THE APPEARANCE AND DEVELOPMENT OF THE VERTICAL INCOME STATEMENT AND ITS AFFECT ON MANAGERIAL ACCOUNTING

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1 THE APPEARANCE AND DEVELOPMENT OF THE VERTICAL INCOME STATEMENT AND ITS AFFECT ON MANAGERIAL ACCOUNTING Prof. Dr. Oktay Güvemli Associate Professor Dr. Barış Sipahi Marmara University, Istanbul, Turkey Abstract The vertical income statement, which is one of the main income statements of accounting, is accepted all across the world. Nevertheless, this vertical form is not compatible with the principles of the double-entry accounting system. The first usage of the vertical income statement came about in the second half of the 19 th century. The emergence of managerial accounting occurred at the same period. In the years of the First World War ( ), banks were not only examining the balance sheets of risky customers before lending credits, they were also bringing to the fore, the relationship between profits and sales. As a result of this, vertical income statements started to be applied. In the beginning, the vertical income statement was based on an arrangement of sales to gross margin from the top to the bottom. This system developed during the 20 th century to give us its current form today. During this development period, the vertical income statement advanced alongside managerial accounting. This was because the vertical income statement system was compatible with financial analysis techniques. It was the 20 th century in which both managerial accounting and the vertical income statement finished their globalization of the world. Unfortunately, there has not been any discussion on the side-effects of this process to the principles of the double-entry accounting system. Keywords: Vertical income statement, double entry accounting system, managerial accounting. 1. Introduction Today, the income statement and the balance sheet are the two main financial statements. However, even though the balance sheet is prepared in accordance with the double-entry bookkeeping system, it is observed that the income statement is not prepared in relation to the credit and debit sides of the double-entry system. However, the income statement could be so organized by placing the expenses on the debit side and the revenues on 1

2 the credit side as a developed style of the statement of profit or loss. Such a style would be compatible with the principles of double-entry bookkeeping. As it is today, the income statement is a vertical income statement and the total amount is shown at the beginning. The figures are listed towards the bottom by subtracting from the previous one. Such an arrangement was known as the stair method (merdiban method) and used by the Ottomans for centuries. In the stair method, the main amount is written at the top and the amounts forming this main amount are listed towards the bottom. Many tables and financial statements can be prepared from accounting information. Generally, these statements are supplementary tables and their forms can change as to necessities. The income statement is prepared to be utilized widely and is one of the two main financial tables. Balance sheet and income statement tables constitute the basic financial statements, they are not supplementary financial statements. It cannot be said that the disadvantages of departing from the formal basis of the double-entry bookkeeping method are covered adequately. The development process of the income statement is reviewed in short, starting from the concept of profit and loss. 2. From The Concept of Profit or Loss to the Profit and Loss Account in the Single-Entry Bookkeeping Method In the early days of accounting, the concepts of profit and loss arose. Since making a profit in a buy and sell operation is the basis of the transaction, it has become necessary to determine the profit or loss in every buy and sell operation. As the volume of trade grows, so must accounting methods grow. For example when Ocean trade developed in Western Europe, it was necessary to determine the profit and loss of a ship and then a fleet. The same development has been observed in the caravan trade on land. As this type of trade in land and sea has developed, and a continuous flow of goods and cash and continuous trade has evolved, it has become necessary to shift from the calculation of profit and loss for one time to the calculation of profit and loss based on time. In addition to the calculation of profit and loss based on time, because of the growth of trading enterprises and the increase of the types of goods and the increase in the number of buyers and sellers, the concept of profit has been transformed into the profit and loss account. When the necessity to determine the revenues 2

3 from continuous trade in a certain period arises, at first daily then weekly, monthly and finally yearly revenues have to be calculated. Before the double-entry method, the method used was called the simple or single-entry method. Both methods were used until the mid 19 th Century. follows: An example of the calculation of profit and loss in the single-entry method is as Table I. CALCULATION OF PROFIT AND LOSS IN SINGLE-ENTRY METHOD 1796 Dr.A.CUNNINGHAM Contra Cr. To Sundries at 30 By Sundries per Sept. 20 days, Oct. 25 Journal, Oct. 25 To Cash, Sept. 26 Dr. PROFIT & LOSS Contra Cr. To Catch paid for license March 1 By Rum gained, to retails Liquors, & c By Tobacco do To do. Paidchar. this month By Sherry Wine do Oct. 31 To do. paid do. Do By Sole Leather do Nov. 3 To do. paid do. on my By Molaffes do Tea and Sugar, 5 By Salt do To do. Paidchar. This 30 month By Wheat do Dec. 31 To do. paid do. Do. 47 By Bohea Tea gained, Jan. 31 To do. paid do. Do By Lump Sugar do Feb. 28 To do. Do By Henry Stewart, my To Wheat for fhort account of March 1 meaf Flaxfeed, To Stock for neat gain fince 1 ft Sept. Laft, Resource: Stone W.E.(1982) In this example, profit and loss is calculated for six months. Only the account used to calculate the profit and loss has been covered here. The profit has been calculated for the period September 1796 to March In book records, due to the fact that profit or loss 3

4 obtained from each transaction is added to the capital account, the calculation of profit or loss is made by the comparison of equity at the beginning and end of the period. The profit and loss in this example is calculated as follows: Beginning of Period- 1 September 1796 Assets 5,000,00 Liabilities Balance 4, End of period 1 March 1797 Assets 7, Liabilities 1, Balance 6, Increase 1, According to these calculations, the difference of the beginning and ending equity (stock nett, remaining after all deductions) is the profit. 3. From the Concept of Profit or Loss to the Profit and Loss Account in the Double-Entry Bookkeeping Method It has been observed that the calculation of the profit or loss and the preparation of the balance sheet were handled together at the beginning of the double-entry bookkeeping method in the 14 th and 15 th Centuries. It is possible to see a sample of this in the records of the famous Datini. Table II: CALCULATION OF PROFIT AND LOSS IN THE 14 TH CENTURY Currency unit Fiornini Soldi Denari Goods and other assets in the workplace at 27 September , Receivable accounts 6,518 9, Total debt including the capitals of two partners named Francesco and Toro 7, Net profit on the period 1, Resource: Peragolla E. (1938). Note: It is understood that 12 Denari equal 1 Soldi, 24 Soldi equal 1 Fiornini. Even though it is called a balance sheet, this financial statement is designed to determine the profit or loss. This shows that the rise of the concept of the balance sheet has its roots in the calculation of profit or loss. 4

5 It was necessary to wait until the 16 th and 17 th Centuries for the balance sheet and income statement to be presented separately even in a limited sense. Profit and Loss according to Pacioli: Luca Pacioli, who in the west is accepted as the founder of accounting and as the author of the first consistent work related to the double-entry bookkeeping method, wrote a famous book named Summa de Aritmethtica, Geometria, Proportioni e Proportionalita in Another well known account named profit and loss or advantage and disadvantage: How it is kept in the ledger records and why it is not present like others in the journal. As it is understood from the name of the relevant part of Pacioli s book, Pacioli opened a profit and loss account in the ledger and recorded the profit or loss arising from trade operations to this account. At the end of the period, the profit and loss account shows the period profit or loss. 4. Developments in the Profit and Loss Account in the 19 th Century and Experiments to Shift to the Income Statement The use of Pacioli s profit and loss account continued for 300 years from the end of the 15 th Century until the end of the 18 th Century. According to the double-entry method principles, the profit or loss incurred from transactions during the period is recorded and gathered in a profit and loss account in the ledger and at the end of the period shows the profit or loss of the period. During this period, the comparison of the equity at the beginning and end of the period was also seen to determine the profit or loss. At the end of the 18 th Century, in the year 1796, when Edward Thomas Jones wrote the book called English System in Book Keeping in England, many things started to change in the double-entry bookkeeping method. After the publishing of this book, accounting writers on the European continent started to publish books one after the other claiming they were the accounting system of their countries. Between the years , many developments were seen in the understanding of accounting. The most important change was the usage of double columns in the journal. Therefore this period is known as the battle of columns in accounting history. The mentioned period is also the period in which the double-entry method became accepted and when single-entry bookkeeping started to fall out of practice. 5

6 At the end of this period, between January 1 st -30 th, 1849, the profit and loss account of the ledger of an enterprise was as follows: Table III: PROFIT AND LOSS IN THE 19 TH CENTURY Dr. Profit & Loss. Cr Jan. 31 To Store Expenses Jan. 31 By Mdse. 1 1, " " " Per. " " " " Stock(net gain) , , Resource: Stone W. E. (1982). In this example, the expenditures with expense characteristics are recorded separately on the debit side of the profit and loss account. These expenditures are the expenses of the store and the personnel. Only one income amount is recorded on the credit side of the account. This income amount has been taken from the goods account and it is the profit amount derived from the sale of goods in that month. Consequently, the profit amount in January is the difference of the profit from the sale of goods and the expenses and this net profit amount is transferred to the stock account which is the capital account. The profit and loss account in this example is the classical recording style of the double-entry bookkeeping method. But in order for the derived profit to be recorded separately in the balance sheet without being added to the capital, one must wait until the end of the 19 th Century when the company capital concept arose. Towards the end of the 19 th Century, due to the industrial revolution, many things changed in the accounting notions of enterprises. As a result of moving from plant production to mass production, the necessities to relate the sales with the gross profit obtained from the sales arose and, moreover, the requirement to follow the general expenses of the enterprise became apparent. The reason for this was the need for the distinction between direct and indirect expenses. In other words, this was the beginning of developments towards cost accounting. Establishing a company, gathering of many partners under an incorporated 6

7 company within a contemporary-trade-law framework, have made the detailed expression of the equity part of the balance sheet necessary. Moreover, the development of the banking sector together with the granting of substantial amounts of long-term credit, have precipated the use of the asset and liability structure of the balance sheet for financial analysis. All these developments have caused the shift from the balance sheet to the income statement. But it is observed that the shift of the profit and loss account is not organized to become an income statement in line with the debit and credit sides of the double-entry method; rather it is in the vertical income statement style. The following is the consideration of an experiment of a vertical income statement at the end of the 19 th Century written in an accounting book. Table IV: VERTICAL INCOME STATEMENT AT THE END OF 19 TH CENTURY Franc Forward sale amount Returns from goods and sales discounts 382, , Forward sale amount (net) 363, Cash sales 123, Total sales 486, Gross probable Profit (486, x 28: 100) 136, General expenses account: Wages 63, Rents 12, Insurance Indirect taxes 2, Office expenses Gas 1, Advertisement 1, Miscellaneous expenses 5, Depreciation (5%) 1, Interest to capital (2.5% ) 7, Total 98, Interest paid to banks Balance 98, , Net Profit 37, Resource : Pigier (1888). 7

8 This table is one of the first practical applications of the vertical income statement. The cost of the goods sold is not shown. It has been calculated in accordance with the arrangements of tax laws applied in continental Europe during the second half of the 19 th Century, where an estimated percentage is used on the net sales to calculate the gross profit. The tax laws of that time predicted a gross profit margin for each business sector and they resolved to collect taxes calculated by using this rate on the gross profit. The calculation culture of the double-entry bookkeeping method and the cost of goods sold were neither proven nor trusted yet. The concept of the cost of goods sold would be on the agenda of accounting, especially for industrial enterprises, in the 20 th Century and this development would facilitate the adoption of the vertical income statement. In spite of all this, it can be observed that the above table is for management purposes. It provides management with a comparison between expenses and profit and net sales. In addition to that, this table contains the information required to calculate the taxes payable to the government. However, there are some questions that need to be answered. The first one of these being what will happen to the difference between the gross profit derived from the accounting dataset, and that which is obtained from cost-inventory workings and the profit calculated by a percentage from the gross profit. There is a need to reconcile the profit shown in the accounting records and the actual enries of sales, expenses, etc th Century: Transition from the Profit and Loss Account to the Vertical Income Statement and the Affect on Managerial Accounting As a result of developments during the 20 th Century, the 21 st Century was entered using the income statement instead of the profit and loss table. The income statement at that time was the vertical income statement. The income statement which replaced the profit and loss table, developed in continental Europe with the name operating account (Le compte d exploitation); the name income statement was used in the US as an Anglo-Saxon term. 8

9 The twentieth century is known as the century of the development of managerial accounting. Managerial accounting, like other types of accounting, deals with the information received from accounting and information in the financial statements. The preparation of a financial table which makes it possible to do a detailed analysis is preferred by managerial accounting. Along with the assets and liabilities sides of the balance sheet, it is desirable for the income statement to be suitably prepared for financial analysis. The characteristics of vertical income statements meet this demand exceedingly well. This circumstance was an important factor in the development of the vertical income statement during the 20 th Century. In the first half of the 20 th Century, there were important legal arrangements which gave a special style to the income statement. With the legal arrangement in France, dated August 30, 1935, a special style was forced upon the profit and loss account. In this legal arrangement the necessity of a profit and loss account which explicitly shows the sources of the factors forming the annual outcome was mentioned. The determination of which part of the profit comes from the basic activities and which from auxiliary activities became a necessary process. In Germany, a legal arrangement having a more explicit and definite expression was dated September 10, As to this arrangement, the necessity of the gross profit (profit earned from sales) being recorded on one side of the profit and loss account, and the expenses used to calculate the net profit from the gross profit being recorded on the other side of the account, was emphasized. While these formal arrangements were being applied to the profit and loss account during the beginning of the 20 th Century, economic developments also made it possible to transfer from the profit and loss table to the income statement. E. G. Snozzi, in his book called L Interpretation du bilan told the story of the first preparation of the vertical income statement as follows (Dunod, 1959, Paris): Just as banks gave long-term credits to industrial enterprises during the First World War, they also gave importance to the operating account (income statement) and the development of this table. The reason for this is that they wanted the economic strength of the enterprise to be considered. It has been observed that two types of income statements were 9

10 considered during the First World War. One of these is the operating account (income statement) prepared vertically and covering the sales and cost amounts which started to be used in the US in The style of this vertical income statement, incorporating these developments in the United States is the long form of the income statement and is reproduced below: Table V: VERTICAL INCOME STATEMENT IN EARLY 20 TH CENTURY IN USA Gross income (sales) Returns and discounts from sales Net sales Cost of Goods Sold Gross profit on Sales Deductions (sales and administrative exp.) Net profit on sales Other income (interest, commission etc.) Gross profit Deductions (interest,diminution in value of stocks etc.) Net profit Dividends Net Profit/ (Loss) for the Period Resource: Snozzi, E. G. (1959). As well as the above resumé of the form of the developing income statement in the United States, there were some developments in Europe during the first half of the 20 th Century. For example, in the book Bilans et Comptes written in 1926 by Gabriel Faure, one of the famous accounting thinkers of Middle Europe, he proposed the following form of the income statement: 10

11 Table VI: VERTICAL INCOME STATEMENT IN EARLY 20 TH CENTURY IN EUROPE Franc Debt Side Credit Side Purchases Sales Ending Inventory Balance Cost of goods sold (balance above) Gross profit and loss Deductible amounts (General expenses, depreciation and other expenses) Net operating profit Resource: Faure, G. (1926). While these developments were taking place in continental Europe during the first half of the century, the development of the income statement according to double-entry method principles was being observed in scientific studies. E. Schmallenbach, who brought forward the Dynamic Balance Sheet Theory, considered the following form of the operating account in his book named Le Bilan Dynamique: Table VII: GENERAL OPERATING ACCOUNT (LE BILAN DYNAMIQUE) Debt Credit Raw materials Sales Work-in-process Wages and additions Misc. Supply expenses Depreciation Miscellaneous expenses Taxes Profit Taxes Total 11

12 Resource: Schmallenbach, E. (1961). This table by Schmallenbach is a special purpose table designed to be utilized in his scientific studies. Hence, it can be observed that expenses that could form the cost of sales are present without considering the cost of sales. But this table shows that the income statement can be organized according to the double-entry bookkeeping method principles. It is appropriate to consider another example to show in which way developments went during the end of the first half of the 20 th Century in continental Europe. The following table was considered in the International Accounting Congress held in Paris in 1948 in the presented Le Plan Comptable. This vertical income statement is long; a condensed form is shown in here. Table VIII: GENERAL OPERATING ACCOUNT IN EUROPE IN THE FİRST HALF OF 20 TH CENTURY Sales Sales Cost Results from Sales Operating results: Results from sales (sales)... Divisional Expenses Distributed Expenses Expenses of Divisions: Production Divisions... Subsidiary divisions... Supply divisions... Sales divisions etc.... Total... Miscellaneous operation revenues and expenses Income Expenses and Expenditures. Results of Subsidiary activities: Result of activity A... Result of activity B etc.... Extraordinary income and expenses. Tax on profit (to be. deducted) Net activity result. Resource: Le Plan Comptable, Congres International de la Comptabilite, 1948, Paris. 12

13 It is known that this style has not been used much in practice; however, the form which started life at the beginning of the first half of the century in the United States was more widely used and accepted there. It would not be wrong to mention that the income statement prepared according to the double-entry bookkeeping principles maintains its importance in spite of developments during the first half of the century. However, the vertical income statement established its sovereignty fully during the second half of the century. General acceptance has been given to the vertical income statement. The 1929 Economic Crisis (the Great Depression) was the second important event increasing the importance of financial tables after the First World War. After the Great Depression, in the 1930s, the necessity for the income statement was voiced as follows in the Independent Public Accountants in the US (Examination of Financial Statements, American Isnstitute of Accountants, Pp.304,1936, USA): Financial tables are prepared for three basic purposes: for management reports, for reports to partners and for credit. In tables prepared for management, statistical detailed information is needed. The preparation of financial reports is a priority for the partners and investors. They are very interested in profitability and the value increase of their investments. Banks are interested in these tables because of trade credits. Credit grantors are especially interested in the liquidity of the enterprise and the adequacy of the enterprise capital. Because of this reason current assets and short-term credits are more important in comparison to the assets that could become cash in the long term and long term debts. Moreover they are really interested in the revenues because the back payment of the granted debt depends on the enterprise profit. Today, according to the opinion of the investor, this earning capacity has vital importance and the income account has an importance which is at least equal to that of the balance sheet. The development of the arrangements related to accounting has been widely effected from the realization of the importance of the income statement. The first objective is the comparison of the appropriate level of expenses or credits in the yearly income account. 13

14 It is seen that the practice of using the vertical income statement which started in the United States, became prevalent in Europe and other countries during the first half of the Century. The globalization process of the capitalist economy since the Second World War has also helped this. It is easily observed that the World Accountants Congresses played an important role in the globalization of accounting operations of the western countries, which started to accelerate in the 1960s. The vertical income statement was adopted as the basis for the development of uniformity for financial tables during the second half of the century. The vertical income statement in the Forth Directive adopted by the European Economic Community at the end of the 1970s and the vertical structure of the income statement in International Accounting Standard (IAS) 1 demonstrate uniformity in the vertical style. After 1990, after the disintegration of the USSR, within the framework of the capitalist economic understanding, it is known that globalization of the application of the double-entry methods of accounting accelerated. It is also observed that the application of a system of uniform financial statements gained importance. One of these uniform financial statements was the vertical income statement. These globalization studies were performed through the International Accounting Standards channel. In recent times the content of the financial statements has become more important than their structure according to International Accounting Standards. The vertical income statement has a structure which does not pay much attention to the debit and credit sides of the double-entry method. However, the double-entry bookkeeping method whether in book records or in financial statements, requires abidance to its fundementals. The formal structure of the book records and financial statements forms the artistic side of accounting to some extent, but the formal side of the double-entry method always prevails; the system, with its formal structure, has become superlative. While examining the development of the income statement, which is one of the products of the double-entry method, many examples were studied. One has to ask whether the transformation of the double-entry method and changes in its application, will bring about its demise. 14

15 6. Conclusion Accounting history shows that the development process of an accounting system sometimes takes centuries. The double-entry bookkeeping system is no exception. From its first appearance in the 13 th century right through to the 21 st Century, sometimes it developed slowly and sometimes rapidly. Like all systems, the double-entry method will disappear when it has completed its function, and then it will take its magnificent place in history. As seen from the above explanations, firstly, the profit and loss concept appeared, and then the profit and loss statement was formed. When this profit and loss table evolved to become an income statement, in accordance with the formal structure of the double-entry bookkeeping system, the formal characteristics of the double-entry bookkeeping were set aside and the vertical income statement started to develop. On the one hand outside factors like world wars, economic crises, the transition from the industrial community to the information society caused this development during the twentieth century; the development within accounting of managerial accounting accelerated this development process on the other hand. Even though it is not completely known how the developments in technical and financial areas in the twentieth century will be manifested, there are signs that there will be formal changes in the double-entry bookkeeping method initially. 15

16 REFERENCES - Faure, G. (1926), Bilans et Comptes en France, Nouvelle Librarie Nationale, Paris. - Peragolla, E. (1938), Origin and Evolution of Double-Entry Bookkeeping A Study of Italian Practice from the Fourteenth Century, New York. - Pigier (1888), Tenue des Livres, Enonce et Solution Raisonnees, Paris. - Schmallenbach, E. (1961), Le Bilan Dynamique, France. - Snozzi, E. G. (1959), L Interpretation du Bilan, Paris. - Stone, W. E. (1982), the American Accomptant, Yushodo Booksellers. - Stone, W. E. (1982), A Complete System of Practical Book Keeping, Volume 12, Yushodo Booksellers. - Examination of Financial Statements, American Institute of Accountants, 1936, USA. 16