice index and the index of domesticspending,which is the deflatorfor the gross nationalproductless exportsplus imports.The importantdifferences between and domestic spendingare the inclusion of domestic consumerspending investmentand of public goods in the latter We have chosen the domestic spendingdeflatoras the indicator of general purchasingpower both because changesin the prices of public and investmentgoods affect welfare and becauseit is definedmore preciselythan the consumerprice index As is well known, the boundarybetweenconsumptionand investmentgoods can be set only arbitrarily becausemany commoditieshave aspectsof both categories.The conceptuallycleanestway out of this dilemmais to include all domesticpurchasesin the deflator.6 These argumentsfor a real-accrual basis for income in an ideal, complete-marketworld leave no room for distinctionsbetween expected and unexpectedgains, betweenextraordinary income and sustainableflow, or betweenoperatingresultsand capitalgains or losses Reportednet income would include all increasesin real net worth, although attempts at categorizingits sourcescould be considered.In fact, one of the advantagesof the accrualapproachis that total profitsso definedare a state variableof the firm,ratherthan a figureover whichmanagershave the discretionthat they have underthe realizationprinciple It may be usefulto contrastthe Haig-Simonsdefinitionof profitadopted here, which can be describedas purchasing-power accrual,with an alternative view of income as that amount of money (or purchasingpower) over and above whatis necessary keep capitalintact.The latterdefinitionwas to For a more detailed examination of these issues, see Edward F Denison, "Price Series for Indexation of the Income Tax System" (paper presented at the Brookings Conference on Inflation and the Income Tax System) 562 BrookingsPaperson EconomicActivity, 3:1975 formulated Pigou, who furthercreditsMarshall.7 by This alternative ceris tainlymore consistentwith currentaccountingpracticethan is the concept of purchasing-power accrual, but even its implementationwould involve substantial accountingreform.The accountant's principlethatthe firmis in the businessof selling some things and not in the businessof selling others aligns with Pigou's capital-maintenance concept It leads to distinguishing between operatingprofits(gains on items that the firm sells) and holding gains (which reflectthe appreciationof items that the firm does not sell) While the purchasing-power-accrual definitioncalls for inclusion of real appreciation capitalassetsin income,currentaccountingproceduresand of the capital-maintenance income definitiondo not The two definitionsactuallyrepresentextremeson a continuumof possibilities The essential differencebetween them can be viewed as the assumed spectrumof the "purchasingopportunityset" of the firm If the corporationis going to maintainindefinitely same portfolio of physical the assets,regardless events,then one can arguethat changesin the value of, of say, depreciable assetsdo not constituteincome.8On the otherhand, if the relevantpurchasingopportunityset of the firm is represented the total by domesticsales of new productsreflectedin the domesticspendingdeflator, then real capitalappreciationshould be includedin income The accounting consequencesof a definitionof income based on capitalmaintenance, as well as those of the purchasing-power-accrual definition, will be describedin the succeedingsections Even if the purchasing-power-accrual definitionof income is acceptedas appropriatein the ideal world sketchedabove, the difficultiesand desirabilitiesof implementingit in the real world must be considered.The first difficulty involvesdetermining marketvalues.Whileadequatemarketsexist to value most inventorieditems and financialassets and liabilities,most used physicalplants and equipmenthave no organizedmarketto provide a guide to eithertheir liquidationvalue or the presentvalue of theirfuture product.This lack presentsa real problemand forces a choice among imperfectprocedures.The purpose of accountingis to paint as accurateand reliablea pictureas possible of the position of the firm (its balancesheet) and the income and expenditureflows it has experiencedduring a par7 A C Pigou, "MaintainingCapital Intact," Economica,n.s., vol (August 1941), pp 271-75 The frequency of conglomerate mergers raises some doubt about the validity of this assumption JohnB ShovenandJeremyL.Bulow 563 ticular time interval (the income statement) The practical question is whetherthe valuationof physicalplant and equipmentwithoutsale is suffiof to to cientlyarbitrary make originalcost preferable approximations current market value The answer probably depends on the lifetime of the in assetand on both the rate of inflationand the size of adjustments relative asset prices.With averageasset lifetimesrangingup to twentyyears, even would a verylow rate of inflationor slow rate of relativeprice adjustments make originalcost, on average,a poor approximationindeed In the absence of reasonablemarketsin most used physical plant and equipment,there are two alternativesto carryingthese items at adjusted originalcost: (1) restatethe originalcost (the depre(that is, depreciated) ciation base) by the change in the purchasingpower of the dollar since acquisition;and (2) base depreciationon currentreplacementcost using price indexes of specificcapital goods While neither procedureis ideal, eitherwouldprobablygive a farmore accuratepictureof the financialposition of a firm in an inflationaryenvironment than would uncorrected the originalcost Conceptually, secondprocedureis superiorsinceit would the closelyapproximate idealworldif priceindexeswereperfectand depreciation schedulesreflectedtrue economic deteriorationrelativeto new replacementunits This method would involve two separateuses of price indexes First, price indexes of specific types of equipment and structures and wouldbe used to approximate aggregatethe currentvalue of particular indexwould be used, assets.Second,a broadpurchasing-power depreciable as discussedabove, to comparethese figureson two balancesheets for differentyears The accuracyof this two-stepproceduredependson the adequacy of indexes of capital-goodsprices.9The first method is simplerin that it does not requireaccurateindividualprice series or informationon We the compositionof the firm'scapitalstock otherthan its age structure have used it in our numericalestimationsof the next section primarilybecausewe lack adequateinformationto use the conceptuallymore desirable and becausewe not have much faith in existing indexes of alternative prices.The shortcomingof the firstmethodis in its failureto capital-goods accountfor realignmentsof relative asset prices, and it should be recognizedthat this will lead to some inaccuracyin the estimatesof real capital gainsand losses Also, assets, such as office buildings, that can be relatively accurately assessed should be carried at recent assessed market valuations with both of the alternative approaches 564 Brookings Papers on Economic Activity, 3:1975 Neither of the two inflation-adjustment methods for physicalplant and equipmentpreciselyrecordsfuture "use values" or liquidationprices.Yet either of these alternativesis a more satisfactorymeasurethan is depreciatedoriginalcost Severalattemptedcorporateacquisitions (for example, Otis Elevator)have involved prices in excess of book value On the other hand, Penn Central was carrying its assets at values far above their liquidationpotential The appropriate price for physicalassets clearlydepends a greatdeal on whetherthey are being activelyboughtor liquidated The currentmarketprice may indicate a kind of averageof the "buyer's price" and the "seller'sprice" and provides a useful measureof the economic position of the firmeven in this world of imperfectcompetitionand high transactionscosts on used physicalassets Adopting accountingproceduresconsistent with an inflation-adjusted definitionof profitinvolvesadjustments everybalance-sheet to entry.However, none of the currentproposals for inflation accounting(or "current value" or "generalvalue" accounting)is that far-reaching The proposal of the Cost AccountingStandardsBoard(CASB), which is the accounting authorityfor U.S government contracts,deals only with depreciation and, in a mannersimilar to our argumentsabove, suggests the adoption of a techniquethat restatesoriginalcost in terms of generalpurchasingpower The board finds that specific replacement-costdepreciationmay be the more desirable approach, but notes that it is complicated and that its promptapplicationis not feasible.The SEC proposalgoes slightlyfurther, requiringfootnote disclosure of specific replacement-costdata for both fixeddepreciable assetsand inventories.The FASB draftcontainsthe most comprehensive plan, proposing,in additionto depreciationand inventory corrections,the inclusionin net income of the declinein the real burdenof net financialliabilities.'0 That has proven to be the most controversialaspect of the draft."Eventhe FASB, however,omits one majorcorrectionin not calling for restatementof all nominal assets and obligations to their marketvalues-an issue that will be discussedin detailin our sequelpaper 10 CASB, "Proposed Rules: Historical Depreciation Costs-Adjustment for Inflation," FederalRegister,vol 40, no 197 (October9, 1975), pp 47517-19; CFR, pt 413; FASB, "Financial Reporting in Units of General Purchasing Power"; Securities and Exchange Commission, Notice of Proposed Amendments to Regulation S-X to Require Disclosure of Certain Replacement Cost Data in Notes to Financial Statements (S7-579) 11 See, for example, "The Numbers Game," Forbes, vol 116 (August 15, 1975), p 40 John B ShovenandJeremyL Bulow 565 Partial adjustments,such as those in these proposals, may not offer a result that is closer to an economic definitionof income These proposals would lower reportedcorporateprofitsand taxes in the presenceof inflation, and may be viewedpositivelyby some for that reason.A more desirable approachis to separatethe issues and first developaccountingprocedures that reflect the impact of inflation on incomes and costs in an economicallymeaningfulmanner.That is the primarypurposeof our two articles Once such a frameworkis developed (even if not unanimously accepted),the debate about how to tax the resulting income can open The need to revise the accountingdefinitionof profits for inflationhas of becomeincreasinglyapparentin light of the performance prices in the from nominal to real accounts first half of the 1970s The transformation by can no longerbe accomplished deflationwith a simplyconstructedindicator of movementsin the generalprice level Moreover, a picture of the real position of both the micro and macro aspects of the economy is as essentialas ever for policy analysis Physical Assets for Accounting Depreciable Currentaccountingproceduresfor depreciationare accurateonly in an environmentof no price changes,relativeor absolute,and only to the extime scheduleof writematchesthe presumptive tent that real depreciation offs used by firms.None of these conditions is met, and the condition of absolute price-levelstability has not recently been approximatedin the U.S economy This section discussesthe currentaccountingtreatmentof depreciableassets and alternativesthat take account of inflation The currentpractice of basing depreciationon historicalcost presents severalrelatedproblems.First and most important,the originalcost of an item is irrelevantas a balance-sheetentry This cost is sunk; taking the of highlightsthe inappropriateness such extremecase of a hyperinflation for assessinga firm'sfinancialposition Second,historical-costdefigures to preciationadds uncertainty some investmentdecisionssince the fraction of forgone purchasingpower that is deductibledependsupon futurerates of inflation Finally, most accountingstatistics, both in national income accountsand corporatereports,are statedin commonunits such as current dollars or constant 1958 dollars Historical-costdepreciationstatistics, 566 BrookingsPaperson EconomicActivity,3:1975 however, representa summation of individualcomponents that are expressed in dissimilarunits due to the dispersion of ages of depreciable propertyand the fluctuationsin the purchasingpower of the dollar As arguedin the previoussection, the purchasing-power-accrual definition of profits,in principle,calls for depreciation accountingbased on specific price indexes for capital goods Assets would be depreciatedon a basisapproximating replacement determined adjustingoriginalcost cost by by the percentagechangesince acquisitionin the appropriate capital-price index In addition,any appreciation a firm'scapitalgoods relativeto an of indicator of generalpurchasingpower (such as our choice, the domestic spendingdeflator)would be enteredas income The use of specificcapitalprice indexesand replacement-cost is depreciation also consistentwith the capital-maintenance definitionof income The one difference that under is this concept,realappreciation wouldnot be countedas income.Whilesuch replacement-cost proceduresseem feasible, given sufficientresources,we believe their introductionshould be postponeduntil the price indexes for capital assets are substantiallyimproved.Furthermore,the alternativeof adjustingdepreciableassets and the correspondingdepreciationbases by the movementof a single broad capital-price index relativeto the general deflatorseems to us an unsatisfactoryhalfwayhouse First, price indexes for aggregatecapital assets, as well as for specificones, are poor; second, it may be betterto ignoreall real gainsfromfixedassetsthan incorrectly to assign all holdersthe averagegain experienced A remainingalternative,then, is simplyto inflatethe originalcost of all depreciableassets by the generalpurchasing-power indicator.This technique, whichhas been proposedby both the FASB and the CASB, is simple, and the impact of its adoptionis relativelyeasy to gauge as very little informationregardingcapital portfolios is required.While this approach, whichwe will term "general-value cannotcapturethe effects depreciation," of changesin relativeasset prices, it does adjustincome and balance-sheet statementsfor generalinflation.In face of the inadequatedata, it is a compromise consistent with the definitionsof income based on purchasingpower accrual and on capital maintenance.Following a brief historical surveyof actualdepreciation policies and an analysisof their adequacyfor varyinginflationratesand for firmswith differing growthrates,this section contains estimates of the impact of adopting a policy of straight-line general-value depreciationon the thirtyfirmsin the Dow Jones industrial index and on nonfinancialcorporationsin the aggregate John B ShovenandJeremyf Bulow 597 In went up 1.8 times as fast as the GNP deflator.26 fact, the IVA correction in of $35.1 billion for 1974is unprecedented magnitude;it was 32 percent corporationsand exceededin of the total before-taxprofitsof nonfinancial earningsfor the firsttime since absolutevalue theirtotal after-taxretained 1938 These IVA inventoryprofits, even though they were partiallyreal, generatedno cash flow as they were not realized.In a sense, the retained net cash flow was negative,whichpartiallyexplainsthe heavy demandfor externalfinancingin 1974even in the face of a weakeningeconomy.Moreover, the differenceof $18.9 billion betweenthe IVA-which is essentially the effect of uniform LIFO-and constant-dollarFIFO revealsthat, in a period of markedchangesin relativeprices,the purchasing-power-accrual concepts of income can divergewidely and capital-maintenance Both the constant-dollarFIFO impacts shown in column of table 5, taken subjectto an awarenessof the accuracythat our manipulationsdemand of the underlying data, and the IVA indicatethat reportedinventory profits seriouslydistort corporateprofit accounts and taxation in periods of inflationas rapidas that of 1973-74.Few signspoint to a futureof stable purchasingpower, and thus it is importantthat inventoryaccountingbe reformedso that corporatereports are more accurate,comparable,and revealing Constant-dollarFIFO has many advantagesover any of the existing techniques.It would give meaningfulbalance sheets and income definition statementsand is consistentwith the purchasing-power-accrual We advocateit as an eminentlyfeasibleinvenof profit advancedabove technique tory-accounting InterimConclusions As was stressedearlier,a set of accountsadjustedfor inflationrequires correctionsof each of the nominalentriesin balancesheets.Partialadjustments such as those proposed by the SEC, CASB, and FASB may be This paper has analyzed in detail the accounting of counterproductive and physicalassetsconsistentwith both the purchasing-power-accrual capidefinitionsof income At this point, we can reachconclutal-maintenance sions about some of the individualfactorsaffectingthe conversionfrom a nominalto a realmeasureof corporateprofits,but we cannotdrawa global p 26 CorrectingTaxes for Inflationt, 28 598 BrookingsPaperson EconomicActivity,3:1975 pictureuntil the treatmentof financialassets and liabilitiesis examinedin our secondpaper We have recommended mandatorypolicy of straight-line a general-value depreciation and of constant-dollar FIFO Our empiricalanalysisdemonstratesthat both adjustments would have impacts on book and tax profits that would vary widely among corporations.This is true for depreciation becauseof the differingoriginal-cost techniquesnow used by the firmsand because the present methods discriminateamong firms with different growthrates and age structures capitalstock With respectto inventory of accounting,the currentuse by firmsof verydifferent accountingmethodsLIFO and FIFO-would be responsiblefor much of the variation In 1974, in the aggregate for nonfinancial corporations, adopting straight-line general-value would have increasedtax-reported depreciation depreciationand reduced taxable profits by $10.3 billion; uniform constant-dollarFIFO inventoryaccountingwould have lowered profits further by $16.2 billion The magnitude of both of these numberswas far greaterfor 1974than for any previousyear due to the acceleratedpace of inflation,and that experiencehas greatlystimulatedthe attentionto inflation accounting.But these adjustmentsare only part of the story Thereare other importantadjustments, most involvingthe liabilityside of the balance sheet for nonfinancialcorporations.Correctionsfor the real diminishing value of a givennominaldebttend to raise profitestimates, and these correctionsmay be largerthan, or of comparablesize to, those for physicalassets.An attemptat estimatingthe impactof a completeset of accounting procedures that adjustfor inflationwill be made in the sequelto this paper Commentsand Discussion William J Fellner: Shoven's and Bulow's interestingpaper provides a good point of departurefor discussion My views differ from theirs in variousrespects,and I believe that readersshould be made awareof alternative ways of looking at these matters This is so particularlybecause problems that the authors believe belong together shape up as separate problemsto some of us Perhapsthis observationdoes not apply literallyto the problem of tax accountingon the one hand and of the national income and product accounts (NIPA) on the other, becausethe authors'intentionmay not have been to merge thesetwo problemsbut to disregard NIPA in their study the But even in that event, readersshould be remindedthat the NIPA call for formulatingprinciplesdifferentfrom those applicableto tax accounting, and differentfrom those advocatedby Shoven and Bulow, who, I think, are concerned mainly with tax accounting even if they not say so explicitly Currentnet output in the usual sense-the net output with which the NIPA are concerned-excludes all revaluationsof physicallyunchanged capital.To the extentthat the revaluationof such capitalresultsfrom using up old capitaland replacingit with identicalbut newlyproducedand more costly items, the equivalentof the revaluationdoes enter into the value of thegross output,but shouldbe eliminatedfromthe net Thisis analogousto sayingthat, if someoneneedsto make a greater(or more costly) effortthan before to stand still, this necessity should not affect a measure of his as achievement expressedin termsof the result.However,due to a "freak," one must qualifythe propositionconcerninga legitimateeffecton the gross (though not on the net) currentoutput of a revaluationof physicallyunchangedcapitalwhenthe revaluationresultsfrommore costly replacement 599 600 BrookingsPapers on EconomicActivity,3:1975 The "freak"is that, as concernsinventorychange,even the "gross"output is net It follows that in national income accountingof inventorychange, but not of the replacementof fixed capital,even the so-calledgross output should remain unaffectedby the revaluationsin question But on a conthe ceptuallevel, this is indeeda "freak,"and it leavesunaltered conclusion that the revaluationof physicallyunchangedcapitalshouldnot show in the NIPA's net output Hence, in measuringnet output, the NIPA call for depreciationand inventoryvaluationmethodsinvolvingestimatesof the cost of usingup capital at the prices of the period in which the fixed capital and the specific inventorywere in fact consumed.For most years, the results of this procedure would be very similar to those of replacement-costdepreciation combinedwith LIFO,but not always.As for the time shape of capitalconfixed capital, the sumptionimpliedin alternativemethods of depreciating NIPA call for relying on some estimate(or best guess) of the rates of decline of asset values to their owners On the other hand, the principles relevant to the NIPA would apply to tax accountingonly if its purpose were to excludeall revaluationsof physicallyunchangedcapital from the problemis more tax base Sincethis is not the purpose,the tax-accounting complex as Even if Shovenand Bulow are interpreted focusingon tax accounting, and not on some combinationof that subjectand NIPA, theirpaperreveals the conviction that it is useful to merge problems that many observers would like to appraiseseparately For example, if considerationof the changeoverfrom acceleratedto is depreciation mergedwith adjustingthe tax base to inflation, straight-line as it is in this paper,then the authorsshould make it easy for the readerto look at the componentsseparately.I will try to that using preliminary estimatesof the Bureauof EconomicAnalysis In the course of the operations suggestedby the authors, on the assumptionof Bulletin F service lives, for the nonfinancialcorporationstaken togetherin 1974,first about by $16 billion of depreciationallowancesis subtracted the postulatedshift from the actual depreciationpracticesto straight-line,and then, as a correctionfor inflation,about $21 billion of depreciationallowancesis added to the new, reduced,figure.Recognizingthat Bulletin F lives are unrealof isticallylong and assuming85 percentof them, the withdrawal depreciais tion allowancesdue to the shift to straight-line $11 billion and the addifor tion to the reducedbook depreciation arisingfrom adjustment inflation John B ShovenandJeremyL.Bulow 601 is $21 billion; the corresponding figuresassuming75 percentof BulletinF lives are $7 billion and $24 billion, respectively Mergingtheir analysisof the two phenomenaleads Shoven and Bulow to expressthe increaseof depreciationdue to the inflationadjustmentas a proportionof a depreciationfigure that has first been diminishedby the shift to straight-line.Since in 1974 the actual depreciationcharges of all nonfinancial corporationsamountedto roughly $70 billion, the numbersI corporapresentedsuggestthat the increaseof depreciationfornonfinancial tions as a group resulting from the Shoven-Bulowinflation adjustment ranges(dependingon the service-lifeassumption)between 35 and 40 percent of a book depreciationbase that was first reduced by the shift to straight-line.Shoven and Bulow obtained a figure of 38.2 percent for a sampleconsistingof the thirtyDow Jonescompanies;they shouldbe comresultfrom a plimentedfor obtainingby theirtechniquethis representative the smallsample,as shouldthose who have constructed Dow Jonessample Yet, Shoven's and Bulow's net addition to the actual book depreciation allowancesof 1974comes out at between8 and 23 percentfor all nonfinancial corporationsif the allowancesare not first diminishedby a shift to straight-line Throughoutthis discussion,I have followed Shoven'sand Bulow'spractice of neglectingthe numericaldifferencebetweenthe generalGNP deflator (whichby their standardsthey should be using for inflationcorrection) and the deflator applicable to nonresidentialfixed business capital (on which the BEA estimatesof current-costdepreciationare based) In summary, I believe that the shift to straight-lineand the shift to inflationaccounting-the two components of Shoven's and Bulow's merged operation-need to be looked at separately As to the authors'mergerof the problemof inflationaccountingwith the problemof shiftingto a profitconceptbasedon accrualratherthan realizabut, quite asidefrom that, tion, not only I findthe mergerunconvincing, I have strong misgivingsaboiutreliance on the accrualprinciple expectedvalue My misgivingsarise from the fact that a probabilistically with very little dispersionabout the mean is not identicalin any decisiontheoreticalsense with the same probabilistically expectedvalue combined with very high dispersion.This distinctionbetween reasonablysafe and process highly conjecturalvalues-plays a large role in the decisionmaking not only of an asset owner,but also of his creditors.Defense of the realization principleis frequentlybased on referencesto the problemof liquidity 602 BrookingsPaperson EconomicActivity,3:1975 but and of limitedcreditavailability, whatlies behindthis is the problemof uncertainty-the problem of the higher moments of probabilitydistributions; and thatproblemlooms verylargein procedures whichunrealized by accrualsare estimated.It should be noted in the presentcontext that accountingtechniquesby which the inflation-corrected value of the stock of assets is set against the inflation-corrected stock of liabilities in balance sheets intended as bases for tax computationinvolve placing exceedingly riskyvaluationson the samefooting as valuationsthat are subjectto very little uncertainty If the relevanceof the distinctionbetween "realized"and "unrealized" is takenfor granted,a numberof thornyquestionsarise.In an analysisthat (like Shoven'sand Bulow's)does not drawthis distinction,these questions get lost thoughthey are of greatpracticalimportance;and they wiUl remain importantbecausethe distinctionis likely alwaysto be relevantto taxation Among the difficultquestions to be faced are those relatingto capital that has remainedphysicallyidenticalbut has been turned over duringthe Does capitalconsumptioncombinedwith pari periodunderconsideration of passu replacement the stock involve realizationduringthe process? answerimpliesthe view that, since the ownercould have An affirmative abstainedfrom usinghis sales proceedsfor replacement, is in a position he no differentfrom that of a producerwho has reinvestedhis net profitsto make an additionto his stock, so that both should be viewedas havingenact gagedin realizationfollowedby a deliberate of purchase.On this view, one must conclude that the conventionalhistorical-costtax-depreciation practicesfor fixed capitalimply the rightjudgmenton "realizationdue to turningover the investor'scapital,"except for the failureto make the kind for of adjustment the generalinflationratethat Shovenand Bulowdescribe correctly;and on this view, one must also concludethat FIFO does, but LIFO does not, imply the righttax-policyjudgmenton "realization to due turningover the investor'scapital," though FIFO too should be supplemented with the kind of correction for the general inflation rate that Shoven and B}ulow describe.To the extent that investmentis financedby debt, supplementingdepreciationpractices or the FIFO valuations with provisionsfor inflation adjustmentcalls for a transferof such tax allowancesto director indirectcreditors,since to that extent, any nominalgains from revaluationthat merelyreflectinflationappearin the tax returnsof creditorsratherthan of investors - But whatif one takes the view that there is no such thing as "realization John B Shovenand JeremyL Bulow 603 due to turningover the investor'scapital"?In other words,what if merely replacing fixed capital and inventoriesinvolves no realization?This view the essentiallymeansemphasizing fact that even a gradualliquidationof an investor'soperationswould create uncertaintiesof valuationof which investors and creditorsare aware, and that justify regardingreplacement (avoidanceof liquidation)differentlyfrom net investmentout of realized of depreciation fixedcapital-rather profits.On this view, replacement-cost than merelya correctionof historicalcost for the generalinflationrateshould be used for computingthe tax base except where the investor is liquidatinghis fixed capital;and, whetheror not the investoris liquidating method for tax purhis inventories,the appropriateinventory-valuation poses in this case is LIFO, ratherthan correctionof FIFO with relianceon a generalinflationindex That is, these practiceswould be appropriateto tax accountingif, in additionto drawingthe usualline betweenrealizedand unrealizedgains, one were willingto rule quite generallythat turningover the investor'scapitalinvolves no realization Yet, the U.S tax code is not based on any consistentlymaintainedconception of this sort Instead,it embodiesa compromise:on the one hand, our tax code impliesthat turningoverfixedcapital whenit is consumedand replaceddoes involverealization(whichis a FIFO-likeconceptionapplied to fixed capital); and, on the other, the investor may opt either for the treatmentof the joint act of using up and replacinginventories as realization (the FIFO option), or againstsuch treatment(the LIFO option) Consideringthe complexitiesof the problem,I find this willingnessto comproBut mise understandable it greatlycomplicatestax problems,especiallyin FIFO inventoryvaluaperiodthat wouldcall for correcting an inflationary practicesby a generalinflationfactor,with tion and FIFO-likedepreciation the tax allowancegoing to the investorratherthan to creditorsonly to the extentof internalfinancing.At the sametime, correctionby a generalinflation index is out of place whereLIFO practicesare applied,becausethere thejoint act of usingup and replacingis not viewedas implyingrealization and the result is that the exclusionfrom the tax base is "automatic"and unrelatedto the problemof inflationaccounting I would like to make several points in summary.First, I suggest that, even for an inflationary we obtain reasonablysimplelogical principles era, are for the NIPA Almost equally straightforward the principlesfor tax accountingbased on the conceptionthat using up physicalcapitalplus replacingit involvesno realization,and hence any gains or losses developing 604 BrookingsPapers on EconomicActivity,3:1975 fromthis practiceshouldnot enterinto the tax base Next, given a tax code that does not take this position but is a compromise, one must work throughrathermessy complexities.Finally, on what is to me the basically unconvincingconception of accrualtaxation combinedwith inflationcorrection,the impression logicalpurityor internalconsistencyemerges;but of this impressionis unjustifiedif there is no consistent way of sharingthe inflationcorrectionbetweeninvestorson the one hand and theirdirectand indirectcreditorson the other Edward Gramlich:The recentrise in priceshas spawnedmuch interest M in the question of the propermeasurementof incomes or profits in inflationary times The papers on indexingincome measuresfor inflationthat have lately resultedfrom this concern have probably already convinced economistsabout one importantbenefitof stableprices:the indexingquestion is so complicatedthat economists,accountants,and tax lawyerswould have a muchimprovedstandardof living if they neverhad to read or write another paper on the topic Working against this constraint, however, Shoven and Bulow have done an admirablejob: their paper is clear and informative,though a little heavy on their own recommendations corand respondinglylight on discussionof some of the underlyingissues I want to bring out a few of these issues Most of the literaturefocuses on the tax implicationsof inflation accounting-ways in which tax schedulescould be adjustedso that real tax levels (and ultimatelythe real incomes and relativeprices facingfirmsand households)would be unaffectedby inflation.For that purpose,there,are two requirements.The first, known as type I indexing, involves setting magnitudessuch as personalexemptions,deductions,rate brackets,and so forth in "real" terms, and hence ensuringthat the average tax rate and progressivityof the schedule not change in inflationarytimes These issues are not discussedin the Shoven-Bulowpaper, which does not concentrateon the tax implicationsof inflationaccounting.The second,type II indexing,deals with the propermeasurementof the tax base duringinflation This is the centralquestion of any inflationadjustment,and the one on which Shoven and Bulow spend their efforts Withintype II indexing,then, one still has to clarifyseveralissues The firstissue is-whether generalpriceinflationappliesmore or less similarlyto all goods, or whetherprices advance at markedlydifferentr-ates Type II indexingbecomesmuch more complicatedif the latter is true and, to their John B ShovenandJeremyl Bulow 605 credit, Shoven and Bulow did not shy away from this complexity.I don't agree with all their conclusions,however, and will try to slug it out with them on that issue The second issue is an economist's favorite: whether inflationis anticipatedor unanticipatedand whetherthat makes a difference Shovenand Bulow have narrowedtheir focus to the accountingconvention and spend little time on its effects, but I want to say something about this aspect of the question.The third questionis whetherincome is to be measured(and taxed) on a realization or accrual basis Here the authors'treatmentlooks fine to me and I have no quarrelwith them The firstimportantpoint raisedby the paperconcernsgeneralversusspecificinflation.If all pricesarerisingat the samerate, Shovenand Bulowand otherswould arguethat at least two types of distortionarise in measuring and taxingthe incomefrom physicalcapital.Sincedepreciation allowances are understated are based on originalcost, they and the firm'sincome and tax liabilitiesare accordinglyoverstated.Also, since some inventoriesare valued under the FIFO convention, there is a similar overstatementof nominal inventorycapital gains In both cases the true economic cost of using up either fixed capital or inventoriesis understatedby originalcost or FIFO, and a possibleremedyis to use Shoven'sand Bulow's "generalin value depreciation" the formercase and somethingI will call "inflated FIFO" in the latter.This means simply allowingthe firmto raise its original cost of consumingthe good or the inventoryby the percentagechange in generalpricessincethe time the good was bought.As Shovenand Bulow point out, if all marketswere nearly perfect and taxation were on an accrual basis, somethingclose to this practicewould happen automatically ratesand the accountingand tax systems But if priceschangeat different are on a mixedaccrualand realization basis,the situationgetsmuddier.Assume that firmA bought an inventorythat rose 15 percentwhile pricesin generalrose 10 percent Most people would agree that if, of the nominal gain of 15 percent, 10 just keeps pace with inflation,it should not be regardedas income, and it can be kept out of measuredand taxableincome by inflatedFIFO costing of inventories.But what about the other percent? The Shoven-Bulowanswer is that that is income (and presumably ought to be taxable),though they don't say exactly why My own is that it probablyshouldnot be taxable,but the mattershouldin any event depend on the substitutionpossibilitiesopen to the firm.If the firm can substitute for this inventoryother goods that have not increasedin price,its costs are in effect no higher,it really did get a capital gain, and this real gain is in- 606 BrookingsPapers on EconomicActivity,3:1975 come and oughtto be taxed.If the firmcannotsubstitute,however,its costs have also increased,it really did not get a capital gain and should not be taxed, and the percent can be kept out of taxable income by using the present(optional)LIFO convention.Of the two possibilities,if the various types of inventoriesthe firmscan purchaseare fairlyclose substitutes,their prices will probably change at close to proportionalrates, the real-gain componentis probablyratherslight,and LIFO seemsto me a more reasonable approach.Thus, I don't see any persuasivereasonfor eliminatingthis option, as Shoven and Bulow recommend,althoughmy view hinges on a possibleunderestimate the degreeto whichfirmscan in fact alterinvenof tory buying patternsin responseto changesin relativeprices The answer to whethergeneral-value depreciation(the analogue to inflated FIFO) is betterthan replacement-cost depreciation (the analogueto LIFO) for fixed capital depends on the same type of considerations.But there,as Shovenand Bulowargue,marketsand pricesare so poor that it is probably impossible to use replacementcost even if it is desirable,and general-valuedepreciationbecomes a second-best alternative-although better than the present original-costsystem This conclusion points to a mild asymmetryin the Shoven-Bulow paper: they oppose LIFO and favor inflated FIFO on principle,yet they favor replacementcost on principle and agree to general-valuedepreciationsolely on pragmaticgrounds If replacement cost is betterin principle,so it would seem is LIFO Two other points should be noted It does not, I think, matter whether the firm respondsto a rise in inventoryprices by raisingproductprices.If the firm does that, the revenuegoing into measuredprofitsincreasesautomaticallyand it is still necessaryto compute true profitsby using the new, cost of consuminginventoriesor capital Second, higher,real replacement if all accruedincome of corporationswereimputedback to stockholders,it may appearthat substitutionpossibilitieswould expandand hence all the above capitalgainswould becomereal; but I don't believethat is true The firmthat has no substitutionpossibilitiesmay have an inventoryasset that appreciatesin relative price, but it also has complementaryprocessing in that has in effectdepreciated value Hence,the realprofitsand equipment relativeprice of the stock of that firm should be substantiallyunchanged, and so should the stockholder'sreal income I want next to raise a second importantquestion,regardingthe distinction between anticipatedand unanticipatedinflation Shoven and Bulow deal almost exclusivelywith a world of unanticipatedinflation,and their John B ShovenandJeremyL.Bulow 607 discussionis framedwhollyin termsof its impacton firmsof varioustypes When inflationpersists,however, it presumablybecomes more and more anticipated.As this happens,rationalfirmsand householdscan take steps to protect themselvesagainst inflation, includingthe tax treatmentof it With respectto taxation,the policy questionchangescharacter:no longer is society trying to protect unknowing fools against random inflationinducedinequities;rather,it is tryingto preventthe adverseeconomic implications of the measures knowing smarties take to protect themselves againstinflation In the case at hand, original-cost depreciation mightbe expectedto raise the rate of returnrequiredon new investmentin inflationary times and thus to hamper investment.This developmentcould be undesirable,first, because it impliesthat the net restrictiveness a given depreciation will of law depend on the anticipatedrate of inflation, and, second, because it may reducethe national proportionof output invested.That the first is a disadvantageof the present original-costsystem is conceded by most economists That the second constitutessuch a disadvantageis not generally conceded, however, and there the question of adjustingdepreciationfor inflationlands smackin the middle of the growthissue Those who believe in the policy relevanceof the "goldenrule" of accumulationpresumably think that the United States is alreadyinvestingtoo little; they look with disfavor on anythingthat raises the cost of capital and hence takes the country farther from the golden-rulepath; and presumablythey would favor somethinglike the Shoven-Bulowgeneral-value depreciation.Those who are beset by otherbugaboos-adverse redistribution incomewithin of generations, environmentaldamage or resource exhaustion, the consequentmacrostabilization problems-would argueagainstthis positionand urge that any general-valuedepreciationbe offset by tighteningor eliminating other investment inducementssuch as accelerateddepreciation, short tax lives of equipment,and the investmentcredit An intermediate possibility, which seems preferableif there is no indexingof the interest costs on debt duringinflations,would be to confer general-value depreciation only on the equity-financed portion of new investment Whatever changesin tax policy shouldbe made,the Shoven-Bulow treatment of this particular questioncan be somewhatmisleading.Theirfigures and calculationsappearto indicatethe rate of inflationat which originalcost depreciation reducesallowancesmore than the acceleration provisions increasethem Yet one must read very carefullyhere because Shoven and 608 BrookingsPapers on EconomicActivity,3:1975 Bulowassumefor thesecalculationsthat the real interestrateis zero, hence proviassumingaway the basic advantageof the accelerated-depreciation sions from the start The fact that the Treasuryis making a loan at zero interestrate is then of no consequence,for firmscould by assumptionborrow at that rate from banks The only advantageof acceleration,then, is that it augmentsthe cash flow of growingfirms,a fact that is not very interestingto those who view investmentas motivatedprimarilyby a comparison of its expected profitabilitywith financial opportunitycosts It turns out that a mathematicalpropertyof the system is that in figure a as growthrate of g in cash flows can also be interpreted an interestrate of g on a given piece of new equipmentin a cost-of-capitalframework.But many words and numbersin the paper with this alternativeinterpretation, not follow, because Shoven and Bulow measure relative gains and to lossesby firmaccording past growthratesof the firms,whichpresumably are not the same as the real costs of borrowingthat firmsface In addition, computingthe cash-floweffectin this way preventsShovenand Bulowfrom dealingat all with the impact of the investmentcreditor of changesin the corporatetax rate,as they couldhave with an approachrelyingon required that allow rate of return-though againthere are changesin interpretation them to say somethingabout the matter GeneralDiscussion The paper'sdiscussionof the appropriatedefinitionof income brought forth a number of comments Joseph Pechmanfavored the Haig-Simons purposesbecause, in his view, concept of income for business-accounting cannot be evaluatedwithout taking into account its a firm'sperformance accrued capital gains and losses The definition of income would differ from the one used in the national income accounts, which does not include capital gains and losses because it is intended for a differentpurpose He also advocated, as did Shoven and Bulow, the adoption of uniformaccountingproceduresto facilitate interfirm comparisonsof performance.Although James Tobin agreed with Pechmanin principle,he offered a qualification.Since capital gains may not be recurrent,the concept of permanentor sustainableincome-that income that could be expectedto be earnedyear afteryear-may be more relevantin assessingthe position of a businessfirmthan the authors'concept of accrualincome in John B Shoven and Jeremy L Bulow 609 purchasing-power terms.For example,sustainableincome could be calculated simply as the Shoven-Bulow net-worthfigurewith some real rate of interestappliedto it That amountshould be sustainableregardlessof the net sourceof the incremental worth-capital gainsor retainedearnings-or in of the extent to which it was accumulated the past year LawrenceKlein was concernedabout any accountingadjustmentsthat would upset the usual identitiesof the balancesheet and income statement by deflatingcomponentsseparatelyinto real units A nominal accounting system (which would still revalue assets and liabilities)seemed preferable to him becauseit is difficultfor realidentitiesto hold for a completesystem, especiallyfor residualitems such as profits or net worth Those subaggregates that have physicalcounterparts could be expressedin real terms.But in some sense, thereis no such thing as real profitsor real income;the concept of purchasing power dependson what spenderswant to with their incomes Donald Nichols criticizedthe paper and previousdiscussionfor assuming that there is a theoreticallyacceptableand objectiveway to measure income when prices are changing over time Capital gains induced by changes in interest rates and by other intertemporalchanges in relative prices should not be treated as income to all stockholderssince not all stockholderswill be made better off by the change.Each stockholderhas an intertemporalconsumptionplan, but the present-valuemethod prowantto consume posedby Shovenand Bulowassumesthat all stockholders everythingthis year Such problems exist with any income measure,and inequitieswill resultif all income must conformto one definition.In a tax systemthat uses consumptionratherthan income as a base, these insoluble problemsare finessed,Nichols concluded ArthurOkun pointed out that the conventionalbalance sheet that was adjustedin the paperignoredone importanttype of "real"asset or liability -orders placed at fixed prices for inputs, and orderstaken at fixed prices to Such (or othercommitments a definiteprice-say, throughadvertising) sale obligationsby sellersrepresent,in effect, a kind of future-market out of inventories;amongfirmsthat have a largevolumeof such commitments, FIFO offersa more accuratedescriptionof performance than does LIFO The remainingcomments dealt with the practicesand the purposes of accounting.GardnerAckley pointed out that a key purpose of accounting is to provide information on which to base managementdecisions and wonderedwhat effect the changes proposed by the paper would have-on 610 BrookingsPapers on EconomicActivity,3:1975 those decisions.Michael Lovell felt that the implicationsfor the business cycle of changing accountingproceduresmerited more considerationby the authors.He noted that businessescould have been encouragedfrom a tax viewpointto accumulate more inventoriesduringthe periodof doubledigitinflationif more firmshad been usingLIFO; yet such behaviorwould have aggravatedinstability.On the other hand, after-taxprofitsnet of the inventoryvaluation adjustmentwere lower than dividendsin 1974 Had investorsbeen fully awareof the distortionsof FIFO accounting,the stockmarketdecline could have been worse than it was CharlesHolt andDaniel Brillstressedthe need for bettercommunication betweenaccountantsand economists.Accountantsbelievethat the validity of their numbersrests on their relianceon actual transactionsratherthan on personaljudgment.Sincethey will be responsiblefor implementing any in accountingprocedures,they must be convincedthat switching changes from a nominal to an inflation-adjusted system will not violate their conventions Economists must clarify the point that the basic operationsof addition and subtractionthat accountantsnow use make sense only in a world of constant prices or under a system of standardizedunits Holt thoughtthat accountants might be reluctantto revalueassetsand liabilities without actual transactionsto guide them In response, Brill maintained that accountantsalreadyexerciseenormousjudgment in that area, especiallyfor financialinstitutions,in decidingwhen and how muchto write off financial assets that bear unrealizedcapital losses They are expressing opinions on what portions of a past decline in value can be ultimately recovered The authorsrespondedto severalpoints raisedin the discussions.Fellner's commentabout the uncertaintyassociatedwith estimatesof unrealized accrued capital gains led Shoven to reiteratehis position that, for long-livedassets,inflationmakes originalcost a veryinaccurate representation of the value of an asset He consideredGramlich'sdistinctionbetween the anticipatedand unanticipated inflationhighly relevantin determining behavioralimpactof any accountingsystem,but felt that it has no bearing on the appropriateness a particularaccountingprocedure.He agreed of with Gramlichthat capitalgains on inventoriesaccrueto a firmonly when there exist substitute inputs whose prices have not risen However, the set fromthat of a purchasing-opportunity of a firmshouldbe distinguished stockholdersince any one stockholdercan sell his interestand thus engage in partialliquidation.Lastly,Bulow pointed out that, althoughthe growth John B Shovenand JeremyL Bulow 611 rate and the real rate of interestare substitutablein some sense, figure reflectsthe ratio of two depreciationschedulesand thus is independentof the real rate of interest ... Financial AccountingStandardsBoard (FASB).3In contrast,this paper and its sequelaim to beginfrom scratchand developa consistenteconomicdefinition of real corporateprofits and associated accountingprocedures.The... becauseundercurrentaccountingpracticefirmscarry many physical and financialassets and liabilitiesat originalcost or book value, figuresthat are expressedin dissimilarunits and that may deviate... accuratedepictionof financialflows and position is more difficult.The accountingproblems are clearest and most severe with regard to assets (suchas inventoriesand depreciable property )and liabilities(such