Department of Accounting and Finance, University of Vaasa,
Finland

3. Accounting for Segments of the Total Period _9/

31. Segmenting a Total Period

311. Reason for Segmenting

It is obvious that income determination is trivial if the total period is under observation. Income must, however, be determined for periods which usually are much shorter than the total period. The total period must therefore be segmented into time intervals called accounting periods. In financial accounting this accounting period almost always is one year.

In expenditure-revenue accounting the stated reason for the need of yearly income determination is assessing annual distributable profit. Originally, nothing was said or assumed of managerial reasons for income determination.

312. The Congruence Principle

The adoption of the congruence principle is a central issue of Professor Saario's expenditure-revenue accounting: Per definition, the sum of annual profits (for accounting periods making up the total period) is equivalent to the total profit (providing that no mistakes are made). Thus in expenditure-revenue accounting the annual profits are considered nothing more than logically dependent slices of the total profit. The purpose of accounting is consequently defined as splitting the total profit into annual profits of the right size.

My ensuing interpretation is the following. In expenditure-revenue accounting the timing of the annual profits is considered inconsequential providing that it does not affect the distribution of profits. Thus early annual profits are not assumed to be preferred to later annual profits, since only the total profit is assumed to count. This means an implicit assumption of zero cost of capital to the owner (entrepreneur), i.e. there is no time value of money in the expenditure-revenue accounting thinking.

To recapitulate, I define
p(t) = annual profit in year t
P = total profit (same as total income Formula (1))
f = the year of the foundation of the firm
t(o) = the year of the latest accounting period
q = the year of liquidation
then in expenditure-revenue accounting we obviously must have

       t(o)        q                        The sum of
(2a)   sum p(t) + sum p(t) = P  if t(o)     annual profits
       t=f      t=t(o)+1        is less     is defined by
                                than q      the total profit
                                            P, not vice versa.
       q
(2b)  sum p(t)            = P   if t(o) is at or beyond q
      t=f

313. Discussion on the Causal Relation between Annual and Total Profits

As can seen from the above, my conclusion is that in expenditure-revenue accounting model the annual profits are dependent on the total profit, _10/ not vice versa! The total period ends when the firm has served its task in generating a total profit, i.e. the desired purchasing power for the entrepreneur.

In my view the following counter argument, concerning the logic of the foundations of expenditure-revenue accounting, can be made at this point. If the annual income of the firm is positive, the firm is seldom liquidated. If, however, negative annual incomes are observed for a prolonged length of time, the firm is likely to be dissolved. _11/ Because the future is uncertain, the historical annual incomes are used by the management and other interested parties as (at least one) criterion in deciding whether to continue operations or dissolve the firm (assuming that the decision makers behave rationally). According to this practical reasoning, it would be the annual incomes that determine the length of the total period and the total income, rather than the other way round, as is assumed in the expenditure-revenue accounting model. Historical observations, which by necessity always are the basis for predicting future, would then be the determining factors rather than a completed profit earning task.

The direction of the relationship between the total profit and the annual profits used in expenditure-revenue accounting seems to indicate an implicit assumption of perfect knowledge of the future. Otherwise income determination is inconsistent until the firm is dissolved. If the argument put forward is accepted that the firm is dissolved when annual incomes continuously remain negative, a circular reasoning results in expenditure- revenue accounting model. This controversy has remained ignored and unresolved for nearly to fifty decades by now. _12/

32. Principles of Annual Income Determination

321. Annual Closing of Accounts

In expenditure-revenue accounting the underlying function of the annual closing of accounts _13/ is taken to be the allocation of the relevant portion of the total profit to the accounting period under observation.

In order to calculate the annual income, the realized revenues are first allocated to the pertinent accounting period. After that, the relevant expenditures are matched against these realized revenues as expenses.

The realization convention applied for recognizing the realized revenues of the accounting period, is the same as in GAAP, and is therefore discussed no further.

As will be seen, the matching convention applied is very similar to the GAAP convention. Differences occurring in the point of view result from the different assumption about the going-concern convention.

322. Expenses and Unexpired Expenditures

In order to determine annual income, the expenditures have to be divided into two categories. The expenditures, which are deducted from the realized revenues of the current accounting period, are called expenses. The other part, which is not yet deducted from the realized revenues, is called unexpired expenditures.

In the annual closing of accounts, the unexpired expenditures become assets._13/_14/ They always will be converted into expenses in the later accounting periods, latest by the end of the total period.

Technically, the unexpired expenditures are transferred to the later accounting periods via the balance sheet. For expenditure-revenue accounting the balance sheet thus becomes necessary as an auxiliary account, when total profit has to be allocated to individual accounting periods for annual income determination.

No accounting practice difference seems to exist here from accounting based on the GAAP, which includes the same dichotomy between assets and expenses. In American accounting literature, however, the sequence of reasoning is often given in a different order when compared with expenditure-revenue accounting. That is: "when incurred, expenditures represent assets, which then expire, either instantaneously or eventually, and thus become expenses". This is a noteworthy conceptual difference.

323. The Matching Convention

Expenditures are matched, as expenses, against the realized revenues of the different accounting periods. Finally all the expenditures must be thus allocated, in the form of expenses, to the accounting periods making up the total period.

The basis of matching in expenditure-revenue accounting is given by the association between expenditures and revenues, and the congruence principle discussed earlier. From the association principle ("expenditures are a prerequisite for revenues") it follows that expenditures expire only when the associated revenues are earned. From the congruence principle ("the sum of annual profits is equivalent to the total profit") it follows, if the principle is applied in a consistent manner, that no losses should be reported for individual accounting periods if the total income will be positive, i.e. a total profit occurs. _16/ The following principle has been propounded by Professor Saario in accordance with the reasoning above. "In periods with little or no realized revenues, little or no expenditures can become expenses".

In actual practice it is seldom possible to establish the true _17/ association between expenditures and revenues. _18/ This fact gives rise to various pragmatic rules for assessing which of the expenditures have expired and should thus be written off as expenses (and which expenditures still are unexpired, and should consequently be entered on the balance sheet). For example, the relevant Finnish legislation has adopted the rule that all expenditures which are no more expected to produce revenues, are expenses. This rule can be regarded as a corollary of the association and congruence principles, when applied to matching. -- The role of expectations is in my opinion important here. If the underlying principle for watching were given as "expenditures which no more produce revenues have expired (since corresponding future revenues are known not to exist)", then, taken strictly, a perfect knowledge of the future would be required with respect to future revenues.

Assumptions made about the knowledge of the future necessarily are critical in any accounting model, since by definition they should be based on historical transactions (ex post) rather than future transactions (ex ante). _19/

In the original presentation of expenditure-revenue accounting, it has been emphasized that in the framework of the dichotomy of expenditures ("expenses"/"unexpired expenditures = assets"), all assets valuation rules should be seen as nothing but matching rules for annual income determination. A point that will be taken up further on.

33. Special Topics

This section reviews the ideas of priority order of matching and realization depreciation method, which are sidelines related to expenditure-revenue accounting. This part can be skipped without a loss of continuity. Because of space limitations, it will not be possible to analyze the underlying concepts at length, but the priority order of matching, and realization depreciation are nevertheless taken up here because they are interesting facets of the Finnish accounting research history.

331. Priority Order of Matching

As has been seen, assuming a total profit, annual expenses must not exceed annual realized revenues according to the theory of expenditure-revenue accounting. This notion gives rise to the question of the manner in which the expenditures should be deducted from the revenues. The fact is that since expenditures precede corresponding revenues, the expenditures gradually become covered by the revenues as they are realized.

It has been suggested that costs, and hence expenditures are covered by revenues, not proportionally, but in a definite priority order. The statement in the Finnish language of the relevant theory, in Finland called "The Priority Order Theory of Costs" is attributed to Professor Martti Saario _20/, and its later refinement to Professor Jaakko Honko. _21/

Two criteria were originally considered for determining a priority order of matching. The first was the length of time it takes an expenditure to cycle once. This criterion was, however, found unsatisfactory already in the original presentation. Instead a second criterion was put forward as the theoretically right one. This was the number of products or revenue items associated with the expenditure. The smaller this denominator, the higher the priority of the expenditure. The following illustration gives the original priority order of matching suggested.

                                  Direct labor
                            Direct materials
                       Variable overhead
               Administrative expenses
          Equipment and machinery
       Plant
     Land
 Entrepreneur

332. Realization Depreciation

Depreciation is one of the most controversial issues in accounting. Depreciation is to allocate a "long-term" expenditure as expenses over the revenue-producing life-span of the expenditure. _22/ The most popular depreciation methods in company practice are the straight-line, double declining-balance, units-of-production, and the years'-digits _23/ methods.

Double declining-balance and the years'-digits methods are accelerated depreciation methods, i.e. methods with decreasing depreciation charges. They often are advocated on the basis of an alleged diminishing revenue-earning power resulting from economic and physical age. _24/

An entirely different pattern of depreciation is suggested in "compound interest" (or "annuity") depreciation method. The revenues associated with the long-term expenditure are assumed to be made up by two parts. The first is the return (interest) on the long-term expenditure. The rest is the amount of the long-term expenditure recovered = depreciation. With the passage of time the part due to interest decreases, when the unrecovered portion of the expenditure gradually decreases. Consequently, the annual amount of the expenditure recovered increases. Thus,a depreciation method with increasing depreciation charges results. _25/

Next we discuss the idea of realization depreciation in more detail.

The basic assumptions of expenditure-revenue accounting, discussed throughout this paper, originate from Professor Saario's doctoral dissertation in 1945 on the "realization principle and depreciation of fixed assets", and foremost from his papers in 1958 and 1959. _26/ In his dissertation and a later paper in 1961 _27/ he put forward the realization depreciation method:

As was discussed earlier, from the association principle of expenditures and revenues it follows that expenditures expire (become expenses) only when associated revenues are realized. As we saw, from congruence principle it follows that losses are not consistent for any of the accounting periods if the net income for the total period is positive. Depreciation (an expense) is, consequently, strictly tied to the revenues produced by a long-term expenditure. _28/ Therefore, in accordance to this thinking, depreciation has absolutely nothing to do with physical aspects of the relevant assets. In periods of no revenues no expense is relevant, and no depreciation can thus be made then. The idea of realization depreciation is, on the basis of the principles above, that depreciation is directly dependent on the associated revenues, being thus a function of them. The relation is given by the internal-rate-of-return model.

To illustrate, consider an extremely simple numerical example involving an expenditure of $100 at the beginning of the first year, and revenues of $57.6 at the end of the first and the second year. The internal rate of return on this investment is 10%, since $57.6/1.10 + $57.6/1.102 = $52.4 + $47.6 = $100. The depreciation for the first year is $52.4 and $47.6 for the second. Contrary to the compound-interest depreciation method, which is also based on the rate of return on the long-term expenditure, realization depreciation usually leads to an accelerated depreciation pattern. _29/

34. Treatment of Expenditure, Revenue, and Financial Accounts in Closing

Figure 4 illustrates the principle of the closing process by depicting the closing entries for expenditure-revenue bookkeeping. _30/
Figure 4. Closing Entries

      Expenditure             Revenue                  Financing
      accounts                accounts                 accounts
      ===========            =========                 =========
           !                     !                         !
           ! :                 : !                      :: ! ::
             :                 :                        ::   ::
             :                 :   .....................::...::
             :                 :   : ...................::....:
             :                 :   : :                  ::
    .........:                 :   : :                  ::........
    :                          :   : :                  :        :
    :         Income           :   : :         Balance  :......  :
    :         statement        :   : :         sheet          :  :
    :         account          :   : :         account        :  :
matching -------------------   :   : :   ------------------   :  :
    o..} expenses ! revenues {.:   : :.} cash    !            :  :
    :             !                :             ! payables {.:  :
    :             !                :...} receiv- !               :
    :             !                      ables   !               :
    :             !                              ! capital {.....:
    :.............+...................} unexpired!
                  !                     expendi- !
                  !                     tures    !
                  !                              !
         profit {-+------------------------------+-} profit
                  !                              !
In order to calculate the annual net income all realized revenues and expenses of the accounting period are gathered from the books on the income statement account, which is the first closing account. The annual net income is given by the balance of the income statement account.

Unexpired expenditures and financing accounts are closed on the balance sheet account, which is the second closing account. Undistributed profit is entered on the credit-side as retained earnings. _31/ Thus the concept of retained earnings, which is central in accounting based on the GAAP, does not come up in expenditure-revenue accounting at all before this stage.

The function of the balance sheet is to transfer the ending balances of the unexpired expenditures and the financing accounts on to the next accounting period, where they become the beginning balances of the relevant accounts. The balance sheet does not have the same conceptual emphasis as a statement of the financial position of the firm as in accounting based on the GAAP.

Income determination is the underlying purpose of expenditure-revenue accounting. As has been discussed at great length in this paper, matching naturally is the critical stage of annual income determination. All rules affecting matching through determination of expenses or unexpired expenditures affect the annual income.

It was stated earlier in this paper that in expenditure-revenue accounting it is emphasized that all asset valuation rules are nothing but matching rules for annual income determination. In other words any valuation of the balance sheet items should be considered a valuation of the annual income. The reasoning is easily demonstrated by writing out the fundamental equation of matching elucidated by Figure 4.

Expenditures = Expenses           + Unexpired expenditures
               (income statement)   (assets/balance sheet)
When the expenditures are given, any change (increase/decrease) made in the value of assets means a reverse change (decrease/ increase) in expenses. A change in the expenses alters the annual income respectively (increase/decrease).

The convention of conservatism is relevant in matching in expenditure-revenue accounting. The convention implies that, given a choice, the higher of the alternative expense figures should be selected. The convention is the same as in the GAAP _32/ except that in expenditure-revenue accounting a conservative asset valuation is regarded as a conservative expense estimate, because of the underlying philosophy of expenditure-revenue accounting.

The conventions of consistency and materiality, which also affect matching, do not differ from the GAAP in principle. Of course there are differences from the U.S. application in some details of practices because of differing accounting legislations.

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