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CONTENTS
KEY WORDS: Accounting theory; Accounting principles; Financial accounting; Accounting model; Finland
Timo Salmi (1993), "A Comparative Review of the Finnish Expenditure-Revenue Accounting", published on the World Wide Web as http://www.uwasa.fi/~ts/comp/comp.html at the University of Vaasa, Finland.
The purpose of this paper in the area of comparative accounting is to facilitate communication about Finnish accounting research and the concepts used in teaching financial accounting in Finland. This is done by reviewing the "expenditure-revenue-accounting" model applied in Finland. This accounting model is of general interest because it is an example of taking an unconventional approach to the going concern convention, and developing the accounting model starting from the income statement concepts rather than the internationally more common expansion from the balance sheet concepts.
The expenditure-revenue accounting model as propounded in the Finnish language is attributed solely to late professor Martti Saario _1/. This accounting theory has been the dominant basis of financial accounting legislation and teaching in Finland.
The the financial accounting practices based on the expenditure-revenue accounting theory resemble in many respects the accounting practices based on the American Generally accepted accounting principles, the GAAP. It will be assumed throughout this paper that the reader is reasonably familiar with the GAAP.
This paper is a review of Professor Saario's accounting theory. The presentation is based on my own interpretation of expenditure-revenue accounting and GAAP. An attempt is made not to express any personal preferences concerning the choice of the accounting concepts. The evaluation of the potential merits or dismerits of Professor Saario's expenditure-revenue accounting as a background for financial accounting practices and teaching, as compared with accounting practices based on GAAP, will be the reader's.
The fundamental difference between the Finnish expenditure-revenue accounting and GAAP is discarding the going-concern convention in the former. _2/ Instead, the total period from the firm's foundation to its liquidation will first have to taken under observation in order to define the total profit for the entire life-span of the firm.
For the entire life-span of the firm the sum of the receipts exceeds the sum of the disbursements if the revenues for the total period exceed the expenditures, provided that distributions of profits have not exceeded the profit for the total period. Expenditures, however, precede corresponding revenues. It is this discrepancy in timing that gives rise to the need of outside financing. Two mutually exclusive, comprehensive sources of outside financing are defined. The first is paid-in capital from the owners. The second is debt.
The life-span of the firm, i.e. the total period thus entails:
1. Acquiring outside financing
a. paid-in capital from owners
b. debt
2. Expenditures
3. Revenues
4. Repaying outside financing
a. debt
b. paid-in capital to owners
Furthermore, the financial flows through the firm, as will
be illustrated by Figure 1, include the distribution of
profits among creditors, government, and owners; in other
words interest, taxes, and dividends.
The aim of expenditure-revenue accounting is solely the determination of income. The evaluation and further usage of the observed income is strictly separated from income determination, and is limited outside expenditure-revenue accounting.
Figure 1. The Financial and Material Flows through the Firm
CAPITAL MARKET
paid-in and
debt capital
:
distribution :
of profits : repayment
-interest : :
-taxes : :
-dividends : +------+
(expen- ) : :
(ditures) : : (revenues)
payments +--------------+--+---------------+ payments
for inputs ! : : ! from outputs
{----------+- accounts {- cash {- accounts {-+--------------
! payable receivable ! financial process
...................................................................
! production flow ! physical process
---------} ! ------------------------------} ! -----------------}
physical ! ! physical output
input flow +---------------------------------+ flow
INPUT MARKET OUTPUT MARKET
In accordance with the entity convention the firm in
Figure 1 is the relevant entity. It acquires a set of
"physical" inputs, transforms the inputs into outputs in
the production process and sells the resultant outputs.
This physical process is reflected in the financial
process as depicted by Figure 1. Financial accounting (in
our case expenditure-revenue accounting) is defined as a
description of the financial process of the business
entity under observation. Figure 1 emphasizes the central
conceptual role assumed for cash in expenditure-revenue
accounting. _6/ Money measurement convention is used in
registering the flows of the financial process. This is
natural because, per definition, monetary flows are under
observation. The measurement of the flows of the financial
process is made according to the (historical) cost
convention (c.f. "stable dollar" assumption).Thus, in comparison with accounting based on the GAAP, no changes are made in entity, money measurement, or cost conventions in accounting based on the expenditure-revenue accounting model.
then
(1) P = sum r(i) - sum d(j) .
icI jcJ
The following subcategorization of financing accounts can be used.
Figure 2. Recording Transactions
. . . . . . . . . . . . . . .
. Sources of cash . Sinks of cash
. .
. +-------------.--------------+
. : Financing . accounts :
. : . :
. Revenue : Capital . C a s h : Expenditure
. accounts : accounts . + - : accounts
. ========= : ========= . --------- : ===========
1a . ! : ! -----+----} ! : !
b . ! : ! -----+----} ! : !
2 . ! : ! . ! ---------------} !
3 . ! ------------+------+----} ! : !
4a . ! : {-+------+------+-- : !
b . ! : {-+------+------+-- : !
. : ! +-------------.--------------+ ! :
. : . :
. . .:. . . . . . . . . . . . :
: :
: Total income :
: ------------ :
+------------------------!--} :
{--!-------------------------+
!
As is seen in Figure 2, the total income is the difference
of the balances of the (total) revenue accounts and
expenditure accounts.All the rules needed for recording various transactions can be deduced from the following convention of expenditure-revenue accounting, which corresponds to the dual aspect convention of the GAAP.
Every transaction is recorded as a debit and equal credit. An increase in cash is recorded as a debit on cash account.For example, it can be deduced with the help of Figure 2 that a revenue is credited on the relevant revenue account, whereas an expenditure is debited (charged) on the relevant expenditure account. The details of recording different transactions in accordance with the expenditure-revenue accounting model have naturally been described in great detail in Finnish accounting text-books.
The position of the cash account in Figure 2 (and later in Figure 3) reflects the central conceptual role of cash. In expenditure-revenue accounting cash is used as the reference account instead of owners' equity, which is the reference account for accounting based on GAAP. It must be stressed, however, that this does not imply a suggestion for cash-flow accounting. The rules for recording transactions do not differ from GAAP rules, since the equation "assets = liabilities + owners' equity" can be derived as a corollary of the "debit equals credit, and increase in cash is a debit"- convention.
Figure 2 shows that for closing purposes an additional account is needed outside the financing / expenditure / revenue accounts classification. Such additional accounts are called closing accounts. _8/ There are exactly two of them. One is the income statement ("total income" in Figure 2), the other is the balance sheet. When the total period is under observation, the balance sheet is not relevant, because in liquidation at the end of the total period the balance sheet becomes an empty set.
Note that no distinction has yet been made between expenditures and expenses.
Figure 3. Accrual Basis in Recording Transactions Revenue Accounts C a s h Accounts Expenditure accounts receivable + - payable accounts ========= ---------- ------- --------- =========== 1 ! ! ! ! ---------} ! 2 ! ! ! --------} ! ! 3 ! --------} ! ! ! ! 4 ! ! ---------} ! ! !The transactions depicted in Figure 3 are
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.
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
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/
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.
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.
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.
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
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/
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.
The difference of the Finnish and GAAP thinking is most pronounced in teaching introductory accounting, because the former is focused on income determination and is geared around the income statement. On the other hand, the financial accounting practices are not significantly different between the Finnish and the GAAP view.
2. This is the basic (different) assumption from which the Finnish expenditure-revenue accounting model follows. The other important difference is not considering transactions in the terms of the balance sheet, and thus not (directly) utilizing the "assets = liabilities + owners' equity" equation (although it can be shown to hold in expenditure-revenue accounting).
3. The expenditures relate to the financial flows resulting from acquiring inputs needed to produce outputs generating the revenues. In other words they relate to the financial flows not directed to the capital market (see Figure 1). As will be seen, the expenditures are measured in accordance with the historical cost convention, and they are recorded on the accrual basis.
4. The revenues relate to the financial flows generated by the outputs. In other words they relate to the financial flows not originating from the capital market (again see Figure 1). As will be seen, the standard conventions apply also in measuring the revenues.
5. The term total income is used this time rather than the total profit in order to indicate the fact that also a total loss is conceivable in case the whole business venture backfires. Thus the word "profit" has the connotation of positive income in this paper.
6. Note that this will definitely not mean a suggestion for a cash-flow accounting model. Accrual basis is used. 7. While this simplification is in effect for the illustrative reasons the subcategory "accounts receivable and payable" is not needed in financing accounts.
8. This term is deliberately used instead of "financial statements" in order to stress their underlying nature.
9. The reader may find it helpful to consult Figure 4 in reading the text of this chapter.
10. In accordance with the original sources (c.f. footnote 1) I use here the word profit instead of income.
11. This assertion is supported by any study of bankruptcy.
12. This argument was brought to my attention by Professor Veikko Jaaskelainen of the Helsinki School of Economics.
13. In our discussion, "closing of accounts" will denote the whole process of preparing the annual financial statements.
14. In the U.S. accounting terminology it is often said that the expenditure is capitalized. (In the Finnish terminology we say it to be "activated".)
15. Unrealized revenues, which have been collected in advance by the firm, are naturally treated in an analogous manner. They become liabilities instead of assets in the annual closing of accounts.
16. In addition to the consistency requirement,the following reasoning has been used to support this argument. Consider, for example, a three-year total period with a total profit of $100. If the annual incomes were defined as $200, -$100, and $0 respectively, and all the reported incomes were distributed (as taxes and dividends), then the firm would in fact be distributing also its basic capital in the first year.
17. For a discussion on the possibility of existence of a true association see the discussion on inseparability, multiplicity, and instability of causal networks by Yuji Ijiri, The Foundations of Accounting Measurement: A Mathematical, Economic and Behavioral Inquiry (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1967), 58-64.
18. Except, of course, in the rare cases where the business venture is so short-lived that the total period can actually be observed. In that case all the expenditures naturally are relevant expenses. Historically, it is interesting to note that the early (1600's) bookkeeping related to one time project-ventures.
19. In Finnish this question has been thoroughly discussed in Jaakko Honko. Yrityksen vuositulos (English summary: The Annual Income of an Enterprise and Its Determination: A Study from the Standpoint of accounting and Economics). (Publications of the Helsinki Research Institute for Business Economics 25. Helsinki, 1959).
20. Martti Saario "Kustannusten etuoikeusjarjestyksesta." Huugo Raninen 50 vuotta. (Helsinki, 1949).
21. Jaakko Honko. Op.cit.
22. Although not always approved of by accountants, depreciation can also regarded as the part of the annual revenues which should be assigned to acquiring assets represented by the long-term expenditures.
23. The years'-digits method is not used in financial accounting in Finland.
24. Accelerated depreciation methods defer income-tax outlays. This increases the present value of aftertax income even though the sum of the taxes remains unchanged.
25. The advocates of this method point out that it is the only depreciation method which results in the correct rate of return on the unrecovered part of the expenditure, throughout the life-span of the expenditure. See Timo Salmi and Martti Luoma, "Deriving the Internal Rate of Return from the Accountant's Rate of Profit: Analysis and Empirical Estimation." The Finnish Journal of Business Economics (No. 1, 1981), 20-45.
26. Martti Saario, op.cit. (C.f. footnote 1).
27. Martti Saario. "Poistojen paaoma-arvo ja oikea-aikaisuus," Mercurialia MCMLXI (Helsinki 1961).
28. It should be noted that it is impossible to ascertain an association between a long-term expenditure and revenues, except under highly simplifying assumptions, as pointed out in connection with realization depreciation by Reijo Ruuhela, Yrityksen kasvu ja kannattavuus. (English summary: A Capital Investment Model of the Growth and Profitability of the Firm.) Doctoral Dissertation. (The Helsinki School of Economics, 1972), p. 32; Also see Reijo Ruuhela & Timo Salmi & Martti Luoma & Arto Laakkonen, "Direct Estimation of the Internal Rate of Return from Published Financial Statements." The Finnish Journal of Business Economics (No. 4, 1982), 329-345.
29. Unless the revenues resulting from the expenditure increase annually at a rate greater than the internal rate of return.
30. For simplicity the revenues have not been divided into realized revenues and deferred revenues in Figure 4, since deferred revenues seldom are a major item. The division is naturally observed in expenditure-revenue accounting in accordance with the realization convention, nevertheless.
31. For simplicity, Figure 4 does not delineate the difference between net income and retained earnings. Retained earnings are net of dividends distributed. Also other differences are conceivable like the effects of currency translation in multi-currency accounting situations.
32. For instance, the lower of cost or market rule is applicable. One special feature of the Finnish accounting and tax legislation is that up to quarter of the direct cost of the inventories can be written off as expense.
Other scientific publications by Timo Salmi in electronic format
General material about Finnish Accounting in English
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