The three different practices cited by Grady in 1965 were used in accounting for the tax effects of "timing differences" (transactions that are reported in financial statements and income tax returns in different periods). Subsequent to the date of Grady's study the differences in tax allocation practices have been substantially narrowed through the issuance of APB Opinion No. 11 (1967), APB Opinions No. 23 and No. 24 (1972), AICPA Interpretations (1969-1972), and FASB Statement No. 9 (1975). Nonallocation of the tax effects of timing differences among periods (the second practice cited by Grady) has been eliminated. Allocation of the tax effects of timing differences among periods is now required except for a limited number of specific timing differences or in circumstances for which recognized criteria have been established to determine whether tax allocation is required. 7. Methods of depreciation Grady cited in 1965 the following four methods of depreciation for charging off the cost of depreciable assets over their estimated lives: 1. Increasing charge (annuity, sinking fund) 2. Production or "use" methods 3. Straight-line 4. Decreasing charge (declining balance, sum-of-years' digits). Depreciation has probably been the subject of more legal controversy in the ratemaking and tax accounting contexts than any other accounting subject. The underlying economic theory is that depreciable cost should be amortized over the useful life of an item in proportion to the consumption of its economic potential. The difficulty in its application is that in most cases no one method can be objectively demonstrated as best carrying out the theory. Therefore, the general accounting principle simply requires that depreciable cost be amortized over the estimated useful life in a systematic and rational manner. All four of the depreciation methods listed by Grady meet this criterion. The annuity or sinking fund depreciation method is rarely used. The unit-of-production (production or use) method is encountered more frequently, but is quite clearly a minority practice. The idea of charging each unit of output the same depreciation cost as all others over the estimated life of a facility is perhaps the most logical method of all. However, in most circumstances, estimating the likely total number of units of output over the useful life of the facility is far more difficult than estimating the useful life itself, and thus for sound practical reasons, this method is not widely used. The straight-line method is by far the most widely used method. Its rationale is that the passage of time is as good as any standard by which to measure the expiration of economic potential of a depreciable asset. The use of accelerated depreciation methods has increased considerably in the last 25 years, in large part because the Internal Revenue Code of 1954 permits the use of accelerated depreciation methods for Federal income tax purposes. The earlier, higher cash flow, through reduced income taxes, recovers dollars of investment sooner. The Government's Cost Accounting Standards Board accepts all three of the abovedescribed widely used depreciation methods. 8. Inventory methods The Study's tabulation relies on the following five “alternative" methods for determining inventory cost described by Grady: 1. First in, first out (FIFO) 2. Last in, first out (LIFO) 3: Average cost 4. Base stock, and 5. Various combinations of these methods. The "base stock” method cited by Grady in 1965 is a forerunner of the LIFO method but for all practical purposes this method is now extinct. Item 5 is not a separate accounting practice, and thus discussion of "alternative” inventory methods must focus on FIFO, LIFO and average cost. An analysis of inventory accounting methods reveals that no single method listed above is likely to result in a fair matching of revenues and costs for all companies under all circumstances. So long as the rate of inflation experienced by an enterprise is not substantial, the FIFO or average cost methods of valuing inventory permit a reasonable matching of revenues and costs. Under inflationary conditions, however, FIFO or average cost results in including in income for the year an “unrealized inventory profit" when lower beginning-of-the-year costs, rather than higher current replacement costs, are matched with current revenues. Under such circumstances, many companies have elected to use the LIFO method of inventory costing, which charges higher current costs against higher current revenues. One aspect of inventory accounting is that the method that achieves a better matching of cost and revenue in the income statement may not produce the most realistic balance sheet. For example, in an inflationary period LIFO puts current cost in the income statement and leaves earlier costs in the balance sheet, while FIFO would put more current costs in the balance sheet. The Government's Cost Accounting Standards Board permits any of the three alternatives. The SEC has given particular consideration to the disclosure of information about inventory values in ASR 151 and ASR 190 without, however, eliminating any of the acceptable inventory methods. 9. Accounting for discounts Grady noted in 1965 two existing accounting practices for cash discounts on sales: discounts may be recognized either at the time of sale or at the time of collection. Discounts are among the numerous types of transactions that have not been dealt with to any degree in recent accounting literature. This is probably because the timing of recognition of discounts taken on repetitive transactions makes little difference in financial statements. Also, in terms of accounting for discounts, the potential for what the Study calls "creative accounting" is almost nil because one method must be used consistently. E-6 10. Fixed asset acquisition Grady's 1965 survey states that acquired properties may be recorded at: 1. cost 2. appraisal amounts 3. original cost to first owner using them for utility purposes, in the case of public utilities, and 4. book value to previous owner in business combinations accounted for as poolings of interests. As with many of the practices tabulated by the Study, those four methods are not true "alternatives" because each particular method applies to a different type of transaction. Except where special circumstances require a different treatment, acquired properties are recorded at cost. (Method 1). Although in the early part of this century there were examples of write-ups to appraised values (Method 2), this procedure was generally eliminated by APB Opinion No. 6. Today, appraisal values are used only to allocate the total cost paid to acquire a group of assets among the various assets acquired. Method 3 describes an accounting practice required by most public utility regulatory authorities and is unique to public utilities. Finally, Method 4 describes the accounting treatment required for assets obtained in a business combination that meets specified criteria to be accounted for as a pooling of interests. Accounting for business combinations is currently on the FASB's technical agenda. 11. Fixed asset construction Grady's 1965 inventory shows constructed properties recorded at: 1. direct costs only 2. direct costs plus partial overhead costs 3. direct costs plus all overhead costs, including interest on all funds used in the construction (funds from equity sources as well as debt). The three methods listed usually apply to three different types of relationships between a company's construction activities and its main business activities. The relationship of construction to main activities can vary widely among companies, of course, as can the involvement of executive and other overhead personnel. A company that uses employees normally employed in its principal business activity in occasional construction may charge the project only with direct costs and not with a part of the overhead that would be incurred in any event. A company that has more frequent selfconstruction activities will usually have assigned to such work more or less continuously a certain number of people from the overhead pool-engineers, draftsmen, etc.—and may assign a portion of the overhead to the construction project. (Method No. 2). Finally, the "full costing" of construction projects (Method 3) exists largely in the area of regulated utilities where regulatory commissions prescribe accounting methods and permit such costs to be included in the utility's rate base. The practice of capitalizing interest during construction is one of general concern within the profession and is currently one of the topics on the FASB's technical agenda. Pending resolution of this issue by the FASB, the SEC, in its Accounting Series Release 163. prohibited the use of this method to those who had not used it consistently in the past. 12. Development costs in extractive industries Grady cited in 1965 three methods of accounting for the development costs of extractive industries: 1. capitalized and allocated to future production through depletion charges 2. capitalized but not charged to future income statements (certain mining enterprises) 3. capitalized in part and the remaining part charged to expense currently; the portion capitalized is allocated to future production through depletion charges. Accounting for exploration and development costs in the extractive industries is on the FASB's technical agenda. In this regard, the FASB recently issued a Discussion Memorandum (December 23, 1976), “Analysis of Issues Related to Financial Accounting and Reporting in the Extractive Industries", specifically addressing this and other problems relating to accounting for extractive enterprises. THE STUDY'S “42 ALTERNATIVES” IN 1977 The following table summarizes the current status of the “42 alternatives" tabulated in the Study: In summary, if current accounting principles are applied to the Study's 1965 table, it is apparent that, on an issue by issue basis, only 10 may be alternative practices. Of these, 2 are currently under study by the FASB in its Extractive Industries project, and of the remaining 8, the 6 dealing with depreciation and inventories are accepted for government contract costing purposes by the Cost Accounting Standards Board. Senator METCALF. Thank you for your statement. TESTIMONY OF ALVA 0. WAY III, VICE PRESIDENT OF FINANCE, GENERAL ELECTRIC CORP., AND CHAIRMAN, COMMITTEE ON GOVERNMENT RELATIONS OF FAF BOARD OF TRUSTEES Mr. WAY. Mr. Chairman, I am pleased to have this opportunity to appear on behalf of the Financial Accounting Foundation. In the interest of saving the committee's time, I should like to submit my full statement. Senator METCALF. Without objection, the statement will be included. in the record as if read at the conclusion of your testimony. We will be glad to have your summary, if it is not longer than your statement. Mr. WAY. I am not here to comment on the staff study; rather, I plan to address some of the concerns expressed in the staff study as they apply to the foundation and the standards board. Let me say at the outset, that the trustees will consider separately the issues raised by the staff study and these hearings. I will limit my statement today to four matters: The role of the foundation, the independence of the FASB, the importance and desirability of accounting standard-setting remaining in the private sector, and the commitment of the foundation to the continuing improvement in the operations of the FASB. The foundation was established in 1973. It is governed by a board of trustees nominated by organizations representing over 235.000 members having special expertise in financial accounting and reporting matters. The principal duties of the 11 trustees are (1) to appoint members to the FASB and to a public advisory board, the financial accounting standards advisory council, (2) to raise funds to support these organizations; and (3) to review periodically the basic structure of the standard-setting organization. The trustees of the foundation are expressly prohibited from interfering with the FASB with respect to its functions in setting accounting standards. As a trustee, I can personally attest to the fact that the trustees have not interfered in the professional work of the board in setting standards. Moreover, I can assure you that the foundation itself is not dominated by any group or interest. The trustees of the foundation unanimously and strongly agree that the setting of accounting standards for publicly owned corporations should remain in the private sector with continuing review and participation by the SEC. In the first place, a direct takeover of standard-setting by the Federal Government would seriously disrupt the progress which is being made and would result in delay while a new system was being developed and launched. Also, there could be a substantial reduction of the significant voluntary efforts which have characterized the commitment of the accounting profession, business and the financial community, and academicians. Furthermore, Government might no longer benefit from the costs now absorbed by the private sector and a new |