Useful Arbitrary Allocations (With a Comment on the Neutrality of Financial Accounting

Reports)
Author(s): Arthur L. Thomas
Source: The Accounting Review, Vol. 46, No. 3 (Jul., 1971), pp. 472-479
Published by: American Accounting Association
Stable URL: http://www.jstor.org/stable/244516
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 Useful Arbitrary Allocations (With a
Comment on the Neutrality of
Financial Accounting Reports)
Arthur L. Thomas
JN A recent monograph I concluded that
most of financial accounting's alloca-
tions are arbitrary, and that this
renders them useless for the general pur-
poses which financial accounting attempts
to serve.' Several friends have been kind
enough to point out that an allocation may
be unsuitable for general purposes yet
highly useful for some specific purpose.2
Although this does not alter the financial
accounting conclusions of SAR #3, it
should be evident by the end of this paper
that the existence of useful arbitrary allo-
cations has implications for managerial
accounting which deserve further study.
These implications are not pursued here;
instead, what follows is merely an initial
examination of when arbitrary allocations
will be useful.'
RANGE OF AMBIGUITY
The concept of the "range of ambiguity"
of an allocation was applied briefly in
SAR #3 to situations in which various
allocation methods are available and no
conclusive reasons for choosing any indi-
vidual possibility can be demonstrated.
An accounting allocation divides a mone-
tary magnitude among recipients (inputs
to the firm, accounting periods, and so
forth). If different allocation methods are
possible, the amounts which could be at-
472
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tributed to individual recipients will vary.
The range of ambiguity of an allocation
with respect to an individual input is the
extent to which the amounts attributed to
that recipient may vary by virtue of choice
of allocation methods.
To get down to specifics, SAR #3 dis-
cusses allocations (such as depreciation) in
which the costs of nonmonetary inputs
are written off. It points out that financial
accounting theory requires that two kinds
of allocations be performed in the amorti-
zation of nonmonetary inputs. First, a
series of contribution allocations must be
made in which the total net revenues of the
I The Allocalion Problem in Financial Accounting
Theory, Studies in Accounting Research #3 (American
Accounting Association, 1969), hereafter designated
"SAR #3." A reply to certain criticisms of this mono-
graph and a study of its implications for revenue-
recognition controversies are now (March 1971) in
process.
I Of these friends, Alfred Rappaport and Yuji Ijiri
were the most persistent. In addition, this paper bene-
fited greatly from criticism by my colleague, L. G.
Eckel, and from technical assistance by Kathleen S.
Martin. Background research was in part supported
by a 1970 McMaster University Summer Research
Stipend.
As a preliminary analysis, I have tried to keep this
presentation brief. For example, only a single line of
argument is used to support the conclusions reached in
the next section and the Appendix, despite the broad
implications of these conclusions.
Arthur L. Thomas is Professor of Ac-
counting at McM aster University.
 Thomas: Arbitrary Allocations 473
firm during successive periods are allocated
to the various inputs which are deemed to
generate them; this yields a pattern of
periodic net revenue contributions which
have been attributed to the individual non-
monetary input. This pattern is used to
determine the amortization allocation of
that input's cost to different accounting
periods.
AMBIGUITIES OF THE Two ALLOCATIONS
With respect to the contribution alloca-
tions, SAR #3 distinguishes between the
separate effects of the individual inputs
and their interaction effects. A major part
of the allocation problem in financial ac-
counting is that at present there is no con-
clusively defensible way to allocate these
interaction effects to the individual inputs. most important range of ambiguity is that
(An illustration of this difficulty is given of the amortization charges for individual
later in this paper.) There is a similar
problem of interaction among the total
inputs of different accounting periods which
afflicts the amortization allocation (inde-
pendently of the difficulties experienced
with the contribution allocations).
SAR #3 demonstrated (page 72) that the
range of ambiguity in the amortization
allocation is at least as large as the differ- allocations. SAR :3 argued that this range
ence between the cost of the input and the
total of the net-revenue contributions
which are attributed to that input during
all accounting periods. This difference may
be perceived as the combined interaction
effect of the contributions made by the
input during the several periods. Similarly,
the range of ambiguity in the contribution
allocation of any period with respect to any
individual input will be at least as large
as the difference between the total net
revenues generated by the particular input
alone or in combination with other inputs
and the total separate effects of these
inputs; this may be designated the "com-
bined interaction effect during theperiod
of the individual input and all other inputs
with which it interacts to generate net
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revenue," or, for brevity, the combined
interaction effect.
As is also illustrated below, there is no
way to determine decisively whether any
one allocation of this combined interaction
effect is preferable to any other. Therefore,
allocation of the entire combined inter-
action effect to any one input is just as
defensible as allocation of none of the com-
bined interaction effect to that input.
From this it follows that the range of
ambiguity in the contribution allocation of
any one period must be at least as large
as the combined interaction effect.
AIMBIGUITY IN THE INDIVIDUAL
AMORTIZATION CHARGE
For financial accounting purposes, the
inputs during individual accounting per-
iods (such as the depreciation charge for a
particular asset during a particular year).
For brevity, this will be designated as the
range of ambiguity in the individual amorti-
zation charge. This range of ambiguity is a
function of the ranges of ambiguity in the
input's amortization and contribution
of ambiguity was apt to be enormous-
large enough to swamp the amortization
charge calculation. The Appendix to this
paper attempts to show that, paradoxical
as this may seem, this range of ambiguity
in the individual amortization charge
usually will be at least as large as the total
historical cost of the input.
It is easily proved that any amortiza-
tion in an individual period which exceeded
the input's historical cost would require
negative amortization (appreciation) of
the input in at least one other period. Such
recognition of appreciation raises issues
which are best reserved for a study of the
impact of the allocation problem on reve-
nue recognition; therefore, the simplifying
assumption that negative amortization is
474 The Accounting Review, July 1971

inappropriate will be made

Accounting instead.
Association's All o
Committee on
this leads to the following minimum con- Foundations of Accounting Mleasurement,5
clusion (which, though probably much and are not examined in detail here
more conservative than the truth, will (though they will be referred to in the
suffice for the purposes of this paper): final section of this paper); for brevity,
they may be termed allocations which are
The range of ambiguity in an individual
usefulfor institutional purposes.
financial accounting amortization charge
2. A totally ambiguous allocation may
usually will equal the total historical cost
be useful to an entity if this allocation
of the related input.
serves the purposes of that entity; it also
This situation (in which any amortization may be useful if it serves a common pur-
of a nonmonetary input from zero to com- pose of two or more entities. Whatever
plete write off is as defensible as any the size of the range of ambiguity, if those
other) will for brevity be designated as one individuals and groups who are affected
of total amzbiguity in the related allocation. by an allocation have similar enough pur-
poses in common to override any conflicts
SIGNIFICANCE OF THIS CONCLUSION
of their separate interests, they may find
But how significant is this? Are there it possible to develop mutually useful allo-
circumstances in which totally ambiguous cations. These kinds of allocations, char-
allocations are useful to recipients of ac- acterized by a community of interest and
counting data? The rest of this paper designated mutually satisfactory allocations,
suggests that totally ambiguous alloca- are discussed below.
tions can be useful in some situations and
AdNd EXAMPLE
for some purposes. Unfortunately, though,
it will turn out that this demonstration A simple example may be used to il-
does not alter the severe conclusions of lustrate two things simultaneously: first,
SAR ,'3. that the range of ambiguity in the con-
Allocations which are totally ambiguous tribution allocation is at least as large
yet perhaps useful may be classified into as the combined interaction effect and,
two broad categories :' second, that entities with a sufficient com-
1. Some totally ambiguous allocations munity of interest can develop mutually
are embodied in law s, regulations, and satisfactory allocations even when the
custom. When an entity is required by an related ranges of ambiguity are large. The
external authority to allocate, the result- particular allocation situation illustrated
ing allocation automatically is useful to is one in which the range of ambiguity,
the entity (regardless of how large the though substantial, is not total. Such a
allocation's range of ambiguity may be) situation gives a clear insight into the
merely because it satisfies that require- nature of the ambiguity in contribution
ment. For example, if tax regulations pre- allocations. For simplicity, the example
scribe that depreciation allocations be chosen utilizes only two interacting inputs
made, such allocations are thereby ren- and does not involve an amortization
dered useful; similarly, if authoritative allocation. However, all of the following
custom requires that manufactured in- ' This is for convenience in exposition, not for rigor;
it is likely that these categories overlap.
ventories be reported at "cost," the neces-
I Committee on Foundations of Accounting Measure-
sary allocations will be useful even if they ment, American Accounting Association, "Report of the
are totally ambiguous. Cases of this kind Committee on Foundations of Accounting Measure-
ment," THE AccoTNT-IG REvIEw, Supplement to Vol.
are discussed in the report of the American XLVI, 1971, pp. 1-48.

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 Thomas: Arbitrary Allocations 475
illustrated points may be extended with-
out modification to the more severe and
complicated allocation situations which
are encountered in financial accounting.6
Let us suppose that two graduate stu-
dents Fast and Slow, have been hired to
grade an examination at a rate of
500 per
paper. (For reasons that will become ap-
parent later, it is also assumed that Fast
is married.) Working alone, Fast can
grade five papers an hour; working alone,
Slow can grade three papers an hour. For
efficiency, each has "specialized" in grad-
ing part of the examination; this allows
them, working together, to grade twelve
papers per hour. The separate effects of
Fast and Slow on physical output may be
perceived as five and three papers an hour,
respectively; net revenues and total reve-
nues are identical, and the two students'
separate effects on net revenues will be
$2.50 (50OX5) and $1.50 (50OX3) per
hour. Total revenues are $6.00 (50#X 12)
per hour, resulting in a combined inter-
action effect of $2 .00 ($6.00 -$2.50 - $1.50)
per hour.
How shall Fast and Slow divide the total
$6.00 per hour between them? SAR #3
contends that in situations like this (where
two or more inputs interact to produce
an output) there will be no single, con-
clusiv ely defensible, answer. The table
indicates a few possibilities.
WAYS tN Wincn rt $6.00 PEi HouR MIGIT
BE ALLOCATED BETWEEN FAST AND SLOW
Fast Slow
1. Split thewhole amount 50/50... $3.00 $3.00
2. Attribute 7 papers per hour to
Slow, on the bsis that if he quit,
total output would drop from 12
to 5 papers per hour ........... 2.50 3.50
3. Attribute 9 papers per hour to
Fast, on the basis that if he quit,
total output would drop from 12
to 3 papers per hour ........... 4.50 1.50
4. Attribute each grader's separate
effects to him, then split the inter-
action effect 50/50 ............. 3.50 2.50
5. Split the whole amount in pro-
portion to each grader's separate
effects ........................ 3.75 2.25
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Comparison of methods (2) and (3)
demonstrates that the range of ambiguity
in this allocation is at least as large as the
entire combined interaction effect of $2.00
per hour; this will always be true of con-
tribution allocations.7
Method (2) is to Slow's short-term
financial advantage. It attributes the
entire combined interaction effect to him
by a calculation which parallels that of the
marginal analysis (something which should
make method (2) even more attractive to
Slow, since such reasoning is widely re-
spected in contemporary accounting the-
ory). Slow could defend method (2) quite
as forcefully as Fast could defend any
alternative allocation approach. Of course,
Fast could defend method (3) equally well
against any alternative that was proposed
by Slow.
DEVELOPMENT OF A MUTUALLY
SATISFACTORY ALLOCATION
For the purposes of this paper, however,
the most important thing to recognize is
that in practice the two graders usually
would manage to agree upon a mutually
satisfactory method of allocation. This
process is much too complicated for its de-
tails to be discussed here; besides, only a
summary of it is needed to support the
conclusions that are reached in the next
section. In this example, ignorance of the
other grader's capacities ordinarily would
be a factor in reaching a mutually satisfac-
tory allocation, but four other factors seem
'I am grateful to Wadsworth Publishing Company,
Inc., for its permission to paraphrase some of what fol-
lows from the author's forthcoming accounting prin-
ciples textbook to be published in 1972.
7 Technically, once the two graduate students have
agreed to grade the exam, the minimum amount which
must be paid to either grader is whatever it will take
to keep him grading. This might be less than $1.50 per
hour for Slow or $2.S0 per hour for Fast; therefore in
theory the range of ambiguity could exceed an amount
equal to the combined interaction effect. But in actual
business situations forces of competition should prevent
the range of ambiguity from exceeding the combined
interaction effect in this way (except, possibly, in the
very short run).
 476 The Accounting Review, July 1971

involved, too. First, people who work to- whose total advantage is maximized by
gether day after day (as graduate students that allocation, or who is constrained to
often do) develop various mutual goals accept it. Other entities will find the allo-
which are best furthered by co-operation; cation unsatisfactory (unless, of course, in
excessive emphasis on purely financial their judgment the gap between the results
interests can jeopardize other, nonfinancial, of the allocation method actually employed
interests. Second, even on strictly financial and those of whatever allocation method
grounds it may not pay either grader to be- would be to their maximum over-all ad-
come so greedy that the other will refuse to vantage is not material).
team with him on future projects. (This
will be true even from Fast's standpoint if APPLICATION TO FINANCIAL ACCOUNTING
Slow is more efficient on other jobs.) Third, Certain qualities or characteristics make finan-
there seem to be pervasive institutional cial information useful. Providing information
that has each of these qualities is an objective of
pressures which encourage individuals who
financial accounting. These qualitative objectives
are in the same station of life to share are relevance, understandability, verifiability,
things fairly equally. Finally, in the grad- neutrality, timeliness, comparability, and com-
ers' situation, bargaining may take place pleteness.
between what resemble two duopolists. * * *

(There is an extensive amount of theoreti-Neutrality. Neutral financial accounting infor-

mation is directed toward the common needs of
cal literature about this kind of bargain-
users and is independent of presumptions about
ing.)
particular needs and desires of specific users of the
The reader is asked to notice, though, information. Measurements not based on pre-
that if Fast and Slow reach a mutually sumptions about the particular needs of specific
users enhance the relevance of the information to
satisfactory allocation here, it is either be-
common needs of users. Preparers of financial
cause they have common goals which over-
accounting information should not try to increase
ride their short-run financial interests, or
the helpfulness of the information to a few users
because in some sense Society constrains to the detriment of others who may have opposing
the bargaining process. interests.10
Perhaps Fast and Slow agree that a
We may conclude by contrasting these
50/50 split would be fair. The resulting al-
graders with individuals who are affect-
location then will be useful to them de-
ed by financial accounting's allocations.
spite the fairly large ($2.00) range of am-
biguity.8 However, from the standpoint of
I Several individuals who have responded to SAR
someone else who does not share their com- J3 in private correspondence have gone further and
would contend that the allocation would not be arbi-
mon goals, or who is not subject to the
trary from the standpoint of Fast and Slow, either. I
same social constraints, this 50/50 alloca- have no real objections to saying this as long as it is
recognized that "arbitrary" is being used here in a
tion may be quite unsatisfactory. For ex-
limited sense which differs from the more general sense
ample, let us suppose that Mrs. Fast is employed in SAR #3.
trying to raise three children on a graduate ' An important parallel situation arises here with
transfer prices. For instance, a transfer price may be
student's earnings and doesn't give two mutually satisfactory to a parent company and its
hoots for Slow; from her point of view the foreign subsidiary, yet be unsuitable from the stand-
points of other affected parties in the host country-see
50/50 allocation may be unsatisfactory, 'Transfer Prices of the Multinational Firm: When Will
even though it is satisfactory to her hus- They be Arbitrary?" forthcoming in Abacus.
10 Basic Concepts and Accounting Principles Underly-
band.9 ing Financial Statements of Business Enterprises, State-
In general, allocations with large ranges ment of the Accounting Principles Board No. 4 (Ameri-
can Institute of Certified Public Accountants, October,
of ambiguity may be useful to an entity 1970), pages 10 and 37.

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 Thomas: Arbitrary Allocations 47 7
There are substantial differences between
the two cases. First, most financial ac-
counting allocations are totally ambiguous.
Second, individuals and groups whose in-
terests are affected by financial account-
ing's allocation practices (hereafter desig-
nated the affected entities) are not in the
position that Fast and Slow were to de-
velop mutually satisfactory allocations by
bargaining. Nevertheless, we have seen
that even total ambiguity need not always
be a barrier. There appears to be a slow
process in lieu of bargaining whereby the
interests of affected entities often are even-
tually reflected in generally accepted ac-
counting principles. One may still ask,
accordingly, whether the totality of af-
fected entities might manage to develop
mutually satisfactory allocations, or
whether the financial accountant might
develop these for the affected entities.
The prospects are not encouraging. So-
ciety's guidance to the affected entities
seems to discourage co-operation, sharing
things evenly, and so forth; instead, maxi-
mization of immediate financial advantage
is encouraged. Moreover, there are rela-
tively few common goals to be advanced encountered
by
entities partially sacrificing their financial
interests. Part of the problem here is that
too many individuals and groups are af-
fected by financial accounting reports.
Consequently, a sense of community is
difficult to develop. Finally, there are
abundant current and potential sources of
conflict between affected entities in which
different allocation decisions will favor the
interests of one set of contending parties
over those of others.
Thus, the chances of financial accounting
developing mutually satisfactory alloca-
tions are at a minimum. This is serious,
since financial accounting's traditional role
has been as a kind of general-purpose re-
porting which supposedly is neutral with
respect to conflicts among its users. If the
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analysis in this paper is correct, financial
accounting cannot be neutral in this sense
because it usually cannot provide mutually
satisfactory allocations (except for institu-
tional purposes, as defined earlier)."1 But
if this is so it follows that much of financial
accounting's traditional social justification
and much of its traditional role in legitimiz-
ing social institutions are at least partly
founded on illusion.'2
APPENDIX
THE RANGE OF AMBIGUITY IN THE
AMORTIZATION OF AN' INDIVIDUAL
INPUT DURING AN INDIVIDUAL
ACCOUNTING PERIOD
What follows is an attempt to demon-
strate that usually the range of ambiguity
in an individual amortization charge will
11 One reviewer of an earlier version of this paper com-
mented that this will depend upon how these alloca-
tions are used and upon how resourceful the users are
in compensating for the limitations of the allocations.
It is worth emphasizing again that if financial account-
ing is to be independent of the desires of special inter-
ests it must report data which are mutually satisfactory
to contending affected entities, and that the limitations
usually are ones of total amnbiguitv. At
present, many of financial accountings readers cope
with (or at least tolerate) such ambiguity. But the
probable explanations of this are not especially com-
forting: reliance upon nonaccounting data instead of
accounting's allocations, acquiesence to present rules
because of institutional compulsion or because they
provide the "only game in town," ignorance of the
ambiguity or of its extent, or indifference to the alloca-
tion because the reader's interests are unaffected by it
(or because he is unaware of any effect). Similarly, if
someone is tolerating a possible error of six hours in his
Match one concludes either that he is using some other
timepiece, has despaired of learning the time, is un-
aware of the ambiguity, or simply doesn't care what
time it is. Finally, of course, some readers cope with
financial accounting's allocation rules because they are
lucky, clever, or powerful enough to benefit from these
rules or to influence development of rules which favor
their own financial interests.
" In contrast, the allocations that are employed in
managerial accounting often need to be satisfactory- only
to a single user or to a small number of users who share
common purposes. I tentatively conclude, therefore,
that accounting's allocation problems do not always
have as serious consequences in managerial accounting
as they do in financial accounting. Further research
seems warranted.
 478 The Accounting Review, July 1971

be total-will be at least as great as the equals the difference between the input's
historical cost of the related nonmonetary total net-revenue contributions and its
input. The reader is warned that what cost:
follows is tentative and subject to refuta- p

tion. Let: R(.4j) = nij-Hj.

R(X) = the range of ambiguity in any
allocation, X
j=any input to the firm, j=l,
i=any accounting period, i= 1,
Were there no ambiguity in the contribu-
tion allocations, the range of ambiguity in
the amortization charge for input j in
period i would equal the range of ambig-

2, *, P uity in the amortization allocation. To the

Ni,= the total net revenue of the
firm in period i that was gen-
erated by input j alone, or in
combination with other inputs
nij= the net revenue contribution
of inputj in period i, as deter-
mined bvZ the contribution al-
location
extent that there is ambiguity in the con-
tribution allocations with respect to input
j, R(ACj) will be greater than or equal to
R(Aj), since one cannot reduce total am-
biguitv by additional ambiguity.
This paper argues that the range of
ambiguity in the contribution allocation of
period i with respect to inputj equals the

sij= the separate effects of input j combined interaction effect in period i of

in generating Nii input j and all other inputs with which it
interacts:
Iii= N.i minus the separate effects
of all inputs which generate
Nir-the combined interac-
tion effect in period i of input
j and all other inputs with
which it interacts to produce
net revenues
Hi= the historical cost of input j
R(Cij) = the range of ambiguity in the
contribution allocation in per-
R(C ij) = I.ij
Therefore, n,, may vary anywhere from
s,, to (sj+Ij,). Since each R(Cj) is inde-
pendent of each other, G n I, may var
anywhere from E-1 sj to DD1 (sij+ ij).
Looking to the most extreme case, if for
each i, Itjj=S,,+Iji, then:
p

iod i, with respect to the R(Aj) = > (siq + Ij) - Ij.

amount allocated to inputj
R(Aj)=given nij for each period, theNow the total range of ambiguity in the
range of ambiguity in the
amortization allocation for
input j
R(A Cjj) =the range of ambiguity in the
amortization charge for input
j in period i.
This notation is used only to clarify the
i -i
amortization charge for input j in period i
must encompass this case, along withall
other cases resulting from varying allo-
cations of the Ni,,'s to the nih's. Accord-
ingly, R(ACj) itself cannot be less than
2.',i (S +Iq)-HJ:
P P

matters to be discussed; what follows R(ACj) > E (Sq) + E (I~j) - Hi.

1-i i-1
should not be regarded as a mathematical
proof. SAR #3 evidenced that the range of But SAR #3 argues that the combined
ambiguity in the amortization allocation interaction effects of most inputs in any

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 Thomas: Arbitrary Allocations 479

period usually are substantial: most of the
total net revenues of the firm are such in-
teraction effects and most inputs interact
with most other inputs. Because of this it
seems very likely that for most inputs
.1 (Iij) will be at least twice as large as
Hi, and that:
R(ACij) Hi.
That is, the range of ambiguity in the
amortization of any given input for any
given accounting period usually will be at
least as large as the historical cost of that
input. This in turn implies that anything
from zero amortization to complete write-
off ill be appropriate for the input in any
given period.

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