H O W T H E A C C O U N T I N G A N D T A X P R O B L E M S O F A R IS IN G P R IC E L E V E L H A V E B E E N D E A L T W I T H IN
S W E D E N
B y Per V . A . H anner, D .H .S ., H andelshogskolan, Stockholm Among the E uropean countries, Sw eden is one of those, in which the general inflation which has taken place all over the w orld during the last decade, has been relatively least serious. T h is is m ainly due to a strict price control, which w as instituted in 1939 and which is still in effect, and other m easures taken by the governm ent.
W h e re a s prices developed com paratively alike in H olland an d Sw eden up to 1944, the price increases after th a t time have been sm aller in Sw e den than in H olland, as can be seen from the following table. (1937 prices = 100 in all columns.)
W h o lesa le C ost of living C onstruction
price index index cost index
H olland Sw eden H olland Sw eden Stockholm
1939 .... ... 97 101 102 105 104 1940 .... . 120 128 117 118 117 1941 .... ... 138 151 134 134 124 1942 .... ... 145 166 143 144 137 1943 .... ... 148 172 149 146 141 1944 .... ... 151 172 153 145 140 1945 .... ... 167 170 176 145 140 1946 .... ... 232 163 192 145 146 1947 .... ... 250 175 199 150 156 1948 .... ... 259 188 205 157 164
T h is continuous but relatively m oderate decline in the value of money in Sw eden has not, a t least yet, m ade necessary the special legal provi sions due to inflation, such as a revaluation of all assets, w hich have been instituted or contem plated in several other E uropean countries. O n the other hand, it has been big enough to have had a substantial inflation ary effect on reported business earnings and taxes, if Sw edish business men, accountants, and legislators had not been relatively well aw are of the dangers and taken m easures to neutralize the results as far as possible. P erhaps the most interesting side of this developm ent, and the one th at specially justifies a description for foreign readers, is the p a rt th at the tax law s have played in making possible to a large extent elimination of inflationary profits from taxable income.
T h e main influences on a co u n try ’s accounting practice generally come from the following fields:
1. A ccounting theory and education. 2. Professional public accountants. 3. Industrial and branch associations. 4. Legislation:
In accounting theory the problem s of a changing price level have of course been long observed an d discussed. P articularly th e experiences during the first w orld w ar, w hen inflation, both in Sw eden an d in most o ther countries, w as m ore severe th an now an d traditional accounting principles proved inadequate to meet the dem ands of the situation, led to the idea th at inflationary „paper p ro fits” should be elim inated from th e profit an d loss account. T h e influence from G erm an authors, w ho have been specially keen in stressing this point of view, on Sw edish accounting theory has been considerable. T h e leading proponent for this idea in Sw eden during the 1920’s and 1930’s has been P rofessor O . Sillen, a most influential scientist and teacher in accounting. T h ro u g h his and his colleagues’ teaching and w riting an d through the professional public accountants the new ideas on inflationary profits in accounting w ere m ade know n to business, w here they becam e quite generally accepted, especially w hen the dangers becam e imminent in 1939 an d the following years.
T h e industrial and branch associations —• very im portant factors in Sw edish business life ■— have not done much to forw ard these points of view in financial accounting, bu t it should be noted th a t in 1936 the F ederation of Sw edish Industries published a book, „U niform Principles of C ost A ccounting” , in which th e replacem ent cost principle w as recom m ended for all cost accounting purposes. T h e book stated th a t m aterial, due to be replaced, should be valued in cost accounting a t replacem ent cost. D epreciation of fixed assets ought to be calculated in cost account ing on replacem ent cost, and interest on replacem ent cost less accum ulated depreciation. T h e „U niform Principles” w ere later recom m ended by the Sw edish S ta n d ard s A ssociation and have had an im portant influence on cost accounting practice. T h e replacem ent cost principle w as also acknow ledged by the P rice C ontrol B oard, w hen this governm ent authority s ta r ted its w ork in 1939.
W ith re g ard to civil law, the most im portant acts concerning account ing m atters are the C om panies A ct (a new C om panies A ct of 1944 has replaced the old act of 1910 from Jan. 1, 1948) an d the A ccounting A ct (1929). T h ese acts contain certain rules on the valuation of balance sheet items, the C om panies A ct for joint-stock com panies an d the A c counting A ct for m ost other forms of business enterprises. In short, the most im portant of these rules require th at stock-in-trade m ay not be carried at a higher value th an „cost or m arket, w hichever is the low er” , and fixed assets not higher th an cost less accum ulated depreciation. T h ese are maximum values, how ever, an d undervaluation in the form of secret reserves is freely perm itted by these acts. T h e legislators have here only w an ted to prevent the show ing of fictitious profits by m eans of over valuation of assets or undervaluation of liabilities.
By special provision in the C om panies A ct of 1944 a com pany is now perm itted to raise th e book value of fixed assets, w hen their actual value is considerably an d perm anently above th eir form er book value, b u t the am ount of this w rite-up may not be paid out in a cash dividend, because it must be used either for a corresponding w rite-dow n of o ther fixed assets or for an increase in the share capital („ sh are dividend” ). T his possibility has seldom been used in practice an d the transaction has no effect on taxation.
on the following pages. H ere I just w a n t to point out a few general facts. T h e taxes of main interest to Sw edish business are the municipal income tax and the national income tax. T h e fundam ental rules for the determ ination of taxable income are to be found in the M unicipal T ax Law (M T L ) . W h e re a s an individual pays a proportional municipal income tax (on his income less certain general deduction) bu t a national income tax according to a highly progressive scale, both taxes are p ro portional for joint-stock com panies t ) . T h e total of municipal and national income taxes, w hich I will call henceforth „the o rdinary tax es”, for a com pany am ounted to around 28 % of the com pany’s taxable net profit in 1938, to 37-39 % in 1940— 1947, and to 46 % since 1948. 1 2)
A very im portant principle in Sw edish tax law s is „the inviolability of the taxable y e a r,” which m eans th at each year is taxed entirely as a separate unit. T h u s a loss suffered during one y ear m ay no t be deducted from profits during the following years, nor does it entitle the taxpayer to a repaym ent of taxes. In order to avoid unfair effects for the taxpayers arising from the application of this principle, it has been found necessary to m ake the rules regarding determ ination of taxable income for ordin ary taxes very liberal. T h is has been carried furthest in the case of companies. Because these have only proportional taxes, it has been the idea of the tax legislators th a t ■—• w ith some lim itations —■ it could be left to the judgm ent of the com panies to determ ine the am ount of profit to be taxed in each year. If a com pany w ants to create or increase a secret reserve one year, the am ount must alw ays app ear on the tax retu rn some time, at least a t the liquidation of the com pany, unless the reserve is used to cover losses during bad years, w hich should also be perm itted. (T h e possibility of low er tax rates in the future has ap p aren tly seemed very sm all). T h is liberal rule has tw o other advantages from the legislators’ point of view. Firstly, it tends to reduce the fluctuations in taxes collected during different years by the state an d the m unicipalities. Secondly, the legislators w ho w ere well aw are of the developm ents in accounting theory, w anted to enable an d even encourage business to apply the ac counting m ethods best suited to the situation, e.g. to deal w ith the p ro blems of a changing price level.
D uring the w ar years an extra national tax on excess w a r profits w as added to the ordinary taxes. W ith some generalization w e m ight say th at every increase in profit from the average profit of 1937 and 1938 w as considered excess w ar profit, unless it could be proved th a t the increase w as due to special conditions, w hich w ould have had the sam e effect even if the w a r had not been going on. T h is excess-profits tax w as in effect Sept. 1, 1939 •— Dec. 31, 1945. Its im portance to the national treasu ry w as small, although tax rates w ere very high, but the reason for m en tioning it here is the fact th a t some of the rules for profit determ ination in the E xcess-P rofits T a x Law are quite interesting for our subject, as will be show n later. Because the tax w as of a tem porary n ature these rules had to be much more restrictive than those applicable to the ordinary taxes, but they w ere specially w orked out so as to exem pt from taxation the fictitious „inflationary p ro fits” .
1) The joint-stock company (aktiebolag) is by far the most important form in which business is carried on in Sweden. There are approximately 30.000 companies in the country.
If w e accept the point of view th a t such accounting principles should be used as elim inate from reported profit and taxable income the effects of the changing price level, tw o groups of balance-sheet items deserve special attention: a. stock-in-trade: b. fixed assets. W h e n a revaluation of assets is not contem plated, either because it cannot legally be done or because a future fall in prices m ay be expected, the question will be: w h a t m ethods of valuation should be used for these assets in the balance sheet (or for corresponding reserves on the liability side, such as replace m ent and depreciation reserves) in a time of rising prices in order to reach the goal set up for the profit and loss account?
T h is is not the place to discuss these problem s theoretically. T h a t has been done by so m any authors all over the w orld during the past few years. Instead w e will give a short description of the principal rules of the Sw edish tax laws and the developm ent in Sw edish accounting p rac tice w ith regard to the assets just m entioned.
Stock-in-trade.
F o r the o rdinary taxes the general rule about stock-in-trade in the M T L runs: „In the calculation of taxable income, the valuation of stock- in-trade th a t the taxpayer has used in his accounts shall be deviated from only w here there are very reasons for so doing”.
If the taxpayer can show th at he has been consequently using a cer tain acceptable m ethod of stock valuation, the tax courts will thus usually approve his calculations. But the legal rule may also be m isused by companies and other taxpayers, w hose only „principle of valuation” is to minimize or postpone taxes as far as possible, and in such cases tax courts have been more restrictive. O ne im portant tax court found it necessary in 1948 to set a limit for these cases: stock-in-trade in industrial u n d er takings m ight be w ritten down only to the lower of 30 % of replacem ent cost or 60 % of p re-w ar cost. It seems probable th a t this court ruling, liberal enough in most cases, will be upheld by the Suprem e T a x C ourt.
A special problem arises w hen, due to scarcity of goods, the supply of goods on hand is far below norm al. A com pany that uses the base stock m ethod or sim ilar m ethods of stock valuation, will then have to deduct from the stock value a reserve for replacem ent, an d if the stock is small enough the result might be a negative stock value. T h is w ould not be accepted according to the o rdinary tax rules, but by a special law, com panies have been perm itted to set up on the liability side of the balance sheet an „investm ent reserve for sto ck -in -trad e” . T h e am ount set aside in this w ay is deductible, bu t not more than 20 % (in special cases up to 35 % ) of the com pany’s profit before income taxes m ay be tran sferred each year to this reserve or the other „investm ent reserves” th a t will be m entioned later on. T h e „investm ent reserve for sto ck -in -trad e” should be used in a following year, w hen stocks are more norm al in size, to w rite dow n the value of stock. A similar provision for other taxpayers th an companies is tem porarily in force (for the taxable years 1947-1949).
tax, w hen valuation a t pre-w ar prices less pre-w ar secret reserve w as only allowed for the qu an tity of stock th a t corresponded to the stock on hand at Dec. 31, 1938 (p re-w ar sto ck ). Stock in excess of pre-w ar stock m ight not be valued a t less th an the low er of actual cost or HO % of pre-w ar prices, as it w as considered im probable th a t the general price level after the w ar would fall below 140 % of pre-w ar prices. If the stock at Dec. 31, 1945, w as less than pre-w ar stock, a deduction of 40 % of pre-w ar cost for the missing quan tity w as granted.
T h e effects of the tax law s on stock valuation in business practice have been considerable. N o tab ly the E P T L called the attention of busi ness men and accountants to the problem s of inflationary profits, and during the w ar years it w as custom ary in all profitable enterprises to use the m ethod of stock valuation th a t w as perm itted bij the E P T L . Similar valuation m ethods -—• such as the base-stock m ethod and others -— have been commonly used in the following years. T h e re are m any less profi table enterprises, however, w ho have not „a ffo rd e d ” to be quite so cautious in their stock valuation, because they would then have been forced to show a loss and lose taxes, and there are others w ho have afte r the w a r w ritten down their stocks far below w h a t the E P T L p e r m itted. T h e developm ent in d ifferent com panies has thus been quite varying, an d it m ust u n fortunately be stated th a t not all companies, p er haps not even the m ajority of them, have consequently adhered to a determ ined m ethod of valuation.
It m ay be said in general th a t now most leading big com panies in Sw eden in their balance sheets rep o rt a value of stock-in-trade th a t is very far — often 50 % or more —■ below p resent replacem ent cost, bu t it is usually not possible for anyone outside a com pany to know exactly the position of the com pany as reg ard s stock-in-trade, as the law does not require the com panies to make public their m ethods of valuation. T h e C om panies A ct prescribes th a t any m aterial changes in the principles of valuation shall be m entioned in the annual report of the com pany, but this m ay be done in a fairly general w ay w ithout giving an y detailed figures on the effect of the change. If a secret reserve is dissolved, how ever, the fact must be disclosed, and it is one of the m ajor respon sibilities of the com pany’s auditors to ascertain th a t this is done.
F ixe d assets.
A s we are here interested m ainly in depreciation policies, I will discuss only the tw o m ost im portant groups of depreciable fixed assets:
a. buildings: b. m achinery and equipm ent (including ships and other tra n s port equipm ent, furniture etc.).
From the point of view th a t has been advanced in this paper, depreciati on should generally be com puted on replacem ent cost, not historical cost.3) T h is is necessary in order to prevent overstatem ent of real profits and to safeguard the real capacity of the business. T h e Sw edish tax law s have not perm itted depreciation on replacem ent cost in principle, b u t in certain cases the rules on depreciation are so liberal th a t it is possible for the tax p ay er to apply this m ethod of depreciation, a t least to some extent.
tax purposes is generally only allowed as a certain percentage —• different for d ifferent kinds of buildings -— of the actual (historical) cost to the p resent owner.
T h e sam e rule stands for m achinery and equipm ent, but here w e have som e very im portant exceptions in the M T L (exceptions nos. 2 and 3 did not appear in the E P T L ):
1. If the expected life-time of the asset is not more th an three years, the w hole cost m ay be w ritten off at once in the y ear of acquisition. 2. If the tax p ay er one y ea r cannot utilize in full the deduction for de preciation —- e.g. because his accounts show a loss for the year — he m ay use the deduction during some following, profitable year.
3. M ost im portant is how ever th a t companies <— an d some other forms of business, w hich have also only taxes proportional to the taxable in come —- have been gran ted since 1938 the rig h t to so-called „free d epre ciation" of m achinery and equipm ent. „F re e depreciation” m eans that, w ithin certain w ide limits, w hatever depreciation the com pany has m ade in its accounts will be accepted by the tax authorities. In this w a y it has even been m ade possible for companies to use depreciation on the rep la cem ent cost of these kinds of assets, provided th a t curren t replacem ents are m ade, so th a t the book value of m achinery and equipm ent less accu m ulated depreciation is kept a positive amount. It would be an o verstate m ent to say th at m any com panies have used the privilege of „free depre ciation” in exactly this w ay, but in any case most com panies’ depreciation of m achinery and equipm ent has been during the w a r years and a fte r w ard s g reatly in excess of norm al depreciation on actual costs. A s has been pointed out before, depreciation on replacem ent cost has for m any years been fairly generally accepted in cost accounting, and it is quite n atural th a t depreciation in cost accounting has influenced the deprecia tion in financial accounting.
„F re e depreciation” is not allowed for buildings. M ost com panies limit their depreciation of buildings in the accounts to the same am ount as is perm itted w ith re g ard to taxes, but there is of course often the possibility to use „free depreciation" ■—- as has been done by some com panies — to com pensate the too small depreciation of buildings (in relation to their replacem ent cost) b y m aking correspondingly bigger depreciation of m achinery and equipm ent.
„F re e depreciation” has frequently been used in a som ew hat less legi tim ate w ay: to equalize profits to some extent, b y m eans of substantial w rite-dow ns in good years and limited depreciation in lean years. T h is practice might perhaps not be considered to be too dangerous, since depreciation m ust be show n as a separate am ount in the profit and loss account, and the com pany m ust at least comply w ith the rule in the Com panies A ct th a t a fixed asset m ay not be carried at a higher value th an actual cost less accum ulated norm al depreciation. Some companies have m ade full use of the possibility th a t „free depreciation” gives them to get a tax credit, by w riting dow n m achinery an d equipm ent to the nom inal am ount of 1 krona.
A s a consequence of the „free depreciation”, the M T L states th a t if a com pany sells some m achinery or equipm ent, the total selling price is taxable income.
„excess prices” paid for new buildings, m achinery an d equipm ent. T h e „excess price” w as th en estim ated to be the difference betw een (a) the purchase price or construction cost of the asset and (b) 125 % (in 1945: 140 % ) of estim ated pre-w ar cost. T h e „excess price” w as w ritten off in the year of acquisition or construction and the rem ainder w as then sub ject to norm al depreciation. A similar rule on „excess prices” existed and still exists in the M T L , bu t it has lost its im portance afte r the end of the w ar, w hen the tax courts have in terpreted it very restrictively.
A s I pointed out before, „free depreciation” will not m ake it possible to use depreciation on replacem ent cost, w hen replacem ents are not m ade currently. T h e re is how ever in this case, too, a w a y out of the difficul ties, sim ilar to the one w e can use w hen stocks are low. T h e sam e special law th a t deals w ith „investm ent reserves for sto ck -in -trad e” also perm its a com pany to set up, tax-free, an „investm ent reserve for buildings” and/or an „investm ent reserve for m achinery and equipm ent” . T h e limit for am ounts th a t can be put aside in this w ay has alread y been m entioned in connection w ith „investm ent reserve for sto ck -in -trad e” . Sim ilar to th a t reserve, the „investm ent reserves” for fixed assets are to be used in some following y ear for a w rite-dow n of new buildings and equipm ent, acquired during th a t year. — T h e „investm ent reserve” legislation is how ever at the sam e time a p art of the governm ent’s program to level out business cycles. It is intended to encourage business to put aside profits in years of prosperity in order to ensure larger investm ents in real capital during a depression. T herefore, the d ifferent „investm ent reserves” set up are not free to be used for their intended purpose w henever the com pany w ants to take them; special perm ission to use them m ust first be obtained from the Labour M ark et Board.
Conclusion.
T h is short survey will have show n th at due to the liberality of S w e dish tax laws ■—’ especially w ith re g ard to stock valuation and deprecia tion of m achinery and equipm ent -—■ it has been possible to a very large extent to avoid the unfortu n ate effects of taxes on fictitious inflationary profits. O n the other hand, the actual developm ent in Sw edish business practice and the often unduly big secret reserves th a t have been accum u lated in m any companies, m ay suggest th a t the tax rules have been too liberal, a t least for companies. T h e re is in fact now a tendency on the p a rt of tax authorities and courts to limit som ew hat the freedom of business in this respect. A t the sam e time, in the field of civil law, a R oyal comm ittee has recently proposed some am endm ents to the Com panies A ct, by which com panies w ould be required to m ake public certain inform ation about their secret reserves.
It may finally be said th a t the tax rules and accounting practice in Sw eden obviously have had some effect in m aking Sw edish business life unusually stable. In the m any h undred million kronor of secret reserves in the companies, these have accum ulated a pow er not only to w ithstand the effect of a future fall in prices but also to a large extent to continue paying taxes and dividends in b ad years th a t m ay come. T h is stability is reflected in the low retu rn th a t is asked for m oney invested in th e big companies. W h ile w ith present (O ctober 1949) quotations Swedish governm ent long-term bonds give a yield of 3 % , a com pany can sell 334 % debentures, secured by m ortgage, a t par. T h e average yield (in dividends) of shares quoted on the Stockholm Stock E xch an g e is now 4 //2 %• T h e re have been only small fluctuations in these figures since
