The regulation of asset valuation in Germany

The origins of valuation: Inventory accounting

Early accounting practice of the fourteenth and fifteenth centuries focused on the supervision of contracts, paid-in capital, and determination of profit. Only in the early sixteenth century did accounting for inventory become increasingly important, which necessarily raised questions regarding valuation. From that time on, inventories in stock were included when determining profit.

Lacking official regulation, merchants consulted other sources for accounting guidance. Grammateus (1518), who wrote one of the first German accounting books, postulated the valuation of inventory at historical costs. Summarizing other accounting books of the sixteenth century, ter Vehn (1929: 165–168) concludes that historical costs were favoured for valuing inventory, regardless of the purpose of accounting. He also finds that fixed assets were rarely mentioned, but, if so, they were valued at historical cost, foremost because fixed assets were not considered essential for operations and should not have an effect on profit.

Similar accounting practice could be observed in France. In 1670, Jacques Savary, a famous merchant and businessman, was ordered to draft a commercial law for France. The resulting Ordonnance de Commerce of 1673 did not include valuation principles. In 1675, Savary composed one of the first systematic accounting textbooks, in which he commented on the Ordonnance and recommended that assets should be valued at historical cost (Savary, 1679). Only if market prices decreased significantly below the book value, that is, by more than 5 per cent, should market prices be used for inventory.

In the wake of financial speculation and bankruptcies, the Ordonnance de Commerce was replaced by the Code de Commerce in 1807, which still did not include valuation principles. In his commentary on the Code, Jean-Baptiste de la Porte (1808: 122) explains that the valuation of inventory did not require historical cost but could also be based on market or fair value. In that case, upward and downward price changes were accounted for. This view of accounting gave merchants additional flexibility when drawing up their inventory and may be explained both conceptually and socio-economically. De la Porte argued that the (primary) aim of inventory accounting was to provide an overview of the merchant’s wealth at a specific point in time, for which market values seemed more appropriate. Conceptually, this interpretation put less emphasis on profit determination. The socio-economic context of the early nineteenth century also made it much easier for merchants to observe market prices, since increased commercial trading led to more transparency in prices.

The influence of the French commercial code on other countries’ commercial law is well documented. Simon (1899: 38) indicates that the Code de Commerce was used to differing degrees in a number of countries, including Belgium, Greece, Italy, the Netherlands and Spain. This development was due to France being among the first to codify a commercial law to which other countries likely looked as a precursor. The Napoleonic Wars further stimulated the use of the French codes. Even after Napoleon’s defeat, the French codes remained effective in formerly occupied territories (e.g. in the German states of Baden, Rheinhessen and Rheinpfalz).

Heterogeneous regulation in independent German states

At that time, Germany was split into many small states, each with their own currency, measurement units and legislation. The Allgemeines Landrecht für die Preußischen Staaten (General National Law for the Prussian States, ALPS) of 1794 stood out among the early national laws in that it was the first to postulate rules for bookkeeping, preparing a balance sheet and valuation.

Following Savary’s Ordonnance closely (Barth, 1953: 128), the ALPS required that “if commercial books are to have evidential value, they are to be kept according to commercial practice” ⁴ (ALPS, part II, title 8, section 566). Merchants would be liable if their business became bankrupt and they had not kept their books appropriately or had not taken inventory at least once a year (ALPS, part II, title 20, section 1468). The ALPS included a relatively specific valuation postulate (part II, title 8, section 644), which was to be applied only by Handlungsgesellschaften (early forms of partnerships originally intended for trading, but later extended to other businesses) and which read as follows:

Given that there are no specific agreements in the contract: when taking the inventory, commercial assets, such as raw materials and goods, shall be recognized at the prices at which they were acquired and, if the market value is lower at the time of stock-taking, [they shall be recognized] at this lower price.

This lower of cost or market principle was to be considered only if the operating agreement between the owners of the company did not specify a different valuation rule. The ALPS represented the first codification of historical cost accounting in the German states. The rule, however, did not go beyond corporate practice and earlier textbooks.

Merchants’ continued use of historical cost is documented by an encyclopedia written by a Gesellschaft Gelehrter und praktischer Kaufleute (Society of Scholars and Practical Merchants, 1845). The book followed the requirements postulated by the ALPS, but established accounting procedures by referring to the French Code de Commerce, again demonstrating the influence of French regulation on German practice. With respect to inventory valuation, the encyclopedia also recommended a lower of cost or market principle and extended early German accounting practice according to Savary’s proposal:

[O]ne shall use the purchase price when determining the value of inventory. This is usually done. However, in case the price of an article has decreased significantly, or in case the [state of the] article has accidentally decreased in the warehouse by any means, one uses that price, for which the same [article] can now be bought (market price) in order to not deceive oneself; in the opposite case, however, one does not use a higher value, because true profit will be shown anyway once the inventory is sold, while the same [profit] would be lower if the value was determined to be higher. (Gesellschaft Gelehrter und praktischer Kaufleute, 1845: 175) ⁵

Harmonizing accounting regulation: The Allgemeines Deutsches Handelsgesetzbuch

Around 1800, when industrialization began, trade among businessmen increased both within and between the German states. Economic development was hindered by the political sectionalism resulting from the large number of borders and customs regimes. Businessmen started to put pressure on the legislators to harmonize the customs and trade laws, which is why several German states, among them the economically and politically strong states of Prussia, Saxony, Bavaria and Württemberg, started the Deutscher Zollverein (German Customs Union) in 1834. The primary purpose of the Zollverein was to coordinate customs, tariffs and trade policies among member states.

As early as 1836, the kingdom of Württemberg raised the idea of a single German commercial code and produced a draft code in 1839. This draft did not contain any rules on valuation because, according to the Motive (explanatory statement) of section 206, para. 1, the legislator considered the Prussian rule of lower of cost or market as “self-evident, and in any case … not to be part of a law”. This attitude reinforced the notion that historical cost accounting was widely established and accepted as common sense.

The other members of the Zollverein did not seriously consider Württemberg’s draft, and efforts to issue a single commercial code halted. They only resumed in the aftermath of the German revolution of 1848 when the Frankfurter Nationalversammlung (German National Assembly held in Frankfurt from 1848 to 1849), inter alia, considered a draft of a commercial code. This draft closely resembled the Code de Commerce (Barth, 1953: 67), but did not include valuation requirements. It seems that, until the mid-nineteenth century, valuation at historical cost was so prevalent that the regulator did not perceive a need to include it in laws.

Although the German revolution failed and the efforts to introduce a commercial code stalled, the economic interests of both merchants and heads of state maintained a striving for German unity, at least with respect to commercial regulation (Schneider, 2001: 914). We assume that the need for a uniform commercial code was also due to the increasing importance of outside financing from banks and other creditors (Stulz-Herrnstadt, 2002: 109). In order to allocate their capital efficiently, creditors had to rely on consistent accounting regulation throughout the German states. In contrast to early accounting guidance, which aimed to calculate profit or prevent disputes among the company’s owners, regulation was now considered necessary for protecting creditors from loss of capital (ter Vehn, 1929: 433). This dogmatic shift was long lasting in that the strong emphasis on creditor protection has been a prevalent feature of German accounting regulation ever since.

Due to its leading position in the Zollverein and its economic power, Prussia exercised considerable political pressure on the Deutscher Bund (German Confederation), a loose union of German states, to endorse a commercial code including accounting regulation for all legal enterprise forms. Prussia offered a draft for such a code in 1856, which was followed by a slightly amended version in 1857. The first draft included the same lower of cost or market rule for inventory as the ALPS, but did not prescribe other valuation requirements. For long-lived assets, the draft assumed valuation at historical cost, from which depreciation was to be subtracted (plant) or not (land). The first Prussian draft was heavily criticized for ignoring value increases (von Hahn, 1877: 128). Entrepreneurs were among the critics, fearing they could not disclose “true company values” in their financial statements. A commission, consisting of legal and commercial experts, was set up and consulted on the first draft. According to Passow (1910: 99–101), a professor of economics, it reiterated the entrepreneurs’ attitude and recommended that valuation rules should be instated for limited liability companies only. It was argued that the limited liability of shareholders imposed a major risk on creditors. For other legal forms, the commission questioned whether a valuation rule was needed at all. As a consequence of this debate, Prussia’s second draft of 1857 merely mentioned that a value for inventory should be determined by subtracting impairment from the “initial value”. While the requirement targeted all company forms, no details were given regarding what this initial value constituted. Using a systematic interpretation of this draft, Passow (1921) assumed the 1857 draft to favour fair valuation less impairment. Seemingly, entrepreneurs were able to seize the opportunity and express their preferences successfully in that they could convince fellow expert commission members. In accordance with the commercial tradition, they viewed accounting as a practical matter that required professional judgement instead of regulation (Schmalenbach, 1925: 266).

Following the controversies surrounding the emergence of Prussia’s draft, the Deutscher Bund installed a commission to craft a joint German commercial code. This commission was made up of lawyers, law professors and Kommerzienräte (distinguished merchants), who met in Nuremburg between 1857 and 1861. The official protocols, which are reproduced by von Lutz (1858), show that the commission based its consultations on three documents – the revised Prussian draft of 1857 as well as two Austrian drafts. ⁶ Initially, one of the members brought in a motion to exclude valuation from the law. However, there was major agreement that such codification was necessary to provide guidance on acceptable valuation and to codify commercial practice (von Lutz, 1858: 47). Although historical cost accounting seemed to be generally accepted, there were significant regional and industry-specific differences (von Lutz, 1858: 932). Such differences concerned, for example, the use of depreciation methods and impairment indicators. Moreover, the debate on the treatment of value increases was influenced by the growing importance of fixed assets following accelerating industrialization. As a consequence, the commission’s debates on a general valuation rule were difficult and lengthy. Commission members from states with powerful merchants, namely Hamburg, Hannover and Kurhessen, opposed detailed valuation rules throughout the deliberations (von Lutz, 1858: 932–934, 4497–4498, and 10–11 of the Appendix). We conjecture that merchants were increasingly interested in presenting their net wealth favourably, for example to raise capital.

In the end, the prospect of a joint commercial code prevailed over settling the commission’s debate on the primacy of a valuation basis. A universal, non-committal valuation principle was sought that took into account the varying commercial practices and appeased merchants, who apparently were resistant to ceding their existing discretion. ⁷ When on 31 May 1861 the Allgemeines Deutsches Handelsgesetzbuch (General German Commercial Code, ADHGB) came into effect in the Deutscher Bund, it read:

When drawing up the inventory and the balance sheet, all assets and accounts receivable shall be recognized at the value which can be attributed to them at the time of drawing up. (Article 31 ADHGB)

For the first time in German accounting history, merchants ⁸ throughout the German states could abandon historical cost and use fair values, if they chose to do so. The valuation rule allowed recognition of both value decreases and increases and merchants could decide subjectively which value was to be “attributed” to an asset. Seicht (1970: 35) proposes that the regulator did not see any harm in providing companies with discretion and may even have intended to do so, possibly to further economic growth. Aiming to clarify the commission’s intention, Schmalenbach (1925: 278), a professor who is typically described as the founder of business administration as an academic discipline in Germany, argues that the rule required valuation to consider the nature of the asset and the purpose of the valuation, as well as industry specifics. While rejecting the notion of one uniform value, he suggests that the commission aimed to give merchants “objective discretion”.

A few years after the ADHGB was issued, formal commentaries emerged specifying the valuation requirement for commercial practice. Von Hahn (1877: 128), a judge at the Reichsoberhandelsgericht (Supreme Court of Commerce of the German Empire, ROHG), indicates that assets had to be measured at current values, which inevitably can be both above and below historical costs. By contrast, Anschütz, a professor of law, and von Völderndorff, who as a lawyer had worked in the Department of Justice for several years and was then a judge at the Commercial Court in Nuremberg, derive more detailed conclusions. Anschütz and von Völderndorff (1867) perceived the valuation principle as requiring a market price, not a liquidation value, and restricted application of the principle to certain classes of assets. For example, they concluded that inventory could be valued at a market price above historical cost, but noted that a prudent (or diligent) businessman would not make use of this regulation. For plant and equipment, they considered historical cost less depreciation and impairment to be in line with the law. Hence, despite allowing departure from historical cost, the valuation requirement of 1861 was interpreted conservatively by appealing to merchants’ prudence. Nonetheless, companies were de facto able to inflate (or deflate) their profits.

1. Aktienrechtsnovelle (1870): A laissez-faire approach

While the ADHGB of 1861 also pertained to Aktiengesellschaften, the requirements for these firms were very general – particularly concerning accounting and financial reporting. Limited experience with Aktiengesellschaften and their recent emergence at first resulted in the notion that stricter regulation was not needed. This attitude was most likely fostered by the favourable state of the economy. Moreover, Aktiengesellschaften still needed a state concession to be founded. Besides following the general rules of the ADHGB (including the general valuation rule), each Aktiengesellschaft had to define its own accounting rules, which – due to operating under state concession – were occasionally examined (ter Vehn, 1929: 436). Still, the very loose regulation provided Aktiengesellschaften with a high level of discretion (Endemann, 1870: 44).

In the course of rapid industrialization, Aktiengesellschaften became increasingly prevalent, such that the legislator eventually needed to address this legal form in more detail. In particular, the differing regulations in the German states needed to be harmonized further. Thus, shortly before the ADHGB became federal law in Germany, the regulations for Aktiengesellschaften were reformed under the 1. Aktienrechtsnovelle of 1870. This reform was implemented via the first Gesetz, betreffend die Kommanditgesellschaften auf Aktien und die Aktiengesellschaften (Federal Law on Partnerships Limited by Shares and Stock Companies) ⁹ and changed those sections of the ADHGB that were relevant to Aktiengesellschaften. Most importantly, Aktiengesellschaften were relieved of governmental supervision and were organized under private law, which was deemed sufficient to protect investors and creditors (Lehmann and Ring, 1902: 373).

Asset valuation remained largely unchanged. The reform introduced one additional article that specified the share price at the reporting date as the upper valuation boundary for marketable securities. The legislator had found evidence that marketable securities were the one class of assets that Aktiengesellschaften overvalued. There had been cases in which this practice led to excessive dividend payments and subsequent bankruptcies, which of course was to the detriment of creditors (Protocols of the Reichstag of the Norddeutscher Bund (North German Confederation) of 12 May 1870, No. 158: 657). The general valuation rule of article 31 ADHGB applied to all other assets.

Overall, we conclude that the 1870 reform furthered the viewpoint on which the ADHGB was initially based, namely that creditor protection was essential for public companies. Despite these regulatory efforts, it seems that due to expanding industrialization no one quite knew the extent to which creditor protection or accounting rules were needed and had to be implemented in the law. Arguably, as a result of the limited experience with Aktiengesellschaften, as well as due to the prevailing economic boom of the late 1860s, a laissez-faire approach was deemed appropriate. Time would tell which sections of the law, if any, required further attention. Nevertheless, while Aktiengesellschaften possibly had sufficient leverage to avoid too many rules, the regulation slowly increased, suggesting that at least some parties were concerned about the economic and social significance of Aktiengesellschaften as well as their increasing power.

The Gründerkrise and the overvaluation of assets

Following the Franco-Prussian War of 1870–1871, Germany received large reparation payments from France, which it subsequently had to invest. The payments further contributed to the prevailing economic boom, which reached its peak in the years following the war. Barth (1953: 75) illustrates the economic development by reporting that in 1870 and 1871, 203 Aktiengesellschaften were founded per year. In 1872 there were 478 new companies and in 1873 an additional 162. While the majority of these companies were based in real estate and the construction industries, all sectors of the economy saw rising numbers of Aktiengesellschaften. According to Mottek (1981), the need to invest money brought about positive developments in some areas, but proved disadvantageous in others: many Aktiengesellschaften were simply founded as a result of the pressure to invest and engaged in all kinds of speculation. At the same time, the economic boom significantly stimulated demand, which in turn raised prices. This economic effect made businesses anticipate a further increase in demand and a price spiral developed. The ensuing speculation first led to vast credit expansion and a shortage in the workforce, but also overcapacities. Soon, it became apparent that the economic boom of the early 1870s was not sustainable and was in fact an artificial bubble.

The Gründerkrise began in the second half of 1873 and turned out to be the most severe economic crisis in nineteenth-century Germany. Of those Aktiengesellschaften founded prior to 1873, 61 became bankrupt, 148 reduced their share capital and 257 had been liquidated by 1882 (Schneider, 2001: 921–922). Although official crime statistics are not available for that time, the crime rates in Prussia indicate that the economic boom of the early 1870s had at least partly contributed to white-collar criminality (Starke, 1884: 63–77):

Particularly later authors (e.g. Barth, 1953: 74–75; Schneider, 2001: 921–922) attribute these developments to weak accounting regulation. Aktiengesellschaften had arbitrarily used fair valuation without having adequate capital reserves since they were still allowed to define their own company-specific accounting rules, which may have promoted criminal activities to an even larger degree. By contrast, contemporary authors (e.g. Hecht, 1874: 121; Wiener et al., 1873: 46) rejected the notion of insufficient financial reporting regulation. Instead, they argued that an upper boundary for the valuation of marketable securities would not have been necessary if the existing regulation had been applied correctly. Conceding that many Aktiengesellschaften had significantly overvalued their assets in their opening balance sheet, the authors argued that this practice at least partly resulted from a lack of enforcement and auditing. Thus, while all the authors agree that insufficient regulation was to be blamed for the crisis, they assess the source of the regulatory deficiencies differently.

While the crisis gained momentum, the Reichsoberhandelsgericht became involved when deciding on a legal dispute concerning asset valuation. On 3 December 1873, the ROHG took a major decision by confirming the primacy of fair valuation for preparing a balance sheet. Refuting “arbitrary subjective discretion or … pure speculation” as the basis for determining fair values, the ROHG stated that a balance sheet should correspond to the “objective truth of the actual net wealth”. As a result, assets with a market value were to be measured at that price, while other assets were to be valued at an otherwise determined objective value. If no market price was available, the best information for a fair value may be the historical cost, a view that gave support to the formal interpretation of the law by Anschütz and von Völderndorff (1867). Although the Gründerkrise had not yet developed in full, the decision supports the notion that the ROHG did not consider the existing valuation requirements to be weak and that the manipulative behaviour resulted from misapplication of the law. The court thus rejected discretionary application of article 31 ADHGB and interpreted the law rather conservatively. To some degree, it strengthened the existing regulation.

Lessons learned from the crisis? 2. Aktienrechtsnovelle (1884)

The debate on the adequacy of the regulations for Aktiengesellschaften produced a variety of reform suggestions that were very heterogeneous and ranged from reintroducing state supervision to keeping the current regulations unchanged (Icking, 2000: 100–101). In 1884, the ADHGB was eventually revised by the 2. Aktienrechtsnovelle. The changes primarily concerned the founding process of Aktiengesellschaften, which was considered to be too lax, as evidenced by the fact that most Aktiengesellschaften that became bankrupt in the Gründerkrise had been established only recently. Following the changes, the founding process had to be audited by members of the supervisory board and management (Gründungsprüfung). Thus, the law required boards to take over one of the major tasks the state previously held. The revised ADHGB also introduced a mandatory review of financial statements by the supervisory board, for which companies could choose to employ external auditors. These changes clearly aimed at strengthening the enforcement of the current accounting regulation.

The reform also brought forth a major change regarding valuation because “unscrupulous overvaluation of assets under the appearance of merchants’ practice” (Protocols of the Reichstag of the Deutsches Reich (German Empire) of 7 March 1884, No. 21: 303) was to be prevented. Whereas the general principle of the ADHGB remained, Aktiengesellschaften henceforth had to comply with a lower of cost or market principle for current assets and historical cost for non-current assets. This differentiation seemed to be appropriate because current assets were sold within the daily business of the firm. Unfavourable changes in these assets’ values should be recognized when determining distributable profit. In contrast, if fluctuations in the market prices of non-current assets were to be considered, distributable profit would be misstated as non-current assets were to remain with the entity for a long period of time. The newly introduced article 185a ADHGB of 1884 read: ¹⁰

For the preparation of the balance sheet, the general rules of article 31 [ADHGB] are applicable with the following exceptions:

1. securities and goods, which have a market price, must not be carried at a value higher than their market price; if this market price is higher than historical costs, they are not to be valued higher than historical costs;

2. other assets must not be valued above their historical costs;

3. plant and equipment that is not intended to be sold but to be used in the operating of business may be carried at historical cost without considering a lower value, as long as an amount is subtracted to reflect usage or an equivalent amount is set aside as replacement fund […].

Due to shareholders’ limited liability, Aktiengesellschaften were considered to potentially endanger creditors, who in turn were seen as being in need of additional protection from loss of capital. The Gründerkrise had made apparent that many Aktiengesellschaften had paid dividends based on overvalued assets, thus distributing unrealized profits. This practice had hollowed out companies’ substance and imperilled corporations, once market prices fell. The Allgemeine Begründung (explanatory statement) of the reform act described the need for change in asset valuation (Protocols of the Reichstag of the Deutsches Reich of 7 March 1884, No. 21: 303):

The … restriction … is justified by the nature of a Aktiengesellschaft because – with respect to the regular distribution of net profit – it needs to be prevented that profits are distributed that nominally exist but that have not yet been realized via sale of the corresponding assets.

In summary, the 2. Aktienrechtsnovelle shows that the legislator was not entirely sure whether weak accounting rules or lack of enforcement led to the Gründerkrise. Consequently, both regulatory aspects were reformed. Mandatory audits of financial statements were introduced and the asset valuation for Aktiengesellschaften was regulated more strictly by introducing a valuation principle that has prevailed until today. In the same manner, the strong preference for creditor protection, introduced into the law following the Gründerkrise, demonstrates the long-lasting impact of that time on accounting regulation in Germany.

The rise of principles-based accounting

Between 1884 and 1900, the economy prospered and the German Empire saw its net domestic product increase by about 60 per cent, while its net investments rose by about 220 per cent (Hoffmann, 1965). When in 1900 a new commercial code (Handelsgesetzbuch, HGB) came into effect, it is not surprising that the HGB did not change the accounting rules, but presented a rewording of the ADHGB (Passow, 1921: 86). The valuation requirement of article 31 ADHGB was moved to section 40 HGB, while the historical cost principle referring to Aktiengesellschaften was moved to section 261 HGB.

Nevertheless, the Denkschrift (in this context to be understood as a statement of reasoning and motivation) accompanying the HGB draft set out that not all assets should be valued at their market value. This limitation pertained, in particular, to long-lived assets. The Denkschrift assumed that management made appropriate and responsible valuation decisions within the boundaries of law and the above-cited formal commentaries. Adding to the emphasis on management’s judgment, Lehmann and Ring (1902: 122), the former a professor of law and the latter a judge at the Kammergericht (Court of Appeal) in Berlin, comment that “by any means, [section 40 HGB] must not be applied literally”. Supporting a careful undervaluation of assets, they stressed that valuation below fair or current value could not be considered a violation of law. Instead, building up reserves for hard times was deemed reasonable. This attitude suggests that at the beginning of the twentieth century creditor protection was further substantiated as a cornerstone of German accounting practice.

While not changing the valuation requirements, the new code introduced section 38 HGB, requiring businesses to follow Grundsätze ordnungsmäßiger Buchführung (principles of orderly bookkeeping, GoB). ¹¹ The GoB are a complex system of accounting principles that provide the means to achieve the predetermined aims of an accounting system. Such aims could be to determine the profit or net wealth of a merchant. In the context of asset valuation, the first legal reference to “principles for inventory and balance sheet as a prudent businessman understands them” was made by the Sächsisches Einkommensteuergesetz (Saxonian Income Tax Law) of 1878. Initially, those principles were not explicitly mentioned in legal texts but merely embedded in commercial practice. The codification of fundamental GoB to assure orderly organization of bookkeeping and accounts can be traced back to the ADHGB (although were not then named principles or GoB). Those principles made companies keep their books and accounts in a clear and understandable manner, for example by requiring records to be made in a modern language and by prescribing copies of correspondence to be kept.

Most GoB, however, were not codified at that time, and even today nor are all GoB. The GoB as referenced by the HGB in 1900 appealed to the “diligent merchant” and expected merchants to behave honourably and properly, particularly with regard to debatable accounting issues like asset valuation. By not precisely defining the meaning or content of most principles, the legislator demonstrated trust in the merchants, arguing that companies’ stakeholders as well as the interested public, foremost auditors, lawyers and academics, will assure proper development and application of companies’ accounting practice as implied by the GoB (Leffson, 1987: 130–131). An early example of the lively debate on GoB is documented by Neumann (1909: 597–598), who describes the opposing views of practitioners, scholars and courts on whether GoB required including the merchant’s personal property and debt in his business’s balance sheet.

One would suspect that, being part of a law, the GoB were mandatory for companies applying the Commercial Code. However, non-compliance with GoB was of no significance and did not result in penalties or sanctions (Lehmann and Ring, 1902: 117). Arguably, merchants, and probably also the legislator, did not know exactly what the GoB were comprised of and how non-compliance was to be determined. Even among scholars, the understanding of the GoB’s significance differed. While Schmalenbach (1925: 282) perceives GoB always to have been an integral, although implicit, part of accounting regulation, Passow (1910: 106) views them as a new regulatory phenomenon. Additionally, as Fischer (1908) and Schmalenbach (1925) point out, section 38 HGB applies not only to bookkeeping but also to the preparation of financial statements. In contrast, Passow (1910: 109) argues that GoB are to be applied when keeping books only and not when preparing the balance sheet. In any case, the GoB enabled merchants to depart from the law’s general valuation rule and, indeed, Fischer (1905: 48–51), who was an attorney-at-law in Leipzig, observes that accounting practice referred to GoB to adhere to historical costs, thus disregarding the HGB’s valuation requirement. Further doubting the authoritative status of section 40 HGB, Fischer (1908) and Schmalenbach (1933: 228) argue that the law merely referred to a point in time when assets should be measured instead of prescribing a measurement basis. Other scholars mention that the law was “good advice” for merchants rather than being strict regulation (Passow, 1921: 105). Overall, it seemed that not only the general valuation requirement but all the accounting sections of the HGB “should not be taken too literally” (Schmalenbach, 1912/1913: 245).

In work published a few years after these discussions on the HGB’s valuation requirement, Schmalenbach (1933: 228) indicates a hierarchy for combining the (written) legal requirements with the (unwritten) principles. He argues that section 40 HGB should be applied only to the extent that the law did not allow discretion. If there was discretion, GoB should be applied instead. Schmalenbach’s assessment was later described as the prevailing opinion (Falkenroth, 1941: 303).

In summary, although the HGB did not change the accounting rules on valuation, its impact was significant in that it introduced a wide spanning reference to accounting principles based on commercial practice. The law’s actual wording and requirements were potentially not as important as the GoB because – due to its vague wording – the law had proven less effective than (traditionally diligent) commercial practice. The early years of the HGB may well be seen as the true cradle of principles-based accounting in Germany as a proper and flexible solution to the shortcomings of formal regulation.

Principles-based valuation and accounting theory

Soon thereafter, scholars noted that the GoB could not be a result of accounting practice only, but needed to be consistent with a theoretical objective of accounting. Consequently, the German debate on accounting theory and practice was most lively in the years following the codified reference to GoB in 1900 when Germany took “the leadership in accounting thought” (Mattessich and Küpper, 2003: 106). ¹² The fierceness with which the debate was held may be explained by the lack of consensus on what was to be considered GoB (Schmalenbach, 1953: 17–24).

One of the first to discuss accounting theory and practice was Herman Veit Simon (1899), a commercial lawyer, who originally published his theory, the static view of financial statements (statische Bilanztheorie), ¹³ in 1886, that is, before the HGB became effective. Simon criticizes the then predominant view of favouring objective values because values were inherently subjective and should reflect merchants’ personal judgements (pp.293–294). Only then, he argues, did the balance sheet show the value that the asset actually had for a merchant, be it a value in use or an exit price. Simon’s idea was very appealing to Aktiengesellschaften because they could comply with the legal requirements of the ADHGB/HGB while taking their practical needs into consideration (Passow, 1921: 102). Railway companies, in particular, experienced difficulties when determining “objective” values for some assets (Schmalenbach, 1925: 40) because they operated under state concession and thus needed the Government’s approval for a sale of assets. Hence, the marketability premise was not fulfilled and market prices could not be determined. Simon’s view of the law enabled these (and other) companies to value their assets in accordance with industry practice by using individual values, or even historical cost less depreciation and impairment.

Eugen Schmalenbach took up these issues and postulated his dynamic theory of financial statements (dynamische Bilanztheorie) in 1919 (Schmalenbach, 1919). In his view, the objective of accounting was the determination of profit. Based on prudence and creditor protection, Schmalenbach’s principles of realization and imparity have been key features of GoB practice to the present day. ¹⁴ The former principle made profit distribution contingent on a market transaction, while the latter principle of imparity required recognition of unrealized losses. This asymmetric treatment of unrealized profits and losses contributed to capital maintenance and prudent accounting. Historical cost accounting was an integral requirement of these principles because upward valuation would imply recognition of unrealized profits.

Fritz Schmidt (1921), like Schmalenbach a professor of business administration, focused on replacement cost accounting (the organic view of financial statements, organische Bilanztheorie). He stated that a company could recognize profit only to the extent that capital was maintained. Consequently, the difference between the selling price and the current cost of goods sold was to be (gross) profit. By supporting the valuation of all assets at replacement cost, Schmidt necessarily needed to address asset appreciation. He proposed splitting profits into those resulting from revenue and holding gains. Any appreciation would be recorded in a hybrid account between equity and liabilities, which he termed Wertänderung am ruhenden Vermögen (value changes of assets held) (Schmidt, 1928). Schmidt was also an advocate of the realization principle, while favouring replacement cost as one version of fair value. ¹⁵

In summary, after 1900, asset valuation was increasingly driven by the GoB. The accounting principles may even have superseded the law’s literal meaning since the HGB was insufficient for addressing measurement issues adequately. As a result, the GoB needed to be defined and specified. Besides using commercial practice as a primary, inductive source for GoB, scholars postulated accounting theories based on normative–deductive analysis. Although each of their views could be followed as in line with the legal requirements, historical cost was the most practical, because it was the easiest to determine measurement basis. As a consequence, Schmalenbach’s view became widely accepted and historical cost accounting was predominant.

Valuation in times of trouble: The years of hyperinflation

To cope with the huge reparation payments from the First World War, the German Empire began to issue national bonds as early as 1919. The interest and principal payments soon exceeded the capacity of the German economy and the subsequent French occupation of the Ruhrgebiet led to a further loss of tax income. This loss was to be compensated for by printing money, which in turn led to a rapid devaluation of the German mark.

Sorge (1926: 700–701), a vereidigter Bücherrevisor (chartered accountant), described the difficulties of asset valuation during this era of hyperinflation. ¹⁶ Between 1914 and 1923, companies considerably expanded their fixed asset base. Whereas during the First World War fixed assets were needed for war production, later acquisitions were mainly driven by the need to invest to shield monetary assets from inflation. Consequently, most of the fixed assets acquired from 1919 onwards were not used in production and companies debated whether unused assets should be written down. In the case that those assets were not impaired, Scheingewinne (fictitious profits) hollowed out the capital substance of companies. ¹⁷ Most notably, Schmalenbach (1921) acknowledged the need to account for inflation and proposed a method of forward indexation based on gold-linked foreign currencies, the price of gold in Germany, or a price index. ¹⁸

On 28 December 1923, the Government eventually issued a directive (Verordnung über Goldbilanzen) aimed at alleviating the effects of inflation. It acted upon authorization from the Reichstag in early December 1923. For reporting periods beginning on 1 January 1924 or later, the directive required merchants to set up opening balances in gold-mark. The gold-mark was an artificial currency created for accounting purposes only and was defined as 10/42 of the “North American Dollar”. ¹⁹ The directive suspended the requirements of section 261 HGB and allowed a departure from historical cost accounting for gold-mark opening balance sheets, which demonstrates the irrelevance of historical cost accounting in a severe monetary crisis. Given that the directive violated the previously established principles and ignored other suggestions on inflation accounting, it is not surprising that, immediately after being published, the gold-mark directive was heavily criticized (Schmalenbach, 1924: 3; Schmidt, 1924: 21). Specifically, gold-mark accounting was disapproved of because it focused exclusively on the “North American Dollar” as an adjustment base and did not place enough significance on the income statement (Schmalenbach, 1924: 3).

Overall, inflation accounting – based on precious metals, foreign currencies, or price indices – led to deviation from historical cost accounting, which seemed unavoidable. The historical cost principle was immediately reinstated following the currency reform of August 1924, which created the Reichsmark as the new legal tender and provided a remedy for the inflation troubles. The effect of the hyperinflation era on German politics and culture was long-lasting and contributed to the political and social turmoil of that time (Frotscher and Pieroth, 2007: 285). The regulatory chaos also fostered a change in the mindsets of German accountants and the era was the main driver of Germany’s strong emphasis on prudence and historical cost accounting that continued in later decades.

The golden 1920s, the Great Depression and afterwards: Blaming Aktiengesellschaften (again)

Aktiengesellschaften again attracted the Government’s attention in the prospering economy of the later 1920s. The favourable social and economic conditions encouraged reform efforts, which could be divided into two opposing streams (Lehmann, 1927: 810). Some considered current regulation to be too lax because Aktiengesellschaften could opportunistically use hidden reserves once these had been built up. Others argued that hidden reserves did not contribute to a true picture of financial statements and thus hindered adequate equity financing of Aktiengesellschaften (Barth, 1953: 82).

Set against this background, the 1924 Deutscher Juristentag, a biannual congress of the association of German lawyers, which was then held in Heidelberg, started advocating a regulatory reform for Aktiengesellschaften. At its subsequent 1926 meeting in Cologne, it followed up on its reform efforts and set up a commission with Schmalenbach representing business administration scholars. The commission produced its final report in 1928 (Bericht der durch den 34. Juristentag zur Prüfung einer Reform des Aktienrechts eingesetzten Kommission). It was argued that hidden reserves should remain permissible since they were not a significant obstacle to the financing of Aktiengesellschaften because the reserves were distributed eventually, at the latest upon liquidation of the company. The reformers thus did not wish to change the existing valuation requirements, although some called for a stronger emphasis on current values to prevent Aktiengesellschaften from creating hidden reserves. In the end, these voices remained unheard, presumably because the recent hyperinflation had suppressed any serious efforts to deviate from conservative accounting.

When coping with the consequences of the Great Depression that started in 1929, the German Government meant to strengthen investors’ confidence in Aktiengesellschaften and financial statements. In their endeavour to reform stock company legislation, the Reichsjustizministerium (Department of Justice) issued a Denkschrift (to be understood as a public memorandum, although Barth (1953: 84) describes it as a draft law) in 1930. Concerning valuation, the memorandum did not postulate any changes and continued to ban the upward valuation of assets, while allowing limited downward valuation. Commenting on the Denkschrift, Schmalenbach (1930) criticized the memorandum for upholding previous valuation requirements, which allowed hidden reserves without restrictions. Thus, Aktiengesellschaften were able to draw up a “distorted picture of economic transactions”.

Subsequently, the economic conditions once again made regulatory change necessary. The hyperinflation years had left financial institutions in a weak position and in 1924/1925 a number of small and medium-sized banks became bankrupt. ²⁰ The short economic boom during the later 1920s did not improve banks’ financial positions, while the unstable political environment contributed further to the pre-existing lack of trust in these institutions. When, in 1931, the Danat-Bank, one of the largest German banks at that time, became bankrupt, a banking crisis erupted and foreign creditors withdrew large sums from all institutions, including the Reichsbank (German central bank). The stock exchange had to be closed for several months (with short periods of opening), monetary transactions and payments were severely disturbed, and withdrawing money from banks was restricted.

Several emergency decrees were released to provide a remedy for the financial system’s problems. A September 1931 decree (Verordnung des Reichspräsidenten über Aktienrecht, Bankenaufsicht und über eine Steueramnestie) dealt with accounting matters and was largely based on the Department of Justice’s Denkschrift of 1930. It aimed primarily at restoring trust in Aktiengesellschaften, which was important for preserving investments in them, but also because these companies employed thousands of people (Naphtali, 1930: 583). The decree extended the obligation to publish financial statements and required Aktiengesellschaften to present an annual report in which financial statements and the condition of the company had to be explained to the supervisory board and to shareholders. In order to enhance their comprehensibility, completeness and comparability, the structure of both the balance sheet and the income statement were specified in more detail and basic consolidation rules were set out. Another major change concerned the requirement for Aktiengesellschaften to have their financial statements audited by an independent external party. ²¹ The revised section 261 HGB specified more detailed rules on valuation. Non-current assets were valued at historical cost, which was in line with the old commercial practice, as described above, and allowed for the creation of hidden reserves. Current assets were to be valued at the lower of cost or market, thus confirming the inventory valuation principle already established by Prussia in 1794. The Great Depression thus defied calls for fair valuation and further affirmed historical cost accounting in Germany. Hidden reserves were now more widely accepted among managers, investors and the public (Naphtali, 1930: 666).

Subsequently, the accounting literature was concerned with refining the GoB, which was made necessary by the Einkommensteuergesetz (income tax regulation) of 1925. This law made financial reporting relevant to tax accounting (Maßgeblichkeitsprinzip) and thus required clearer guidance on how transactions should be accounted for. Moreover, the previously heralded common accounting practice of merchants as the main source of GoB had not prevented the recent crises, but produced arbitrary accounting that focused only on bringing about the desired profits (Leffson, 1987: 30–35). A normative description of what the GoB constitute and a deductive analysis to define GoB was considered necessary (Leffson, 1987: 130–135; Schmalenbach, 1933: 232). Consequently, scholars issued commentaries and fundamentally changed both the interpretation and the application of the GoB. Taken together with the increasing importance of financial reporting for taxation, the corporate environment of the 1920s and 1930s reinforced the prominence of Schmalenbach’s dynamic theory. Both influences furthered historical cost as the sole measurement basis.

In 1937, a separate Aktiengesetz (AktG) was created by extracting requirements for Aktiengesellschaften from the HGB. The separate law was based mainly on the decree of 1931. Valuation was not revised, but merely moved to section 133 AktG. The practice of creating hidden reserves thus remained unchanged (Walb, 1937: 283). A 1936 ruling by the Reichsgericht (German Federal Supreme Court) upheld this practice and merely stressed that hidden reserves needed to be reasonable, again appealing to the diligent merchant. Asset valuation remained a critical issue in the accounting debate (Dankmeier, 1937: 567–574).

In summary, advocates of weaker accounting regulation gained momentum when Germany experienced a short economic boom in the 1920s. However, the departure from historical cost accounting was implemented only to cope with the effects of hyperinflation. Continuing reform efforts were silenced by the Great Depression and the banking crisis, following which stricter regulation implemented historical cost as the sole measurement basis for Aktiengesellschaften. From the early 1930s onwards, the GoB also changed. Instead of deriving them from commercial practice, which had arguably contributed to fraudulent activities, scholars increasingly aimed to specify the principles deductively, that is, on a theoretical basis. Schmalenbach’s dynamic view of accounting was most influential in these debates.