The feasibility of using accounting information to measure economic profit and performance

One of the serious shortcomings of current public policy for the control of industrial organizations is the lack of sufficient criteria for the evaluation of economic performance of a firm or industry. Because of the lack of an adequate measurement of economic profit, current public policy legislation is based upon the use of market structure, an inadequate criteria for the evaluation of desirable market performance. Statement of the Problem : The current antitrust legislation is built on the unsubstantiated hypothesis that monopolistically-controlled market structure is, in itself, indicative of poor market performance. Even though it has not been possible to measure the amount of, or demonstrate the existence of, economic profits, it is an assumption of current public policy that these profits do exist and such profits can best be eliminated by changing the market structure. In fact, operating with this assumption, there is the possibility that the real effect of current legislation is the opposite of its intention; that is, it may well be causing higher prices and smaller output by breaking up existing market structures (perhaps because of efficiencies of large scale production). With adequate measurement techniques, the appropriateness of existing antitrust legislation and enforcement cannot be evaluated. Summary : The basis of this research study has been to determine the feasibility of directly measuring economic profit (and hence, the revenues and costs associated with that profit), rather than simply assuming the existence of the profit. One of the obvious sources for the determination of revenue and cost data would be the use of published financial statements to serve as a basis for computing economic profit. Within the research study are considered the deficiencies inherent in these statements, rendering them unusable, in their present form, for this purpose and hence, as a tool for evaluating performance. The deficiencies of the statements are of two major types. First, problems of consistent, comparable data are attributable to the diversity within accounting principles or practices. Then further, the information contained in the statements is not complete because of economic activities or events which are completely omitted from the statements, are only partially reflected, or are reflected in a period of time not appropriate to the related economic event or activity. These deficiencies are sufficiently significant to render any estimation of economic profit derived from these statements highly questionable not only because of the inaccuracies in the determination of the accounting profit, but also due to the determination of an owner's equity figure which could serve as a basis for imputing certain economic costs. How these deficiencies could be surmounted was the next major consideration of this research, resulting in the conclusion that adequate information could be obtainable by revising and/or supplementing present reporting practices. The logical method for obtaining the necessary information would be through the voluntary cooperation of the accounting profession (the body that currently is instrumental in establishing reporting standards). If this does not prove successful, another alternative would be to force the elimination of the deficiencies through government-prescribed practices for general reporting purposes (that is, standardized reporting practices for published financial statements). A third alternative would be to ignore current reporting practices and establish specialized standards for the specific purpose of measuring economic profit in order to evaluate market performance. A special-purpose questionnaire filed periodically by each firm (much as a tax return is filed) would be the source of this data. After developing an adequate measure of economic profit, such a measure could be used to isolate chronic, long-run economic profit, if it existed within a firm or an industry as a whole. Then, if this monopolistic profit could be segregated from the short-run, justifiable, and acceptable economic profits, the undesirable excess profit could be eliminated. The device used to eliminate this profit was called a Monopolistic Profits Tax. This punitive measure would be levied periodically and in the amount of the measured undesirable profit. This research demonstrated that the predicted short-run and long-run effects of this tax, if it were rapidly assessed and adequately enforced, would be an increased output at a lower price. A behavioral assumption necessary in order to reach this conclusion was that businessmen have a natural or inherent desire to avoid taxes. Also, the research generated the conclusion that the tax could be effectively used when supplemented by legislation for the control of market structure. Recommendations for Further Inquiry : From this investigation, there appear to be at least four areas which should be thoroughly examined before the operatability and effectiveness of this Monopolistic Profits Tax can be substantiated. These areas of further inquiry are as follows: 1. Format and content of questionnaire or financial statement necessary to elicit adequate information for the measure of economic profit. 2. Relative cost of obtaining and analyzing information. 3. Validity of behavioral assumption of firms with respect to their reaction to the Monopolistic Profits Tax. 4. Applicability of measurement to conglomerates and other firms which produce goods not all classified within a single industry. These avenues of further research should substantiate the need for an approach to public control of industrial organization which eliminates monopolistic profit-the incentive for, or the cause of, undesirable economic performance.