Wealth and Value Added

Wealth and Value Added: Reporting, Analysis, Prediction, and Taxation

Ahmed Riahi-Belkaoui

Copyright © 2010 Ahmed Riahi-Belkaoui All rights reserved. ISBN: 1450511600 ISBN-13: 9781450511605

Introduction Wealth is an abundance of valuable resources or material possessions. Changes in wealth are sought as resources or possessions are used for productive purposes. The measurement of these changes in wealth is generally considered to be the accounting profit, computed as the difference between the realized revenues and corresponding costs. The theory is that the profit does measure the changes in wealth that accrue and may be distributed to shareholders. The reality is that the shareholders are not the only stakeholders of the firm. Other stakeholders include labor, bondholders, government and society. The measurement of wealth that is created then distributed to all these stakeholders is measured only by the value added concept. It is a more accurate measure of the total wealth of the firm as shown in Chapter 1, and a more useful basis for financial analysis as shown in Chapter 2, for reporting under different price change models as shown in Chapter 3, for behavioral effects as shown in Chapter 4, for a basis for taxation in Chapter 5, and for event prediction and explanation as shown in Chapter 6.

iii

Chapter 1. 1.Wealth and Value Added Reporting

1.1. INTRODUCTION The focus on the measurement of wealth, according to generally accepted accounting principles, is on income measurement. The rationale behind the focus stems from the belief that the purpose of accounting is to inform the owner—the shareholder— of the wealth in income accruing to him as a result of the business activities of the firm. Value added reporting takes a different view from generally accepted accounting principles by arguing that (a) it is the value added, rather than profit, that is the real wealth of the firm, and (b) it is the whole production team, rather than just a shareholder, that is the beneficiary of such wealth. Therefore, value added reporting differs from conventional accounting by a focus on value added measurement as wealth measurement and value added distribution as wealth distribution. Value added reporting is an easy concept as it relies on the same data and measurement techniques used and advocated 1


by generally accepted accounting principles. Its disclosure is therefore far from costly to the typical firm. It only takes a commitment to the “social” impact of accounting to justify the measurement and disclosure of value added information in a value added report. The popularity of the value added report is increasing internationally in both practice and research. Accordingly, the present chapter attempts to explicate the origin, nature, and usefulness of the value added report. 1.2. THE DEBATE ON THE VALUE ADDED CONCEPT The value reporting issue has been a continuous subject of debate in the international accounting literature. Its popularity rose in most European countries starting in the 1970s. What followed in the United Kingdom was an increased interest by the professional accounting institutes. Suggestions for its inclusion in U.S. companies’ annual reports have frequently been made. Such suggestions can be traced as far back as the eighteenth century and from as influential a source as the U.S. Treasury. The value added concept was given serious attention in the late 1970s in various European countries. It reached great popularity in the United Kingdom with the publication of the Corporate Report, a discussion paper published by the Accounting Standards Steering Committee (now the Accounting Standard Committee) in August 1975.1 2

Wealth and Value Added

It recommended, among other things, a statement of value added showing how the benefits of the efforts of an enterprise are shared by employees, providers of capital, the state, and reinvestment. The rationale for the value added statement is contained in the following paragraphs: 6.7 The simplest and most immediate way of putting profit into proper perspective vis-à-vis the whole enterprise as a collective effort by capital, management and employees is by presentation of a statement of value added (that is, sales income less materials and services purchased). Value added (that is, sales income less materials and services purchased) is the wealth the reporting entity has been able to create by its own and its employees’ efforts. This statement would show how value added has been used to pay those contributing to its creation. It usefully elaborates on the profit and loss account, and in time may come to be regarded as a preferable way of describing performance.2 6.10 The statement of value added provides a useful measure to help in gauging performance and activity. The figure of value added can be a pointer to the net output of the firm, and by relating other key 3


figures (for example, capital employed and employee costs) significant indicators of performance may be obtained.3 The recommendation was obviously accepted; one of the legislative proposals contained in the 1977 U.K. government report The Future of Company Reports was for a statement of value added.4 What followed was an increasing number of companies each year producing value added statements. One survey reported in 1980 that more than one-fifth of the largest U.K. companies disclosed value added statements.5 The growth of value added reporting was helped by trade union support of the concept. A document produced by one of the trade unions stated, “The Federation therefore aims to encourage the use of the added value as a discipline, so that all managers, with or without experience of accounting practices, will appreciate the financial environment within which decisions affecting manpower are taken.”6 To the labor movement, the value added report was deemed a good vehicle for information disclosure and a basis for determining wages and rewards—what is termed value added incentive payment scheme (VAIPS).7 In addition to these uses, Stuart Burchell, Colin Clubb, and Anthony Hopwood8 mention its occasional use in the context of the performance of British industry,9 in reforming 4


company-wide profit-sharing schemes,10 and in facilitating financial performance analysis.11 Aware of these developments, the Institute of Chartered Accountants in England and Wales,12 the Institute of Chartered Accountants of Scotland,13 the Institute of Cost and Management Accountants,14 and the Association of Certified Accountants15 produced research reports on the value added concept. 1.3. COMPUTING THE VALUE ADDED The value added statement may be conceived as a modified version of the income statement. Consequently, it can be derived from the income statement as follows: Step 1. The income statement computes retained earnings as a difference between sales revenue, on one hand, and costs, taxes, and dividends on the other hand. R = S – B – DP – W – I – DD – T (1) Where R = retained earnings S = sales revenue B = bought-in materials and services DP = depreciation W = wages I = interest DD = dividends T = taxes

5


Step 2. The value added equation can be obtained by rearranging the profit equation as R – B = W + 1 + DP + DD + T + R (2) or S – B – DP = W + 1 + DD + T + R (3) Equation (2) expresses the gross value added method. Equation (3) expresses the net value added method (see Exhibit 1.1). In both cases, the left part of the equation shows the value added among the groups involved in the managerial production team (the workers, the shareholders, the bondholders, and the government). The righthand side is also known as the additive method and the left-hand side the subtractive method.

6


Exhibit 1.1 Statement of Value Added Suggested in the Corporate Report

£

Turnover Bought-in Materials and Services Value Added

XX XX £XXX

Applied the following way to Pay Employees’ Wages, Pensions and F. Benefits

XX

To Pay Providers of Capital Interest X Dividends to Shareholders X

XX

To Pay Government Corporate Tax Payable

XX

To Provide for Maintenance and Expansion of Assets Depreciation X Returned Profits X Value Added XX £XXX

7


Exhibit 1.2 shows the value added statement can be derived from a regular income statement. The company in this example deducted boughtin materials, services, and depreciation from sales to arrive at a value added of $1,120,000. The $1,120,000 was divided among the team of workers ($400,000), the shareholders ($100,000), bondholders and creditors ($120,000), and the government ($300,000), leaving $200,000 for retained earnings. Because of the options available to present the value added statement on either the gross or net format, the relative merits of each need to be appraised. The gross value added format was the only one suggested by The Corporate Report, which may explain its popularity. In addition, various other reasons may be advanced in its favor. Morley suggests as reasons the flexibility and subjectivity involved in the computation of depreciation, the availability of the total amount available in a given year for reinvestment (namely depreciation), and retained earnings, and the congruence with the economists’ views and preferences for gross measures of national income.16 The net value added format, as expressed in equation (3), also has some merits worth considering: 1. It has a better connotation for wealth creation ready for distribution than the gross value method. 8


The gross value method is overstated by depreciation as measure of wealth creation, and its total distribution may lead to asset depletion. The net value added is distributable; the gross value added is not. 2. It provides a fairer base to determine productivity bonuses for workers than the gross value method given the allowance it makes for capital changes. 3. It conforms to accounting principles of consistency and matching. 4. It eliminates some double-counting by deducting depreciation when the asset exchange between two firms is a depreciable fixed asset.17 5. It appears to be more congruent with the notion of a return to the team of workers, capital providers, and the government. There will be an improvement in team spirit within the company.18

9


Exhibit 1.2 Deriving the Value Added Statement A. The conventional income statement of a company for 1928 was Sales $2,000,000 Less: Materials Used $200,000 Wages 400,000 Services Purchased 600,000 Interest Paid 120,000 Depreciation 80,000 Profit Before Tax 600,000 Income tax (assume a 50% tax rate) 300,000 Profit After Tax 300,000 Less Dividend Payable 100,000 Retained Earnings for the Year 200,000 B. A value-added statement for the same year would be Sales Less: Bought-in Materials and $2,000,000 Services and Depreciation Value Added Available 880,000 for Distribution or Retention Applied as Follows 1,120,000 To Employees To Providers of Capital $400,000 Interest $120,000 Dividends 100,000 To Government Retained Earnings 300,000 Value Added 200,000 1,120,000

10


While the treatment of some items is obviously defined by the value added equations (2) and (3) cited earlier, some other items have been the subject of various statements. These include nontrading credits (those revenues not arising out of a firm’s own manufacturing or trading activities) and extraordinary gains and losses. While revenues (referring to operating revenues) and bought-in materials and services are subjected to a unique treatment, the nonoperating revenues (also labeled nontrading credits) have been treated as follows: 1. U nderstatement of input costs. If it is accepted that nontrading credits do not represent the organization’s own value added, this treatment effectively overstates value added. 2. P resentation as a separately disclosed addition to value added calculated by subtractive method. 3. N etting against an application of value added. If it is accepted that nontrading credits do not represent the organization’s own value added, this measure yields a proper measure of the organization’s value added but understates the total value added.

11


4. P resentation as a separately disclosed deduction from value added calculated by the additive method. 5. E limination from the statement entirely. This treatment poses the problem of determining what application is to be matched with the credit as the statement of value added (SVA), so that the amount of the applications included in the SVA is reduced; the solution is invariably retained profit.19 The extraordinary gains and losses also pose a problem because each item has a different impact on value added. The best treatment for an extraordinary credit depends on the nature of the income or gain, or whether value can be said to be added by it. The same applies to extraordinary losses.20 This potentially leads to a diversity of treatments and lack of comparability. The Corporate Report did not make things easier by recognizing many of the problems associated with the presentation of profit and loss accounts; for example, the treatment of extraordinary profits and losses.21 There is a need for more experimentation before final accounting policy is enacted on all the issues subject to diverse treatments … although not everyone agrees. There are also some possible misconceptions. One is that value added 12


could not be prepared in the service industry because no tangible wealth is created. Nevertheless, services are considered as valuable today as any tangible product, and a value added statement can be easily prepared for a company in a service industry. Another misconception concerns the relationship between the value added statement and value added taxation. Although both are based on the concept of deducting input costs from sales, they can and do exist separately. 1.4. THE CASE FOR VALUE ADDED REPORTING Value added refers to the increase in wealth resulting from the use of the firm’s resources before its distribution to the members of the production team; namely, the shareholders, the bondholders, the workers, and the government. Basically, while profit, as computed according to the generally accepted accounting practices, is only distributable to the shareholders, value added is distributable as a total return to the whole team of workers, shareholders, bondholders, and government. It is, therefore, the true measure of the wealth of a firm. It has been defined as the “net output” of a firm; i.e., the difference between the total value of its output and the value of the corresponding inputs.22 It is basically a measure of the wealth generated by a firm during a period before distribution. 13


Various rationales may be advanced to justify the use of value added as a measure of wealth, and value added reporting as a form of a reporting and disclosure accounting system. The Corporate Report identifies the following user groups: a. The equity investor group, including existing and potential shareholders and holders of convertible securities, options, or warrants. b. The loan creditor group, including existing and potential holders of debentures and loan stock, and providers of short-term secured and unsecured loans and finance. c. The employee group, including existing, potential, and past employees. d. The analyst-advisor group, including financial analysts and journalists, economists, statisticians, researchers, trade unions, stockholders, and other providers of advisory services such as credit rating agencies. e. The business contact group, including customers, trade creditors, and suppliers; and, in a different sense, competitors, business rivals, and those interested in mergers, amalgamations, and takeovers. f. The government, including tax authorities, departments and agencies concerned with the 14


supervision of commerce and industry, and local authorities. g. The public, including taxpayers, ratepayers, consumers, and other community and special interest groups, such as political parties, consumer and environmental protection societies, and regional pressure groups.23 All these potential users have specific useful value added information. Each of these users will value better decisions relying on value added rather than profit as a measure of wealth. If they need to use profit as a decision variable, they can derive it as the proportion of value added that has been deemed distributable to the shareholders. The same conclusion is reached by Gray and Maunders as they identify the following numbers of possible direct users of value added information: 1. for the prediction of “managerial efficiency”; 2. f or the evaluation of “relative equity” among shareholders within companies; 3. a s an indicator of the “ability to pay in relation to productivity bargaining”; and, 4. a s a basis for evaluating the “social performance” of a company.24 15


A second rationale provided for the use of value added reporting stems from the economist’s use of the value added concept in the measurement of national income. Richard Ruggles and Nancy D. Ruggles describe the rationale for the economist’s model of value added as follows: The value added by a firm—i.e., the value created by the activities of the firm and its employees—can be measured by the difference between the market value of the goods that have been turned out by the firm and the cost of those goods and materials purchased from other producers. This measure will exclude the contribution made by other producers of the total value of the firm’s production so that it is essentially equal to the market value created by this firm. The value added measure assesses the net contribution made by each firm to the total value of production by adding all of those contributions; therefore, it is possible to arrive at a total for the whole economy that will represent the market value of production.25 Basically, the adoption of value added reporting by a firm makes the determination of the gross natural product a little easier through an aggregation of the value added of all firms in the economy. 16


It would constitute the beginning of an integration of financial accounting to macroeconomic accounting. This assumes that, other things being equal, the value added model is additive in the sense that individual measures for the firm may be summed up to equal aggregate value added. In fact, before such integration of financial accounting and macroeconomic accounting is made possible, various differences between the value added as measured by the accountant and as measured by the economist need to be corrected. Examples of differences include the following: 1. T he economist includes value added in the public sector; for example, he assumes the value added by our defense expenditure is exactly equal to its cost. 2. T he economist concentrates on production rather than sales. 3. T he economist makes rough-and-ready adjustments to his stock-building figure to allow for stock appreciation. 4. T he economist is satisfied with broad aggregate approximations to reflect depreciation; for example, when reducing gross national product (GNP) to net national product. 17


5. T he economist does not bother to reflect some types of depreciation—for example, on consumer durables. 6. T he economist, in measuring the GNP of the United Kingdom, naturally excludes value added overseas. 7. T he economist seeks to adjust value added to reflect the notional value of transfers of value “in kind.”26 A third rationale stems from the nature of the company’s objectives. If the company’s objective remains the maximization of shareholders’ return, then the focus will remain the profit of the firm. But if the company’s objective shifts to a consideration of the welfare of the total production team, then the focus will shift to the value added or total return of the firm. The generally more progressive atmosphere surrounding the business environment puts the focus on all the partners rather than simply on the shareholders. The value added as a measure of total return, is, therefore, more useful as a measure of the return due to all the partners: the shareholders, the bondholders, the workers, and the government. The exact rationale is that the accounting indicator of performance to be provided should be the total return to the team of workers and capital providers rather than merely 18


to the shareholders. The new responsibility of the firm shifts from the shareholders to the total cooperating team of workers, investors, and government. The measurement and disclosure of “value added” per se will generate the new spirit of cooperation between the workers, the investors, government, and a new responsibility of the economic entities to all the members of the production team. The new responsibility may make the distribution of the value added fairer, taking into account each individual contribution as a basis for the distribution. A final rational stems from social changes that require adjustments in financial reporting. With government as representative of society and labor taking a more powerful role in its demands, the importance of shareholders has slightly diminished, leading to a reduction in the importance of profit; social change dictates a production and disclosure of value added to meet the needs of government and labor.27 A question arises over whether value added is a determining factor in the process of social change. Three different views may be stated on the subjects: 1. O ne might report value added in order to hurry the change along and to give impetus to the movement of power from capital owners toward labor and central government. 19


2. O ne might report value added in order to alert the business community to this change, hoping that it may thereby be reversed. 3. O ne might report value added in the hope that it would help one’s new masters to make sensible decisions.28 These three attitudes may explain why value added enthusiasts can be found at both ends of the political spectrum. Those on both the left and the right support this new statement, although their expectations of it differ greatly.29 1.5. ADVANTAGES AND DISADVANTAGES OF VALUE ADDED REPORTING The descriptive and professional literature has focused on the advantages and disadvantages of reporting a value added statement. These evaluations are based on comparisons to the conventional reporting model, which is limited to disclosure of a balance sheet, income statement, and a statement of cash flows. Some of the most cited advantages include: 1. Labor Organizing. Value added reporting produces a good organizational climate for labor

20


by highlighting its contribution to the final result of the firm. 2. Productivity Bonus Measurement. Value added reporting provides a more practical way of introducing productivity bonus increases, and links rewards to changes in the value added amounts. 3. Explanatory/Predictive Power. Value addedbased ratios can be more useful in explaining and/or predicting economic events of importance to the firm. 4. National Income Measurement. Value added reporting is more congruent with concepts used to measure national income and creates a useful link to the macroeconomic data and techniques used by economists. 5. Size/Importance Proxy. Value added reporting acts as a better measure of the size and importance of the firm than sales or capital. 6. Labor Negotiations. Value added reporting may be more useful than conventional statements to employee groups since it could affect aspirations, particularly those of its negotiating representatives. 21


7. Investor’s Predictions. Value added reporting is useful to equity investors as a tool for the prediction of earnings, expected returns, and total risks associated with securities. 8. Economic Development Measurement. The inclusion of a local value added statement in the host country annual reports of multinationals would provide information to analyze the contributions of these firms to the process of national economic development. 9. Performance Measurement. Net value added is a better index of performance than net profit, especially in cases where arbitrary and incorrigible accounting techniques result in recognition of an accounting loss rather than an accounting profit. 10. Better Proxy. Value added-based ratio analysis may provide a better index for the measurement of managerial efficiency and vertical integration. Some of the most cited limitations are as follows: 1. False Assumptions. Value added relies on false assumptions including: (a) a firm is a team of 22


cooperating groups, (b) the government is a legitimate group, and (c) all legitimate member groups have been included. 2. Possible Confusion. Value added statement may lead to confusion, especially in cases where wealth (as measured by value added) is increasing while earnings or other value added components are decreasing. 3. Possible Management Misdirection. The inclusion of the value added statement may wrongly lead management to pursue maximization of firm’s value added. 4. Fallacies. The naïve approach to the interpretation of a firm’s value added statement can crease the following five fallacies: a. “Increasing value added must increase profits.” b. “Increasing value added per unit of labour must benefit shareholders.” c. “It is possible to identify in advance an equitable distribution of changes in value added.” d. “A relatively high value added per unit of labour represents a superior economic performance.” 23


e. “A labour force taking a high proportion of value added does not deserve even high wages.”30 5. Misconceptions. A number of misconceptions are held for value added reporting.31 First, value added is different from profit. Profit measures the return accrued to the shareholders; value added measures the wealth accrued to those who participated in the entity: the employees, the providers of loan capital and risk capital, together with the government. Second, the value added statement is wrongly assumed to deal with the administration of value added tax. Value added taxation and value added reporting are not the same. In the British case, for example, various modifications are needed to create a correspondence between value added tax (VAT) and value added reporting because (a) productions of certain goods and services are zero rated or exempt for VAT purposes, (b) value added outside the United Kingdom is not liable to VAT whilst the value added reported by a large U.K. group will usually incorporate the results of overseas subscriptions and branches, (c) the concept of depreciation of fixed 24


assets does not apply to VAT as the taxpayer pays all the VAT when he buys the long-lived assets, and (d) the headings for bought-in items in the value added statement include goods and services used, while VAT is levied as these goods are purchased.32 Third, value added as computed by an accountant is different from that computed by an economist. Economists add the value added of all firms in the economy, including value added in the public sector, concentrating on production rather than sales, and making sweeping generalizations to arrive at aggregate value added figures for regions, industries, and nations. Finally, value added is preferable for manufacturing, as well as service-oriented firms. 6. Suggestions for a more useful value added statement. Various suggestions have been made in the literature for the determination of a more useful value added statement. For example, Gray and Maunders offered the following main conclusions and suggestions as a contribution to the debate concerning the development of a more useful value added statement.

25


a. The measurement of value added on a production rather than a sales basis appears desirable and worthy of experiment. b. Value added should be measured and disclosed on both a gross and net basis if it is to serve a wide range of uses. Depreciation should not be treated as a distribution of value added. c. Inflation adjustments are necessary if net value added is to be meaningful. d. Nonoperating items should be disclosed separately below the calculation of value added. They should not be excluded from the value added statement. There is a pressing need for a more comprehensive and systematic approach to disclosure and presentation. e. The segmentation of the value added statement is desirable and at the least should involve a geographical segmentation between the United Kingdom and overseas activities of the firm. f. The disclosure of relative shares in the distribution of value added should be made on a more systematic basis. The share of employees and government should be disclosed on the basis of amounts actually payable. In the case of shareholders, the amount of profit attributable,

26


as well as payable in the form of dividends, should be disclosed in their share.33 1.6. CONCLUSIONS Value added reporting, even though not always mandated, is becoming increasingly popular in Europe, South Africa, Australia, and Singapore. This adoption reflects a greater concern for the public interest and for what may be perceived as socioeconomic accounting. The greater concern for the rights and opportunities of individuals in the United States and Canada has not yet resulted in a favorable climate for the adoption of value added reporting. As accounting becomes more and more actively and explicitly recognized as an instrument of social management and change, value added reporting will constitute the intertwining of the accounting and the social because, unlike conventional reporting, it reveals something about the social character of production. The clear massage conveyed by value added reporting is that the wealth created in production is the result of the combined effort of a team of cooperating members.

27


NOTES 1. Accounting Standards Steering Committee, The Corporate Report (London: Accounting Standards Steering Committee, 1975), 48. 2. Ibid. 3. Ibid. 4. Department of Trade, The Future of Company Reports (London: HMSO, 1977), 7–8. 5. S. J. Gray and K. T. Maunders, Value Added Reporting: Uses and Measurement (London: Association of Certified Accountants, June 1980). 6. Engineering Employers Federation, Business Performance and Industrial Rela-tions (London: Koan Page, 1977). 7. M. Woodmansay, Added Value: An Introduction to Productivity Schemes (London: British Institute of Management, 1978). 8. S. Burchell, C. Clubb, and A. G. Hopwood, “Accounting and Its Social Context: Towards History of Value Added in the United Kingdom,” Accounting, Organizations and Society 10, no. 4 (1985): 387. 9. F. C. Jones, The Economic Ingredients of Industrial Success (London: James Clayton lecture, Institution of Mechanical Engineers, 1976). 10. S. Cameron, “Added Value Plan for Distributing ICI’s Wealth,” Financial Times (January 7, 1977).

28


11. T. Vickers da Costa, “Testing for Success,” mimeo (London, 1979). 12. M. Renshall, R. Allan, and K. Nicholson, Added Value in External Financial Reporting (London: Institute of Certified Accountants in England and Wales, 1979). 13. M. F. Morley, The Value Added Statement (London: Gee & Co., 1978). 14. B. Cox, Value Added: An Application for the Accountant Concerned with Industry (London: Heinemann, 1971). 15. Gray and Maunders, Value Added Reporting, 15. 16. M. F. Morley, “The Value Added Statement in Britain: The Accounting Review (May, 1979): 626. 17. Ibid. 18. M. F. Morley, “The Value Added Statement: A British Innovation,” Chart and Accountant Magazine (May 1978): 33. 19. B. A. Rutherford, “Published Statements of Value Added: A Survey of Three Years’ Experience,” Accounting and Business Research (Winter 1980): 23. 20. Morley, The Value Added Statement, 87. 21. Accounting Standards Steering Committee, Corporate Report, 50. 22. S. J. Gray and K. T. Maunders, Value Added Reporting: Uses and Measurement (London: The Association of Certified Accountants, June 1980), 1.

29


23. Accounting Standards (Steering) Committee, Corporate Report, A discussion paper (July 1975), 17. 24. Gray and Maunders, Value Added Reporting: Uses and Management, 17. 25. R. Ruggles and N. D. Ruggles, National Income Accounts and Income Analysis, 2d ed. (New York: McGraw-Hill, 1965), 50. 26. Michael F. Morley, The Value Added Statement: A Review of the Use in Corporate Reports (London: Gee & Co., 1978), 16–17. 27. Morley, The Value Added Statement, 3. 28. Ibid., 5–6. 29. Ibid., 19. 30. B. A. Rutherford, “Five Fallacies about Value Added.” Management Accounting (September 1981): 31–33. 31. Morley, The Value Added Statement, 15–18. 32. Ibid., 15–16. 33. Gray and Maunders, Value Added Reporting: Uses and Management, 37.

30


REFERENCES Accounting Standards Steering Committee. The Corporate Report. London: Accounting Standards Steering Committee, 1975. American Accounting Association. “Committee on Accounting and Auditing Measurement, 1989–1990.” Accounting Horizons (September 1991): 81–105. Askren, Barbara J., Bannister, J. W., and Palik, E. “The Impact of Performance Plan Adoption on Value-Added and Earnings.” Managerial Finance 20, no. 9 (1994): 27–43. Ball, R. J. “The Use of Value Added in Measuring Efficiency.” Business Ratios (Summer 1968): 5–11. Bannister, James W., and Riahi-Belkaoui, Ahmed. “Value Added and Corporate Control in the U.S.” Journal of International Financial Management and Accounting (Autumn 1991): 241–257. Bao, Ben-Hsien, and Bao, Da-Hsien. “The Time Series Behavior and Predictive Ability Results of Value Added Data.” Journal of Business Finance and Accounting (April 1996): 449–460. Barlev, Benzion, and Levy, Haim. “On the Variability of Accounting Numbers.” Journal of Accounting Research (Autumn 1979): 305–315. Belkaoui, Ahmed. “The Entropy Law, Information Decomposition Measures and Corporate 31


Takeovers.” Journal of Business Finance and Accounting (Fall 1976): 45–57. _______. “Financial Ratios as Predictors of Canadian Takeovers.” Journal of Business Finance and Accounting (Spring 1978): 93–107. Burchell, Stuart, Clubb, Colin, and Hopwood, Anthony. “Accounting and Its Social Context: Towards a History of Value Added in the United Kingdom.” Accounting, Organizations and Society 10 (1985): 381–413. Chua, K. C. “The Use of Value Added in Productivity Measurement.” In Productivity Measurement and Achievement: Proceedings of Accountancy. Victoria: University of Wellington, 1977. Cox, Bernard. Value Added: An Application for the Accountant Concerned with Industry. London: Heinemann, 1978. Cruns, R. P. “Added-Value: The Roots Run Deep into Colonial and Early America.” Accounting Historian Journal (Fall 1982): 25–42. Cubbins, J., and Leach, D. “The Effect of Shareholder Dispersion on the Degree of Control in British Companies: Theory and Measurement.” Economic Journal 3 (1983): 351–369. Deegan, C., and Hallman, A. “The Voluntary Presentation of Value Added Statements in Australia: A Political Cost Perspective.” Accounting and Finance (May 1991): 1–29.

32


Dewhurst, James. “Assessing Business Performance.” Accountant (March 3, 1983): 17–18. Easton, P. D., and Harris, T. S. “Earnings as an Explanatory Variable for Returns.” Journal of Accounting Research (Spring 1991): 19–36. Egginton, D. A. “In Defense of Profit Measurement: Some Limitations of Cash Flow and Value Added Data as Performance Measures for External Reporting.” Accounting and Business Research (Spring 1984): 32–43. Financial Accounting Standards Board. Statement of Financial Accounting Concepts No. 5: Recognition and Measurement in Financial Statements of Business Enterprises. Stamford CT: FASB, 1984. Foley, B. J., and Maunders, K. T. Accounting Information Disclosure and Collective Bargaining. London: Macmillan, 1977. Gilchrist, R. R. Managing for Profit: The Value Added Concept. London: Allen and Unwin, 1971. Gray, Sidney. Value Added Reporting: Uses and Measurement. London: Association of Certified Accountants, 1980. Gray, Sidney, and Maunders, K. T. “Recent Development in Value Added Disclosures.” Certified Accountant (August 1979): 255–256. Harris, G. J. “Value Added Statements.” The Australian Accountant (May 1982): 261–264.

33


Hill, C. W., and Snell, S. A. “Effects of Ownership Structure and Control on Corporate Productivity.” Academy of Management Journal 32 (1989): 25–46. Hoskisson, R. E. “Multidivisional Structure and Performance: The Contingency of Diversification Strategy.” Academy of Management Journal 2 (1987): 625–644. Ismail, B. E., and Kim, M. K. “On the Association of Cash Flow Variables with Market Risk: Further Evidence.” The Accounting Review (January 1989): 125–136. Karpik, P., and Belkaoui, Ahmed. “The Relative Relationship between Systematic Risk and Value Added Variables.” Journal of International Financial Management and Accounting (Autumn 1989): 259–276. Karpik, P., and Riahi-Belkaoui, Ahmed. “The Effects of the Implementation of the Multi-divisional Structure on Shareholders’ Wealth: The Contingency of Diversification Strategy.” Journal of Business Finance and Accounting (April 1994): 349–366. Lev, B., and Ohlson, J. A. “Market Based Empirical Research: A Review, Interpretation and Extension.” Journal of Accounting Research Supplement (1982): 239–322. Litzenberger, R. H., and Rao, C. W. “Estimates of the Marginal Rate of Time Preference and 34


Average Risk Aversion of Investors in Electronic Utility Shares: 1960–66.” Bell Journal of Economics and Management Science (Spring 1971): 265–277. Maunders, K. T. “The Decision Relevance of Value Added Reports.” In Frontiers of International Accounting: An Anthology, Frederick D. Choi and Gerhard G. Mueller (Eds.). Ann Arbor, MI: UMI Research Press, 1985: 225–245. McLead, Charles, C. “Use of Value Added.” Bests Review (January 1984): 80–84. McLeay, Stuart. “Value Added: A Comparative Study.” Accounting Organizations and Society 8, no. 1 (1983): 31–56. McSweeney, Brendan. “Irish Answer to Value Added Reports.” Frontiers of International Accounting: An Anthology, Frederick K. Choi and Gerhard G. Mueller (Eds.). Ann Arbor, Mich: UMI Research Press, 1985: 225–245. Meek, Gary K., and Gray, Sidney J. “The Value Added Statement: An Innovation for the U.S. Companies.” Accounting Horizons (June 1988): 73–81. Morck, R. A., Shleifer, A., and Vishny, R. W. “Management Ownership and Market Valuation: An Empirical Analysis.” Journal of Financial Economics 20 (1988): 293–315. Morley, M. F. “The Value Added Statement: A British Innovation.” The Chartered Accountant Magazine (May 1978): 31–34. 35


_______. “The Value Added Statement in Britain.” The Accounting Review (May 1979), 619–689. Morley, Michael F. “Value Added Reporting.” In Developments on Financial Reporting. Thomas A. Lee. (Ed.). London: Philip Allan, 1981: 251–269. _______. The Value Added Statement. London: Gee and Co. for the Institute of Chartered Accountants of Scotland, 1978. Ohlson, J. A. “Earnings, Book Value and Dividends in Security Valuation.” Contemporary Accounting Research (Spring 1995): 661–687. Pendrill, Davie. “Introducing a Newcomer: The Value Added Statement.” Accountancy (September 1981): 121–122. Rahman, M. Zubaidur. “The Local Value Added Statement: A Reporting Requirement for Multinationals in Developing Host Countries.” International Journal of Accounting (February 2, 1990): 87–98. Renshall, M., Allan, R., and Nicholson, D. Added Value in External Financial Reporting. London: Institute of Chartered Accountants in England and Wales, 1979. Riahi-Belkaoui, Ahmed. “Earnings-Return Versus Net Value-Added Returns Relations: The Case for Nonlinear Specification.” Advances in Quantitative Analysis in Finance and Accounting 4 (1996): 175–185. 36


_______. Handbook of Management Control Systems. Westport, CT: Greenwood Publishing, 1986. _______. “The Information Content of Value Added, Earnings, and Cash Flows: U.S. Evidence.” The International Journal of Accounting 28, no. 2 (1993): 140–146. _______. “Multidivisional Structure and Productivity: The Contingency of Diversification Strategy.” Journal of Business Finance and Accounting (June 1997): 615–627. _______. “Performance Plan Adoption and Performance: The Contingency of Ownership Structure.” Managerial Finance 23, no. 5 (1997): 18–27. _______. Performance Result of Value Added Reporting. Westport, CT: Greenwood Publishing, 1996. _______. Value Added Reporting: The Lessons for the U.S. Westport, CT: Greenwood Publishing, 1992. Riahi-Belkaoui, Ahmed, and Bannister, J. W. “Multidivisional Structure and Capital Structure: The Contingency of Diversification Strategy.” Managerial and Decision Economics 15 (1994): 267–276. Riahi-Belkaoui, Ahmed, and Fekrat, Ali. “The Magic in Value Added: Merits of Derived Accounting Indicator Numbers.” Managerial Finance 20, no. 9 (1994): 3–15. 37


Riahi-Belkaoui, Ahmed, and Pavlik, Ellen. “Asset Management Performance and Reputation Building for Large U.S. Firms.” British Journal of Management 2 (1991): 231–238. _______. “The Effect of Ownership Structure on Value Added Performance.” Managerial Finance 20, no. 9 (1994): 16–26. Riahi-Belkaoui, Ahmed, and Picur, D. Ronald, “Explaining Market Returns: Earnings Versus Value Added Data.” Managerial Finance 20, no. 9 (1994): 44–55. Rutherford, B. A. “Easing the CCA Transition in Value Added Statements.” Accountancy (May 1983), 121–22. _______. “Five Fallacies about Value Added.” Management Accountant (September 1981): 31–33. _______. “Published Statements of Value Added: A Survey of Three Years’ Experience.” Accounting and Business Review (Winter 1980): 15–28. _______. “Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems.” Accounting and Business Research (Summer 1972): 215–220. Sinha, Gokul. Value Added Income. Calcutta: Book World, 1983. Suojanan, W. W. “Accounting Today and the Large Corporation.” The Accounting Review (July 1954): 391–398. 38

Chapter 2. 2. Value Added-Based Financial Analysis

2.1 INTRODUCTION Financial analysts, managers, investors, and other users of accounting information rely on financial analysis in general, and ratio analysis in particular, to assess the financial position, performance, and conduct of firms. This analysis relies in general on conventional financial statements and/ or data bases that do not include value addedbased data. This chapter contrasts conventional financial analysis with value added-based financial analysis, with particular application to U.S. firms that have the necessary data to allow both analyses. 2.2 CONVENTIONAL ANALYSIS

FINANCIAL

STATEMENT

Conventional financial statement analysis is an information processing system used to provide relevant information for decision making. The main 39


source of information is the conventional published financial statement, including the balance sheet, the profit and loss statement, and the statement of cash flows. Basically, various accounts from the conventional published financial statements are evaluated in relation to each other to form performance indicators, which are then compared to established standards. These performance indicators, better known as ratios, constitute the main tool of conventional financial analysis. Some of these ratios are particularly popular in practice, while others are better known in academic research and writing for their predictive ability of economic events. 2.2.1 Role of Conventional Financial Statement Analysis The question of the role of financial statement analysis is important considering the theoretical and empirical evidence supporting the efficiency of the capital market. It is generally assumed that the securities market is efficient. A perfectly efficient market is in continuous equilibrium, so the intrinsic values of securities vibrate randomly, and market prices always equal underlying intrinsic values at every instant in time.1 Applied to the securities market, this assumption implies that market prices fully reflect all publicly available information, and, by implication, market prices 40

Value Added-Based Financial Analysis

react instantaneously and without bias to new information. Of the three levels of market efficiency, the semi-strong form is the most relevant to the role of financial statement analysis.2 The semi-strong form of the efficiency market hypothesis states that the equilibrium expected returns (price) “fully reflect” all publicly available information. In other words, no trading rule based on available information may be used to earn an excess return. The semi-strong form is most relevant to accounting because publicly available information includes financial statements. Tests of the semi-strong hypothesis have been concerned with the speed with which prices adjust to specific kinds of events: stock splits, announcements of annual earnings, large secondary offering of common stocks, new issues of stocks, announcements of changes in the discount rate, and stock dividends. The results again support the efficient market hypothesis in the sense that prices adjust rather quickly after the first public announcement of information. This brings to question again the role of financial analysis in such an efficient capital market. There is definitely a role for financial analysis in such a market. The first role results from the two findings that (1) accounting information and stock price movements are significantly associated, even when the effects of other information (e.g., dividend 41


announcements) are taken into account, and (2) accounting information appears to be able to assist in the assessment of prospective return and risk. Both findings imply that financial statements analysis may assist in making intelligent investment decisions. For this role to be possible, the financial statement analysis must be expertly and quickly done. Another role of financial statement analysis is to explain and predict economic events that may affect the firm and are not reflected in some capital market framework. Examples include bond ratings, bankruptcy, and takeover. The likelihood of these events requires a careful analysis of the financial, operating, and extraordinary dimensions of the firm. 2.2.2. Financial Ratios Financial analysis is designed to provide data to decision makers. It is intended to be flexible enough to assist different users. Financial analysis rests entirely on the use of financial ratios. Financial ratios are then compared to established standard ratios for the firm or other firms in the industry. If the comparison is with similar ratios for the firm over a number of years, the analysis is referred to as time-series analysis. If the comparison is with similar ratios for other firms over a certain number of years, the analysis is referred to as cross-sectional analysis. Whatever the type of analysis chosen, 42


ratio analysis is intended to evaluate important financial aspects of the firm that depict its financial strengths. Examples include liquidity, leverage, profitability, and turnover dimensions, which are examined next. They are classified into four major categories: (1) the firm’s ability to meet its short-term obligations, (2) the capital structure of the firm and its ability to meet its long-term obligations, (3) the profitability and efficiency resulting from the use of capital, and (4) the efficiency resulting from the operational use of its assets. 2.2.2.1 Liquidity Ratios

Liquidity ratios are used to assess the ability of the firm to meet its short-term financial obligations when and as they fall due. These ratios are of prime interest to short-term lenders. The current ratio may be expressed as: Current assets Current liabilities Current assets are composed mainly of cash, short-term marketable securities, accounts receivable, inventories, and prepaid expenses. Current liabilities are composed mainly of accounts payable, dividends, tax payable, and short-term bank loans. For a long time, the current ratio has been considered a good indicator of a firm’s liquidity. 43


It is, however, susceptible to manipulation intended to approximate a desirable current ratio. The quick ratio may be expressed as: Quick assets Current liabilities Quick assets are composed of cash, short-term marketable securities, and receivables. The quick ratio is intended to focus on immediate liquidity. Like the current ratio, it has been criticized for a failure to incorporate information about the timing and magnitude of future cash flows. The defensive interval measure is considered better than the current ratio and the quick ratio. It may be expressed as: Total defensive assets Projected daily operating expenditures The total defensive assets have been appropriately defined as follows: Defensive assets include cash, short-term marketable securities, and accounts receivable. Inventories are not included in the total, nor are current liabilities deducted from the total. The denominator includes all projected operating costs requiring the use of defensive assets. Ideally, this would be based 44


on the cash budget for the next year or shorter period. Since this information is unlikely to be available to external analysts, the total of operating expenses on the income statement for the prior period will usually serve as a basis for calculating the projected expenditures. The adjustments must be made to the total expense figure on that statement: (1) Depreciation, deferred taxes, and other expenses that do not utilize defensive assets must be subtracted. (2) Adjustments should be made for known changes in planned operations.3 Other measures of liquidity based on a fund flow concept include the ratio of net working capital to funds provided by operations, the ratio of funds provided from operations to current debt, and a liquidity index based on projected fund flows. Each of these fund-flow-based ratios reflects the idea that liquidity depends on the ability of liquid assets and cash inflows to cover the cash outflow by a material margin. A measure of future liquidity may be expressed as follows: the five-year cash flow as a percentage of five-year growth needs is equal to the fiveyear sum of (1) net income available for common stockholders, plus (2) depreciation and amortization, 45


plus (3) income from discontinued operations and extraordinary items net of taxes, divided by the five-year sum of (1) capital expenditures, plus (2) changes in inventories during the most recent five years, plus (3) common dividends. 2.2.2.2 Leverage/Capital Structure Ratios

Leverage ratios are used to assess the longterm solvency risk of the firm—that is, its ability to meet interest and principal payments on longterm obligations as they become due. These ratios are of prime interest to long-term lenders and bondholders. There are two possible debt-to-equity ratios: (1) long-term debt to equity, Long-term debt Shareholders’ equity and, (2) total debt to equity. Current liabilities + long-term debt Shareholders’ equity Both express the degree of leverage in the capital structure of the firm. They are also used as a measure of the financial risk associated with the firm’s common stock. 46


The times interest earned ratio may be expressed as: Net income (from continuing operations) before interest and income taxes Interest expense or Net income plus total interest (adjusted by tax rate) Interest expense (adjusted by tax rate) + preferred dividend requirement 2.2.2.3 Profitability Ratios

Profitability ratios portray the ability of the firm to use the capital committed by stockholders and lenders efficiently to generate revenues in excess of expenses. Consequently, these ratios are of interest to both stockholders and bondholders. The rate of return on assets, also known as the rate of return on investment (ROI), is computed, as follows: Net income + interest expense net of income tax savings + minority ROI = interest in earning Average total assets This ratio measures the efficient use of the assets by the firm to generate earnings. One way 47


to explain changes in ROI over time is to disaggregate the ratio as follows: ROI = Profit • assets turnover ratio or

ROI =

Net income + interest expense net of income savings + minority interest in earnings = Sales

Sales Average total assets

where the profit margin ratio reflects the firm’s ability to control the level of costs corresponding to the sales realized, and the assets turnover ratio corresponds to the ability to generate sales from the assets used. ROI may be improved by improving the profit margin ratio, or the assets turnover ratio, or both. The return on equity is computed as: Income available for common stockholders Common stockholders’ equity This ratio indicates how efficiently the capital supplied by the common stockholders was employed within the firm. Other examples of profitability ratios are: the expense to revenue ratio, the operating income 48


ratio ([sales – cost of goods sold – selling and administrative expenses]/sales), the earnings per share, the price-earnings ratio (market price of a common stock/earnings per share), the dividends to net income or pay-out ratio, and the operating income to operating assets ratio. 2.2.2.4 Turnover Ratios

Turnover or efficiency ratios are intended to convey various aspects of operational efficiency. They are generally computed on the basis of a sales figure in the numerator and the balance of an asset in the denominator. The total assets turnover ratio is one example of a turnover ratio. Inventory turnover is computed as: Cost of goods sold Average inventory It is used as an indicator of operational efficiency. Accounts receivable turnover is computed as: Sales Average (net) accounts receivable Dividing the accounts receivable turnover by 360 days yields the average collection period for accounts receivable. It is an indicator of the 49


efficiency of the collection efforts of accounts receivables. Plant assets turnover is computed as: Sales Average plant assets It is used as a measure of the relationship between sales and the plant assets used by the firm for its operations. 2.2.2.5 Other Ratios and Indexes

The main financial ratios already examined are summarized in Exhibit 4.1. Among other ratios that have gained some popularity in the financial analysis literature as potential explanatory and predictive indicators are the following: • To measure the firm’s relative cash position: (Cash + marketable securities)/ Current liabilities (cash + marketable securities)/Sales and (cash + marketable securities)/Total assets. • To measure the firm’s cash generating abilities: Working capital from operations/Sales, working capital from operations/Total assets, cash flow from operations/Sales and cash flow from operations/Total assets.

50


• To measure leverage: (Current liabilities + Long-term liabilities)/Shareholders’ equity. To measure debt service coverage: Cash flow from operating/Annual interest payments. 2.2.3 Shortcomings in Financial Analysis

Before using financial ratios, the rater and/or the analyst should be aware of their limitations. Financial statements serve as the primary source of data for computing ratios. Because of the flexibility in choosing among various generally accepted accounting principles, the ratios among firms may not be comparable unless appropriate adjustments are made to the financial statements. Moreover, comprehensive financial rates analysis is constrained by the lack of standard accepted computational rules. With the exception of computations of earnings per share, regulatory agencies have refrained from enacting or even suggesting guidelines. As a result, there is no consensus on the computational methodology of the ratios.

51


Exhibit 2.1 Summary of Main Financial Ratios RATIOS

NUMERATOR

DENOMINATOR

Current

Current assets

Current liabilities

Quick

Quick assets

Current liabilities

Defensive inter- Total defensive as- Projected daily val measure sets operating expenditures Long-term debt Long-term debt to equity Total debt equity

Shareholders’ equity

to Current liabilities + S h a r e h o l d e r s ’ long-term debt equity

Times interest Net income (from Interest expense earned continuing operations) before interest and taxes Times interest Net income + total earned interest expense (adjusted by tax rate)

Interest expense (adjusted by tax rate) + preferred dividend requirement

Rate of return Net income + inter- Average total ason assets est expense net of sets income tax savings + minority interest in earnings Return on eq- Income available Common stockuity for common stockholders’ equity holders 52


Inventory inven- Cost of goods sold tory

Average inventory

Accounts re- Sales ceivable turnover

Average (net) accounts receivable

Plant assets Sales turnover

Average plant assets

Five-year cash flow as percentage of five-year growth needs

Five year sum of (1) capital expen ditures + (2) change in inventories during most recent five years + (3) common dividends

Five-year sum of (1) net income available for common stockholders + (2) depreciation and amortization + (3) income from discontinued

Ratio analysis rests on a proper definition of income, especially when income is required in computing the ratio. There is actually a big gap between the economic definition of income and accounting income as based on a historical cost valuation. Economic income has been defined as “the maximum amount a person can consume during a week, and still expect to be as well-off at the end of the week as he was at the beginning.”4 Although this definition has become the basis of many discussions on the concept of income, it nevertheless raises one problem: the lack of consensus on or interpretation of the term “as well 53


off.” The most accepted interpretation is that of capital maintenance, in which case the “Hicksian” income is the maximum amount that may be consumed in a given period and still maintain the capital intact. There are actually four concepts of capital maintenance: 1. Financial capital measured in units of money— maintenance—which is the concept used to compute accounting income. 2. Financial capital measured in units of the same purchasing power—general purchasing power money maintenance—which is the concept used to compute accounting income adjusted for changes in the general price level. 3. Physical capital measured in units of money— productive capacity maintenance—which is the concept used to compute current income adjusted for changes in the general price level. 4. Adjusted physical capital measured in units of the same purchasing power. Which of these is a good surrogate of economic income and should be used in the computation of ratios? The theoretical and sound answer is in 54


favor of current income adjusted for changes in the general price level. FASB Statement No. 33 goes one step forward in helping the computation of such figures by requiring the presentation of both general price level and specific price level information. Ratios are generally used to control for the systematic effects of size on the variables under examination. However, Lev and Sunder showed that the ratio form adequately controls for size only under highly restrictive conditions and sounded an important warning: When these conditions are not met, size is not adequately controlled for, and more seriously, the amount of bias varies with size; it is large for small firms and relatively small for large firms. Given these problems, the use of ratio analysis in financial analysis and research should be accompanied by a theoretical justification and an empirical analysis of the degree to which the data meet the ratio assumptions. In the likely case of deviations from these assumptions, an analysis of the sensitivity of findings to these deviations should be conducted.5 The second major issue they examined is the choice of the size variable where the choice should be justified on the theoretical grounds or “information should be provided on the degree of 55


substitutability of the different measures, and the sensitivity of the finding to alternative measures.”6 Ratio analysis relies primarily on the comparison of the specific ratios of a specific firm with an industry average. Knowledge of the industry’s average and standard deviations is crucial for inferences based on ratio analysis. However, measures of dispersion of the ratio distribution are rarely communicated to users; moreover, financial ratios are not normally distributed, and skewness exists.7 To approximate normality, some transformation of financial ratios may be necessary. Examples of possible transformations include the logarithmic and the power and square root transformations. Ratio analysis relies most often on the use of standardized computer databases that contain a large number of items for a cross-section of firms. There are, however, problems in the use of these data banks. The databases are likely to exclude currently surviving firms, may exclude nonsurviving firms, may not contain the most recent data, may exclude items for firms included, may classify financial statement items inconsistently across firms, and may contain recording errors.8 Outlier observations—those that are inconsistent with the remainder of the set of data—need to be dealt with. In general, researchers trim the sample by deleting the top N observations and the bottom N observations. 56


In general, financial ratios are nonnormally distributed. If normality is rejected, Foster suggests the following options: 1. Impose normality on the data. . . . 2. Attempt to transform the data such that a normal distribution assumption is descriptive. . . . 3. Attempt to impose normality by resetting extreme observations to less extreme values (this is called winsorizing the data). 4. Attempt to impose normality by deleting observations that deviate most from normality (this is called trimming the sample). 5. Recognize nonnormality without attempting to identify the specific normal distribution. 6. Identify the specific nonnormal distribution that characterizes the data of interest.9 2.3. VALUE ADDED-BASED FINANCIAL STATEMENT ANALYSIS 2.3.1 Role of Value Added-Based Financial Analysis

The role of value added-based financial analysis is similar to that of conventional financial analysis, 57


with two notable differences. First, the ratios in the value added-based financial analysis include net value added or gross value added as either a numerator or a denominator of the ratios. Second, the ratios in the value added-based financial analysis are assumed to be better predictive of economic events affecting the firm compared to conventional ratios. The value added represents the total return of the firm and serves as a better basis for the computation of ratios to express relationships to total return rather than to a less informative concept like net income. 2.3.2 Value Added-Based Ratio Analysis 2.3.2.1 Managerial Efficiencies

Various value added-based ratios have been proposed as indexes of managerial efficiency: • Net value added/total assets is considered a better expression of return on assets than the conventional profit/total assets. • Net value added/shareholders’ equity is considered a better expression of return on equity than the conventional profit/shareholders’ equity.

58


• Net value added/common stock is considered a better expression of return on common stock than the conventional profit/ common stock. In each of these ratios, net value added expresses the total return to the firm compared to profit that is only the return accruing to the shareholders. A value added-based index as a measure of managerial efficiency. It is computed as follows:10 Value added or net output of the firm Costs of the inputs of labor and capital Ball puts forward the following argument for using a value added-based measure of efficiency in preference to return on capital: Efficiency measures are concerned with the interrelationship between inputs and outputs. Efficiency measurement consists in relating inputs to work done. But the work done by the firm is not measured by its profit or by its sales. Neither of these figures can be brought into relation with the resources employed by management.11

59


2.3.2.2 Productive Efficiency

Various value added-based ratios have been proposed as indexes of productive efficiency: • Value added/sales may be considered a better measure of productive efficiency than the conventional net profit/sales. • Value added/wages, value added per $1 of wages, value added per employee, and value added per man-hours worked may be considered excellent measures of labor productivity. • Value added/machine hours worked may be considered an excellent measure of machine productivity. 2.3.2.3 Contribution to Total Return

Value added is the result of a team effort. The contribution of each member of a team can be assessed also: • Wages/net value added is a good measure of labor’s share of and contribution to the total return. • Net profit/net value added is a measure of the shareholders’ share in the return pool. 60


• Taxation/net value added is a measure of the government’s share in the return pool. • Interest expense/net value added is a measure of the bondholders’ share in the return pool. These four ratios can be compared for the same firm and across firms, and for the same year and across years to indicate changes in the relative share in the return pool held by the shareholders, bondholders, workers, and the government. 2.3.2.4 Measure of Vertical Integration

Value added/sales has been suggested as a measure of vertical integration, with a fully integrated company having a ratio equal to one. Morley provides the following explanation: For example, if a company owned forest plantations and felled its own timber and matured it and made wood products, then its ratio of value added to sales would be high as the bought-in costs would be fairly low. However, a company which restricted itself to the manufacturing of wood products would have all its timber costs appearing as bought-ins, and this would give a lower ratio of value added to sales.12 61


Value added/sales can also be used as an index of vulnerability to disruptive actions affecting supply of materials and services. Morley has stated, “If the ratio is high, and bought-in costs are trivial, the company is safe from its suppliers who then have little commercial leverage or monopoly power over it.”13 2.3.2.5 Immediate Benefit to Shareholders

Dividends payable/net value added may be considered a good measure of wealth creation that is of immediate benefit to shareholders. It is superior to the conventional dividends payable/ net profit. 2.3.2.6 Firm’s Flexibility

Depreciation plus retentions/gross value added may be considered a good measure of a firm’s flexibility or ability to change. Similarly, investment (fixed assets and stock building) to gross value-added may be considered a good measure of the extent to which the flexibility is exploited.14 2.3.2.7 Research Intensity of the Firm

Research and development/net value added may be used as an indicator of the research 62


intensity of a firm. A high ratio reflects a managerial policy favorable to research and development effort. It is clearly superior to the conventional ratio of research and development/profit, which shows only the proportion of research and development coming out of profit rather than of the total return of the firm. 2.3.2.8 Other Ratios and Indexes

Other ratios and riches based on the value added concept could also be proposed: • Gross value added or net value added could be used as a good surrogate of size. • Net value added/annual interest payments could be used as a better measure of debt coverage than the conventional times interest earned. • Cash plus marketable securities/net value added may be used as measure of the relative cash position of a firm. • Working capital from operations/net value added, and cash flow from operations may be used as measures of the cash-generating abilities of firms. • Net value added/accounts receivable may be used as a measure of accounts receivable turnover. 63


• Net value added/plant assets may be used as a measure of plant assets turnover. 2.4 CONCLUSIONS Value added-based financial analysis can be used in addition to conventional financial analysis to provide a better assessment of the financial position, performance, and conduct of firms. Various value added-based ratios are offered in this chapter to evaluate certain important attributes of firms that are either not now measured or measured only poorly by conventional financial analysis. Some of these attributes include managerial efficiency, productive efficiency, contribution to total return, vertical integration, immediate benefit to shareholders, firm’s flexibility, and research intensity of the firm.

64


NOTES 1. P. Samuelson, “Proof That Property Discounted Present Values of Assets Vibrate Randomly,” Bell Journal of Economics and Management Science (Autumn 1973): 369–74. 2. E. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance (May 1970): 383–447. 3. S. Davidson, G. H. Sorter, and H. Kalle, “Measuring the Defensive Position of a Firm,” Financial Analyst Journal (January–February 1964): 23. 4. J. R. Hicks, Value and Capital (Oxford: Clarendon Press, 1946), p. 172. 5. B. Lev and S. Sunder, “Methodological Issues in the Use of Financial Ratios,” Journal of Accounting and Economics (December 1979): 190. 6. Ibid., p. 198. 7. Paul Barnes, “Methodological Implications of Non-normally Distributed Financial Ratios,” Journal of Business in Finance and Accounting (Spring 1982): 51–62. 8. George Foster, Financial Statement Analysis, 2d ed. (Englewood Cliffs, N.J.: Prentice-Hall, 1986), pp. 81–83. 9. Ibid., pp. 103–4. 10. Ibid. 11. R. J. Ball, “The Use of Value Added in Measuring Managerial Efficiency,” Business Ratios (Summer 1968): 6. 65


12. Michael F. Morley, The Value Added Statement (London: Gee and Co., 1978), p. 131. 13. Ibid., p. 132. 14. Ibid., p. 137.

66


SELECTED READINGS Ball, R. J. “The Use of Value Added in Measuring Managerial Efficiency.” Business Ratios (Summer 1968): 5–11. Belkaoui, Ahmed. Accounting Theory. 2d ed. San Diego, Calif.: Harcourt Brace and Jovanovich, 1981. Copeman, George. “Wages of Added Value.” Management Today (June 1977): 84–88, 138. Fama, E. “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance (May 1970): 383–447. Foster, George. Financial Statement Analysis, 2d ed. Englewood Cliffs, N.J.: Prentice-Hall, 1986. Hicks, J. R. Value and Capital. Oxford: Clarendon Press, 1946. Morley, Michael F. The Value Added Statement. London: Gee and Co., 1978. Pendrill, David. “Introducing a Newcomer – The Value Added Statement.” Accounting (December 1977): 92–94.

67

Chapter 3. 3.Value Added Reporting Under Price Change Models

3.1. INTRODUCTION Various sources have supported the coverage of international accounting issues in the curriculum of college and university accounting programs.1,2 One fundamental issue is the measurement of changes in wealth. Given some of the known limitations of accounting profit as a measure of changes in wealth, international accounting proposals call generally for a consideration of both value added reporting and accounting for inflation as potential useful alternatives.3 Value added reporting advocates the measurement and disclosure of value added, the increase in wealth generated by the productive use of the firm’s resources before its allocation among shareholders, bondholders, workers, and the government. Its use by European firms is on the increase.4 Its potential use in the United States has generated favorable positions.5,6 Justification 69


of its potential use in the United States is supported by empirical research. Although the disclosure of a value added statement is not mandatory, its derivation is possible if adequate information on the distribution of value added is available from the income statement or other sources. Gray and Maunders7 recommend, however, that inflation (price level change) adjustments are necessary if net value added is to be meaningful. Coverage of value added reporting in international accounting courses needs to be integrated with the asset valuation alternatives required by the different price change models. Accordingly, this chapter illustrates the derivation of a value added statement under different price change models. 3.2. VALUE ADDED REPORTING AND ACCOUNTING FOR INFLATION 3.2.1. Value Added Reporting

As a supplement to the income statement, the value added statement is viewed as a report on the income earned by a larger group of “stakeholders”— all providers of capital plus employees and government.8 It can be obtained by the following rearrangement of the income statement: S – B = W + I + DP + DDT + T + R (1) or S – B – DP = W + I + DD + T + R (2) 70

Value Added Reporting Under Price Change Models

where R = retained earnings, S = sales revenue, B = bought-in material and services, DP = depreciation, W = wages, I = interest, DD = dividends, and T = taxes. Equation (1) expresses the gross value added, whereas equation (2) expresses the net value added. In both equations, the left side (the subtractive side) shows the value added (gross or net), and the right side (the additive side) shows the disposal of value added among the stakeholders. A number of academic writers support the net value added concept for a variety of reasons.9,10,11 3.2.2. Price Change Models Various models have been proposed to deal with the effects of changing prices on a firm. The debate centers on the merits of the conventional historical cost model versus some form of current value. The differences between the price change models arise from the different attributes to be measured and the units of measure to be used. The attributes of assets and liabilities – referring to what is being measured – include mainly 71


(a) historical cost, (b) replacement cost, and (c) net realizable value. In addition, financial accounting measurements may be made in one of two units of measure: units of money or units of general purchasing power. Combining the three attributes and the two units of measure yields the following six price change models: 1. Historical cost accounting measures historical cost in units of money. 2. Replacement cost accounting measures replacement cost in units of money. 3. Net realizable value accounting measures net realizable value in units of money. 4. G eneral price level historical cost accounting measures historical cost in units of purchasing power. 5. G eneral price level replacement cost accounting measures replacement cost in units of purchasing power. 6. G eneral price level net realizable value accounting measures net realizable value in units of purchasing power.12 These six price change models are used in the derivations of the value added statement of a fictional example. 72


3.2.3. Fictional Example

To illustrate the derivation of the value added statement under the different price change models, let us consider the simplified case of the Hellenic Company, which was formed January 1, 19X6, to distribute a new product called “KALLIOPI.” Capital is composed of $3,000 equity and $3,000 liabilities carrying a 5 percent interest. On January 1, the Hellenic Company began operations by purchasing 600 units of KALLIOPI at $10 per unit. On May 1, the company sold 500 units at $15 per unit. At the end of the year, the company made the following cash payments: 1. 2. 3. 4.

Interest Wages Taxes Dividends

= = = =

$150 $ 30 $100 $ 20

Changes in the general and specific price levels for the year 19X6 are as follows:

January 1 May 1 December 31 Replacement Cost $10 $12 $13 Net Realizable Value – $15 $17 General Price-Level Index $100 $130 $156

73


3.3. VALUE ADDED STATEMENTS EXPRESSED IN UNITS OF MONEY 3.3.1. Historical Cost

Historical cost accounting, or conventional accounting, is characterized primarily by (1) the use of historical cost as the attribute of the elements of financial statements, (2) the assumption of a stable monetary unit, (3) the matching principle, and (4) the realization principle. The derivation of the income statements and the value added statement under historical cost accounting is shown, respectively, in Exhibits 3.1 and 3.2. The net value added after gains and losses is equal to $2,500, which is the net wealth generated by the firm using the assumption of historical costs expressed in units of money. It includes a plowback to the firm of $2,200. The $2,200 represents the income reinvested after distribution to shareholders, bondholders, employers, and the government. It contains $700 timing errors because (1) it includes in a single figure operating income and holding gains and losses that are recognized in current period and that occurred in previous periods, and (2) it omits the operating profit and holding gains and losses that occurred in the current period but are recognizable in future periods. Second, it contains measuring unit errors because (1) it does not take into account changes in the general price level 74


that would have resulted in amounts expressed in units of general purchasing power, and (2) by relying on historical cost as the attribute of the elements of financial statements rather than either replacement cost or net realizable value, it does not take into account changes in the specific price level. In summary, the net value added under historical cost accounting contains timing and measuring unit errors.

75


Exhibit 3.1 Hellenic Company Income Statements Expressed in Units of Money Income Statements

Historical Cost

Replacement Cost

Net Realizable Value

(1) Revenues

(2)

$7,500

$7,500

$9,200

(3)

(4)

(5)

$5,000

$6,000

$7,300

B. Interest

$150

$150

$150

C. Wages

$30

$30

$30

$2,320

$1,320

$1,720

Included

(6)

Minus Expenses: A. Cost of Materials

Operating Profit Realized Holding Gains & Losses Unrealized Holding Gains & Losses

General Price Level Gains & Losses

Above

$1,000

Not Applicable

$1,000

(7) $300

$300

Not

Not

Not

Applicable

Applicable

Applicable

76


Net Profit Before Tax – Taxes Net Profit After Taxes

$2,320

$2,620

$3,020

$100

$100

$2,220

$2,520

$2,920

$20

$20

$20

$2,200

$2,500

$2,900

Taxes

– Dividends Retained Earnings

(1) 500 × $15 = $7,500 (2) 7,500 + ($17 × 100) = $9,200 (3) 500 × $10 = $5,000 (4) 500 × $12 = $6,000 (5) 6,000 + ($13 × 100) = $7,300 (6) 500 ($12 – $10) = $1,000 (7) 100 ($13 – $10) = $3,000 3.3.2 Replacement Cost Replacement cost accounting is characterized by (1) the use of replacement cost as the attribute of financial statements, (2) the assumption of a stable monetary unit, (3) the realization principle, and (4) the dichotomization of realized and unrealized holding gains and losses. The derivation of the income statement and the value added statement under replacement cost accounting is shown, respectively, in Exhibits 3.1 and 3.2. The net value added after gains and losses 77


amounts to $2,800, which is the net wealth generated by the firm under the assumption of replacement cost expressed in units of money. It includes a plowback to the firm of $2,500. The $2,500 amount represents the income reinvested after distribution to shareholders, bondholders, employers, and the government. It contains $400 timing errors because (1) it omits the operating profit that occurred in the current period but that is realizable in future periods, (2) it includes the operating profit that is recognized in the current period but that occurred in previous periods, (3) it does not take into account changes in the general price level that would have resulted in amounts expressed in units of general purchasing power, and (4) it does take into account changes in the specific price level because it relies on replacement cost as the attribute of the elements of financial statements. In summary, the net value added under replacement cost accounting contains (1) operation profit timing errors, and (2) measuring unit errors.

78


Exhibit 3.2 Hellenic Company Value Added Statements Expressed in Units of Money Value Added Statements

Historical Cost

Replacement Cost


A. Source of Net Value Added Revenues

$7,500

$7,500

$9,200

– Cost of Material

$5,000

$6,000

$7,300

$2,500

$1,500

$1,900

Incl. Above

$1,000

$1,000

$300

$300

Net Value Added Before Gains & Losses Realized Holding Gains & Losses Unrealized Holding Gains & Losses General Price Level Gains & Losses

Not Applicable Not

Not

Not

Applicable

Applicable

Applicable

79


Net Value Added After Gains & Losses

$2,500

$2,800

$3,200

$150

$150

$150

$30

$30

$30

$2,200

$2,500

$2,900

Taxes to Government

$100

$100

$100

Dividends to Shareholders

$20

$20

$20

$2,500

$2,800

$3,200

B. Distribution of Net Value Added Interest to Bondholders Wages to Employees Retained Earnings to Firm


80


3.3.3. Net Realizable Value Net realizable value accounting is characterized primarily by (1) the use of net realizable value as the attribute of the elements of financial statements, (2) the assumption of a stable monetary unit, (3) the abandonment of the realization principle, and (4) the dichotomization of operating income and holding gains and losses. The derivation of the income statement and the value added statement under net realizable value accounting is shown, respectively, in Exhibits 3.1 and 3.2. The net value added after gains and losses amounts to $3,200. It includes a plowback to the firm of $2,900. The $2,900 amount represents the income reinvested after distribution to shareholders, bondholders, employers, and the government. It does not contain any timing errors because (1) it reports all operating profit and holding gains and losses in the same period in which they occur, and (2) it excludes all operating and holding gains and losses occurring in previous periods. It contains measuring unit errors because (1) it does not take into account changes in the general price level, and (2) it does take into account changes in the specific price level because it relies on net realizable value as the attribute of the elements of financial statements. In summary, the net value added under net realizable value accounting contains no timing errors, but contains measuring errors. 81


3.4. VALUE ADDED STATEMENTS IN UNITS OF PURCHASING POWER 3.4.1. Historical Cost

General price level-adjusted historical cost accounting is characterized primarily by (1) the use of historical cost as the attribute of the elements of financial statements, (2) the use of units of general purchasing power as the unit of measure, (3) the matching principle, and (4) the realization principle. The derivation of the income statement and the value added statement under general price level-adjusted historical cost accounting is shown, respectively, in Exhibits 3.3–3.5. The net value added after gains and losses amounts to $1,380. It includes a plowback of $1,080. The $1,080 amount represents the income reinvested after distribution to shareholders, bondholders, employers, and the government. It contains the same type of timing errors as under historical cost accounting. It contains no measuring unit errors because it does take into account changes in the general price level. It does not, however, take into account changes in the specific price level because it relies on historical cost as the attribute of the elements of financial statements rather than on replacement cost or net realizable value. In summary, the net value under general price level-adjusted historical cost accounting contains timing errors, but does not contain measuring unit errors. 82


Exhibit 3.3 Hellenic Company Income Statements Expressed in Units of Purchasing Power Income Statements

Historical ReplaceNet Cost ment Realizable Cost Value (1)

Revenues

(2)

$9,000

$9,000

$10,700

(3)

(4)

(5)

$7,800

$7,200

$8,500

B. Interest

$150

$150

$150

C. Wages

$30

$30

$30

$1,020

$1,620

$2,020

Minus Expenses: A. Cost of Materials

Operating Profit

Real Realized Holding Gains & Losses

Real Unrealized Holding Gains & Losses

(6) Incl. Above Not Applicable

83

($600)

($600)

(7) ($260)

($260)


General Price Level Gains & Losses Net Profit Before Tax – Taxes Net Profit After Taxes – Dividends Retained Earnings

(8) $180

$180

$180

$1,200

$940

$1,340

$100

$100

$100

$1,100

$840

$1,240

$20

$20

$20

$1,080

$820

$1,220

(1) $7,500 × 156/130 = $9,000 (2) $9,000 + ($17 × 100 units) = $10,700 (3) $5,000 × 156/100 = $7,800 (4) $6,000 × 156/130 = $7,200 (5) $7,200 + ($13 × 100 units) = $8,500 (6) [(12 × 156/130) – ($10 × 156/100)] × 500 = ($600) (7) [13 – ($10 × 156/100)] × 100 units = ($260) (8) See Exhibit 1.5

84


Exhibit 3.4 Hellenic Company Value Added Statements Expressed in Units of Purchasing Power Value Added Statements

Historical Cost

Replacement Cost


A. Source of Net Value Added Revenues

$9,000

$9,000

$10,700

– Cost of Materials

$7,800

$7,200

$8,500

$1,200

$1,800

$2,200

($600)

($600)

($260)

($260)

$180

$180

$180

$1,380

$1,120

$1,520

Net Value Added Before Gains & Losses Realized Holding Gains & Losses

Incl. Above

Unrealized Holding Gains & Losses

Not Applicable

General Price Level Gains & Losses Net Value Added After Taxes

85


B. Distribution of Net Value Added Interest holders

Bond-

$150

$150

$150

Wages to Employees

$30

$30

$30

Earnings

$1,080

$820

$1,220

Taxes to Government

$100

$100

$100

Dividends to Shareholders

$20

$20

$20

$1,380

$1,120

$1,520

Retained to Firm

to


86


Exhibit 3.5 General Price Level Gain or Loss, December 31, 19X6 Unadjusted

Conversion Factor

Adjusted

$3,000

156/100

$4,680

During 19X6: Sales

$7,500

156/100

$9,000

Net Monetary Items

$10,500

Net-Monetary Assets on January 1, 19X6 Add Monetary Receipts

$13,680

Less Monetary Payments: Purchases

$6,000

156/100

$9,360

Interest

$150

156/156

$150

Wages

$30

156/156

$30

$100

156/156

$100

$20

156/156

$20

Taxes Dividend Total

$6,300

$9,660

Computed Net Monetary Assets, 19X6

December

31,

$4,020

87


Actual Net Monetary Assets, December 31, 19X6

$4,200

General Price Level Gain

$180

3.4.2. Replacement Cost

General price level-adjusted replacement cost accounting is characterized primarily by (1) the use of replacement cost as the attribute of the elements of financial statements, (2) the use of units of general purchasing power as the unit measure, (3) the realization principle, (4) the dichotomization of operating income and real realized holding gains and losses, and (5) the dichotomization of real realized and real unrealized holding gains and losses. The derivation of the income statement and the value added statement under general price level-adjusted replacement cost accounting appears, respectively, in Exhibits 3.3-3.5. The net value added after gains and losses amounts to $1,120. It includes a plowback of $820. The $820 amount represents the income reinvested after distribution to shareholders, bondholders, employees, and the government. It contains the same type of timing errors found under replacement cost accounting. It contains no measuring unit errors because it takes into account changes in the general price level. In addition, it takes into account changes in the specific price level because it adopts replacement cost as the attribute 88


of the elements of financial statements. In summary, the net value added under general price level-adjusted replacement cost contains timing errors, but contains no measuring unit errors. 3.4.3. Net Realizable Value

General price level-adjusted net realizable value accounting is characterized primarily by (1) the use of net realizable value as the attribute of the elements of financial statements, (2) the use of units of general purchasing power as the unit of measure, (3) the abandonment of the realization principle, (4) the dichotomization or operation income and real holding gains and losses, and (5) the dichotomization of the real realized and unrealized gains and losses. The derivation of the income statement and the value added statement under general price level-adjusted net realizable value accounting appears, respectively, in Exhibits 3.3–3.5. The net value added after gains and losses amounts to $1,520. It includes a plowback of $1,220. The $1,220 amount represents the income reinvested after distribution to shareholders, bondholders, employees, and the government. It contains no timing errors and no measuring unit errors. 3.5. CONCLUSIONS The application of the different price change models resulted in different values for the net value 89


added. As shown in Exhibit 3.6, there are six different values for net value added. These values are evaluated in terms of whether or not both timing error and measuring unit error are eliminated. The net value added of $1,520, under general price level-adjusted net realizable value accounting, contains nothing from the two errors. It is the ideal measure of net value added under a situation of organized and proper liquidation. Another useful measure is the net value added of $1,120 obtained under general price level-adjusted replacement cost accounting. It indicates the wealth created under operating rather than liquidating conditions after accounting for both changes in the general and specific price level. Whatever the choice made of these six net value added measures, it is important for the student and the user to understand the various assumptions made in the choice of the attribute and the choice of the measuring unit.

90

1. Historical Cost Accounting 2. Replacement Cost Accounting 3. Net Realizable Value Accounting 4. General Price Level Adjusted, Historical Cost Accounting 5. General Price Level Adjusted, Replacement Cost Accounting 6. General Price Level Adjusted, Net Realizable Value Accounting

Accounting Model

Error Type Analysis

Exhibit 3.6

$3,200 $1,380

$1,120

$1,520

$1,080

$820

$1,220

$2,800

$,2500 $2,900

$2,500

Net Value Added

$2,200

Net Income

91 Eliminated

Yes

Yes

Eliminated

Yes

Yes

Profit

Eliminated

Eliminated

Yes

Eliminated

Eliminated

Yes

Gains

Timing Error Operating Holding

Eliminated

Eliminated

Eliminated

Eliminated

Yes

Yes

Measuring Unit Errors



NOTES 1. Mintz, S. M., “Internationalization of the Accounting Curriculum,” The International Journal of Accounting Education and Research (Fall 1980); 137–151. 2. Sherman, W. R., “Internationalization of Accounting Curriculum: Implementation of the Worldwide Dimension Requirement,” Journal of Accounting Education (Fall 1987); 259–276. 3. Riahi-Belkaoui, A., Value Added Reporting: Lessons for the United States (Westport, CT: Greenwood Press, 1992). 4. Meek, G., and S. J. Gray, “The Value Added Statement: An Innovation for U.S. Companies?” Accounting Horizons (June 1988): 73–81. 5. Morley, M. F., “The Value Added Statement in Britain,” The Accounting Review (July 1979): 618–689. 6. American Accounting Association, “Committee on Accounting and Auditing Measurement, 1989–1990,” Accounting Horizons (September 1991): 81–105. 7. Gray S. and K. Maunders, Value Added Reporting: Uses and Measurement (London: The Association of Certified Accountants, 1980). 8. Meek and Gray, 75. 9. Morley, M. F., “The Value Added Statement: A British Innovation,” The Chartered Accountant Magazine (May 1978): 31–34. 92


10. Morley, M. F., “Value Added Reporting,” in Developments in Financial Reporting, ed. Thomas A. Lee (London: Philip Allan, 1981), 251–269. 11. Rutherford, B. A., “Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems,” Accounting and Business Research (Summer 1977): 215–220. 12. Other price models have been used in the academic literature. They have not researched the degree of acceptance of the six models examined in this study. See, for example, Chasteen, Lanny, “A Taxonomy of Price Change Models,” The Accounting Review (July 1984): 515–523; Riahi-Belkaoui, Ahmed, Accounting Theory, 3rd ed. (London: Academic Press, 1993).

93


REFERENCES American Accounting Association. “Committee in Accounting and Auditing Measurement, 1989–1990.” Accounting Horizons (September 1991): 81–105. Bannister, James W., and Ahmed Riahi-Belkaoui. “Value Added and Corporate Control in the U.S.” Journal of International Financial Management and Accounting (Autumn 1991): 241–257. Bao, Ben-Hsien and Da-Hsien. “An Empirical Investigation of the Association Between Productivity and Firm Value.” Journal of Business Finance and Accounting (Winter 1989): 699–717. Chasteen, Lanny. “A Taxonomy of Price Change Models.” The Accounting Review (July 1984): 515–523. Gray, Sidney J., and K. T. Maunders. Value Added Reporting: Uses and Measurement. London: The Association of Certified Accountants, 1980. Karpik, Philip, and Ahmed Belkaoui. “The Relative Relationship Between Systematic Risk and Value Added Variables.” Journal of International Financial Management and Accounting (Autumn 1989): 259–276. Meek, Gary, and Sidney J. Gray. “The Impact of Stock Market and Corporate Globalization on Disclosure Trends in International Financial 94


Reporting.” In Changing International Financial Markets and Their Impact on Accounting, 43–66. Champaign, IL: Center for International Education and Research in Accounting, 1992. _______. “The Value Added Statement: An Innovation for U.S. Companies?” Accounting Horizons (June 1988): 73–81. Mintz, S. M. “Internationalization of the Accounting Curriculum.” The International Journal of Accounting Education and Research (Fall 1980): 137–151. Morley, M. F. “The Value Added Statement: A British Innovation.” The Chartered Accountant Magazine (May 1978): 31–34. _______. “The Value Added Statement in Britain.” The Accounting Review (July 1979): 618–689. _______. “Value Added Reporting.” In Developments in Financial Reporting, edited by Thomas A. Lee, 251–269. London: Philip Allan, 1981. Riahi-Belkaoui, Ahmed. Accounting Theory. 3rd ed. London: Academic Press, 1993. _______. “Earnings-Returns Relation Versus Net Value Added-Returns Relations: The Case for Nonlinear Specification.” Advances in Quantitative Analysis in Finance and Accounting (Forthcoming). _______. “The Information Content of Value Added, Earnings and Cash Flows: U.S. Evidence.” The International Journal of Accounting 28, no. 2 (1993): 140–146. 95


_______. Value Added Reporting: Lessons for the United States. Westport, CT: Greenwood Press, 1992. Rutherford, B. A. “Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems.” Accounting and Business Research (Summer 1977): 215–220. Sherman, W. R. “Internationalization of the Accounting Curriculum: Implementation of the Worldwide Dimension Requirement.” Journal of Accounting Education (Fall 1987): 259–276.

96

Chapter 4. 4.The Effects of Accounting Knowledge on the Omission of Value Added in Wealth Measurement and Distribution

4.1. INTRODUCTION Because the shareholders are considered the ultimate owners of the firm, wealth measurement has consisted in various ways of income measurement that includes schemes of earnings management and/or income smoothing. If the corporation was instead perceived as an alliance of a concerned team that includes the shareholders, the bondholders, the employees, and the government, then the measurement of wealth is reduced to the determination of the value added that is ultimately distributed as dividends to the shareholders, interest to bondholders, wages to employees, taxes to the government, and undistributed value added as retained earnings. Because accounting focused on shareholders’ wealth and changes in wealth with the resulting measurement of profit, empirical research does 97


not report any overwhelming use of value added by decision makers. The belief is that decision makers tend to ignore or underweigh value added information. The omission of value added in wealth measurement and distribution affects the decision-making process by associating wealth with profit rather than with the total value added resulting from the activities of the firm. The reasons believed the omission of the value added in wealth measurement and distribution are either ignored or totally misunderstood. Accordingly, it is the objective of this chapter to develop and test prediction about the tendency of decision makers to omit value added information out of their wealth measurement and distribution, and, in the end, help decision makers improve the quality of their decision. The chapter uses Holland et al.’s1 theoretical framework of cognitive processing to examine the effects of accounting knowledge on the omission of value added in wealth measurement and distribution. The cognitive processing literature suggests that people rely on knowledge structures stored in memory to guide their decision. The higher the knowledge in the given area, the higher the likelihood of the recall of a familiar knowledge structure considered suitable for a given decision context. Because the accounting knowledge structure stored in memory does not emphasize the use or 98

The Effects of Accounting Knowledge

the relevance of value-added information, it is possible to hypothesize that decision makers with high-accounting knowledge will have a greater tendency to ignore value added in wealth measurement than decision makers with low-accounting knowledge because the former group of decision makers will recall accounting knowledge structures that do not incorporate value added information. The impact of accounting knowledge on the use of value added information in wealth measurement and distribution was examined in a between-analysis laboratory experiment. Subjects in the experiment assumed the role of a preparer of accounting reports asked by a superior to determine the wealth of an entity on the basis of a given set of accounting. Accounting knowledge was measured (a) as a discrete variable by classifying the subject into high- and low-accounting knowledge classes based upon the program of business study in which the subject was enrolled, and (b) as a continuous variable by classifying the subject on the basis of the number of accounting courses he had completed. The effect of analytical ability on income measurement and distribution performance was also controlled. The results of the experiment showed that contrary to intuitive expectation, high-accounting knowledge interferes with a decision maker’s 99


ability to rely on value added rather than profit as a measure of wealth. In particular, the subject’s ignorance of value added in wealth measurement and distribution increased significantly with increases in the subject’s accountancy knowledge. Validity tests rule out differential knowledge about value added reporting as a potential explanation of their average tendencies not to rely on value added in wealth measurement. This study presents the first formal attempt to provide an explanation for why decision makers may ignore value added information in wealth measurement and distribution by focusing on the role of knowledge structures. Where knowledge structures do not include information on the role of value added in wealth measurement and distribution, the result is an ignorance and/or avoidance of the concept and a fixation on income measurement as the only concept of wealth measurement. This result was obtained even after controlling for analytical ability as a potential explanation. Finally, this study adds to the emerging studies that focuses on the dysfunctional effect of knowledge of a subject matter by an examination of specific conditions where high-accounting knowledge may hinder performance.2-4 The findings of this study suggest that the benefits of high-knowledge or experience may be 100


hampered by the incongruence between the knowledge structure stored in memory and the decision problem faced by the decision maker.5-7 4.2. THEORETICAL CONSIDERATIONS 4.2.1, Use of Value Added Information in Wealth Measurement

By definition, value added is the economic measure of wealth. While the economist relies on value added for measurement of the wealth of a nation, the accountant relies on value added for measurement of wealth. In effect, generally accepted accounting principles are primarily used in the case of the income statement for the measurement of the income of a period as an expression of the wealth generated for that period. Alternative uses of information used for income measurement can be easily used to construct a value added statement containing the net value added or the gross value added generated by the activities of the firm in a given period. Because value added reports are not mandated in the United States, the reconstruction of value added from the information used to determine income is not accomplished for either external disclosure or internal uses. While optimal wealth measurement incorporates value added, externally reported financial accounting 101


data do not include value added. Empirical research on why decision makes may tend to ignore value added information in wealth measurement when it is not explicitly provided is practically nonexistent. The current study starts this research by examining whether differential knowledge of generally accepted accounting principles (GAAP) is the main cause for the ignorance and/or avoidance of value added information in wealth measurement. As will be discussed later, the knowledge structures created by the mental storage of GAAP-based information may explain the role of accounting knowledge in wealth measurement that includes value added information. 4.2.2. A Cognitive View of the Judgment/Decision Process in Accounting

In what follows, a model of the judgment/decision process in accounting is proposed as an exercise in social perception and cognition, requiring both formal and implicit judgment.8 The primary input to this process is an accounting problem or phenomenon that needs to be solved and requires a judgment preceding either a preference or decision. The model consists of the following steps: 1. Observation of the accounting phenomenon by the decision maker 102


2. Schema formation or building of the accounting phenomenon 3. Schema organization or storage 4. Attention and recognition process triggered by a stimulus 5. Retrieval of stored information needed for the judgment decision 6. Reconstruction and integration of retrieved information with new information 7. Judgment process 8. Decision/action response Observation of the Accounting Phenomenon by the Decision Maker

The decision maker is assumed to have the opportunity to observe the accounting phenomenon. To understand the accounting phenomenon, the decision maker may be given some information that is deemed diagnostic. If this information is not provided, the decision maker may seek the information and test available information judged

103


most relevant to the phenomenon. Following H. H. Kelly’s approach to casual attribution,9 the search behavior may concentrate on these types of available information: 1. Consensus information: how this accounting phenomenon and other accounting phenomena were rated or performed on given dimensions. 2. Distinctiveness information: how this accounting phenomenon was rated or performed on various other dimensions. 3. Consistency information: how this accounting phenomenon was rated or performed on important dimensions in the past. Evidence shows that subjects tend to focus more on distinctiveness or consistency information than on consensus information.10 Studies examining search behavior in reaction to an accounting phenomenon are very limited. The search behavior is not misguided. It is fair to assume that the decision maker has some expectations about the accounting phenomenon that may determine the type of information sought. These expectations are termed preconceived notions in De Nisi et al.’s model.11 They result from the 104


decision maker’s previous experiences with the accounting phenomenon. These expectations or preconceived notions may bias the decision maker toward choosing some information rather than other information. Providing background information prior to observation contributes to this phenomenon.12,13 R. S. Wyer and T. K. Srull maintain that prior information predisposes the subject to select one of a number of frames of references.14 Bias is a result of the tendency to seek evidence confirming preconceived notions rather than neutral or disconfirming evidence.15-17 Schema Formation or Building

Once the accounting phenomenon has been observed, the relevant information is encoded in the sense that it is categorized on the basis of experience and organized in memory along schemata or knowledge structures. As stated by R. E. Nisbett and L. Ross: Few, if any, stimuli are approached for the first time by the adult. Instead, they are processed through pre-existing systems of schematized and abstracted knowledge-beliefs, theories, propositions and schemas. These knowledge structures label and categorize objects and events quickly and, for the most part, accurately. They also define a set of 105


expectations about objects and events and suggest appropriate responses to them.18 A schema can be simply an update of a template that exists prior to the occurrence of a known accounting phenomenon or a new template generated by the occurrence of a new accounting phenomenon. In the first case, little ambiguity is assumed to exist, and therefore the encoding follows an automatic process.19 In the second case, no immediate available schema exists, and a controlled categorization process is triggered to determine which schema is consistent with the dimensions of the accounting phenomenon. Both processes are suggested in the case of the encoding of information or performance appraisal: Thus, both the automatic and controlled processes have the same end result: the assignment of a person to a category based on prototype-machine process. The difference is whether the stimulus person’s behavior is sufficiently consistent with other cues to allow the categorization to proceed automatically, or whether a controlled process must be used to determine which category is consistent with the individual’s behavior. The actual category assignment is a function of contextual factors influencing the 106


salience of particular categories and stimulus characteristics, as well as individual differences among perceivers that render some categories and their prototypes more available than others and some stimulus features more salient than others.20 Basically, an accounting phenomenon may be categorized in a given schema by virtue of its possession of obvious or salient attributes known to the perceiver. When no salient category prototype or schema provides a natural framework, the automatic process is superseded by a controlled process or a consciously monitored process.21 The controlled process can be triggered by either a new accounting phenomenon or new features of a known phenomenon that are inconsistent with a previous categorization. In the latter case, a recategorization is invoked until the inconsistency is resolved, and a new schema is used to describe the accounting phenomenon, causing a reconstruction of memories about the phenomenon such that memories consistent with the new categorization are more available. Schema Organization and Storage

After information about a given phenomenon is encoded to form a representation or schema, 107


it is stored and maintained in long-term memory. E. Tulving distinguishes between episodic and semantic memory.22 Basically, a person’s episodic memories are personal while semantic memory is knowledge of words and symbols, their meanings and referent knowledge of the relations among words, and the rules or algorithms for manipulating words, symbols and the relations among them. R. C. Atkinson and R. M. Shiffrin maintain that the basic structural features of episodic memory are three memory stores: the sensory register, the short-term store, and the long-term store.23 Information enters the memory system through the various senses and goes first to the sensory register whose function is to preserve incoming information long enough for it to be selectively transmitted into the memory system. It is kept there less than a second and is lost through either decay or erasure by overwriting. The information then goes to the short-term store, “working in memory where conscious mental processes are performed.” It is where consciousness exercises its function. Information can be kept indefinitely here provided it is given constant attention; if not, it is lost through decay in twenty to thirty seconds. The information next goes to the long-term store through a conscious or unconscious process where it can be held indefinitely and often permanently 108


(although it can be lost due to decay or interference of various sorts). The long-term store is assumed to have unlimited capacity. In this multistore model, information about the accounting phenomenon moves through different and separate memory systems, ending with a long-term store where semantic information is maintained along meaningbased codes or schemata. It is important to realize at this stage that if the person intends to remember the accounting phenomenon for all time, he/she must perform a different analysis on the input than when his/her intentions are temporary.24 A person’s intention determines whether the storage of the information on the accounting phenomenon is permanent or temporary. A different coding is used: a memory code for permanent storage and a perceptual role for temporary storage. Different codes have different permanence. Codes of the sensory aspect of an input, such as appearance, are short lived. Hence, a person who looked at a word to decide whether it was printed in red or green would not remember the word’s name very long because his coding would have emphasized color, not meaning. In contrast, a person who looked at a word to decide whether it was a synonym for some other word would form a semantic code, 109


and he/she would remember the name of the examined word for quite a while.25 Stimulus and Attention and Recognition Process Upon observation of a triggering event or stimulus, the schema in the accounting phenomenon is activated. The activation, as a process of detection, search, and attention, can be either a controlled or an automatic processing.26 Basically, automatic detection triggered by the recognition of a stimulus operates independently of the person’s control. Automatic processing is the apprehension of stimuli by the use of previous learned routines that are in the long-term storage. Automatic processing as learned in longterm store is triggered by appropriate inputs, and then operates independently of the subject’s control. An automatic sequence can contain components that control information flow, attract attention, or govern over responses. Automatic sequences do not require attention, though they may attract it if training is appropriate, and they do not use up short-term capacity.27 In these automatic processes, no conscious effort is involved in the search, as well as in demanding 110


attention due to the learned sequence of the elements composing the schemata. On the other hand, controlled processes involve a temporary activation of novel sequences of processing steps that require attention, use short-term memory, and involve a conscious effort. It is important to realize that in both processes, the use of a schema for encoding or retrieving information depends on accessibility in memory, where the accessibility of a schema is the probability that it can be activated, either for use in storage of incoming information, or for retrieval of previously stored information.28,29. Accessibility of a schema depends upon such factors as the strength of the stored information, the extent of the overlap or match between input and schema, and the recency and frequency of previous activations. The instrumental effect of an activation on the accessibility of a schema is presumably a decreasing function of its prior strength. That is, a weak schema benefits more from an activation than a strong one.30 Empirical evidence on the increased accessibility of information with the frequency of activation is available.31,32 111


Retrieval of Stored Information Needed for Judgment/Decision Either the automatic or controlled search process activates the appropriate schema for the accounting phenomenon and allows the retrieval of information on the phenomenon. It is, however, the schema, a representation of the phenomenon, that is recalled rather than the actual phenomenon.33-35 The effect becomes strong as the time between observation and recall increases.36 The potential for different types of biases exists at this stage. For example, people may be more likely to recall information consistent with a schema confirming an expectation,37 or may recall schema-consistent information that they never saw.38 A good deal of evidence also suggest that schema-inconsistent information is more likely to be recalled39 because of its novelty, saliency, and difficulty of incorporation into a schema.40 What is more likely to be recalled when faced with an accounting phenomenon, what types of biases affect the recall of schemata of accounting phenomenon, and what can be done to reduce or eliminate the distortions in recall are some of the important questions in need of investigation. This model will assume that familiarity with the accounting phenomenon through constant record 112


keeping, and other forms of monitoring may result in less biased recall. The solution, in fact, is more complex and depends on the type of relationship between memory and judgment. Reid Hastie and Bernadette Park investigated these relationships and distinguished between two types of judgment tasks, memory-biased and on-line. They also identified five information-processing models that relate memory for evidence to judgment based on the evidence: (1) independent processing, (2) availability, (3) biased retrieval, (4) biased encoding, and (5) incongruity-based encoding.41 With regard to the five information-processing models, the distinction is threefold: (1) cases where there is no relation between judgment and memory processes, which include the independent processing models; (2) cases where memory availability causes judgment, which include the availability-based information-processing model and the automatic search process described earlier; and (3) cases where judgment causes memory, which include the biased retrieval, the biased encoding, and the incongruity-biased encoding models. The biased retrieval model is selective in the sense that traces that “fit” the judgment are more likely to be found at the memory decision stage. Such biases have been termed selective recall, confirmatory memory, and access-biased memory.42-45 113


The biased encoding model assumes that biasing takes place at the time of the encoding of evidence information, and memory search will locate a biased sample of information reflecting the initial encoding bias. The incongruity-biased encoding model assumes that after the initial encoding, incoming information that is incongruent or contradictory is given special processing to enhance its memorability by being placed in “special tags” that strongly attach to memory. In memory search, the subject is more likely to find the incongruent information.46,47 This model assumes that where the accounting phenomenon calls for an online task, the availability, or automatic search model, will characterize the retrieval of stored information needed for judgment decision. Selection of a processing model will depend on the individual objectives of the subject and the perceived consequences of his/her judgments on his/her economic and psychological welfare. Reconstruction and Integration of Retrieved Information with Other Available Information At this stage the process involves the integration of the information retrieved from memory and

114


other available information into a single evaluation of the accounting phenomenon. Where familiarity with the phenomenon is present and previously learned routines are retrieved, active integration will not take place. An earlier integration is recalled from past stored output on the phenomenon. “What was once accomplished by slow, conscious, deductive reasoning is now arrived at by fast, unconscious perceptual processing.”48 Where the phenomenon presents challenging and novel dimensions and where controlled processes were involved in attention and recognition, a cognitive integration of all the information is required to reach a single evaluation of the accounting phenomenon. G. Mandler describes the process of “response learning” as follows: First, the organism makes a series of discrete responses, often interrupted by incorrect ones. However, once errors are dropped out and the sequence of behavior becomes relatively stable—as in running a maze, speaking a word, reproducing a visual pattern—the various components of the total behavior required in the situation are “integrated.” Integration refers to the fact that previously discrete parts of a sequence come to behave functionally as 115


a unit; the whole sequence is elicited as a unit and behaves as a single component response as in the past; any part of it elicits the whole sequence.49 Brunswick’s lens model and Anderson’s weighted average model provide support to the types of integration of information that take place.50 The integration process is, however, also subject to various biases: 1. People may attach and give great weight to some type of information. For example, evidence in the employee appraisal literature shows that negative information has greater weight.51,52 2. There is evidence in both psychology and accounting of an underutilization or underweighting of base rate or consensus information.53 3. There is ample evidence in psychology and accounting of the effect of various heuristics involved in decisions on and about accounting phenomena. They include: (1) representativeness, (2) availability, (3) confirmation bias, (4) anchoring and adjustment, (5) conjunction fallacy, (6) hindsight bias, (7) illusory correlation and contingency judgment, (8) selective 116


perception, (9) frequency, (10) concrete information, (11) data presentation, (12) inconsistency, (13) conservation, (14) nonlinear extrapolation, (15) law of small numbers, (16) habit/”rule of thumb,” (17) “best-guess” strategy, (18) complexity in the decision environment, (19) social pressure in the decision environment, (20) consistency of information sources, (21) question format, (22) scale effects, (23) wishful thinking, (24) outcome-irrelevant learning structures, (25) misperceptions of chance fluctuations (gambler’s fallacy), (26) success/failure attributions, and (27) logical fallacies in recall.54 The Judgement Process

The judgement process is the result of the integration process of information and the forming of a single evaluation of the accounting phenomenon if the attention, recognition, and integration processes are the result of controlled process. The judgement made in this case requires a conscious access to all the mental processes implied in the model. If, however, the attention, retrieval recognition, and integration process were the result of automatic processes, the judgement is not the mental process implied in this model.55,56 It is a routine judgement.

117


Routine judgement involves the rapid matching of immediate perceptions to a template which provides, and executes, a specific response, “if total debts do not equal total credits, re-add the total balance.” In the above example, there is no awareness of how the brain actually decides that the debits do not equal the credits. Even if awareness were possible, it is not normally necessary—a great many of our routine activities, such as keeping our eyes open or holding our pencils, are done without any particular conscious awareness, at least until something causes us to become aware.57 Decision/Action (Response)

The final step of the model is the decision or selection of a response to the accounting phenomenon. It is a conscious response preference resulting from the judgment process. It is an output of the judgment process and is clearly influenced by all the mental processes and biases described earlier. As a result, a new schema on the phenomenon will develop that will be part of the knowledge structure or the phenomenon stored in long-term memory. The move from judgement to decision is a bridging process. It assumes that no obstacles stand in the way. 118


The decision/action has been investigated in various accounting environments and using various accounting phenomena. It has been found to differ from various normative decision models, including Bayesian-decision theory and expected value model.58,59 The bridging process, however, will be influenced by the cognitive steps described in this model, as well as by other factors, including the possible consequences of the decision on the accounting phenomenon. Gibbins, for instance, cites the following factors: Personal attitudes may play a direct role, such as determining priorities within the search process. For example, some public accountants may use financial return as their first selection criterion; others may use moral propriety as their first. Personal attitudes can also play an indirect role, limiting past actions and thus limiting the experiences on which judgment guides are built. The applications of such attitudes to the judgment process need not be conscious— particularly for deeply ingrained beliefs.60 4.2.3. The Role of Accounting Knowledge Structure in the Use of Value Added

The essence of cognitive relativism in accounting is the presence of a cognitive process that 119


is assumed to guide the judgment/decision process. The model outlined earlier shows that judgments and decisions made about accounting phenomena are the products of a set of social cognitive operations that include the observation of information on accounting phenomena and the formulation of schemata or knowledge structures that are stored in memory and later retried to allow the formulation of judgments and/or decisions when needed.61 It is the steps of (a) retrieval of stored information needed for judgment/decision, and (b) the reconsideration and integration of retrieval information with other available information that is important to this study. Basically, it is the steps where information from external sources is combined with knowledge structures recalled from long-term memory. Because cognition is highly knowledge- and context-dependent, a specific context will induce the recall of knowledge structures that are expected to be relevant to the context. Because the formal accounting training focuses on GAAP, the end result is that the knowledge structures stored and recalled will not include value added-based knowledge for wealth measurement and distribution. The same phenomenon of a lack of fit between the knowledge structures recalled from memory and the given problem-solving structure has been observed in a chess context,62 a tax context,63 and 120


an opportunity cost context.64 In all these contexts the studies show evidence of the dysfunctional effects resulting from the lack of fit between the knowledge structures recalled from memory and the decision situation examined. What may be concluded from the above studies is a similar situation for value added information in wealth measurement and accounting knowledge. Basically decision makers with highaccounting knowledge who are faced with a wealth measurement task may be more inclined to recall GAAP-based knowledge structures that fail to incorporate value added information. Accordingly, the following hypothesis is proposed: H1: The amount of value added information ignored in a wealth measurement task will be greater for decision makers with high-accounting knowledge than for decision makers with low- and no-accounting knowledge. 4.3. RESEARCH DESIGN 4.3.1. Subjects

Three groups of subjects were asked to participate in a wealth measurement task. The three groups differed in the level of accounting 121


knowledge possessed. The level of accounting knowledge was measured both as a discrete variable of classifying subjects into high- and low- and no-accounting knowledge classes based on the program of business study in which the participants were enrolled and the number of accounting courses taken. A total of 180 students from the graduate and undergraduate accounting program of a large university participated in the experiment. The subject received a flat compensation payment of $5.00 plus a performance-contingent bonus, paid after the experiment was conducted. The bonus was based on a composite score that includes the number of value added information used by the subjects in their wealth measurement tasks, plus their scores on an analytical ability test. Participants whose scores were in the top quartile received a bonus of $3.00, the second quartile received $2.00, and the third quartile received $1.00. The bottom quartile did not receive a bonus.

122


Exhibit 4.1 Experimental Procedures A: Experiment Phase Procedure

Description

1. Read general instruction.

Information about the study, tasks and compensation.

2. Read assignment and data memorandum.

Description of the wealth measurement task and detailed financial information.

3. Complete response memorandum.

Compute the wealth, with supporting calculation and a brief explanation of the rational used.

B: Post-Experiment Phase Procedure 1. Complete reaction questionnaire.

Description Debriefing question.

2. Complete reasoning exercise.

Analytical ability and value added knowledge tests.

3. Complete background questionnaire.

Academic background and work experience questions.

4. Receive monetary compensation.

Flat compensation upon completion of both parts of the experiment.

123


4.3.2. Case Materials and Procedures

An experiment phase and a post-experiment phase characterized the study. In the experiment phase, the subjects were provided with the instruments, the assignment, and data memorandum and a response memorandum. In the post-experiment phase, the subjects were provided with a reaction questionnaire, a combined test of analytical ability and value added knowledge, and a background questionnaire. Both phases are summarized in Exhibit 4.1. For part one, in the response memorandum the subjects were provided with revenues and expenses data for a fictional company for a given year and were instructed to (a) compute the wealth generated by the firm for the given year based on the data provided, and (b) indicate how that wealth was distributed. Appendix 3.A. shows the materials used for both part one and part two of the experiment. The case materials were calibrated in a two-stage pilot test. In the first stage three accounting professors evaluated the materials and suggested changes that were later incorporated. In the second stage three graduate students completed the tasks required and provided the comments that were also included in the materials presented to the subjects.

124


4.3.3. Independent and Dependent Variables The three knowledge groups formed included a high-accounting knowledge group, a lowaccounting knowledge group, and a no-accounting knowledge group. The subjects in the highaccounting knowledge groups (1) were enrolled in the Master of Science in Accounting program, and (2) had completed more than the minimum six accounting background courses required before being admitted to the program. The subjects in the low-accounting knowledge group (1) were enrolled in the undergraduate accounting group, and (2) were in the first week of taking the second required accounting course, giving them a maximum of one accounting course taken. The noaccounting knowledge group (1) were enrolled in the undergraduate business program, and (2) were in the first week of taking the first required financial accounting course, giving them a maximum of zero accounting courses taken.65 Value added can be defined by either the subtractive method as sales minus bought-in materials and services, or the additive method as wages + interest + depreciation + dividends + taxes + retained earnings. Therefore, there are two value added information options that can be provided by the subjects: (1) when the subjects used the subtractive method for wealth measurement,

125


and (2) when they used the additive method for wealth distribution. The information provided to the subjects included revenues and expenses that can be used in either the subtractive or the additive methods. The subjects were instructed to compute wealth and indicate how it was distributed. The expectation is that subjects in the no- and low-accounting knowledge groups will intuitively think of the situation in terms of value added measurement and distribution. Subjects in the high-accounting knowledge group are expected to think of the situation in terms of profit measurement and dividend distribution. The key feature of the design is the presentation of sufficient information on both revenues and expenses for a given year to permit either a profitbased or a value added-based wealth measurement and distribution. The memorandum is silent on both profit and value added as accounting concepts of wealth. This omission makes it possible to test whether the subjects in the zero- and low-accounting knowledge groups intuitively rely on value added as a measurement of wealth before being socialized differently by a heavier exposure to GAAP. The two different variables of wealth measurement and distribution were coded by two trained graduate research assistants, completing their last semester in the Masters program. 126


They were adequately compensated and trained with facsimile wealth measurement and distribution cases. There were no differences in the results provided by the two coders. 4.4. RESULTS 4.4.1. Validity Test

Validity tests focused on task difficulty and familiarity, value added reporting knowledge, and analytical ability. To test the assumption of similar perceptions of task difficulty, subjects were asked to evaluate the task on a ten-point scale ranging from “not difficult” (1) to “very difficult” (10). The mean scale for high- (5.22), low- (5.85), and no- (5.81) accounting knowledge subjects did not differ significantly (F = 0.062; p = 0730). To test the assumption of similar familiarity with the tasks, subjects were asked if they had encountered analogous wealth measurement and distribution situations within the last two years that help them perform the tasks on a ten-point scale ranging from “Nothing analogous” (1) to “Completely analogous” (10). The mean score for high- (4.38), low- (4.21), and no- (3.44) accounting knowledge subjects did not differ significantly (F = 1.275; p = 0.346). To test the assumption of constant knowledge of value added reporting. All the students in the 127


three groups provided answers indicative of complete ignorance of value added reporting. The result is not surprising as value added reporting is neither taught nor used in practice in the United States. To test the assumption of similar analytical ability, the subjects were given the same eight questions indicative of analytical ability selected from prior Graduate Record Examinations66 and used by Vera-Munoz.67 Analytical ability is composed of analytical reasoning and logical reasoning. Analytical ability is the ability to analyze a given structure of arbitrary relationships and to deduce new information from that structure. Logical reasoning is the ability to analyze and critique argumentation by understanding and assessing relationships among arguments or parts of an argument.68 The mean scores for high- (7.89), low- (7.32), and no(7.23) accounting knowledge subjects did not differ significantly. 4.4.2. Tests of Accounting Knowledge Descriptive statistics and planned comparison tests for the average number of value added information omitted by accounting knowledge groups are presented in Exhibit 4.2. The descriptive statistics for the average number of value added information omitted by the subjects are shown in Panel A, which shows that the overall 128


mean number of value added information omitted by the subjects was 0.785. The mean number of omissions was higher for subjects with highaccounting knowledge than for subjects with lowaccounting knowledge (0.937 vs. 0.858, respectively) and no-accounting knowledge (0.937 vs. 0.560, respectively). The total number and percentage of subjects who omitted value added information in both wealth measurement and wealth distribution is presented in Panel B of Exhibit 4.2, which shows two important results. First, the percentage of subjects who omitted value added information is higher for high-knowledge and low-knowledge groups than for the no-accounting knowledge group. It also shows that the number of omissions for the three groups is smaller for wealth distribution than for wealth measurement.

129


Exhibit 4.2 Descriptive Statistics and Planned-Comparisons Tests for the Number of Value Added Information Omitted, by Accounting Knowledge Panel A: Descriptive Statistics (Standard Deviation in parenthesis; the maximum possible number of value added information omission was two, and the minimum was zero.)a Accounting Knowledge

Average Value Added Omissions

High

0.937 n=64b

Low

0.858 n=148

No

0.560 n=148

Overall

0.785 n=360

Notes: a: Results of the statistical analysis that control the analytical ability are qualitatively similar to those that do not control the analytical ability. Thus, for presentation purposes, the means reported here are the raw (observed) means – i.e. not adjusted for analytical ability. b: n = n umber of subjects in a group × two decisions (one on wealth measurement and one on wealth distribution). 130


Panel B: Total Number (Percentage) of Value Added Information Omitted, by accounting knowledgec Value Added Information 1. Value Added Measurement

2. Value Added Distribution

Notes:

Accounting Knowledge

Data

High

30 (93.7)

Low

63 (85.1)

No

43 (58.1)

High

28 (87.5)

Low

63 (85.1)

No

23 (31.08)

c: Entities are number (and percentage) of subjects omitting the value added information. The percentages are the ratio of the number of subjects omitting the value added information in the total number of subjects in each category.

131


The result of the planned comparison for the purpose of testing H1 after controlling for analytical ability are shown in Panel C of Exhibit 4.2. H1 predicts that high-accounting knowledge decision makers are more likely to ignore value added information in wealth measurement and distribution than either low-accounting knowledge decision makers. The planned comparison for testing H1 shows that, as predicted, the effect of accounting knowledge after controlling for analytical ability is positive and significant (F = 71.61; p = 0.00001). This result indicates that, on average, the number of value added information omitted is higher for subjects with high- and/or low-accounting knowledge than for subjects with no-accounting knowledge.

132


Exhibit 4.2 (continued)

Panel C: Planned Comparison (dependent variables is the number of value added information omitted) Groups

Mean

Standard Deviation

High Accounting Knowledge

1.812

0.4709

Low Accounting Knowledge

1.698

0.5447

No Accounting Knowledge

0.888

0.3582

Notes:

F = statistic = 71.61. p = 0.00001.

133


To test the effects of accounting knowledge on the tendencies to ignore value added information, the following regression analysis was conducted: Yi = βo + β1AKi + β2AAi + β3PEi + Ei where Yi is the number of value added information omitted by subject i; AKi is accounting knowledge measured by the number of accounting courses reported by subject i; AAi is the analytical ability; and PEi is the number of months of practical experience of accounting of subject i. Exhibit 4.3 shows that the regression equation is significant (F = 26.355; p = 0.0001) and explains 37.21 percent of the variation in the number of value added information omitted. The significant and positive coefficient for β’s indicates that the effects of accounting knowledge were, as predicted, significant (t = 1.994; p = 0.040). It shows that more value added information is omitted by those subjects with greater accounting knowledge (as measured by the number of accounting courses completed). Also as expected, the negative and significant coefficient for β3 indicates that the value added information omissions increase with analytical ability increase (t = –5.741; p = 0.2201). Finally, the practical experience in accounting, as another surrogate of accounting knowledge, 134


indicates a positive and significant coefficient (β3). It shows that more value added information is omitted by those subjects with greater practical experience in accounting (t = 6.409; p = 0.017). Exhibit 4.3 Regression Results for the Effects of Accounting Knowledge Yi = βo + β1AKi + β2AAi + β3PEi + Ei Variable

Expedition

Intercept

Coefficient

t-statistic

Probability (one-tailed)

3.486

8.557

0.0001

AK

(0)

0.035

1.994

0.0401

AA

(–)

–0.990

–5.741

0.0001

PE

(0)

0.004

2.429

0.0172

Notes: F-statistic 96.355 (p = 0.0001) R2 0.3452 (adjusted = 0.3321) Variable definitions: Yi = the number of value added information omitted by subject

135


AKi = accounting knowledge, measured by the number of accounting courses completed by subjects AAi = analytical ability measured by subject i’s score on analytical ability test PEi = number of months of practical experience in accounting for subject i Ei = error term for subject i

136


4.5. DISCUSSION AND IMPLICATIONS This study provides empirical evidence that both high- and low-accounting knowledge interferes with a decision maker’s ability to incorporate value added information in wealth measurement and distribution decisions. The evidence supports the cognitive processing literature suggestion that people rely on knowledge structures stored in memory to guide their decision. Basically students with high- and low-accounting knowledge make their wealth measurement and distribution decisions as if they access from memory GAAPbased rules, which do not include value added information. The subjects with no-accounting knowledge at all seem to have intuitively thought of using value added information in their wealth measurement and distribution decisions. The results imply that while the use of value added information may be the most intuitive way of measuring and distributing wealth, the accounting knowledge as based on GAAP rules led the subjects to rely on profit measurement and dividend distribution. This is another case showing the dysfunctional effect of accounting knowledge where accounting knowledge seems to hinder performance in wealth measurement and distribution. The lack of fit between the accounting knowledge structures based on GAAP recalled

137


from memory, and the wealth measurement and distribution decisions that require consideration of value added information contributes to the erosion of decision quality.

138


NOTES 1. J. Holland, K. Holy, R. Nisbett, and P. Thagard, Induction: Process of Inference, Learning, and Discovery (Cambridge, MA: The MIT Press, 1986). 2. W. Chase and H. Simon, “The Mind’s Eye in Chess,” in Visual Information Processing W. G. Chase (Ed.) (New York: Academic Press, 1973). 3. G. Marchant, J. Robinson, W. Anderson, and M. Schadewald, “Analogical Transfer and Expertise in Legal Reasoning,” Organizational Behavior and Human Decision Process 48 (1991); 277–290. 4. C. Vera-Munoz, “The Effects of Accounting Knowledge and Context on the Omission of Opportunity Costs in Resource Allocation Decisions,” The Accounting Review (January 1998); 47–72. 5. P. Frensch and R. Sternberg, “Expertise and Intelligent Thinking: When Is It Worse to Know Better?” in Advances in the Psychology of Human Intelligence, R. Sternberg, (Ed.). (Hillsdale, NJ: Erlbaum, 1989): 5. 6. M. Nelson, R. Libby, and S. Bonner, “Knowledge Structures and the Estimation of Conditional Probabilities in Audit Planning,” The Accounting Review (January 1995): 804–824. 7. R. Libby and J. Luft, “Determinants of Judgement Performance in Accounting Settings: Ability, Knowledge, Motivation and Environment,” Accounting, Organizations and Society (July 1993): 425–450. 139


8. Similar models have been proposed for the performance appraisal process. See, e.g., A. S. De Nisi, T. P. Cafferty, and B. M. Meglino, “A Cognitive View of the Performance Appraisal Process: A Model and Research Proposition,” Organizational Behavior and Human Performance 33 (1984): 360–396; J. M. Feldman, “Beyond Attribution Theory: Cognitive Processes in Performance Appraisal,” Journal of Applied Psychology 66, no. 2 (1981): 127–48. 9. H. H. Kelly, “Attribution in Social Interactions,” in Attribution: Perceiving the Causes of Behavior, E. E. Jones et al. (Eds.) (Morristown, NJ: General Learning Process, 1972). 10. B. Major, “Information Acquisition and Attribution Processes,” Journal of Personality and Social Psychology 39 (1980): 1010–1023. 11. De Nisi, Cafferty, and Meglino, “Performance Appraisal Process,” 367–368. 12. H. I. Tajfel, “Social Perception,” in Handbook of Social Psychology, G. Lidzkey and E. Aronson (Eds.), vol. 1 (Reading, MA: Addison-Wesley, 1969). 13. P. Slovic, B. Fischoff, and S. Lichtenstein, “Behavioral Decision Theory,” Annual Review of Psychology 28 (1977): 119–139. 14. R. S. Wyer and T. K. Srull, “Category Accessibility: Some Theoretical and Empirical Issues Concerning the Processing of Social Stimulus 140


Information,” in Social Cognition: The Ontario Symposium, E. Higgins, C. Herman, and M. Zarma (Eds.), vol. 1 (Hillsdale, NJ: Erlbaum, 1981). 15. M. Snyder and N. Cantor, “Testing Hypotheses about Other People: The Use of Historical Knowledge,” Journal of Experimental Social Psychology 15 (1979): 330–342. 16. M. Snyder, “Seek and Ye Shall Find: Testing Hypotheses about Other People,” in Social Cognition: The Ontario Symposium, M. Higgins, E. C. Herman, and M. Zarma (Eds.), vol. 1 (Hillsdale, NJ: Erlbaum, 1981): 33. 17. E. B. Ebbensen, “Cognitive Processes in Inferences about a Person’s Personality,” in Social Cognition: The Ontario Symposium, M. Higgins, E. C. Herman, and M. Zarma (Eds), vol. 1 (Hillsdale, NJ: Erlbaum, 1981): 55. 18. R. E. Nisbett and L. Ross, Human Inference: Strategies and Shortcomings of Social Judgement (Englewood Cliffs, NJ: Trent and Hall, 1980), 7. 19. Wyer and Srull, “Category Accessibility.” 20. Feldman, “Beyond Attribution Theory,” 129. 21. M. Snyder and W. Uranowity, “Recontracting the Past: Some Copgnitive Consequences of Person Perception,” Journal of Personality and Social Psychology 37 (1979): 1660–1672. 22. E. Tulving, “Episodic and Semantic Memory,” in Organization of Memory, E. Tulving and W. Donaldson (Eds.) (New York: Academic Press, 1972). 141


23. R. C. Atkinson and R. M. Shiffrin, “Human Memory: A Proposed System and Its Control Process,” in Advances in the Psychology of Learning and Motivation Research and Theory, K. W. Spence and J. T. Spence (Eds.), vol. 2 (New York: Academic Press, 1968. 24. R. I. Craig, and R. S. Lockart, “Levels of Processing: A Framework for Memory Research,” Journal of Verbal Learning and Verbal Behavior 11 (1972): 671–684. 25. R. Lachman, J. L. Lachman, and Earl C. Butterfield, Cognitive Psychology and Information Processing: An Introduction (Hillsdale, NJ: Erlbaum, 1979): 274. 26. Walter Schneider and Richard M. Shiffrin, “Controlled and Automatic Human Information Processing: I. Detection, Search, and Attention,” Psychology Review (January 1977): 1–53. 27. Ibid., 51. 28. E. Tulving and Z. Parlstone, “Availability versus Accessibility of Information in Memory for Words,” Journal of Verbal Learning and Verbal Behavior 5 (1966): 381–391. 29. B. Hayes-Roth, “Evolution of Cognitive Structures and Processes,” Psychological Review 84 (1977): 260–278. 30. P. W. Thorndyke and B. Hayes-Roth, “The Use of Schema in the Acquisition and Transfer of Knowledge,” Cognitive Psychology 11 (1979): 86–87. 142


31. J. Pealmutter, P. Source, and J. L. Myers, “Retrieval Process in Recall,” Cognitive Psychology 8 (1976): 32–63. 32. B. Hayes-Roth and F. Hayes-Roth, “Plasticity in Memorial Networks,” Journal of Verbal Learning and Verbal Behavior (1979); 253–262. 33. Ibid. 34. A. G. Greenwald, “Cognitive Learning, Cognitive Response to Persuasion, and Attitude Change,” in Psychological Foundations of Attitudes, A. Greenwald, T. Brock, and T. Ostron (Eds.) (New York, Academic Press, 1960). 35. R. Shanke and R. Abelson, Scripts, Plans, Goals, and Understanding (Hillsdale, NJ: Erlbaum, 1977). 36. T. K. Srull and R. S. Wyer, “Category Accessibility and Social Perception: Some Implications for the Study of Person, Memory and Interpersonal Judgements,” Journal of Personality and Social Psychology 38 (1980): 841–856. 37. K. P. Sentis and E. Burnstein, “Remembering Schema Consistent Information; Effects of Balance Schema on Recognition Memory,” Journal of Personality and Social Psychology 37 (1979): 2200–2211. 38. C. E. Cohen, “Person Categories and Social Perception: Testing Some Boundaries of the Processing Effects of Prior Knowledge,” Journal of Personality and Social Psychology 40 (1981): 441–452. 143


39. S. E. Taylor et al., “The Generalizability of Salience Effects,” Journal of Personality and Social Psychology 37 (1979): 357–368. 40. R. I. Craig and E. Tulving, “Depth of Processing and the Retention of Words in Episodic Memory,” Journal of Verbal Learning and Verbal Behavior 11 (1972): 671–684. 41. R. Hastie and Bernadette Park, “The Relationship between Memory and Judgement Depends on Whether the Judgement Task Is Memory-Based or On-Line,” Psychological Review 93, no. 3 (1986): 258–268. 42. E. J. Learner, A. Blank, and B. Chanowitz, “The Mindlessness of Ostensibly Thoughtful Action; The Role of Placebo Information in Interpersonal Interaction,” Journal of Personality and Social Psychology 36 (1978): 635–642. 43. E. E. Learner, “False Models and Post-Data Model Construction,” Journal of the American Statistical Association 69 (1974): 122–31. 44. E. E. Learner, “Explaining Your Results as Accent-Biased Memory,” Journal of the American Statistical Association 70 (1975): 88–93. 45. M. Snyder and W. Uranowitz, “Reconstructing the Past: Some Cognitive Consequences of Person Perception,” Journal of Personality and Social Psychology 36 (1978): 941–945. 46. A. C. Graesser and G. V. Nalsamura, “The Impact of Schema on Comprehension and 144


Memory,” Psychology of Learning and Memory 16 (1982): 60–102. 47. Graesser, Gordon, and Sawyer, “Memory for Typical and Atypical Actions in Scripted Activities,” Journal of Verbal Learning and Behavior 18 (1979): 319–332. 48. W. Chase and H. Simon, “Perception in Chess,” Cognitive Psychology 4 (1973): 55–87. 49. G. Mandler, “From Association to Structure,” Psychological Review 69 (1962): 415–427. 50. Ahmed Belkaoui, Human Information Processing in Accounting (Westport, CT: Quorum Books, 1989). 51. D. L. Hamilton and L. J. Huffman, “Generality of Impression Formation for Evaluative and Nonevaluative Judgements,” Journal of Personality and Social Psychology 20 (1971): 200–207. 52. R. S. Wyer and H. L. Hinlele, “Information Factor Underlying Inferences about Hypothetical People,” Journal of Personality and Social Psychology 34 (1976): 481–495. 53. Belkaoui, Human Information Processing in Accounting. 54. Ibid. 55. J. Jaynes, The Origin of Consciousness in the Breakdown of the Bicameral Mind (Toronto: University of Toronto Press, 1978). 56. R. E. Nisbett and T. D. Wilson, “Telling More Than We Can Know: Verbal Reports on Mental 145


Processes,” Psychological Review (May 1977): 231–259. 57. M. Gibbins, “Propositions about the Psychology of Professional Judgement in Public Accounting,” Journal of Accounting Research (Spring 1989): 103. 58. Belkaoui, Human Information Processing in Accounting. 59. R. M. Hogarth, Judgement and Choice: The Psychology of Decision (Chichester: Wiley, 1980). 60. Gibbins, “Propositions about the Psychology of Professional Judgement in Public Accounting,” 114. 61. Ahmed Belkaoui, Judgement in International Accounting: A Theory of Cognition, Cultures, Language, and Contracts (Westport, CT: Greenwood Publishing, 1990): 15. 62. Chase and Simon, “The Mind’s Eye in Chess.” 63. Marchant, Robinson, Anderson, and Schadewald, “Analogical Transfer and Expertise in Legal Reasoning.” 64. Vera-Munoz, “The Effects of Accounting Knowledge and Context on the Omission of Opportunity Costs in Resource Allocation Decision.” 65. Ibid. 66. Ibid., 47–72. 67. Ibid. 68. Ibid.

146


REFERENCES Bartlett, F. C. Remembering. London: Cambridge University Press, 1932. Belkaoui, Ahmed. Human Information Processing in Accounting. Westport, CT: Quorum Books, 1989. Bobrow, D. G., and Norman, D. A. “Some Principles of Memory Schemata.” In Representations and Understanding: Studies in Cognitive Science, D. G. Bobrow and A. M. Collins (Eds.). New York: Academic Press, 1975. Brewer, W. F., and Nalsamura, G. V. “The Nature and Functions of Schemas.” In Handbook of Social Cognition, R. S. Wyer, Jr., and T. K. Srull (Eds.). Hillsdale, NJ: Erlbaum, 1984: 139–150. Canton, N., and Mischel, W. “Prototypes in Person Perception.” In Advances in Experimental Psychology, L. Berkowitz (Ed.), vol. 12. New York: Academic Press, 1979. Chase, W. G., and Simon, H. A. “The Mind’s Eye in Chess.” In Visual Information Processing, W. G. Chase (Ed.). New York: Academic Press, 1982. _______. “Perception in Chess.” Cognitive Psychology 4 (1973): 55–87. Chi, M. T. H., and Koeske, R. “Network Representations of Child’s Dinosaur Knowledge.” Developmental Psychology 19 (1983): 29–35.

147


Chiesi, H. L., Spilich, G. J., and Voss, J. F. “Acquisition of Domain-Related Information in Relation to High and Low Domain Knowledge.” Journal of Verbal Learning and Verbal Behavior 18 (1979): 257–273. Cohen, C. E. “Pearson Categories and Social Perception: Testing Some Boundaries of the Processing Effects of Prior Knowledge.” Journal of Personality and Social Psychology 40 (1981): 441–452. Craig, R. I., and Lockart, R. S. “Level of Processing: A Framework for Memory Research.” Journal of Verbal Learning and Verbal Behavior 11 (1972): 671–684. Craig, R. I., and Tuvling, E. “Depth of Processing and the Retention of Words in Episodic Memory.” Journal of Verbal Learning and Verbal Behavior 11 (1972): 671–684. De Nisi, A. S., Cafferty, T. P., and Meglino, B. M. “A Cognitive View of the Performance Appraisal Process: A Model and Research Proposition.” Organizational Behavior and Human Performance 33 (1984): 360–396. Ebbesen, E. B. “Cognitive Processes in Inferences about a Person’s Personality.” In Social Cognition: The Ontario Symposium, M. Higgins, E. C. Herman, and M. Zarma (Eds.). Hillsdale, NJ: Erlbaum, 1984: 52–59.

148


Emby, C., and Gibbins, M. “Good Judgment in Public Accounting: Quality and Justification.” Contemporary Accounting Research (Spring 1988): 287–313. Feldman, Jack M. “Beyond Attribution Theory: Cognitive Processes in Performance Appraisal.” Journal of Applied Psychology 66, no. 2 (1981): 127–148. Felix, W. L., Jr. and Kinney, W. R., Jr. “Research in the Auditor’s Opinion Formulation Process: State of the Art.” Accounting Review (April 1988): 245–271. Ferguson, T. J., Rule, B. G., and Carlson, D. “Memory for Personally Relevant Information.” Journal of Personality and Social Psychology 44 (1983): 251–261. Vera-Munoz, Sandra C. “The Effects of Accounting Knowledge and Context on the Omission of Opportunity Costs in Resource Allocation Decisions.” The Accounting Review (January 1998): 47–72.

149

Chapter 5. 5.Value-Added Taxation

5.1. INTRODUCTION Like universal health care, the value-added tax (VAT) is used by most industrialized countries and about 100 emerging countries generate most of the revenues of these countries. In the United States, the present federal structure, composed primarily of corporate and individual income taxation and payroll taxes, has been questioned as being sometimes inferior to the VAT, generating in the process a continuous debate about the feasibility and desirability of a VAT in the United States. In addition to the United States, most other countries are seriously considering a VAT similar to the European method as a necessary way to promote economic growth, stability, and productivity. In the USA, with a ceiling on suggested spending cuts or higher taxes on the rich, it is clear that a consumption tax based on VAT will be a necessity in the future, given the prediction that federal

151


revenues will need to rise by 20% to 30% in the next few years. Accordingly, this chapter elaborates on the major facets of the debates surrounding the feasibility and desirability of the VAT as an alternative to other types of taxes. 5.2. HISTORY OF VAT The value-added tax is not a new idea. The roots run deep into colonial and early America. Robert P. Crum showed that the concepts of ad valorem, transaction basis, indirect levy, multistep collection, and transaction of net product were present during that early period.1 The combination of these factors existed in the form of the value-added tax. The American economists’ early embrasure of statistical economic and business analysis, and the development of a formula for computing the gross national product (GNP) led economists and fiscal experts to think of using the GNP as a tax base. The idea was more easily supportable than implementable and European countries jumped on the bandwagon first. France adopted the VAT in 1954, thirteen years before the European community recommended its adoption by its members. The creation of the European Economic Community (EEC) following the Treaty of Rome (March 25, 1957) spurred the need for tax harmonization and the eventual acceptance by all 152

Value-Added Taxation

members of all-stage value-added tax systems. It specifically called for replacing the gross turnover tax systems with value-added tax systems. Two directives dated April 11, 1967 called for the implementation of the value-added tax systems, and after more delays from Belgium and Italy all the EEC countries adopted the system. Outside the EEC, Scandinavian countries—such as Denmark in 1967, Sweden in 1969, and Norway in 1970—followed suit. 5.3. DEFINITION AND COMPUTATION The VAT is basically the tax on the value added by a firm in the course of its operation. The value added, as stated in Chapter 1, can be defined by using either the subtractive method as the difference of the sales and purchases, or the additive method as the sum of the wages, rent, interest, and profits. Because of its practicality, the subtractive method is generally favored for the computation of the VAT in European countries. The calculation of the VAT is, as a result, a double process involving tax on a firm’s sales and a credit received by the firm for the VAT paid on its purchases. Exhibits 5.1 and 5.2 show the computation for a retailer, and for a manufacturer, a wholesaler, and a retailer. Exhibit 5.1 uses the subtractive method to compute the value added. In that case, the value 153


added due ($500) is computed as the difference between the value added due on sales ($1,000) and the VAT credit on purchases ($500). Assuming a simple tax rate, the VAT in this case could be directly obtained by taxing the tax base of $5,000 by 10%, resulting in a $500 VAT.

154


Exhibit 5.1 Computation of the Value-Added Tax for a Retailer Profit and Loss Statement

VAT computed at 10%

Sales

$10,000

+ $1,000 VAT debit on Sales

Less Purchases

5,000

– 500 VAT credit on Purchases

Value Added

5,000

$ 500 VAT net due

Less Labor and other 2,000 costs Profit before tax

3,000

Exhibit 5.2 uses the subtractive method to compute the value added throughout the chain of production and distribution formed by the manufacturer, the wholesaler, and the retailer. The VAT due at each stage is $1,000 for the manufacturer, $2,000 for the wholesaler, and $2,000 for the retailer.

155

Manufacturer Sales Less Purchases Value Added Less Other Costs Profit

$10,000 0 $10,000 $ 5,000 $ 5,000

Profit and Loss Statement

$1,000 0 $1,000

VAT Computation

$1,000

Net VAT due at Each Stage

VAT Computed at 10%

$1,000

Cumulative VAT due to the Government

Computation of the Value-Added Tax for a Manufacturer, a Wholesaler, and a Retailer

Exhibit 5.2


156

157

$50,000 $50,000

$50,000 $30,000 $20,000 $10,000 $10,000

Retailer Sales Less Purchases Value Added Less Other Costs Profit

Price to Consumer Value Added

$30,000 $10,000 $20,000 $ 7,000 $13,000

Wholesaler Sales Less Purchases Value Added Less Other Costs Profit

$5,000

$5,000 $3,000 $2,000

$3,000 $1,000 $2,000

$2,000

$2,000

$5,000

$5,000

$3,000



Exhibit 5.3 shows the computation of the VAT among the subtractive, the additive, and the invoice method. Exhibit 5.3 Alternative Methods of Value-Added Tax Computation for 10% VAT Rate (Consumption-Type VAT Base) Method 1. Subtraction Method: Net Sales Less: Purchases Capital Acq’n Net VAT Base VAT @ 10% 2. Addition Method: Payments to Productive Factors: Payroll/Int. Rent Profit Total Payments Less: Change in Inv. Cap.Acq’n Net VAT Base VAT @ 10%

Firm A

Firm B

Firm C

$300

$500

$700

-0$100 $200 $ 20

$300 $ 50 $150 $ 15

$500 -0$200 $ 20

$700 $ 70

$200 $100 $300 -0$100 $200 $ 20

$100 $100 $200 -0$ 50 $150 $ 15

$100 $100 $200 -0-0$200 $ 20

$700 $ 70

158

Consumer


3. Invoice Method: Invoiced VAT on Sales Less: Invoiced VAT on Purchases Net VAT Due

$30

$50

$70

$ 10 $ 20

$ 35 $ 15

$ 50 $ 20 $ 70

159


5.4. VAT COLLECTION METHODS There are two possible VAT collection methods: the cash-collection or tax-credit method and the invoice-collection or additive method. The cash-collection or tax-credit method recognizes VAT liability in sales and VAT credits on purchases at the time of cash payment. Under this method, the VAT must be determined and shown separately on all merchandise invoices. One of its advantages is that it is self-policing: A merchant (manufacturer, wholesaler, or retailer) collects the VAT on his sales, as with any other sales tax. He then pays the taxing authority that amount minus any other allowable offsets. (The allowable offsets are the VAT paid by the merchant on purchases.) Thus, the individual’s net tax due is determined on the basis of and traceable to sales and purchase invoices. Any buyer of goods therefore has a direct interest in ensuring that the amount of VAT charged and reported by his supplier is correct, as that charge becomes his tax credit. The system relies less on voluntary compliance than does an income tax system.2 The invoice-collection or additive method recognizes VAT liability on sales and VAT credits on purchases at the time of invoicing. 160


Basically, the value added tax, a broad tax on goods and services, will be collected at every step of the production process rather than solely on the final consumer. It will work as follows: Transaction 1. A leather store sells leather to a shoemaker.

2. The shoemaker makes A pair of shoes which are Sold to a retailer.

Base 10%VAT What happened? Price Cost $10

$!

The shoemaker pays the the leather store $11, and the leather store remits $1 to government.

$30

$2

The shoemaker does not send The full $3 VAT. He sends only $2 to the government after Subtracting the $1 tax he had paid To the leather store.

161

$11

$33


3. T he retailer sells the Shoes to a shopper $50

$2

The shopper pays $55, and given That $3 had already being paid, the Retailer will remit $2

$55

The government collects taxes at every stage of production, $! from the leather store, $2 from the shoemaker, and $2 from the retailer, receiving 10% of the final purchase price. The shopper pays $55 ($50 + $5 VAT) in addition to other applicable state, county and city sales taxes.

162


5.5. TYPES OF VAT: CONSUMPTION, INCOME, AND GROSS PRODUCT Because purchases may include both purchases of goods and purchases of capital assets, the alternative method of treating purchases of capital assets generate three possible types of VAT: the consumption type, the income type, and the gross product type. Under the consumption type, the VAT credit for purchases includes purchases of both goods and capital assets. It is labeled the consumption-type VAT because the economic base of the VAT is total private consumption. Under the income type, the VAT credit on purchases includes both the purchase of goods and the amortization value of the capital assets for the year. It is labeled the income-type VAT because the economic base of the VAT is net national income. Under the gross product type, the VAT credit on purchases includes only the purchase of goods and does not include any credit for capital assets (in total or in part). It is called the gross product type because the economic base is the gross national product, which is equivalent to consumption plus investment. Exhibit 5.4 illustrates the computation of the VAT for the three types: consumption, income, and gross national product.

163

Facts: Sales Input: Purchases Value Added Labor/Rent/Interest Profit Capital Acq. (5-Year Life) Fraction of Value Added $500 $300 $200 $100 $ 100 $ 50 2/7

-0$300 $200 $100 $100 3/7

Firm B

$300

Firm A

Value-Added Transactions and Alternative Tax Bases

Exhibit 5. 4

$500 $200 $100 $100 -02/7

$700

Firm C

Consumer


164

165

3. Gross Product Type VAT Sales Less: Purchases Net VAT Base

2. Income Type VAT Sales Less: Purchases Depreciation on Capital Acq’n Net VAT Base

Alternative VAT Bases 1. Consumption Type VAT: Sales Less: Purchases Capital Acq’n Net VAT Base

$500 $300 $200

-0$300

$ 10 $190

$ 20 $280

$300

$300

-0-

$500

$300 $ 50 $150

-0$100 $200

$300

$500

$300

$500 $200

$700

-0$200

$500

$700

$500 -0$200

$700

$700

$700

$700



5.6. OTHER CHARACTERISTICS OF THE VAT The examples used up to now assume that a single rate is being used and no adjustments are made. In fact, most existing VAT systems include at least one of the following adjustments: 1. Multiple rates applicable to different categories of goods. 2. Specific exemptions from the VAT to include, for example, (a) exemption of separate products, (b) exemption of products for political or social reasons, (c) exemption given to certain retailers, and (d) the exclusion of some stages in the production-distribution process.3 3. Reduced taxable base. With regard to the exemptions, we can include items of consumption that are intrinsically difficult to tax under the VAT or any other consumption tax, such as domestic services and expenditure abroad by Americans. The most important services that are difficult to tax under the VAT are the services of financial intermediaries, including insurance companies. The following quote illustrates the difficulty:

166


Banks, insurance companies, and other financial institutions are exempt from the Danish value-added tax simply, it is said, because of the difficulty of applying to them the concept of total sales and total purchases. Interest as such is of course not subject to the consumption-type of valueadded tax, but “interest” as a payment for services rendered by a bank free of direct charge (e.g., free checkbook and checking services) is in principle taxable. Such a service would have to be given an imputed value, and divided into that part rendered to business firms and that part rendered to households so that the tax levied on the service rendered to firms could be taken by those firms as a credit against the tax on their own sales. An approximate solution would be to tax the financial institution on its payroll, and divide this tax between the two groups of customers on some relevant basis, perhaps number of checks handled, but Denmark has been unwilling to attempt this or any other rough substitute. Meanwhile the exclusion of these financial institutions from the value-added tax system has caused some difficulty. The banks have set up a cooperative electronic data processing institute to perform their own EDP 167


[electronic data processing] services, and pay no tax on that value added.4 New Zealand, and other countries, chose to just exempt the financial services industry. This may be difficult in the USA where recent history shows that we came close to the brink because of a major banking crisis. Some suggest the retail sales tax as an alternative to the VAT. There are fundamental differences between the VAT and the retail sales tax, although both of them are consumption taxes. While the VAT is collected at every level of the business process, the retail sales tax is levied only at the point of final sale. There are also administrative and political differences underlying the comparison between the retail sales tax and the VAT. First, the VAT requires more paperwork than a national sales tax. Second, evasion is more difficult under the VAT, given that under VAT evasion would be limited to the level of production where it occurred, while under a retail sales tax the whole potential tax revenue could be eliminated. Finally, most states have a sales tax and would not welcome the addition of a VAT by the federal government. 5.7. MAJOR ADVANTAGES ATTRIBUTED TO THE VAT 1. The VAT system will be easy to administer with its reliance on the invoices generated in the 168


normal course of business, which will give the IRS all the information needed to compute the tax due. The system will be self-policing since at every step, businesses will pressure others to prove that they paid their VAT. 2. The pure VAT, with all goods and services subject to the same rate, will be economically neutral in the sense that no sector of the economy will be favored over any other. In addition, unlike income taxes, which are front-loaded on the rich, everybody is subject to VAT. It is this argument of providing a broad tax which led the IMF to frequently recommend VAT to countries that need to raise cash quickly. 3. The VAT may restore an edge in international trade, since the tax would be rebated on American exports and imposed on imports. In effect, under the General Agreement on Tariffs and Trade (GATT), indirect taxes—such as the VAT, the excise tax, and the commodity tax—can be rebated on exports and levied on imports, while direct taxes—such as income taxes—cannot. Because most U.S. trading partners levy a large percentage of their revenues through indirect taxes like the VAT, allowing them to enjoy a tax holiday while American exports are double taxed creates an inequity 169


in the tax structure. A VAT system may help correct the situation by helping domestic exports and by making domestic products more competitive with imports. 4. Because VAT’s consume only income, they may encourage savings. Higher savings would reduce the adverse effects on domestic competitiveness by reducing the flow of foreign capital in the United States, and thereby lowering the value of the dollar. 5. The VAT would be noninflationary if it is a net tax increase but a replacement tax that will restructure taxes that are currently inefficient and inequitable. 6. Use of the VAT would alleviate the underground economy because it provides incentives for more participants to stay in the system to obtain credits for their import taxes. While this advantage has not been proven empirically, the European experience seems to contradict it. For example: The underground economy does exist under a VAT. For example, it is uncommon for a European home owner dealing with tradesmen—such as painters, plumbers 170


and carpenters—to be given a choice between a price with the VAT included or a lower price without a VAT. The reason this practice can be profitable under the VAT is that typically in labor intensive activities the input tax incurred by the business person may be relatively small. Accordingly, only a small number of taxable transactions need to be entered into to insure that the VAT collected is sufficient to offset credits for VAT paid. Once this balance is achieved, service can be offered “underground” free of VAT, with no adverse tax consequence to the business and with possibly higher favorable results because of the competitive advantage gained from the lower prices. Although the principal audit problems arise at the retail level, more complex avoidance schemes involving chains of selling and purchasing can be devised.5 7. When compared with other types of taxes, VAT appears to be the most neutral toward businesses of all types. 8. The VAT has been assumed to contribute to a drastic increase in inflation because it raises prices at each level. According to Alan Tait, data on prices can show the effects of the introduction of the VAT in four ways: 171


• There may be a single upward shift in the consumer price index clearly associated with the period when the tax was introduced but with an unchanged, or little changed, rate of increase in prices if the tax increases government revenue and if traders pass forward the increase. This is called the shift case. If inflation is defined as a continuing general increase in prices, the tax that results in a once-and-for-all price change cannot be inflationary by itself. • There may be an increase in the rate of change of the index as a result of the introduction of the tax. This is called the acceleration case. • The acceleration may be combined with a shift in the overall price level. This is referred to as the shift plus acceleration case. • There may be no discernible effects at all if the tax substitutes perfectly for the one it replaces, or if the authorities can offset any accompanying pressures to increase prices.6 In fact, using data and circumstantial evidence, the analysis of thirty-one countries using the VAT showed that the introduction of the tax need not be inflationary. In the case of accelerated inflation, the cause was more often than not

172


apparently due to expansionary wage and credit policies.7 Another argument refuting the inflationary effect of a VAT goes as follows: “An all-round use in consumer prices not accompanied by an increase in money incomes will force consumers to restrict their demands for some goods or services, and this will tend to bring prices down to their previous level.”8 9. One of the advantages of the VAT is that under this system the tax burden is shifted forward from stage to stage all the way up to the consumer, thus creating the usual characterization of the VAT as a tax on consumption. Questions are generally raised about the realism of such an assumption: “How much weight should be given to special situations of highly depressed markets that force taxpayers at some preconsumption stage to absorb part of the tax to avoid curtailing demand on the part of their customers?”9 10. One advantage of the VAT comes from the borderline tax adjustments (BTA) on goods entering international trade, where it is customary to rebate any VAT previously collected on reports and apply VAT to the imports. These

173


mechanisms, if adopted by the United States, would go as follows: In the case of imports, the VAT would be applied at the same rate applicable to value added in domestic production to the full value of the imports as reported to the Customs Bureau as the imports entered customs. In the case of exports, the U.S. exporter would deduct the invoice value of export sales from his total net sales and receipts before deducting his purchases from other businesses in arriving at his taxable value added, assuming the subtraction method is used for computing the tax. Under the invoice method the taxpayer has no VAT liability on his export sales land claims a credit for all of the VAT shown on his purchase invoices.10 11. The matter of evasion is important when considering the adoption of a tax system. The VAT system is considered efficient at reducing some of the tax evasion taking place under other systems. For one thing, if the VAT is evaded at the retail stage, where it is the most unbearable, the government would have at least collected it in earlier stages. If the “credit” method of tax deduction is used, the VAT 174


system acts as a self-policing mechanism. Under such a system, at each stage one actor specifies to the other the VAT he or she has paid and wants to recoup. The invoice serves as evidence of the exact amount to be paid. The relative burdens of record that VAT requires, where firms must keep tax records with respect to their purchases as well as their sales, act as a hindrance to any evasion schemes. 5.8. MAJOR TO THE VAT

DISADVANTAGES

ATTRIBUTED

1. The VAT is perceived as regressive and likely to affect lower-income groups and bigger families that spend a larger share of their income. This feature may be corrected if a higher VAT rate is levied on luxury goods, and food and pharmaceuticals are exempted, making the VAT more progressive. 2. It could contribute to a drastic increase in inflation because it raises prices at each level. The impact could be, however, reduced by the appropriate combination of fiscal and monetary policy. 3. It will disturb some of the states which rely on retail sales taxes and which may resent the 175


federal government’s intrusion into their domain. The VAT, because of its similarity to a sales tax, will allow the government to cut into these states’ favorable revenue source, and that may handicap the states at a crucial moment. 4. The VAT, coupled with cuts in personal and corporation income taxes, would have no effect in aggregate exports, even though the income tax cuts would induce companies to lower prices. Henry J. Aaron, a senior fellow at the Brookings Institution, explains as follows: Initially, all exporters and import-competing companies would tend to sell more, but in a world of flexible exchange rates, a drop in the prices of American exports and importcompeting goods would cause the dollar to appreciate, since foreign demand for dollars to buy American goods would increase and American demand for foreign currencies to buy imports would decrease. The appreciation of the dollar would substantially offset the price cuts. Companies that cut their prices by more than the average would tend to gain market share; those that cut prices less would tend to lose share. But the aggregate effect would be negligible. So, if one looks only at trade, 176


replacing part of the personal and corporation income taxes with a B.T.T. [business transfer tax] would have little or no effects on our companies’ capacity to meet foreign competition.11 5. Limited merit is given the argument that the VAT will improve American exports, and thus its exchange position. Witness the following quotation: The corporate income tax reduces our competitive position in world markets only to the extent that the tax is shifted forward in higher export prices. Even for domestic sales, that tax shifting remains doubtful, and it is less likely that the tax is shifted at all to export prices. To the extent that the corporation tax is shifted, removal of the tax would initially improve our export position. This can be done as effectively by devaluation of the dollar. However, the present foreign exchange value of the dollar reflects any shifted elements of the corporate tax, and the value may be slightly lower than it would be if the tax did not exist. Furthermore, other countries use corporate income taxes in addition to value added taxes. They normally do not replace the former by the latter. 177


These foreign corporate taxes are roughly comparable to those of the United States government. Essentially, the American firms are now at a disadvantage even to the extent that the corporation tax is shifted, and if the United States would replace its corporate tax with a value added tax, retaliation almost certainly would follow. It is important to note that one of our chief competitors in the world market, Japan, does not employ a value added tax.12 6. One of the disadvantages of the VAT is its assumed regressivity given that consumption as a percentage of income falls as income rises. Then the VAT would take a larger proportion of the income of the poor than of the rich. This leads proponents of the VAT to suggest that various exceptions or exemptions from the VAT be allowed, and that various output classes such as food, clothing, shelter, and health care be excluded. Some, however, would argue that the view that VAT is a consumption tax is, at best, only partially correct. The argument goes as follows: People are likely to reduce their consumption and their saving in equal proportions in response to the VAT, thus shifting the burden 178


of the tax back to the producers—to those supplying production inputs. The VAT may appropriately be seen as burdening consumption insofar as revenues are used to finance government activities, the products of which offered less satisfaction than those which would have been consumed in the absence of the tax. But in this sense, there is no way of telling whether the VAT burdens consumption more or less than any other tax producing the same amount of tax revenues. Nor is there any a priori basis for determining whether this sort of consumption burden is heavier on the poor than on the affluent.13 5.9. THE POTENTIAL FOR THE VAT IN THE UNITED STATES 5.9.1. How Much Longer Can We Stand the Federal Debt?

The federal debt is reaching enormous proportions. The outstanding public debt as of December 11 2009 at 9:PM was $12,096,450,034,852.61. The estimated population of the United States is 307,449,468, so each citizen’s share of this debt is $39,344.51. The national debt has continued to increase at an average of #3.48 billion per day since September 28, 2007.re was about $2.25 of debt for 179


each dollar of GNP in 1995. The deficit for the fiscal year 2009, which ended September 30, came in at a record $1.42 trillion, more than triple the record set just one year earlier. When one examines the overall debt relationship to GNP, trying to rely on foreigners to continue to finance the federal deficit at a rate of about few hundred billions a year is a false solution with serious consequences. People’s attitudes toward financial leverage add to the problem. This is reflected in the increase in leveraged buyouts and corporate takeovers financed with the so-called junk bonds ; in second mortgages outstanding, from $40 billion in 1981 to $150 billion in 1985; and in consumer debt, with credit cards of $4,662 per cardholder in 2007. Are we mortgaging the future of our children? The obvious remedy is lowering the federal deficit and changing the attitudes of all, including the federal government toward debt. This calls for a revision of a tax code that includes obvious and powerful incentives for debt accumulations both at the corporation and household levels. With the federal budget deficit going toward the gigantic figure of $1.42 trillion plus, the supply-side notion that tax cuts generate rising revenues sounds ludicrous. As put by Yale University professor William D. Nordhaus: Arthur B. Laffer’s theories are no more than “economic Laetrile” after he cancer drug that most doctors scoff at. The notion that the 180


United States could cut tax rates and bring more money is at best absurd. The notion still made Laffer the intellectual godfather of the tax cut movement. 5.10. CONCLUSIONS The VAT appears as an interesting alternative to corporate and individual income taxes in the United States. It has its advantages and limitations. From the discussion in this chapter, the advantages seem to outweigh the limitations. In addition, the VAT has been successfully implemented in mot European countries. For the sake of a worldwide tax harmonization, the VAT appears to be a practical and efficient tool. What is needed in those countries that have not yet adopted a VAT is some bold attempt to change the status quo and convince entrenched interest groups of the feasibility and desirability of a system deemed to become accepted worldwide as a revenue raiser and a necessary way to promote economic growth, stability, and productivity.

181


NOTES 1. Robert P. Crum, “Value-Added Taxation: The Roots Run Deep into Colonial and Early America,” Accounting Historians Journal (Fall 1982), pp. 25–42. 2. Philip M. J. Reckers and H. L. Bates, “Ready for VAT?” Financial Executive (February 1980), p. 25. 3. Dan Throop Smith, James B. Webber, and Carol M. Cerf, What You Should Know about the Value Added Tax (Homewood, IL: Dow JonesIrwin, 1973), p. 8 4. Carl S. Shoup, “Experience with Value Added Tax in Denmark, and Prospects in Sweden,” Finanzarchiv (March 1969), p. 245. 5. Paul R. McDaniel, “A Value Added Tax for the United States? Some Preliminary Reflections,” Journal of Corporation Law (Fall 1980), p. 29. 6. Alan Tait, “Is the Introduction of a ValueAdded Tax Inflationary?” Finance and Development (June 1981), p. 42. 7. Ibid., p. 42. 8. Eric Schiff, Value-Added Taxation in Europe, Foreign Affairs Studies (Washington, DC: American Enterprise Institute for Public Policy Research, 1973), p. 22. 9. Ibid., p. 23. 10. Normal B. Ture, “Economics of the Value Added Tax,” in Value Added Tax: Two Views, 182


Charles E. McLure, Jr., and Norman B. Ture (Washington, DC: American Enterprise Institute for Public Policy Research, 1972), p. 77. 11. Henry J. Aaron, “How a V.A.T. Would Hurt Our Exports,” New York Times (March 23, 1986), p. 2F. 12. John F. Due, “Economics of the Value Added Tax,” Journal of Corporation Law (Fall 1980), p. 71 13. Normal B. Ture, “The Basic Economics of a United States VAT,” Journal of Corporation Law (Fall 1980), p. 59. 14. William V. Roth, “Why We Need to Tax Consumption,” New York Times (March 23, 1986), p. 2F.

183


SELECTED READINGS Aaron, Henry J., ed. The Value-Added Tax: Lessons from Europe. Washington, DC: Brookings Institution, 1981. Brecher, Stephen M., Donald W. Moore, Michael M. Hoyle, and Peter G. B. Trasker. The Economic Impact of the Introduction of VAT. Morristown, NJ: Research Foundation of the Financial Executives Institute, 1982. Brown, Ray L. “Management Accountants: Are You Ready for VAT?” Management Accounting (November 1981), pp. 40–42, 44, 52. Calkins, Hugh. “Role of the Value-Added Tax in the Developing United States Tax System.” Journal of Corporation Law (Fall 1980), pp. 83–102. Campet, C. Influence of Sales Taxes on Productivity. Paris: European Productivity Agency of the Organization for European Economic Cooperation, 1958. Carlson, George N. “Value-Added Tax: Appraisal and Outlook.” Journal of Corporation Law (Fall 1980), pp. 37–47. Crum, Robert P. “Value-Added Taxation: The Roots Run Deep into Colonial and Early America.” Accounting Historians Journal (Fall 1982), pp. 25–42. Curtis, John E. “Legislative Perspective on the Value Added Tax.” Tax Management International Journal (June 1980), pp. 7–9, 16. 184


Dickinson, J. A. “Adding Value Can Be Fun.” Management Accounting (November 1979), pp. 52–53. Dresch, Stephen P., An-Loh Lin, David K. Stout, and Milton L. Godfrey. Substituting a Value-Added Tax for the Corporate Income Tax: First Round Analysis. Cambridge, MA: Ballinger, 1977. Due, John F. “Economics of the Value Added Tax.” Journal of Corporation Law (Fall 1980), pp. 61–81. _______. “Universality and Neutrality of the Value Added Tax Reexamined.” Taxes—The Tax Magazine (July 1977), pp. 469–475. Foley, B. J., and K. T. Mauncers. Accounting Information Disclosure and Collective Bargaining. London: Macmillan, 1977. Godwin, Michael. “VAT—Compliance Costs to the Independent Retailer.” Accountancy (England) (September 1976), pp. 48–50, 52, 54–56, 58, 60. Kirchhofer, John D. “Value-Added Tax: Proposed Use in the U.S. and Possible Effects on CPA’s.” Georgia Journal of Taxation (Spring 1980), pp. 171–188. Laffer, Arthur B. “International Impact of a ValueAdded Tax.” Journal of Corporation Law (Fall 1980), pp. 119–125. Landers, Mathew P. “Motivations Behind VAT Proposals.” Tax Executive (October 1979), pp. 13–20. Lindholm, Richard W. “VAT Designed for the United States.” Tax Executive (October 1970), pp. 13–20. 185


_______. The Economics of VAT: Preserving Efficiency, Capitalism, and Social Progress. Lexington, MA: Lexington Books, 1980. _______. “Origin of the Value-Added Tax.” Journal of Corporation Law (Fall 1980), pp. 11-14. McDaniel, Paul R. “A Value Added Tax for the United States?, Some Preliminary Reflections.” Journal of Corporation Law (Fall 1980), pp. 15–36. McKee, Thomas E. “Value-Added Taxation: New Federal Revenue Source or New Federal Headache?” Atlanta Economic Review (January– February 1975), pp. 14–17. McLure, Chares E. “Administrative Considerations in the Design of Regional Tax Incentives.” National Tax Journal (June 1980), pp. 177–188. _______. “State and Federal Relations in the Taxation of Value Added.” Journal of Corporation Law (Fall 1980), pp. 127–139. McLure, Charels E., Jr., and Normal B. Ture. Value Added Tax: Two Views. Washington, DC: American Enterprise Institute for Public Policy Research, 1972. Messere, Ken. “Defense of Present Border Tax Adjustment Practices.” National Tax Journal (December 1979), pp. 481–492. Murray, Bart R. “Value Added Tax and the United States.” Tax Adviser (September 1979), pp. 546–549.

186


Norris, Alf. Value Added Tax: A Tax on the Consumer. London: Fabian Society, 1970. Parker, Seth K. “Compliance Costs of the ValueAdded Tax.” Taxes—The Tax Magazine (June 1976), pp. 369–380. Prest, A. R. Value Added Taxation: The Experience of the United Kingdom. Washington, DC: American Enterprise Institute for Public Policy Research, 1980. Reckers, Philip M. J., and H. L. Bates. “Ready for VAT?” Financial Executive (February 1980), pp. 24–26, 28. Rutherford, B. A. “Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems.” Accounting and Business Research (England) (Summer 1977), pp. 215–220. Sanford, C. T., M. R. Godwin, P. J. W. Hardwick, and M. I. Butterworth. Costs and Benefits of VAT. London: Heinemann, 1981. Schiff, Eric. Value-Added Taxation in Europe. Foreign Affairs Studies. Washington, DC: American Enterprise Institute for Public Policy Research, 1973. Smith, Dan Throop, James B. Webber, and Carol M. Cerf. What You Should Know about the Value Added Tax. Homewood, IL: Dow Jones-Irwin, 1973. Storrer, Philip P. “Tax Reform and a Proposal: The Value Added Tax.” Taxes—The Tax Magazine (October 1978), pp. 629–634. 187


Sullivan, Clara K. The Tax on Value Added. New York: Columbia University Press, 1966. Symonds, Edward. “Very Potent Revenue Source.” Accountant (January 24, 1980), pp. 111–113. Tait, Alan. “Is the Introduction of a Value-Added Tax Inflationary?” Finance and Development (June 1981), pp. 38–42. “Tax Division Study Examines if VAT is Applicable in U.S.” Journal of Accountancy (February 1976), pp. 22, 24. Ture, Normal B. “The Basic Economics of the United States VAT.” Journal of Corporation Law (Fall 1980), pp. 49–60. Wagner, Richard E., et al. Perspective on Tax Reform, Death Taxes, Tax Loopholes, and the Value Added Tax. New York: Praeger, 1974. Walduer, Charles. “Comment on the Variable Rate Value-Added Tax as an Anti-Inflation Fiscal Stabilizer.” National Tax Journal (March 1981), pp. 131–132. Wetzler, James W. “Role of a Value Added Tax in Financing Social Security.” National Tax Journal (September 1979), pp. 334–344. White, Daniel L. “Variable Rate Value Added Tax as an Anti-Inflation Fiscal Stabilizer.” National Tax Journal (June 1980), pp. 227–232. _______. “Variable Rate Value Added Tax as an Anti-Inflation Fiscal Stabilizer.” National Tax Journal (March 1981), p. 133. 188

Chapter 6. 6. Usefulness of Value Added Reporting: A Review and Synthesis of the Literature

6.1. INTRODUCTION The role of earnings in external financial reporting is being seriously challenged by the emerging role of value added data. Inclusion of such data in the financial reports of U.S. corporations has been suggested by the American Accounting Association Committee on Accounting and Auditing1 and in the international accounting and research literature.2-4 Value added represents the total wealth of the firm that could be distributed to all capital providers, employees, and the government. Earnings represents the return to shareholders, while other value added components reflect returns to the other stakeholders, i.e., the government, bondholders, and employees. The investigation of value added reporting has been the continuing subject of a descriptive 189


literature, which has been complemented by a growing empirical literature. This chapter provides an overview of the empirical literature, which has generally focused on the benefits and limitations of value added reporting in the U.S. context. 6.2. USEFULNESS OF VALUE ADDED REPORTING: EMPIRICAL RESEARCH The empirical research evaluating the usefulness of disclosing value added data—in addition to earnings and cash flow data—has been conducted from three perspectives: (1) value addedbased performance of firms in different contexts, (2) the informational content of value added data in market valuation, and (3) the predictive ability of value added data. A review of each research perspective follows.

190

Usefulness of Value Added Reporting

Exhibit 6.1 Value Added Performance of Firms Study

Context

Results

1. Riahi-Belka- Multidivisional struc- Following the M-form oui (1997c) ture and diversifica- implementation, protion strategy ductive efficiency decreases for vertically integrated firms and increases for related diversified firms. The moderate increase in productivity is not significant for unrelated diversifiers. 2. RiahiEffects of owner- There is a significant Belkaoui ship structure nonmonotonic reand Pavlik lationship between (1994) value added performance and ownership structure. 3. Askren Performance plan Firms adopting acet al. (1994) adoption counting-based performance plans do not experience any greater gains in accounting return or productivity measure than do a set of control firms. 191


4. R iahi-Belka- Performance plan Following perforoui (1997a) adoption and own- mance plan adopership structure tion, profitability will increase in ownercontrolled firms, but not manager-controlled firms.

192


6.3. Value Added Performance of Firms The value added performance of firms has been examined under different contexts, which are summarized in Exhibit 6.1. The first context concerns the M-form hypothesis; it stipulates a better performance following the implementation of the multidivisional structure.5 Most studies examining the M-form hypothesis measured the economic performance of firms before and after implementation of the M-form using either earnings-based or market-based performance indicators.6,7 The results were mixed. One study by Riahi-Belkaoui8 instead relied on a value added-based measure of productivity as a measure of economic performance of the firm before and after the implementation of the M-form. Values for a sample of U.S. firms found that following the implementation, productive efficiency decreased for vertically integrated firms and increased for related diversified firms. The increase in productivity was not significant for unrelated diversifiers. In sum, the adoption of the M-form seems to be more beneficial in terms of productivity to those firms adopting a related diversification strategy. The strategy allows the realization of synergistic economies of scope through the joint use of input. The second context concerns the effect of ownership structure on performance as reflected in the debate regarding the importance of stock 193


ownership on corporate efficiency and strategic development.9,10 Empirical examination of the issue led to conflicting results11 that were attributed to data problems when attempting to construct meaningful measures of performance.12 The study by Riahi-Belkaoui and Pavlik13 argued that the effects of ownership structure and performance are best examined when performance expresses total return rather than being restricted to accounting returns. Using a sample of U.S. firms, they found a significant nonmonotonic relationship between value added-based performance and ownership structure. Value added-based performance declines up to a turning point before increasing proportionally to the increases in ownership structure measures. The phenomena held regardless of whether ownership structure is measured by management stockholding, stock concentration, or a sum or the two measures. This result is compatible with: (a) a dispersion of ownership and non-value maximizing behavior where holdings are less than 10 percent ownership, and (b) a convergence of interest for the maximization of value addedbased performance between managers and shareholders where there is more than 10 percent ownership. The third context concerns the firm performance resulting from the adoption of performance plans. This context follows from theoretical 194


arguments indicating that long term accountingbased performance plans motivate executives to improve firm performance in the long run. Askren et al.14 present results based on a sample of U.S. firms indicating that firms adopting accountingbased performance do not experience any greater gains in accounting return or value added-based productivity measures than do a set of control firms. However, Riahi-Belkaoui15 argued that the nature of the relationship varies with the ownership structure of the firm. Using the same sample of firms, his results supported his contention with respect to owner-controlled but not manager-controlled firms. 6.4. Market Valuation and Value Added versus Conventional Data The information content of value added data versus conventional earnings and cash flow data has been examined in various studies.16-20 Several studies relied on various market valuation models.21-25 Exhibit 6.2 results confirm the thesis; namely, the association between firm value and value added measures of performance is stronger than the association between firm value and either earnings or cash flow measures. The results hold for both linear and nonlinear valuation models. When the research question examined the functional specification relating earnings or net value added to 195


market invested returns, the models relating accounting and market returns have more explanatory power under the following conditions: (a) the accounting returns are expressed by the relative changes in net value added, and (b) the relation is nonlinear, convex-concave function.26

196

Research Question

Model Used

Results

197

2. Riahi-Belkaoui Relative and in- Earnings valuation Value added information (1993) cremental content model. can supply some explanaof value added, tory power beyond that proearnings and cash vided by earnings or cash flow. flow measures.

1. Bao and Bao Association be- L i t z e n b e r g e r The association between (1989) tween productivity and Rao (1971) firm value and productivity and firm value. valuation model. in the oil refining and apparel industries is stronger than between firm value and earnings measures.

Study

Market Valuation and Value Added versus Conventional Data

Exhibit 6.2 Usefulness of Value Added Reporting

198

5. R i a h i - B e l k a - Information con- Book value and oui and Picur tent of level versus wealth models. (1994) change in net value added.

Both the levels of net value added and the changes in net value added play a role in security valuation.

4. R i a h i - B e l k a - Relative and incre- Combined earnings The study confirms an asoui and Picur mental information and value added sociation between both (1994) content of value valuation model. relative changes in earnings added and earnand net value added and ings. the relative changes in security prices.

3. R i a h i - B e l k a - Merits of derived Accounting indica- The derived performance oui, and accounting indicator numbers (Barlev indicator numbers based on Fekrat (1994) tor numbers. and Levy, 1979). net value added had lower variability and higher persistency than corresponding numbers based on either earnings or cash flows.


199

Models relating accounting and market returns have more explanatory power when: (a) the accounting returns are expressed by the relative changes in net value added, and (b) the relation is a nonlinear convex-concave function.

7. Riahi-Belkaoui Informational con- Earnings valuation Earnings component of val(1997b) tent of net value model. ue added is viewed favoradded compoably by the market while the nents disclosed nonearnings components concurrently with (interest, tax and wages) are earnings. negatively related to market return.

6. Riahi-Belkaoui Functional specifi- Linear and nonlinear (1996) cation relating un- valuation models. expected earnings or net value added to market-adjusted returns.



6.5. Predictive Ability of Value Added Data The predictive ability of value added data has been examined in three studies that differ in terms of the nature of prediction or the economic event predicted. (See Exhibit 6.3.) The first study, by Karpik and Belkaoui,27 follows from earlier works establishing the empirical / theoretical relationship between accounting variables and market risk.28 It tested the incremental abilities of value added measures to explain crosssectional variation in market betas beyond that provided by risk measures that are either earnings or cash flow based. The results based on a sample of U.S. firms point to the superior explanatory power of value added variables in explaining the variability in market betas. The second study, by Bannister and RiahiBelkaoui,29 follows from previous empirical endeavors to investigate the characteristics differentiating merger target firms from other firms.30,31 The study instead relies on value added to: (a) assess the differences in the characteristics of target firms compared to their industries, and (b) explain target firms’ abnormal returns during the takeover period. The results indicated that (a) takeover targets have lower value added ratios than other firms in their industries in the year preceding the completion of the takeover, and (b) target firm abnormal returns observed during 200


the takeover period are positively related to the difference between target firm and average industry valuation added to total assets. The results suggest that while acquired firms are, on the average, underperformers, acquiring firms value the access to and possibly the ability to redistribute the resources of target firms. The third study, by Bao and Bao,32 is consistent with other studies regarding time series properties of accounting earnings. It examined the time series properties of value added-based measure using four well-known time series models: the pure mean reverting model, the mean reverting model with a growth trend, the random walk model, and the random walk with a drift term. Using a sample of U.S. firms, the results showed that the value added-based measures can be described as a random-walk process, which has the lowest forecast errors in terms of two error metrics: the autocorrelation coefficient test and a predictability test. The results are consistent with those of annual earnings and stock prices.

201


Exhibit 6.3 Predictive Ability of Value Added Data Study 1. Karpik and Belkaoui (1989)

2. Bannister and RiahiBelkaoui (1991)

Nature of Prediction Explaining market risk.

Model Used Market model.

Explaining Market target firm’s model. abnormal returns during the takeover period.

202

Results Value added variables process incremental information beyond accrual earnings and cash flows in the context of explaining market risk. Takeover targets have lower value added to total ratios rather than other firms in their industries in the year preceding the completion of the takeover, and target firm abnormal returns observed during the takeover period are related to the difference between target firm and average industry value added.


3. Bao and Bao (1996)

Examining Four time the structure series and the models. forecasting accuracy of firm value added measure.

203

The four value added measures can be diversified as a random walk model. The process/model has the lowest forecast errors in terms of two error metrics.


6.6. SUMMARY AND CONCLUSIONS This chapter reviewed the descriptive and empirical literature on the usefulness of value added data. Coincidentally, the use of value added reporting is on the increase worldwide.33 Calls have been made for its adoption by U.S. corporations. The current disclosure system does not mandate the disclosure of the information needed to compute the value added metric. The descriptive and empirical results summarized in this chapter make a favorable case for the adoption of value added reporting in the United States. The cost of reporting this data should be relatively immaterial given the availability of all the information comprising value added. Given the low cost relative to the potentially much greater benefits shown in this chapter, releasing value added reports, or disclosing the underlying data needed to compute value added, appears to be an improvement over the present U.S. reporting system. In addition, the FASB’s Statement of Financial Accounting Concepts No. 534 notes that supplementary financial statements can be useful for introducing and gaining experience with new kinds of information. The American Accounting Association Committee on Accounting and Auditing Measurement35 has also recommended that value added be considered for mandatory disclosure. In sum, a strong case can be made for both mandatory disclosure and increased research on the usefulness of value added reporting in the U.S. context. 204


NOTES 1. American Accounting Association, “Committee on Accounting and Audition Measurement, 1989–1990,” Accounting Horizons (September 1991): 81–105. 2. M. Zubaidur Rahman, “The Local Value Added Statement: A Reporting Requirement for Multinationals in Developing Host Countries,” International Journal of Accounting (February 2, 1990): 87–98. 3. Gary K. Meek and Sidney J. Gray, “The Value Added Statement: An Innovation for the U.S. Companies,” Accounting Horizons (June 1988): 73-81. 4. C. Deegan and A. Hallman, “The Voluntary Presentation of Value Added Statements in Australia: A Political Cost Perspective,” Accounting and Finance (May 1991): 1–29. 5. R. E. Hoskisson, “Multidivisional Structure and Performance: The Contingency of Diversification Strategy,” Academy of Management Journal 2 (1987): 625–644. 6. P. Karpik and Ahmed Riahi-Belkaoui, “The Effects of the Implementation of the Multidivisional Structure on Shareholders’ Wealth: The Contingency of Diversification Strategy,” Journal of Business Finance and Accounting (April 1994): 349–366.

205


7. Ahmed Riahi-Belkaoui and J. W. Bannister, “Multidivisional Structure and Capital Structure: The Contingency of Diversification Strategy,” Managerial and Decision Economics 15 (1994): 267–276. 8. Ahmed Riahi-Belkaoui, “Performance Plan Adoption and Performance: The Contingency of Ownership Structure,” Finance Management (1997). 9. Meek and Gray, “The Value Added Statement.” 10. Ahmed Riahi-Belkaoui and Ali Fekrat, “The Magic in Value Added: Merits of Derived Accounting Indicator Numbers,” Managerial Finance 20, no. 9 (1994): 3–15. 11. J. Cubbin and D. Leach, “The Effect of Shareholder Dispersion on the Degree of Control in British Companies: Theory and Measurement,” Economic Journal 3 (1983): 351–369. 12. C. W. Hill and S. A. Snell, “Effects of Ownership Structure and Control on Corporate Productivity,” Academy of Management Journal 32 (1989): 25–46. 13. Ahmed Riahi-Belkaoui and Ellen Pavlik, “The Effect of Ownership Structure on Value Added Performance,” Managerial Finance 20, no. 9 (1994): 16–26. 14. Barbara J. Askren, J. W. Bannister, and E. Pavlik, “The Impact of Performance Plan Adoption 206


on Value Added and Earnings,” Managerial Finance 20, no. 9 (1994): 27–43. 15. Riahi-Belkaoui, “Performance Plan Adoption and Performance.” 16. Ben-Hsien Bao and Da-Hsien Bao, “The Time Series Behavior and Predictive Ability Results of Value Added Data,” Journal of Business Finance and Accounting (April 1996): 449–460. 17. Ahmed Riahi-Belkaoui, “The Information Content of Value Added, Earnings and Cash Flows: U.S. Evidence,” The International Journal of Accounting 28, no. 2 (1993): 140–146. 18. Riahi-Belkaoui and Fekrat, “The Magic in Value Added.” 19. Ahmed Riahi-Belkaoui and Ronald D. Picur, “Explaining Market Returns: Earnings versus Value Added Data,” Managerial Finance 20, no. 9 (1994): 44–55. 20. Ahmed Riahi-Belkaoui, “An Empirical Case for Value Added Reporting in the United States,” Indian Journal of Accounting (December 1996): 40–47. 21. R. H. Litzenberger and C. W. Rao, “Estimates of the Marginal Rate of Time Preference and Average Risk Aversion of Investors in Electric Utility Shares: 1960–66,” Bell Journal of Economics and Management Science (Spring 1971): 265–277.

207


22. P. D. Easton and T. S. Harris, “Earnings as an Explanatory Variable for Returns,” Journal of Accounting Research. (Spring 1991): 19–36. 23. Benzion Barlev and Haim Levy, “On the Variability of Accounting Numbers,” Journal of Accounting Research (Autumn 1979): 305–315. 24. J. A. Ohlson, “Earnings, Book Value and Dividends in Security Valuation,” Contemporary Accounting Research (Spring 1995): 661–687. 25. Ohlson, J. A. “Accounting Earnings, Book Value and Dividends: The Theory of Clear Surplus Equation,” Working paper (New York: Columbia University), 1988. 26. Ahmed Riahi-Belkaoui, “Earnings-Return versus Net Value-Added Returns Relation: The Case for Nonlinear Specification,” Advances in Quantitative Analysis in Finance and Accounting 4 (1996): 175–185. 27. P. Karpik and Ahmed Belkaoui, “The Relative Relationship between Systematic Risk and Value Added Variables,” Journal of International Financial Management and Accounting (Autumn 1989): 259–276. 28. B. E. Ismail and M. K. Kim, “On the Association of Cash Flow Variables with Market Risk: Further Evidence,” The Accounting Review (January 1989): 125–136. 29. James W. Bannister and Ahmed RiahiBelkaoui, “Value Added and Corporate Con208


trol in the U.S.,” Journal of International Financial Management and Accounting (Autumn 1991): 241–257. 30. Ahmed Belkaoui, “Financial Ratios as Predictors of Canadian Takeovers,” Journal of Business Finance and Accounting (Spring 1978): 93–107. 31. Ahmed Belkaoui, “The Entropy Law, Information Decomposition Measures and Corporate Takeovers,” Journal of Business Finance and Accounting (Fall 1976): 45–57. 32. Bao and Bao, “The Time Series Behavior and Predictive Ability Results of Value Added Data.” 33. C. Deegan and A. Hallman, “The Voluntary Presentation of Value Added Statements in Australia: A Political Cost Perspective,” Accounting and Finance (May 1991): 1–29. 34. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, Recognition and Management in Financial Statements of Business Enterprises (Stamford, CT: FASB, 1984). 35. American Accounting Association, “Committee on Accounting and Audition Measurement, 1989–1990.”

209


REFERENCES Accounting Standards Steering Committee. The Corporate Report. London: Accounting Standards Steering Committee, 1975. American Accounting Association. “Committee on Accounting and Audition Measurement, 1989–1990.” Accounting Horizons (September 1991): 81–105. Askren, Barbara J., Bannister, J. W., and Pavlik, E. “The Impact of Performance Plan Adoption on Value Added and Earnings.” Managerial Finance 20, no. 9 (1994): 27–43. Ball, R. J. “The Use of Value Added in Measuring Efficiency.” Business Ratios (Summer 1968): 5–11. Bannister, James W., and Riahi-Belkaoui, Ahmed. “Value Added and Corporate Control in the U.S.” Journal of International Financial Management and Accounting (Autumn 1991): 241–257. Bao, Ben-Hsien, and Bao, Da-Hsien. “The Time Series Behavior and Predictive Ability Results of Value Added Data.” Journal of Business Finance and Accounting (April 1996): 449–460. Barlev, Benzion, and Levy, Haim. “On the Variability of Accounting Numbers.” Journal of Accounting Research (Autumn 1979): 305–315. Belkaoui, Ahmed. “The Entropy Law, Information Decomposition Measures and Corporate 210


Takeovers.” Journal of Business Finance and Accounting (Fall 1976): 45–57. _______. “Financial Ratios as Predictors of Canadian Takeovers.” Journal of Business Finance and Accounting (Spring 1978): 93–107. Belsley, D. A., Kuh, E., and Welsh, R. E. Regression Diagnostics: Identifying Influential Data and Sources of Collinearity. New York: Wiley, 1980. Bentley, Trevor. “Value Added and Contribution.” Management Accounting (March 1981): 17–21. Burchell, Stuart; Clubb, Colin; and Hopwood, Anthony. “Accounting and Its Social Context: Towards a History of Value Added in the United Kingdom.” Accounting, Organizations and Society 10 (1985): 381–413. Chua, K. C., “The Use of Value Added in Productivity Measurement.” In Productivity Measurement and Achievement: Proceedings of Accountancy. Victoria: University of Wellington, 1977. Cox, Bernard. Value Added: An Application for the Accountant Concerned with Industry. London: Heinemann, 1978. Cruns, R. P. “Added-Value: The Roots Run Deep into Colonial and Early America.” Accounting Historian Journal (Fall 1982): 25–42. Cubbin, J., and Leach, D. “The Effect of Shareholder Dispersion on the Degree of Control in

211


British Companies: Theory and Measurement.” Economic Journal 3 (1983): 351–369. Deegan, C., and Hallman, A. “The Voluntary Presentation of Value Added Statements in Australia: A Political Cost Perspective.” Accounting and Finance (May 1991): 1–29. Dewhurst, James. “Assessing Business Performance.” Accountant (March 3, 1983): 17–18. Easton, P. D., and Harris, T. S. “Earnings as an Explanatory Variable for Returns.” Journal of Accounting Research. (Spring 1991): 19–36. Egginton, D. A. “In Defense of Profit Measurement: Some Limitations of Cash Flow and Value Added Data as Performance Measures for External Reporting.” Accounting and Business Research (Spring 1984): 32–43. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5. Recognition and Measurement in Financial Statements of Business Enterprises. Stamford, CT: FASB, 1984. Foley, B. J., and Maunders, K. T. Accounting Information Disclosure and Collective Bargaining. London: Macmillan, 1977. Gilchrist, R. R. Managing for Profit: The Value Added Concept. London: Allen and Unwin, 1971. Gray, Sidney. Value Added Reporting: Uses and Measurement. London: Association of Certified Accountants, 1980. 212


Gray, Sidney, and Maunders, K. T. “Recent Developments in Value Added Disclosures.” Certified Accountant (August 1979): 255–256. Harris, G. J. “Value Added Statements.” The Australian Accountant (May 1982): 261–264. Hill, C. W., and Snell, S. A. “Effects of Ownership Structure and Control on Corporate Productivity.” Academy of Management Journal 32 (1989): 25–46. Hoskisson, R. E. “Multidivisional Structure and Performance: The Contingency of Diversification Strategy.” Academy of Management Journal 2 (1987): 625–644. Ismail, B. E., and Kim, M. K. “On the Association of Cash Flow Variables with Market Risk: Further Evidence.” The Accounting Review (January 1989): 125–136. Karpik, P., and Belkaoui, Ahmed. “The Relative Relationship between Systematic Risk and Value Added Variables.” Journal of International Financial Management and Accounting (Autumn 1989): 259–276. _______. “The Effects of the Implementation of the Multidivisional Structure on Shareholders’ Wealth: The Contingency of Diversification Strategy.” Journal of Business Finance and Accounting (April 1994): 349–366. Lev, B., and Ohlson, J. A. “Market Based Empirical Research: A Review, Interpretation and 213


Extension.” Journal of Accounting Research Supplement (1982): 239–322. Litzenberger, R. H., and Rao, C. W. “Estimates of the Marginal Rate of Time Preference and Average Risk Aversion of Investors in Electric Utility Shares: 1960–66.” Bell Journal of Economics and Management Science (Spring 1971): 265–277. Maunders, K. T. “The Decision Relevance of Value Added Reports.” In Frontiers of International Accounting: An Anthology, F. D. Choi and G. G. Mueller (Eds.). Ann Arbor, MI: UMI Research Press, 1985: 225–245. McLead, Charles C. “Use of Value Added.” Bests Review (January 1984): 80–84. McLeay, Stuart. “Value Added: A Comparative Study.” Accounting Organizations and Society 8, no. 1 (1983): 35–56. McSweeney, Brendan. “Irish Answer to Value Added Reports.” Frontiers of International Accounting: An Anthology. Frederick K. Choi, and Gerhard G. Mueller (Eds.). Ann Arbor, MI: UMI Research Press, 1985, 225–245. Meek, Gary K., and Gray, Sidney J. “The Value Added Statement: An Innovation for the U.S. Companies.” Accounting Horizons (June 1988): 73–81. Morley, M. F. “The Value Added Statement: A British Innovation.” The Chartered Accountant Magazine (May 1978): 31–34. 214


_______. “The Value Added Statement in Britain.” The Accounting Review (May 1979): 618–689. _______. “Value Added Reporting.” In Developments on Financial Reporting, Thomas A. Lee (Ed.). London: Philip Allan, 1981, 251–269. _______. The Value Added Statement, London: Gee and Co., for the Institute of Chartered Accountants of Scotland, 1978. Morck, R. A., Shleifer, A., and Vishny, R. W. “Management Ownership and Market Valuation: An Empirical Analysis.” Journal of Financial Economics 20 (1988): 293–315. Ohlson, J. A. “Accounting Earnings, Book Value and Dividends: The Theory of Clear Surplus Equation.” Working paper. New York: Columbia University, 1988. _______. “Earnings, Book Value and Dividends in Security Valuation.” Contemporary Accounting Research (Spring 1995): 661–687. Pendrill, Davie. “Introducing a Newcomer: The Value Added Statement.” Accountancy (September 1981): 121–22. Rahman, M. Zubaidur. “The Local Value Added Statement: A Reporting Requirement for Multinationals in Developing Host Countries.” International Journal of Accounting (February 2, 1990): 87–98. Renshall, M., Allan, R., and Nicholson, K. Added Value in External Financial Reporting. London: 215


Institute of Chartered Accountants in England and Wales, 1979. Riahi-Belkaoui, Ahmed. Handbook of Management Control Systems. Westport, CT: Greenwood Publishing, 1986. _______. “The Information Content of Value Added, Earnings and Cash Flows: U.S. Evidence.” The International Journal of Accounting 28, no. 2 (1993): 140–146. _______. Value Added Reporting: The Lessons for the U.S. Westport, CT: Greenwood Publishing, 1992. _______. Performance Results of Value Added Reporting. Westport, CT: Greenwood Publishing, 1996a. _______. “Earnings-Return versus Net Value-Added Returns Relation: The Case for Nonlinear Specification.” Advances in Quantitative Analysis in Finance and Accounting 4 (1996b): 175–185. _______. “Performance Plan Adoption and Performance: The Contingency of Ownership Structure.” Finance Management 23, no 25 (1997). _______. “An Empirical Case for Value Added Reporting in the United States.” Indian Journal of Accounting (December 1996): 40–47. _______. “Multidivisional Structure and Productivity: The Contingency of Diversification Strategy.” Journal of Business Finance and Accounting (June 1997): 615–714. 216


Riahi-Belkaoui, Ahmed, and Bannister, J. W. “Multidivisional Structure and Capital Structure: The Contingency of Diversification Strategy.” Managerial and Decision Economics 15 (1994): 267–276. Riahi-Belkaoui, Ahmed, and Fekrat, Ali. “The Magic in Value Added: Merits of Derived Accounting. Indicator Numbers.” Managerial Finance 20, no. 9 (1994): 3–15. Riahi-Belkaoui, Ahmed, and Pavlik, Ellen. “Asset Management Performance and Reputation Building for Large U.S. Firms.” British Journal of Management 2 (1991): 231–238. _______. “The Effect of Ownership Structure on Value Added Performance.” Managerial Finance 20, no. 9 (1994): 16–26. Riahi-Belkaoui, Ahmed, and Picur, Ronald D. “Explaining Market Returns: Earnings versus Value Added Data.” Managerial Finance 20, no. 9 (1994): 44–55. Rutherford, B. A. “Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems.” Accounting and Business Research (Summer 1972): 215–220. _______. “Easing the CCA Transition in Value Added Statements.” Accountancy (May 1983): 121–22. _______. “Five Fallacies about Value Added.” Management Accountant (September 1981): 31–33. 217


_______. “Published Statements of Value Added: A Survey of Three Years’ Experience.” Accounting and Business Review (Winter 1980): 15–28. _______. “Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems.” Accounting and Business Research (Summer 1972): 215–220. Sinha, Gokul. Value Added Income. Calcutta: Book World, 1983. Suojanen, W. W. “Accounting Today and the Large Corporation.” The Accounting Review (July 1954): 391–398.

218

About the Author Ahmed Riahi-Belkaoui is an Emeritus Professor at the University of Illinois at Chicago. Previously, he was named University Scholar at UIC (2000-2003), CBA Distinguished Professor (1996-2001), 2000 AAA Outstanding International Educator, and as founding Editor of the Review of Accounting and Finance (2001-2007). His research interests embrace socio-economic accounting, behavioral accounting and social and political issues. He has published over 75 books, including Social Status Matters, and Qaddafi: The Man and His Policies, and more than one hundred eighty articles and reviews in major journals.

219

Wealth and Value Added

Wealth and Value Added

Suggest Documents